Why Optometry and Ophthalmology Practices Should Consider Being S Corporations

Whether you’re a seasoned practice owner or a new optometrist or ophthalmologist thinking of opening a private practice it’s important to understand the basics of corporate structure so that you can maximize your earning potential and avoid paying unnecessary tax.

You likely will or have spent a tremendous amount of time planning, implementing, and troubleshooting every aspect of your practice. What a shame it would be to fork over money to the IRS that you didn’t need to or to limit your growth by choosing the wrong type of corporation! Corporate tax rules may benefit optometry or ophthalmology business owners, but it’s up to the business owner, along with their CPA and attorney to do the research and pick the appropriate entity. Pick the wrong corporation type and it’s no one’s fault but yours.

I am fortunate to meet with dozens of optometrist and ophthalmologist practice owners every year at our office, at trade shows, and on phone calls and I’ve identified common trends when it comes to corporation type.

First off, it’s critical to understand that the C corporation is the default corporation under IRS rules. The S corporation is a corporation that has elected a special tax status with the IRS. Both business structures get their names from the parts of the Internal Revenue Code under which they are taxed.

The Tax Cuts and Jobs Act brought into effect in December 2017 by President Trump reduced the top corporate income tax rate from 35% to 21%, which was the largest tax overhaul in over 30 years. S Corporations do not pay a federal tax, but the profits are taxed at the individual shareholder level which could be as high as 37%. C Corporations on the other hand do pay a federal tax.

There are seemingly numerous differences between a C Corporation and an S Corporation. This chart outlines the core differences between C Corporations and S Corporations when it comes to tax, class of shares, shareholder volume, and shareholder origin.

Not all states and localities recognize S corporations and, consequently, do not extend the pass-through taxation advantages to them since they treat them as C corporations. The District of Columbia, New Hampshire, Tennessee, New York City and Texas do not afford special treatment to S corporations. Similarly, Louisiana taxes S corporations as C corporations, but allows an exclusion regarding the portion of income with respect to which Louisiana shareholders pay income tax. This article addresses US taxes and not necessarily state or locality taxes.

There are a variety of differences that distinguish LLCs taxed as partnerships and S Corporations from one another.

This chart outlines the core differences between LLCs taxed as a partnership and S Corporations when it comes to tax, class of shares, shareholder origin, who can own each, subsidiary flexibility, what to do with profit and loss, and how and when tax is paid.

In the past, some S Corporation owners avoided paying Social Security and Medicare taxes by not having wages paid to the active shareholders of the S Corporation. However, in two different court decisions, one in 2006 and the other in 2010, this avoidance of self-employment tax was addressed and these cases are used by the IRS to determine reasonable compensation.

An active LLC owner does not receive wages, and therefore the LLC does not contribute to state unemployment or statutory disability benefit funds. Because of this, an active LLC owner cannot receive state unemployment or statutory disability benefits.

S Corporations are pass-through entities so the corporation itself is not subject to federal income tax. Instead, the shareholders are taxed upon their allocated share of the income. These S Corporation shareholders report this passed through income on their personal tax returns.

In an S Corporation, after salaries are paid to the active shareholders (business owners), the remaining profit or loss passes through to the business owners, and with it the tax liability or tax savings. With C Corporations, after salaries are paid to the active shareholders (business owners), the company pays a corporate tax on the remaining profits and then, if the remaining profit is paid to the shareholders as a dividend, the shareholders will pay income tax on the dividend at a “capital gains” tax rate. This is known as double taxation and there is an example below. In summary, S Corporations are not subject to federal income tax that C Corporations are.

In an S Corporation, if shareholders are actively working in the business, they are also employees and they must take what the IRS calls a reasonable salary. The IRS does not provide a definition of a reasonable salary. The salary is subject to Social Security and Medicare tax as well as regular income tax. An LLC is similar except that no salary is required to be taken and all profits and losses flow through to the owners. All of the profits that are allocated to the active owners are subject to self-employment tax as well as regular income tax.

One disadvantage of an S Corporation is that the shareholders will still need to pay taxes on the corporation’s income based on their proportion of ownership, even if the business didn’t pay dividends to shareholders. This can be a drawback to an S Corporation since the shareholders may be subject to a tax on income that is retained by the company, even though they did not physically receive the income because the company decided to retain these earnings. In a C Corporation this isn’t the case because the corporation can accumulate earnings and profits, without paying them out to business owners, and pay tax at a flat 21%. However, if a C Corporation accumulates more than $250,000 beyond the reasonable needs of the business, it may be subject to a 20% accumulated earnings tax.

Although just mentioned above, let’s clarify this again. S Corporations are not required to pay dividends to shareholders. The business files a tax return (Form 1120S) that shows its net profit or loss for the year. This amount is then passed to individual shareholders and reported on their personal returns. Even if the shareholders don’t actually receive the amount of profit in the form of dividends, the profit will still be taxable to the shareholder. When businesses pass through a loss, the shareholder receives a deduction for the loss limited by their basis in the corporation. To explain the concept of basis in its most simple terms—it’s the amount of the shareholder’s original investment, plus profits, less losses, plus loans from shareholders. You should consult your tax advisor for a more detailed explanation of S corporation basis.

Each shareholder then receives a Schedule K-1 from the S Corp, which shows the amount of profit or loss that each individual receives. Shareholders must then report K-1 income on their personal tax returns, and the profit or loss will then be added to or subtracted from their other income.

Owners of S corporations and other pass-through entities (like LLCs, sole proprietorships, and partnerships) are able to deduct 20% of qualified business income from their personal tax returns. The problem is that if you make too much money you do not qualify for this deduction. In 2020, the limits are taxable income of $163,300 for single filers or $326,600 for joint filers. Above those income thresholds, businesses in specific service trades or professions, such as consulting, medicine, or law are precluded from taking this deduction.

Corporations are generally set up by registering with the state where the corporation is located. Once a corporation is formed, the corporation elects to be an S-Corporation with the IRS and possibly the state in which the company is incorporated. The “S” in S Corporation refers to Subchapter S of the Internal Revenue Code. S Corporations provide the same protection against business liabilities for shareholders as C Corporations. You should consult an attorney regarding the protection that is provided.

What is required to establish an S Corp?

Owners of C Corporations and S Corporations have the same protection for shareholders against the corporation’s lawsuits, referred to as a “Corporate Shield.” Generally, shareholders can’t be held liable for other than professional liability, and they also aren’t responsible for any debts incurred unless there are guarantees by the shareholders. You should consult an attorney to discuss legal protections provided by a corporation.

Methodology For This Example: In this example we compare 3 business types, a start up doing $1,000,000 in revenue, an expanding business doing $1,500,000 revenue, and a mature business doing $3,000,000 in revenue. In all 3 examples, the practice owner takes 15% of revenue as their salary and also runs a net profit margin of 20%. Additionally, the net profit is paid to the C corporation shareholder as a dividend.

We can see that for the Start Up and the Expanding Business there is no real tax difference for choosing one type of corporation over the other. For a mature business the advantages begin to show as the S-Corporation has a 2.27% tax savings over the C-Corporation.