The S Corporation trap – revisited

by Brian Hufford, CPA, CFP®

Immediately before the last presidential election, I was asked to submit two articles for magazine publication -- one for the financial implications of a Mitt Romney win, and one for a Barack Obama victory.

The plan was that the editor would select the appropriate musings based upon the election outcome. In my Obama-win article, I stated that an Obama victory would be most beneficial to young dentists. My belief was based on the Keynesian tendency to incentivize equipment purchases to grow the economy with very favorable tax laws.

This forecast has indeed come true. With Fiscal Cliff negotiations early in 2013, Section 179 Expensing was increased from the scheduled $25,000 limit up to a maximum of $500,000. With the on-again/off-again character of tax laws in these times, the expensing limit is scheduled to drop once again to $25,000 in 2014. This $500,000 amount creates tremendous tax incentives for dentists in 2013 to purchase and write off large amounts of equipment.

The purpose of this column is not only to ensure that you are aware of the 2013 $500,000 Section 179 expensing deduction, but also to support your planning for actually realizing the deduction in an S Corporation.

With the dozens of dental S Corporation tax returns that I review annually, I rarely see a dentist who is able to realize the full or even any of the tax benefits associated with equipment purchases. This S Corporation trap of losing the benefits of Section 179 Expensing is perhaps the most common large-tax mistake among dentists who practice in the S Corporation form.

Here is how the lost deductions happen. Suppose a dentist, who practices as an S Corporation, wants to purchase and equip an office with $200,000 of new equipment purchases in 2013. This dentist obtains a loan in the corporate name and purchases the equipment, hoping to expense $200,000. Instead, next April, the dentist learns from his or her accountant that none of the equipment could be deducted in 2013, and that the full amount must be carried to future years. So, instead of a hefty tax savings, this dentist has a hefty tax bill in spite of the large equipment purchases. How could this outcome have been prevented?

The tax law concept that creates the S Corporation trap is called S Corporation "basis." In order for a Section 179 Expensing deduction to be used by the dentist, there must be sufficient "basis" in the S Corporation to allow the deduction on the dentist's personal tax return.

Let me create a simplified example to illustrate this "basis" concept. Suppose in our $200,000 equipment example that this dentist had paid no salary in his or her S Corporation -- this is actually not possible under current IRS audit guidelines -- and had $250,000 of profit prior to the equipment purchase. Also, assume that the dentist has simply distributed the $250,000 of profit to himself or herself as nontaxable S Corporation distributions.

The dentist's basis in the S Corporation is $250,000 of profit minus $250,000 of distributions -- or zero. Loans inside the S Corporation do not increase basis. We want the tax result to be $250,000 of profit minus $200,000 of expensing or $50,000 of taxable income. But because of the "basis" problem, the dentist is still taxed on $250,000 of income in 2013.

There are typically three ways around this "basis" problem in the S Corporation trap.

The first is to be independently wealthy and simply pay cash for the equipment within the S Corporation.

The second is to leave $200,000 of cash in the S Corporation and not distribute it to the dentist. This is a unique approach to weight loss due to insufficient funds for food at home because of a lack of useable income.

The third method is having the bank make the loan to the dentist personally, outside the corporation. Since the loan is outside the corporation, it creates a basis for the dentist to be able to deduct the expensing amount. Most dentists are not wealthy enough or heavy enough for the first two methods.

S Corporation basis problems are the largest tax barrier for lowering income tax obligations with Section 179 for dentistry. Before purchasing any equipment this year, it is important that you have a "basis" discussion with your accountant and orient any equipment loans properly to avoid the shock of being ineligible for the large deductions available in 2013.

Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].