74: Dental Partnership Legal Structure

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Welcome everybody, to another episode of the Dental Boardroom podcast. Sorry, everybody. It's been a little while. December is a very busy month for us over at Practice cfo. We are doing a lot of year end planning for our clients. It's so important for all of our advisors and our full team here that we dot our I's and cross our T's with getting the most tax deduction as possible for our clients, all of whom are dental. And so we sort of know the specific nuances of the tax deductions for a dental business. And we spend a lot of time making sure the payroll is designed right. We make sure that the 401k and if there's a defined benefit plan, a cash balance plan in the practice, that that also ends off exactly where we need it to be. It's almost like you've got these, these 30 different levers and you want all of the levers to be positioned in just the right way to maximize the output financially for the year and minimize the taxes for the year. We've got a great tax team here and they are working so hard right now getting ready for the launch of the 2025 tax season, doing the 2024 tax returns. And also our 401k department is also busy at work working on the annual testing and all the requirements for those darn complicated 401k plans. We really do take off all the complication from our clients and handle that ourselves as much as we can. All right, so I am carrying on the thread of partnerships, specifically dental partnerships. We've covered the pros and cons of dental partnerships, some of the risks with dental partnerships. We've covered how dental partnerships are valued when a new partner is joining in. This one, I want to talk about the legal structures of a dental partnership. Now, let me caveat that I am not an attorney and I am not the one, as a CPA and financial advisor who will actually set up the legal documentation with the Secretary of State to register you as a live business. That is generally what you will get from an attorney. Now, some dentists will DIY this, they'll do it yourself. This. I don't recommend that. I think it's such a minimal cost for the value to have it properly set up by an attorney, specifically a dental attorney would be great. Although any attorney should be able to do the basic setup work for you. Now, some of you may know that every state has different rules around the type of entity that you can operate as a dental practitioner, as a dental owner, a dental business Owner. Some states require you to be set up as a corporation, or what's called a professional corporation, California being one of them. Other states allow you to be set up as an llc, a limited liability company company, and those are much more easy to administer from a regulatory standpoint. However, LLCs do not exist to the IRS. The IRS does not even have an LLC tax return. Doesn't exist. An llc, when it files its tax return, has to decide is it going to file as what's called a sole proprietorship, or is it going to file as a corporation? And if it's a corporation, is it going to be an S corporation or a C corporation? You can drop kip the C corporations. You should not be, under any circumstance a C corporation. You should be either a sole proprietorship or an S corporation, or preferably in virtually every case, an S corporation. For single doctor owners. When there's multiple owners, that changes things. And that's what we're going to get into today. Now, in addition to the sole proprietorship tax return, which goes right on the 1040, and the corporate tax return, which files a separate return separate from the 1040, that files what's called an 1120 tax return, if it's an S corporation, it files an 1120s tax return. So there's one more, though, and that is the partnership tax return. Yep, it's literally called a partnership tax return. And sometimes we think of the term partnership as just a few people going into business together. And that's true. You can use it, colloquially speaking, in that manner. However, to the irs, partnership has a very specific terminology and a very specific meaning to it. A partnership is a specific legal structure from a tax standpoint that determines how taxes are recognized across those business partners. Now, two people can go into business as a partnership and run as a corporation. That's totally fine. But in this podcast episode, as I use the word partnership, I'm referring to the IRS stated terminology of what a partnership is. All right, let's dive into this now. Going one more comment back on the states. Any state allows you to be set up as a corporation or a partnership. All states allow that. And depending on which one you choose, you would file with the IRS a corporate tax return or partnership tax return. Some states, as I mentioned, allow LLCs, and the LLC can file as a sole proprietorship, as a corporation. But also, and this is why I'm bringing up the LLC again, it can also file as a partnership. It can choose any one of those. So depending on your state, you're going to want to talk to an attorney, a legal advisor preferably. I'm always a fan of the dental specialty service providers in the accounting space, in the tax base, in the financial advisory space, and in the legal space as well. So find that dental attorney on my tech company practice orbit.com if you create a free account, log in, there's a directory there at the top and in the directory you can choose attorneys. And I have a great list of some vetted, wonderful attorneys who can help you set up your entity structure in your state.

