Physicians who own and operate their practices wear two hats: clinician and business owner. Although owning a practice can create a complex tax situation, it also presents many tax opportunities.

The keys to optimizing your taxes as the owner of a medical practice lie in your entity’s legal structure. Many structures offer the flexibility needed to change how you’re taxed as your business and its needs grow, but there may be some pitfalls to avoid if you anticipate outside investment.

Consider the tax impact of your legal structure

Your practice’s legal structure has a significant effect on how you’re taxed. The state where you practice will drive which legal structures are available to you. Here’s a rundown of the most common options.

Limited Liability Company (LLC)

If you’re taking on a loan to build your practice, it’s a good idea to set up shop in a way that protects your assets. A go-to option is the LLC, which can shield the owner’s personal assets from being seized to pay off business debt. If your practice’s legal structure does not provide liability protection, lenders may potentially take your personal assets to settle unpaid business debt.

With an LLC, your risk of loss is generally capped at your investment in the company. Also, one of your co-owner’s malpractice debts can’t create debt for you.

Example: Let’s say you’re a physician who opened a medical practice that you co-own 50/50 with another physician. When you set up your LLC, you each contributed $250,000 in cash to the company and took out a $600,000 loan. If your business defaults on the entire loan amount, you can only lose up to your $250,000 investment; lenders can’t go after your personal assets to settle your remaining $50,000 portion of the unpaid loan.

Remember that an LLC member’s personal assets can be used to pay business debt when the member commits intentionally wrongful acts.

The benefits go beyond legal protection: LLCs provide ultimate taxation flexibility, too. By default, an LLC with a single owner is treated as a so-called “disregarded entity” for federal tax purposes, meaning the owner files taxes as a sole practitioner. An LLC with multiple owners is automatically treated as a partnership for federal tax purposes.

With either of these tax statuses, owners report and pay income tax on their portions of business profits through their personal returns, with the entity paying no income tax directly. This simplifies your tax return, but sometimes that simplification can result in missing out in some other tax savings in other entities that we’ll discuss below. However, an LLC can also elect C corporation or S corporation taxation, two options we’ll discuss in a bit.

Pros of LLCs:

• Limited liability protection that shields your personal assets from being taken to settle unpaid business debt
• Flexibility to choose how your business is taxed — including as a corporation or an S corporation

Cons of LLCs:

• Not a permissible legal entity for medical practices in some states
• Potentially high fees involved in starting an LLC

Professional LLC (PLLC)

Some states bar physicians’ medical practices from being LLCs. Instead, they offer the PLLC structure to doctors, dentists, and other professionals who work in fields that require designations.

PLLCs are taxed the same as LLCs and offer similar legal protections. However, they may have a few special requirements related to your profession. For example, many states mandate that all PLLC shareholders be licensed to practice in the profession. In other words, the PLLC form might not be a good choice for a business seeking venture capital investment. That’s because a venture capital group is not a licensed medical practice and therefore can’t always be an owner in a PLLC.

Consider a PLLC if:

• Your state doesn’t allow medical practices to be LLCs
• You want the flexibility to choose how your business income is taxed, whether through your personal tax return or on a corporate tax return

Consider other options if:

• You plan to seek venture capital investment

Professional Corporation (PC)

Some states, such as California, require medical practices to be PCs. PCs are generally treated as regular C corporations for federal tax purposes, meaning the company pays a flat 21% federal income tax on its profits. Unlike sole proprietorships and partnerships, which tax business profits solely through their individual owners, C corporations pay income tax on their own tax return, separate from their owners.

PC owners who participate in the company are salaried employees. PC owners, called shareholders, can also receive additional compensation through dividends, which aren’t subject to payroll taxes, such as Medicare and Social Security taxes.

This is one example of a tax advantage: receiving dividend income that isn’t subject to payroll taxes. But there’s obviously a downside, too: the C corporation structure creates double taxation. The corporation pays an entity-level tax on profits, and owners pay tax on that same money when it’s distributed to them as dividends.

