Most psychologists’ businesses are too small to justify the cost of an in-house controller or business manager. They can instead rely on a small business accountant to act as that business manager/controller on an as-needed basis. An accountant can make recommendations to hire bookkeepers, purchase billing/accounting software, develop business strategies, and find acceptable payroll services. An accountant can also help separate cash and check depositing, billing, payment posting to accounts receivable, and bill paying duties. These steps minimize the opportunity for financial mistakes. Having a small business consultant take over these responsibilities allows the psychologist to focus on building a practice.
1) Business Entity Decision: LLCs
In establishing a practice, determining the type of business entity is one of your first important decisions. No single method fits all psychologists, but generally we recommend starting with a Limited Liability Company (LLC). For a one-person practice, a single-member cash-basis LLC is the entity of choice. The IRS calls this a “disregarded entity” for tax purposes but it is still a recognized entity for legal purposes. This structure allows for psychologists to file business income and expenses on Schedule C of their personal tax returns. This eliminates the need for a separate return required by other types of legal entities.
If two or more psychologists are establishing a joint practice, the LLC is taxed as a partnership since there is more than one member. Partnerships offer flexibility in revenue and expense sharing arrangements, and make practice expansion easier.
Despite the proliferation of LLCs, there are some strong arguments for incorporating. Many attorneys prefer the corporate form of organizing businesses because of the longer case-law history to support its protective attributes, sometimes referred to as the “Protective Shell” or “Corporate Veil.” Additionally, every state authorizes the practice of health professionals in the corporate form (or as associations, with a similar effect) in order to provide special protections and responsibilities. As you will see below, by making a Subchapter “S” Election, members of a LLC can almost have the best of both worlds.
The choice of business entity will determine the type of tax return(s) a practitioner will file. Limited Liability Companies (LLC) and Subchapter S filing entities ultimately report the owner’s respective share of earnings in that owner’s personal income tax returns. With that in mind, we recommend looking at business income and expenses as an extension of the individual owner’s personal taxes.
Some practitioners prefer the corporate form of organization. When you incorporate, you create a legal entity and a separate taxpayer, the “C” corporation. The downside for health service providers is that the internal revenue code treats a “C” corporation as a “personal service corporation” and taxes every dollar of profit at 35%. We see no good reason for health service providers to establish a personal service corporation.
We recommend associates sign corporate documents simultaneously with all shareholders signing the federal form 2553, Election by a Small Business Corporation. This is commonly referred to as an “S” election, “S” Corporation or small business corporation. For tax purposes, these corporations are treated similar to partnerships. “S” corporations do not pay federal income tax; rather their profits and losses pass through directly to shareholders. Notice the word “similar” when referring to partnerships. This is still the same corporate legal entity subject to the applicable state laws governing corporations. The “S” corporation is an internal revenue code provision relating to both federal and usually state tax treatment. Many tax practitioners recommend using “S” corporations because of the potential payroll tax savings on the distributions of profits in excess of reasonable professional salaries and wages.
Although it sounds like we just made the case for incorporating and making the subchapter "S" election, member(s) of an LLC can be treated as a corporation for tax purposes and simultaneously elect Subchapter "S" status without changing the legal entity from an LLC. So, there are two ways to reach the subchapter “S” tax treatment. Generally, start-up practitioners should begin their careers as limited liability companies and progress to the subchapter “S” status when profits are sufficient to produce payroll tax savings. More established practitioners associating together should consider starting with the corporation/subchapter “S” entity.
3) Accountant’s Reporting on Financial Statements: Compilations, Reviews, and Audits
There are three basic levels of financial reporting: compilation, review, and audit. The differences relate to the level of assurances expressed on the financial statements. For a higher level of assurance, more work is required to be performed by the accountant. A compilation differs from a review in that the compilation does not contemplate performing inquiry, analytical procedures, or other procedures performed in a review. Additionally, compilations and reviews differ from audits in that neither obtains an understanding of the entity’s internal controls, assesses fraud risk, tests accounting records by obtaining sufficient appropriate audit evidence through inspection, observation, confirmation, or performs other procedures of a typical audit.
