In this very long and detailed blog post, I’m going to discuss:
1. The new 20% pass through deduction.
2. Why you are subject to a extremely high marginal tax rate (over 47%) during the phaseout of the deduction and what you should do for tax planning.
3. Whether to form LLCs separate from your practice for consulting or real estate to take advantage of income limits on the new 20% pass through deduction.
4. Loss of the entertainment and some meals deduction, as well as other changes that affect business owners.
5. The new 21% corporate rate for C corps and why it almost always makes more sense to be taxed as a S corp rather than a C corp.
6. The effect of lower rates on your overall tax burden at different levels of income (from $200,000 to $600,000)
If I didn’t make something clear please email or comment for the benefit of all readers!
How will the tax reform law affect me as a solo medical doctor? How does the pass through deduction affect medical practices?
I’m not going to go into every detail about changes that affect most individuals. Most importantly for 2018 and onward the marginal tax rates are lower than they will be for 2017. This should reduce taxes for everyone, whether employed or as a business owner (please refer to the last section of this post for actual calculations). There is a new limit on state and property tax deductions of $10,000 as well as a higher standard deduction of $12,000 for individuals and $24,000 for married (the exemption is going away).
Many people on our google group think this limitation on SALT deductions will cause their taxes to significantly go up, but in previous years they were taxed by the AMT (Alternative minimum tax). From 2018 and on, the AMT will have a higher exemption and slower phaseout.
The AMT frequently hits taxpayers within the $200,000- $600,000 range, where many physicians fall. So guess what, many of us were subject to the AMT in 2017 and previous years, meaning that you weren’t able to completely deduct your state and property taxes anyway! If you’re curious, look at line 45 from last years’ 1040 form and multiply by 3 to 3.5- this is a quick estimate of the amount of the itemized deduction that you weren’t able to deduct.
There are many other changes, but I’m going to focus on the most important one: the 20% deduction for pass throughs. Yes, we count as a LLC taxed as sole proprietor or S Corp election or corporation taxed as S Corp. Even if you aren’t in solo practice and get paid as a 1099 independent contractor, you are taxed on schedule C as a sole proprietor pass through and should get the 20% break.
Physician offices count as specified service corporations. The tax law for better or worse favors capital intensive businesses. At one point when they were writing the tax law they were going to completely exclude service corporations from the 20% deduction. But the law was written so specified service corporations have a phaseout for which if you earn higher the a certain income, the deduction is phased out.
For single folks the phaseout of the 20% deduction begins at $157k of QBI (qualified business income) and ends at $207k. For married the phaseout begins at $315k and ends at $415k. But this new break will really help those of you who just started or are in first few years and/ or have a spouse that doesn’t earn much. If you have a spouse that works, their income is counted towards the amount towards which the phaseout begins. So if your spouse earns $100k, then when your business earns $215k the phaseout begins and is complete at $315k. My understanding is that income from any other jobs and investment income, but not qualified dividends capital gains applies towards the phaseout threshold. Retirement plan contributions and HSA deductions will lower your income calculating the phaseout.
For sole proprietors or single member LLC taxed as sole proprietor it is whatever profit you report (on schedule C). Remember that you do not pay wages. If you are LLC or corporation with S corp election, you pay wages to yourself and also a distribution, the sum of which are your business profits. QBI for S corps is limited to distributions and doesn’t include wages. So interestingly enough if you elected S Corp taxation and plan to have your wage higher than the FICA limit (about $134,000 per year) you might pay more taxes than if you hadn’t elected S Corp taxation and elected to be taxed as a sole proprietor or disregarded entity, because the S Corp distributions only save you on the 2.9%/3.8% Medicare tax, which may not offset the larger pass through deduction.
For a couple filing as married if the only income were from the practice assuming “qualified business income” equals profits, $100k profits means 20% or $20k not taxed at the 22% bracket or a $2200 federal tax savings. This is a below the line deduction, so it only applies to federal but not state taxes.
