Beware of S corporation distribuations and basis limitations

Many practices are set up as S corporations for tax reporting purposes, enabling owners to receive dividend payments that aren't subject to Social Security tax. Doctors usually receive these payments when the practice pays for veterinary services and management.

Gary I. Glassman, CPA

However, if you distribute more than the practice earned either this year (net income) or in prior years (retained earnings), the Internal Revenue Service usually reclassifies the distributions as additional wages subject to Social Security taxes. In this case, distributions can create a practice loss with possible basis limitation issues.

As an S corporation, you can't deduct losses from practice financial activity if you don't have what the IRS calls "basis." You obtain basis by contributing money to your corporation in exchange for stock or loans. For example, say you put $1,000 into your new practice in exchange for stock and you also personally loan the practice $10,000. You now have basis of $11,000. Your practice then produces a $15,000 loss for the year. You'll be able to deduct $11,000 of the loss, and the remaining $4,000 will carry over to another year when more basis is developed. The lesson here: Take the time to learn whether a loss will occur in excess of basis, and consider making an additional loan to the practice, so you can deduct the full amount of the loss.

New practice owners should be careful not to get caught in the trap of borrowing money in the corporate name to start their new practice. Many new practices develop losses in the first few years. If the money to start the practice is in the corporate name, you don't develop basis, and you can't take losses when the tax rebate would be most beneficial.

A better way to structure the transaction: The practice owner borrows the money in his or her own name and then contributes the funds to the corporation in the form of a personal loan. Now the loan from the owner qualifies as basis and the early losses are deductible in full.

Gary I. Glassman, CPA, is a partner with Burzenski and Co. PC in East Haven, Conn., and a Veterinary Economics Editorial Advisory Board member.