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Let's not dive into legal structures. And if you're watching this on YouTube, I've got a PowerPoint which I'm showing right now, and I'm going to kick off by talking about what are the pros and cons of setting yourself up with another partner as a corporation. So whether it's one partner you have, so there's two of you, total or more partners, you can set yourself up as a corporation. And typically the corporation is what I recommend for a single doctor. We recommend the S corporation for partnerships. We don't. And I'm going to get into why. But I want you to understand how a corporation works and how it is different from a partnership. Because the more that you can understand this, the more intelligently you will be able to communicate with your advisor, your cpa, and even understand your cash flow and your tax planning. And as much as I want you to delegate financial decisions to your team, like your practice CFO advisor or your CPA or your practice management consultant, there are certain aspects of being a great business leader as a CEO that I do not believe you can delegate. I think you have to be intelligent around your numbers. I think you have to review your numbers and I think you have to understand them very well. And in order to be effective in understanding those numbers, there are certain key points about the legal structure that you are set up as that I think you need to understand. So let's talk about a corporation. First of all, a corporation files its own tax return separate from you and it can be a C corporation or an S Corporation. Think of S as like small business. C corporations generally are for larger businesses. Small C corporations allow. All public businesses are going to be C corporations where there is endless shareholders, so to speak, trades on public stock exchange, et cetera. You could be a C corporation as a dentist, but the reason why you don't want to be a C corporation is because the C corporation pays taxes as its own taxpayer and then it issues its income, its net income out to its shareholders, the owners of that corporation, and as dividends. And the shareholder will then pay taxes on those dividends as income. They call that double taxation. Taxes at the corporate level and taxes at the individual level. Double taxation, not good. That's a lot of money getting routed to the irs and we want to avoid that. So as a dentist, you can control this. You're not planning on having investors most likely. Maybe if you're going dso, you eventually you create a central organization, a management entity, and that could be a C corp generally. Those are even partnerships though too. But I do not recommend it because of that double taxation. So I'm just going to kick that out of the conversation. We're not even going to talk about C Corporations. Please don't be. As a small dental practice owner, you know, sub 5 million, even sub 10 million, whatever. Don't be a C corporation. All right, let's talk about the S corporation then. Now, S corporations don't pay taxes like a C corporation. Yes, they are a separate entity from you, the individual. Yes, they have their own tax ID called an employer Identification number or ein. And yes, that tax return is going to spin out profits on the return that goes to the irs. But guess what? The IRS does not make you pay taxes on your profits of an S corporation. Instead, what happens? And try to follow this. If you've been around as a business owner for a long time you probably already get this. But what happens is those profits in your S corporation roll out to you and they land on your personal 1040 tax return and they're added to your W2 income to sum up to what is your total taxable income. So if you don't have any other sources of income, spouse doesn't have any income, you don't have any rental properties, you don't own any stocks with dividends and interest, no other investments, and all you have is your dental practice as a corporation, you're going to get that rollout of profits. It's called a flow through. The profits flow through on this document called a K1. K1 is a big terminology. It's a big kind of term in the tax base. Every entity that's not set up as a C corporation, or whether that's a partnership, whether that's an S corporation, is going to issue out or flow out this document called a K1, and it's going to show your share of profits that you're going to be taxed on as a individual owning shares in that entity. And so it avoids double taxation. Now it's taxed at ordinary rates where dividends from a C corporation are taxed at lower long term capital gain rates generally. However, the single taxation at the individual level is almost always lower than the double taxation when you combine the corporate tax with the dividend income tax. All right, hopefully this isn't too complicated for you. You can rewind it. Listen again, I think this is important to understand how these C corporations work and why they're not a great idea for partnerships. And so let's go back to this S corporation for a minute on the S corporation. As a corporation, you are required to pay yourself as an employee