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Selecting the Right Practice Entity: Understand the Tax Benefits and Implications


7/13/16

Most medical practices formed today are limited liability companies (LLCs). Forming as an LLC – instead of an S corporation or C corporation – is attractive because LLCs generally offer greater tax benefits. Whereas S corporations have inherent restrictions – including the types of eligible owners (individuals, estates, and certain trusts), the number of owners (cannot exceed 100), and the inability to allocate profits other than based on ownership percentages – LLCs, which are typically taxed as partnerships, can be owned by any other taxpayer. This includes corporations, partnerships, retirement plans, and even foreigners. Special allocations of income and deductions are also permissible.
 
Liquidating Events and Tax Implications
 
A regular corporation, commonly referred to as a “C corporation” due to being governed by Subchapter C of the Internal Revenue Code, typically gives rise to double taxation upon a liquidating event. For this reason, LLCs likewise provide greater tax benefit. An LLC is only subjected to a single level of tax upon a liquidating event because there is no federal income tax ever imposed at the partnership level.1
 
Prior to 1987, there was only a single level of tax when a C corporation liquidated. This was changed by the Tax Reform Act of 1986, which also created the “built-in gains” tax on S corporations. The objective was to prevent C corporations from electing S corporation status just prior to a sale event to avoid being double taxed at the corporate and shareholder levels. Initially, the built-in-gains tax period was 10 years. It was changed to five years by the Preventing Americans Against Tax Hikes (PATH) legislation enacted in December 2015. 
 
For medical practices considering conversion to an S corporation, the built-in-gains tax is imposed at a rate of 35% on any net unrealized gain as of the date of the S corporation election. That gain is realized during the first five years as an S corporation, to the extent it exceeds taxable income. If the corporation can avoid reporting a profit for its first five years as an S corporation, then it can avoid the built-in-gains tax. Eliminating profit for five years would typically require increased payments of officers' compensation, resulting in increased Medicare taxes being incurred. Collection of accounts receivable on hand as of the date of the S election would result in a recognized built-in-gain, as will sale of goodwill – neither of which will have any cost basis. However, the built-in gain recognized from collecting accounts receivable could be offset by a built-in loss from accrued officers' compensation associated with the uncollected revenue.
 
Converting an existing C corporation to an LLC will typically produce two levels of tax. First, the corporation is deemed to have liquidated with assets deemed sold at their fair market value on the conversion date. The asset value reduced by deemed tax on sale would then be a deemed capital gain to the shareholders. Factoring in state income taxes, the total tax bite could exceed 70% - a very steep price to pay.
 
Accordingly, medical practices that are conducted through existing C corporations will probably remain as C corporations. Unlike individuals who are taxed at a lower rate on long-term capital gains, there is no favorable corporate tax rate for long-term capital gain income. Only in the rare instance where a C corporation has a carry forward of prior year capital losses (permitted to carry forward unused capital losses for five years) will there be any tax benefit as a result of capital gains. If a C corporation has a sizable capital gain event and chooses to wipe out its taxable income for the tax year in which the sale occurs via shareholder bonuses, it runs the risk of an IRS attack for unreasonable compensation. 
 
1Various states do impose filing fees on partnerships, including LLCs. For example, New Jersey imposes a $150 per partner filing fee on partnerships that have more than two partners. New York City imposes a 4% Unincorporated Business Tax (UBT) on the taxable income of a medical practice that is not incorporated.
 
Contact 
 
For more information on the tax implications of each respective legal entity and for guidance on selecting a structure that is appropriate for your practice, please contact Neil Becourtney, Partner, at 732-380-8678 or neil.becourtney@cohnreznick.com, or Richard Puzo, Partner and Healthcare Industry Practice Leader, at 973-364-6675 or richard.puzo@cohnreznick.com.
 
To learn more about CohnReznick’s Healthcare Industry Practice, click here.
 

Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 

 
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