Nephrology practices are often have the opportunity to purchase commercial real estate that is either owned or occupied, strategic partner occupied or a straight investment property. How to structure these purchases can have a strengthening or weakening effect on your practice. This article will examine how particular structures could help to limit liability, minimize tax treatment and facilitate succession planning.
In a typical scenario a practice might have the opportunity to purchase a new building in which to house their main practice. In addition to the primary practice, nephrologists may also have the opportunity to purchase dialysis units and access centers as an extension to the practice. When faced with these opportunities the first question you must ask is, Do I want to use a legal entity to purchase my asset? For our purposes here a legal entity is a partnership or any creation by the state that combines sale assets separate from the primary practice. Some types of legal entities are partnerships, LLCs, S corps and C corps.
Partnerships are created by definition, which is dictated by the action partners take. In many states, when two or more people transact business for a profit, they are by definition a partnership. In some cases this can transfer rights and responsibilities to a partner that they may not fully appreciate and could create personal liability where none was anticipated. LLCs, S corps and C corps are creations of the state. Each state has a different set of rules that is going to govern the creation of each one of these legal entities. Below I will generally consider these entities; please consult your lawyer for in forming entities may in the particular jurisdiction you are considering—this article is intended only to give the reader a general overview of some types of entities and should not be considered legal or tax advice.
Partnerships are flow-through or pass-through entities, which generally means that tax and liability flow through to the partners. For the partner/owners this means profits are taxed at their individual tax rates. This can offer advantage over a C corporation, which will pay taxes on profits at the applicable corporate tax rate. Distributions to shareholders will then be taxed again at their personal tax rates. C corporations are subject to this double taxation. Although the corporation income tax rate is currently 35 percent, less than the top personal rate of 39.6 percent, one can see that this double taxation makes a C corporation much less desirable from a tax standpoint. In addition, administrative filing requirements are fairly simple for a partnership. C and S corporations are also subject to rigorous allocation and distribution requirements. Generally, income and loss is distributed proportionally to the owners by state statute. A partnership may adjust its allocations of income and cash flow among the partners each year according to their needs as long as certain standards are met. Many states also impose more reporting requirements on LLCs, S corps and C corps than they do on partnerships.
Some drawbacks of a partnership to remember are that a general partnership may not fully protect the partners from liability. That means if a partnership is sued, they may be able to sue the partners individually. Number two, a partnership is not perpetual. When a partner dies, a partnership might be required to dissolve. This could cause some problems in the timing of recognizing taxes because the partnership will have to be valued at the time of its dissolution. The basic rules for partnerships are fairly complex; you should use a licensed CPA to help you with the reporting requirements in figuring inside and outside basis—simply put, the amount of capital that is being contributed by each partner, whether that capital is in the form of cash or property. Although partnerships are not subject to taxation a form 1065 needs to be filed annually on behalf of the corporation. This tracks any income and/or expenses that need to be imputed to the partners for their individual income tax returns.
Subchapter C corporations, often referred to as C corps, are governed by subchapter C of the IRS code. As stated previously, C corporations are not flow-through entities. C corporations are treated as entities for the purpose of taxation and pay their own tax rate to the government. Taxes are reported on form 1120 or form 1120A. Typically, no liability flows through to the shareholders of C corporations, which typically have a higher standard of regulation and reporting than partnerships. Although the highest marginal tax rate for a C corp is 39 percent, the average tax rate is 35 percent, which is lower than the individual tax rate but if you take into account the double taxation inherit with the C corp, a partnership tends to offer tax advantages in a closely held situation. C corps are typically governed by the regulations in the state in which they are formed. Delaware tends to have the most favorable regulations from a corporate standpoint. That is why you see so many Delaware corporations being formed today. Nevada seems to be trying to get into this business also and we are seeing more and more Nevada corporations being formed. It may be most cost effective for a small, closely held, corporation that is just to hold assets to be formed in the state in which you are doing business. This might be the case because local lawyers may be more familiar with the local statues than they are with Delaware and/or Nevada statutes. In a C corp., profits and losses are going to be distributed proportionally to the ownership of the corporation. A C corp. is a perpetual entity. That means if a shareholder dies, the C corps survives and the stock in most cases can be distributed according to the wishes of the decendents estate. The four main advantages of a C corp are continuity of life, centralized management, limited liability and free transfer of interests. This means that stock in the corporation typically can be bought and sold at a market rate or a partnership interest may not be sold without the dissolution of the partnership. Typically a corporation will hire management to be governed by the board to manage a corporation thus centralizing the decision-making and freeing the partners/owners from those duties.
