Authors: Alan H. Matilsky, Esq. and Lawrence Geller, MS, MBA
Author’s Note: This is the third in a series of articles on starting a solo ophthalmology practice. Read Starting a Solo Practice, Part One: The Pros and Cons and Starting a Solo Practice, Part Two: A Sound Tactical Plan is Key to Financing Your New Practice.
So, you’ve done your research and made the decision to start an ophthalmology practice. As a sole provider you may think to yourself, "choice of legal entity is not important . . . after all, it's just me". However, choice of legal entity affects even the solo practitioner, both at the outset and in the future. This article addresses the types of legal entities that should be considered by a solo ophthalmologist, and some of the major advantages and disadvantages of each. This article will not consider partnerships as these entities, by definition, require two or more owners at all times.
The primary advantage of a sole proprietorship is that it is relatively easy and inexpensive to form and maintain. There are no state filings required to form and maintain a sole proprietorship, and a sole proprietorship is not required to file a separate tax return. Rather, the practice's profits are reported on Schedule C of the ophthalmologist’s personal tax return. However, while a sole proprietorship may be the easiest entity to form and maintain, this single advantage is far outweighed by its significant disadvantages.
A sole proprietorship does not provide the physician-owner with any personal liability protection from claims against the practice. In other words, in the event of a claim against the practice, the physician-owner's personal assets are at risk. While no form of legal entity offers a physician-owner personal liability protection from his own malpractice, or that of other physician or non-physician employees directly supervised by the physician-owner, certain other business entities (e.g., corporations and limited liability companies) offer liability protection from (i) creditors' claims against the practice; (ii) slip and fall injuries to employees or patients; (iii) medical malpractice claims against co-owners; and (iv) medical malpractice claims against associate physicians and other non-physician employees not under the physician-owner's direct supervision.
Further, as its name suggests, a sole proprietorship may only have one ophthalmologist owner. Thus, the entity does not provide for future growth of the practice through the addition of other ophthalmologists as owners. While conversion to another form of entity at a later date is possible, this creates administrative complications with third-party payors which can be time consuming and expensive to address. If you think you may desire to add other ophthalmologists as owners to your practice in the future, selection of a different legal entity that allows for that type of growth would be preferable.
As compared to a sole proprietorship, a professional corporation (P.C.) is more expensive to establish and maintain. Formation of a P.C. will require a state government filing and development of various internal (non-recorded) documents. Most states also require that P.C.s file an annual registration each calendar year. However, incorporating your ophthalmology practice provides the advantage of shielding your personal assets from liabilities associated with your practice, with the exception of liabilities arising out of your own professional negligence or the negligence of employees under your direct supervision. Specifically, a P.C. will shield your personal assets from (i) creditor's claims against the practice; (ii) slip and fall injuries to employees or patients, and (iii) malpractice claims against employees not under your direct supervision. Further, should you add additional owners to your practice, the corporation will shield your personal assets from professional liability claims incurred by your co-owners.
In general, corporations can be separated into two major tax categories: "C" corporations and "S" corporations. Both provide the same liability shield for your personal assets.
S corporations are subject to certain restrictions that do not apply to C corporations. Specifically, (i) S corporations are limited to a maximum of 100 shareholders; (ii) the shareholders, in general, cannot include other legal entities or non-resident aliens (i.e., non U.S. citizens who do not reside in the United States); and (iii) the corporation cannot have more than one class of stock. Practically speaking, the restrictions applicable to S corporations do not prohibit most medical practices (especially sole practitioners) from organizing as S corporations.
Unlike C corporations, S corporations are not taxed at the corporate level. Rather, the income flows through to the shareholders and is reported on their personal returns. Shareholders should beware that the P.C.’s profits are deemed to flow through to the shareholders and are treated as taxable income, even if the cash is not actually distributed by the corporation to the shareholders. This is sometimes known as "phantom income". Owners of an S corporation should be aware of this issue and should work with their professional advisors to avoid the tax impact that can be created by phantom income.
As with income, losses incurred by an S corporation also flow through to the P.C.’s shareholders. With proper tax planning, these losses can be used to offset taxable income received by the shareholders from other sources. This can be important at the outset of your practice as the costs of establishing a practice sometimes cause start-up losses in the first year of practice. Note that S corporation losses are only deductible by a shareholder to the extent of the investor’s tax basis (i.e., investment) in the P.C. In an LLC (described below), a physician-owner receives tax basis for debts of the practice guaranteed by that shareholder. However, in an S corporation, a shareholder does not receive tax basis for guaranteeing corporate debt. To receive tax basis for debt of an S corporation, the shareholder must personally borrow the money and loan the money to the P.C.
With proper tax planning, an S corporation may be able to issue dividends to the shareholders exempt from self-employment tax. This tax advantage does not apply to C corporations or limited liability companies.
C corporations are not subject to the same restrictions as S corporations. There is no limitation to the number of shareholders, and any individual or entity may be a shareholder of a C corporation. Also, C corporations may issue two or more classes of stock when there are other shareholders in the practice, one class of stock can be used to grant certain preferential rights to you as the “founding shareholder”.
