Medical Practice Series: How Important is Entity Selection?

In the last publication of WNY Physician’s Magazine, we described to you a fictional medical practice, Mensch Medical Group, P.C. (the “Group”), consisting of three physicians:  Henry, the senior physician; Samuel, the middle-aged physician with a progressive disability, and Lucy, the newly-admitted physician to the practice.  The Group is organized as a professional corporation (“P.C.”).  Presumably, the Group has elected Subchapter “S” status so that the corporation avoids the double taxation problem inherent in a Subchapter “C” corporation.  If an S election was made, then the P.C. has the benefit of limited liability but its physician-shareholders receive pass-through taxation.

In practical terms, this means that each physician- shareholders’ portion of the P.C.’s pro-rata taxable income on an annual basis “passes through” to the individual physician, who then reports the income and pays income taxes on his or her personal tax return, while still avoiding personal liability for the debts of the corporation in the event it becomes insolvent as well as for the bad acts of the other shareholder-physicians, with the exception of malpractice, for which the Group and all of its shareholders remain personally liable as a matter of law. 

Assuming that Henry, Samuel and Lucy, the physician-shareholders of the Group, each hold one-third of the P.C.’s issued and outstanding shares of stock, then under the IRS rules, they must each declare and pay income taxes on one-third of the P.C.’s income, regardless of the actual contributions that they each may have made to the practice.  This is the case because in the context of a P.C., profit and loss must be allocated to each physician-shareholder proportionate to stock ownership.  Stated another way, in a P.C., there can be no unequal allocation of profit and loss.  

If unequal allocation of profit and loss were important to our physician-shareholders, then organizing as a limited liability company (“LLC”) (or converting to a limited liability partnership if they were initially organized as a general partnership) may have been a better choice in the first instance.  Unlike an “S” corporation, a LLC permits unequal allocation of profit and loss (as if organized as a partnership), while affording the same limited liability that the equity owners receive when organized as a corporation.  Keep in mind that a general partnership does not afford limited liability; hence, the LLC is a hybrid form of doing business that is increasingly popular with medical practices. 

An added bonus to the limited liability company form of doing business is that it avoids most of the administrative complexity (and added expense) of a corporation.  For example, in an LLC, there is no need for a Board of Directors and Officers.  All that is required is a well thought-out Operating Agreement that includes management provisions that either appoint a Manager to be responsible for day to day operation and affairs of the Group or that require the physician owners to act collectively, typically by majority vote, to conduct the business of the practice.

However, our Group is organized as a P.C., not as an LLC.  Given Henry’s age, chances are that Henry started the practice many years ago, well before LLC’s were a legally permitted form of doing business.  Most likely, Samuel and then Lucy each were offered an opportunity to buy-in to the practice, probably at a point in time when Henry had already developed a very significant patient base.  Accordingly, Henry may in fact have retained a significantly higher proportion of the corporation’s issued stock, in most cases a majority interest that will not only provide Henry with actual control of the corporation, but that will virtually guarantee that Henry will always receive a higher percentage of the P.C.’s net income at year end. 

On the other hand, the P.C. may also have entered into an employment agreement with each physician, at a stated annual salary that may be different depending on each physician’s contributions to the practice, including status as a founder, actual time commitment and other factors such as gross billings or services as the Manager of the practice.  Under this scenario, the salary (which can vary by physician) is then treated as compensation for services rendered to the P.C. as opposed to a distribution or dividend paid as a consequence of the physician’s status as a shareholder.  Under this approach, any taxable income remaining at year end would then be distributed to each physician-shareholder pro rata to his or her stock ownership.  So long as the salary paid to each physician is reasonable, the IRS will respect this arrangement.

Another important aspect of this P.C. arrangement is voting control.  Assuming that Henry, as the founder, owns 51% or more of the issued and outstanding stock, Henry is in complete control of the P.C. and the Group.  This is the case because the shareholders vote pro rata to their stock ownership to elect the Board of Directors, who ultimately set policy for the Group and make all significant decisions, appointing the officers to carry out their directives, voting on a per capita (or one vote for each director) basis.  A young physician, like Lucy, with a minority stock interest, therefore has absolutely no control over her own destiny, unless of course, Lucy has a good lawyer and advocates for some control when she joins the Group. 

There are number of ways for Lucy to accomplish this objective, including but not limited to insisting on a voting agreement among all of the physician-shareholders that requires each of them to vote their respective shares to appoint each other to the P.C.’s Board of Directors.  This will assure Lucy (and Samuel too!) a seat on the Board of Directors.  Another technique is for Lucy to insist on an employment agreement for a term of years that prohibits a termination of her employment as a physician with the Group except “for cause.”  Since the degree of protection afforded Lucy is directly proportional to the care with which “for cause” is defined in the employment agreement, this is one of those situations where hiring a good lawyer at the outset is a necessity.   The issue of restrictive covenants, including covenants not to compete and not to solicit employees of the Group post-termination are also typically negotiated and included in the employment agreement.  Likewise, a well-drafted shareholders’ agreement is recommended in this situation that includes buy-sell provisions, both for the protection of the P.C. and each of the individual physician-shareholders.  Robert Frost taught us that, “good fences make good neighbors.”  Likewise, medical practices that make the investment in good contracts will stand the test of time and flourish. 

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