of your corporation. And so if you don't have a payroll to yourself as the owner, you're going to get audited. Almost guaranteed you're going to get audited. And then the IRS is going to get their nose in the tent and they're going to want to open up everything sometimes and then it gets nasty. Insufficient W2 wages is the number one reason why small businesses get audited by the IRS. And that's their foot in the door. You don't want to get on their radar. So make sure you pay yourself a sufficient wage, which I think should be at least 40 to 50% probably of what is the combined total profit of that S corporation. The second thing that rolls out to you, as I mentioned, is the K1. So you got these two things rolling out these two pieces of paper they roll out into your 1040 tax return. The W2 and the K1, and you add those up, and that is your total income. Income. All right, now let's go through the pros and the cons of corporations as they relate to partnerships. So let's say you and I decided to form a dental partnership together, and we decide to do it in the formation of an S corporation. Here are the pros. Corporations have better liability protection than partnerships do. And also this one's. Try to follow me on this on this next benefit. One of the benefits of S corporations is that you have two forms of income flowing out. As I mentioned, you have W2 income, and whatever's left in profits is K1 flow through income. Think of it like a teeter totter. If your total profits before paying you a W2 out of your corporation are $500,000, and you pay yourself $200,000 as a W2 through your payroll company, and you have $300,000 therefore left, your total is 500,000. 200,000 as a W2, 300,000 as a partnership. Guess what? You only pay FICA taxes on the W2 as of right now. And there's been discussion for many years of applying FICA taxes to your K1 flow through income. You get to save a little bit in FICA taxes. What are FICA taxes? And that's Social Security and Medicare, which is a total of 15.3%. It's 7.65% employee and 7.65% employer. And so it ends up being 15.3%. That can be a lot of money. However, keep in mind that the Social Security caps at around $160,000, and that changes every year. And so after that, you're only paying Medicare. And the Medicare tax is 1.45% each. That's 2.9% total, therefore. So the difference between if you're paying yourself more than 160,000 W2, and if you're a bigger practice doing, you know, $1.52 million, you should probably be paying yourself a couple hundred thousand in W2. You could probably get away with 150,000 just fine. But the more you get above the 160,000 Social Security cap, the less of a benefit is to pay yourself a lower W2 and have the rest issue out to you in the K1 flow through profits. But it can be a benefit. And if your corporation is a little bit smaller, your business is a little bit smaller, maybe you can get away with paying yourself $100,000 W2, and then you're saving 15.3% on the next $60,000. That's a lot of money. And then of course for 2.9% on anything above that. So what we typically do with our clients who don't have 401 s is, is we try to get them as low as a W2 as possible. However, when you have a 401k or DB plan, then you typically want to raise your W2 to allow you to fund more into your retirement plan. So going over a lot of key financial topics here as a dental practice owner. Okay, so those are the pros. Now the cons are that profits must be distributed on the K1 Pro Rata with ownership. Let me say that again. Profits must be distributed to the owners pro rata based on ownership in corporations. So if you're a 5050 owner with another partner in your corporation, meaning that you want 50% of the shares and your partner owns 50% of the shares. And let me emphasize, shares relate to corporate stock. Corporate corporations, you have ownership through share ownership. Just like shares in Apple, you have shares in your corporate stock if it's a 5050 split of the share ownership in your S corporation between you and your partner, no matter how much each of you produces. Are you looking to buy or sell a dental practice? 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No matter how much one of you works overtime and one of you doesn't, it doesn't matter if one person will works one day a week. It doesn't matter if one person doesn't work, period. They're completely passive. Whatever the profits to the corporation are, those profits are split 50 50. Now you're gonna have to perk up your ears a little bit on this one. With these flow through entities like an S corporation you have, the profits are required to be split 5050 between the two partners. In that case of a 5050 ownership, if it's 75 25, profits are going to be split 7525 on the K1. But keep this in mind, the K1 is just a document. It's like the W2 you get at the end of the year. It's just a document. It doesn't matter if you ended up taking 90% of the cash and transferred that into your own checking account outside of the corporation, or if you took 10%, it doesn't matter. You're going to be taxed on 50% of the profits. Generally what you do is you align the actual cash distributions out of the partnership checking account to the personal account in the same manner that you do on the K1. So if you're 50 50, every dollar that comes out as a profit distribution should be allocated 50 50. So 50 cents