IRS warns Subchapter S doctors

Irecently incorporated my dental practice and made a Subchapter S election. I was told by my CPA that I can take part of my practice profit out as salary and the balance as a Subchapter S dividend, free from payroll taxes.

I recently incorporated my dental practice and made a Subchapter S election. I was told by my CPA that I can take part of my practice profit out as salary and the balance as a Subchapter S dividend, free from payroll taxes. I could save over $10,000 in payroll taxes if I take out no salary, and remove all of my practice profits in the form of a dividend. Will this fly with the IRS?

No. The IRS has won several recent cases recharacterizing Subchapter S dividends as salary, in cases where no salary was withdrawn. It now is warning Subchapter S business owners that they must take “reasonable compensation” for their services in the form of a salary, with the balance available to be taken as a dividend.

“Reasonable compensation” is defined as what your corporation would have to pay another doctor to perform the same services in your practice. In most cases, that means the doctor would have to withdraw 25 to 30 percent of his collections in the form of salary to meet the reasonable compensation test. Accordingly, I would recommend you discuss this with your CPA to make sure you are claiming an adequate amount of salary to meet the “reasonable compensation” test.

I am working as an independent contractor in several practices, and am not covered in any of their retirement plans. Recently, I heard doctors in my situation can start a solo 401(k) retirement plan. How does this work?

As an independent contractor, you are your own employer. As such, you can set up a 401(k) profit-sharing plan for yourself and defer part of your practice income into the plan, up to a maximum of $14,000 in 2005 ($18,000 if age 50 or older), and $15,000 in 2006 ($20,000 if age 50 or older). You also can have your practice make a matching contribution of up to 100 percent of the amount you defer. Finally, you can maximize total tax-deductible contributions by making a profit-sharing contribution to the plan. The maximum contribution on your behalf (including regular salary deferrals, matching, and profit-sharing contributions) cannot exceed $42,000 in 2005. This maximum is increased to $46,000 for doctors age 50 or older, as a result of the “catch up” salary deferrals available.

My practice sponsors a defined-benefit pension plan. Recently, an insurance agent recommended that I convert my traditional defined-benefit plan into a Section 412(i) plan, funded solely with insurance contracts. Is this possible? If so, is it a good idea?

Converting the plan from a traditional to a Section 412(i) defined-benefit pension plan is possible as long as it meets the requirements set forth in IRS Revenue Ruling 94-75 (available at www.taxlinks.com). For example, all future benefits must be tied to insurance contracts calling for level annual premiums. In addition, benefits accrued by plan participants prior to the conversion must be guaranteed. Also, “meaningful” accruals must continue for at least three years.

While it is legally possible to take this step, I would recommend that you have an independent third party, such as your CPA, evaluate whether this will prove cost-effective for you. While Section 412(i) plans may provide larger contributions for you, there may be substantial hidden costs of which you may not be aware. Substantial commissions on the insurance contracts and poor investment performance have historically hindered 412(i) plan investment returns. Accordingly, before you undertake the cost to make this conversion, you should make sure that the “benefits” are worth it.

I need to revise my wills and trusts, since I haven’t done so in more than 20 years. I would like to use a family-credit shelter trust to fund the maximum amount which can pass to our children tax-free. In addition, I would like for my wife to be able to have access to these funds as well. Can this be done?

Yes, according to Blake Hassan, CPA, and tax attorney with McGill and Hassan, P.A, at (704) 424-5450. The trust can be structured so that, upon your death, your wife can receive all of the income from the trust, plus whatever principal is required, in order to maintain her standard of living. If your wife’s access to the principal of the trust is not limited by an ascertainable standard (e.g., maintaining her current standard of living), she can withdraw no more than $5,000, or 5 percent of the trust principal, whichever is greater. Any withdrawals in excess of this amount would cause the trust assets to be included in her estate upon her death.

John K. McGill is a tax attorney, CPA, and MBA, and is the editor of The McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes, and protect assets. The newsletter ($199 a year) and consulting information are available from John K. McGill and Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217. Call McGill at (704) 424-9780 or visit his Web site at www.bmhgroup.com.

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