Update: Regulations significantly tighten the new 20% pass-through deduction
All dentists want to make the most of their earnings. But taxes are confusing. Who better to explain the ins and outs of taxes than two tax experts who work closely with dentists. Here’s the latest on the changes to the 20% pass-through deduction.
We concluded our July 2018 Dental Economics article about tax-planning tactics by saying, “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.”1 Little did we know that the IRS would dramatically limit what would work under the new framework for the deduction.
In this article, we’ll outline what will or will not work, and despite heavy regulation, this will still benefit many doctors.
As a refresher, Congress added Section 199A in late 2017. It provides an extra tax deduction equal to 20% of profits from sole proprietors (schedule C), LLCs and partnerships, and subchapter S corporations. However, Congress limited this deduction for service businesses, which include dentistry. The new deduction is phased out for doctors with taxable incomes beginning at $157,500 (single) and $315,000 (married) and is totally eliminated at taxable incomes of $207,500 (single) and $415,000 (married). Thus, doctors whose taxable incomes exceed $207,500 if single or $415,000 if married are eligible for no (zero) deduction under Section 199A.
There was much ado about what is often referred to as “crack and pack”—breaking up certain parts of a business into different entities to avoid personal service limitations:
• Establishing a dental management organization (DMO) for a business’s billing, collection, insurance coding, and other management and administrative services,
• Establishing a separate lab or x-ray business and paying the highest reasonable rate for its services through a separate entity owned by you and/or your children,
• Increasing the rental amount paid for the use of the practice real estate owned by you and/or your children (through an LLC or FLP).
Unfortunately, under the regulations released by the Department of the Treasury on August 8, 2018, these strategies will not work for most practices. For most doctors, this means the only meaningful planning that can be done is controlling taxable income to fall below the thresholds outlined above.
One positive is that the thresholds are not adjusted gross income thresholds; they are taxable income thresholds, which means that itemized deductions can have an impact on whether a doctor will qualify for the deduction. This creates opportunities for doctors who earn between $315,000 and $600,000 of taxable income to force it to threshold levels. Here’s how they can do this:
• Increase retirement plan contributions by making profit-sharing contributions (up to approximately $60,000) or potentially adding a cash-balance retirement plan (up to $200,000-plus). These plans can be used to directly target $315,000 in taxable income due to their flexibility of contributions.
• Convert additional personal expenses into legitimate business tax deductions as the tax savings effect will be magnified.
• Review investment asset allocation to minimize investment income on personal return, particularly for income-producing investments such as bonds and dividend-paying stocks, which should be held predominately in retirement accounts.
• Optimize depreciation. Careful management of depreciation deductions can help doctors stay under the income threshold for as many years as possible. Keep in mind that partial elections of IRC 179 depreciation can be used to target a $315,000 taxable income.
• Make batch charitable contributions in a single year to a donor-advised fund to maximize itemized deductions. This can also be used to precisely target a $315,000 taxable income. Thereafter, the proceeds can continue to grow in the donor-advised fund to be given to charity in the timetable originally intended.
As more alterations occur, we will continue to update the Dental Economics community on planning development and changes to the law or regulations.
1. McGill J, Tucker A. Unlocking the new 20% pass-through deduction—regardless of your income level. Dental Economics website. https://www.dentaleconomics.com/articles/print/volume-108/issue-7/money/unlocking-the-new-20-pass-through-deduction-regardless-of-your-income-level.html. Published July 1, 2018.
Andrew Tucker, JD, CFP, CPA, 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.