Forms of Business
A Primer for Optometrists
An optometry practice can operate through a number of different forms of business. Any optometrist that is buying or opening a practice, or hopes to do so one day, needs at least a basic understanding of the different forms, what the limitations are, and, of course, the pros and cons. This short article is intended to give you that basic understanding.
So, what forms of business are available to an optometrist?
- Sole Proprietor
- Partnership
- Professional Corporation
- "S" Corporation
- "C" Corporation
- (Professional) Limited Liability Company
That's it. Those are the forms in which your practice entity can exist. Let's walk through them and get that basic understanding. But before doing that, it is important to first address the elephant in the room that most people believe is the reason for choosing one form over another: liability risk.
Liability Risk
Many people are "aware" that by being a corporation (or LLC) they can largely or entirly avoid the risk of personal liability for business wrongs. This means their home, personal bank accounts, retirement savings, etc., are protected. While technically true, in today's world that is usually a myth, or wishful thinking. Why? Two reasons: malpractice/negligence is a risk personal to the doctor/person that committed it and, in business transactions, the people you do business with are smarter than that; they will typically require that the corporate/LLC owner(s) provide a personal guarantee when opening an account or signing an agreement or lease. That personal guarantee effectively transfers the business liability of the entity to the shareholder(s) as personal guarantors of the corporate obligations. Landlords and vendors (labs, frame companies, CL distributors, etc.) typically include and require personal guarantees in their agreements.
As for malpractice and other negligence risk (i.e., slip and fall, etc.), first, and foremost, there will be insurance that covers most of the risk of that liability so your form of business usually doesn't matter, you are protected from the risk by the insurance. That said, exposure for the liability is with the doctor that is alleged to have committed malpractice and the business. If there are associate doctors in the practice and one of them is accused of malpractice, a corporate or LLC form of business DOES protect the personal assets of the practice owner(s). But, again, because there is insurance that is a relatively small concern.
The one area where being a corporation or LLC does have a meaningful benefit in terms of liability risk is with respect to employee risk.
COMMENT: Here is the reality. As the owner of a practice you are -far- more likely to face a lawsuit from an employee than from a patient. Malpractice lawsuits in optometry are relatively uncommon. Employment lawsuits are not. Every time you fire an employee, and sometimes even when you don't, there is a real risk it will lead to a lawsuit. Employee lawyers know that they can force $25,000 settlements out of meritless claims simply because it can be less expensive for the owner to settle than to win.
Employees generally bring two areas of liability risk: tort and wage/hour. You can purchase insurance for the tort liability, but many practices do not do so. Tort liability refers to the risk of age/race/gender/etc discrimination, harassment, retaliation, etc. Wage/hour refers to the risk of unpaid overtime, failure to provide breaks, inaccurate pay, and similar claims related to wages. Tort liability operates much the same as malpractice: the person that allegedly engaged in the tortuous conduct is personally liable and the business may also be. If you are a corporation or LLC the owner(s) avoid most potential liability risk (there is an exception if an officer of the entity "ratified" the conduct) for tortuous conduct. Wage/hour liability attaches to the business entity only so, again, if you are a corporation or LLC the owner(s) avoid personal liability for wage/hour claims.
EXPERT ADVICE: The risk of an employee lawsuit increases with the number of employees you have. There are two very practical steps every practice should consider. First, generally speaking, if you have five or more employees, the risk of a lawsuit warrants the extra cost of adding an employee lawsuit rider to your general liability insurance policy. But five is not a magic number and depending on the cost and the revenue of the practice it may be worthwhile to add that rider for even a 2 or 3 employee practice. Second, every employee should sign a written Employment Agreement that contains a few clauses that can greatly mitigate/lessen your risk: an arbitration agreement, a class-action waiver, and specific requirements against harassment, discrimination, etc. These go a very long way toward protecting you from the potentially very high cost of defending even a meritless lawsuit. Finally, be sure to have a good Employee Handbook which sets out the day-to-day operational rules and expectations. These offer great help in defending lawsuits.
Forms of Business
Sole Proprietorship
Sole proprietorship is the "default" form of business if there is a single owner of the practice. In a sole proprietorship the owner and the entity are one-and-the-same. There is no distinction between them and the owner is personally liable for all business obligations and risks. Sole proprietor's report their income and expenses for tax purposes on their personal 1040 tax return through a Schedule C. The owner does not receive a W2 or 1099.
