Should You Restructure Your Medical Practice After the New Tax Law?
Converting from an S corp to a C corp isn’t a decision to make lightly
Now that the dust has settled from the rollout of the Tax Cuts and Jobs Act (TCJA), medical practices structured as pass-through entities are facing a dilemma: Since the tax reform significantly reduces the tax rates imposed on C corporations’ taxable income, is it beneficial to switch your structure?
The answer depends on several factors.
Since the release of the Internal Revenue Service’s (IRS) “check-in-the-box” regulations in the 1990s, U.S. businesses can choose whether they want to be taxed as C corporations or pass-through entities like S corporations, sole proprietorships, limited liability companies, or partnerships, subject to certain requirements. A wealth of variables may factor into this important decision, including state laws, creditors’ rights laws, securities laws, and, of course, tax laws.
Traditionally, doctors have preferred pass-through entities, with only a quarter of medical practices filing as C corps. That’s largely because of the double taxation that plagues C corps – once at the corporate level and again for any dividends reported on a doctor’s individual or joint return.
But the new tax reforms offer an enormous tax break for C corps – slashing the old maximum tax rate of 35 percent to a flat 21 percent. The TCJA also repealed the corporate alternative minimum tax (AMT) intended to ensure that corporations pay a minimum amount of tax by limiting or eliminating certain deductions, credits, and other tax preference items.
Pass-through entities also received a significant tax break with a 20 percent Qualified Business Income deduction that reduces the top federal tax rate on their income from 37 percent to 29.6 percent. Profits from pass-through entities are taxed according to the owner’s personal tax rate.
But here’s the thing: the QBI deduction is only temporary – it’s on the books through the end of 2025 – while the C corp tax relief is a permanent cut. And, of course, a 21 percent tax rate is better than 29.6 percent.
Also, doctors who own medical practices – as well as other skilled service providers – can only qualify for the pass-through break if they earn no more than $415,000 a year for a married couple filing jointly or $207,500 for a single filer. Skilled services are defined as any trade or business where the principal asset is the reputation or skill of one or more if its employees or owners.
Owners of pass-through entities who don’t fit the new law’s definition of a specified service trade or business aren’t subject to the same income limits to qualify for the tax break.
The challenges of C corps
So, what’s the hesitation about switching from a pass-through entity to a C corp? For one, there’s still that pesky matter of double taxation to consider. At C corp status, income is first taxed at the entity level rate of 21 percent, and then dividends are taxed to the individual at up to 23.8 percent. Once both taxes are paid, the effective tax rate of a C corps can actually be higher than a pass-through entity – especially if the owner can claim the QBI deduction.
It is, however, worth noting that C corp dividends are only taxed in the year they are paid. That means substantial tax savings could await medical practices that convert to C corps if they invest a high percentage of their profits back into the business as equipment or other property as part of a long-term strategy, instead of distributing them as dividends.
C corp structures also tend to make practice sales more problematic – something to consider as more and more doctors increasingly give up their independence to join larger groups or hospital systems. The double taxation generally makes asset sales by corporations less tax-efficient for sellers. If it is likely that your practice will be sold soon, retaining the pass-through structure may be wiser than converting to a C corp.
Another important consideration is that laws are never “permanent.” While the reduction to the maximum corporate tax rate was written for longevity, it could change, for instance, if Democrats win back the Senate and vote through alterations. At that point, converting back to a pass-through entity from a C corp could be quite complex.
Legal loopholes that lower your taxes
Skilled tax advisors may be able to find legal ways to help high-income doctors qualify for the lower pass-through tax rate. For instance, they may consider converting their office building into a real estate investment trust and charging themselves rent, thus reducing their income.
Of course, there also can be workarounds to avoid the double taxation of C corps for doctors and other professional service providers whose income is too high to qualify for the pass-through deduction. One tactic, while complex, is slicing the business into two or three separate entities to take advantage of the reduced corporate rate and other aspects of the new law. For instance, real estate or medical equipment could be owned by a C corps while practice income stays in an S corp to avoid being double taxed.
Practice owners can also extract money from a C corp by taking advantage of an array of tax-free benefits that are not generally available in pass-through entities. In a C corp, benefits such as health insurance and educational assistance are paid with pre-tax dollars; in an S corp, individuals pay taxes on their income before paying for benefits.
In fact, benefits costs are treated as wages for S corp owners, so they don’t interfere with their ability to claim the self-employment deduction on their personal returns.
There’s also a special benefit for owners of small C corps to exclude most – if not all – gains from the sale of corporate stock. Although this perk has existed since 1993, the previously high tax rate of C corps prevented most doctors from choosing this structure and taking advantage of this benefit.
Making the change
Changing from a pass-through entity to a C corps is relatively easy – in fact, if your practice is based in a state that allows for “statutory,” or streamlined, conversions, it can take less than a week if the process goes smoothly. Only about 15 states don’t allow this practice, including Arizona, New York, and Pennsylvania.
In most cases, the transformation is tax-free – but special circumstances could apply that could lead to a taxable event, so it’s wise to consult with a tax advisor before converting. That said, the cost of hiring lawyers and accountants to help with the process can add up; thus, it’s also important to tally your potential savings ahead of time to make sure you won’t wind up spending more money than you save by restructuring.
Also keep in mind note that the tax-free transition door only swings one way, so doctors need to do their homework and make sure restructuring is the proper path before walking through it. Converting back to a pass-through entity if you’re unhappy with the results could come at a hefty tax price. And read this carefully: The IRS only allows one change in your tax election every five years – unless the previous election was for a newly-formed entity or more than half the business’s ownership interests have changed.
So, what’s the right answer?
Switching from a pass-through entity to a C corp is not a decision to make lightly, and ultimately also involves many factors that have nothing to do with taxes. But the major changes enacted by the TCJA can make this option worth exploring under certain circumstances – especially for medical practices that don’t qualify for the 20 percent QBI deduction or want to maintain a long-term re-investment strategy in the business.
Of course, every medical practice will have unique circumstances to consider before contemplating such a significant change. Qualified tax advisors can help you carefully consider the pros and cons of converting, conducting extensive calculations and projections that help you make the best long-term choice for your practice.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact on their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on tax planning, and to find out how we can help your business exceed your expectations.