When it comes to taxes, we are all looking for a way to save some of our precious income. Here are 11 ways that some dentists are keeping their fair share.
Charles Blair, DDS, and
John McGill, MBA, CPA, JD
As the new millennium approaches, we?re seeing more doctors paying higher federal and state income taxes than ever before. What are your colleagues doing in order to minimize their federal and state tax bite?
Recently, we conducted an in-depth review of doctors? practice-related, tax-saving strategies. The survey was designed to determine the specific tax strategies, as well as the level of deductions taken below in each category. In the results below, the strategies are ranked in descending order by the average deductions claimed.
Family lab business
Doctors who operate a separate lab business, either through a Subchapter S corporation or family limited partnership, generated the highest tax savings of any reported strategies. Nineteen of the 58 doctors surveyed reported using this strategy. Annual profits generated by the lab operations ranged from a low of $13,000 to a high of more than $174,000. The average profit generated by this strategy was $51,551.
Establishing a separate lab business is a relatively easy and low-cost strategy for most orthodontists and many general dentists. The lab represents an effective means of withdrawing funds from the doctor?s corporation without federal or state payroll taxes. Furthermore, most doctors also generate significant income tax savings through shifting income to lower-bracket family members (children age 14 or older), parents, brothers, or sisters.
Since most doctors employing this strategy were at or near the 50 percent marginal federal and state income tax bracket, the ability to shift over $51,000 in taxable income to a lower bracket (averaging 20 percent), produced income tax savings averaging more than $15,000 annually. Furthermore, employing this strategy shifts assets out of the doctor?s estate and to the next generation without federal or state transfer taxes, creating additional estate tax savings as well.
Paying highest reasonable building rent
Twenty-eight of the doctors surveyed (48 percent) had their professional corporations pay the highest reasonable rental rate possible for the use of the office building owned by the doctor and/or other family members. The average doctor using this strategy was paying rent of approximately $28,125 more than the lowest reasonable rental rate.
Paying the highest reasonable rent represents another means of moving funds from the doctor?s corporation without payroll taxes and shifting income to lower-bracket family members. This created savings of more than $8,000 annually in federal and state income taxes based upon the average deduction claimed.
While the IRS has begun challenging rentals paid to doctors by their corporations for the use of office real estate, the rental deduction will be upheld as long as it is reasonable, even if it exceeds the rental paid by another tenant in the doctor?s building. In Associated Dentists of River Falls vs. Commissioner, T.C. Memo 1998-287, the court upheld the corporation?s deduction for rental paid to the doctor, even though the rental rate charged was higher than that charged to an orthodontist using the facility only one day a week, since the orthodontist?s presence also provided a business benefit to the practice.
Paying the highest reasonable rental rates also makes sense from a practice transition standpoint. In the event of a practice sale, whether due to death, disability, or retirement, a potential buyer will typically balk at paying a higher rental rate than was previously charged for the use of the office building.
Furthermore, in some cases, the value to be paid for the practice may be psychologically OcappedO by a buyer, or his advisers. So charging a higher rent is another means of increasing the selling doctor?s total take from the transaction. As a result, the doctor looking to sell needs to charge the higher rent early on. The change in rental value should not appear during the three to five years preceding the sale when the doctor?s tax returns and financial statements are subject to review by the buyer and/or his representatives.
The next most effective strategy involves the leasing of new or used dental and/or office furniture and equipment owned by a Subchapter S corporation or family limited partnership to the doctor?s corporation at the highest reasonable rate. As a general rule, a third-party equipment vendor or leasing company would charge 25 to 33 percent of the equipment?s fair market value as an annual lease rate over the typical three- to five-year lease term. Accordingly, this establishes the fair market rental rate range which the doctor?s corporation can pay and deduct as a reasonable rent.
While only nine of the 58 doctors surveyed (16 percent) used this strategy, the annual income shifted through this arrangement averaged $21,646, resulting in federal and state income tax savings of more than $6,000 annually, when the profit generated was to be taxed to lower-bracket family members.
Employment of spouse
Employing the doctor?s spouse through the practice was a more popular tax-saving strategy, as 25 of the 58 doctors surveyed (43 percent) participated. While most doctors paid modest salaries of roughly $3,000 per year for their spouse?s part-time duties, salaries escalate to more than $60,000 for spouses employed full-time in office management and/or sales positions. The average salary paid was $15,778.
