Article Date: 12/1/2001

Incorporating
Should You Incorporate?

What you need to know to make a wise decision.
BY KATHERINE A. BUMGARNER, M.B.A., Pinehurst, N.C.

At this time of year, many of us try to reevaluate business practices and start to plan for next tax season.

One question I inevitably hear is, "Should I set up my practice as a corporation instead of as a sole proprietorship or partnership? What benefits would I gain from a corporation that I don't get as a sole proprietorship or partnership?" While the legal form of business ownership that's best for you depends on many factors, most people base their decisions on taxes and liability, as I'll explain here.

ILLUSTRATION BY CAM WILSON

5 ways to organize your practice

Five common ways exist to organize an optometric practice. Below, I'll define them. (For more information, visit www.mycorporation.com.)

1) Sole proprietorship. This is the simplest form but isn't its own separate entity. Instead, a sole proprietor owns the business and is directly responsible for its debts.

2) Partnership. Here, two or more co-owners engage in business for profit. For the most part, the partners own the business assets together and are personally liable for the business debts.

3) Limited Liability Company (LLC). An LLC is a hybrid of a partnership and a corporation; it combines the "pass-through" treatment of a partnership with the limited liability afforded to corporate shareholders.

"Pass-through" means that the the profits automatically pass to the owners instead of being retained in the corporation. But like a corporation, an LLC is recognized as a separate legal entity from its owners. In most states, an LLC must consist of two or more owners (called members), whereas a corporation may have only one shareholder.

4) Corporation. To form a corporation, an incorporator must file Articles of Incorporation and pay certain fees and taxes. The label "C-corporation" merely refers to a regular, state-formed corporation.

5) S-corporation. An S-corporation begins as a general, for-profit corporation when the incorporator files the Articles of Incorporation at the state level. But after the corporation has been formed, its board of directors may elect "S-corporation status" by filing the appropriate forms. This allows the income to "pass-through" to the shareholders for computing tax liability. To qualify for S-corporation status, the corporation must be a U.S. one with only one class of stock and with 75 or fewer shareholders who are U.S. citizens.

Note: Incorporated optometric practices are deemed "professional corporations" in most states, and are thus subject to additional licensing requirements.

Many accountants and tax attorneys say an S-corporation typically is best for most businesses with fewer than 100 employees, including optometric practices.

Below, I'll highlight some benefits of incorporating an optometric practice. Consult an attorney or accountant who's well-versed in these issues before deciding which form of business is best for you and your practice.

Income shifting

A major benefit of being a corporation is the ability to shift income between the practice and its shareholders, which lowers overall taxes (you can accomplish this through a dividend). But what about "double taxation" and corporate tax rates? Smaller corporations often aren't concerned with corporate tax rates because profits are usually paid out as tax-deductible salaries and fringe benefits to employees including the doctor, or paid as dividends to the doctor.

If you're set up as a corporation, you may also shift income by leasing your personal property (real estate, equipment, automobile or even domain name) to the corporation, thus providing tax savings. However, because the Internal Revenue Service (IRS) often scrutinizes this type of leasing arrangement, the lease terms must be fair to both parties in the transaction (you and the corporation).

 

Taking Stock of Ways to Organize a Business

Type of Company Liability Operations Management Liquidity & Exit Strategy
Sole proprietorship Unlimited Simple Proprietor Most difficult
Partnership Partners Simple Partners Difficult
Limited liability company None Medium Members Medium
Corporation None Difficult Board Less difficult
S-corporation None Difficult Board Less difficult

 

Self-employment tax savings

In 2000, the IRS's self employment tax rate on a taxpayer's first $76,200 was 15.3%. Any self-employment income above that amount was subject to 2.9% additional taxation, plus the taxpayer's income tax payments. Further, self-employment taxes apply to all of the income a sole proprietor earns, even if he keeps some of the it in the practice to buy equipment, etc.

In an S-corporation, however, only earnings actually paid to an owner as compensation for services are subject to payroll taxes. Money left in the business for reinvestment or distribution to shareholders as dividends isn't subject to payroll or self-employment taxes.

Fringe benefits

Corporations enjoy these fringe benefits:

They receive financial benefits that non-corporate entities don't. Corporate retirement and medical plans can offer higher contribution caps and more flexibility. Unlike traditional sole proprietors, corporations can deduct 100% of insurance premiums with the proper insurance plan.

Corporations can also adopt a medical reimbursement plan and allow deductions for medical expenses that aren't covered by insurance. And they have better retirement plan benefits, with larger contributions.

The business has a legal and tax life distinct from its owners'. The entity can survive even the death of an owner. Also, a corporation has stock, which makes it more "liquid" and transferable than a sole proprietorship or a partnership. If a practice is bought by or merged with an entity of the same type (say both are S-corporations), the transaction isn't taxable as in other transactions involving two different types of entities.

These factors often make a corporation a more attractive prospect to a buyer than a sole proprietorship or partnership.

Becoming incorporated limits the liability of the individual owners. In a sole proprietorship or partnership, the owners have unlimited personal liability for the practice, which places their entire personal assets and wealth at risk.

If an owner is married, he puts the community property at risk, too. Personal liability exists regardless of who was at fault for a problem -- the owner, the partner or an employee.

Consider the disadvantages

The grass isn't always greener on the other side. Here are some disadvantages to consider when deciding whether to incorporate:

Most practices benefit from becoming an S-corporation. However, seek professional counsel before committing to any new form of business.

Ms. Bumgarner is vice president of Eye America, LLC, in Pinehurst, N.C.


Optometric Management, Issue: December 2001