by Rick Willeford, MBA, CPA/CFP
It's that time of year where the old worn out tax myths surface again. Some are interesting, but others are downright dangerous. The Academy of Dental CPAs (www.ADCPA.org), a national association of accounting firms that specialize in services to more than 7,000 dentists, wants to put some of these myths to rest once and for all. These folks should know the real scoop since they actually sign tax returns and have to deal with the IRS on a regular basis.
Of course, any good myth begins with a kernel of truth so it will sound believable. It then gets passed around, unquestioned, until it takes on a life of its own. That's when you have to remember that the plural of anecdote is not data!
Myth 1
Get an extension to file your tax return late so you can reduce your risk of audit.
The theory is that the IRS selects a certain number of tax returns to audit each year, and these are chosen from "front to back," with most being chosen by the time April 15 rolls around. So if you purposely file late, you will miss the selection process. Believe it or not, this was probably correct — many years ago. This phenomenon was discovered and first reported in a book, "How to Beat the IRS at its Own Game" by Dr. Amir Aczel. However, contrary to popular opinion, the IRS is not totally stupid. Shucks, the IRS barely had computers back then, and a lot has changed since.
To fill us in on the "rest of the story," I talked with Bob Creamer, CPA, an Oregon ADCPA member. He has a special perspective because he was the former internal auditor in charge at the IRS Fresno (Calif.) Service Center!
"I was working for the IRS in 1977. I was an internal auditor who audited the auditors who audited the dentists. We found that people were filing tax returns late, knowing that the inventory of returns to be audited for the year were all selected early in the year," Creamer said. "This procedure became so well known, people — including IRS employees — started to file false returns after April 15 and were requesting and getting false refunds.
"Once the processing problem with audit selection was identified, the IRS took action to make sure that returns to be audited were selected throughout the whole year. In fact, due to the earlier problem, they put extra emphasis on selecting those tax returns that were filed on extension!"
Since the IRS reads publications such as The Wall Street Journal and Dental Economics, an anomaly can't last for long. It does not take a rocket scientist at the IRS to realize that most returns that are filed late are typically the more complicated or "interesting" ones. It sounds like you may be playing right into their hands if you file late. Remember, you have also delayed the ticking of the three-year statute of limitations clock. To put his money where his mouth is, Creamer always files his own tax return by April 15.
Keep in mind that there are some legitimate reasons to get an extension, like waiting on other investment data or to extend the date to fund your retirement plan. Your tax preparation cost may be higher with an extension if you need your accountant to do a rough draft byApril 15 anyway in order to calculate your first estimated tax payment for the next year. So, these days, filing before or after April 15 does not appear to affect your likelihood of being audited either way.
Myth 2
Report dental supplies and lab fees in the Cost of Goods Sold section of your tax return to reduce the chance of audit.
The theory is to reduce your "gross profit" (Gross Collections minus Cost of Goods Sold). Thus your tax return may look less appealing to the IRS computer for an audit. Sounds reasonable, but Chicago ADCPA member Elaine Pesavento, CPA, MST (that's a Master in Tax), points out that you may be heading into a buzzsaw.
"When a return is filed, it is 'scored' by a computer for audit potential," she said. "This scoring is known as the Discriminant Function (DIF). One part of DIF scoring is to calculate Total Positive Income (TPI). The IRS defines TPI as 'only total positive values from the income fields listed: wages, interest, etc. U and Schedule C Net Profits (collections minus all expenses).' Cost of Goods Sold and TPI have nothing to do with each other, and Gross Profits are not even looked at!
"But we need to go a little further, because there is another part of the DIF calculation. That step looks at Total Gross Receipts (TGR) for business returns (corporations, partnerships, and Schedule C for a sole proprietor/LLC). TGR for Schedule C is Gross Receipts from Sales (i.e., the top line on Schedule C, Part 1, Line 1). Specifically, this is not Gross Income, which is on line 7.
"What if TGR really was Gross Income (line 7) as opposed to Gross Receipts (line 1)? Then it would make sense to keep line 7 as high as possible so that the expenses below line 7 (such as auto expense, meals and entertainment, promotion, etc.) are smaller in relation to TGR! If we put salaries, drugs, and dental supplies, etc., up in Cost of Goods Sold, thereby lowering line 7, that would cause the ratios of the deductions we are more concerned with (auto, meals, etc.) to be larger in relation to TGR. In my way of thinking, this could do a great disservice and potentially cause an audit. For those interested in more details about DIF, enter 'internal revenue manual' into Google. That will take you to the IRS site and right to the manual."
