John K. McGill, MBA, CPA, JD, and Brad Kucharo, CPA, CFP®
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Benefit of post-closing services
In many cases, the selling doctor is employed on a part-time basis for a number of years following the practice sale, either in the capacity of an employee or as an independent contractor. Such post-closing employment can prove essential to the success of the practice transition.
Meanwhile, the opportunity to continue working after the sale can provide the selling doctor with income to meet his living expenses, allowing his retirement plan and IRA assets to continue to grow and compound tax-free.
Huge tax savings available
Establishing a contract for post-closing services between the seller’s corporation and the buyer assures that the arrangement can legally qualify for independent contractor status, if properly structured. In his recent seminar “Planning for Retirement,” Brad Kucharo, CPA, CFP®, provided an example of the tremendous tax savings possible for a seller who would receive $100,000 annually for services rendered.
Kucharo noted that the $100,000 salary paid to the seller as an employee would be subject to payroll taxes (Social Security and Medicare) of $7,650 to the employer (buyer) and employee (seller) alike, or $15,300 total. Moreover, assuming a 25% marginal income tax rate applied to the $100,000 annual compensation would result in $25,000 of income tax liability. The combined income and payroll tax liability of $40,300 would leave the seller with $59,700 of after-tax cash flow available.
Having all compensation paid directly to the seller’s corporation provides several tax benefits. The seller’s retirement plan can be amended to eliminate the 1,000 hours of service requirement for eligibility, thereby allowing the doctor to participate in the plan. If the seller’s corporation pays him an annual salary of $24,000, he could defer $22,000 from that salary into the 401(k) on a tax-deductible basis. Likewise, the corporation could employ the doctor’s spouse to provide marketing and/or management services at a salary of $24,000. This would also qualify the spouse for the maximum 401(k) salary deferral of $22,000.
Moreover, the practice could provide a 6% of pay matching 401(k) contribution, creating an additional deduction of $2,880. In contrast, if treated as an employee, the doctor and spouse would not work the 1,000 hours annually required to participate in the buyer’s retirement plan.
Since only $48,000 of salaries would be paid from the corporation to the doctor and spouse, the related payroll taxes would be only $3,672 from the employee and employer alike, or $7,344 total. This provides savings of $7,956 annually compared to the employee option.
Furthermore, the seller’s corporation could provide significant fringe benefits and professional expenses for the benefit of the seller, free of federal and state income and payroll taxes.
In his example, the seller’s corporation provided post-closing supplemental medical insurance coverage for the doctor and spouse ($6,000 annually), medical reimbursement benefits ($6,000), business car expenses ($8,000), continuing education and travel expenses ($10,000), dues and subscriptions ($5,000), licenses ($1,000) and practice promotion expenses ($4,000). Subtracting these tax-deductible expenses, along with the salaries paid and related employer payroll taxes and retirement plan contributions, from the corporation’s income of $100,000 annually would leave a profit of $5,448 in the S Corporation available for distribution as a dividend.
Combining that S Corporation profit ($5,448) with the $4,000 of taxable salaries not deferred into the retirement plan leaves taxable income of $9,448 on the doctor’s personal return. This attracts income taxes of $2,362 at a 25% rate.
Combined with the $7,344 of payroll taxes (employee and employer share) levied on the salaries of $48,000 withdrawn, this results in $9,706 in federal and state income and payroll taxes due annually. This leaves the selling doctor with $90,294 of cash flow available. This results in savings of $30,594 annually, compared to the cash flow available if the seller is treated as an employee.
Treating the seller as an independent contractor through making all payments directly to his corporation also avoids reducing the buyer’s small business health insurance tax credit (Section 45R), and makes this approach a “win-win” situation. As a result, it allows the buyer doctor to claim the maximum health insurance tax credit, which could save thousands of dollars each year.
John McGill and Brad Kucharo provide planning for retirement services exclusively for the dental profession, and also publish the McGill Advisory through John K. McGill & Company, Inc., a member of the McGill & Hill Group, LLC. The McGill & Hill Group’s members and affiliates collectively serve as a one-stop resource for tax and business planning and much more. Visit www.mcgillhillgroup.com.