Solving Common Group Practice Challenges
By: Blake W. Hassan, CPA, JD*
The percentage of doctors practicing in a group (rather than solo) format jumped from 27% in 2003 to 38% in 2013, and we expect the trend to continue for several reasons. Increased competition, and the growing penetration of managed care and corporate practice have motivated traditional doctors to expand the scope of services provided and their clinical hours to increase patient convenience and related revenue, which is more easily accomplished through group practice.
Group practice presents unique challenges that can cause huge problems if not properly addressed. Below, we discuss two such challenges: how to fairly allocate practice income and overhead between partners, and strategies to maximize tax avoidance in a group practice setting.
Allocation of Income and Overhead
There are a number of methods for allocating practice income and overhead, depending upon the practice specialty as well as the particular circumstances. Some group practices share profits equally among the partners. While this has the virtue of simplicity, it rarely provides fairness unless the practice production between the doctors is fairly equal. As a result, it works in less than 10% of group practice arrangements.
Allocating profits based solely on the relative collections generated by each doctor is at the other end of the spectrum. This system takes into account differences in productivity and days worked among the doctors, and provides fairness as long as management duties are shared equally among the partners. If not, a certain percentage of practice profits (usually 60%) should be allocated based on productivity, while the remaining portion (usually 40%) should be allocated to management duties. These percentages are derived from publicly traded corporate dental groups, where in a general dental practice with a typical 40% profit margin, doctors are often paid 25% of their production (roughly 60% of the profit margin) for their clinical services, while the management company retains the remaining 15% (roughly 40% of the profit margin) for their services.
And there are numerous variations in between. In orthodontics, for example, it’s common for 50% of the practice profit to be allocated based upon productivity (days worked), while the remaining 50% is allocated based upon stock ownership, assuming an equal sharing of management responsibilities. Accordingly, a new doctor buying in will see her income phasing up as her stock ownership grows during the buy-in period.
Issues also arise as to how practice overhead expenses should be allocated among group members. When profits are allocated among the doctors based upon their relative collections, doctors who produce more bear a larger share of the overhead costs. That may prove a fair method for variable expenses that fluctuate with production (dental supplies, lab fees, etc.), but not for fixed overhead expenses. Often, the partners will agree that fixed overhead expenses (rent, property taxes, insurance, etc.) should be allocated equally. However, if doctors are not working the same number of days/hours, or using the same number of operatories and assistants, an unequal allocation of fixed overhead expenses may be appropriate.
The situation becomes even more complicated when doctors are providing different types of specialty services (e.g. a group practice that includes general dentistry, orthodontics, oral surgery, etc. all under one roof), which is becoming more common these days. Doctors providing specialty services in such a captive arrangement will typically earn a somewhat lower percentage of profits than their colleagues in a non-captive specialty practice, since they are spending no time or money on marketing, as all of their patients are being provided through the captive referral arrangement.
Regardless of the method of allocating income and overhead expenses in a group, there are several basic principles which must be honored. First, while each group member may not necessarily be treated “equally,” the arrangement must be equitable in its approach. Moreover, the allocation method must be reasonably simple and clearly understood by all group members. In addition, there must be a proper incentive to work for the growth of the group as a whole, through practice management and marketing. Most importantly, the arrangements made must be clearly spelled out in the employment agreements between the practice (corporation) and each of the partners as employees, so that the practice’s CPA can assure that the allocations are made fairly in accordance with the agreements.
Maximizing Tax Avoidance
While the tax-saving strategies we recommend apply to all doctors, less than 25% of group practices take full advantage of them. That’s usually due to lack of knowledge about the methods available to optimize tax avoidance while still maintaining fairness among the partners (shareholders). As a result, the average partner ends up overpaying his taxes by at least $10,000-$20,000 a year while underfunding his retirement plan contribution.
While the ability of doctors to vary 401(k) salary deferral amounts is well-known, the practice may also be able to vary the practice-paid contributions on behalf of each partner if the doctors (as a group) have a significant age advantage relative to the average age of the staff. Through using a 401(k) cross-tested profit sharing plan and/or defined benefit plan, employees can be placed in different classes with different contribution rates. This allows contributions to vary for each doctor, while minimizing staff funding costs.
Subchapter S Corporation dividends provide added complexity for group practices operating in that format, since any dividend must be allocated based on the stock ownership percentages, regardless of the doctors’ profit allocation. As a result, the shareholders should agree at the beginning of each year on the total amount of practice profits which will be paid out as Subchapter S dividends, and allocated based on stock ownership. While Subchapter S distributions are subject to federal and state income taxes, they are not subject to payroll taxes, providing an opportunity for significant tax savings. For example, if the shareholders in a 3-doctor group practice agree that $300,000 will be allocated as S Corporation dividends, $100,000 will be allocated to each of the equal shareholders, achieving payroll tax savings of up to $11,400 annually ($300,000 x 3.8%). These savings are not available to group practices operating as regular C Corporations or partnerships, including LLCs.
Each partner should determine the optimum retirement plan contribution and professional expenses (i.e. medical insurance, travel, continuing education, dues, auto expenses, meals and entertainment, etc.) that they wish to take, consistent with the current retirement plan design and their share of the practice profits. Once the group’s income division formula has determined the amount of practice profits allocable to each doctor, the partners then take the agreed upon Subchapter S dividend distributions. Thereafter, each partner can take his remaining share of the practice profits in the most tax-favored manner, based on his needs.
Partners receiving larger retirement plan contributions will end up with less salary, bonuses, and other professional expenses (perks). Conversely, doctors with lower retirement plan contributions will receive more salary, bonuses, and other professional expenses. In this manner, each doctor will be assured that they receive the correct share of practice profits distributed through a combination of Subchapter S dividends, salary, bonuses, retirement plan contributions, and professional expenses.**
In some circumstances, further refinements must be made. For example, if each equal shareholder in a group practice purchases a business automobile, the respective car payment and related expenses will typically be charged against that doctor’s share of the practice profits. However, because the doctors are equal shareholders, the tax benefit of the depreciation and related expenses will be allocated equally between them on the corporate tax return, and reported to them on Schedule K-1. Absent some type of true-up in the allocation of practice profits, there will be a disparity between the amounts paid by each doctor and the tax benefit received.
It should be noted that if the practice operates as an unincorporated partnership/limited liability company, special allocations of income and expenses to individual partners can be achieved for tax purposes, which can avoid this problem. However, special allocations are not permitted with S or C Corporations and, as a result, the disparity will exist unless properly handled.
In order to achieve maximum tax savings, it’s important for doctors to agree on how they can maximize tax deductions in a group practice. Most importantly, their corporate documents (employment agreements and corporate minutes) must be carefully drafted to allow doctors to achieve their goal of maximizing tax avoidance while maintaining fairness among the group members.
In our article "How To Handle Practice Real Estate Matters," we will discuss group practice buy/sell and real estate arrangements.
* Hassan is a CPA, attorney, and partner in McGill and Hassan, P.A., a law firm specializing in providing legal services to dental professionals. For more information, call 877.306.9780.
** For a comprehensive discussion of the recommended system, see “How To Maximize Tax Avoidance In Group Practices,” April 2013.Back
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