Are you an owner of a dermatology practice taxed as a flow-through entity, such as an S corporation? In working with more than 1,000 doctors of all specialties, we estimate that 70 percent of medical practices operate as S corporations. As such, you may be paid both as an employee of the practice—receiving a W-2—and as an owner of the practice through a K-1 distribution. One key difference between income earned as employee compensation (W-2) and that earned as a K-1 profit distribution is that you pay FICA (Medicare and Social Security) tax on the income earned as an employee but not necessarily on K-1 profit distributions. While the large Social Security portion of FICA phases out after income of $132,900 in 2019, the Medicare tax has no phase-out. Also, the Medicare tax increased a few years ago under the Affordable Care Act to 3.8 percent for higher income taxpayers.
While this is only a 3.8 percent tax, we have seen poor advice cost physicians $10,000 or more each year of their careers. Over one’s career, this can amount to nearly half a million dollars of lost capital—for no good reason!
Another key difference is that W-2 wage income is not eligible for the new Qualified Business Income (QBI) deduction, but profit distributions could be. Keep in mind that a medical practice is considered to be a specified service business, and thus may not be eligible for the new QBI deduction. But for medical practice owners whose personal taxable income falls below certain thresholds, a QBI deduction may be available on medical practice profit distributions.
How Are You Paid?
Let’s look at two examples. Do you see yourself in either of these?
1. Dr. Smith is part of a three-physician dermatology practice. She earns about $400,000 annually as a dermatologist. She calls the two other doctors “partners” but technically they are co-owners of the practice, an S corporation. Each month, Dr. Smith gets paid $20,000. At the end of each six-month period, she gets another $80,000 based on the practice’s performance. Her accountant deems both the monthly and semi-annual payments to be salary payments. Thus, she pays Medicare tax on all $400,000 for a tax of $12,950 at the 3.8 percent rate on wages exceeding $250,000 and at 2.9 percent on the first $250,000 of wages. This, of course, is in addition to state and federal income taxes, property and other taxes. Assuming a 5 percent growth rate, if she works for 25 years earning the same income, she will have lost over $615,000 in Medicare taxes. In addition, if Dr. Smith’s deductions reduce her income such that her taxable income falls below $321,400, assuming she files a joint tax return, she is also missing out on a potential 20 percent QBI deduction.
2. Dr. Jones, also a dermatologist, is in the exact same economic situation. However, his CPA treats the monthly payments as W-2 wages and the semi-annual payments as K-1 distributions of the profit earned by the practice. Thus, he pays Medicare tax on $240,000 for a cost of $6,960. If Dr. Jones works for 25 years earning the same income, he will have lost about $330,000 in FICA taxes, assuming a five percent growth rate—an improvement of $285,000 over Dr. Smith. In addition, if Dr. Jones is married and files a joint tax return, and his mortgage interest, taxes and charitable contributions cause his taxable income to be under $321,400, he may also be able to take a QBI deduction of up to $32,000 per year.
The above cases are hypotheticals and any change or deviation from the circumstances discussed above could affect the outcome. However, you would definitely not want to be Dr. Smith.
Yet, we are continually astounded when we see so many physicians in the same set of circumstances—having all, or most, of their income treated as W-2 compensation when, in fact, much of it is earned from the profitability of the practice rather than from the doctor’s personal services.
Wouldn’t all of us prefer to be in Dr. Jones’ position? If we are allowed to be—yes. So, the question really comes down to— what are the tax rules that govern this situation?
One Simple Rule
In discussions with several CPAs with more than 15 years of experience, the consensus is that one should follow a simple rule: basically, one can reasonably be paid as a W-2 salary what one would need to pay an outside physician with the same training to join your practice. The rest of your compensation can be characterized as distributions.
One CPA, practicing for more than 20 years, commented, “this is what I do for my clients, and when the issue has been discussed in audits over the years, the IRS finds it very difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job.”
Looking again at the examples above, Dr. Smith could attract another dermatologist to her practice paying a $250,000 salary. This would allow her to avoid Medicare tax on $150,000—saving over $5,500 annually. Not coincidentally, Dr. Jones is in the right situation.
As hard as physicians work, throwing away hundreds of thousands of dollars over the course of a career, for no good reason, is unfortunate. Yet it happens every day. The authors welcome your questions.
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.