by Brian Hufford, CPA, CFP
Recent tax law changes have made 2007 the best year ever for dramatically reducing income taxes. Tax laws continue to greatly increase in complexity, requiring dentists to significantly plan to achieve the tax benefits offered. Previously, it was just a matter of understanding available deductions. Now, to realize the full benefit of desired deductions, a dentist must walk through a minefield of alternative minimum tax (AMT), basis limitations, and unintended consequences.
More than ever, it is important to obtain help from your tax advisor prior to entering significant tax-motivated transactions. Following is a numbered list of the top strategies dentists use to dramatically reduce income taxes.
1. Consider a defined benefit plan if you are age 50 or older.
While there are some disadvantages with defined benefit plans, particularly their incredible complexity, recent changes in the law have put tax deductions in the stratosphere. The Pension Protection Act of 2006 allows “advanced funding” of these plans with acceptable actuarial support, putting potential deductions in the $200,000 range and up.
2. Consider pairing a cash balance plan with your 401(k) plan.
The same Pension Protection Act of 2006 authorized the use of a hybrid-type defined benefit plan called a cash balance plan. A cash balance plan looks more like a defined contribution plan. Savvy dentists are coupling a cash balance plan with their 401(k) arrangement to push deductible retirement contributions to more than $100,000 per year.
3. Fully utilize deductible 401(k) contributions.
The allowable 2007 401(k) contributions are $15,500. For those dentists age 50 and older, a catch-up provision of $5,000 allows for a total of $20,500. To fully utilize these benefits, consider employing a spouse to receive an additional contribution of $15,500 with additional catch-up available. Your spouse does not qualify if he or she is covered elsewhere. Be sure to have these amounts withheld by Dec. 31 and be sure the spouse meets the plan participation requirements.
4. Replace SIMPLE-IRAs with qualified retirement plans.
If you have contributed to a SIMPLE-IRA in 2007, you are not eligible for a qualified retirement plan. In 2007, you may contribute $10,500 plus 3 percent of pay to a SIMPLE-IRA with a $2,500 age 50 catch-up. Qualified plans for practice-owner dentists offer a much higher $45,000 deduction limit with eligible compensation in 2007. Utilize a qualified plan whenever possible.
5. Determine the suitability of Roth IRAs and 401(k)s for your situation.
Roth 401(k) plans have been made permanent. This allows you to designate your 401(k) contribution as a Roth contribution in eligible plans. These payments are nondeductible upon contribution but are nontaxable on withdrawal once tax provisions have been met.
You may contribute up to $4,000 to a Roth IRA in 2007 with a $1,000 catch-up for those age 50 or older, if your income is below maximum limits - phasing out at incomes greater than $156,000 for married filers. You can convert a regular IRA to a Roth IRA in 2007 if your eligible income is less than $100,000.
This area of tax law is possibly the most complex area in the tax code for individuals to determine suitability. To determine the suitability for your situation, consider such factors as the years of available compound growth, future income tax brackets, estate planning considerations, etc.
Capital expenditure and depreciation
6. Maximize Section 179 equipment deductions.
Recent law changes now allow dentists who meet the requirements to expense up to $125,000 of equipment purchased in 2007. As the law reads, larger deductions will be available through 2010. Currently, they are scheduled to revert to $25,000 in 2011.
7. Consider purchasing an SUV for Section 179 deductions.
While the big expense deductions are gone, you are still allowed to expense up to $25,000 of an SUV with a gross weight greater than 6,000 lbs. if purchased for eligible business use in 2007. Under pending legislation, this deduction could end in 2008. With high gas prices, this loophole appears to be one of the less attractive tax planning “wins.”
8. Properly plan Section 179 expenditures
Consider making large purchases of eligible Section 179 property that exceed $125,000, over two tax years to gain additional deductions. Avoid destroying your pension deductions with excessive expensing and its subsequent effects on your eligible pension compensation. Avoid putting yourself in too low a tax bracket with excessive expensing.
