Practice Economics
Consider "S" Corporation Status
Part 3: It's a viable option for some practices.

BY MARK E. KROPIEWNICKI, J.D., LL.M.

In Part 1 of this series we discussed the Pediatric Surgical Associates, P.C. v. Commissioner of Internal Revenue case. That case spotlighted the problems a professional corporation (PC), which is a "C" corporation for federal income tax purposes, may have in being able to legally deduct the full amount of the salaries and bonuses it pays its shareholders.

In Part 2, one of our suggestions to head off potential problems with the IRS was to consider converting a C corporation PC into a "pass-through" entity such as an "S" corporation. Here, I'll discuss that option in more detail.

WHY BECOME AN S CORPORATION?

An S corporation is taxed under Subchapter S of the Internal Revenue Code. This allows the corporation to avoid being taxed at the corporate level and instead be taxed as a pass-through entity. Simply stated, this means that an S corporation's "profit" is passed through to the corporation's shareholders and taxed on their personal income tax returns.

An S corporation avoids the burden of double taxation, which is created by having tax liability at both the corporate and shareholder levels. When an entity such as a medical practice is organized as an S corporation, the corporation's shareholders are taxed individually on their share of the corporation's entire profit, regardless of whether that profit is actually paid out to them in dividends. The S corporation's entire profit isn't taxed at the higher corporate tax rate because all of the profit is deemed to be distributed to the shareholders.

ELECTING S CORPORATION STATUS

Can an existing C corporation PC elect S status now and avoid the double tax? The answer is essentially "yes and no." The PC can easily elect S status. However, it may not be able to avoid the double tax because of what's called the "built-in gains" tax.

For C corporations that convert to S status, gains on the PC's appreciated assets -- such as goodwill and equipment -- remain subject to a special corporate tax on built-in gains if the corporation's appreciated assets are disposed of during the 10 years following the making of the S corporation election.

The amount of net built-in gains subject to this corporate level tax is equal to the difference between the fair market value of the PC's assets on the date of the S election and the basis of those assets on that same date.

The built-in gains tax disappears 10 years after the election. However, even if the corporation's appreciated assets are sold before the 10 years are up, it's still possible to avoid all or most of the double tax on asset appreciation that occurs after the date of conversion to S status. You should check with your accountant to develop financial strategies that will exempt you from these taxes.

Accounts receivable can be problematic for a newly created S corporation. Receivables are treated as disposed of as they are collected. As a result, they may be subject to built-in gains tax if not properly planned for. Here again, your accountant can help you with strategies that will exempt you from the built-in gains tax.

THEY'RE NOT FOR EVERY PRACTICE

Other limitations are imposed on S corporations, which might make this structure impractical or not feasible for some practices. Also, not all states recognize S corporation status and so may require them to pay state income taxes on their profit at the corporate level. The limitations and tax issues can sometimes be substantial enough to erode much of the benefit of S corporations.

Whether converting to an S corporation is an appropriate choice for your PC requires careful consideration based on the specifics of your practice and situation. The negatives may outweigh the benefits. Consult your practice attorney and accountant early on to deal with any potential problems and properly plan for the change.

Mark E. Kropiewnicki, J.D., LL.M., is a principal consultant with The Health Care Group, Inc., and a principal and president of Health Care Law Associates, P.C., in Plymouth Meeting, Pa. He regularly advises physicians and practices on their contracting matters and business law obligations. He can be reached at (800) 473-0032.