Choosing your medical practice entity

By Dennis Hursh, Esq.

Congratulations! You have decided to form a new medical practice. You are probably already discovering that the power to manage your world and make major decisions that will affect your practice carries with it the obligation to make countless other decisions that you would just as soon avoid. One of the decisions that you will have to make very early in the process is the choice of legal entity for your medical practice. The purpose of this article is to allow you to consider some of the major factors involved in the selection of entity, so that you have a better sense of your options when you consult with legal counsel.

Some of the significant considerations involved in the various types of entities are summarized below.

Sole Proprietorship

This one is easy. In many respects, a sole proprietorship is not a separate legal entity. The sole proprietorship is really just you operating a business. Income and losses from the sole proprietorship are reflected on a Schedule C that is part of your personal income tax return. You may need a separate tax identification number for payroll tax purposes, but generally, there are no federal or state filings to “form” this entity or to maintain a “registration.” As noted below, many other entities do require annual registration fees.

A sole proprietorship will provide no personal liability protection from creditors’ claims against the practice. This is generally not a major consideration, however, since the largest exposure you will probably face will be from a malpractice claim. Since no entity shields you from claims relating to your own malpractice, exposure to creditors is probably not a big deal to most sole proprietors.

However, a sole proprietorship is not for everybody. By definition, no one else can ever own a part of this entity. Therefore, if you plan to expand and someday bring in partners, you probably do not want to start with a sole proprietorship. Why not start with a sole proprietorship then change the form of entity later when you want to bring in new partners? Quite simply, third-party payers will make you crazy if you try this. Managed care companies identify you through a tax ID number. Causing most companies to change this number is the equivalent of being credentialed from scratch. CMS often takes months to recognize this change, during which time your Medicare reimbursements could be suspended. Accordingly, a sole proprietorship is probably not the best choice if you think your practice is going to expand to include other physician owners some day.

General Partnership

Do not try this at home! If you are considering a general partnership, there is obviously more than one physician involved. (Generally, any entity providing professional services must only have licensed professionals as owners). Under Pennsylvania law, each general partner is jointly and severally liable for all debts of the partnership. Accordingly, if your partner is subject to a malpractice claim that also names the partnership, your personal assets will be exposed.

Therefore, a general partnership is rarely an appropriate form of entity for a medical practice.

Registered Limited Liability Partnership

A registered limited liability partnership (LLP) is a general or limited partnership that registers with the state in order to obtain limited liability for its partners. “Limited liability” for this purpose means liability for the debts of the partnership other than liability relating to malpractice claims for an individual partner’s own malpractice or the malpractice of an individual directly supervised by that partner.

Annual registration is required to maintain LLP status. The registration fee to Pennsylvania is annually adjusted for inflation. In 2008, this fee is $280 per partner.

An LLP can be formed through either an oral or written partnership agreement, but it would be foolhardy to rely on an oral agreement for such an important business enterprise. Competent legal counsel should be involved in drafting any such agreement. Although it will obviously increase the total expenses, it would be preferable to have each partner separately represented in negotiating the partnership agreement.

An LLP does not pay income taxes at the entity level. Instead, income and losses are “passed through” to the individual partners, generally based upon their ownership percentage. However, an LLP is required to file a tax return to reflect the amounts passed through to its owners.

New owners will be deemed to purchase partnership interests from the existing owners, thereby triggering tax consequences each time a new partner is admitted to the partnership.

Professional Limited Liability Company

A professional limited liability company (PLLC) provides shelter from debts of the entity not caused by an individual owner’s own malpractice (or the malpractice of somebody directly supervised by that owner). If there is more than one owner, the rights and duties of the individual owners of a PLLC are set forth in an “operating agreement.” The operating agreement may be oral or written, but it would be foolhardy to rely upon an oral agreement for an enterprise of this magnitude. As is the case with a partnership agreement, ideally each owner should be represented separately in negotiation of the operating agreement.

A PLLC, like a LLP, is a pass-through entity. That is to say, although a tax return is filed by the entity, no income taxes are paid by the PLLC. Instead, income and losses are passed through to the individual owners (“members”).

Pennsylvania requires an annual registration fee for each member. In 2008, this amount is $420 per member. This annual registration fee is indexed for inflation.

A PLLC could be utilized by a sole practitioner who intends to expand the practice and bring in new owners over time. However, additional owners necessitate negotiation of an operating agreement – which could be costly.

New members will be deemed to purchase membership interests from the existing members, thereby triggering tax consequences to the existing members each time a new owner is admitted.

Professional Corporation

A professional corporation (PC), like most of the other entities discussed above, shields its owners (“shareholders”) from liabilities related to malpractice of professionals that are not directly supervised by that shareholder. A PC is generally less expensive to form and maintain. Unlike the other entities discussed above (except for sole proprietorships), the governance of the entity is generally not set forth in an agreement signed by all of the owners. Instead, corporate bylaws provide for the governance of the entity. The author has formed dozens of these entities, with only about two questions over 20 years concerning bylaws. This may be the result of superb legal draftsmanship. More probably, few physicians bother reading the document. A partnership agreement or operating agreement executed by the physician will obviously receive much greater scrutiny than boilerplate bylaws.

A PC is required to file annual income tax returns. In the absence of an election otherwise, income is not passed through to the shareholders, but is paid at the corporate level. This is frequently referred to as “double taxation.” However, since most medical practices exist solely to provide an income for the owners, it is somewhat unusual for a PC to have significant taxable income, since the salaries paid to the employees of the corporation (including its owners) represents a tax deduction. These salaries tend to be very close to the actual cash flow of the entity.

A PC can be structured as a pass-through entity, by making an election to be taxed under Subchapter S of the Internal Revenue Code. Tax lawyers and accountants, being the creative individuals they are, call this election an “S election” and refer to corporations that have made this election as “S corporations.”

No annual registration is required of a PC. Although it may be subject to capital stock and franchise tax in Pennsylvania, this tax rarely generates a liability for professional practices because the tax is based on the income (net of expenses) and assets of the PC, which tends to exempt most practices.

A PC can be a good choice for a sole practitioner who intends to expand the practice over time, since the entity lends itself easily to admittance of new owners with no tax effect on the existing owners, by causing the PC to issue new stock directly to new owners.

Common Threads

In any entity other than a sole proprietorship, an employment agreement should be utilized to set forth each physician’s rights and obligations as an employee of the practice. In addition, governance and “buy sell” provisions should be agreed upon by the owners.

A dizzying array of choices is available with respect to the formation of a medical practice. Competent legal counsel should be obtained early on to help you sort out your options and choose the best form of entity for you. This article should give you a reasonable background for discussions with your lawyer.

Dennis Hursh, Esq., is a principal in Hursh & Hursh, P.C., a Middletown, Pennsylvania law firm concentrating on representation of physicians and physician group practices.