Professional Practices: Choosing The Best Entity For Tax And Asset ProtectionAugust 27, 2019 | Category: Asset Protection, Corporate and Taxation, News
Professional Practices: Choosing The Best Entity For Tax And Asset Protection
Copyright © 2019 Robert M. Kramer
Drs. Jose Smith and Ryan Abraham, fed up with the bureaucracy of their large group practice, left to start a new practice together. They consulted their tax attorney for advice as to the best entity for tax and asset protection.
Here’s what the lawyer said.
Without making this overly complicated, we will only consider a corporation (“P.A.”) and a professional limited liability company (“P.L.”). In both cases, we will consider the effect on “inside liability” and “outside liability.” We will also consider whether the chosen entity should be taxed as a partnership, “S” corporation or as a “C” corporation.
When an entity is sued (such as when a doctor-employee allegedly committed malpractice), the choice of entity does not matter. Liability is liability. Entity liability is sometimes referred to as “inside liability.” All assets of the entity are vulnerable except for those assets in which a bank or other creditor has a security interest.
The key is to keep the operating entity with limited assets. Real estate and equipment should be owned by another entity and leased to the operating entity. Cash should not be allowed to accumulate and receivables should be kept to a minimum. Some practices have set up a management company to perform administrative/ management services. As part of this arrangement, the management company has a security interest in the operating entity’s assets.
We now need to consider “outside liability.” Should either Dr. Smith or Dr. Abraham be sued for a matter unrelated to the practice (e.g., automobile accident occurring on a personal errand, bad investment, etc.), we need to protect their ownership interest in the practice.
Stock in a professional association or a corporation is vulnerable. A membership interest in a P.L. is a far better choice. Here, the creditor’s sole right is to obtain a “charging order.” This only allows the creditor the right to intercept distributions, if any, from the P.L. This usually induces the creditor to work out a settlement quite favorable to the debtor- member.
Thus we have determined that the organizational entity should be a P.L. The next question is whether it should be a partnership, an “S” corporation or a “C” corporation, for tax purposes.
Because taxable income of a “C” corporation is taxed at the Federal level at a flat 21 percent (21%), this is an intriguing possibility. However, this would involve accumulating profits in the entity instead of distributing the profits in the form of additional compensation, which is not a good idea.
Now we are down to either a partnership or an “S” corporation.
All partnership income attributable to a trade or business is subject to Self-Employment Tax/ Medicare Tax of 15.3 percent on the first $132,900, then 2.9 percent up to $200,000 for single filers / $250,000 for married filing jointly; and 3.8 percent thereafter. It does not matter if the payment is from a guaranteed payment or from profits of the trade or business. All of it is subject to these taxes.
The “S” corporation has the best of all worlds. All wages are subject to Social Security Tax up to the taxable wages base of $132,900 at the rate of 6.2 percent for both the employer and employee. Then there is Medicare tax of 1.45 percent for both the employer and employee with no maximum. The 0.9 percent tax on the employee applies to wages over $200,000 for single filers/$250,000 for married filers.
In contrast, the allocable share of profits to the shareholder (i.e., dividends), are not subject to the 3.8 percent Medicare tax at all. Some individuals have tried to game the system by taking minimal or no compensation and thus trying to avoid or reduce both Social Security and Medicare taxes. In such event, the IRS can reallocate the profits to wages.
Therefore, the most tax efficient/ asset protection entity is a professional limited liability company that has made an “S” election.