each. Otherwise you start to have problems. One partner is going to be taxed for for more than they received in cash and you don't want that. And here's the other thing. Let's say you had $100,000 of net profit in your corporation, but you did not distribute a single dollar it's just sitting there in your corporate checking account. Guess what? That $100,000 is still going to flow out on the K1 paper, and it's going to show $50,000 to partner A and $50,000 to partner B and you're going to pay taxes on it. So the benefit of the S corporation is you don't pay double taxes. But the disadvantage is that you have to roll out the profits on paper and pay taxes on it whether or not you actually took the cash out of the corporation. So there is a decoupling of the cash flow with the tax reporting for purposes of taxation. This is why it's very important to be intentional with your CPA or your advisor to, to meet with them during the year to project out cash distributions and taxable distributions. And caveat. If you get a loan in your corporation that puts cash in your corporate checking account and you pull out more cash than you have in actual profits, taxable profits, you may end up paying a penalty on that. The IRS does not want you to pull out more cash than your income, your taxable income on the K1. If you do, you're going to have what's called excess distributions, penalty tax. You want to avoid that. That's why. And that happens a lot, especially for young dental practice owners who buy a dental practice, they have very low taxable income on their K1 because they're depreciating all the goodwill and equipment that they bought. They're deducting all of that. And so they have a very low taxable income, but they pull money out because the bank gave them $100,000 of working capital and they use that to live on. And then they have excess distributions, and that's not a good thing. So you got to plan around this stuff. Now, coming back to partnerships, summing this up, if you're a partnership and if you have a partner and you're set up as an, as a corporation, you have to take distributions based on your corporate ownership, regardless of how things play out, in who produces what and who produces more value. And so that's one of the disadvantages. There's no flexibility in how you allocate the taxable income and indirectly how you allocate the cash. You've got to do it based on ownership. The other thing, too is that dentists like to and should run certain perks through the corporation to give more tax deduction, things like your car expenses, things like certain meals, certain travel, maybe some ce. You know, we get a little bit aggressive sometimes with that kind of thing to reduce your taxes. What if one partner is doing a lot of that and the other one isn't? What if one partner just bought into Tesla, put it in the corporation and the other one didn't buy a car and yet each doctor is getting the tax effect of that decision, of that financial decision, and so it ends up being skin off one partner's back to benefit the other partner. And it's very difficult. And so what a lot of times partners will do who are set up as corporations is at the end of the year they sort of have a ledger of how much personal money personal expense was run through the corporation versus the other. And they issue a W2 to one partner to True them up or make them whole from the other partner. Now visually you're probably struggling to conceptualize that in your mind, but just know that's a sticky thing at the every year, at the end of every year to true up who ran more personal expenses through the corporation through this W2, which then you can't control your W2 because your W2 is being controlled by other factors. And I don't like that. I like my W2 to be controlled purely on tax planning and 401k planning and personal financial planning. A lot of reasons then to not be a corporation as a partnership. Alright, let's go on to the next option, which is a partnership. Now, when I started the podcast, I said this is actually a legal entity with the irs. It's called a partnership. And the pros with partnerships, which file what's called a 1065 tax return, the pros with the partnerships is that profits can be taken in any way partners agree. So let's say you're a 5050 owner in this partnership and one partner is completely passive. Now, that's generally never the case, but I'm going to use that as an extreme, just to punctuate my point. You can say that 100% of the profits flow out to one partner, the partner that's working even though ownership is held 50, 50, and the passive partner may only be in it for the equity. Eventually when it sells, they will cash out equity, almost like a stock, for example. And you can do anywhere in between. You can do 99%, 1%, you can do 50, 50, whatever you want to do, you can do. And I love that flexibility of partnerships. It sort of unstraps us from the ownership allocation of 5050 or whatever that ownership allocation is. And it lets us be much more. It lets us distribute profits and cash in a way that's Much more commensurate with the input of value. And so we generally recommend partnerships. Now, by way of terminology, you don't have shares in a partnership like you do have shares in a corporation. Instead you have what's called partnership interest. You have interest in a partnership. Interest is to partnerships as