When a dentist starts a dental practice or restructures an existing dental practice, one would think there are best practices when it comes to what type of entity should be formed and how it should be taxed. But there are many nuances and considerations that well-respected tax and legal professionals differ on when it comes to these matters. Therefore, rather than provide a detailed summary of each and every entity and tax choice that a dental practice can have, this article focuses on the practical options for one- or two-person dental practice entities.
Are there certain business entity forms that should be avoided?
Yes, there are certain business entity forms that are either (a) not a good choice or (b) simply not relevant to today's choices of business entities.
First, a sole proprietorship should be avoided at all costs. A sole proprietorship does not involve the creation of an entity. Rather, all assets belong to the dentist; all tax consequences are borne by the dentist; and all liabilities, which can be unlimited, are borne by the dentist. It simply makes no sense for anyone to operate a business as a sole proprietorship.
Second, limited liability companies (LLCs) have supplanted general and limited partnerships. The lack of limited liability protection for the partners of a general partnership or the general partner of a limited partnership is a significant disadvantage when compared to other options. Thus, the partnership entity—whether general or limited—is rarely used by service professionals, especially one- or two-doctor dental practices.
What entities are recommended for state law purposes?
In most instances, it is recommended a dentist form either a limited liability company or a corporation, both of which are discussed below. Both entity forms shield the owner(s) from the acts or omissions of the entity employees as well as other liabilities generated by the business operations. Thus, either entity form is a good choice when it comes to personal liability protection. Under no circumstances, however, will entity formation protect the individual dentist from his own tort, such as malpractice.
What about a corporation?
By forming a corporation, dentist-owners may protect themselves from personal liability. That is, the owning doctors are not personally liable for any debt, obligations, or liability of the corporation merely by reason of being a shareholder. There are, however, certain disadvantages in operating the corporation, including certain corporate formalities that must be followed. As an example, there are certain requirements to maintain minutes and have certain meetings within a corporation that limited liability companies do not have. That said, this formality in and of itself is not determinative as to the entity choice. We must also consider the tax implications of each entity.
What about a limited liability company?
By forming a limited liability company, dentist-owners have similar protections as corporations. The owning doctors are not personally liable for any debt, obligations, or liability of the limited liability company merely by reason of being members. But most state laws regarding limited liability practices do not require similar corporate formalities as the laws do for corporations. According to many advisors, this lack of a corporation formality requirement is a distinct advantage for limited liability companies. But as mentioned above regarding corporations, the tax implications of each entity must be considered.
What are our tax options for a corporation and a limited liability company?
Prior to discussing the distinctions between a limited liability company and a corporation for tax purposes, we have to discuss certain tax concepts.
• Partnership—A partnership is what is known as a pass-through entity. This means that the entity itself is not subject to taxes. Instead, all income, losses, and credits flow through to the partnership's individual owners and are recognized on their individual income tax returns. But unlike a single-member limited liability company, a partnership must file a tax return even though the entity itself is not subject to tax. One of the benefits of a partnership is that it affords flexibility in determining how the income and losses of the entity will be allocated among the partners. But this means that you must have partners before you can be taxed as a partnership.
• C corporation—A C corporation is subject to double taxation because it is not a pass-through entity. The C corporation itself is taxed on all of the business earnings, and those earnings are taxed a second time as dividends when they are paid out to the C corporation's shareholders.
• S corporation—An S corporation, on the other hand, is a pass-through entity subject to only one level of tax, similar to a partnership, but with some very important differences. The main difference is that S corporation distributions must be allocated in proportion to the shareholders' ownership percentages. One of the significant S corporation benefits is that owners can reduce their employment tax liability by managing their reasonable compensation in relation to the S corporation's net-profit distributions.
• Disregarded entity taxed as a sole proprietorship—When a business is operated as a sole member limited liability company, it is treated as a sole proprietorship for tax purposes. A business that is treated as a sole proprietorship is disregarded for tax purposes. All items of income, loss, and credit from the business are reported directly on the owner's individual federal income tax return.
If a dentist chooses a state law corporation as his or her entity, the dentist must understand that corporations are limited in terms of how they may be taxed. Generally, the corporation can be taxed as either a C corporation or an S corporation. This limits the owning doctors' flexibility in terms of the initial formation, all the way through to the sale of the dental practice. On the other hand, a limited liability company, depending upon whether it is owned by one or more dentists, can be taxed as a C corporation, S corporation, partnership, or a sole member disregarded entity taxed as a sole proprietorship. This flexibility, when it comes to the tax side, is a significant benefit over state law corporations. Thus, we encourage all of our dental practices, if allowed by state law, to form limited liability companies versus corporations.
Finally, how a limited liability company should be taxed will depend upon how many owning doctors there are and whether this is a new dental practice or an existing dental practice, including whether that dental practice is losing money or making money. It all depends upon the facts and circumstances of that particular practice. Ultimately, if the facts are favorable, we recommend limited liability companies taxed as S corporations.
Vincent J. Nardone, Esq., LLM, is the managing member of Nardone Limited, headquartered in Columbus, Ohio. Nardone Limited is a boutique business and tax advisory firm specializing in representing dental practices, individual dentists, and dentists' families, as well as other professionals in the dental industry across the United States. Mr. Nardone can be reached at [email protected] or via telephone at (614) 223-0123.
