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Corporate Conversion: Dealing With Zero-Basis Patient Receivables

11/3/2017

In certain circumstances, it can be a good tax idea to convert a medical practice operating as a C or S corporation into a limited liability company (LLC) or limited liability partnership (LLP). Here's why: Both LLCs and LLPs can be treated as partnerships for federal tax purposes. The tax rules for partnerships are far more flexible than the rules for corporations.

Word cloud with a question mark in the center and corporation-related words surrounding it

In addition, a practice that's treated as a partnership qualifies for favorable pass-through taxation. Under the pass-through concept, the income, deduction and tax credit items of the practice are passed through to the individual owners and taken into account on their personal returns (LLC owners are called members rather than partners). There's no practice-level federal income tax to worry about. For this reason, pass-through taxation avoids the classic C corporation problem of potential double taxation of the profits of the practice (once at the corporate level and again at the shareholder level when taxable dividends are paid out to the owners). Of course, pass-through taxation also applies to practices run as S corporations. However, other aspects of the S corporation tax rules are generally much less favorable than the rules for medical practices treated as partnerships (including those operating as LLCs or LLPs).

Converting to LLC or LLP status could make sense for your medical practice because of the long-term tax advantages such status would deliver. Here's the problem: When a C corporation converts to LLC or LLP status, it's considered to be liquidated for federal income tax purposes. In other words, the corporation is deemed to sell all its assets, become liable for the resulting corporate-level taxes on appreciated assets (if any), and then distribute all the assets remaining after paying the tax bills to the shareholders in complete liquidation. To the extent the imaginary liquidation proceeds deemed to be received by a shareholder exceed his or her tax basis in the stock of the practice, taxable capital gain is triggered at the shareholder level. This is double taxation -- something you undoubtedly don't want to pay. (Sections 331 and 336 of the Internal Revenue Code)

If your practice operates as an S corporation, there's generally no corporate-level federal income tax bill, but the corporate-level gain from the deemed asset sale must be passed through to the shareholders, where it can trigger personal income tax bills.

Key Point: This deemed liquidation treatment means an incorporated medical practice with appreciated assets may trigger significant taxable gains and large current tax liabilities, from converting into an LLC or LLP. If so, the tax cost of converting may simply be prohibitive.

Watch Out For Zero-Basis Patient Receivables

You now can see the negative tax impact of converting an incorporated medical practice that owns appreciated assets. Before concluding that your practice is unaffected by this issue (because it doesn't have much in the way of appreciated assets), don't forget that your practice's zero-basis patient receivables count as an appreciated asset. These receivables obviously have value, but they have no tax basis if your practice uses the cash method of accounting (as most professional offices do). The difference between the fair market value of the receivables (which is probably a big number) and their tax basis of zero must be recognized as taxable income at the time the practice converts into an LLC or LLP. This could create a painful tax hit.

What can be done about it? With some advanced planning, your medical practice may be able to avoid the zero-basis patient receivables problem. For example:

  • The practice could factor the receivables (sell them to an outfit that specializes in this type of financing) and then pay out the resulting cash as deductible salary to practice shareholders and employees. That way, the taxable income triggered by selling the receivables is offset by the salary expense deduction and the appreciated patient receivables are removed from the books with no tax harm done.
  • Assuming your incorporated medical practice will actually be liquidated in a legal sense as part of the switch to LLC or LLP status, you could pick a date to start running all new patient fees through the new entity. Meanwhile, you could leave the corporation in existence to finish up with the old business of collecting outstanding patient receivables and paying out the resulting cash as deductible salary to your shareholders and employees. At that point, the corporation could be liquidated without tax consequences from the patient receivables, because there wouldn't be any.

Warning: Your practice may have another significantly appreciated asset to worry about in the form of professional goodwill. For more on that subject, click here to read our previous article, "Watch Out for Potential Tax Bill When Converting Corporation."

Conclusion: Converting an existing incorporated medical practice into an LLC or LLP can be problematic from a tax standpoint. The key factor is whether the corporation is considered to own significantly appreciated assets. If not, conversion should not have major negative tax consequences. However, if it does own significantly appreciated assets, converting could trigger a significant and unexpected current tax bill, which could make converting an unattractive proposition. However, it may be possible to plan around the tax problems caused by appreciated assets. In any case, all tax issues associated with converting the practice into an LLC or LLP should be carefully assessed before the transaction has been completed. Contact us for advice.

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