To make matters worse, Seattle member Sam Martin, CPA/CFP, MBA (tax), reports that the use of the Cost of Goods Sold area is neither discretionary nor optional, it's required. As the name implies, you use this area only to report costs related to goods that you sell. The sale of goods implies having inventory. Since the sale of goods is typically insignificant in a dental office, it would look quite curious to an IRS computer when it processes your Industry Classification Code ("dentist") and notes the presence of Cost of Goods Sold. Until recently, this could be fatal because the IRS would have tried to put you on the accrual vs. cash basis of accounting. This is no longer an imminent threat, but does not dismiss the curious inconsistency on your tax return. This is not good if you are trying to stay under the IRS radar.
Myth 3
An associate can't be an independent contractor.
Many authors have needlessly stirred things up in the I/C-Employee controversy. They religiously trot out a "20-factor test" every year or so — and they fail to mention that this list initially came about as a test for leased computer techs and specifically did not apply to professionals. They also forget to mention that there is a safe-harbor exception for professionals under Code Section 530 that trumps that test. Doctors who satisfy the 530 safe harbor exception need to be encouraged to not roll over when the IRS shows up.
The Revenue Act of 1978 introduced Section 530 as a safe harbor against the IRS reclassifying workers as employees when the employer had classified the worker as an I/C. This safe harbor applies if three conditions are met by the employer:
1) the employer had always treated that class of worker as an I/C and never as employees;
2) the employer had issued a 1099-MISC for all workers for all years; and
3) the employer had "reasonable cause" to treat the worker as an I/C. The section went on to say that you could show "reasonable cause" if a substantial segment of the industry also treated the same class of worker as an I/C. If you ever commingle worker status by treating even one associate as an employee, you are stuck with treating all associates as employees.
Even when the 530 safe harbor works, it gets more interesting at the state level. Many states do not follow the IRS on this, and associate doctors are employees for state purposes — period. California, Illinois, Georgia, and other states are after the unemployment tax. That just means the accountant does a Sched. C as an I/C for the IRS and a W2 for the state.
"We tend to go against all attempts to have associates reclassified as employees, because once you go the employee route, you can't go back," Pensavento said. "So if one of our dental clients has consistently treated their associates as I/Cs since 1978, we encourage continued behavior so we can show that a substantial segment of the industry treats associates as I/Cs. This satisfies the third requirement of the 530 safe harbor. We've only had one case in 25 years and more than 270 dentists where Illinois challenged the I/C status, and, for that client and for Illinois only, we treated that associate as an employee."
Myth 4
Operate as an S Corporation to save a lot of payroll taxes.
The possibility of minimizing payroll (Social Security and Medicare) taxes is appealing, but the savings are often terribly exaggerated. In fact, for a new doctor, the extra cost of accounting and tax returns may overshadow the tax savings for awhile. While all our members generally favor S Corporations, we just don't want you to have unrealistic expectations — or get yourself into trouble.
Here's the story. If you owned stock in General Motors, it makes sense that any dividends you receive would not be treated as "earned income," so the dividends would not be subject to self-employment/Social Security taxes. You are just an investor. However, some folks are distorting this principle and naively applying it to a personal service S Corporation and its dividends. While, technically, an S Corporation can indeed pay dividends that are not subject to payroll taxes, the situation is complicated by the fact that your personal efforts generated the profits used to pay the dividends (unlike the General Motors situation).
Why is this important? Consider a simplistic case where you have, say, $150,000 profit, either as a sole proprietor or in W2 income from your corporation. The total FICA tax on that kind of profit is about $14,000 (remember, you will pay regular IRS and state income tax on this profit no matter what the income is called, so it can be ignored for this comparison). Suppose you decide to take no income as a W2 and take the entire $150,000 as an S Corporation dividend or distribution instead. Since that is not subject to FICA, you just saved yourself $14,000! However, this is the classic case of "over reaching." The technical phrase is, "A pig gets to go back to the trough, but a hog gets slaughtered!"