Many tax advisers see no benefit in employing a spouse through the practice since most doctors are filing a joint tax return anyway. However, practice employment is necessary in order to qualify for the child-care tax credit and fully deductible travel expenses. Moreover, substantial retirement plan contributions can often be generated on behalf of an employed spouse, as a result of retirement plan rule changes.
We?ve seen several doctors sponsor cross-tested retirement plans that allocate contributions based on an employee?s age, compensation, and job classification. The plans generate tax-deductible contribution allocations of $15,000-$30,000 on behalf of employed spouses. Furthermore, even larger tax-deductible contributions can be generated on behalf of an older spouse who is employed in the practice when a defined pension plan is utilized.
Employment of children
Thirty of the 58 doctors surveyed (52 percent) employed one or more of their children through their practice and paid them tax-deductible salaries. Total annual salaries ranged from a low of $2,000 to more than $59,000 (the average salary was $12,456). The highest salaries were paid to employed children in dental school who could perform lab procedures, assist, and do other higher-level clinical duties. Furthermore, the average is higher than might be expected, since most doctors employed more than one child through their practice.
In 1999, each child could earn $4,300 free of federal and (in most cases) state income taxes, so that most of the salaries were received income tax-free.
Accordingly, the average doctor was saving more than $5,000 annually in federal and state income taxes. More importantly, this strategy qualified the child to establish a Roth IRA and contribute $2,000 annually thereto. This allows the child to accumulate a sizable IRA balance, which can be withdrawn tax-free upon reaching age 591U2.
Business travel expenses
Converting personal travel into fully deductible business travel was a popular tax-saving strategy employed by 44 of the 58 doctors surveyed (76 percent).
Deductions ranged from a low of $883 to a high of $25,000 (the average deduction was $10,664). Doctors employed two methods to convert travel expenses that would otherwise have been personal in nature into fully deductible business expenses.
First, they combined business with pleasure through scheduling vacations in conjunction with continuing education meetings. Also, when doctors desired vacations to areas where there was no continuing education meeting, they arranged consults with noncompeting colleagues in that area in order to justify business deductions.
Deducting automobile expenses through the doctor?s practice was again the most popular tax avoidance strategy. Fifty-six of the 58 doctors (97 percent) participating had auto deductions ranging from a low of $1,000 to a high of $62,900 (a group practice with multiple business locations). The average deduction was $10,143 per practice, which generated annual tax savings of $5,000.
We continue to recommend that the doctor?s practice purchase, rather than lease, its business automobiles and pay all acquisition and operating costs through the practice in order to generate the maximum deduction. Furthermore, doctors purchasing a sport utility vehicle, rated at 6,000 pounds or more fully loaded, can avoid the luxury automobile excise tax on purchase, and utilize the $19,000 expensing election for a portion of the new car cost, with the balance written off over a six-year period.
Of the 58 doctors participating, 42 (72 percent) tookdeductions for medical insurance and/or medical reimbursement payments from their practice. Under current tax law, incorporated (regular C) doctors can claim a full (100 percent) deduction for the cost of medical
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A MOMENT IN TAX HISTORY
The Tax Act of 1861 proposed that Othere shall be levied, collected, and paid, upon annual income of every person residing in the U.S. whether derived from any kind of property, or from any professional trade, employment, or vocation carried on in the United States or elsewhere, or from any source whatever.O
The 1861 Tax Act was passed but never put in force. Rates under the Act were 3 percent on income above $800, and 5 percent on income of individuals living outside the United States.
The Tax Act of 1862 was passed and signed by President Lincoln on July 1, 1862.
The rates were 3 percent on income above $600 and 5 percent on income above $10,000. The rent or rental value of your home could be deducted from income in determining the tax liability. The Commissioner of Revenue stated, OThe people of this country have accepted it with cheerfulness, to meet a temporary exigency, and it has excited no serious complaint in its administration.O This acceptance was primarily due to the need for revenue to finance the Civil War.
Although the people cheerfully accepted the tax, compliance was not high. Figures released after the Civil War indicated that 276,661 people actually filed tax returns in 1870 (the year of the highest returns filed) when the country?s population was approximately 38 million.
Taken from www.taxworld.org
For More Information
National Association of Financial
and Estate Planning
Internal Revenue Service (IRS)
Tax Information for Business
Self-Help Law Center