The Corporate Decision: C-Corporation or Subchapter-S Corporation? Vernon A. Schotanus, CPBC
Owner, The Dental Consultant

Health professionals began incorporating their businesses in the late 1960s. Since then, it has been debated whether they should file as a C- or a Subchapter-S Corporation. It would not surprise me if you received what sounded like good advice supporting both of these corporate elections. If you did not receive conflicting opinions, my guess would be you merely took the advice of one trusted advisor. I say this because the controversy between C- and S-Corporations has existed even since the tax laws prohibitively favored the C-Corporation. In recent years, there appears to be a trend in healthcare away from the C-Corporation to the Subchapter-S Corporation.

Corporate elections were designed by the IRS to slot taxpayers into the election best suited for their business needs. As a result, there are numerous corporate elections to choose from. Of all the corporate elections, the only two suitable for healthcare professionals area: C-Corporation or a Subchapter-S Corporation.

On the surface, these two elections seem quite similar. For the scope of this article there are two, and in some cases three major differences.

The first difference is in regard to deductions. There are certain deductions allowed to C-Corporations not permitted by Subchapter-S Corporations or S-Corporation shareholders (Table 1).

The second difference is probably the most difficult to explain. It deals with C-Corporations and the taxation of profits at the corporate level should they not be distributed in a timely manner to the owners at corporate year-end. In effect, a C-Corporation needs to distribute all of its profits at the end of its corporate year. Failure to do so will cause the undistributed earnings to be taxed at the corporation level.

The bad news is that the tax rate applied to these undistributed profits is the rate prescribed by the Personal Service Corporation’s (PSC) rules. A “PSC” is simply a definition that applies largely to C-Corporations. It determines how undistributed profits are taxed at the corporate level. The definition is simple: If the majority of the corporation’s gross revenue is derived from the personal services of the owners, then your business is, by definition for corporate tax purposes, a PSC. Hence, healthcare professionals who incorporate under subchapter C will be defined as a PSC.

Those C-Corporations, that fall under the PSC definition pay tax at the highest corporate rate (35%) without the benefit of the lower brackets.

A PSC creates problems in the form of potential double taxation. The undistributed earnings, after being reduced by the 35% corporate tax rate (and corporate state tax as well) will result in net-retained earnings. These net-retained earnings are then trapped in the corporation with only three viable avenues to escape.

1. Liquidate the corporation, which of course is impractical and often not feasible.
2. Pay a dividend to the owners. This presents a couple of problems. First is the taxation (for a second time) as the dividends are reported on the owner’s individual tax returns. The second problem is that dividends must be paid based on stock ownership. This may cause problems in group practices, especially if profits are intended to be allocated by production.
3. Over distribute profit within three years and incur a net operating loss. This is easy to do and provides a double benefit. It allows the corporation to file a net operating loss carry-back and recover the taxes previously paid (plus interest). Secondly, in a group practice, it allows a production-based allocation formula to correct itself for the year profits were not paid out on time.

Conversely, the Subchapter-S Corporation is not subject to any form of corporate taxation. Therefore, undistributed profits do not have to be bonused out to the owners by December 31 of each calendar year. However, the undistributed earnings do not go away, nor are they trapped in the corporation. They automatically are taxed to the shareholders by virtue of the corporation issuing form K-1. Form K-1 (should you not be familiar with it) is submitted to the IRS with the corporate tax return. It informs the IRS that the owner or owners must report the undistributed income on their respective individual tax return. This is regardless of whether the owner receives the actual cash or not. However, the cash can be paid out later without consequence because the shareholders have already paid taxes on them.

This is where the potential third difference can occur. It is only an issue with group practices. In a Subchapter-S Corporation, any undistributed income is required to be allocated by stock owner-ship and stock ownership only. This presents a problem as most group practices allocate profits by some form of production-based formula. Hence the integrity of such a formula is skewed and unlike the C-Corporation, there is no effective way to correct it. The only method I know of is to have look-back adjustments, which can become tedious and cumbersome, especially as the years go by.

