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Did you know your dental practice LLC can be taxed 4 different ways?

Oct. 11, 2016
Taxes. As if they weren't bad enough, dental business owners should know about different types of taxes for different types of corporations. Where does your dental practice come in? Find out here what you need to know about your taxes.

Taxes. As if they weren't bad enough, dental business owners should know about different types of taxes for different types of corporations. Where does your dental practice come in? Find out here what you need to know about your taxes

An LLC can be a great choice as the business entity for your dental practice. What you may not realize is how flexible the LLC can be when it comes to deciding how your business entity will be taxed. Depending on elections made by the LLC and its members, your company can be taxed up to four different ways. This article will review the four different types of LLC taxation, and what to consider when choosing among them.

First, let’s review what an LLC is and how it works. LLC stands for a limited liability company. It’s a hybrid entity that has aspects of both a partnership and a corporation. Like a corporation, an LLC has limited liability, so personal assets cannot be taken to satisfy business liabilities.Like a partnership, it has the ability to provide pass-through income taxation. An LLC has fewer required formalities than a corporation. Whereas a corporation is expected to adopt bylaws, issue stock, hold annual meetings, and keep minutes of those meetings for corporate records, those formalities are not required for an LLC.

An LLC can be a more flexible entity than a corporation with regard to its structure, management, and governance. This can be particularly important when there are multiple owners making unequal contributions to the business. This flexibility has made LLCs a popular choice for new businesses, and as a result it’s the fastest growing type of business entity in the US today.

The simplest type of LLC is a single member LLC. As you can probably guess from the name, a single member LLC is an LLC created and wholly owned by a single person. A single member LLC, by default, is taxed like a sole proprietorship. Just like with a sole proprietorship, the IRS will treat a single member LLC as a "disregarded entity," which means it effectively ignores the entity for income tax purposes. Just like a sole proprietorship, Schedule C is used on the 1040 to report income or loss from the business. When would this tax regime be chosen? If you’re just starting out, a simple pass-though entity is easy to understand. If you’re not making much money, the tax benefits of, for example, S-corporation status will probably not be great enough to justify the extra expense of preparing the separate S-corporation return.

It’s also popular to own the real estate property of your practice. A separate LLC insulates your practice from real estate-related liability and allows you to pull income out of practice in the form of rent paid to your LLC.

If you form an LLC with more than one person, you have created a multiple member LLC. Multiple member LLCs, by default, are taxed as partnerships by the IRS. Partnerships, like sole proprietorships, are not considered to be separate from their owners, and instead are "pass-through" tax entities. The profits and losses pass through the business to the partners, who then pay taxes on their share of the profits on their individual tax returns. Because there’s more than one person involved, taxes on partnerships are complicated. Even though it doesn’t directly pay any tax, the partnership will file a Form 1065 with the IRS and prepare Schedule K-1s to report each partner’s share of the income, losses, deductions, and credits. Each partner will then report his or her share of the partnership on Schedule E of their 1040.

The IRS also allows LLCs to be taxed as a C-corporation by filing IRS Form 8832. Filing this form for your LLC will dramatically affect the tax treatment of your business entity. A C-corporation is not a "pass-though" entity like a partnership or a sole proprietorship; it is a separate entity from its owners. A C-corporation must file a Form 1120 with the IRS and pay separate taxes each year on its net income.

As a dentist, under IRC Section 11(b)(2), your corporation is a personal service corporation, which means it pays a flat income tax rate of 35% at the corporate level from the very first dollar that it takes in. Upon distributing dividends to its shareholders, income tax is then paid a second time, at the individual level of the shareholders. This is what produces the double taxation of C-corporations. This double taxation can be minimized by paying out all business income in salaries, bonuses, or benefits to reduce or eliminate net income at the corporate level. But there are potential risks associated with this. A C-corporation owner will usually pay a higher amount of payroll tax than an S-corporation owner in the same financial circumstances. As a result, many dentists have moved away from the C-corporation.

However, the C-corporation does have its charms. The ability to deduct benefits such as disability insurance is greater with the C-corporation than with other business entities. Depending on your age, income, and the cost of your disability insurance, it’s possible that a C-corporation may be a cost effective entity choice. Have your advisors do the math to see if it makes sense.

The fourth option for your LLC is to be taxed under subchapter S of the Internal Revenue Code, also known as an S-corporation. S-corporations were created as a simple way for small business owners to gain liability protection. They pair a simple pass-through tax regime with limited liability for business owners, and are the most popular type of business entity in the US, with over 4.6 million corporation owners in 2014.

Subchapter S, in a sense, is the grandfather of the current LLC business entity. S-corporations have some very big pluses as well as some drawbacks. The S-corporation, like its big brother the C-corporation, provides limited liability for the owners. An additional benefit of the S-corporation is to avoid paying the self-employment tax of 15.3% on a portion of your compensation through the use of distributions instead of salary. This is generally considered the greatest benefit of the S-corporation over other business entities.

What are the drawbacks? S-corporations are more restrictive than other business entities regarding their ownership structure. For example, S-corporations can have only one class of stock. This can be a problem when you have multiple owners making unequal contributions to the business. If all stock pays out the same, then compensation through distributions must mirror ownership. This might not always be desirable. Another drawback is that corporations, whether S- or C-, simply require more legal legwork than some other business entities. This legwork usually costs money. Making errors in stock ownership, filing requirements, elections, notifications, and consent means you could accidentally terminate your S-corporation status, which can be expensive.

What’s the best tax choice for your LLC? It depends entirely upon your circumstances, and there’s no one right answer. Talk to your accountant and attorney and discuss the pros and cons of each option.

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Allen Reece regularly counsels dentists in a variety of personal and professional matters, including the formation of corporations and limited liability companies, shareholder and buy-sell agreements, practice valuation and purchase agreements for practice acquisitions and sales, real estate acquisitions and sales and lease agreements, employment documents, non-compete and nondisclosure agreements, asset protection planning, estate planning, and any other significant business transactions a dentist will face during his or her career. Mr. Reece has a JD from the University of Michigan Law School, and is an attorney with Frank & Kraft, PC.