Mid-Atlantic Health Law TOPICS

A version of this article was published in The Daily Record on November 7, 2006.

Today, the most common forms of business entities for new medical practices are: (1) a professional service corporation that elects to be taxed under the subchapter S corporation income tax regime, or (2) a limited liability company (LLC) taxed as a partnership for income tax purposes.

The most common features of both types of entities are the same, namely: (1) the owners are protected from personal liability from contractual debts of the business and from liability to victims of torts committed by other employees of the entity; (2) there is generally no federal or Maryland income tax liability imposed on the entity; and (3) the owners of the entity must report their respective proportionate shares of the entity's taxable income on their individual tax returns and pay tax on those amounts.

Besides these similarities, the two forms of entities also have certain differences, including those discussed below.

A. Payroll Taxes

Generally, the federal government imposes payroll taxes at the rate of 15.3 percent on the first $90,000 of compensation paid to an employee, and 2.9 percent on the balance of the employee's compensation. As long as a medical practice that is an S corporation pays a reasonable salary to its employed doctor/shareholders, the dividends paid by the S corporation to those shareholders in proportion to their ownership interests in the S corporation are not subject to these payroll taxes. This means that medical practices that are S corporations can lower the federal payroll taxes paid by their owners.

The same is not true for medical practices that are LLCs. While federal payroll taxes are not due with respect to amounts paid to the owners of LLCs, the taxable income allocated to those owners is subject to the federal self-employment tax. Moreover, such federal self-employment tax is equal to federal payroll taxes, namely 15.3 percent of the first $90,000 of taxable income and 2.9 percent of amounts above such threshold.

B. Liquidation

While most doctors do not imagine ever liquidating their medical practices, that event sometimes happens, and the liquidation of S corporations is different than the liquidation of LLCs. After creditors are paid, the assets of S corporations are generally distributed to the shareholders of the S corporation in proportion to the shares owned by each shareholder.

That is not the case with LLCs. Generally, after creditors are paid, the assets of an LLC are distributed to its owners, called members, in proportion to their capital accounts, and not in proportion to the member's percentage ownership of the LLC. Moreover, each member's capital account will depend upon when he or she became a member, and how much he or she paid for the membership interest, as well as other factors.

While accountants and tax attorneys would likely conclude that the LLC treatment of liquidating distributions is fairer than the corporate treatment, the LLC treatment is usually unexplored territory for doctors. Doctors understand shares of stock, but doctors are much less familiar, and much less comfortable, with capital accounts.

C. Flexible Rules Versus Settled Law

A distinct disadvantage of the LLC is that it is a relatively new form of business entity, having been introduced in Maryland only in 1992. Because of this, there is relatively little case law to assist in resolving disputes, and the rights and obligations of the owners of LLCs are not completely defined by statute. For example, the Maryland Limited Liability Company Act does not state whether members of an LLC have a fiduciary duty to each other.

On the other hand, corporate law has been evolving for over 100 years, and, therefore, there are many more settled answers to questions about S corporations, as opposed to questions about LLCs. However, this stability can also be a curse. Corporate law requires many governance formalities, while the management of LLCs can be structured in infinite variations.

The relative novelty of LLCs also infects the documents that many lawyers use in regard to medical practices that are LLCs. Such documents often incorrectly refer to the members of LLCs as employees, while members of LLCs may not be employees. Similarly, such documents often incorrectly refer to severance payments as severance payments, when they are actually guaranteed payments. Such confusion only exacerbates the ambiguities already inherent in using a novel form of entity, such as an LLC, in the first place.

Similarly, S corporation form documents are often more finely tailored to medical practices than LLC form documents, simply because of the immaturity of form LLC documents. For example, while form corporate documents sometimes adjust amounts paid to departing S corporation shareholders for certain accrued liabilities, such as pension contributions and medical malpractice payments, it is rarer to see such adjustments being made to distributions of capital accounts pursuant to form LLC documents.

D. The Bottom Line

The bottom line is that, in time, well structured and well explained LLCs may become the entity of choice for new medical practices due to the flexibility of LLCs. Nevertheless, many of the most important features of an LLC can be replicated in an S corporation, and implemented in a format that is both more familiar to doctors, and less prone to omissions by their attorneys.