Covering Your Assets: S-Corps as Tax Shelters

MDNG Primary Care, March 2011, Volume 13, Issue 2

Recent court case highlights risks and opportunities

Robert J. Mintz, JD

Many physicians use S-Corporations (S-Corp) to conduct the business side of their practice. Although an S-Corp cannot shield a physician from medical malpractice claims, it can help limit personal liability from other obligations of the practice. For example, if your practice leases office space or equipment and is organized as an S-Corp, you have no legal responsibility for payment unless you have personally guaranteed the contract (see “Pros and Cons of Professional Corporations” http://HCP.LV/dRZX6m).

A Limited Liability Company (LLC) would achieve the same result but physicians are generally prohibited from practicing medicine in an LLC, so the choices for how to organize your practice are usually restricted to partnerships, sole proprietorships, and corporations.

One challenge with corporations is that they have the potential to produce two layers of tax obligations—once at the corporate level and again at the shareholder level. The corporate tax can produce some nasty and surprising tax problems, but fortunately, the law allows shareholders to opt out of the corporate tax by filing an S-Corp election if they meet certain qualifications. Under this treatment, all income from the S-Corp flows through to the shareholder’s personal return and is taxed there, similar to a sole-proprietorship or a partnership.

Profits or wages?

S-Corps have a unique hybrid tax status, capable of producing savings not available to other business entities. These benefits are created by grey areas within the tax law that treat certain types of business income more favorably than others. If income can be characterized to take advantage of the lower available rates, substantial savings can be generated. The income generated through an S-Corp and reported on the shareholder’s return can be classified as wages or as a profit distribution based upon a variety of factors. The outcome of that determination matters a great deal, because amounts treated as wages are subject to payroll taxes, whereas profit distributions are not. Depending on the amount involved, the difference in taxes can be substantial. For example, in the years after 2011, the FICA (Social Security) tax is 12.4% of the first $106,800 of salary and the separate Medicare tax is 2.9% of all salary. If an S-Corp has profits of $250,000, taking that full amount as salary, results in combined payroll taxes of roughly $20,000. If the amount of salary was instead lowered to $50,000, with the balance claimed as a profit distribution, tax savings for the year would be about $11,000.

What is “reasonable salary”?

The issue in most cases turns on what is considered a “reasonable salary” under the circumstances. What amount of corporate income is properly allocable to invested capital and what amount represents income from the shareholder’s services? It’s not an easy question, as illustrated by the case David E. Watson PC v. US (http://HCP.LV/fsU94X), in which the key issue had to do with how Watson handled several hundred thousand dollars distributed to his S-Corp over a two-year period by the accounting firm in which he was a partner. Watson claimed only $24,000 in salary in both of those years, claiming the balance of the money as “profit distribution,” resulting in a tax savings of nearly $20,000.In keeping with its position that earnings attributable to corporate capital or assets may be properly classified as a profit distribution, but that payments for shareholder services must be treated as wages, the IRS rejected this treatment and asserted that Watson’s reported salary was unrealistically low in relation to the pay for other accountants with similar experience. Ultimately, the District Court decided that a reasonable salary for Watson should have been about $90,000 per year and full payroll taxes were due on this amount. The balance of the corporate income was treated as profit distribution.

In a medical professional corporation, it is often true that a large percentage of the income is related to services performed by the physician shareholder, but there are significant exceptions. If profits are generated by the services of non-shareholder employees or from charges for lab work, equipment use, the sale of products or from other investments, then income earned from these activities might not be related to the physician shareholder’s services. In these cases, the allocation between profits and wages is subject to considerable interpretation, and the amounts claimed for each can significantly impact the amount of payroll taxes that may be owed. Although Congress may take steps in the future to clarify these issues, for now, the outcome of disputes on this issue depends on the circumstances involved. You should certainly obtain the assistance of an experienced tax advisor when navigating the rocky landscape of tax strategies.

Robert J. Mintz, JD, is an attorney and the author of the 2011 new and revised edition of the book Asset Protection for Physicians and High-Risk Business Owners. To receive a complimentary copy, visit www.rjmintz.com.