Compilations: A compilation, the basic form of reporting, consists of presenting financial statement information that is the representation of management without undertaking to express any assurance on the statements. The accountant accepts the clients’ figures and presents them in the proper financial statement format and categories consistent with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. The quality of the clients’ financial statements is determined by the quality of the bookkeeping services provided by the client’s bookkeeping staff and the accountant’s assistance and training. It is common for bookkeeping services and compilation of financial statements to be performed by the client’s accountant.
We estimate that greater than 90% of all reporting on financial statements for psychology practices are compiled financial statements without footnotes (no disclosures). The financial statements are usually prepared on the tax basis of accounting used by the practice, typically cash basis. Income is recognized when received rather than when earned and expenses are recognized when paid rather than when incurred. This method is cost effective since the financial statements and resulting report come from figures used in the preparation of the practice’s income tax returns.
Reviews: Reviews are sometimes required by banks when large amounts of lines-of-credit are requested or large equipment purchases are financed. However, instead of a review, lenders may ask for certain agreed upon procedures to be performed by the accountant. One such procedure is to review and report on the accuracy of accounts receivable, which would include an off-balance-sheet asset used as collateral for a line of credit.
Audits: Audits are generally required for very large financing requests, absentee owners, numerous locations, and publicly held entities. Psychology practices are usually the opposite in that they are owned by the people working in them every day who have a good sense of how their practices are operating before the accountant or banker would know. This would be a highly unusual engagement for psychologists.
Audits are predicated on an evaluation of internal control and while an audit is rare for psychologists, an optimum system of internal control is integral for the smallest of practices. Developing the best system of checks and balances to minimize the opportunity for financial impropriety is always money well spent.
While many psychologists perform their own bookkeeping tasks and maintain their records, these activities can be streamlined through outsourcing. Accounting firms can establish an easy flow of information to allow bookkeeping maintenance with minimal involvement by the psychologist. Routine bookkeeping tasks are best performed using business software packages such as QuickBooks. This program integrates easily with other industry specific billing software to make it very flexible and easy to use. It is inexpensive, training is available online and in classroom settings, and it was created for small business accounting and accountants. Whatever software you choose, the psychologist or accounting firm needs to track clients and billing, establish a general ledger, and classify income and expense transactions. Most bookkeeping work is performed with the ultimate goal of tax returns and financial statement preparation in mind.
5) Financial Statement Preparation
Financial statements are an excellent management information tool for businesses, but they are not the only one. Practitioners should develop plans/budgets of daily billing goals and compare with actual results on a daily or weekly basis. The most successful businesses are managed daily. Budgets, goals, and plans should be communicated to professionals and non-professional staff in writing and continually reviewed and monitored by management.
In addition, business owners should understand their financial statements and relate those statements to the daily and weekly results of production. Financial statements are one more tool that psychologists can use to better manage their practices and plan for taxes. Accountants are allowed to issue financial statements without issuing an accountant’s report if the statements are restricted to internal use by management. This makes statement preparation more cost effective, easily available to practitioners, and satisfies the banker’s requirements when tax returns are prepared.
6) Payroll Preparation and Payroll Tax Returns
Our recommendation for payroll preparation, deposits, and forms preparation is simple: outsource it! This is an area of your practice that can consume a large amount of time and expose you to significant liabilities. The paperwork is burdensome, the tax deposit requirements vary by state and can be very complicated, and the penalties for mistakes are costly. There are good payroll service providers that prepare all of those functions for you at reasonable prices. We encourage allowing them to withhold and pay your payroll taxes as well as file your quarterly and annual reports, including W2s for employees. A payroll service will guarantee the payroll deposits are made in a timely fashion so you will not incur any interest or penalties. When selecting a payroll service provider, we encourage you to choose a large, well known national company - and check local references.
7) Banking Relationships
A strong banking relationship is essential for psychologists, and establishing a business line-of-credit is always a good idea. You can access it to purchase computer hardware, software upgrades, expand office space to bring on additional practitioners, or prepay expenses to reduce taxes for the current year. Lines-of-credit smooth those spikes in cash needs. The first step in establishing this relationship is the preparation of high quality financial statements.
The Powell Accountancy Group
The Powell Accountacy Group has more than 30 years of experience in tax preparation, accounting, and businees consulting services. Based in Birmingham, AL, The Powell Group is available to provide high-quality services to National Register credentialed psychologists regardless of location. For more information, see www.powellaccountancygroup.com or call 205-824-8813 or 4537.