Why Small Medical Practices Overpay on Self-Employment Tax
Why Small Medical Practices Overpay on Self-Employment Tax
Is your practice is still running as a sole proprietor, a single-member LLC, or an S-corp? If so, there’s a good chance you’re handing the IRS more than you have to, every single year. Most doctors don’t find out they’re overpaying self-employment tax until their accountant finally says something — and usually years too late.
Here’s why that happens, how to tell if it’s happening to you, and what a real fix looks like — no jargon.
Why do medical practices overpay self-employment tax?
Most small medical practices overpay self-employment tax because all of the practice’s net income gets taxed at the full 15.3% self-employment rate. Even when it doesn’t have to. The IRS allows owners who’ve elected S-corp status to split their income into two buckets: a “reasonable” W-2 salary, which is subject to payroll tax, and shareholder distributions, which aren’t. Practices still filing as a sole proprietor or single-member LLC pay the full rate on everything. Practices that elected S-corp status but never revisited the salary split as the practice grew often leave real savings on the table, too.
The fix isn’t complicated. It’s an entity structure and compensation review most CPAs set up once and never look at again.
How does self-employment tax actually work for a medical practice?
Self-employment tax covers Social Security and Medicare — 12.4% and 2.9%, for a combined 15.3% — on net self-employment earnings, up to the annual Social Security wage base for the Social Security portion. If you’re a sole proprietor or a single-member LLC taxed as a disregarded entity, that 15.3% applies to essentially all of your practice’s net income. There’s no way to reduce it inside that structure — the only lever is changing how the practice is taxed.
Why does an S-corp election change the math?
Once a practice elects S-corp status, the owner becomes an employee of the corporation for tax purposes. The corporation pays the owner a W-2 salary — subject to Social Security and Medicare tax, same as any employee’s paycheck — and the remaining profit can be paid out as a shareholder distribution, which isn’t subject to those payroll taxes. Only the salary portion gets taxed at that 15.3% rate; the distribution doesn’t.
As net income goes up, the potential savings generally go up too. This is because a bigger share of the total profit can sit in the distribution bucket instead of the salary bucket.
What counts as “reasonable compensation,” and why does the IRS care?
This is the part practices get wrong. The IRS doesn’t let you set your salary to $1 and call the rest a distribution — that’s the exact scheme reasonable-compensation rules exist to stop. Per the IRS, factors courts and examiners weigh when judging whether a shareholder-employee’s salary is reasonable include:
- Training and experience
- Duties and responsibilities in the practice
- Time and effort actually devoted to the business
- The practice’s dividend/distribution history
- What the practice pays its non-owner employees
- What comparable practices pay for similar work
Set the salary too low relative to those factors and the IRS can reclassify distributions as wages — with back payroll taxes and penalties attached.
The mistake we see most often in medical practices
A practice elects S-corp status early, sets a salary that made sense at the time, and never revisits it. Two or three years later, revenue has grown, the salary hasn’t. And now the practice is sitting in one of two bad spots: either the salary is genuinely too low for what the IRS would consider reasonable — an audit risk. Or the practice never resets the split to reflect current earnings, and quietly overpays year after year without realizing it.
Either way, the fix is the same: an annual comp review, not a one-time setup.
What this means for you
If your practice is still a sole proprietorship or a single-member LLC and you’re clearing meaningful profit after expenses, it’s worth a real conversation about whether an S-corp election makes sense. If you’ve already elected S-corp status, it’s worth asking one question at your next tax planning meeting: “When did we last actually review my salary versus distribution split?” If the honest answer is “not since we set it up,” that’s the conversation to have before the next tax season, not during it.
Frequently asked questions
It depends on current entity structure, net income, and how you’ve set the salary/distribution split — which is exactly why this isn’t a DIY calculation.
No. It generally makes the most sense once a practice has consistent, meaningful profit above a reasonable salary. Practices with thin or unpredictable margins may not see enough benefit to justify the added payroll and compliance overhead.
There’s no fixed IRS formula — it’s judged on the factors above, compared against your training, role, and what comparable practices pay. A CPA who does this regularly can benchmark it for you.
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Disclaimer: This article is provided for general informational purposes only and does not constitute tax, legal, accounting, or financial advice. Every business situation is different. Before acting on anything you read here, please consult with a qualified advisor — including, we hope, us. Reach out to Accounting Freedom for guidance specific to your situation.
Frank Fiore, CPA, is the President and Visionary of Accounting Freedom and Payroll Freedom, serving small business owners across Illinois and Wisconsin. He and his team work with medical practices, contractors, and family-owned businesses on the tax planning, entity structure, and compensation decisions that actually move the needle on what owners keep.