For this same couple, $200k QBI means 20% or $40k not taxed at the 24% bracket, or $9600 tax savings. For $300k, 20% of $60k is not taxed at the 24% bracket, a savings of $14,400. That’s not chump change if my calculations and understanding of the tax code are correct.
Let’s assume the numbers in the above paragraph are total profits for the practice as a LLC taxed as sole proprietor and the spouse doesn’t work. If you elected S Corp taxation in the first instance of $200k, and took $100k wage and $100k distribution, the pass through deduction would be half at $4800. The FICA and Medicare taxes saved from the distribution is $6674; you pay ordinary tax rates on both the wage and distribution. A total $11,474 tax break vs $9600 with being taxed as sole proprietor. So you’d pay less taxes with S Corp election.
Now look at the example of the same couple making $300k. Let’s assume they want a wage of $150k to contribute more to their retirement plan (retirement plan contributions for S Corp election entities are based on wages and not distributions; also the IRS expects you to take a “reasonable” wage which for a physician making a profit of $300k is at least 50%).
For S Corp election, $150k in wages and $150k in distributions would decrease the pass through deduction to $7200 and add the Medicare tax savings from taking the distribution to $5250. The total tax savings is $12,450 which is less than the $14,400 for being taxed as a sole proprietor and taking the pass through on all profits.
All of this is explained very well in these blog posts and articles:
With the 20% deduction, this is effectively a 20% discount in your marginal tax rate (percent tax on the next dollar you earn) up to the phaseout threshold. But as you’re being phased out, you move into a very high marginal tax bracket. The reason why it’s so high is to “make up” for the 20% “discount” you got for the first $315k taxed.
For married at $315,000 your deduction is $63,000. At the 24% bracket this is a tax savings of $15,120. You lose this deduction in a linear between income of $315k and $415k- for example when your income is $365,000 (halfway between) your pass through deduction falls to $7560. This means you’re being taxed at an additional 15.1% over the $50,000 from $315 to $365k. Add this to the 24% regular rate, and it’s a 39.1% marginal rate. If you move up into the 32% marginal rate, then adding the 15.1% recovery is 47.1%.
For singles the phaseout is between $157,000 and $207,000. At $157,000, you get a deduction of $31,400. At the 24% bracket, this is a $7536 tax break. For the next $50,000 you earn you’re taxed at the regular rate of 24% plus the phaseout of 15.7%, a whopping 39.7%. And once you move up into the 32% bracket your marginal rate is 47.7%. Furthermore, as a single once your MAGI is over $200,000 you’re subject to the Obamacare investment tax of 3.8%. If you have capital gains or mutual fund distributions you could be in the 43.5% marginal bracket for a short period, for the amount of investment income you have.
The good news is as business owners we can do things to accelerate or decelerate income or expenses depending on the situation.
If you’re just under the phaseout, you should accelerate income or defer expenses just enough to not go over the phaseout limit. If you’re in the phaseout, you should defer income (perhaps by delaying sending in claims) or prepay expenses, or even buy equipment you think you really need (outfit another exam lane for example), but just enough to get out of the phaseout. You can prepay EHR fees, office rent, phone bill, and advertising among other expenses. But buy equipment if you really need it, not just for the tax break. One good way to accelerate expenses is to take the section 179 election on equipment purchases.
So what number do you want to lower? Believe it or not, you could potentially have a $416k business profit but still be under the $315k limit to get the full pass through deduction without being phased out. Why? By deducting a $56k IRA contribution, $6k HSA contribution and $24k standard deduction. This is assuming your spouse doesn’t work, any wages would be counted.
According to IRS form 1040 2018 instructions page 36 and 37 for the QBI simplified worksheet- look at lines 11, 12 and 15. Per line 15, QBI is the income is the lesser of your business profit (S Corp distribution or Schedule C bottom line) or your MAGI (form 1040 lime 7) minus itemized or standard deduction (form 1040 line 8)minus qualified dividends and capital gains (form 1040 line 3a plus schedule D bottom line).
