Tom Bodin, a Practice Integration Advisor with Buckingham Strategic Wealth, works with dentists to help them achieve financial freedom through a comprehensive approach to wealth management.
This is the second in a series of three articles on business entity selection. In our previous post, my colleague, Katie Collins, CFP®, discussed the advantages and disadvantages of forming a sole proprietorship. In this post, I will discuss the advantages and disadvantages of forming an S Corporation. To round out this series, another colleague, Mike McAninch, CPA, CFP®, will discuss the advantages and disadvantages of forming a C Corporation.
Selecting the best business entity can be a tricky task. It generally is done early in the practice’s existence, and the decision should be made with an eye toward the practice’s future. When selecting an entity structure, one should consider, among other factors, three important questions:
- What is the desired ownership structure?
- What is the tax impact of the entity selection?
- What is the desired level of personal liability protection?
What is the desired ownership structure?
If you have or plan to have partners in the dental practice, S Corporations provide a vehicle that can be owned by multiple entities (people or additional S Corporations). This provides greater flexibility for ownership changes than a sole proprietorship.
Note, however, that S Corporation distributions must be allocated proportionate to ownership share. If you and your business partner allocate income based on production or collections as a way to offer revenue incentives, you will need to do it at the W-2 wage level. If two partners own an entity 50/50, all distributions will be allocated 50/50.
What is the tax impact of the entity selection?
When you choose an S Corporation, you have a certain level of freedom in how your income is recognized. You may be tempted to set your W-2 income to a minimal level and take the lion’s share of your compensation via distributions to avoid FICA, Medicare and Sur-tax. If so, proceed cautiously. Keep in mind that three factors should guide your W-2 compensation. First, the IRS requires that compensation paid to the dentist must be “reasonable for like services by like enterprises under like circumstances.” While the IRS provides no guidance as to what reasonable compensation for dental services may be, it surely is not a de minimis amount. The second guiding principle to consider when recognizing W-2 income should be your use of qualified plans. For dentists saving aggressively in 401(k) and defined benefit plans, W-2 income is the compensation considered in the percentage-of-payroll calculation for allocation purposes. In 2019, up to $280,000 in W-2 income can be recognized for qualified plan purposes. Recognizing higher income than your staff can greatly increase your allocation into these qualified plans. For dentists creating wealth by utilizing qualified plans, we generally look to the $280,000 income figure and work down. Why work down? This introduces the third factor, the qualified business income (QBI) deduction.
Starting in 2018, certain professional service providers (dentists included) can deduct 20% of their pass-through income for tax purposes. This deduction phases out at between $315,000 and $415,000 of income if you are married filing jointly (the range is between $157,000 and $207,500 for single filers). This deduction applies to income recognized as a distribution, not W-2 income. For the past two years, we have worked to identify the appropriate balance of W-2 income to maximize allocations to the owner while ensuring substantive enough distributions to maximize the QBI deduction and at the same time engineering income with qualified plans to ensure it is within or below the phase-out limits.
What is the desired level of personal liability protection?
While the sole proprietorship may provide ease of administration (see our previous article for more details), its personal liability protection is lacking. An S Corporation provides a corporate barrier between the practice owner and his or her personal assets. Layering corporate protection with appropriate insurance protection is a wise risk-mitigation tool for any business owner.
Entity selection is a complicated decision and the pros and cons of your various options run far deeper than we could cover in a few short articles. If you have questions related to entity selection, consult your team of advisors (CPAs, business attorneys and financial advisors). If you have follow-up questions related to the financial planning aspects of this decision, please do not hesitate to reach out to any of Buckingham Strategic Wealth’s Practice Integration Advisors.
As I mentioned, our next post on entity selection will look at the advantages and disadvantages of operating as a C Corporation. If there are specific topics you’d like us to tackle in Finance32, please send us an email!