Types of Business Entities
By Sandra J. McDuffy, CPA
When a physician starts his or her own medical practice, a choice will need to be made about the type of business entity to operate through. The physician who is joining an on-going practice will need to gain an understanding of the business structure he or she is about to join. Have you ever wondered, "What's the difference?" This article sets out to provide some of the answers.
In most situations, the business entity choice will be based on two issues: (a) how the entity and its owners will be taxed, and (b) the extent to which the entity will shield the owners from liabilities. This article will cover some of the basic aspects of taxation on the common business structures and the impact it can have on the owner's personal income taxes. A comprehensive analysis of business entities and their differences is beyond the scope of this article, so it is important to obtain specific legal advice from an attorney and consult with a CPA about the tax and accounting considerations before making a decision on the type of business entity to practice through.
The most common types of business structures are: sole proprietorships, partnerships, limited liability companies (LLC), C corporations and S corporations. Although the three primary entity types for the practice of medicine have different names from the business structures mentioned above, for federal income tax purposes, they are taxed under the rules for the business structures as follows: (1) a professional association (PA) is treated as a corporation for tax purposes, (2) a professional limited liability company (PLLC) is taxed under the LLC rules, and (3) a limited liability partnership (LLP) is taxed under the general partnership rules.
The most basic type of business structure is the sole proprietorship. If an individual operates as a sole proprietor, he or she is the only owner and there is no separate income tax return to file. The biggest advantage of this type of entity is its simplicity. The income and expenses of the business are reported on the owner's federal individual income tax return on schedule C and the business is not subject to the Texas franchise tax. The profits of the business are subject to both federal income taxes and self-employment taxes (Social Security and Medicare taxes). These taxes are calculated as part of the owner's federal income tax return. Since the sole proprietor is not an "employee" of his own business, he or she does not have income tax withholding on the earnings. Therefore, the sole proprietor must estimate his or her tax liabilities and make estimated tax payments to the IRS, at least quarterly during the year, to avoid underpayment penalties. The main disadvantage to operating as a sole proprietorship is the unlimited liability for the debts and liabilities of the business.
A Partnership requires at least two owners. The basic types of partnerships are general partnerships (GP), limited partnerships (LP) and limited liability partnerships (LLP). The differences in the partnership types are mostly about the liability protection provided to the partners and have little to do with the federal income taxation (although there is a difference in how the self-employment taxes are imposed). Although a partnership files an income tax return (Form 1065), the partnership itself does not pay any income taxes. It gives each partner a form called a schedule K-1, which provides the partner with the information needed to report his or her share of the profits and losses on his or her personal income tax return. In tax terminology, this is called a "pass-through" entity because it passes the federal tax liabilities for the profits (or the tax benefits for the losses) out to the partners. In addition to receiving a share of the profits and/or losses based on an agreed upon percentage, partners may also be paid an amount to compensate them for their services. Payments of this sort are called "guaranteed payments" and are also reported to the partner on schedule K-1. Be aware that the profits of the partnership are taxable to the partners whether distributed or not. If a partnership retains some of its profits, it should make distributions to its partners large enough to cover the income tax liabilities the partners may owe on the undistributed income.
A general partnership is not subject to the Texas franchise tax while partnerships that provide limited liability to their partners are. Since partners are not technically considered "employees" of the partnership, their partnership income is not subject to withholding and they should not receive a W-2 from the partnership. Each partner will need to estimate his or her personal income tax liability after taking into account his or her share of the partnership profits and losses, and may need to make estimated tax payments to the IRS during the year to avoid underpayment penalties. In addition to federal income taxes, self-employment taxes are imposed on individual partners for business income passed through to them as general partners and partners of an LLP. Since limited partners in an LP are not typically active in the business, they will not owe self-employment taxes on the pass-through income except to the extent they have guaranteed payments on their schedule K-1s.
