As a broad proposition, double taxation is a concept that theoretically describes the taxation of earnings at the corporate level, and the subsequent taxation of such earnings upon their distribution to the shareholders. In order to mitigate or reduce the impact of double taxation, taxpayers have historically employed various strategies that have had the effect of reducing either the corporate-level tax or the shareholder-level tax (or both). In many cases, however, taxpayers have employed a rather simple solution to the issue of double taxation by taking advantage of Subchapter S of the Internal Revenue Code. Subchapter S permits taxpayers to elect out of double taxation by making a so-called "S-election." Under Subchapter S, earnings are generally taxed only at the shareholder level, and not at the corporation level. As such, the election under Subchapter S effectively eliminates the impact of double taxation, subject to certain exceptions imposed by Congress (such as the built-in gains tax and the excess passive income tax) in order to prevent abuse and similar unintended tax avoidance schemes.

Jobs and Growth Tax Relief Reconciliation Act of 2003

On May 28, 2003, the landscape of double taxation changed when President George W. Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Under JGTRRA, Congress reduced the impact of double taxation by reducing the maximum tax rate for certain dividends to a maximum rate of 15 percent for dividends received between January 1, 2003 and December 31, 2008. In order to qualify for the lower tax rate, the dividend must be a "qualified" dividend. In general, a dividend is "qualified" if it is received from a domestic corporation or from certain qualified foreign corporations. A dividend is not qualified if received from a tax-exempt corporation, nor is it qualified if it is, in essence, an interest payment (such as a dividend paid by mutual savings bank), or if it is paid on stock owned by an employee stock ownership plan.

In order to qualify for the lower tax rates, the taxpayer must hold the dividend-paying stock for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. A dividend is not a qualified dividend if the taxpayer includes the dividend as investment income for purposes of computing his or her investment interest expense deduction.

Caution must be exercised in any analysis involving qualification of a dividend. The qualification of a dividend for the lower tax rate structure is complex and beyond the scope of this article. Accordingly, the foregoing discussion is intended merely to introduce the concept and is not intended to provide a comprehensive list of exceptions to, and prerequisites for, qualified status.

Application to Physician Practices as S Corporations

Assuming that a dividend is a qualified dividend, a lower tax rate applies, which has the impact of mitigating the effect of double taxation. Taxpayers have historically employed various means by which to avoid or reduce the impact of double taxation, and election under Subchapter S of the Internal Revenue Code has such an effect. At issue is whether the concept of the S corporation remains viable in light of the reduction of tax rates applicable to dividends under JGTRRA.

As a result of the enactment of JGTRRA, a physician practice that is taxed under Subchapter S must now focus on whether there are any disadvantages to continuing as an S corporation, as opposed to terminating the S election. Upon termination of the S election, the corporation becomes subject to double taxation under Subchapter C of the Internal Revenue Code. That is, it becomes a "C corporation." The issue is whether the impact of this double tax structure is sufficiently adverse to dictate against termination of the S election.

It is certainly clear that the advantage of the single tax concept of Subchapter S is less significant due to the reduction in tax rates applicable to dividends paid by C corporations after JGTRRA. Consequently, it is important to examine the advantages of taxation under Subchapter C. One advantage might rest with the benefits available to the shareholders of a C corporation. As an example, unlike the S corporation, where reasonable minimization of compensation prevails, there is a disincentive to minimizing compensation in a C corporation setting. This has the potential effect of increasing retirement plan contributions on behalf of the shareholders. Given the appropriate set of demographics, retirement plan techniques may be available to benefit the shareholders, such as new comparability (cross-tested) plans and defined benefit plans. In addition, proper year-round planning can operate to effectively further mitigate the impact of double-taxation. Finally, the passive income tax regime that is applicable to S corporations is not applicable to C corporations.

Before any termination of an S election in favor of C status is contemplated, however, the disadvantage of doing so must be considered. Although beyond the scope of this article, the disadvantages are primarily administrative in nature, and the complexity of the administrative process, including the treatment of certain tax items and attributes after the termination, may be cost-prohibitive. It is important to note that, while JGTRRA reduced the impact of double taxation applicable in the C corporation context, Congress did not eliminate double taxation. Double taxation continues as a vital part of the C corporation tax regime. Thus, unlike a physician practice operating under an S election, operation as a C corporation will always require some level of planning in order to reduce the impact of double taxation, albeit reduced. Such planning requires careful (and sometimes costly) analysis.

For example, a C corporation might be inclined to increase compensation payments to its shareholders and/or management in order to reduce taxable income. However, the Internal Revenue Service will be keenly interested in the nature of such compensation payments. Specifically, the Service will be most interested whether the compensation is reasonable under the circumstances. This is a critical issue, since the portion of any salary or compensation that is considered to be excessive can be reclassified by the Service as a non-deductible dividend. While the impact of such a reclassification is mitigated by the fact that any reclassed compensation should be eligible for the lower dividend tax rates under JGTRRA, extreme caution should be exercised, since there is case law that permits the Service to disallow a deduction at the corporate level while continuing compensation treatment at the shareholder level. Compensation is taxed at higher ordinary income tax rates.

Consequently, there may be significant support for maintaining the S election rather than terminating the election. More important, under Subchapter S, losses continue to pass through to the shareholders, assuming the shareholders have sufficient basis in their stock. Capital gains experienced by the S Corporation generally retain their character as they pass through to the shareholders, so that long-term capital gains will be taxed at a maximum rate of 15 percent. While the S corporation must contend with the passive income tax imposed under the Internal Revenue Code, proper planning can mitigate the impact of this tax. For example, an S corporation with accumulated earnings and profits from a prior existence as a C corporation might be inclined to make a distribution under an available taxpayer election that reduces the impact of the passive income tax. While the shareholders will pay taxes on such distributions, the distributions should be taxed at the lower tax rate that applies to qualified dividends.

However, assuming a physician practice decides to retain its S election, S corporation planning must nonetheless proceed with caution. As an example, the rules related to reasonable compensation apply to S corporations as well. Unlike the C corporation, where increased compensation levels tend to benefit the parties, the opposite can be true in the case of an S corporation. The Internal Revenue Service will be most interested in situations in which compensation is unjustifiably low and tax-free distributions are unjustifiably high.

The continued viability of the S election has become somewhat more questionable since the enactment of JGTRRA. It is clear, however, that taxpayers should not hastily make a decision without adequately considering all the advantages and disadvantages of continuing as an S corporation as opposed to terminating the S election in favor of status as a C corporation.