This is the easiest and least expensive form of business but it does offer no benefits in terms of tax saving opportunity or liability risk protection. It is advisable only for new/small practices that have only a couple employees and generate less than $1M in revenue annually (generally less than $600k annually). Most tax advantaged retirement savings will be through the individual owner's own regular or Roth IRA, which limits the amount that can be saved. (For this reason these practices often "employ" the owner's spouse in some capacity so that additional retirement savings can be made.)
Pros: Easy. Default. Least expensive to operate.
Cons: No personal liability protection. Limited opportunity for tax benefits.
Partnership
A partnership arises by law any time there are two or more "sole proprietor" owners. If a sole proprietor sells any of his/her ownership to another person, they are partners. If they do not have a partnership agreement then their partnership is governed by the Uniform Partnership Act (the "UPA"). However, the UPA varies from state to state. Most states used the so-called Revised Uniform Partnership Act, but even then, many states have modified the rights and responsibilities pertaining to fiduciary duty, dissolution, and other details.
As a practical matter, there are several important considerations. First, every partnership should have its OWN written partnership agreement because the UPA's are often (usually) NOT what the partners want governing them and its important to know what your agreement is! Second, in general, especially as to an outsider, every partner is liable for the acts and omissions of the other partners. So, not only is there a lack of protection from personal liability like with a sole proprietorship, but you are personally liable for things you did not do, did not know about, or did not want done. This alone effectively removes partnership from being a viable option. For instance, say Partner1 gets sued for something arising from his vacation home 1000 miles away and there's a judgment against him. That creditor can put a lien on the entire practice and take money that is one-half Partner2's money! Or, as another example, say Partner1 sexually harasses an employee and that employee gets a judgment -- she can collect on that judgment from the personal bank account of Partner2! Nobody wants that.
In instances where two or more optometrists wish to have a partnership it is advisable for each to form his/her own professional corporation then create a partnership of corporations. That at least allows each individual partner to obtain liability protection from his/her corporation.
Pros: None.
Cons: Vicarious liability. Uncertain rules.
Professional Corporation
First, two principles which are often misunderstood but very fundamental:
- A corporation can be a "regular" corporation or a "professional" corporation. The difference is that in a professional corporation all shareholders (and often all Directors) must be qualified professionals based on state law. A professional corporation is created by filing Articles of Incorporation with the state Secretary of State (or other similar office) designating it as a professional corporation and including whatever special language the state requires for a professional corporation.
- A corporation can be a "C" corporation or an "S" corporation. This is a tax designation for IRS purposes. In an "S" corporation all profits (and losses) of the corporation pass thru to the shareholders in proportion to their ownership percentage. Thus, an "S" corporation is called a "pass thru entity." There is NEVER any tax paid at the corporate level and there is no risk of double taxation (where tax is paid first on the corporate profit, then paid again when that money is distributed to the owners). Thus, an S Corporation is very tax efficient. In a C Corporation that operates as a small business like optometry, the owners need to make sure they "draw down" the corporate profit at the end of the year by distributing it as bonuses or draws to the shareholders in order to avoid paying a significant corporate tax (for no reason). Most optometry corporations are S Corporations. To create an S Corporation there is a form which must be filed with the IRS -- Form 2553 -- typically within about two months of forming the corporation. (Some states may require their own form for an S Corporation.)
In the end, an optometric corporation will be a professional corporation that elects to be taxed as a subchapter "S" corporation. Your CPA will take care of filing the IRS form. Once formed, the corporation will obtain its own tax ID number from the IRS (called an EIN, or Employer Identification Number in IRS language).
IMPORTANT TIP: When you obtain your Tax ID number online at irs.gov you will receive a PDF document called an SS-4. KEEP your SS-4! Make several copies and keep a copy with your paperwork. These are often requested when accounts are opened with vendors or banks, etc. Also keep a copy of your Form 2553 filing. To open a bank account you will need your filed Articles of Incorporation, your 2553, your SS-4, your Bylaws, your Organizational Minutes with resolutions authorizing you to open the account, and often your shares of stock.
In a professional corporation ("PC") the owners own SHARES OF STOCK in the corporation and the corporation owns the practice and all its assets. Most people will need a lawyer to help them get a new PC started as there is required paperwork (Bylaws, Organizational Minutes, etc.) and the shares need to be properly distributed. Many CPAs will offer to do this for you, but they make a lot of errors and about half the time the corporation is not properly formed.