An owner of a limited liability company is called a member, and an LLC may be single member or multi-member. The default treatment of an LLC for federal income taxation is as follows: (1) a single member LLC is a disregarded entity for federal income tax purposes and is treated as a sole proprietorship, and (2) a limited liability company with two or more members is treated as a partnership for federal tax purposes (files the same tax return as a partnership and provides the members with a schedule K-1). Because members of multi-owner LLCs are treated like partnerships, the members are not considered employees of their LLC and therefore do not have tax withholding on their income. In addition to federal income tax on LLC profits, members will owe self employment taxes on the business profits if the member is active in the business. On the contrary, a member of a multi-member LLC that is not active in the business operations will not be subject to self-employment taxes on his or her share of the LLC profits. An LLC, whether single member or multi-member, is subject to the Texas franchise tax.
C corporations can have a single shareholder or an unlimited number of shareholders. The entity pays income tax at the corporate level and shareholders report only the income paid to them as compensation or distributed to them as dividends. Dividends paid to shareholders are not deductible on the corporate income tax return, so dividends are subject to double taxation, once when earned at the corporate level, and then again at the shareholder level when distributed. The double taxation on dividend income usually more than off sets any benefits associated with the dividends being exempt from self-employment taxes. C corporation losses must stay at the corporate level and cannot be passed through to the shareholders and used to offset their other sources of income. Although a regular C corporation enjoys graduated income tax rates beginning at 15%, a personal service corporation (PSC) is taxed at a flat rate of 35% on its net income. Since a medical practice taxed as a corporation will be considered a personal service corporation, the corporate profits will be taxed at 35% unless it has elected to be treated as an S corporation. With proper planning, this disadvantage can be overcome by paying the corporate profits to the shareholders each year as compensation, thus eliminating the corporate income tax. Shareholders who provide services to the corporation are employees of the corporation and may receive wages subject to income tax withholding and a W-2 at the end of the year. Corporations are subject to the Texas franchise tax.
An S corporation is a corporation (including a PA) that makes an election with the Internal Revenue Service to be taxed as an S corporation. There are certain restrictions on S corporations that do not apply to C corporations, so some corporations may not be able to make the election. S-corporations enjoy many of the benefits of partnership taxation. Like a partnership, it generally pays no income taxes, but passes the income through to the shareholders on a schedule K-1. A difference between a partnership and an S corporation is that the owner providing services to the S Corporation may be considered an employee of the corporation and therefore may receive wages subject to withholding. Another difference between a partnership and an S corporation is the pro-rata distribution requirement of an S corporation. A partnership may make distributions to partners without regard to their ownership percentage. An S corporation must make distributions in proportion to the shareholders' ownership percentages or risk losing its S corporation status. An S corporation shareholder's pass-through income will not be subject to self-employment taxes. Although the shareholder may still need to make some estimated tax payments to cover the income taxes on any passthrough income, the income tax responsibilities on the compensation received from the S corporation may be taken care of through withholding. S-corporations are subject to the Texas franchise taxes.
In addition to federal tax treatments described above for the different business structures, several of the business structures are allowed under the "check the box"" rules to elect to be treated as a different type of entity for federal tax purposes. For example, an LLC and a partnership can elect to be treated as a corporation for federal tax purposes. Partnerships and multi-member LLCs that have elected to be treated as a corporation may then also elect S corporation status if they otherwise qualify. This article has not discussed the differences in how fringe benefits to the owners are taxed under the various business structures, so this may be an important issue to discuss with your advisors as part of the decisionmaking process.
With all of these choices, how does one decide which entity to choose? Probably the best starting point is to consult with your CPA and determine which entity is best for you from a tax and accounting perspective. Next, consult with an attorney to determine which entity is best from a legal standpoint.
Sandra J. "Sandy" McDuffy is a CPA at David J. Bailey & Company, PC, which is a BCMS Circle of Friends sponsor. The office may be contacted at: (210) 344-5000 or www.djbcompany.com.