By Brian Hufford, CPA, CFP®
If we are indeed approaching the Last Days, in the case of federal income taxes we know the exact date — Jan. 1, 2013. The media is reporting that the New Year will usher in a $500 billion tax increase, the largest one-year change in our nation’s history, unless Congress takes action. Dentistry has been a large recipient of tax incentives during the past 10 years. Is all of this about to change? In this column, I want to examine planning opportunities and provisions to watch during this critical year.
Tax rate changes
Many dentists could be subjected to a compounding effect in tax rate increases for 2013 due to a multitude of expiring 2012 provisions. For instance, dividend income has been limited to a top federal tax rate of only 15%. With no changes in expiring provisions, dividends will be taxed in 2013 at a top federal rate of 43.4%!
This is due to a combination of an increase in top income tax brackets from 35% to 39.6% plus an additional health insurance tax of 3.8%, which applies to investment income, along with the repeal of favorable tax treatment of dividends. A dentist could be subject to higher Social Security taxes due to the expiring 2% payroll tax holiday, higher income tax brackets, an additional 3.8% health insurance tax on investment income, and alternative minimum taxes due to the expiration of temporary fixes.
It is this compounding effect that creates tremendous complexity at the individual level, along with the likelihood that no dentist will be able to plan effectively due to an election year inability of politicians to address the expiring provisions in a timely fashion.
Tax deduction changes
Dentistry has been the recipient of very favorable tax depreciation rules. Dentistry is a capital-intensive profession. In 2012, dentists benefit from the ability to expense up to $139,000 of qualifying equipment purchased under Section 179, with an alternate provision allowing bonus depreciation of up to 50% of the cost of eligible property.
In 2013, expensing is limited to $25,000 and bonus depreciation disappears. This greatly decreases the tax benefits of purchasing large amounts of equipment or building out a dental office space. Other changes in deductions scheduled to expire would also greatly affect most dentists. These include the reinstating of the marriage penalty, and the loss of significant benefits from itemized deductions with higher adjusted gross incomes.
The keys to effective planning
If in fact many of the existing provisions are allowed to expire in 2013, the keys to effective tax planning will revolve around managing tax brackets. One of the provisions for 2013 that is already on the books is the new health insurance tax of 3.8% on investment income (including net rental income) for those with incomes in excess of $250,000.
Dentists have two important tools to manage income tax brackets. These two tools are family income splitting and qualified retirement plans. It likely will be more important than ever to include a spouse on the payroll for additional 401(k) plan contributions, as well as paying large (and reasonable) salaries to children to reduce the overall income tax brackets of the parents. Even though children’s brackets could be rising, they will be significantly lower than most parents’ tax brackets.
Likewise, overall income tax savings on retirement plan contributions could exceed 50% when factoring in state tax savings, due to the new health insurance tax and the loss of other deductions for those with higher incomes.
Even with higher tax rates in 2013 possible, it still may be wise to accelerate capital expenditures into 2012. With expensing limited to $25,000 in 2013 and the expiration of bonus depreciation, dentists will need to determine the overall effects of large deductions for expenditures in 2012 compared to higher brackets and smaller deductions in 2013. This could be critical for large planned capital expenditures during the next 12 months.
The good news for dentists is that many of the traditional income tax planning strategies remain unaffected with potential expiration of temporary provisions in 2013. The benefits of these strategies have always been large and peculiar to the nature and economics of dental practice. They include employing large cost-segregation deductions for dental office buildings, employing a tax-beneficial choice of practice entity with incorporation of the practice, paired plan arrangements with 401(k) plans/cash balance plans to generate retirement deductions in excess of $100,000, rapid depreciation on dental equipment irrespective of Section 179, and family income splitting.
Even though tax planning has become almost impossible with tax law changes on a monthly basis, income tax management is more important than ever.
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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