One of the most important decisions when starting a dental practice is choosing what business structure to use as the right business structure could save dentists thousands in tax annually and make running the practice easier. Choosing a business structure not only impacts how the entity pays tax but also how the dentists are compensated.
Even though there are many business structures to choose from, most dentists form either an LLC or an S-Corporation. This article will detail the differences between these two entities and explain why they are popular among dentists.
Why is it important to setup a legal entity?
The primary reason dentists choose to set up a legal entity is to insulate the owner, or owners (in the case of a multi-doctor practice) from legal liability. Although limited liability entities do provide some form of legal protection, dentists can always be held personally liable for malpractice or negligence. However, setting up a legal entity typically protects dentists from the legal repercussions of other dentists’ or hygienists’ actions.
Why should you choose an LLC?
LLCs are great for smaller, single owner practices that distribute most, if not all, of the business income. The greatest benefit from incorporating as a Limited Liability Company is the low setup and maintenance cost as business income and expenses will be reported on schedule C of the 1040, which will significantly reduce tax filing costs.
Another great aspect of choosing an LLC is its flexibility when it comes to sharing profits and losses. Unlike S-Corporations, Limited Liability Companies allow owners to have a disproportionate share of income and losses. Having more than one owner of an LLC will change how the entity is reported for tax purposes and therefore how income and losses flow through to the owners. For income tax purposes, LLCs with more than one owner will be treated as a partnership. Therefore, income or losses can be shared based on agreements other than ownership interest.
For example, a practice that is equally owned by two dentists can share income and losses based on production rather than ownership interest. S-Corporations, on the other hand, require owners to share income and losses based on a pro-rata share of ownership. This means that a 50% owner will share in 50% of the income even though they only produce 40% of the production.
Why should I choose an S-Corporation?
S-Corporations are great for medium to larger practices that are experiencing a high level of growth. Choosing an S-Corporation helps dentists shelter income from FICA (Federal Insurance Contributions Act) taxes as well as Obamacare taxes on high wage earners.
All the income that passes to the owners of an LLC is considered to be income subject to self-employment tax. This means that the owners will pay 12.4% Social Security tax on wages up to $127,200 (for the tax year ending December 2017) and 2.9% on all wages. Even more so, there is an additional medicare tax of .9% on wages in excess of $250,000 for married couples and $200,000 for individuals.
Dentist in S-Corporations can pay themselves wages that will be subject to self employment tax but can be deducted from business income. The remainder of business income will be shared among the owners on a pro rata basis and will not be subject to self employment tax.
However, the IRS requires shareholders in an S-Corporation to pay themselves reasonable compensation. Typically, the IRS considers reasonable compensation to be equal to the greater of the maximum compensation considered for retirement plan purposes ($270,000 for 2017), or 25% of collections. This allows dentist to avoid some of the 2.9% medicare tax along with the .9% additional medicare tax.
S-Corporations can bypass the pro rata ownership share of income and losses by structuring bonuses and pay around production or other considerations. This allows for the flexibility of an LLC while also providing the tax savings of an S-Corporation.
Choosing between an LLC and an S-Corporation can be difficult but with the help of a CPA, dental, as well as other professionals, can ensure they are protected and pay the least amount of tax legally possible. This is especially true for practices that are outgrowing the LLC business structure and can benefit from electing the S-Corporation status.