9. Consider cost segregation planning for building purchases.
My top candidate for overlooked tax deductions is using a cost segregation study to increase depreciation deductions for an office building owned by the dentist. A cost segregation study can change a depreciation life on an office building from 39 years to five years, seven years, or 15 years. Typically, between 25 percent to 40 percent of an office building’s cost can be changed to more rapid depreciation. This can result in increased deductions of potentially hundreds of thousands of dollars during the first several years of ownership.
Practice entity planning
10. Consider practicing as a Limited Liability Corporation (LLC) under the laws of your state.
Dentists who earn less than $300,000 are likely best served by practicing as an LLC when state laws are favorable. Traditional corporate forms, such as S and C Corporations, create severe planning problems for larger purchases of equipment and for employing children. Children under age 18 may be employed in the LLC form without Social Security and payroll taxes. In a traditional corporate form, children’s payroll is subject to payroll taxes.
11. Consider electing to practice as an S Corporation if you have income in excess of $300,000.
For dentists with incomes in excess of $300,000, an S Corporation can save significant Medicare taxes. It also has reduced potential for audit risk compared to proprietorships or LLCs. An S Corporation is superior to a C Corporation for dental practices in nearly every circumstance. S Corporations have advantages over sole proprietorship LLCs in their ability to bunch income tax withholding at the end of the year while still avoiding estimated tax penalties.
Fully utilize children’s lower tax brackets
12. Beat the new Kiddie Tax.
Recent tax law changes increase the age of children subject to Kiddie Tax rules to children under age 18 as opposed to under age 14 in prior law. In 2007, children under age 18 must pay taxes at their parents’ tax rates for unearned income in excess of $1,700. The new Kiddie Tax does not apply to earned income, such as salary from the dental practice. Earned income qualifies for the standard deduction of $5,350 in 2007, along with lower tax brackets for wages in excess of the standard deduction amount. It is still a good idea to help fund future college costs by paying children for work performed in your practice. The recent Kiddie Tax rules do not affect this planning idea. Be sure to check state employment laws.
13. Fund college costs with tax deductible dollars.
By using gift/leaseback arrangements, it is possible to fund older children’s college costs on a tax deductible basis. This can be accomplished by using family limited partnerships or other entities to hold either dental equipment or the dental office building in a lease arrangement with the dental practice. The rent paid by the dental practice is deductible to the dentist and taxable in the children’s tax brackets with proper planning (the new law states that children ages 19 to 23 must have earned income in excess of 50 percent of their support while a student after 2007 to avoid the Kiddie Tax rules). By avoiding dependency status and the 2008 Kiddie Tax rule changes, children can qualify to offset taxes on the rent income with educational tax credits (the Hope Credit and Lifetime Learning Credit). Typically, these are not available to dentists because of incomes greater than the maximum married income amounts of $110,000. In this way, the child could earn from $20,000 to $40,000 with little income tax payable.
14. Give appreciated securities to children to pay zero tax on sale.
With proper planning, by gifting appreciated stock to a child and having the child sell the stock, you can avoid any tax. In 2007, gifts of property are subject to an annual $12,000 gift-tax exclusion based upon the fair market value of the gift. If the child holds the stock until the Kiddie Tax rules no longer apply, the resulting capital gain will be taxed at 0 percent if the sale takes place from 2008 to 2010 (assuming the current rate structure is still in place). This would be true if the child is single and taxable income doesn’t go greater than $32,000.
Fully utilize self-employed fringe benefits
15. Combine business and vacation travel to maximize tax deductions.
If you go on a business trip in the U.S., and tack on some vacation time, you can still deduct the expenses. The question is how much vacation time can you add to the trip? The IRS does not specify how to determine if the trip is primarily business. The rules for foreign travel provide some guidance. Travel days count as business days as do weekends and holidays if they fall between business days. If you can show the IRS that staying a few additional days decreases airfare costs (such as not flying home on Saturday), then the extra lodging and meal costs would be deductible up to the amount of the airfare saved. This would be subject to the 50 percent rule for meals.
16. Utilize a Health Savings Account (HSA) to deduct health-care costs.
In 2007, you can contribute up to $5,650 to an HSA account to cover high deductible out-of-pocket medical expenses. Prior to 2007, if you installed a plan midyear, you had to prorate the deductible amount. In 2007, this requirement no longer applies. Health insurance is now fully deductible regardless of whether you practice as a C Corporation, an S Corporation, or a proprietorship.