Once created, with an EIN and a bank account, the PC is ready to operate. The officers (which are designated as part of the organizational minutes) run the business.
IMPORTANT: If there are two or more shareholders it is essential that you have a "Shareholders Agreement." This is similar to a partnership agreement -- it defines the rights and obligations of the shareholders with respect to the business and each other. And, most importantly, it addresses what happens if someone dies, wants to sell, retire, etc. Unlike with a partnership there is no uniform code for this -- there must be a written agreement among the shareholders. This should be one of the very first things done.
Since the corporation owns and operates the practice, the owner-doctor will be a W2 employee of the corporation and should be paid a "fair" wage for his/her work as an optometrist. Whatever profits there are beyond that are corporate profits. Those pass thru and are reported via a K-1 on the corporate tax return (an 1120S). While you pay income tax on the K-1 revenue, you do not pay typical payroll taxes (social security, Medicare, workers' comp., etc.). As an example, let's assume your corporation grosses $1M and you net $250,000. You take a salary of $150,000. As an employee you pay about 7% in payroll taxes and the corporation pays about 7%. If you were a sole proprietor you'd pay 14% of $250,000. As a corporation you pay 14% of your W2 salary of $150,000. That reduces your taxes by 14% of $100,000, or $14,000. (Please rely upon your CPA for all tax advice. This is a legal site, not a tax-advice site.)
Pros: A degree of liability protection, especially for employee claims. Opportunity to minimize taxes and maximize retirement contributions.
Cons: Costs for a corporate tax return and in many states, a minimum corporate tax. Corporate formalities must be complied with annually.
[Professional] Limited Liability Company
A limited liability company, LLC, is very similar to an "S" corporation. It offers the same level of liability protection and defaults to being a pass thru entity. Some states provide for a professional LLC (a PLLC) and others do not distinguish a regular LLC from a professional LLC.
LLC's do not have shareholders, they have "members." And they do not have directors, they have "managers." They do not have Articles of Incorporation, they have Articles of Organization. They do not have Bylaws, they have an Operating Agreement. But beyond these semantics they are similar to a corporation. (Note: the Operating Agreement will typically include the provisions found in a Shareholder's Agreement if there are two or more owners to the LLC).
LLC's have a few advantages over corporations (for our purposes). First, they are not as tied to formalities like annual meetings of the shareholders. Second, they do not require that the company profits pass thru in relation to ownership. If you own 25% of the shares of an S Corporation, 25% of the corporate profits pass thru to you. But if you own 25% of the membership interests in an LLC the operating agreement can provide that you receive more or less than 25% of the LLC's profits. Finally, there can be an element of asset protection built into an LLC operating agreement that is not available to a corporation.
There is one big limitation to LLC's, however: many states do not allow doctors to operate as an LLC. California, for instance, does not allow professional LLCs except for lawyers. So you cannot operate as an LLC / PLLC unless your state allows optometrists to be an LLC. If they do, then it is often the preferred form.
Pros: Like an S Corporation, same tax and retirement advantages, same liability protection. Some additional asset protection if formed properly.
Cons: Like an S Corporation: additional tax return and possibly a minimum state tax.
Concluding Comments
To summarize the topic, while practices can exist in a variety of business forms, only a couple are practical. A small practice with just 2-3 employees and a doctor-owner CAN operate as a sole proprietorship, but doing so takes away some tax saving opportunities. Any practice that reaches $1M in gross revenue, or which employs five or more people, is probably best operated as a professional corporation with an election to be taxed as an "S" corporation, or as an LLC. Partnerships should almost always be avoided.
EXPERT TIP: If you own more than one practice you must decide if you want to hold each as a separate entity (corporate or LLC) with its own EIN/Tax ID number or own each practdice as a separate entity. There are advantages and disadvantages to each. The primary advantages to a single entity are cost and simplicity: it costs less because there is one corporate tax return to prepare and only one potential state tax and its easier because you don't need to worry about separating expenses. However, it also means liabilities are not isolated to a single practice and selling can be difficult because you lack separate the financial records when they are blended into a single tax return. Generally, the advantages of operating each practice as its own corporate entity outweigh the benefits of operating them all under one corporation/LLC.
Much of the choice is driven by tax and legal considerations and ANY/EVERY owner should always consult with their own CPA and legal advisor to be sure they are choosing the best form of practice for their situation.