First Month: Legal Formation

All right, associates, let's now talk about the legal entity structure. Now we've spoken about this in different areas of the Associates on Fire program. But I just want to dive into this at least one more time or maybe go into a little bit more depth here. Typically, as a dentist, you can set your, you set yourself up as either a sole proprietor or, or an S corporation. Now there's also what are called C corporations. And if you're going into ownership with somebody else in a dual ownership or maybe multiple partners, then you form what's called a partnership. That's the legal term, a partnership. And I'm going to leave the partnership structuring out. I'm just going to talk about a single doctor owned practice. Now a lot of times, the simplest thing is you don't even set up an entity and you just operate yourself and that's called a sole proprietorship. When there is no divide between you as an individual and you as a business. And you virtually don't have to do anything for that. Just by default of you not setting up a corporation and getting a separate tax id, you're by default a sole proprietor. Or if you do, what I'm recommending is you set up a corporation and you file what's called an S election to be designated as an S corporation. There are benefits to that. Let me talk about those benefits first. Let's start off with a sole proprietorship. The configuration or anatomy a little bit of a sole proprietorship. Let's look at an example. You have net income in your practice before paying you of $250,000. Let's say the practice is grossing 800,000 and you've got $550,000 of expenses, labor, lab supply, facility, marketing and overhead. And now you're left with $250,000. And that is your form of compensation. And you simply go and transfer that out of your business checking account, your sole proprietor checking account, into your personal checking account. And even as a sole proprietor, let me emphasize you're going to want to, you're going to want to set up a separate checking account for your business that's completely different than your checking account from your, for your personal use. And you're going to want to have all business expenses over here and all collections deposited over here. And then you're going to want to have just a transfer over to your personal account where you have all of your business, all your personal expenses on this side. You want to keep them very, very separate, a Chinese wall between the two for many different reasons, especially for Being able to organize yourself and understand the financial health of your practice, you need to keep all the personal stuff out of the numbers in your business checking account. So again, we're on the subject of a sole proprietor or the example of a sole proprietor. You have $250,000. Now you are going to pay all of your staff a salary. You're going to pay them a wage, an hourly wage, or perhaps just a salary amount. And they're going to rece at the end of the year, a W2 form, and the W2 states, here's how much you paid them, and then they use that to report their taxes on their 1040. Many of you already know this. The interesting thing, though, about a sole proprietor is that you don't pay yourself as an employee of your own business as a sole proprietor. Instead, you simply make transfers from your business checking account to your personal checking account completely outside of payroll. Now, when you do that, you've got to make sure that you're setting aside money for taxes, because as you know, when you're on payroll, you have taxes withheld out of your paycheck, gets remitted to the irs, and at the end of the year you file your tax return and hopefully you get some money back. If not, you end up having to pay a little bit. When you're a sole proprietor, you don't have a W2 for yourself. You're not on payroll. So you have to write checks every quarter to the irs. And those are called quarterly estimated tax payments. Your first year you have a buy, you don't have to do it per quarter. Second year, you have to start making those per quarter. And here is the disadvantage of the sole proprietorship format of running or owning your business is that number one, 100% of that $250,000 is subject to FICA taxes. And FICA taxes are Social Security and Medicare. And Social Security is 6.2 and Medicare is 1.45%. And so that, that adds up. Now that's only half of it because you also have to pay the employer portion. Now that is so that's 6.45, 6.2, and then 1.45%. That's just what all of your employees have to pay that out of their own paycheck. And and then you match that dollar for dollar as an employer. Now, if you're a sole proprietor, you're both, in a way, the employee and the employer. So you're paying 15.3% is the total on what you end up paying just on your own salary. So you're going to pay 15.3% on that income. Now, not all of it, because the Social Security portion, the 6.2% portion, that is only subject on your income to about 140,000, it's a little bit less than that in 2020, but that sort of goes up every year. The other 1.45% is subject on all income you make, no matter how much income you make. So you're paying full FICA tax on every dollar of income with that cap of the Social Security at about $140,000. And a second disadvantage, by the way, I'm going to emphasize with the corporation, you may be able to get away with paying lower FICA taxes, but that's a lot. Remember, 15.3% on say, $100,000 is $15,300. And you haven't even gotten to federal or state income tax. This is just FICA tax. So the second disadvantage, as a sole proprietor, you're probably making a lot more money than most sole proprietors because remember, sole proprietors are people out there maybe, maybe cleaning some windows or just doing some, you know, some random basic jobs here and there. And they don't set up a corporation and they want to keep every, all their expenses really low. And relative to those people, your income probably stands out to the irs. And so as a sole proprietor, if you have higher income, there's probably a higher likelihood of IRS audits. Now these days, the number of audits of the IRS is just dropping and dropping and dropping and dropping, and they're focusing a lot more on very high income earners. But nonetheless, you still stand out a bit more. If you're a high earning sole proprietor, doesn't mean you're going to be audited. It means the probability could be perhaps a little bit more that you might be audited. The other thing too is you don't have liability protection because you don't have what's called a corporate veil. You don't have anything protecting your personal assets. And so if you are, if you are sued because somebody in your office comes in on their way out, they slip on the sidewalk and you didn't apparently clean it or whatever, and you know, they fall and they sue you, then you could be forced to sell your house, you could be forced to sell your cars, you could be forced to garner your income, garnish