Practice Economics
Are You Overpaying Yourself?
The IRS is now examining salaries paid by "C" corporations.

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

A 2001 Tax Court case, Pediatric Surgical Associates vs. Commissioner of IRS, challenges the deductibility of the full amount of the salaries a professional corporation (PC) pays its shareholders.

In this, the first of a three-part series, I'll explain why the IRS is now questioning allegedly excessive salaries paid to physicians by practices organized as "C" corporations of the PC type. In Parts 2 and 3, I'll tell you how to set up your practice to avoid problems with the IRS.

WHAT'S THE PROBLEM?

Many ophthalmology practices are organized as C corporations for federal income tax purposes. C corporations are separate taxable entities. Those that fit the category of professional corporations pay federal income tax at a flat 35% rate. However, C corporations aren't permitted to deduct any dividends they pay out.

In addition, the corporation's shareholders must pay income tax on dividends received. Thus, dividends are taxed once at the PC level and again at the shareholder level. This results in classic "double taxation," with a possible effective tax rate of more than 70%. Because of this double taxation, practices organized as PCs try to pay salaries and bonuses rather than dividends.

THE IRS MAKES ITS CASE

The medical practice in the Tax Court case was a Texas PC organized as a C corporation, with both shareholder and nonshareholder physician-employees.

The PC did what most PCs do. After paying all of its operating expenses, it paid most of its remaining cash to its shareholder physicians as monthly and year-end bonuses. These bonuses included the so-called "profit" the corporation made on its nonshareholder physicians. This profit was the difference between what the associate physicians generated in revenue, less the total of what they were paid and an allocable share of the practice's operating expenses.

Any compensation, including bonuses, that a C corporation pays to employees, whether they're shareholders or not, is a fully deductible expense for the corporation, provided that the compensation is reasonable and is paid "purely" for the personal services rendered.

The IRS challenged the deduction for the bonuses the corporation paid to its shareholder physicians, saying that, to the extent those bonuses represented profit generated by the nonshareholder physicians, the bonuses were actually disguised dividends that should have been reported as such. The Tax Court agreed with the IRS. The court focused on the concept that the bonuses weren't paid purely for services rendered by the shareholder physicians, and as a result found that the bonuses didn't legitimately qualify as deductible compensation.

WIDER CHALLENGES ARE POSSIBLE

Although not discussed by the court, ophthalmology practice C Corporations can also generate profit in other areas besides nonshareholder physicians. The IRS might consider profit from the following as nondeductible dividends instead of deductible compensation:

• the technical component of ancillary services (such as YAG lasers and visual fields)
• optical shops
• facility fees for ASCs
• drug markups (e.g. Visudyne)
• the optometrists you employ.

Because many ophthalmology practice PCs are set up as C corporations, this tax case raises some real concerns. It doesn't necessarily mean that your C corporation has to begin declaring corporate dividends on profit you make on associates and ancillary services. It does mean, however, that PCs need to consider how best to cope with this type of tax situation. I'll discuss this subject in Part 2.

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.