See the table below. The white with writing are the marginal rates with the 20% deduction discount and then during the phaseout:
Should I form a separate LLC for my equipment to lease back to my practice?
In terms of equipment, if the average solo ophthalmologist has $250,000 of equipment and rents it back at $30,000 a year, the 20% deduction is $6000. At a marginal rate of 35%, that’s a $2100 tax break. Trouble is if your accountant charges you $1300 to do the accounting and taxes for a second corporation, you’re only saving $800 per year. You can decide if this is worth your time. The new tax laws definitely benefit accountants and TurboTax etc the most!
Additionally if you elect S corp taxation and section 179 all your equipment the first year, then you can’t take the tax break from self employment taxes by deducting equipment from your practice income if the equipment is in a separate LLC.
One advantage of forming a separate LLC for your equipment is for asset protection, if someone sues your practice and bankrupts it (this is extraordinarily unlikely if you are properly insured) it makes it more difficult for the creditor to take your equipment. Whether this is worth the time and effort of the additional paperwork is your call.
What about a separate LLC for billing services?
We will cover billing in a later post. Many practices outsource their billing at 6% of total collections. Given overhead is about 40%, this is 10% of your take home pay! Ho Sun and I are both fervent about supervising most of the billing tasks ourselves. Likewise most people on our google group keep billing in house.
So what about starting a billing company as a LLC and paying it out of your practice to get the 20% break once you’re over the specified service corporation income limits? (Update December 2018: the IRS has issued rulings stating that if there is at least 50% common ownership and the business provides 80% of its services to a specified service business, then the pass through deduction will not apply).
The question is whether a billing company counts as a specified service corporation. If it’s a specified service corporation then the phaseout at $157k single and $315k married is applied; if it isn’t (like real estate) then no matter what your income is you get the 20% deduction. Again, the $157k/$315k includes income from all jobs as well as investment income.
The IRS does consider consulting as a specified business (section 199(A)(d)(2)(A)). In fact it says that if the “principal asset of such trade or business is the reputation or skill of one or more of its employees” then it’s a service business and subject to income limits. However the IRS has excluded architects and engineers from specified service corporations.
If you look at the Forbes article linked above, after 10,000 words they state “it may be a while before clarity is forthcoming.” So I don’t know if medical billing counts as a specified service corporation and is subject to income limits.
If a billing company didn’t count as a specified service corporation, for a practice that grosses $800,000, 6% would be $48,000 paid to the billing company. 20% of this is $9600 to be deducted, at the 35% rate that’s a $3360 tax break. And this is assuming the billing company has no overhead; a good argument can be made to allocate some of the practice overhead for computers and practice management system for the billing company.
The IRS might make rulings that the two companies (such your practice and a billing company) are too closely held and disallow the 20% pass through deduction. Or it may not. Who knows at this point? I will await further clarification before establishing another LLC for this purpose. (August 2018 update: the WSJ reports that the IRS is not allowing “crack and pack”, or the splitting of businesses to take advantage of the pass through deduction).
And finally what about a separate LLC for real estate?
Because of a tax savings strategy called cost segregation analysis, most real estate LLCs take a loss on paper the first several years. We will have a detailed post on cost segregation analysis, but in a nutshell commercial real estate is depreciable over 39 years. Cost segregation analysis is including as many individual components of the property as possible under accelerated 5, 7, and 15 year depreciation. You get your tax break faster- the time value of money.
So often real estate takes a loss on paper the first five to seven years. No profit, no 20% deduction. Once you begin to get a profit through the real estate LLC then it makes sense to charge as high rent as possible because you get the 20% deduction for the real estate LLC; the rents paid from your practice are tax deductible from your practice. You pay lower taxes running the rent amounts through your real estate LLC.