The next entity I will review is the S corporation. The S corp. was first created in 1958 under section S of the IRS regulations. Before the tax reform act of 1986, there was little reason to use the S corp., but since that reform the popularity of the S corp has increased exponentially. By the mid 1990s, there was more that 2 million businesses claiming S corporation status or close to half of all corporate returns filed. S corporation rules minimize the owner’s tax liability and is the entity of choice of many small businesses. S corporation status provides taxation similar to partnerships but also limits liability similar to the way that C corps limit liability. An S corporation has passed through taxation in most cases. S corporations are creatures of the state in which they are formed and different states have differing regulations.
Michigan, for example, until recently, continued to tax S corporations more closely to the way they taxed C corporations than partnerships. Although S corporations do have pass through taxation like a partnership, they do not follow the same taxation rules as a partnership when it comes to liquidation of the entity or how liabilities affect the basis of the owners/ partners. But as you can see by the popularity of the S corporations, they do seem to provide the attractiveness of limiting liability and minimizing taxation by avoiding a double taxation inherit in the C corp entity. Because of these positive considerations, the requirements or rules that are required to qualify as an S corporation are fairly strict and can be tough hurdles to clear. In most states, an S corporation needs to be a domestic corporation that is incorporated in the United States, and can issue only one class of stock and is limited to a maximum number of shareholders of 125. Only individuals and certain trust can act as shareholders and no non-resident, alien shareholders are permitted. If each of these requirements are met, an entity can typically elect S corporation status. The small business corporation does define certain ineligible corporations for “S” status. These include foreign corporations, certain banks, insurance companies and Puerto Rico as possession corporations. So S corporations offer certain advantages over the C corporation and the partnership and this is evidenced by its popularity. But there is another form of entity that former IRS commissioner Donald S. Alexander believes is the entity that any sensible tax professional will recommend. “The LLC clearly is the choice of the future if you are dealing with rational people, and most of the time we are dealing with rational people.” The LLC is a limited liability corporation, which is a pass through taxation entity similar to the S corporation. Instead of being governed strictly by the regulations set by the state of formation, the LLC is governed by the operating agreement that is written by its members. Members is the term for owners and shareholders in an LLC corporation. Similar to a partnership agreement, the operating agreement can set out how profits and losses can be distributed among the members, can govern how votes must be taken in one, how the LLC can be managed and spell out the rights of succession for the members. The LLC will clearly marries the best features of a partnership on an S corporation and I agree with Donald Alexander when he says that any sensible professional would recommend the LLC for a closely held corporation. Some drawbacks of the LLC are that an operating agreement is required and recommended. A typical operating agreement drafted by a law firm could cost in the neighborhood of $10,000-$20,000 to draft but can certainly protect the LLC’s interests and how a value far in excess of that cost. Despite this cost the LLCs pass through taxation and flexibility in setting out succession policies make the LLC an excellent choice of entity in many circumstances. It is important to note that any state-created entity you chose must be run as a separate entity or you run the risk of having the structure voided by a court. This means you minimally have to ensure that your corporate registration is always current, you maintain the books and records separately form your personal business and you hold regular meetings of the governing body.
Each formation offers different attributes, but I tend to recommend the LLC because of its limitation of personal liability, one layer of taxation and flexibility in succession planning and operational issues. In choosing any entity it is important to review the goals of the businesses considering formation and consult competent legal and accounting advice. A little understanding of the issues and some planning will pay big dividends in the long run. RBT
O’Dea is chief financial officer for Nephrology Associates, which is based in Oak Park, Ill.and founder and board member of INphoton Inc., a biotech research company.