For years we have said that the “entity of choice” for dental practices is an S Corporation. New tax reform, commonly referred to as the Tax Cut and Jobs Act, has made that more true with reduced individual tax rates and a special deduction of up to 20% of “qualified business income” (See our post “5 Ways Dental Practices Can Take Advantage of the 20% Pass-Thru Deduction“).
We have been approached often over the last several years by practice owners wanting to move from their existing C Corporation to an S Corporation. Many of these existing C Corporations are not only wanting to take advantage of the 20% deduction, referenced above, but also to avoid the nasty double tax that exists in C Corporation structures.
Here’s an overview of how the double tax works. Any profits left in a C Corporation are subject to income tax as a C Corporation, currently 21% and any respective tax within the State in which they reside. After that tax is paid, those profits can then be distributed to the owner as a dividend. The dividend is then taxed at the individual federal capital gain rate which is likely 20%. Without even factoring in state income taxes, that’s a total of 41% tax on profits retained by a C Corporation and then distributed as dividends to their shareholders. Add in state income tax, and it’s likely that your overall tax on retained profits in a C Corporation is over 50%. It’s easy to see why practices are wanting to convert to a different structure in order to take advantage of lower tax rates.
The “BIG” Problem
Because a conversion from C Corporation to S Corporation avoids this double tax, existing tax laws do not simply let you switch. You need to consider the BIG (Built-In Gains) Tax, which essentially taxes you as if you were a C Corporation for 5 years after the conversion date.
Here’s a little example: Say you operate your C Corporation on the cash basis. On the day you convert to the S Corporation, your C Corporation has patients who have not paid their bills, assets that have value but zero cost basis, and the practice may also be worth more than the carrying cost of its assets (referred to as goodwill). Let’s say that the C corporation balance sheet looks like this, prior to conversion or planning strategies:
| Receivables from patients | $100,000 |
| FMV of Assets | $50,000 |
| Goodwill (Practice Value) | $900,000 |
| Liabilities | ($20,000) |
| Net assets subject to the BIG Tax | $1,030,000 |
If you were to convert to the S Corporation and collect your accounts receivable, or sell assets or the practice itself, the government wants the tax as if you were a C Corporation. This is a substantial hurdle with practices wanting to make the change.
With proper tax planning you can mitigate or even eliminate the dreaded BIG double tax to allow your practice to take advantage of the pass-through tax structure. Here are a few options:
OPTION 1 – Eliminate Goodwill:
The BIG tax does not apply to goodwill if you don’t sell your S Corporation during the 5 year built-in gains penalty period. However, most of the time, you don’t know if you are going to sell the practice or if you may be forced to sell the practice because of some unforeseen circumstance such as death or disability. This is where the planning takes place.
First, let’s define “Goodwill.” Goodwill is the excess value paid for the business over the net identifiable tangible and intangible assets. You might attribute some of the goodwill to the company’s name or location, but in most dental practices, the dentist is the key reason patients are attracted to the business. The more the practice depends on the owner’s personal relationships, knowledge, skills, talent, reputation, or experience, the greater the value can be attributed to “Personal Goodwill” rather than “Corporate Goodwill”. If you can determine that the dentist is the reason for the goodwill, then the goodwill is no longer a corporate asset and instead becomes an asset owned by the dentist outside of the corporation.
The key is to identify what is “Personal Goodwill” at the time of the conversion from C to S. Unfortunately you can’t personally decide this. We would advise that you have a proper appraisal of the goodwill so you can prove to the IRS the amount allocated to personal goodwill is reasonable. Remember that the BIG tax on goodwill is only a problem if 1) the goodwill is corporate goodwill, and 2) you sell the S corporation during the 5 year BIG taxation period.
Option 2 – Accrue Bonus Against Receivables from Patients:
Sound strange? Even though your C Corporation is on the cash basis for income tax purposes, the BIG tax is calculated as if it had been on the accrual method. This is why your accounts receivables and payables are such a problem when making the conversion.
In order to get around the tax on those receivables, one could argue that you were significantly underpaid in prior years or that you deserve a bonus for the work completed prior to the end of the tax year. The strategy here is to accrue a “Bonus” liability against those receivables. According to the law, that payable can be used as a built-in loss that offsets the built-in gain as long as it is paid two and a half months after conversion. This strategy would eliminate any gain on receivables collected the year following conversion.
Option 3 – Treat new S Corporation as C Corporation for BIG Period:
The BIG tax is calculated as the lesser of the BIG tax or taxable income as if the practice continued as a C corporation. So for instance, let’s say you did no planning and collected all your accounts receivable the year after conversion. You would calculate the BIG tax on the $100,000 recognized built-in gain on those receivables amounting to Federal tax of $21,000 (21% X $100,000). However, if the S Corporation taxable income was $0, there would be no built-in gain tax owed for that period. You pay the lesser of the two, which would be $0 tax. As long as you continue this strategy over the 5 year BIG period, you are then free of the BIG tax and from that period forward, you can operate the S Corporation as you wish. The downside to this strategy is that you have to wait in order to take advantage of some the tax savings opportunities currently available to S Corporation practices.
The BIG tax is something that you want to pay special attention to if you are intending to convert from a C Corporation to an S Corporation. But with proper tax planning, you can potentially eliminate the BIG tax or substantially reduce its impact. The most important thing is that you know what the BIG tax situation is prior to converting and that you consider all of the planning tools above to determine how you are going to go about eliminating it or reducing its effect. There are substantial tax savings available to practices that can work around this problem.