by Barry F. Levin, Esq. and Philip M. Bogart, Esq.
Choosing the appropriate entity under which to practice is one of the early decisions a dentist preparing to start a dental practice--or merging existing dental practices--will face. Unfortunately, as with a retainer, braces, or a night guard, there is no “one size fits all” legal entity.
The primary reason for setting up a legal entity is to insulate the owner (or owners) from liability. These types of entities are generically referred to as “limited liability entities.” Although a dentist could always be personally liable for his or her malpractice or negligence, practicing within an appropriate legal entity typically shields him or her from the liabilities that are caused by other dentists (or hygienists) in the practice and from other nonmalpractice claims against the practice (e.g., claims by vendors or creditors). Provided that the appropriate legal formalities are observed, the legal entity should serve as a shield protecting the owners’ personal assets from these other claims and liabilities.
Although most legal entities provide similar liability protection, there are differences among the various types. Two entities are used the most often for dental practices:
1) The professional corporation that elects to be taxed as an “S” corporation (an “S Corp”), and
2) The limited liability company (the “LLC”). In many states, LLCs are referred to as professional limited liability companies or PLLCs.
The S Corp and LLC are alike in that both are "pass-through" entities for tax purposes. This means that the income of each of these entities "passes through" to the owners and is reported on their individual tax returns. As a result, unlike the traditional “C” corporation, there is no double taxation in most situations because there are no income taxes due on the income at the entity level. But, the limitation of liability protection is the same.
One of the important distinctions between an LLC and an S Corp, however, concerns the employment taxes imposed upon the earnings of members or shareholders who are also employees of the entity.
S Corp shareholders, who are also employed by the S Corp, must pay Federal Insurance Contributions Act (“FICA”) tax, which is a 12.4 percent tax (also referred to as Social Security) for compensation up to $106,800 (1) and a 2.9 percent Hospital Insurance (“HI”) tax (also referred to as Medicare) on all compensation. S Corp shareholders share the cost of these taxes with their employers, so each party is responsible for paying one-half of the Social Security tax and the Medicare tax.
Active members of an LLC are considered to be self-employed for tax purposes and thus pay Self-Employment Contributions Act (“SECA”) taxes (rather than FICA taxes) and Medicare taxes. As with FICA and Medicare taxes imposed upon S Corp employees as described above, SECA and Medicare taxes are composed of a 12.4 percent Social Security tax (on wages up to $106,800) and a 2.9 percent Medicare tax (on all wages; there is no ceiling). SECA and Medicare taxes imposed on self-employment income of active members of an LLC differ from FICA and Medicare taxes imposed on wages in that the self-employed taxpayer is responsible for the entire tax because there is no employer contribution. To make up for this, self-employed individuals may deduct one-half of their SECA and Medicare tax liability in calculating their adjusted gross income.
The IRS considers every single dollar of the distributive share of an active member of an LLC as “self-employment” income. Even if part of the distributive share of the member is actually a return on his or her investment (and not wages), the entire amount of the distribution is subject to employment taxes. However, if an S Corp is used, only the actual salary paid to the shareholders is subject to employment taxes. Any other amount paid to an owner as a dividend or a distribution is not deemed to be wages and, therefore, is not subject to Social Security and Medicare taxes.
Many owners believe that this difference between LLCs and S Corps presents an opportunity for large tax savings. However, an owner cannot simply reduce his or her salary to a nominal amount and deem the remaining amount paid to a shareholder as a distribution in order to pay less employment tax. The IRS is generally very skeptical of shareholders who receive a salary that is below what is deemed by the IRS to be reasonable compensation. Therefore, owners should work with their legal advisors and accountants to determine the appropriate amount of salary that will be respected by the IRS.
Of course, part of the savings provided by the S Corp may be offset by the expense of preparing a corporate tax return (which may be more costly than the requisite tax forms for a single-member LLC) and the other costs associated with satisfying the additional formalities of an S Corp.
Apart from the modest tax savings described above, most dentists favor the LLC because of its operational simplicity and flexibility. The S Corp, on the other hand, has certain legal formalities and procedures that must be observed. For example, using an S Corp requires annual meetings of stockholders and directors, and a formal election of directors and officers. In addition, more paperwork is generally required by an S Corp (e.g., a charter, bylaws, a buy-sell agreement, minutes, and resolutions).
An LLC, on the other hand, is not required to have meetings and elections. In addition, the operating agreement (or, as it is called in many states, the “limited liability company agreement”) may address all of the operational issues, transfer issues, and management terms typically addressed in corporate bylaws, buy-sell agreements, and other documents. In addition, while an S Corp must distribute its profits on a pro rata basis based upon ownership (after the payment of salaries to its stockholders), the LLC has flexibility in how cash and profits are split up among its owners regardless of their ownership percentage. For example, in an LLC, while two dentists may own the practice equally, they can agree to split profits and losses based upon production or other circumstances.
Various other issues should be considered before selecting a legal entity for a dental practice. Many states have unique provisions that should be considered.
This article is not intended to provide tax advice. Dentists must work with trusted legal and tax advisors who understand the operational and business issues involved with a dental practice to ensure the choice of entity provides the maximum benefit for each dental practice and its dentist-owners.
1. The OASDI wage ceiling changes annually. The presented figure is the ceiling for 2009.
Barry F. Levin is a partner and vice chair of Saul Ewing LLP’s Business Department.
Philip M. Bogart is an associate in the Business Department in Saul Ewing LLP’s Baltimore office. They represent dentists, and the business entities in which clinicians practice, in all aspects of the dental practice including the structuring, negotiation, documentation, and implementation of associateships or employee arrangements, partnership arrangements, acquisitions, sales, and mergers of mature practices.
