Brian Hufford, CPA, CFP®
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While major tax reform is not imminent, there likely will be major tax reform after the 2012 elections. It is important for dentists to pay close attention to this debate, since future changes will likely have a major impact on investments in equipment, office buildings, Roth IRAs, and future tax planning for capital expenditures.
As I have said in previous columns, 2011 and 2012 are particularly favorable years for dentists’ investments in equipment and office buildings. Through bonus depreciation and increased Section 179 expensing, this year and next are favorable for capital expenditures. However, this may change radically in 2013. Government policy makers are in a difficult dilemma. They need to increase tax revenue without killing economic growth. This makes it somewhat unlikely that large overall individual tax rate increases will be the primary tax prescription to raise revenue.
Many dentists have made Roth IRA conversions with the belief that individual income tax rates will rise significantly in the future. What is more likely to happen in future income tax policy is a substantial broadening of the tax base. This could mean that marginal tax rates could actually decline or flatten while many deductions could disappear. Favorable tax treatment for capital gains could be a casualty of a more flattened tax rate structure, as could rapid depreciation deductions for equipment and office buildings. Here are specific areas to watch:
Capital gains: In 1986, in line with lower flat tax rates, Congress taxed all gains as ordinary income. With the 1986 law, capital gains tax rates were limited to 33%, but subject to ordinary income tax rates below that ceiling amount. With recent discussions of lowering corporate income tax rates and possibly eliminating popular itemized deductions, such as mortgage interest, policy makers may be signaling a tax strategy that is lower overall but with no favorable treatment for such revenue losers as capital gains and dividend transactions in the 15% tax bracket. This could mean that dentists may want to consider the possibility of huge tax savings from selling appreciated property prior to 2013.
Dental equipment and office buildings: It is very likely that the favorable expensing of dental equipment and rapid depreciation deductions for office buildings and leasehold improvements will be greatly curtailed by new tax legislation. In a flatter-tax/deduction-eliminating environment, dental capital expenditures could lose most of their current tax appeal. This would mean that any significant office building and equipping projects would be much more tax favorable if completed prior to 2013, under existing tax laws. In 2011, dentists have 100% bonus depreciation and $500,000 Section 179 expensing. In 2012, bonus depreciation drops to 50% and Section 179 drops to $125,000, under current law. Favorable deductions for equipment and office building expenditures are important to dentists.
Roth IRA conversions: The primary reason to convert to a Roth IRA and pay taxes up front is the belief that future tax rates will be at least the same or significantly higher. There are also other reasons, such as no required minimum distributions or payouts to heirs. If the trend in future tax policy is toward a lower, flatter tax — along with a broadening of the tax base by eliminating deductions — it could be that the decision to convert and pay taxes now could subject these accounts to higher taxes. While it is hard to imagine with current budget deficits that tax rates could be lower in the future, the trend in tax policy appears to be leaning toward advancing economic growth with lower tax rates and raising revenue by limiting tax deductions. Dentists should at least question the wisdom of subjecting themselves to significant taxes now in doing a major Roth IRA conversion if the only reason is the belief that there may be major tax rate increases in the future.
Entity selection and other tax planning issues: Current government policy discussion favors lower corporate income tax rates. Dental corporations lost favorable tax treatment many years ago with the classification as personal service corporations subject to the highest brackets. This could change in the future and bears watching. Dental corporations have not been fertile ground for income tax planning recently. My biggest fear for dentists would be a change in the tax deductibility of mortgage interest deductions. While no change has currently been proposed, this subject area would be a primary candidate for change in a flatter tax environment. This would impact dental real estate holdings in a major way.
Don’t overreact to anticipated tax law changes, but certainly be prepared to filter current planning with an eye toward the potential for large tax law changes. Significant capital expenditures and the disposition of capital gain property should be aligned with large potential changes.
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].