If you set up your medical practice as a PC, your business will pay corporate income taxes on business profits. Those profits can be taxed again on your individual return as you receive dividends from your practice.

S Corporation tax status

Unlike an LLC or PC, an S corporation isn’t a legal structure. Rather, it’s a tax status that can help active owners of profitable practices save handsomely on their taxes. LLCs, PLLCs, and most states’ PCs allow owners to elect S corporation taxation for federal tax purposes.

S corporation owners who participate in management are considered employees for tax purposes. These shareholder-employees take home a salary just like regular employees. Aside from this, S corporations are generally taxed like sole practitioners or partnerships, paying income tax on profits solely through their owners.

However, there’s a subtle difference here that can lead to significant tax savings. S corporation shareholder-employee compensation is split into two parts: a reasonable salary (subject to 15.3% in federal self-employment taxes) and distributions (not subject to self-employment taxes). That means distributions can create meaningful savings if the business has enough profit.

Example: Say that you are one of two physicians who operate and co-own a primary care practice that profits $750,000 before you and your partner are paid. If taxed as a partnership, you and your partner will each be responsible for paying income taxes and self-employment taxes on $375,000 — whether or not it’s deposited into your personal bank account. Self-employment taxes are both the employee and employer halves of Medicare and Social Security taxes; at a rate of 15.3%, you’re looking at $57,375 in self-employment taxes.

If taxed as an S corporation, you and your partner could each take home a $250,000 salary and pay yourselves an additional $125,000 in distributions. By taking the $125,000 as distributions, you’re saving $19,125 in self-employment taxes. Keep in mind that you and your partner will still pay federal income taxes through your personal returns on the entire $250,000 that’s left after your salaries, even if you don’t deposit it into your personal bank accounts — but the 15.3% won’t apply.

S corporation shareholder-employees often try to exploit the reasonable salary requirement by paying themselves a small salary and taking most of their compensation as a distribution, which is taxed at a lower rate. The IRS is aware of the potential abuse and closely monitors whether S corporation shareholder-employees report market-value salaries before taking large distributions. If you’re caught disguising distributions, you face hefty IRS penalties.

Keep in mind that the S corporation status is only available to taxpayers that meet several strict requirements. For example, all S corporation shareholders must be U.S. citizens or residents, and you can have no more than 100 shareholders. Also, when you make a distribution to one shareholder, all shareholders must receive a distribution in proportion with their ownership percentage. These restrictions — and many more — often keep business owners from electing S corporation status.

An S election is made on IRS Form 2553, Election by a Small Business Corporation.

Consider electing S corporation status if:

• You own or plan to own and operate a profitable medical practice
• You want to save on self-employment taxes each year

Avoid the S corporation election if:

• You plan to have more than 100 shareholders or any foreign shareholders
• You want to split business distributions disproportionately among owners
• You don’t want to spend too much getting your business set up

Bottom line

As a physician practice owner, it's essential to consider the tax implications of your business's legal structure and re-evaluate the effectiveness of the structure as your business grows. LLCs, PLLCs, and PCs each offer meaningful tax benefits, but they have plenty of drawbacks, too. And don't forget the benefits of electing S corporation taxation for practitioner-owners of profitable practices.

What you've read may serve as a solid foundation, but there is so much more to taxes as a physician practice owner. Before you start your medical practice, talk to your team of legal and tax professionals to discuss the requirements of each legal entity type and other tax consequences of each.

Join the Discussion

If you are a physician in private practice, what has your experience navigating taxes been like? What questions do you have and what do you wish you knew sooner? Share any resources or learnings that have been particularly helpful to you that you think would be helpful to fellow physicians in the comments.

Ryan Lasker is a certified public accountant licensed in Washington, D.C., and Virginia. He writes and edits accounting and personal finance content with work published in Morning Brew and The Motley Fool.