By Steve Tiret, C.P.A.
Director of Financial Planning
Tiret & Company, CPAs

You have recently graduated from dental school and are entering the workforce as a practicing dentist, with your eyes set on the goal of one day purchasing your own practice. You keep hearing about incorporation, but don’t understand the ins and outs of the reasons to incorporate or not incorporate. As such you are asking yourself “should I incorporate.”

The short answer is maybe.

There are a lot of factors involved in the decision as to whether or not it makes sense to incorporate your dental practice. There are elements of asset protection, tax ramifications, business structure and complexity issues, and economic factors.

The first factor, asset protection, is the benefit that most attorneys have in mind when they suggest incorporation. The corporation is a newly created separate tax entity from the individual. It creates what is called the “corporate veil” wherein the only assets at risk in a lawsuit against the corporation are the assets of the corporation. Personal assets of the owner are protected against lawsuit claims.

The idea of asset protection can be misleading though. The first thing to know is that any suit stemming from malpractice opens the door to pierce the corporate veil. Actions of malpractice on the part of the corporate owner are considered to be actions of the owner as an individual. Thus, the claimant in a malpractice suit against the corporation can go after corporate assets as well as the individual owner’s personal assets.

The corporate veil can indeed provide shelter against other lawsuits though. Workplace accident suits, such as someone tripping and falling at your office, will be subject to the limitations imposed by the corporate veil. The corporate structure will also provide protection against employment suits, such as harassment.

With or without corporate protection, it is important to protect yourself against potential legal claims, whether they be malpractice, employment related, or any other type of claim related to your business. This is where insurance comes into play. Whether you are incorporated or not, you will want to be well insured to mitigate your risks and minimize the potential claims you would have to pay out in a lawsuit.

A key element in deciding on whether or not to incorporate is whether or not you need the corporate veil, and whether or not the costs involved in incorporating are worth the protection afforded. The protection of the corporation is only as valuable as the assets that it is protecting. Often, recent graduates have little to no personal assets that would need to be protected by the corporation. With little to no assets to protect, it may not make sense to incur the extra costs and extra complexities involved with incorporating. Incorporation can be done at a later date should you want the protection once you have built up your personal assets. Incorporating at a later date is most easily done once the practice is relatively debt free, so it can take some time to get to a point where the transition can be done smoothly.

There are tax ramifications to incorporating as well. Currently, being an S-corporation can actually save you about 1% in tax on income over the social security wage threshold ($106,800 for 2010). However, this law is under political debate at this point in time, and that savings could soon disappear.

For the early years of practice, the tax ramifications of incorporating tend to be negative. It’s common in the first year or two of the practice to show a tax loss. The corporate structure can delay the deductibility of some of that loss though, because unlike a sole proprietorship, a loss in a corporation can’t be taken against borrowed money. Most dental practice purchases are completely funded by borrowed money, so this limitation can often lead to delayed deductions. This is especially relevant for those with a working spouse, as deductible losses from the dental practice can reduce the taxable income earned by your spouse. But, if the losses are delayed due to corporate restrictions, that reduction can not be immediately accomplished. Additionally, if the corporation is showing a tax loss in the early years it can limit the amount of cash that can be taken from the corporation by the owner. Money taken by the owner from the corporation can potentially create currently taxable income to the owner while providing no deduction or a delayed deduction for the corporation. All of these elements combine to make your business and personal tax situation more complex. It is very important, if you are incorporated, to work closely with your accountant to ensure that you avoid any missteps.

Incorporating can also potentially add extra costs to funding your retirement account in the early years of owning a practice. If you associate as an independent contractor and then buy a practice as a sole proprietor, the new practice is simply a continuation of your business as a self employed dentist. You can fund your retirement through either a SEP IRA or a SIMPLE IRA without being forced to include any employees in the plan for up to three years. However if you incorporate when you buy the practice, then the corporation is seen as an entirely new business and you have the same start date as all your initial employees. Should you want to fund a retirement plan, you would be forced to make those initial employees eligible for the plan as well. This could lead to you being forced to incur an extra cost to fund employee retirement plans in order to be able to fund your own.

One other factor related to incorporating is particular to San Francisco. If you incorporate and your practice is in San Francisco, then you are creating additional tax for yourself. San Francisco has a city business payroll tax of 1.5% of wages. As a corporation you would need to pay yourself wages (as a sole proprietor you do not pay yourself wages, rather you just have the right to take the profit from the business) which would lead to paying an additional 1.5% tax on those wages in San Francisco. At a salary of $250,000 this would lead to an additional $3,750 in tax.

The last downside to incorporating is the additional cost. As a California corporation you would have to pay at least $800 in tax to the state of California each year. You would also have an additional cost for the preparation of a corporate tax return in addition to your personal tax return.

As noted above, there are some plusses and some minuses to incorporating. Early in your career the downsides often seem to outweigh the benefits. The last element though is what we call the “sleep test.” It is not something that can be quantified, rather it is just how you feel about the situation every night when you lay down to go to sleep. If you simply feel more comfortable practicing as a corporation, and are willing to take on the costs and potential hassles inherent in the first few years of incorporation to receive the peace of mind that you garner from the corporate entity, then it may very well make sense to incorporate. If you feel that you are going to want the corporate protection down the road and don’t want to wait until your practice is nearly free of debt to convert to a corporate structure, then it may make sense to incorporate immediately. Likewise, if you don’t really garner any peace of mind from the corporate structure, and don’t want to deal with the extra costs, formalities and potentially negative tax consequences involved in the first few years of incorporation then don’t feel that you are under any sort of requirement to incorporate your practice.

The items outlined herein are basic guidelines surrounding the decision of whether or not to incorporate. Ultimately, each situation and each individual is unique. Use the issues outlined in this newsletter to have some knowledge on the matter when you bring this issue to your CPA and your attorney. Work with your CPA and your attorney, and have them discuss the matter with each other to come up with the best decision for you.