Tax advantage or not, it always makes sense to segregate rental real estate, whether personal or business, into a separate LLC for asset protection purposes. If there is a accident and a claim against your property, usually the creditor can’t go after your practice or personal assets.
Why is anyone declaring any income through their S Corp? Should we all be either taking distributions of that income or prepaying our notes on drugs and such to show a “loss”?
This doesn’t have to do with the new tax law but someone on our google group asked. S corps are pass through, so if your company makes a profit, you take the profit by paying yourself a salary and distribution. The IRS states your salary (vs distribution) has to be “reasonable” but gives lots of leeway on this. By taking distributions you save on self employment taxes (link in next section to previous post that explains this in detail).
If your company has a profit of $500k (which you would take perhaps as a $250k salary and a $250k distribution), feel free to zero it out by sending me a check for consulting! That will zero out your income (both your salary and distribution) and then you won’t have to pay any taxes!
Personally I’ll happily pay the $200k or so in taxes on the $500k and take the remaining $300k to lie on a beach in Hawaii for the next year…
Last year at our annual academy meeting I was trying to convince someone their accountant was wrong when telling them to buy equipment as a tax deduction. Sure on a $10,000 piece of equipment you get a $4000 tax deduction, but $6000 out of your pocket from salary or distribution. If you need the equipment and it will help your practice get it for sure. But don’t buy it solely for tax purposes.
Seriously, paying a truckload of taxes is a good thing because it means you’re making money. If you don’t run your company well you can take a operating loss and pay no taxes, but this isn’t a good thing!
Yes, you want to shuffle around your income and deductions to maximize income in low bracket years and maximize deductions in high income years. This is why I laugh and then shake my head when I hear docs in startups brag “my accountant had me pay zero in taxes”.
Guess what, your accountant should save the deductions for future years when you’re in a high tax bracket, such as when you’re in the 20% pass through deduction phaseout as described above. A single person can make about $23,000 and pay only self employment taxes of 15.3%. ($6000 standard deduction, $4000 exemption, $13000 simple IRA).
How I would love to be in the 15.3% bracket…
Other important changes for business owners under the new law, such as restrictions on meals and entertainment expenses
The TCJA has new much more restrictive parameters on entertainment. Specifically, meals and entertainment for clients was previously 50% deductible. It is now NOT deductible at all for entertainment, but for meals only. (Updated October 2018: the WSJ says that the IRS has issued guidance stating meals will still be tax deductible). It was previously feared that the meal deduction would be eliminated.
My attorney buddy is dropping his Suns NBA tickets next year. Without the deduction, in his tax bracket they are over 50% more expensive! If the sports ticket price includes meals, they must be a separate line item to be deducted. Moreover, meal expenses cannot be “lavish or extravagant.”
Meals provided for employees while working as well as office coffee and snacks are deductible now at 50% rather than 100%, and after the year 2025 no deduction.
Thankfully office holiday parties are still 100% deductible. Please invite me over!
Section 179 allows the owner of a medical practice to take the entire deduction for equipment put in service during that year, rather than using the traditional MARCS depreciation over five to seven years. Whether or not it is wise to elect section 179, or how much to elect, depends on what your marginal tax bracket is as well as the time value of money. You want to lower your income enough so you aren’t taxed at high rates, but you want to have some income taxed at low rates.
The previous law had a section 179 limitation of $510,000. The new law has a limitation of $1 million. This is unlikely to affect those of you who are just opening, because starting a ophthalmology medical solo practice typically costs $200,000 to $300,000 of equipment. If you are in a small medical group and purchasing lots of equipment, this may be advantageous to you.
Often times accountants will have solo physicians take a net operating loss (NOL) and carry it back to a previous tax year. Again I would argue that as long as you have good cash flow, it makes sense to have some income taxed at low brackets and save your deductions to when you are taxed at higher rates. The new tax law allows NOLs to be carried forward, but not backwards.