Prior to the mid 1980s, deductions were this was the largest issue of all. Table 1 illustrates the historical differences along with the corresponding current rules. As one can see, the IRS has eliminated four notable differences:

1. Retirement Plans: Of the four changes, this one is by far the most important. Prior to the law changes, Subchapter-S Corporations were simply not allowed to have retirement plans that covered its owners. From a historical viewpoint, the main reason to incorporate was to avail oneself of the ability to fund a retirement plan.
2. Heath Insurance Premiums: This is next most important issue. Prior to the tax law changes, which occurred during the 1990s, Subchapter-S shareholders were unable to deduct their health insurance premiums. Now they are fully deductible.
3. Corporate Owned Vehicles: Similar to changes one and two above, such deductions were originally not allowed. The rules are now the same and allow S-Corporations to take the deduction.
4. Retirement Plan Loans: Retirement plans can elect a loan feature whereby participants (owners included) can borrow up to half their account balance, but not to exceed $50,000. I, for one, am not a fan of plan loans, but most healthcare professionals prefer to have it. The bottom line is that a quirk in the law previously prevented Subchapter-S Corporations from allowing retirement plan loans. This quirk in the law was eliminated in 2001. Now Subchapter-S Corporations are allowed to have the loan provision.

The remaining four differences, separately are not all that significant. However, when added together they likely will sway the informed professional towards the C-Corporation.

1. Out of Pocket Medical Reimbursement Plans: Prior to 1984, virtually all C-Corporations maintained such a plan. Prior to this time the IRS allowed such plans to legally discriminate and only reimburse the medical expenses of its owners. After 1984 the rules changed whereby the highest benefit awarded to any given owner had to be provided to each eligible employee of the corporation.

   This usually made such programs cost prohibitive, except for those situations where the only employee of the corporation is the owner. However, times have changed. Health insurance premiums have escalated at an alarming rate. A quality family policy can cost $1,000 to $1,500 per month. To counteract this issue many healthcare professionals have revived these plans and instead of giving eligible employees an annual pay raise, they instead provide an increase to the non-taxable benefit level of the reimbursement plan. Then, they increase the deductible for the health insurance to achieve lower premiums. This can result in huge savings in premiums and payroll taxes. In addition, the owner gets to participate and receive the same annual benefit, all on a pre-tax basis.

2. Owner Disability Insurance Premiums: C-Corporations can deduct the owner’s disability insurance premiums, S-Corporations cannot. This is regardless of whether it is group disability or an individual policy. In regards to individual policies, the C-Corporation is permitted to legally discriminate between owners and the other employees. In effect the C-Corporation may simply elect to only pay the premiums of the owner. It should be duly noted that if the C-Corporation pays and deducts the premium, then the benefits, if received, would be taxable to the recipient; otherwise the benefits would be tax-free.

   Because of this tax issue, professionals used to be inclined to pay their premiums personally (outside of the corporation). More recently the trend is to pay and deduct them through the corporation. This is because only 2% of disability policies ever pay out benefits. Furthermore only a quarter of this 2% (or one-half percent overall) ever pay out benefits on a long-term basis. So the current prevailing theory is to roll the dice and take the deduction.

3. Cafeteria Plan: This, like the medical reimbursement plan, has become a very popular vehicle to help defray escalating healthcare costs. Once again a quirk in the law prohibits owners of Subchapter-S Corporations from participating in such plans.
4. Group Term Life Insurance: This is probably the least significant of the remaining differences. A C-Corporation can establish and deduct group term life insurance premiums whereby the owner receives $50,000 in coverage while the other eligible employees are awarded lower coverages. The lower coverages are defined by employee class––as defined by the IRS. Consult with your accountant or insurance agent should you have questions about how this program works.

The strongest prevailing arguments for the Subchapter-S Corporation centers on the self-employment tax, easier administration and practice sale and/or liquidation issues.

Self-Employment Taxes
Self-employment taxes represent Social Security and Medicare taxes. Social Security is currently set at 6.2% of one’s earned (W-2) income up to a maximum earnings of $90,000. After this level of income it ceases to apply. Then, the employer has to match the tax. Since Healthcare professionals own their own corporations, they in effect absorb both the Social Security tax and the match. So, the true cost to the dentist is 12.4% (2*6.2%) of the first $90,000 of one’s W-2 income.

The Medicare tax rate is 1.45% and is also matched by the employer (owners). Hence the effective rate is 2.9% (2*1.45%). It unfortunately applies to all W-2 income.

Therefore a C-Corporation, by virtue of its need to timely distribute all of its profit cannot avoid any self-employment taxes.

