Classifying doctors as employees can significantly increase their tax burden
An increasing number of doctors are banding together to form medical “super groups” and the benefits can be significant: economies of scale, greater leverage in negotiations with insurance companies and large hospitals, administrative support that leaves doctors free to focus on patient care, and a competitive advantage in the market.
Since 2016, less than half of practicing physicians in the U.S. still own their medical practice, according to a Modern Healthcare report.
But there’s also a major downside to this trend: Many physician groups are unwittingly causing their doctors to pay higher taxes than they should. Here’s a look at the reasons why, and what doctors can do to minimize their tax burden while reaping the rewards of regional physician groups.
The pass-through deduction: a significant tax break for independent contractors
Many large physician groups favor an employment model, where the group is structured as a corporation that employs individual doctors. Previously, few physicians paused to consider the difference between becoming a 1099/independent contractor or a W2/employee of their physician group.
Independent contractors are people or entities contracted to perform work or provide services to another entity as a non-employee. A growing trend in today’s gig economy, independent contractors generally exchange the perks of being an employee like benefits, 401(k) match, and greater job security for a significant tax advantage, potentially higher income, and the freedom to pick and choose their own hours and projects.
The Tax Cuts and Jobs Act (TCJA) of 2017 enacted sweeping changes to the tax code, including the addition of a completely new concept: a 20 percent “pass-through” deduction for individual taxpayers on qualified business income earned in a qualified trade or business.
This Qualified Business Income (QBI) deduction stands as a significant tax break for small business owners – including independent contractors – who operate as pass-through entities such as sole proprietorships or single-member limited liability corporations (LLCs). In these businesses, profits or losses “pass through” to the business owner, who pays personal income tax on the earnings at his or her individual tax rate.
In the past, employees paid slightly lower taxes on equivalent pay than 1099 contractors. But this new deduction changes the game – significantly tipping the tax scale in favor of contractors as long as they qualify and stay under certain high-income levels.
There is, of course, a caveat: the deduction is limited for skilled service providers like doctors, who 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. But a skilled tax advisor may be able to find legal ways to help high-income doctors qualify for the pass-through tax rate as well, such as reducing their income by converting their office building into a real estate investment trust and charging themselves rent.
More tax deductions await
Even doctors whose incomes are too high to qualify for the pass-through deduction threshold can reap many tax rewards from changing their employment status from employee to independent contractor. Independent contractors can claim significantly more business-related deductions than employees. In fact, almost anything contractors spend on their business can be deducted from business income before any taxes – including FICA (Federal Insurance Contributions Act) payroll taxes – are paid, from scrubs to mileage to continuing medical education. In contrast, employees pay for these types of expenses with after-tax dollars.
Independent contractors can also claim business deductions for many of the benefits they pay out of pocket that would normally be provided by employers, such as health care coverage. Even so, doctors should attempt to negotiate a higher rate before changing their employment status, since their employer will no longer have to pay toward their benefits.
Independent contractors also have the freedom to choose their own retirement accounts, customizing a plan that leads to the most significant tax savings down the road for their personal situation. While that means they will miss out on an employer match, costs can be low for single-person plans such as individual 401(k)s, SEP-IRAs, and personal defined benefit/cash balance plans.
Inefficient corporate structure increases the tax burden
Many physician groups were inefficiently structured as corporations when they were formed, and now bounce out 100 percent of their taxable income to their doctors to avoid paying corporate tax. That leaves high-income doctors classified as employees facing a hefty tax bill – at the highest individual rate of 37 percent – with no or at least very few write-offs to offset their income. It also forces them to pay 100 percent of their FICA payroll tax, which eats up 7.65 percent of an employee’s salary up to a certain income level.
The income ceiling only applies to the 6.2 percent Social Security portion of the FICA tax, however. Not only is there no wage limit for the 1.45 percent Medicare portion of the tax, but there’s an Additional Medicare Tax that high-income individuals must pay that adds another 0.9 percent tax to any income that exceeds a certain threshold. This limit is currently $250,000 for married couples filing joint tax returns and $200,000 for single filers.
In contrast, these same doctors allowed to contract with the physician group through their own company could reduce their tax burden by a whopping $150,000 on between $500,000 and $600,000 of income by taking advantage of the many deductions now available to them.
Other factors to consider before making a change
Of course, tax deductions aren’t the only factor to consider before changing your employment status. When you are an employee, your employer withholds taxes on your behalf and remits them back to the IRS. If you become an independent contractor, you must have the diligence to ensure that your estimated taxes are paid throughout the year.
Independent contractors are also hit with a Self-Employment Tax of 15.3 percent that covers the 7.65 percent Social Security and Medicare payroll tax you would have paid as an employee, as well as its 7.65 percent counterpart your employer would have paid on your behalf. Since independent contractors are technically the employer and employee, they cover the full amount. While you can claim a tax deduction for half of it, the Self-Employment Tax can be a sizable expense that should be taken into account.
A skilled certified public accountant can help you weigh the financial benefits of both types of employment options. By adding a monetary value to all the benefits included in the W2 status – from paid time off to health insurance to Self-Employment Tax savings – you can make sure the tax break you realize from becoming an independent contractor outweighs the perks of remaining an employee.
