Tax Planning for Physicians: What Are the Benefits of Using S-Corp Tax Strategies?

*The information presented in this article should not be viewed as legal advice.

Tax season can be more complex for self-employed physicians, such as locum tenens and practice owners. Your physician income already puts you in a higher tax bracket, but having to pay additional self-employment taxes can really cut into your earnings. It’s understandable that your ears might perk up when you hear the buzzword “S-corp” used as a way to save money. 

But using S-corp tax strategies to lower taxes for physicians isn’t always as clear-cut as it sounds.

S-corporations, or S-corps, can be used as both a legal and tax maneuver. For the purposes of this article, we’ll focus on S-corp tax strategies for physicians — meaning we aren’t necessarily suggesting you become a corporation. Instead, we’re specifically exploring how an S-corp election could potentially reduce your business taxes (or cost you more in some cases).

What exactly is an S-corporation?

An S-corporation functions as a pass-thru entity, allowing you to report business income and losses on your personal tax return. Because of this, taxes are assessed at individual income tax rates and, therefore, prevent double taxation on corporate income.

It’s important to note that when using the S-corp tax strategy for physicians, you can either be:

1. A corporation electing an S-corporation classification.
2. An LLC electing to be taxed as an S-corporation.

Note that an LLC is a legal decision. But in the eyes of the IRS, being an LLC is disregarded. This means that a single-member LLC defaults to a sole proprietorship taxation, and a multi-member LLC defaults to a partnership taxation. Filing IRS Form 2553 changes the default and creates an election as an S-corp for taxation purposes.

Could an S-corp be a game-changer for physicians?

Using S-corp tax strategies for physicians can potentially reduce your tax burden. But there are a lot of nuances to this advanced tax strategy.

For example, when you elect S-corp tax treatment, you earn money through two means:

1. Salary. The amount you pay yourself via W-2 wages.
2. Distributions. The profits that pass through the S-corp directly to you. They aren’t considered employee wages, nor are they treated as self-employment income.

As an S-corp, you’ll pay payroll taxes on your salary, just like you would for any other W-2 job. But you don’t have to pay them on distributions from your S-corp. Therefore, the more you can categorize as distributions and the less as wages, the more money you can save on payroll taxes. 

But here’s where it gets complicated. The IRS requires S-corp owner-employees to receive “reasonable compensation” in the form of W-2 wages, meaning you must receive a salary. Reasonable compensation generally refers to how much you’d need to pay someone to replace your role as a physician and any other hats you’re wearing within the business, which can be a substantial amount.

“S corporations must pay reasonable compensation to a shareholder-employee in return for services…”
The IRS on S Corporation Compensation

The concept of “what is a reasonable compensation” is a heavily debated topic within the S-corp discussion, and it can cause problems if you aren’t careful.

For example, if you don’t pay yourself enough, you could cause substantial interest and penalties in the event of an audit. But if you pay yourself too much, you could negate the tax savings you're aiming for altogether. This is the reason S-corps aren’t always the clear strategy for physicians. But when done right, there’s the potential for significant savings.

The surprising savings on self-employment taxes

A big tax benefit of filing as an S-corp is that you get to pay yourself some as a salary and some as distributions from your business profits. The real savings comes from having the ability to avoid paying self-employment taxes on distributions, meaning you won’t have to pay Social Security and Medicare taxes for that portion of your earnings.

Social Security savings

For 2024, the Social Security tax rate on taxable wages is 6.2% each for the employer and the employee. But the Social Security wage base, which serves as the maximum amount of earned income that can be taxed, is $168,600.

As a self-employed physician (aka the employer-employee), anything you earn up to the Social Security wage base is taxed at 12.4%. However, as an S-corp, your distributions aren’t subject to Social Security taxes. Which means if you can knock some of your earnings off your wages and instead take them as distributions, you can avoid that additional tax of 12.4% and keep more money in your pocket.

But here’s where understanding the ins and outs of S-corp tax strategies for physicians matters — specifically, meeting the IRS requirement of “reasonable compensation”.

Realistically, you probably can’t replace yourself as a physician for less than $170,000, unless you’re working part-time or some equivalent variation. So, your potential savings from an S-corp election really start to diminish because you’ll be paying yourself more than the Social Security wage base. Therefore, you won’t receive the benefit of avoiding the additional 12.4% tax rate.

Medicare savings

Just like with Social Security taxes, you can avoid paying Medicare taxes on distributions from an S-corp. However, Medicare doesn’t have a wage base, and the tax rate can be as high as 3.8%.

To illustrate, let’s say your business profits $400,000 for the year and you pay yourself a reasonable salary of $200,000. You then take the remaining $200,000 as a distribution. With Medicare taxes at 3.8%, that could save you $7,600.

The financial perks of pass-through entity taxes

Although it shouldn’t be a deciding factor, pass-through entity (PTE) taxes are another way to potentially save money with an S-corp.

