One common tax mistake can cost you thousands of dollars

Are you the owner of a medical practice taxed as a flow-through entity, such as an S corporation? Most physicians are. We would estimate that 70 percent of medical practices operate as S corporations. As such, you may be paid both as an employee of the practice, receiving a W-2, and as an owner of the practice, through a K-1 distribution.

The key difference between income earned as employee compensation (W-2) and that earned as a K-1 profit distribution is that you pay FICA (Medicare and Social Security) tax on the income earned as an employee, but not necessarily on K-1 profit distributions.

While the large Social Security portion of FICA phases out after income of $110,100 in 2012, the 2.9 percent Medicare tax has no phase out. What’s more, it is scheduled to increase to 3.8 percent in 2013 under the Patient Protection and Affordable Care Act signed into law in March 2010.

While this is only a 2.9 to 3.8 percent tax in 2012 and 2013, we have seen poor advice here cost physicians $10,000 or more each year, every year of their career. Over one’s career, this can amount to nearly half a million dollars of lost capital … for no good reason!

Let’s look at two examples. Do you see yourself in these?

1. Dr. Smith is part of a three-doctor cardiology practice. He earns about $400,000 annually as a cardiologist. He calls the two other doctors “partners,” but technically they are co-owners of the practice, which is an S-corporation. Each month, Dr. Smith gets paid $20,000. Then at the end of each six-month period, he gets another $80,000 based on the practice’s performance. His accountant deems both the monthly and semi-annual payments to be salary payments. Thus, he pays Medicare tax on all $400,000 for a tax of $11,600. This, of course, is in addition to state and federal income taxes, property taxes, etc. If he works for 25 years earning the same income, he will have lost more than $550,000 in Medicare taxes, assuming a 5 percent growth rate.

2. Down the road, Dr. Jones is in the exact same economic situation. However, his CPA treats the monthly payments as W-2 wages and the semi-annual payments as K-1 distributions of the profit earned by the practice. As a result, he pays Medicare on $240,000, for a cost of $6,960. If Dr. Jones works for 25 years earning the same income, he will have lost about $330,000 in FICA taxes, assuming a 5 percent growth rate - an improvement of more than $220,000 over Dr. Smith.

Obviously, any of you reading here would not want to be Dr. Smith. Yet we are continually astounded when we see so many physicians come to us in the same position - having all, or most, of their income treated as W-2, when in fact much of it is earned because of the profitability of the practice rather than the doctor’s personal services. Wouldn’t all of us prefer to be in Dr. Jones’ situation? So, the question really comes down to this: What are the tax rules that govern this situation?

In discussions with a number of CPAs who have more than 15 years of experience, the consensus is that one should follow a simple rule of thumb. That rule is basically that one can reasonably be paid as a W-2 salary what one would need to pay an associate physician with the same training to come join your practice. The rest of your compensation can be characterized as distributions.

One CPA commented, “This is what I do for my clients, and when the issue has been discussed in audits over the years, the IRS finds it very difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job.”

Looking again at the examples above, Dr. Smith could easily attract another cardiologist to his practice paying $250,000 salary. This would allow him to avoid Medicare tax on $150,000, saving more than $4,000 annually. Not coincidentally, Dr. Jones is in the right situation.

As hard as physicians work, throwing away hundreds of thousands of dollars over a career for no good reason is a shame. Yet it happens every day.

David Mandell, J.D., M.B.A., is an attorney, author of five books for doctors, and principal of the financial consulting firm OJM Group. Carole Foos, C.P.A., works at OJM Group as a tax consultant. They can be reached at mandell@ojmgroup.com or 877-656-4362. We encourage you to contact us at OJM for a free consultation to discuss your 2011 taxes and what you can do to reduce them. Please contact David B. Mandell, J.D., M.B.A. at 877-656-4362.