A C corporation pays tax on income at the corporate level. The shareholders report income only on the amounts paid to the shareholders as compensation or distributed to the shareholders as dividends. However, shareholder dividends are not tax deductible expenses of the corporation. Accordingly, a C corporation cannot cost effectively issue dividends to the shareholders, due to the dividend funds being subject to income tax at the corporate level. When the corporation distributes funds to the shareholders as dividends, those dividends are also subject to taxation at the individual shareholder level. Hence C corporations try to reduce their net income to zero at the end of the fiscal year to avoid double taxation. This "double taxation" scenario more than offsets any possible benefit associated with the dividends being exempt from self-employment tax. In the event of a sale of an ophthalmology practice organized as a C corporation, the double taxation treatment results in the corporation paying tax on the gain, and the shareholders paying tax on the distributions of those gains to the shareholders. This was a major problem for ophthalmologists in the mid-1990s when many sold their practices to a physician practice management company.
Also, in a C corporation, start-up losses, if any, are applied at the corporate level and do not flow through to the shareholders. This eliminates the ability of the shareholders to use those losses to offset other sources of income.
Another tax disadvantage to a C corporation is that medical practices organized as C corporations are classified for tax purposes as personal service corporations. Personal service corporations are subject to taxation at flat tax rate of 35% on all corporate profits, rather than being taxed at graduated rates as with non-personal service corporations.
Although C corporations may cause tax disadvantages for the uninformed physician-owner, with proper business and tax planning, many of these disadvantages are avoidable. Further, if tax deductibility of fringe benefits is important to your practice, then a C corporation may be a good choice of entity, as certain fringe benefits (e.g., group term life insurance, disability insurance, parking expenses and cafeteria plan expenses) are tax deductible by C corporations, but not by S corporations or limited liability companies.
Limited Liability Companies
As with a corporation, a limited liability company ("LLC") is more expensive to form and maintain than a sole proprietorship. However, unlike a sole proprietorship, an LLC provides liability protection for a physician-owner's personal assets substantially equivalent to the personal liability protection provided by a corporation.
For tax purposes, an LLC is treated as a sole proprietorship, if you practice alone, and as a partnership (or S corporation), if you have co-owners. In other words, unless you elect otherwise, an LLC is a flow-through entity, and will not be subject to income taxation at the LLC level. LLC start-up losses (if any) flow through to the individual and may, to the extent of the physician-owner's tax basis in the LLC, be used to offset other sources of income. Members of an LLC (unlike shareholders in an S corporation) have the advantage of receiving tax basis for LLC debt guaranteed by the members. The "phantom income" concerns discussed above with regard to S corporations are equally applicable to LLCs.
The ownership restrictions that apply to S corporations do not apply to LLCs. Therefore, in that respect, an LLC is more flexible than an S corporation. Further, unlike a corporation, an LLC is not required to allocate profits and losses in proportion to ownership percentages. While this flexibility may be helpful in certain unique situations, it is not generally utilized by most ophthalmology practices.
Many experts say that an LLC is easier to maintain than a corporation because the LLC is not subject to the same "corporate formalities" as a corporation (i.e., required meetings and minutes). However, in practice, the corporate formalities required of a corporation are easy and inexpensive to satisfy. By comparison, the complexity of an LLC governing agreement (known as an Operating Agreement) can cause that agreement to be expensive to prepare and difficult to understand. The issues related to a typical operating agreement are far more complicated than the issues related to compliance by a corporation with basic corporate formalities. Therefore, in some respects, an LLC is actually more difficult to maintain than a typical corporation.
Unlike owners of a corporation, owners of an LLC are not employees of the company, and cannot satisfy their income tax obligations through tax withholding. Rather, owners of an LLC are self-employed individuals who must pay estimated taxes on a quarterly basis in order to satisfy their personal tax obligations. Further, in an ophthalmology practice organized as an LLC, all distributions to the physician-owners will be subject to self-employment tax. By comparison, dividends paid by an S corporation, if properly structured, may be exempt from self-employment tax.
Your Practice Legal Name
This article is intended to be an overview of some of the major issues related to choice of legal entity for a solo ophthalmologist, and should not be relied upon as legal or business advice.
As you evaluate the pros and cons of legal entities, there is one related issue – what name shall I choose for my practice? You can always use your own name “John Smith, M.D., P.C.” But if you intend to grow your practice by adding other ophthalmologists first as associates and eventually as partners, or wish to identify your practice geographically, you may want to consider a generic name – “Midtown Ophthalmology Consultants, P.C.”.
Like the choice of legal entity the right practice name will vary by practice. Each type of legal entity has its advantages and disadvantages, and no single entity type is "right" for all situations. Accordingly, choice of legal entity for the start-up ophthalmology practice should be made only after careful planning with your legal and business advisors.
ABOUT THE AUTHORS:Alan H. Matilsky is a health care and business attorney in Atlanta. He has been advising physicians and medical practices on legal issues for the past 20 years. Contact him at email@example.com.
Lawrence Geller is a senior consultant with Medical Management Associates, Inc., in Atlanta. He has been advising physicians and hospitals on medical practice issues for the past 20 years. Contact him at firstname.lastname@example.org. Mr. Geller has been a frequent presenter at the Academy’s Annual Meeting.