17. Deduct 100 percent of long-term care insurance for a spouse in a practice LLC.
A single-member LLC can deduct accident and health insurance coverage, including long-term care insurance, as a fringe benefit for an employee-spouse. If the employee-spouse then elects family coverage, the owner-dentist and dependents can be covered. The coverage is tax-free to the spouse, and so are the benefits from the policy. The premiums are deductible as a business expense on the owner’s Schedule C. You need not cover other employees because there are no nondiscrimination rules for employer provided accident or health insurance coverage.
Accelerate practice overhead deductions
18. Pay invoices received in December by credit card and then pay the credit card balance in January 2008.
It is possible to accelerate nearly a full month’s overhead from January into December by merely paying for overhead items with a credit card. Tax law states that items paid for by credit card qualify for deduction in the year the expenditure is paid. Thus, any advances on a credit card are deductible when incurred, not when the balance on the card is paid. Be sure to alert your CPA of the balances paid with a credit card. If you fail to do so, the deductions could be missed when your accountant posts your checks.
Fully realize personal deductions
19. Take advantage of expiring tax breaks in 2007.
The itemized deduction for state and local sales taxes in lieu of state income taxes expires at the end of 2007 unless Congress takes further action. If you live in a state with low or no state income tax, you may want to purchase big ticket items - such as a new car or a boat - prior to the end of the year.
Likewise the credit of up to $500 for nonbusiness energy expenditures for energy efficiency improvements - such as qualifying exterior windows and doors, insulation and heat pumps -will expire unless Congress takes action.
20. Watch for unfavorable tax law changes.
Several anti-taxpayer law changes took effect this year, or in the middle of last year, that you might not have noticed.
All cash donations to a charity must be documented with no exceptions. You are no longer allowed any deductions by cash or check unless you retain a bank record that supports the donation, such as a cancelled check or credit card receipt or a written statement from the charity that meets tax-law requirements. For donations of $250 or more, a bank record is not sufficient. You must obtain a charity-provided statement that meets tax law standards.
There are stricter rules for donating used clothing and household items. You are no longer allowed to claim deductions for charitable donations of used clothing and household items that are not in good condition (no more dirty laundry). Be sure to keep a list and a photo to help establish the item’s condition.
21. Avoid the Alternative Minimum Tax.
Unfortunately, it is very difficult to plan around the AMT. This tax law was cleverly planned to allow easy avoidance of the tax. To avoid the AMT, you may need to refrain from certain strategies commonly used to lower income tax. In other words, common income tax avoidance strategies may backfire and create an AMT liability.
For instance, one classic personal tax planning strategy to avoid paying federal income taxes is prepaying state and local income taxes. Prepayment of state and local income tax generates a larger itemized deduction on the federal income tax return; however, the state tax deduction is completely disallowed when calculating the AMT. In fact, this strategy could turn an expense that could otherwise be deducted in 2008 into an expense that will never be deductible because the AMT was imposed in 2007.
It may be advisable to defer paying part of the 2007 state and local taxes until 2008, if the taxpayer will not be in an AMT payment situation in 2008.
Another AMT trap is using a home equity loan to pay debts that normally generate nondeductible personal interest, such as auto loans or personal credit card balances. For AMT purposes, home equity loan interest is only deductible to the extent it is used to buy, build, or construct improvements to the taxpayer’s first or second residence.
The year 2007 offers great opportunities for dramatic income tax reduction in dentistry. Planning to reduce income taxes is much different now than in the past. For instance, you could purchase $125,000 of equipment in an S Corporation this year, thinking you have a large tax deduction, only to realize that - due to shareholder basis and other issue - you had lost all of the benefits. You must learn to be careful in preplanning tax transactions to assure you receive the desired benefits. With adequate planning and a good tax advisor, you can significantly reduce your taxes.
Editor’s Note: 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. The company is recognized as the only strategic alliance partner for financial planning services for the Academy of General Dentistry. Contact Hufford at (888) 470-3064, or at firstname.lastname@example.org.