There were three dental specialists working together in a group practice in the Northeastern section of the U.S. The practice was well run and extremely profitable (providing approximately $900,000 of annual income to each of its stockholders). Their accountant had formed their corporation and allowed it to remain a “C” corporation rather than taking the time to file for a Sub “S” election (which would have eliminated any possible double-taxation and/or unnecessary payment of taxes that can result from operating as a “C” corporation).

When asked about electing Sub “S” status, the accountant assured the doctors that he could manage their tax issues quite well using the current “C” corporation, that there was no need to convert it to an "S" corporation. The accountant did not bother to explain to the doctors that, as a result of keeping their “C” corporation, that their annual income (which was paid out as W-2 income) was now going to be subject to the 2.9% Medicare tax on their entire income, but if they had taken the Sub “S” election they could have easily avoided this tax on 60% of their annual income (by paying it out as dividends), saving each doctor at least $15,000 in taxes each year, or a cumulative of $45,000 each tax year for all three doctors. But the doctors believed their accountant knew what was best and went along with his decision (and continued to pay this additional $45,000 each year in Medicare Taxes)!

Everyone is aware that the tax revenues for individual States have dropped recently and they are looking everywhere for additional sources of tax revenues, and unfortunately, healthcare practices are at the top of their list. One day the State revenue department (not the IRS) called on the doctors and audited their practice for the years 2005, 2006 and 2007. This particular State does not have a State income tax but it does have an 8.5% Business Enterprise Tax (“BET”) and a 5% Dividend Tax (“DT”). They concluded that the doctors $900,000 per year of W-2 income represented unreasonable compensation and that 50% of that compensation was really corporate profit and as such, was subject to the 8.5% BET (or $450,000 for each doctor times 3 doctors times 3 years = $4,050,000 x .085% ). That tax was computed to be $344,250 for the BET, plus interest and penalties.

Then the now reclassified corporate income of $4,050,000 was now considered a dividend (not W-2 income), and that was therefore subject to the 5% Dividend Tax which added $202,500 to the doctor’s tax bill for a total amount of $546,750 plus penalties and interest that is now due the State, but that is not all.

The State now notifies the IRS of this income reclassification, and that $4,050,000 of reclassified income (over the three years) becomes corporate income subject to the 35% Federal corporate tax rate so the doctors now owe the IRS $1,417,500 for corporate income taxes plus penalties and interest which, altogether will probably increase the amount due to around $1,700,000!

If the doctors had elected Sub “S” status for the corporation, then the corporation could have paid each doctor $200,000 in W-2 income (avoiding unreasonable compensation issue) and then saved the 2.9% Medicare Tax on the remaining $700,000 (saving them $20,300 each); however, they would have had to pay the 5% Dividend Tax which would have cost them $35,000 each for each year ($35,000 minus the Medicare Tax saving of $20,300 = a net tax of $14,700) plus the 8.5% BET or $59,500 for each doctor each year. If they were an “S” corporation, those profits would flow through to the doctors without any State or Federal corporate tax becoming due, so they would not now be facing that $1,700,000 of taxes, interest and penalties to the IRS!

Whether your State has an income tax, a business enterprise tax, dividend taxes or whatever other name they may give it, then prepare yourself for an audit if you have been operating as a “C” corporation and have been paying out all of your profits as W-2 earnings. These revenue agents are looking for additional tax revenue, and the IRS is right behind them. These doctors are now facing over $2,250,000 of taxes, interest and penalties because of bad advice or just by not being informed of the consequences of not electing Sub “S” status. All because the accountant assured the doctors that remaining a “C” corporation was not a problem, and it wasn’t… for the accountant.

The information given in this article does not constitute legal or accounting advice or opinion, and should not be relied upon for any planning purposes. It is provided solely and exclusively for general, non-specific educational purposes.