your income, all to pay that back. Because there is no separation between your corporation and you personal, between your business and you personally when you're set up as a sole proprietor. Now Keep in mind that malpractice is not going to be protected by a corporation. And in fact, why don't we jump to a corporation now? And one of the first benefits is that you do have greater liability protection. But I'm no attorney, but from what I've understood from the attorney is malpractice pierces the corporate veil. A malpractice lawsuit and you could be subject to give up personal assets in order to satisfy a legal claim against you on a malpractice lawsuit. But any other type of lawsuit is an employment lawsuit or an injury lawsuit that doesn't relate to clinical treatment. That is going to stop at the corporate level. And whatever you have personally, savings accounts, retirement accounts, your house, all that stuff that's going to be protected from a lawsuit. So there is that benefit of having an S corporation. Now, one thing that's really important is that a lot of states allow you to set yourself up as a limited liability company or an LLC. In other states they're called professional associations or PAs. Some states require don't allow those, those formats of setting yourself up. Well, one thing I want you to remember is that the LLC and the PA are simply a state designation. That is a simpler format administratively than forming yourself up as what's called a professional corporation. And that said, for tax purposes, I all of these will file the tax return the same way. They'll file the same tax return. Taxes are all going to be the same, both at the state and the federal level. The IRS doesn't even recognize an LLC for purposes of filing an LLC tax return. There's no such thing as an LLC tax return. The LLC has to decide to file as a sole proprietor or to file as an S corporation. So many of our clients who are in states that permit it are LLCs at the state level, but they file as an S corporation. If you're here in California, you set yourself up as a professional corporation. LLCs are not allowed, but you still file the exact same tax return. The only disadvantage is that as a professional corporation, you have to do corporate minutes every year. And it's just a little bit more cumbersome from an administrative standpoint to manage the mechanics of a corporation than say an llc, which is a much simpler version of forming your entity. So if you're in a state that allows an llc, do the llc. If you're not, then you've got to do the professional corporation. So back on topic. So now you're an S corporation and you've got $250,000 of income before paying anything to the doctor. Now, as an S corporation, guess what. You are an employee of your own corporation. And as an employee, guess what? You have to pay yourself a wage on payroll in the same way you do your staff. Now, that doesn't mean that you have to pay yourself 30% production, 35% of collections, whatever, you know, whatever how associates are typically paid. But you got to pay yourself something. And guess who decides that? You. Now, if you're working with practice cfo, it's really you and me. You and us is we design the right payroll structure to meet certain objectives from a tax and financial planning standpoint. But the key point is that you get to choose that. And one thing that is important in deciding how much you pay yourself as a W2 is note that up here you can see there's two ways of paying you. One is that W2. But the other one is what's called a draw, which is simply where you make a distribution or a transfer or you write yourself a check from corporate from your corporate checking account to your personal checking account outside of payroll. That's called a draw. Notice which of these is subject to the FICA taxes. That's Social Security and Medicare. That's right. The W2 portion is your compensation portion is. And that's subject to the 15.3% on that 100,000. But the other 150,000, guess what? It's not subject to FICA taxes. It escapes that tax. And so you could end up saving five $10,000 in FICA taxes, depending on how low you're willing to go on your W2 compens versus your versus taking it home as draws. And those are teeter totters. The more W2 you have, the less you're able to take home as a draw. And the less W2 you have, the more you can take home as a draw. Because the less W2 you have, the more money you have in your checking account to make as a distribution. And the higher the W2 you have, the less you have in your corporate checking account to make as a distribution. Now, from a tax standpoint, these draws, what you're transferring out of your account, you end up getting something called a K1 out of your corporation, a K1. Remember that term when we get to our tax modules, we talk about that a little bit more. You'll at the end of the year get a W2 and a K1. The K1 will show all of your profits after paying all of your expenses, including your W2. It'll show what is your what are your total profits? And that is distributed to you on paper, called a K1. You're going to pay taxes on that. Whether you took all of that money as an actual distribution physically into your account, whole different story. It doesn't matter. The IRS is going to make you pay taxes on 100% of your K1 income, together with your W2. But the key thing is that your K1 income is not subject to FICA taxes when you're structured as an S corporation. So you can save potentially some taxes there. But you got to keep this in mind. The IRS looked very closely when an S corporate owner doesn't pay themselves to sufficient wages. Why? Because what does the IRS want that they only get from a W2 wage? FICA taxes. They don't get that from the draw. So they. If you pay yourself a dollar of wages, they're going to come after you and they're going to say, whoa, you didn't pay yourself a reasonable salary. Is what they say a reasonable salary. Well, what's a reasonable salary? Well, we CPAs may give you different opinions on that. Some will say it should be 50, 50, but it'll be a little bit unique to what maybe what your overall situation is. And that's a key part of some of our planning we do for our doctors. So that's one of the. That's one of the. Some of the important differences between a sole proprietor and an S corporation. This is something you'll probably want to talk with your CPA a little bit further about. But if I. Bottom line it, you really want to be set up as a. As a corporation, but file an S election. Now, you can be an llc, but you're going to the irs. You're going to be a corporation. File an S election to be an S corporation. Pay yourself the right W2. Take the rest as draws. If you have a 401. My last comment here, if you have a 401, then you may need to actually bump your W2 way up. Even though you're going to pay more in FICA taxes, it will allow you to contribute more into your 401 or other retirement plan. And we have a module where we talk about that as well.