Few service professions carry an entry barrier as high as that of dental practices, due in great part to the need for high-tech equipment. However, some significant tax benefits are available that allow the astute dentist to greatly lower the net-of-tax cost.
Generally, the cost of equipment is deducted through depreciation over a long period of time-typically five to seven years. This is true even if no financing is involved and the related outlay is made in the year of acquisition. However, there are several methods of greatly accelerating these deductions.
With a "Section 179" election, qualifying assets can be deducted in full during the year placed in service. This deduction is capped at $500,000 per year and is reduced if total such acquisitions exceed $2,000,000 in that year. This deduction cannot be used if the entity generates a tax loss for that year.
Planning tip: Deduction timing is not determined by date of acquisition or payment. The deduction is available only during the year the asset is "placed in service" (available for use) and can include equipment bought on credit that remains unpaid at year-end.
Little-known fact: Partnerships, LLCs, and S-corporations can use the Section 179 deduction even in loss years if (and to the extent) the owners' wages produced that loss.
Bonus depreciation is similar to Section 179 but differs as follows: First, it allows only 50% of the cost to be deducted in the year placed in service; the balance is depreciated over the asset's tax life (generally five to seven years). While Section 179 is now permanent, bonus depreciation exists only through 2019, and the initial write-off of 50% is reduced to 40% for 2018 and 30% for 2019. It can be used at any level of income or loss. Finally, bonus depreciation may be used only by the taxpayer to first place assets into service; "used" equipment does not qualify.
Planning tip: Section 179 is more potent, but in years of large acquisitions (such as the purchase or formation of a practice), the cap may be reached. Bonus depreciation and Section 179 can be used in the same year. Taxpayers may "pick and choose" which method to apply on an asset-by-asset basis, using Section 179 to the extent possible (and for any "used" assets), while using bonus for the balance (but only for "new" assets).
De minimis election
Taxpayers annually may choose a capitalization threshold that allows immediate deduction of each asset that costs less than that threshold. Taxpayers who issue audited financial statements may choose a threshold from $0 to $5,000; others may choose a threshold from $0 to $2,500. This limit is applied on a unit-by-unit basis. For example, a payment of one invoice for $20,000 that represented 10 computers at $2,000 each would carry a unit cost of $2,000. If the chosen threshold exceeds $2,000, the entire $20,000 cost qualifies.
The catch? This is allowed for tax purposes only if also applied for financial statement purposes. It also must be applied to all assets under the chosen threshold; the "pick and choose" flexibility of Section 179 and bonus does not extend to this election. Assets not deducted under this method (because they exceed the cost threshold) remain eligible for Section 179 or bonus depreciation.
Planning tip: Of the categories discussed in this article, this is the only one that, if used for tax purposes, must also be used for internal book purposes. The significance of this characteristic is discussed later.
This last category applies to repairs of existing assets. The rules are complex, but generally repairs to existing equipment will qualify for immediate deduction. Unlike prior years, this holds true even if the value is increased or the useful life is extended. If capacity is somehow increased or a new use for the equipment is generated by the modifications, treatment as repairs may not be appropriate.
Planning tip: Unlike the other categories, there is no flexibility here. If the criteria are met, the repairs deduction must be used.
There are several ways a dental practice can deploy these options, and optimizing depends on whether tax or "book" records are used for lending purposes.
GAAP (Generally Accepted Accounting Principles) are followed for most practices that provide financial statements to banks or investors, and they vary significantly from tax rules. An ideal situation is one in which GAAP (also known as "book") income is high and tax income is low. This allows debt covenants to be more easily met and new loans to be approved, while simultaneously delaying taxes.
One way to achieve this is with careful use of the de minimis method. Recall that this is the only benefit described above that must be used for book purposes if used for tax purposes, and its threshold may be changed annually. For this reason, choosing a small de minimis threshold during years when the other tax methods are available will maximize tax write-offs while delaying the related book deductions-the best of both worlds!
If separate "book" financial statements are not produced, meaning the practice allows its tax return and supporting documents to serve as its only "financial statements" for lending purposes, avoiding the de minimis exception altogether could make sense. Why? Because banks often focus on "EBITDA" (earnings before interest, taxes, depreciation, and amortization). The de minimis deduction is not depreciation; it instead is deducted in arriving at EBITDA, and low EBITDA is looked on unfavorably by lenders. Repairs are also a component of EBITDA, but there is little flexibility to avoid its use if the criteria are met.
This article provides only an overview of some very complex rules, and is limited to federal treatment. State rules vary greatly, and numerous federal exceptions exist as well. Understanding the basics of these alternatives, and careful use and combination of them on an annual basis, will preserve strong income for internal book purposes and delay taxes as long as possible.
Timothy R. Hepburn, MBA, CPA, is a principal in the tax department of regional New England accounting firm Baker Newman Noyes. He specializes in federal and state corporate, partnership, and individual tax compliance and planning. He also assists not-for-profit entities, health-care organizations, medical and dental practices, closely-held businesses, and high-wealth families with financial decisions. Based in its Portsmouth, New Hampshire office, he may be reached at (603) 626-2213 or [email protected].