The Tax Cuts and Jobs Act of 2017 limits the state and local taxes (SALT) deduction to $10,000 per year for individuals. For example, if you live in California and pay $30,000 in state income taxes, you can only deduct $10,000 on your federal tax return.

But instead of state taxes paid being reported on your personal return and getting capped at $10,000, this PTE election can allow you to report the state taxes paid as a business expense of your S corporation, with no cap.

However, each state has different rules and ways to elect this. Plus, some states don’t recognize it at all. Additionally, there might be a situation where this election reduces your qualified business income (more info on this tax deduction below) and lowers the impact of the strategy.

The other side of the coin: Considerations for S-corp tax strategies for physicians

Although there’s the potential for tax savings with an S-corp, there’s also extra expenses and limitations that often get overlooked.

Additional S-corp filing fees

There’s a whole separate tax return you have to file, Form 1120-S, which tax accountants charge extra for. For example, SLP Wealth’s tax services are available for $99 to $199 per month. But if you’re an S-corp, the cost increases to $299 per month (or $2,400 annually). These extra filing fees and other associated costs — such as payroll services, bookkeeping and legal guidance — can quickly eat away at the tax savings benefit of filing as an S-corp.

Loss of qualified business income (QBI) deduction

The QBI deduction, also called the Section 199A deduction, allows self-employed and small business owners to deduct up to 20% of their qualified business income on federal taxes. 

But there’s a phase out that can greatly impact physicians as health services are classified as a “specified service trade or business”, or SSTB. That said, if you have a side hustle that isn’t medically-based and not considered an SSTB, you’ll be subject to different QBI rules.

For 2024, if your taxable income (before accounting for the QBI deduction) is between $191,950 to $241,950 as a single physician or married filing separately, the QBI deduction starts phasing out. This range is $383,900 to $483,900 for married filing jointly. Note these amounts apply regardless of whether you file as an S-corp or not.

Even if your taxable income is below the QBI deduction threshold, an S-corp can take away from your QBI deduction because anything you pay in wages doesn’t count toward QBI.

Let’s say a married physician earns $380,000 after accounting for retirement plan contributions, health insurance premiums and other pre-tax deductions. Their spouse cares for their family and home with no income.

As a non-S corporation, they’d receive the full QBI deduction, allowing them to deduct $76,000 from the federal income taxes.

But if they decided to file as an S-corp, they might take half as a salary and half as business distributions. Since wages don’t count toward QBI, they will lose a $38,000 deduction.

This is an example of where you might miss out on a huge deduction because you have to pay yourself “reasonable compensation” in an attempt to save on self-employment taxes, which again, might only realistically be Medicare taxes.

Limit on 401(k) contributions

You might be limiting how much you can put toward your 401(k) retirement account by filing as an S-corp as you can only contribute 25% of your wages. Let’s look at how this could play out if you have $200,000 of total income.

As a non-S corporation, you can contribute up to $23,000 as employee contributions in 2024 and then choose to put another 20% of your income (or $40,000 in this example) as the employer, giving you a total of $63,000 toward your 401(k).

But as an S-corp, you might pay yourself $100,000 in wages and take the remaining $100,000 as a business distribution. You can still contribute $23,000 as an employee. But since you can only put 25% of your wages into a 401(k), you’d hit the max at $25,000 — for a total of $48,000 toward your 401(k). This decision lost you $15,000 of retirement savings in the form of employer contributions that are deductible to you.

Are you at risk? Common pitfalls when using S-corp tax strategies for physicians

An S-corp isn’t something to jump into without doing thorough research. Here are some common mistakes physicians make when trying to file as an S-corp on their own.

Juggling S-corp and other W-2 employment

With a traditional W-2 job, you pay your portion of Social Security taxes and your employer pays their half. If you set up an S-corp for extra 1099-income, the S-corp has to pay Social Security taxes on your behalf again. 

You can unintentionally have to double pay Social Security taxes as a business. In which case, it might be better to file as a disregarded entity or sole proprietorship for additional independent contractor income. Alternatively, you can compare how much you’d save by filing as an S-corporation after taking into account the extra Social Security taxes.

Overlooking state-specific issues

The majority of states follow the federal government’s lead when it comes to taxing S-corps. But there are a few states that might tip the scale in determining whether it’s worth filing as an S-corp. Additionally, not all states allow for PTE taxes. You’ll need to consider whether your state is S corporation-friendly or not.

Thinking S corp? Here's why seeking professional help is crucial

Because filing as an S-corp is an advanced tax strategy, it’s best to work with a qualified professional to understand potential benefits and consequences. You want to understand how much you could save overall by balancing tax savings of an S-corp with lost opportunities, such as extra fees and limitations on the QBI deduction. But you also need to be wary of any risks and other complications.

For example, you could increase your audit risk solely by filing as an S-corp, as the IRS might impose harder scrutiny due to the requirements of paying a reasonable compensation. In which case, you might have to pay back missed taxes, as well as penalties and fees, for however long it took for them to catch your misstep.

Let our team of SLP Wealth tax advisors review your finances to find the most advantageous path for your physician income.