David B. Mandell
Are you an owner of a medical practice taxed as a flow-through entity, such as an S-corporation? Most physicians we speak to who are "partners" in their practice are in this situation. As such, they are paid both as employees of the practice—via W-2s—and as owners of the practice, as S-corporation owners through a K-1 distributions. The key difference between income earned as W-2 employees and that earned through a K-1 is that you pay FICA (Medicare and Social Security) tax on the income earned as W-2 employees but not on K-1 distributions. While the large Social Security portion of FICA phases out after income of $90,000, the 2.9-percent Medicare tax has no phase-out.
While this is only a 2.9 percent tax, we have seen poor advice in this matter cost physicians $10,000 or more every year of their career. Over their career, this can amount to nearly half a million dollars of lost capital … for no good reason.
How It Works
Let's look at two examples.
• Dr. Smith is part of a three-doctor ophthalmology practice. He earns about $400,000 annually as an ophthalmologist. He calls the two other doctors "partners" but technically they are co-owners of the practice, 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 or so 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.
• 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. Thus, 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 rate—an improvement of more than $220,000 over Dr. Smith.
Obviously, you would not want to be Dr. Smith. Yet, we are continually astounded when see so many physicians come to us in the same position—having all, or most, of their income treated as W-2 income. Wouldn't all of us prefer to be in Dr. Jones' situation? If we are allowed to be, yes. So, the question really comes down t What are the tax rules that govern this situation?
In discussions with a number of CPAs with more than 15 years of experience, the consensus is that one should follow a simple rule of thumb. That rule is that you can reasonably be paid a W-2 salary equal to what you would need to pay a young associate physician with the same training to come join your practice. The rest of your compensation can be characterized as distributions. One CPA, practicing for more than 20 years, 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 his W-2 than a staff member doing the same job."
Looking again at the examples above, Dr. Smith could easily attract a young ophthalmologist to his practice paying a $250,000 salary. This would allow Dr. Smith 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 all the time.
Mr. Mandell is an attorney, lecturer and author of Wealth Protection, MD. He is also a co-founder of the Wealth Protection Alliance, a nationwide network of elite independent financial advisory firms whose goal is to help clients build and preserve their wealth. Mr. Johnson is a partner in Total Planning Concepts LLC, and provides sophisticated business planning to physicians around the country. Total Planning Concepts, LLC is a charter member of the WPA, and can be reached at 1 (800) 554-7233.