Overcoming administrative concerns
Some physician group administrators hesitate to allow doctors to transition from employees to independent contractors out of fear that restructuring will harm the group. But contracting with doctors won’t affect the group’s negotiating power or control over its people; it only impacts how they are paid and enables them to do better tax planning.
A more valid concern is ensuring that doctors in the group fit the IRS framework for independent contractors. The employee vs. independent contractor designation is an area the IRS highly scrutinizes and penalties for getting it wrong are severe. While the circumstances surrounding many doctor-physician group relationships fit the bill, a qualified tax advisor can help everyone move forward with a structure that minimizes doctors’ tax burdens without imposing undue risk on either party.
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.
Find out what’s really at stake
There is a perception that malpractice lawsuits may cost doctors everything – their assets, savings, or even their house. But while malpractice cases can be lengthy and expensive, it’s actually very rare that a doctor would lose it all in these cases if he or she has the proper insurance coverage.
As far as a doctor’s house being lost – under Florida law, for example, homeowners actually have protection from losing their residence if they own the home they live in, aside from creditors that hold a mortgage or lien on the home. Other states offer similar protections, so it’s important to check local laws.
Here are additional details about malpractice statistics and how doctors can better protect themselves by obtaining sufficient malpractice insurance, even if it’s not a state requirement:
Malpractice claims statistics
Getting sued is a reality for a wide range of practicing physicians. Research from the American Medical Association (AMA) showed that 49.2% of physicians over age 55 have been sued at least once.
These legal battles can be expensive. Another AMA report revealed that the average cost of defense for a physician when dealing with a medical liability claim went up to $47,158 in 2010, which was a 62.7% increase since 2001. Average expenses incurred for medical liability claims in 2015 were $54,165, up 64.5% from 2006.
However, AMA also says that 60-65% of these lawsuits are dropped or dismissed. But even when they’re dropped, legal costs alone can still be high for doctors – an average near $30,000.
So how can doctors protect themselves from these costs, especially if they have a near 50/50 chance of being sued?
What’s really at risk if you’re sued
There’s no doubt that a malpractice payout is expensive if the plaintiff wins. The AMA released data that showed the average indemnity payment made to a plaintiff for a medical liability case in 2010 was $331,947.
Medscape also says the average settlement in court is around $425,000. But, that’s only for the 18% of cases that actually make it that far. 90% of cases are settled out of court and 82% don’t go to trial. And, what’s more – most cases are settled without doctors having to spend their own money. The physician’s insurer usually handles the settlement.
There have been cases when doctors have to payout from their own funds. But it’s hard to estimate how often that happens, partially because it’s uncommon. That said, a judgment against a physician that exceeds the amount of insurance they carry – such as $3 million with only $2 million in coverage – does mean that personal assets are at risk. Mere claims against a doctor will also increase the cost of an insurance policy moving forward, and physicians with multiple claims may have difficulty finding an affordable policy – or a policy at all.
The bottom line: The chances of a doctor having to pay from their own funds or assets are slim, as long as the doctor has sufficient malpractice insurance. But there will still be significant expenses associated with a claim.
Some states across the nation don’t require doctors to carry malpractice insurance. But deciding to opt out of this important coverage isn’t a wise choice considering what’s at stake and how much insurers cover doctors in the long run.
The cost of premiums can be pretty high and depend on a number of factors and, as a doctor for the American Academy of Orthopaedic Surgeons points out, these factors include:
- the probability of errors
- the cost of defending claims
- the cost of potential settlements
- operational costs
The average cost of malpractice insurance varies from $4,000 to $20,000 annually, depending on
Individual states also have varying mandates for physicians who aren’t required to have insurance. Continuing the Florida example, that state sets conditions for those who choose to “go bare” and not to have insurance. These are:
- setting up an escrow account
- obtaining professional liability coverage of at least $100,000 per claim
- obtaining an unexpired, irrevocable letter of credit of at least $100,000 per claim
- posting a notice prominently displayed to patients that they don’t carry a type of insurance
Again, make sure you are very well-versed on any requirements in your area before considering this option.
Other potential costs of a malpractice claim
While malpractice insurance is always a good idea for physicians, keep in mind that a malpractice claim is no small matter. Some doctors experience depression, lack of self-confidence, or fear when returning to work after a case, even if they won. They could have also lost a lot of money because they weren’t able to practice during the case when they were in court or dealing with other related matters.
Medscape provided a case study of an OB/GYN who had been sued three times. The doctor decided to settle all three because it was cheaper, but also because the emotional turmoil would have been too much to handle.
There’s no easy way for doctors to protect themselves from the emotional costs of malpractice lawsuits. But doctors shouldn’t make the process even more difficult by failing to have the proper insurance coverage. Because dealing with a malpractice claim takes extreme emotional and financial tolls, it’s always best to consult with a legal professional.
Physicians who are looking to save on taxes and maximize their income should also work with an accounting professional who is well-versed in medical employment issues. An experienced CPA may be able to find tax benefits and ways to structure employment relationships that accomplish these goals – such as realizing immense tax benefits from working as a contractor rather than a full employee of a medical facility or physician’s group. To learn more about lowering your tax burden and maximizing your wealth, contact the experienced team at Provident CPA & Business Advisors today.