Mid-Atlantic Health Law TOPICS

Most professional corporations are taxed as corporations, and are thereby known as C corporations. Some professional corporations have elected small business or S status, and are thereby known as S corporations. S corporations are generally not taxed at the corporate level.

This article examines the pros and cons of the conversion of a C corporation engaged in the practice of medicine to an S corporation.

A. Differences Between C and S Corporations

Earnings— A C corporation's earnings can be taxed twice. It is taxed on its earnings, and, if it distributes those earnings as dividends or liquidation proceeds, the earnings will be subject to tax again at the shareholder level. A corporation that elects S status, however, is generally not taxed at the corporate level. An S corporation's earnings are treated as the earnings of its shareholders.

The double taxation of a C corporation's earnings is usually avoided by physicians, since professional corporations generally distribute all of their income as salaries or bonuses, leaving no taxable income at the corporate level.

Health Insurance— There are advantages to C corporation status relating to the tax treatment of certain fringe benefits. Specifically, a C corporation can deduct 100% of the health insurance premiums that it pays for its share-holder/employees, and such shareholders are not subject to tax on those premiums. A shareholder/employee of an S corporation owning 2% or more of the corporation's stock is allowed to deduct 60% of the premiums in 1999 through 2001, 70% in 2002, and 100% in 2003 and thereafter.

Parking— A C corporation can also pay parking expenses for its shareholder/employees, and deduct those parking fees against its income, while the shareholder/employees do not have to pick up such amounts as income. Parking expenses paid by an S corporation for its shareholder/employees who own at least 2% of its stock do not reduce the taxable income of the shareholder/employees.

Life  Insurance— Group term life insurance pre¬miums for life insurance up to $50,000 is deductible by a C corporation, and does not constitute income to its shareholder/employees. Such premium payments are not deductible with respect to shareholder/employees owning 2% or more of the S corporation's stock.

Payroll Taxes— On the other side of the coin, however, payroll tax savings can be realized by S corporations, since the amount of the shareholder/employees' income paid as dividends is not subject to payroll taxes, provided that such income is not re-characterized by the IRS as salary. The tax authorities take the position that shareholder/employees of S corporations must be paid a reasonable salary for services rendered on behalf of the S corporation, and, if the shareholder/employees' pay is unreasonably low, some or all of the dividend income might be re-characterized as salary subject to payroll taxes.

Illustration— The chart below provides an illustration of tax differences between an S corporation and a C corporation, assuming that the professional corporation in question has one physician owner and that that physician's taxes equal 40% of his or her taxable income.

As illustrated, the C corporation results in slightly greater tax savings than the S corporation. However, as a physician's dividend income increases, the S corporation eventually becomes more favorable. Dividends of $71,741, instead of $62,500 in this example would result in equal tax savings. (Dividends of $71,741, however, are 29% of the corporation's total income, an amount that the IRS might consider excessive.)

Generally, S corporate status will likely be superior to C status for physicians with incomes over $300,000, because the payroll tax savings become more significant as income, and therefore dividend income, increases.

Sale— Further, if a sale of the practice at a significant gain by a C corporation is considered likely, or if there exists a significant threat that the IRS will re-characterize some of the salaries and bonuses as dividend income, resulting in double taxation, conversion to an S corporation would be appropriate, unless the built-in gain rule described below prohibits the conversion.

B. Why Not Switch?

If S status is superior, because, for example, a physician's income exceeds $300,000, then such a physician should now elect S status, unless the conversion from C to S, itself, causes the doctor to incur significant tax liability.

In this regard, a C corporation that converts to an S corporation will not be subject to income tax by reason of the conversion, itself, unless (1) the corporation has accumulated earnings and profits from years when it was a C corporation and more than 25% of its gross receipts consist of passive investment income such as dividends and interest, or (2) the corporation disposes of "built-in gain assets" during the ten-year period beginning with the first day of the first taxable year for which the corporation is an S corporation.

Generally, the first part of this test will not be a problem, because corporations practicing medicine do not own valuable real estate or own stocks and securities. However, such corporations have receivables, and the conversion of such receivables into cash after the conversion to S status will trigger the built-in gain rule.

This problem, nevertheless, can be solved by "factoring" the corporation's receivables. In other words, physicians who want to switch from C status to S status should sell their receivables at the end of their last year as a C corporation. (Such a sale might cause some shareholders to pay a higher rate of tax because their incomes are artificially increased in the corporation's last year as a C corporation.)

In fact, many high income physicians may want to follow this route, especially at the end of 2002, because in 2003, S corporations, like C corporations, will be able to fully deduct health insurance premiums paid on behalf of shareholders who own 2% or more of the corporation, and, therefore, the benefits of S status will be more pronounced.

Lester D. Bailey
410-576-4014 • lbailey@gfrlaw.com