Converted single-owner medical practice from a C corporation to an S corporation yielding substantial annual tax savings.
Overview
Until 2016, the Company had two shareholders and netted about $1.5M per year. The strategy during these earlier years was to bonus compensation in December to ensure the corporation showed little to no taxable income. The intent here was to avoid taxation at the corporate level, and instead, transfer the taxable event to the individual owners. Compensation was then more or less evenly split between the two owners and reasonable compensation limits were never a concern. In 2016, gross revenue reached $9.3M at its peak. After a stock redemption at the start of 2017, the remaining sole shareholder was netting about $1M between 2017 to 2018 with consistent annual revenue of $9.3M. In 2019, annual revenue grew to $10.2M, again in 2020 to $14.7M and once more in 2021 to $19.2M. The surge in revenue increased the corporation’s taxable income to $6.7M before owner compensation. We began working with this Company in early 2022 after acquiring a local firm. In addition to clients of the firm, we brought over a longstanding employee that has worked directly with the Company since its inception. During our review of the account, our first question was why is this entity still operating as a C corporation?
Our primary focus was on potential income and payroll tax savings. We evaluated the Built- in-Gains (BIG) tax, considering asset creation and income earned as a C corporation. This involved listing assets and liabilities, estimating fair market value, and calculating the BIG tax impact. We explored ways to mitigate this tax, including reincorporating, converting the existing entity, or considering a potential sale of the Company. With the BIG tax recognition periods varying for federal and California taxes, we also had to address the timing of the S election, as the deadline for 2022 had passed. We then planned a meeting with the Company to discuss our findings and address any concerns.
Converting to an S corporation saved the physician owner approximately
$607,000
annually in payroll and income taxes at a minimum.
Tax
Savings
Planning
It began with a simple question which led to
a collaborative effort
to achieve a positive tax outcome while considering any negative implications to the owner.
Approach
During our meeting, several key points emerged. We determined that the client could delay a sale of the Company for 5 years, mitigating concerns about certain corporate assets being subject to federal Built-in-Gains (BIG) tax, although California BIG remained a concern. We also noted that any sale of company stock was ineligible for certain stock gain exclusions due to industry-specific rules. Additionally, we discussed the potential tax savings from converting to an S corporation, including deductions, compensation adjustments, and payroll taxes. Our calculations indicated that the physician owner could save approximately $607,000 annually, excluding BIG realization, which surprised the client. We also assured the owner that the S corporation benefits would scale as income rose, adding to further upside.
Our preemptive planning enabled us to guide the client effectively and avoid unexpected issues. We acknowledged that BIG would arise in the first S corporation year due to net cash earned while operating as a C corporation but planned to mitigate this by accurately accounting for all liabilities and receivables. The client, comfortable with the BIG implications due to prior corporate tax levels, agreed to file a late S election for the 2022 tax year. This move would provide immediate tax benefits and reduce the BIG recognition period. Following the meeting, we promptly filed Form 2553 to elect S corporation status effective 1/1/22, ahead of the 3/15/23 deadline. We then collaborated with the client to verify asset values and determine the exact net cash received by reviewing current assets and liabilities.
OVERALL IMPACT
- This case demonstrates the importance of having a CPA ask questions and take action. Creating a plan while considering the advantages, weak points and challenges took an upfront investment by our firm, although we knew this could be a major opportunity.