However, the Subchapter-S Corporation provides a vehicle to potentially avoid some of these taxes. The Subchapter-S Corporation can elect to pay part of its income as W-2 compensation and let the rest flow out via the K-1 as non W-2 income. Hence some self-employment taxes are avoided.

In regards to this potential savings there are two basic issues you need to be aware of:

1. The ability to substantially save on self-employed taxes is unfortunately relegated to those who have extremely profitable practices. If you earn less than $250,000 you will likely want to take as much W-2 salary as possible. Failure to do so could dramatically reduce your ability to fund the retirement plan on behalf of yourself. Here is why. Even if you make $500,000 the retirement plan can only count $200,000 for its internal calculations when determining the owner’s contribution. Hence, assuming you make enough profit it behooves you to achieve a W-2 of $200,000 and leave the remaining $40–50,000 for your plan contribution costs. Therefore the potential to save on the 2.9% Medicare tax becomes a function of how much your earnings exceed $250,000; otherwise you undermine your own retirement funding.
2. How does the IRS feel about these non-W-2 earnings? For years they have stated that they felt self-employment taxes should apply.

   Well here comes the bombshell! They have accomplished it! They did so by establishing revenue ruling 74-44. They have even gone so far as to issue a warning to newly created Subchapter-S Corporations as part of their notice of acceptance of the S election.

I filed a Subchapter-S election for a new corporation in March 2004. Below is a direct quote from that acceptance notice: We would like to take this opportunity to inform you of your tax obligation related to the payment of compensation to shareholder employees of S-Corporations.

When a shareholder- employee of an S-Corporation provides service to the S-Corporation, reasonable compensation is subject to employment taxes.

Tax practitioners and Subchapter-S Corporations shareholders need to be aware that revenue ruling 77-44 states that the internal revenue service (IRS) will re-characterize small business corporation dividends paid to shareholders as salary when such dividends are paid to the shareholders in lieu of reasonable compensation for services.

The IRS may also re-characterize distributions other than dividend distributions as salary. This position has been supported in several recent court decisions.

Easier Administration
When it comes to administration, the only true difference is in regards to the timing of when the corporate closing functions are performed by the accountant. The C-Corporation requires this attention precisely at year-end. So, in effect the corporation accountant needs to complete this work sometime between late December and January 15th (depending on when the corporation is required to deposit payroll taxes). The accountant for a Subchapter-S Corporation has from late December until March 15 (or September 15 if an extension is filed) to take care of the year-end work. So the issue is not the amount of work, (which is the same either way), but purely the timing of when it needs to be completed.

My personal bias is to get the closing work done sooner rather than later versus letting it linger into the heart of tax season. Furthermore, by virtue of doing the work right at year-end, the accountant has the opportunity to catch overlooked items and make timely corrections. Lastly, my clients preferred to know the year-end results now versus waiting until February, March or later.

I have found that attorneys and accountants who specialize in healthcare corporations almost always recommend the C-Corporation. Attorneys and accountants who only service some or few healthcare providers usually favor S-Corporations. It is my belief that these advisors either do not grasp all the issues or they just don’t want to deal with the crunch of performing all these corporate closings over the holidays. Furthermore, it is my opinion that it is the responsibility of the advisor to provide the client with the best product available. The dentist should not suffer because the accountant desires to spread out their closings to March 15th.

Conclusion
To me it is quite obvious that the C-Corporation still consistently outperforms the S-Corporation, even given the changes in the law. Hopefully, the information contained in this article will help you realize that (at least for healthcare providers) the S-Corporation still takes second place to the traditional C-Corporation.

Vernon A. Schotanus owns The Dental Consultant. He’s been a Certified Professional Business Consultant (CPBC) since 1985, and his exclusive focus is in the area of providing support and advice in the area of dental management. Schotanus has been a member of the Society of Medical and Dental Management Consultants (SMD) since 1982, and served as its Midwest Regional Director from 1985 to 1990. Author of a number of articles for dental management publications, Schotanus is a graduate of the University of Wisconsin with a BBA in accounting, and is also a member of the National Collegiate Honor Society (Phi Eta Sigma). Available for onsite practice evaluations, Schotanus can be reached at (262) 818-1220 or through e-mail at info@thedentalconsultant.net.