As one of the leaders of our firm’s healthcare divisions, a great number of dentists come to me for tax advice on setting up a new practice. More often than not, this is a typical conversation with a hypothetical client upon our first meeting:
Q: What have you done at the state level regarding your practice?
A: I formed my entity.
Q: What type of entity?
A: A PLLC (Professional Limited Liability Corporations).
Q: And did you make any elections at the federal level?
A: Yes, I am going to be an S-Corp.
Q: Where are you in the loan process?
A: I got the loan.
Q: Who is the money loaned to?
A: The loan is to my practice.
And that is when I deliver the bad news: because they have elected to be an S-Corp with the loan going to the practice, any losses they may incur may not be tax deductible at this time.
What are elections?
Basically, elections are the classifications chosen to determine how business will be treated for tax purposes. When setting up a new entity, for legal purposes and for filing state franchise taxes, the first step is to incorporate in the state where the practice will be located. Most dentists choose a PLLC at the state level. Once that is done deciding on what to do at the federal level is next.
On the federal level, the type election will impact how you taxes are filed. Keep in mind, the state does not care which federal election is chosen and, conversely, the IRS does not care which state election is chosen. To keep it simple, the choices are, generally, as follows:
- Standard C-Corp which pays its own income taxes and is a completely separate entity from the owners.
- S-Corp which pays no federal income taxes; it is a pass through entity. The corporate income and/or losses are "passed" through to shareholders for reporting on their own personal tax returns. More times than not, single practice doctors choose this election. In general, shareholders can deduct losses only to the extent of their adjusted tax basis in the S-Corporation stock plus their adjusted tax basis in loans made directly to the S corporation.
- Partnership suggested for practices with multiple dentists (doctors), but for the purposes of this discussion it is not relevant.
How do you determine which election to choose?
If you are opening your own practice, as opposed to purchasing an existing practice, it may not be advisable to immediately elect an S-Corp. The reason: if your losses exceed your investment in your practice, which is your basis, you will not be able to deduct those losses. Those losses must be carried forward until positive basis is established (when income is greater than expenses). This can put a huge burden on a fledgling practice.
Let’s go back to my conversation with my hypothetical client. If during our conversation, when asked whether a loan has been secured, the answer is “not yet” we have a chance to salvage this S-Corp selection with a beneficial tax outcome. Instead of lending the money to the corporation, have the bank make a personal loan to you. Once that is secured, you can turn around and personally make a loan to the corporation. This will generate basis in the corporation and allow you to deduct all of the losses you incur at the start of your practice.
What if, at the beginning of my conversation, my hypothetical client tells me he has formed an entity at the state level but not yet at the federal level? Depending on his situations, I may advise him to stop right there and not make any federal election at that time. That will classify his practice as a disregarded entity, and technically will not exist in the eyes of the IRS. He becomes a sole proprietor whose obligation, as such, is to report income and losses on a 1040, not on a corporate tax return. That frees him to take advantage of those losses incurred in the early years of his practice. Once his practice turns a profit, he can then make the S-Corp selection.
Seek trustworthy counsel
It is advisable to discuss plans for opening a new practice with professional trusted advisors (CPA, attorney, banker, real estate agent) before any decisions are made. The wrong choices will have an enormous impact on the success of the practice.
This article should be viewed for information only and not as tax advice. Please be advised that S-Corporation tax issues are highly complex and any decisions should be in consultation with a tax advisor.
If you have any questions, please contact Erick at 214-635-2541.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.