Henry Rosevear, MD, discusses the pros and cons of S corporations and why he decided to create one.
Henry Rosevear, MD
UT Blogger Profile
Dr. Rosevear is a urologist in community practice in Colorado Springs, CO.
People who know me know that I’m pretty cheap. OK, cheap isn’t the right word as I certainly do like to vacation, but when I can save a dollar, even if it creates a bit of a hassle, I will. On the other hand, I’m also very conservative when it comes to the taxman, so I tend to avoid maneuvers that may increase my risk of an audit even if my accountant says they’re legal.
As a result, even though I’ve heard stories of doctors incorporating themselves for years, I’ve always avoided it as one of those maneuvers that, while technically legal, didn’t pass the sniff test. This year, though, I changed my mind and now I am the owner of a new S corporation, Five Roses Urology, PC (named after my wife and four beautiful daughters).
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Why the change? As a resident, I found a website called whitecoatinvestor.com, which is written by an ER doctor and offers physician-specific financial advice. The author of this website has the same conservative financial leaning as I do and, to this date, I have found his advice to be honest and insightful. This year, he converted his company to an S corp, which he says was an easy decision when he considered some of the defensive advantages of an S corp.
Before I explain my reasoning for the switch in more detail, as I think there are numerous other urologists out there who may be in this same situation, let’s go over some background.
Companies can choose to be taxed as a sole proprietor, a partnership, or a corporation depending on the number of owners (one, more than one, or unlimited, respectively). If you choose a corporation, you can decide to be either an S corp, where the person receiving the money pays the taxes, or a C corp, which has its own tax rates. Further, as doctors, we can choose to limit who can join our companies by making it a “professional” corporation (hence the “PC” after Five Roses Urology, PC).
Unless you have a background in accounting, one of the problems with this strategy is that not only are there startup costs, as I had to pay my accountant to draft and file the appropriate paperwork with the state and federal government, but there are yearly accounting costs associated with running the business. My startup costs were under $1,000, and I estimate that my annual costs should be about $1,600 a year, which is not huge, but real.
So why bother? Two reasons. First, from a defensive point of view, having your primary company pay your S corp isolates you in some ways from any potential tax shenanigans by your partners.
For example, maybe one of your partners has decided to write off his Maserati as a business expense. If you are all part of one corporation or partnership, some of that liability may fall to the company, whereas if every partner is an S corp, only the partner who deducted his Maserati is responsible for that decision. And being a little more responsible for my own fate with the IRS is worth some amount of money to me. Maybe not $1,600 a year, but maybe.
Of note, the other significant liabilities that go along with being a doctor (malpractice) and owning a company (accidents and business issues) unfortunately aren’t helped with the S corp. And sure, deducting a Maserati may seem like an egregious example that won’t happen, but there are plenty of gray areas in tax law that two reasonable accountants can disagree on and only the IRS gets the final say during an audit.
The second reason to be an S corp, and this time from an offensive point of view, is to minimize your taxes. As an S corp, you can pay yourself with either “wages” or “distributions.” You pay normal income taxes on both but you only pay payroll taxes (Medicare and Social Security) on your “wages.” This means that you save the 2.9% Medicare tax and the special 0.9% Obamacare tax on any distributions, and that 3.8% can be real money (assuming your “wages” are over $117K so that you max out your Social Security contribution).
Before we crunch the numbers, we need to talk a bit about how you set your “wages” or salary.
There are two factors to consider when defining your salary. First, you could obviously avoid paying payroll taxes completely by simply taking no wages and taking everything out as a distribution. But the IRS states that you have to pay yourself a reasonable wage. So what is a reasonable wage?
According to the Medscape annual compensation report, the median salary for a physician is $294K and assuming that you practice in Colorado (like me), you can discount this 10%, as my region tends to pay less (the average doctor here makes approximately $265K; turns out other people than me like the mountains so we pay a price in salary to live here). The second consideration, though, is retirement. If your company offers a profit-sharing plan, you probably want to maximize that contribution, which means your salary needs to be at least $271K.
With that in mind, let’s do an example. According to Beckers, the median compensation for a urologist is $441K and of that $441K in compensation, you make $271K in wages (that allows you to maximize your profit-sharing plan contribution while paying yourself a “reasonable” wage). This means that you have $170K ($441-$271) in distributions on which you save 3.8%, giving you a “profit” of $6,460 ($4,860 after paying the yearly expenses of running the company).
Let’s be honest though, you’re not going to retire on $5K. But in my world, (remember I’m a cheap man), $5K is worth the hassle, especially when combined with the defensive advantages discussed earlier. For some, the hassle may not be worth it. Another way to look at the math is that if you’re not making around $312K, you likely aren’t making enough to pay for the administrative costs of an S corp with the 3.8% payroll tax savings. You still get the defensive benefits of the structure, but there won’t be a bonus check at the end of the year.
What about the downsides? First, if you employ your children to do anything (which, while it sounds a bit sketchy, my accountant swears is legal), the tax burden goes up a bit. If you were in a partnership, no payroll tax is due and if you keep the total amount low, there is no federal or state income tax either. Further, since it is earned income, not only is no kid tax due but you could also put it in a Roth IRA and let it grow tax-free for years.
The only thing that changes as an S corp is that you do have to pay payroll tax (about 15.1%, including Social Security), but that is much lower than my marginal tax bracket of 45% (remember, distributions are still taxed as income). On the other hand, it only takes $1,300 a quarter to earn a quarter credit with Social Security and you need 40 quarter credits to earn Social Security, so this may be a way to help someone earn Social Security who may otherwise not. (I have four daughters and one of them may become a stay-at-home mom and never contribute to Social Security.)
The other downside is the temptation to not fully fund a 401k, profit-sharing plan, or Social Security contribution so that you can lower your salary and take more out as distributions. Think of an actual plumber who makes $100K a year. He could argue that the average plumber only makes $25K, but as an S corp, he saves 15.3% on the $75K in distributions (plumbers’ math is a bit different given that their salary assumes savings for Social Security at 12.4% and Medicare at 2.9%, but they do not have the 0.9% Obamacare tax on high income earners). The problem with this strategy is that by not fully funding retirement, you are giving up significant future earnings. This is less of a problem for us, given the average salary of a urologist, but it should be something to think about for a urologist working part time.
Overall, for us small-town urologists, electing to incorporate as an S corp can limit exposure to some risks while providing a small tax benefit with minimal hassle. No one is going to retire on this maneuver but given the average urologist’s salary, it shouldn’t cost you money either.
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