Tax planning: aggregation aggravation

Brian Hufford, CPA, CFP®

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Nearly every time I speak to a dental group, I ask how many dentists own office buildings. Typically, half of the group responds affirmatively. One of the largest sources of lost tax deductions in dentistry is related to office building ownership. Let me explain the problem and its solution.

Dentists typically practice as S Corporations and own their buildings separately in Limited Liability Corporations (LLCs). The LLC leases the office building to the dental practice for a predetermined rent amount. I would like to think that the rent is determined to be an appropriate fair market value rental, but many times the rent is simply the amount needed to cover the mortgage payments in the LLC.

Why do dentists structure their practices and office buildings this way? The primary reason for this S Corporation/LLC structure is to insulate the building from legal liability that might be incurred in the dental practice. This is appropriate planning. The challenge with this structure is the potential for large lost tax deductions. The practice deducts the rent. The LLC has rent income and other deductions.

Let me illustrate the problem. It is rather simple to describe, yet much more complicated to solve. Suppose that the dentist has a $100,000 profit in his or her practice S Corporation. In the office building LLC, rent has been structured to cover the mortgage payments. Let’s assume that the rent is $50,000 per year, and the mortgage interest deduction is $42,000 per year (with nondeductible principal of $8,000 per year). This is very easy so far. With no other facts, the dentist would report $100,000 of S Corporation income and $8,000 of rental income on his or her tax return.

Now allow me to make the example more realistic. Assume that in the previous example, in addition to the mortgage interest, that the dentist had additional deductions for the building of $12,000 related to property taxes, insurance, and repairs. Oops, the rent is too low. Perhaps the dentist should increase the rental to $62,000 per year to cover the additional costs. There is no problem with that either, assuming that the IRS doesn’t challenge the rental amount as unreasonable for like property.

The real tax problem is related to depreciation deductions. Assume that this dentist is the beneficiary of great tax planning, performing a cost segregation study and creating a 2011 depreciation deduction of $58,000 related to the building. The LLC now has a large tax loss as follows: rent income of $62,000, mortgage interest and other deductions of $54,000, and depreciation of $58,000. Total deductions are $112,000. This creates a tax loss of minus $50,000. What happens to the tax loss? Now the dentist has $100,000 of income from the S Corporation practice and a $50,000 tax loss in the LLC.

The tax code says that the LLC is what is called a Passive Activity under Section 469. Passive losses can only be offset against passive income. The dental practice is not a passive activity. Therefore, the $50,000 loss would be lost and carried forward to the future (there are minor exceptions but allow me to stay focused on the problem).

This dentist would pay tax on $100,000 of practice income along with any wages from the S Corporation with no offset for the depreciation deduction allowed in the LLC. The tax problem then is that, because of the passive activity rules, dental office building deductions may be lost in any given year simply because of the choice of entity structure. What is needed is the ability to aggregate the practice income and the rental loss so that the dentist only pays tax on $100,000 minus $50,000, or $50,000. Is this possible?

Believe it or not, the tax code offers a solution. Unfortunately, most dentists do not use the solution because they are not aware of it.

Under the same code Section 469, there is a provision that allows “integrated interrelated business activities” to be grouped as a single economic unit. What this means is that even though the dental practice and the dental building are in separate entities, the income, or losses, may be treated as a single economic unit. Thus, the dentist in our example would be taxed on only $50,000 instead of $100,000! This principle in the tax code is called aggregation. There are several requirements to be able to aggregate. But most dentists would have no problem meeting these requirements. Dentists simply need to be aware of the provision and check off the requirements.

In summary, do you aggregate? Avoid aggregation aggravation and lost tax deductions by checking with your accountant about the implications of office building entities and lost deductions.

Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].