There is also a limitation on business interest deductions. However most of us are under the limit of $25 million in annual gross receipts so this doesn’t apply to us.
Why not be taxed as a C Corp? I hear that there is the new 21% corporate tax rate.
As mentioned in a earlier post, if you incorporate as a LLC you can choose to be taxed on schedule C as a sole proprietor, or elect for S Corp taxation. Both of these are pass through taxation at regular tax rates.
If you incorporate as a corporation which is required by some states for a solo physician office (see previous post linked in last paragraph), you are taxed as a C Corp but can choose to elect S Corp taxation. Most people choose to elect S Corp taxation. C Corp taxation is NOT pass through but S Corp taxation is.
In most cases it doesn’t make sense to be a C Corp because you can’t skip out on self employment (social security and Medicare) taxes like you can for S corp distributions. Finally the 20% deduction for S corps and passthroughs is outlined above. You don’t get this deduction for C corps.
C corps pay the business overhead plus wages to the owner. Anything that is left after wages is taxed as a profit the corporate level 35% (old rate for service corporations), now 21% at new tax rate. So 21% sounds lower than most marginal rates. So why doesn’t this make sense?
Because there’s double taxation, at the corporate level and then on your individual or joint return. First 21% at the corporate level. Secondly the corporate profit is reported on your individual return as a corporate dividend, and there’s a 15% dividend tax- bringing the total rate for C Corp dividends to 39.8% for married above $450k, and 35.8% below $450k. This is higher than the regular brackets of 37% for 2018 under new tax law for over $600k and 35% for over $400k.
How did I come up with 39.8% and 35.8%? With the new corporate rate of 21%, for every $100 of corporate profits $21 taken out in tax leaving $79. This $79 is then taxed at the individual level for qualified dividends at 15%. There a 3.8% Investment tax including qualified dividends for income over $250k married, and another 5% increase (capital gains 20% plus 3.8% investment tax for 23.8%) for married income over $450k.
So the $79 left would be taxed at 18.8% or 23.8% depending on if your income as married was over or under $450k.
As mentioned earlier, S corp owner compensation is broken down to salary and distribution. The salary is subject to the self employment tax, but the distribution isn’t. So for a $500k owner profit as a S Corp you could take $250k salary and then $250k in distribution, and avoiding the 3.9% Medicare tax on $250k is worth $9750.
With the new 20% deduction for pass throughs (again, S corps are pass throughs, C corps are not) this makes S corps a even better deal.
Say your company made $200k. If you were a C Corp it wouldn’t make sense to take profits rather than wages because of the higher rates as outlined above. You’d want to take the full $200k in wages. You’d pay the full FICA (social security) and Medicare taxes on the $200k.
As a S Corp you could take say a $130 salary and $70k distribution, thus saving $2030 Medicare taxes. Moreover, if married 20% of the $200k or $40k would be deductible, at a marginal tax rate of about 24%, for $9600 tax break. So this is a $11,600 tax savings by electing S Corp over C Corp taxation!
The effects are even more exaggerated if you take less than $128k in salary because of the 12.4% social security FICA tax. If your company makes $130k and you take $80k salary and $50k distribution, you save $7500 on self employment taxes, 20% of $130k is $26k deduction at the 22% bracket is $5720. This is a $13,200 tax savings! A bigger savings than when your company made $200k!
C corps do have deferred compensation (can retain $250k, if over $250k you pay a retained earnings tax of 20%, ouch). For C corps you can hold $250k profits and then theoretically take them out in retirement tax free. This is because when you’re in the 10 or 15% bracket on regular income you get a special rate of 0% on investments such as capital gains and qualified dividends.
For $250,000, saving 39.8% in taxes is $100k. But the problem with this is that if most of us have post tax mutual funds with dividends it will push us out of the lowest brackets and then we’ll be taxed at least 15%. Even if you were taxed at 15% rather than 39.8% it would be a tax savings of $62,000. But as I said, this means you’d be paying Medicare taxes for everything you took home except for the $250k held in the company. $62,000 at 3.8% Medicare tax is $1.6 million of earnings. This sounds like a lot, but if you are a S Corp and take $200k salary and $300k dividends, in just over five years you’ll come out ahead as a S Corp.
