by Brian Hufford, CPA, CFP
Whether ’tis nobler to suffer the slings and arrows of outrageous monthly payments or to arm oneself against a sea of troubled deprivation of the latest gadgets ...
On such a full sea - or perhaps more appropriately - convention floor, you are now afloat. This article is aimed to equip you (pun intended) with strategies to buy the latest technology of your dreams, without guilt and unintended tax consequences. Let’s start with the guilt part.
While you may know that current income tax laws greatly favor the purchase of equipment for your practice, you might be struggling with how to overcome the nagging feeling of guilt about purchases. Do you really need this equipment, and how will you pay for it? How do you balance the tax benefits against the bigger picture of financial issues? How are you going to get and remain out of debt?
Somehow, knowing that you will receive a large tax deduction does not silence these concerns. Technology is rapidly changing in dentistry. You want your patients to experience the best possible care. How can you be sure you can afford the needed equipment?
Most dentists make equipment purchases with good old-fashioned gut instinct. The thought process related to large purchases does not go much deeper than, “I need this equipment, how do I find the money to pay for it?” This approach can lead to financial failure. A more enlightened approach is needed if you hope to meet ongoing needs for new equipment, and at the same time, meet annual savings goals.
Let me introduce you to The Decision Matrix Process. This process is a treatment plan to help assure that you can purchase needed equipment and get out of debt while still saving significantly each year. This TDMP recognizes that ultimate financial success cannot be realized unless three variables - large purchases, debt elimination, and permanent savings - are balanced every year. If we add taxes, then there are four variables to recognize: equipment purchases, debt, savings, and taxes.
Approximately 25 percent of your practice’s gross production can be committed to the four variables of equipment, debt, savings, and taxes. The key to success is balancing the four variables in the correct manner so that savings can be maximized.
Perhaps some clarification is necessary. Maybe you are thinking, “My practice net income is only 35 percent. I know I must spend more than 10 percent of my gross production at home. How can the four variables of equipment purchases, debt, savings, and taxes total 25 percent?”
Actually, if you look closely at cash flow, you likely will notice that cash paid for equipment purchases, plus cash principal payments on debt, equal to an additional 8 percent. So, if you added back these cash payments, your actual practice cash flow - before debt and equipment purchases - would be closer to 43 percent. Thus, you probably could spend about 18 percent of gross production at home.
During the growth stage of a dental career - from ages 30 to 45 - equipment expenditures are high, debt payments are high, savings are low or nonexistent, and taxes are low. During this stage, most dentists focus their attention on getting out of debt. Without careful planning, these critical 15 years race by without significant savings. Meanwhile, approximately $3 million of potential savings accumulation at age 62 is forfeited due to lost compound growth.
Unfortunately, you cannot simply forgo equipment purchases, nor can you escape the large amount of debt needed to start a dental practice. I recommend that every dentist save 10 percent of gross production (pension and personal savings) throughout a career, even during the growth stage from ages 30 to 45. Thus, a process must be in place to manage cash flow for equipment purchases and debt so that savings occur.
During the accumulation stage of a dental career - from ages 45 to 60 - equipment expenditures are high, debt payments are low, savings are increasing, and taxes are increasing. The relief that comes from eliminating debt incurred during the growth stage creates a behavior pattern of attempting to pay cash for equipment to stay out of debt. Since equipment purchases have favorable tax consequences, and taxes are increasing, there is an incentive to continue high-equipment expenditures. Although most practice-related debt has been eliminated during the accumulation stage, paying cash for equipment can still inhibit the ability to save - even with the tax benefits and lower debt payments.
The Decision Matrix Process: A treatment plan for equipment purchases
The Decision Matrix Process forces a solution for how much may be spent on equipment purchases and practice debt, in total, annually. It forces a savings amount. In effect, it makes you pay yourself first. If, in fact, your total cash outlay on the big four expenditures is 25 percent of gross production, then the recommended annual treatment plan is to save 10 percent of gross production with income taxes of 10 percent of gross production. This leaves only 5 percent for equipment purchases and practice debt payments. This process recognizes that you will have ongoing annual purchases throughout your career. It creates specific strategies for how to handle equipment purchases and practice debt annually.
The specific strategies of TDMP are designed to keep equipment expenditures in line. First, you should obtain a practice line of credit of $25,000 to $100,000. Stop paying cash for new equipment purchased in your dental practice. Remember, your primary goal is to save 10 percent of gross production every year. Use the line of credit to pay for all equipment purchased throughout the year.