shares is to corporations. Just a little education there. All right, what are the cons of dental partnerships? They don't have the same level of liability protection as corporations do. And that I don't like. And most attorneys don't like that either. So that's number one. Number two is that let's say you're 5050 and you're both in the practice by and large the same amount of days. One of the issues still is if you want to get extra tax deductions for things like your travel and CE and car, and putting your kids on payroll, for example, or a spouse on payroll to fund the 401k for your spouse. And a lot of these tax planning strategies, you still have the challenge of having to true it up at the end of the year. And again, that's just a sticky, complicated Excel spreadsheet based exercise that you got to go through the ledger and make sure you have all of that. Now sometimes you may have a CPA who keeps track of those throughout the year and at the end of the year they sort of do a troop. Now you can do that, but it's still a bit sticky and usually not going to be done perfectly right. The other thing too is that it sort of creates this fluffy inaccuracy in the true profitability of the practice when you cloud it with those personal expenses. And that is a con that I don't like about partnerships. So now let me go to the next one actually, before I do, one more comment about the partnerships. Just like S corporations, partnerships are also flow through entities. So whether or not you keep the profit cash inside of the partnership or distribute it during the year, it doesn't matter. The net profits that are calculated on the tax return are going to get pushed out on a K1, just like the S corporation, and and it's going to be added to your 1040 tax return and you'll pay taxes at ordinary rates on that. But again, it's a flow through. So the partnership does not pay an income tax and so it does not have double taxation. One other comment on partnerships. Unlike S corporations, partners of partnerships do not pay themselves a W2 compensation. Instead, 100% flows out on the K1 to the partner. As a partner, you can pay Yourself, what's called a guaranteed payment. Think of that as like your salary. Think of that maybe as like 33% of your own production, as if you were an associate. And you would call that a guaranteed payment, not a W2A guaranteed payment, but the guaranteed payment flows out on your K1. And then once you, after the guaranteed payment and after all your employee expenses, and after your labor, lab supplies, facility, marketing, admin, after all of that overhead, whatever's left is then distributed as profit. And so your K1 would have two boxes filled. It would have one for your guaranteed payment, and it would have one box for your flow through profits. I think it would be really valuable to pick up a K1 and look at it and understand that. Okay, let's now move on to my preferred legal structure. Most dental attorneys that I work with also recommend this. It's almost universally accepted a among those who understand dental to structure it this way. And it's called a partnership of corporations. And a partnership of corporations incorporates both the corporation and the partnership together. And here's how. Instead of you owning that 50% partnership interest in the 1065 partnership, you own 100% of an S corporation. And in turn, your S corporation will own your partnership interest, interest. So you own the interest in your partnership, but you own it indirectly through this layover called your own. I usually call it your own personal corporation. And then your personal corporation, that middle entity between the partnership and you personally, will receive 100% of your guaranteed payments and distributions from the partnership. It'll receive 100% and then from there, Here are some of the benefits. You can be as aggressive as you want in your corporation, and it's no skin off the back of your partner. You can put kids on payroll, spouse on payroll, run your trip to Hawaii if you want to get that aggressive, and say you had a dental CE event while you were there. All of that stuff you can run through your own corporation. And it doesn't cloud the true profitability of the partnership. The partnership is where all the true operating income and expenses of the dental practice run through. And then once a month for our clients that we do partnership work for. And we have somewhat of a specialty here at practice CFO in dental partnerships. Once a month we give you a statement, and it tells you how much you can distribute out of that dental partnership into your S corporation. And then from there, we structure your own W2 payroll, we structure your family payroll. We direct you on what to run through the business, what not to run through the business, et cetera. And that way we get a lot of these benefits S corporations without the disadvantages that partnerships create. And so that's just such a great option. If you have four partners, you could have a partnership and then each partner has their own personal corporation that they own 100% and they get their monthly distributions here at practice CFO, for example, I'll be a little open book with you. I've got five partners and each month we pay each other a guaranteed payment, which is essentially a salary. And, and then once a quarter when we run the numbers, we determine