Not to mention that when you’re in lower income you get the 20% pass through break as well as the time value of money- if you Invest the money post tax out of the C Corp it will continue to grow, but if you invest within the C Corp you’re subject to 20% tax on held profits.
Unless you want to go public (have over 100 shareholders or classes of shareholders with different classes of stock for voting purposes), or raise a ton of capital to buy equipment, or have a family member with expensive health problems for which C corps have certain tax advantages, S Corp is the way to go. These situations usually don’t apply to solo doctors.
The paperwork for C corp taxation is significantly more complicated than for S corp taxation. Unfortunately some accountants are less than scrupulous and advise you to be taxed as a C corp so they have more paperwork to fill out, leading to more in their pocket.
Bottom line: you usually want to be taxed as a S Corp rather than as a C Corp.
The effects of lower tax rates on your tax burden at different levels of income under the TJCA compared to 2017 rates
Here are the effects of lower tax rates at any given income from $200,000 to $600,000. The calculations are based on income reported on line 43, taxable income. So the numbers below don’t take into account the AMT (Alternative Minimum Tax) which affects many taxpayers who take large itemized deductions and fall into the $200,000 to $600,000 income range. They also don’t take into account the standard or itemized deduction (property and state taxes, mortgage interest and charitable contributions) and the exemption or child credits.
This article has a similar analysis for lower income levels for a single filer although they did take deductions and exemptions into account.
The numbers below are for married filing jointly:
Income 2017 2018 Tax savings under new plan
$200,000 $42,884 $36,579 $6305
$300,000 $74,217 $60,579 $13,638
$400,000 $107,217 $91,379 $15,838
$500,000 $143,231 $126,379 $16,852
$600,000 $182,831 $161,379 $21,452
As you move up in income, the savings become more pronounced. To put things in perspective for those who are worried that they are getting hosed because of the new limit on state and property taxes, even at a $200,000 income you’d need an additional $26,270 of state and property taxes to offset the savings of $6305 from lower tax rates. At a $300,000 income you would need an additional $56,825 of state and property taxes to offset the savings of $13,638 from lower tax rates. And don’t forget, under the old system the AMT limited your deductions anyway. Also if you are taxed as a pass through and your income is less than $415,000 you get the pass through deduction on top of the tax savings illustrated above.
Here are the numbers for filing as single:
Income 2017 2018 Tax savings under new plan
$200,000 $59,892 $46,565 $13,237
$300,000 $82,399 $81,565 $834
$400,000 $115,399 $116,565 (-$1,166)
$500,000 $153,819 $151,565 $2254
$600,000 $193,419 $188,565 $4854
Interestingly enough, the tax savings for 2018 vs 2017 is greater at $200,000 than any other income. That’s because many of the tax rates on income between zero and $200,000 were cut. Paradoxically, at $400,000 of income taxes are higher under the new law. This has to do with the fact that with the old law income of about $200,000 to $425,000 was taxed at 33%; with the new law it is taxed at 35%. The highest rate in the new law is 37% compared to 39.6% with the old law which is why the savings difference for 2018 becomes more pronounced at higher incomes.
Don’t get me wrong, although I want to pay less taxes, I’d rather earn $400,000 and pay a extra $1166 in taxes than earn $200,000 and save $13,327 in taxes.
In my second post I’ll talk about whether it’s worth trying to get around the phaseout limits by filing as married filing separately, as well as whether surgery center and optical shop distributions are eligible for the pass through deduction.
Ho Sun has written about his high earner S Corp TCJA strategy: to do nothing! Read and find out why.
This post about the tax law explains what the repeal of the individual mandate to carry health insurance means.