The problem is that the IRS does not have to buy your version of reality. (They are not going to give up that kind of payroll tax revenue lightly, due to the cash crunch coming with the Social Security system.) No matter what your corporate paperwork says, the IRS has the ability to reclassify your income and change some of the dividends to W2 income. In fact, the IRS is starting a new program specifically to look at the disparity between W2 income and dividends. If you have ever been late making a payroll tax deposit, you know this could be expensive!
The fact is, you can treat some of the profit as dividends, but the issue is where to draw the line. At a minimum, you should probably pay W2 equal to about 30 percent of your individual doctor collections (excluding hygiene). You could argue that this is the going rate for an associate and that any excess is owner profit. If greater, you may want to pay yourself enough as a W2 to equal the FICA wage base, which is $87,900 for 2004. The good news is that the IRS interest level may drop once you get to the amount of W2.
Unfortunately, the reason is that the expensive 12.4 percent Social Security component of FICA stops at this point, so the IRS got its pound of flesh. Only the relatively minor 2.9 percent Medicare part continues, and half of that is tax-deductible. So, if the doctor above took $87,900 W2 and the rest of the $150,000 as dividends ($62,100), then he or she only saved about $1,800 — better than a poke in the eye, but a far cry from $14,000!
However, he or she can only contribute to a retirement plan based on the W2 earned income — not the full profit of $150,000! In fact, I have new clients (after the fact) who took the hog approach and had zero W2 when they came to me, telling me how clever they were, until they then wanted me to calculate a retirement contribution for them. Well, 25 percent of zero is pretty small, except for very large values of zero.
If you are interested in maximizing your retirement plan contribution, you may want to take W2 income of at least $200,000 ($205,000 in 2004) since this is the highest wage used to calculate a contribution. So, now you need profits of more than $200,000 to get excited about the payroll tax savings of an S Corporation. At that level, you save about $2,800 per $100,000 in dividends. Nice, but not extravagant. On the other hand, if you have a very profitable practice, perhaps with several associates, and you generate profit of, say, $500,000, then $300,000 of dividends begins to generate substantial savings.
You may want to consider starting out as an unincorporated sole proprietor (or LLC where available) and then incorporate in a few years when the benefits outweigh the cost. It's almost a coin toss, and that is why many accountants are ambivalent about the decision in the first few years, unless you have some unique circumstances.
Myth 5
The new $100,000 and 50 percent depreciation deductions are no-brainers!
Unless you have been living under a rock, you know by now that you can elect to immediately write-off the first $100,000 of equipment you buy in 2003, 2004, and 2005. In addition, you can immediately deduct 50 percent of the excess of new items over the $100,000. Before you get out your checkbook, there are a few "gotchas" to consider. Don't take the full deduction if your income (and marginal tax bracket) is too low to fully benefit from the deduction. This could be especially true of new startups buying a lot of equipment.
Most states do not follow these new rules, so be sure to project your state tax liability properly to avoid surprises. Also, this could be a real problem if you have a C corporation that would have to pay state corporate income tax.
If you are an S corporation, you are still not out of the woods. If the S corporation has a tax loss after these deductions, that loss may not be immediately deductible! This happens if you do not have enough "tax basis" in the corporation. The best way to have sufficient basis to take the deduction is to borrow funds from the bank personally and then lend them to the corporation. It may look like the same thing, but if the corporation directly borrows the money from the bank, and you personally guarantee the loan (the typical arrangement), that does not give you "tax basis" and you can't use the deduction personally. Technicality? Yes. Fatal mistake? Also, yes!
Don't bother to get too clever and buy the equipment personally and lease it to your corporation. You are not considered to be in the "trade or business" of equipment leasing, and the $100,000 deduction is only available for equipment used in a trade or business.
Although the new deductions apply to SUVs, they may be cut back. Unless or until that happens, you need to remember that you have to be able to document at least 50 percent business use every year for the next five years. Your casual attention to details in the automobile deduction area may have not placed you on the IRS's radar screen before, but the IRS and much of Congress are not happy about this deduction. It doesn't take a lot of computer horsepower for the IRS to identify tax returns taking this deduction, so you'd better have good records.
As with your own profession, there are gray areas that require professional judgment and expertise as you tackle the issues above. A good accountant can help you make informed decisions based on your individual risk tolerance and comfort level. In fact, their biggest job may be to tell you when you are approaching the line between aggressive and reckless!