Let’s assume you will have purchased $25,000 of equipment in 2007. This purchase should be placed on the line of credit. You would pay interest only throughout the year. At the end of 2007, you would obtain a term loan of $25,000 with a term of five to 10 years to return the line of credit balance to zero to start the new year. You would then make monthly payments on the term loan until it was paid in full. This process would be repeated annually. If payments on new debt plus existing debt total more than 5 percent of gross production, you would not save the amount I recommended. At this point, you would need to look at all of your debt - both practice and personal - so that it may be structured properly to avoid sabotaging your cash flow. My definition of practice debt does not include office building debt. While separate from this calculation, it is also important.
The idea of TDMP is to pay debt more slowly and evenly throughout your career so that you do not lose 15 years of compound growth. You cannot afford to throw away $3 million of savings during your career due to poor management of capital expenditures. When you sell your practice at the end of your career, simply repay any remaining debt, - if any - from the sale proceeds. If you do not intend to sell your practice, the additional savings accumulation would allow you to pay off the debt but not until you have accumulated at least $1 million in savings.
The Equipment Tax Planning Guide: a guide to maximize tax benefits from equipment purchases
The next process I want to discuss is The Equipment Tax Planning Guide. This process is based upon income tax laws in place as of June 30, 2007. Your accountant should assist you in applying current law to your situation. In today’s complicated tax structure, knowledge of tax benefits is the ultimate prize. Realizing the benefits deals with application and implementation. I have known many dentists who purchased a large amount of equipment, thinking they would receive an anticipated large tax deduction. After reviewing each of their situations, I had to advise these dentists - after the fact - that they did not implement purchases properly, and therefore did not obtain any tax benefits. It is difficult to correct a transaction once it has been completed.
Step 1: Prior to the transaction, involve your accountant in any equipment purchase in excess of $10,000. There are two reasons that you need prior planning for equipment purchases in order to obtain an anticipated deduction. As you might know, Section 179 was extended by the 2007 Small Business Tax Act, which was passed on May 25, 2007.
Under current law, if you meet the legal requirements, you are able to expense $125,000 of equipment purchased under Section 179 for 2007. Let’s assume you purchase $125,000 of eligible equipment in 2007. First, even if you are able to expense the entire amount this year, you may not want to. Why? By expensing all of the equipment, you may ruin your ability to fully fund a pension plan. You also might put yourself into such a low tax bracket during the year that you end up with much lower overall tax savings. Second, if you practice in a C or S Corporation, other factors, such as the amount of corporate taxable income or stock basis, may eliminate totally your ability to receive the full tax benefit. These issues are difficult, or even impossible, to fix after the fact.
Unfortunately, many accountants may not be tax specialists. They may hope to look like a hero by expensing as much of the equipment as possible in the current year to obtain tax benefits this year without considering your pension plan or overall tax bracket. So you need to be proactive in alerting your accountant to these issues, and do some planning prior to any large equipment purchase.
Step 2: Consider the impact of your practice entity on ongoing capital expenditures. Depending on your situation, corporate entities such as C and S Corporations can make it nearly impossible to obtain the benefits from larger purchases of equipment and from the favorable benefits of owning an office building. Depending on state laws and legal issues, we typically recommend that younger dentists practice in an LLC rather than in the more traditional corporate entity. During the growth stage of a dental practice, it is much easier to obtain tax benefits of equipment purchased as an LLC rather than as a traditional corporation. I believe an S Corporation has many disadvantages for a typical dentist - unless a dentist’s taxable income is in excess of $300,000. If you are a C Corporation in dentistry, you should - in all probability - change your form of practice. This is a complex issue, and requires excellent tax advice to accomplish.
Step 3: Assure that financing options will not sabotage income tax benefits. How you finance equipment purchases is extremely important to obtaining overall tax benefits. For instance, some leasing arrangements that qualify as operating leases can prevent you from expensing the equipment under Section 179. Instead you deduct the lease payments like rent. So, instead of expensing the equipment in the year of purchase, you must deduct the lease payments over the life of the lease. A capital lease is treated like a loan and not a lease under the tax code. An operating lease is treated as a true lease. Your accountant can explain the differences.
If you purchase a large amount of equipment in an S Corporation with a loan made by the lender to the corporation, you will - in many cases - not be able to deduct Section 179 expenses related to the equipment since the loan inside the S Corporation will make the deduction difficult because of special tax rules. Without sophisticated planning, you could lose the deduction for many years.Finally, to buy or not to buy, that is the question. With diligent application of The Decision Matrix Process and The Equipment Tax Planning Guide, you will feel like a king or queen, and not like those of the Shakespearean variety!
Editor’s Note: Footnote disclosure for this article required by IRS Circular 230: (Pursuant to IRS Circular 230, please be advised that, to the extent this article contains any tax advice, it is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of avoiding penalties under U.S. federal tax law.)
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. The company is recognized as the only strategic alliance partner for financial planning services for the Academy of General Dentistry. Contact Hufford at (888) 470-3064, or at bhufford@ huffordfinancial.com.