By Brian Hufford, CPA, CFP®
Large, increasing, Obama-era tax rates have snuck up on dentists like the proverbial frog boiling in water.
First, it was higher marginal income tax rates at 39.6% and a corresponding increase to 20% in capital gains rates. The impact of these higher rates was mitigated in the past for hard-working dentists with bonus depreciation available and Section 179 expensing at $500,000.
Then in 2013, the new Medicare Tax of 0.9% on high income wages, the Net Investment Income Tax of 3.8% on investment income, and the phase-out of itemized deductions created the potential for many dentists to be taxed in excess of 50% for federal and state income taxes.
In 2014, bonus depreciation for equipment is gone and Section 179 expensing is limited to $25,000. The era of small ball income tax planning has ended. It's time for deep strategic tax planning to minimize overall tax burdens.
Most tax planning in the past by dentists exhibited more of a one-off tactical nature, such as expensing equipment at year-end to achieve a much lower bracket or planning a large allocation to goodwill in a practice sale to benefit from low capital gains rates. These days are gone.
Tax planning today is a multistep strategic process, as well as a highly personalized endeavor. Let me give you an example. Recently, I met with a dental specialist who practices as a C corporation. Due to the nature of C corporations, this dentist had high wages subject to the new Medicare Tax and Surtax on wages, and had lost deductions of more than $85,000 in the current year due to improper planning in zeroing-out the C corporation income. The total additional income tax just due to poor entity planning was more than $50,000 in the current year through additional taxes on wages and lost deductions.
Here are important areas of strategic tax planning in this environment:
- Entity planning is critical. The large increase in tax rates has made entity planning extremely important. Subchapter C corporations are a huge problem in the current tax environment. Planning for an S corporation election to escape these problems is necessary. Likewise, S corporations have their own issues. Ongoing wage and "basis" planning as an annual discipline is necessary to assure that large deductions are not sent to the tax twilight zone, unusable in the current year. Wage planning is important for hefty Medicare taxes, and basis planning is critical to avoid the loss of depreciation and retirement deductions due to insufficient S corporation basis.
- Proper "grouping" is the strategic tax planning topic du jour for dentists. Under the no-more-small-ball theme of this column, the arcane topic of tax grouping should be at the forefront. Tax elections to group the incomes of different entities can mean the difference of usable or lost deductions. The most common example is a dentist who practices as an S corporation and leases office space from an LLC rental entity. Recently, I met with a dentist who had performed a cost segregation study that resulted in $75,000 of additional depreciation deductions in the LLC rental entity. Because of the limits on passive loss deductions, all of this depreciation was unusable in the current year. A simple grouping election to group the LLC office rental with the S corporation practice as a single economic unit would have caused all of the deductions to be available. Likewise, dentists who invest in several rental properties need to be aware of opportunities offered by grouping.
- Qualified retirement plans offer multiple tax planning benefits. I feel like the proverbial nagging mother-in-law when it comes to "paired-plan arrangements" for dentists' tax planning. The combination of 401(k) plans and cash balance plans solves numerous tax problems for not only ongoing practice income, but also for dentists trying to avoid higher taxes on the sale of a practice. Perhaps my tendency to nag comes from the reality that, in the past five years, I cannot remember a single prospective dental client who -- prior to calling me -- had properly implemented a high-deduction paired-plan arrangement.
There are two problems that have to be resolved to benefit from paired plans. First, the dentist has to confidently manage debt payments and ongoing large purchases to produce the large savings needed. Second, the dentist must have access to sophisticated pension design support to make staff costs affordable.
You can thrive in the current tax planning big leagues with the realization that times have changed and tax planning really is about planning. Ask yourself whether you have a tax planner or a tax preparer supporting you.
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].
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