Since physicians within a group may have different financial, compensation, and benefit needs, choosing a single set of plans for all providers may not meet the needs of any individual. For example, an unmarried physician with few expenses may prefer to maximize contributions to a pension plan, whereas a physician who is married with a large mortgage and a large family may wish to devote his or her entire paycheck to living expenses. Such a physician may be unable or unwilling to put money into a pension plan. Similarly, a physician may have an employed spouse who has full health insurance provided for the family. This physician might wish to avoid any deductions that would be contributed to health insurance.
Advantages of Employee Status
It is a matter of human nature that people are most comfortable with the status quo. In other words, it is easier to accept that which is familiar than that which is unfamiliar. Since residents in training are employees, when they graduate from their training programs, they generally prefer to stay employees. Multiple aspects of the employee classification, that is, dealing with benefits, tax payments, write-offs, pension plans, and so on are addressed simply by virtue of the employee relationship and involve no complex decision making. This simplicity of tax and benefit management is very attractive to many practitioners.
The benefits of an employee relationship may be substantial. Employees may receive multiple “free” benefits, including paid vacation and sick time. Insurances are often paid by the employer and at a lower cost because of participation in a group plan. Taxes (federal, state, local, social security, Medicare, etc) are automatically withheld and paid by the employer. There is little or no financial risk, as most or all payments are known in advance. Pension plans, if any, are managed by the employer. Also, an employee relationship can be structured with bonuses and incentive payments.
Further, the transition from employee (as a resident) to IC status (postresidency) is fraught with unknowns, complex decisions, deadlines, benefit decisions, and so on. Finally, should the IRS subsequently reclassify the IC as an employee, there are potential significant penalties.
Conceptually, the IC is his own boss. In other words, the hiring entity (ie, contract group) “hires” the services of the provider, rather than hiring the provider. ICs generally are paid more money than employees, since the employer is no longer responsible for withholding taxes or paying benefits. From these additional payments, the IC must separately pay taxes (state, local, federal, including social security and Medicare, etc), benefits (health and other insurances), business expenses, and make contributions to retirement plans. Most ICs separately hire accountants to advise them on the more complex management of payments required by the nonemployee status.
If the employee status is simple and limits risk and complex decision-making, then why would anyone, who has a choice, consider becoming classified as an IC? What are the benefits and advantages?
Simply stated, the answers are flexibility, self-determination, and enhanced contributions to retirement savings.
ICs have greater opportunities to deduct business expenses (BEs). Employees can only deduct BE when they are greater than 2% of their adjusted gross income (AGI). When determining BEs, ICs have no minimum prior to deduction and greater flexibility. Types of BEs deducted by ICs include car expenses (when used to commute for work), equipment purchases, education, and so on. To be clear, to deduct an expense as a BE, it must be a legitimate BE and not a personal expense masquerading as a BE. Discussing a medical situation with friends while at a restaurant would not be deductible.
Payroll taxes on adjusted gross income (FICA) will be the same for both employees and ICs. In an employment model, the employer pays one-half of the taxes and the employee pays one-half as a payroll deduction. An IC pays the entire amount as self-employment taxes, similar to FICA. Under Section 2042 of the Small Business Jobs Act, ICs are permitted to take a deduction on one-half of their self-employment taxes. All other taxes are the same.
Deferring pretax money is considered one of the major advantages to IC classification. As an example, using the year 2012,
- Employees could contribute a maximum of $17,000 ($22,500, if older than 50 years). The employer could contribute as much as $33,000 creating a potential total contribution of $50,000 ($55,500, if older than 50 years). However, not all employers contribute to the employee's benefit plan and most that do only “match” a small percent of the employee's salary up to a certain limit.
- ICs can defer $50,000 into a pretax retirement plan through a combination of four plans (401k, SEP IRA, Defined Benefit Plan, or Simple IRA). Of interest, using a defined benefit plan, ICs can contribute substantially more than $50,000.
To compare the “potential” advantage of the IC, the following case example will be illustrative (Table 87-3). Assuming that
- The practitioner has a gross income of $300,000 and wishes to take home $250,000 after contribution to a retirement plan.
- The employee contributes $50,000 - $17,000 pretax in a 401-K plan and $33,000 subject to taxes ($19,800 after federal and state taxes). The total investment contribution of the employee on an annual basis is $36,800.
- The IC contributes $50,000 (all pretax).
- The differential is $13,200 annually.
- The annual investment rate of return is 10% (assumption).
Over 30 years of steadily investing $50,000 (IC) or $36,800 (employee) with an annual rate of investment return of 10%, the IC will accumulate well over $2,000,000 more than the employee.2 To be clear, some
- Employers will contribute to their employees' plans increasing the pretax contribution
- ICs may utilize a defined benefit plan to defer substantially more than $50,000 annually.
Table 87-3 Comparison of Employee and IC Contribution to Retirement Plans |Favorite Table|Download (.pdf)
Table 87-3 Comparison of Employee and IC Contribution to Retirement Plans
Pre tax contribution
After tax contribution
Annual earnings on contributions
Differential after 30 years
The complexities associated with classification as an IC, and its associated deductions, generally require more substantial and costly involvement of an accountant. Among the many calculations required are quarterly estimates and payments of taxes, determination of BE and benefit deductions, management of deferred income, and so on. These additional steps require regular attention and must be managed accurately to avoid IRS reclassification and penalties.