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Optometrists ask if they should use an S-corporation to run their practice but often don’t understand what that means. I will go over the difference between a legal entity and tax rules, the mechanics of S-corporations, and most importantly how to tell if an S-corporation will save you money.
Legal Entities and Tax Rules
I first want to distinguish between a legal entity and a set of tax rules. Legal entities are -
- Limited Liability Companies (LLC)
LLCs and corporations are formed by filing paperwork with a state and the state then recognizing the existence of that legal entity. Partnerships can be formed by an agreement between two or more people.
Legal entities exist separate from the owners, can own property, and can be transferred between people.
If you operate without one of these legal entities you’re operating as a sole proprietor.
Congress created sets of tax rules to apply to each of the forms of business listed above. They are –
- C-corporation (found in subchapter C of the Internal Revenue Code)
- S-corporation(found in subchapter S of the Internal Revenue Code)
- Partnership(found in subchapter K of the Internal Revenue Code)
- Sole proprietor (No specific subchapter)
Then Congress made rules about which set of tax rules applies to which entity.
- Corporations are taxed as C-corporations by default unless they elect to be taxed as an S-corporation
- Partnerships are always taxed as partnerships
- Sole proprietors are always taxed as sole proprietors
- LLCs can be taxed as a C-corporation, S-corporation, partnership, or sole proprietor. The default treatment is as follows –
- Single owner – sole proprietor
- More than one owner - partnership
- Single owner – sole proprietor
LLCs can elect to be taxed as a C-corporation or S-corporation by filing a form with the IRS.
As you can see, an S-corporation can be a state law corporation or an LLC. Some states, California is one, don’t allow doctors to use LLCs so they would use a corporation if they wanted to be taxed as an S-corporation.
Now that we know the difference between legal entities and sets of tax rules, let’s dig into how S-corporations work.
An S-corporation is a flow-through or pass-through entity. This means that any profit (aka net income or just income) that the S-corporation earns flows through to the owner’s tax return. And the owner is taxed directly on the income.
It’s important to distinguish between flow-through income and distributions (aka draws) from the S-corporation. Owners are always taxed on their share of the flow-through income whether they receive any distributions from the S-corporation or not.
Distributions are payments from the S-corporation to the owner that isn’t a wage or salary. People often use the term dividend to describe a distribution, but this isn’t correct. Dividend has a specific definition in the tax code that refers to a payment made from the earnings and profits of a C-corporation. Dividends are taxable payments to the owner while distributions are generally not.
Unless your S-corporation used to be a C-corporation, there will never be a dividend payment.
The owner’s share of flow-through income from an S-corporation is subject to income tax but not self-employment tax. If operating as a sole proprietor or partnership, all your income is subject to self-employment tax.
Self-employment tax is a social security and Medicare tax that is similar to what gets withheld from your wages when working as an employee. But unlike working as an employee where you’re responsible for half of the tax, you’re responsible for the entire amount.
How An S-corporation Saves You Money
Avoiding self-employment tax on your income is the main benefit of using an S-corporation. But there’s a catch. You’re required to pay yourself a reasonable salary which is subject to payroll taxes. Payroll taxes are not technically self-employment tax but the payroll taxes on the salary are the same as the self-employment tax on the same amount of income. Different name, same tax.
The key to saving money with an S-corporation is having a big enough difference between your total profit and what you pay yourself in salary.
Here’s an example:
Profit (before owner salary) - $400,000
Owner Salary - $250,000
Income Not Subject to Payroll Taxes - $150,000
At this level of income, the payroll tax is 3.8% (2.9% Medicare + .9% Additional Medicare). So, the savings in payroll taxes is $5,700.
But the payroll tax piece is only part of the story. There are additional administrative costs to using an S-corporation, some states charge an S-corporation tax (I’m looking at you California), and you can miss out on the Qualified Business Income deduction or retirement contributions in some cases.
For our example, we would need to subtract at least the following –
Estimated Admin Costs - $1,500
CA Tax - $2,250 (1.5% of $150,000)
This leaves us with only $1,950 of savings.
As you can see, the bigger the spread between total income and owner salary the more you can save.
So Why Not just Set your Salary Low?
In all the court cases dealing with reasonable salary, the court looks to what other people doing similar work are getting paid. There is a false notion I often hear that the salary should be at least a certain percentage of the total income. I disagree with this approach because it’s not consistent with the case law. Rather, look to what other employed optometrists are making in your area and adjust for differences like full or part time and experience.
If the IRS thinks your salary is too low, they can reclassify distributions you received as salary and assess the company payroll taxes. The IRS can only reclassify as salary what you received as a distribution.
This means that you can technically earn $1,000,000 of profit in your S-corporation and not pay yourself a salary so long as you never took any money out. You’ll pay income tax on the $1,000,000 but no payroll taxes.
Not taking distributions isn’t realistic for an established practice but presents a planning opportunity for new practices if you have other sources of income. If you can avoid taking distributions, you can avoid payroll taxes entirely. I’ve planned this out with several clients of mine. Some have even been able to put money back in on the last day of the year to offset earlier distributions.
When you do start taking distributions, you’d want to also start paying yourself a salary.
Before switching to be taxed as an S-corporation, I recommend running a tax calculation comparing the total taxes paid as an S-corporation and as a sole proprietor/partnership. It can be difficult to pay a reasonable salary and save money with an S-corporation.
S-corporations are either an LLC or corporation that has elected for the tax rules of an S-corporation to apply. You can save money by paying less in payroll taxes/self-employment tax when compared to a sole proprietor or partnership. This savings must be reduced by additional administrative costs and state-level taxes to see if you’re ahead.
You must pay a reasonable salary, which is determined by looking to comparable salaries but is ultimately limited to what you receive in distributions during the year. You can completely forego a salary if you’re not taking distributions and this presents a planning opportunity for those with other sources of income.
The only way to tell if an S-corporation saves you money is by running a tax calculation both ways. In addition to the payroll tax savings, you can miss out on the Qualified Business Income deduction and retirement contributions. Because of so many moving parts, you should do a full calculation both ways.
David Glenn, CPA is the owner and founder of Glenn Advisory, a doctor-focused CPA firm based in Hawaii. He holds a Master's degree in Taxation, has taught tax and accounting classes as an adjunct faculty, consults with other CPAs on technical tax matters, is a presenter at CPA continuing education webinars, and is a recovering IRS auditor. David is married, has three children, and enjoys golfing, cycling, and the ocean.