In the recent tax law changes, Congress added the highly complex Section 199A, which provides an extra deduction for doctors and other owners of pass-through business entities. In general, the new law provides an extra deduction equal to 20% of the combined qualified business income (net profits) from all businesses and practices operated by the doctor and spouse. However, Congress also sought to limit (or eliminate) the deduction for higher income doctors and other business owners based upon the type of business operated.
For doctors, lawyers, accountants, or any other business where the principal asset is the reputation and skill of one or more of its employees, the deduction is phased out for single taxpayers with taxable incomes beginning at $157,500 and eliminated at $207,500 of taxable income, and for married taxpayers beginning at $315,000 of taxable income and eliminated at $415,000 of taxable income (the income threshold). Thus, doctors get no (zero) deduction if their taxable income exceeds $207,500 if single or $415,000 if married. However, even though it appears on the surface that all savings is lost above this level, careful planning can still salvage this deduction for doctors above this income. Below are a few strategies that, as of now, will help doctors save thousands—regardless of their income level.
Implement a cash balance plan—This is in addition to the doctor’s defined contribution plan. A cash balance plan is an excellent strategy to reduce income at specific dollar levels. It crafts a benefit formula that leaves the doctor with a projected taxable income that will trigger the deduction.
Employ your children through the practice—Pay them the highest reasonable value for their services. Thanks to the increased standard deduction, each child can now earn up to $12,000 annually that is free of federal income taxes. By increasing income paid to children for services rendered, this can have a substantial impact on taxable income to the owner of the practice.
Establish a separate lab or x-ray records business—Pay the highest reasonable rate for its services through a separate entity owned by you and/or your children. Since this separate business is an imaging or laboratory business (and not a dental business), it will report taxes outside of the dental specialty code and is not a personal services corporation.
Establish a dental management company (DMO)—This strategy should be reserved for larger practices that have a significant amount of profit, even after establishing a lab business. This separate qualifying business can provide billing, collection, insurance coding, and other management and administrative services to your practice through a separate pass-through entity. This aggressive strategy is subject to IRS audit risk unless the DMO is organized and operated correctly. As such, we do not recommend establishing a management company until the IRS issues guidance.
Increase the rental amount paid—Do this for the use of the practice real estate to the real estate LLC or family limited partnership (FLP) owned by you and/or your children. Real estate rental income is viewed favorably under the new code.
Review your investment asset allocation—Do this to minimize investment income on your personal return. For example, moving assets out of taxable bonds and into individual stocks or tax-free bonds will help reduce taxable income. By reallocating and holding income-producing investments in retirement plans rather than personal investments, this reduces needless income on the doctor’s return that phases out the deduction.
Keep in mind that this tax bill has created many questions, and the IRS has yet to issue any definitive regulations interpreting the new law. Nor have they issued any guidance in the form of questions and answers concerning the calculation of the new Section 199A deduction. For that reason, it’s difficult to know for certain what regulations will limit or preclude any of the strategies defined above from being implemented to reduce taxable income. However, it’s difficult to adjust the doctor’s taxable income after year’s end in order to increase his or her Section 199A deduction. Accordingly, doctors should begin their tax planning as early as possible in 2018 to qualify for the maximum deduction under the new law.
Andrew Tucker, JD, CPA, CFP, and John K. McGill, JD, MBA, CPA, provide tax and business planning for dentists and specialists. Mr. McGill publishes the McGill Advisory newsletter through John K. McGill & Company Inc., a member of the McGill & Hill Group LLC, the one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment advisory services. Visit mcgillhillgroup.com.
