Key Tax Mistakes to Avoid

Are you an owner of a dermatology practice taxed as a flow-through entity, such as an S-corporation? Most physicians are—in working with more than 1,000 doctors, 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. The 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 $117,000 in 2014, the Medicare tax has no phase-out. Also, the Medicare tax increased from 2.9 percent to 3.8 percent in 2013 for higher income taxpayers, under the Affordable Care Act.

While this is only a 3.8 percent tax, we have seen poor advice here cost physicians $10,000 or more each year, every year of their career. Over one's career, this can amount to nearly half a million dollars of lost capital…for no good reason!

Let's look at two examples. Do you see yourself in any of these?

Dr. Smith is part of a three-doctor dermatology practice. He earns about $400,000 annually. He 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. Then at the end of each six-month period, he gets another $80,000 based on the practice's performance. His accountant deems both the monthly and semi-annual payments to be salary payments. Thus, he pays Medicare tax on all $400,000 for a tax of $12,950 at the new 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, etc. If he works for 25 years earning the same income, he will have lost more than $645,000 in Medicare taxes, assuming a 5 percent growth rate.

Down the road, Dr. Jones 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 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 $350,000 in FICA taxes, assuming a 5 percent growth rate—an improvement of $295,000 over Dr. Smith.

When to Take K-1 Distributions

The above cases are hypotheticals and any change or deviation from the circumstances discussed above could affect the outcome. However, obviously, you would not want to be Dr. Smith. Yet, we are continually astounded when see so many physicians come to us in the same position—having all, or most, of their income treated as W-2 compensation when in fact much of it is earned because of the profitability of the practice rather than the doctor's personal services. Wouldn't all of us prefer to be in Dr. Jones' situation? If we are allowed to be—yes. So, the question really comes down to—what are the tax rules that govern this situation?

In discussions with a number of CPAs with more than 15 years of experience, the consensus is that one should follow a simple rule: basically that one can reasonably be paid as a W-2 salary what one would need to pay an associate physician with the same training to come join your practice. The rest of your compensation can be characterized as distributions. One CPA, practicing for over 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 easily attract another dermatologist to his practice paying a $250,000 salary. This would allow him 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 a career—for no good reason—is a shame. Yet it happens every day. n