This post will outline the basic structure of how to manage the income from your practice so you know where your money is going, and how to plan for your long term benefit. Simple disclaimer: all of the recommendations that follow should be vetted by your tax adviser for best applicability to your situation. I will address a few common errors and pitfalls.
Financial structure of the practice
Most practices benefit from being organized as either a corporation or as a limited liability company. If you choose to organize as a corporation, a sub-chapter S selection makes the most sense. This is an entity designed by the IRS to best describe a privately held company whose officers provides services to others. This means that your company will never be publicly traded and the main business of the company does not involve manufacturing, agriculture, shipping, etc.
Remember that if you are currently a sole proprietor and you choose to re-organize as a company, the IRS will assign a new tax number to you, no longer using your social security number. This means that all insurance panels need to be notified of the new tax number, which can be tedious and time-consuming.
If there are several principals in the company, an LLC may be best, depending on the overall tax structure. Confusingly, you can elect to be taxed as an S-corp, even if you are organized as an LLC. Here are the main benefits:
- An S-corp would pay some of your income to you as an employee W2 income, just like any other employee. Social Security taxes and Medicare taxes are deductible form this gross income, and are split by the company and the employee. The current tax rates are 13% for Social security and 2.9% for Medicare. So far, this is the same as a sole proprietorship paying SE taxes.
- Some of your income would be in the form of K1, which is defined as the profit from owning and running the company. This income is still subject to income tx, but is exempt from Social Security and Medicare. At a combined rate of nearly 16%, this is an important number.
- You can better protect your personal assets from exposure to legal attack if a corporation or LLC owns the company’s assets.
- You have more flexibility in properly expensing home offices, operating expenses, insurance expenses, etc. This portion is highly detailed and outside the scope of this blog, but does bear a discussion with your consultant or CPA.
If you are following the above structure you need to take the following precautions:
- Your W2 paycheck will withhold your Social Security and Medicare taxes just like for any employee. The program you are using will assume that the W2 income is the only income source, however. If there are other income sources, such as your own K1 income or a spousal income source, the payroll program may under-withhold for the year, leaving you with a tax liability for the next April. A good way to check on this is to monitor your total household gross income and the amount of Income tax that has been withheld. A quick check with your CPA should tell you if you are in the right ballpark or not. If you are low, you can increase the withholding rate, and you will have enough time to do this without having an odious tax burden all at one time.
- Whenever you take money out of the practice as a shareholder draw, this is still considered income by the IRS and will have an income tax liability attached to it. If you take $1000 out of the business checking account, you need to withhold a percentage corresponding to your maximum tax bracket and not spend that amount. For example, let’s use 25% withholding. In the above example, $1000 would be deducted form the business checking account. $750 would go into your personal account, and $250 would go into a separate tax savings account. If you need to spend the $1000 personally, would have to withdraw about $1300 to be left with $1000 after taxes.
- Your quarterly estimated taxes (1040-ES) can be paid out of this separate savings account.
Since the quarterly estimated taxes are due April June, October and January, this is a good time of year to start this planning process. If you do not have the tax liability saved, you will be unpleasantly surprised next April by having to pay the previous years liability as well as the current 1040-ES. Fun, right? Next post will address simple methods for debt retirement and wealth accumulation over time.