how much we want to keep inside of practice CFO's checking account. We take any surplus above that and we distribute it pro rata based on ownership. And that's a profit distribution right there. And it goes into our own personal S corporations. And then from there we all do our own thing for tax planning W2 and 401k purposes. Now, on the note of a 401k, in that example, you've got various entities, one partnership, multiple S corporations. Those all are what are called affiliated groups and all subject to the same 401k plan. Same with a medical plan. You can't just carve out your employees and do a 401k in your personal corporation to the Department of Labor. It's all one entity. And so for testing purposes, it all runs or flows together for purposes of these government sponsored benefit plans, like health insurance plans or flex spending accounts or 401ks or defined benefit plans. So keep that in mind as well. Okay, so to summarize, never be a C corporation. If you're a partnership, don't be an S corporation for the lack of flexibility. Be a partnership, but own your partnership interest through your own 100% owned personal s corporation. And that is the best structure. Now if you're watching this on YouTube, here's a little diagram of how this would work. If you're listening, I'll try to explain this. Just what I'm looking at. In the middle you have a circle, that's your partnership. And up on the top right and top left you have two corporations owned 100% by owner one and owner two. And distributions are made out of that central partnership entity up to the corporations every month. And then from there in the Corporations, the Owner 1 and Owner 2 can respectively run their own perks, their own W2, and they can take draws out of those corporations to themselves personally as well as their W2. And that is called a partnership of corporations. And what I recommend for dental partnerships. All right, let me close up by Just stating that in these partnerships you have what are called partnerships agreements. In corporations you have what's called operating agreements. But partnerships have partnership agreements. Now, I know I'm delving into the space of an attorney right now, but I think this is pretty basic, so I'll just go ahead and share my thoughts on this. It's extremely important when you set up a partnership of corporations or just a partnership. Now in that partnership, you have a partnership agreement that outlines how that partnership is going to be run, who has voting rights, who has certain responsibilities, how profits are going to be allocated. So if you're on YouTube watching my screen right now, make sure that in the partnership agreement you clearly define responsibilities. And I mentioned this before and I'll mention it again in my next podcast on profit distribution methodologies of a partnership. But define responsibilities. Who's handling the financial matters, who's handling marketing, who's handling hr, who's handling facilities and, or negotiating or working with the insurance companies, or training your team or looking at your analytics like dental intel, all of that stuff. Who is going to be doing each of those? Really define that out. Have a clear, what I call accountability chart set up on what you're doing and what each partner is doing and that should be stipulated. And in the partnership agreement number two, define decision making, meaning voting rights. Are the voting rights, 50, 50 are there certain unique aspects to the voting rights so one partner has more voting control than the other partner. Be sure to have that well delineated and understood by all parties going into the partnership. Number three, define profit allocations. More to come on this in my next podcast. There's various ways to allocate that dollar that flows in once it lands into the corporate, into the partnership checking account as it flows through its expenses and whatever's left, how does that get distributed to each owner? And number four, including non compete provision. So if one partner pulls the eject lever, wants to go out on their own, maybe they're mad, whatever. You don't want them going down the street and being able to pull the patience of the practice and leaving the existing partner with all of the overhead potentially and struggling financially. So include a non compete provision in the partnership agreement. Other things not on my screen would be things like buy sell provisions. What triggers would cause or force a partner to sell their interest? Perhaps disability. Obviously death should be a trigger so that the remaining partner can buy them out. And you may want to attach insurance to that. Buy, sell disability, buy, sell life, such that the remaining partner has the capital needed to buy out the other partner Practice CFO can help with all of those items as well. This was a very, very heavy, I would say technically heavy podcast one maybe you want to listen to a couple times. If you can watch my YouTube version of this, maybe that would help as well. If you're a client of practice cfo, you know in all of our meetings that we are always putting this in Excel, projecting out, mapping cash flows to get all those levers lined up just the right way to stick the landing every year and ultimately accelerate growth, financially speaking for you. Thanks everybody for listening. Hope you can tune in next time.