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An S Corporation with the benefits of a corporate form paired with the pass-through of income is the entity of choice for many dental practices. But as we review new client tax returns in our financial planning process, we find that many dentists lose significant tax deductions due to what we call the "S Corporation Trap."
The primary source of lost deductions in dental S Corporations is the inability to gain tax benefits from expensing equipment under Section 179. Let's assume you are a 48-year-old dentist who has production of $850,000 this year. Overhead is $550,000. This leaves a $300,000 net practice income. Wisely, you have implemented a new 401(k)-cash balance retirement plan that allows you to deduct $100,000 in retirement funding. This leaves $200,000 to pay yourself in W-2 wages. The large retirement deduction could save you $40,000 in federal and state income taxes and the S Corporation form keeps you from paying Medicare taxes on the retirement deduction. So far, things are great; however, the S Corporation Trap is activated when you also purchase $50,000 of equipment this year in hopes of expensing this amount under Section 179. For 2008, Section 179 has been amended to allow you to expense up to $250,000 of equipment placed in use this year.
Why do you fall into the Trap? Due to a tax code requirement, you must have sufficient "basis" in S Corporation stock to realize the benefits of expensing $50,000 of equipment. So, the law allows the Section 179 deduction of $50,000 for the S Corporation, but only to the extent of "basis" in S Corporation stock (S Corp Basis, in general, represents the initial investment in the corporation plus net income or minus loss, less distributions to the owner).
Since you borrowed $50,000 from the bank to purchase the equipment, you had no basis in S Corporation stock. The bank loan to the S Corporation to purchase the equipment does not count as basis. Had you conducted business as a sole proprietorship or as a Limited Liability Corporation, taxed as a sole proprietorship, there would have been no problem expensing the $50,000 of equipment since you met all other aspects of expensing requirements. The basis issue does not present itself in the sole proprietorship form as explained.
Another S Corporation Trap issue is the employment of children in the dental practice. Because children are employed by a corporation instead of a parent, the children are subject to 15.3% FICA payroll taxes, along with state and federal unemployment taxes. In effect, these additional payroll taxes negate to a large extent the income tax benefits of shifting income from a parent to children to achieve lower tax brackets on earned income. Had the dentist who employs children under the age of 18 been taxed as a proprietorship, the law allows an exemption from payroll taxes for children who are employed by a parent.
To avoid the Trap, we promote a rule of thumb dictating that dentist-clients should not use an S Corporation form if the following issues are present: 1) the dental practice has less than $300,000 of net income before the dentist's retirement plan and wage deductions; 2) the dentist has large capital expenditures ahead for equipment that could be expensed under Section 179; or 3) the dentist employs children under the age of 18 in the practice. If you are currently an S Corporation, and any of these three issues apply, it is likely you are paying more income taxes in the S Corporation form than you would be as an LLC Sole Proprietorship.
Finally, if you are an S Corporation, you should apply an added planning step to any large purchase of equipment. Since dentistry is capital intensive and frequent equipment and technology purchases are a normal part of practice, it is crucial that you alert your tax advisor of any major purchases prior to the planned transaction. By planning for large purchase transactions, your advisor should be able to arrange sufficient basis in your S Corporation stock to allow the large deductions that are available under Section 179.
S Corporations do offer many benefits. But to the uninformed, there awaits an S Corporation Trap that traps hoped-for tax deductions.
Disclosure: This article is intended to give general tax advice only and may or may not be appropriate for use by the reader. The reader is encouraged to speak with a tax professional.
IRS Circular 230 Notification: Pursuant to IRS Circular 230, please be advised that, to the extent this article contains any tax advice, it is not intended to be, was not written to be, and cannot be used by any taxpayer for the purpose of avoiding penalties under U.S. federal tax law.
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 at [email protected].
