My Professional S Corporation Trump Tax Plan Strategy as a “High Income Earner”

In this post, I’m going to solely focus on the professional S corporation that earns more than $207,500 as a single person or $415,000 as a married couple, where the 20% pass through deduction has been completely phased out. For further details on how the new tax plan affects the solo practice LLC or corporation as a whole, please refer to Howie’s excellent post: How the new tax law affects solo practice doctors. Contrary to this post’s title, there actually aren’t too many things you can do to capitalize on the Trump tax plan as a designated high earner. However, here’s a few approaches I have explored, of which most ended up as a wash.

First off, I’ve come to realize that the S corporation for a medical practice is overrated. As a physician starting a brand new medical practice, you really don’t get to see most of the benefits that a typical business would gain from being an S corporation. We will go over my views on the S corp structure in more detail in a later post. For this post, I will just limit my thoughts to how they pertain to your income taxes.

One of the purported benefits of being an S corporation is that it helps reduce your tax burden compared to being a sole proprietor. As an S corp, you can take your earnings in the form of wages or distributions. Wages require you to pay FICA (Social Security and Medicare) taxes, whereas distributions do not. For 2017, the FICA rate is 15.3%. 12.4% goes toward Social Security, capped at $118,500. The remaining 2.9% goes toward Medicare with no cap. In addition, Obama has levied an additional 0.9% surcharge on all modified adjusted gross income (MAGI) greater than $200,000 as a single person or $250,000 as a couple, increasing the Medicare tax rate to 3.8%. Distributions, on the other hand, are exempt from FICA taxes. The employee and employer each pay half of your FICA taxes. However, as both the employee and employer of your solo practice, you would be responsible for the whole shebang.

One thing I have learned throughout my tax education is that the tax code is quite elegant, and there really aren’t too many loopholes out there. That means you are not allowed to take all your earnings as distributions, thus avoiding the FICA tax altogether. As an S corp, you need to pay yourself a “reasonable” salary prior to taking a distribution. Now, if you’re a plumber that owns 100 trucks, earning $500,000 a year, you can give yourself a $40,000 salary, saving around $23,000 ($10,000 in Social Security taxes and $13,000 in Medicare taxes). However, no one will believe that $40,000 is a reasonable salary for a physician. Hence, you will unfortunately have to pay yourself at least $100,000 to $120,000, pretty much maxing out on your Social Security tax burden. I’m currently taking a $140,000 salary, with the rest in distributions. So, I pretty much just get to save 2.9 to 3.8% in Medicare taxes as an S corp. However, California has a 1.5% tax on S corporation distributions.  So, my real tax savings is 1.4 to 2.3%, which ends up being about $5,000 for a $415,000 income. For the amount of work you have to put into keeping an S corp, I’m not too sure if the tax savings are worth it.

Enter the Trump tax plan. I had kept much of my hopes up when I heard that pass through entities would get a 20% deduction. Of course, it was too good to be true. Congress just had to add on a professional service corporation exemption! As someone who’s been phased out of all pass through deductions for my professional S corp, here are some strategies I entertained to divert as much income as possible away from my practice.

1. Hold all equipment and property in a Real Estate Investment Trust (REIT) 

As far as I’m aware, REIT’s can distribute all its earnings to its shareholders without paying any wages first. I would set up an REIT, which would take ownership of all my equipment, and charge monthly rent to the practice. I have about $350,000 of equipment, of which 80-90% have already been depreciated. In 2017, I collected $110,000 from all my equipment. Having said that, I think it would be reasonable to say that I can still charge the practice $5,000 a month or $60,000 a year. 20% of that amount would result in a $12,000 deduction, which translates to about a $5,000 in tax savings. The question, once again, is whether it’s worth the effort and cost of setting up an REIT. It might be a completely different story if you own your  own office or building.

2. Create a Management Service Organization (MSO) run by spouse

My wife helps out with the managerial and billing duties of my practice. My practice  currently pays her a salary. I could fire her and rehire as an independent contractor. She would set up her own nonprofessional S corporation, which would qualify for the 20% pass through deduction. However, since our combined income would be greater than $415,000, she would be subject to a W-2 wage limitation. So, her deduction would be the lesser of the following:

a. 50% of your share W-2 employee wages paid by the business

b. 20% of qualified business income (QBI)

With a little high school algebra, you can calculate the sweet spot:

0.5 x wages = 0.2 x (total income-wages)

I anticipate my wife to collect close to $130,000 next year: $80,000 as a manager and $50,000 as a biller (6% of $800,000 collections). Plugging in the numbers, my wife should take $37,000 in wages and $93,000 in distributions or QBI. Hence, she would get $18,500 in pass through deductions, which would translate to about $7,500 in tax savings. However, close to $1,500 would go back to California as corporate tax. On top of that, my wife would have to pay $5,700 in FICA taxes on her $37,000 in wages, which I wouldn’t have to pay if I just did my own management and billing. In essence, after all this work, we would end up saving $300 in taxes… Of course, if you have a spouse that maxes out her Social Security tax through another employer, it might be worth the effort.

There also might be some question as to whether MSO’s or office managers are considered consultants or not, which would then disqualify them from any pass through deduction as a professional service provider. I personally think office managers are not consultants like financial advisors and those darn worthless practice management consultants that you shouldn’t waste a penny on (No! No! No!). This law is so new, there’s really no consensus on many of its nuances.

Lastly, I also considered having my wife create a SEP IRA for her corporation. However unfortunately, the IRS has controlled group rules, where two or employers with a common ownership interest is considered a single employer for the purposes of retirement plans. Hence, if my wife’s corporation offers a SEP IRA for its employees, my S corporation has to do the same. So, that idea is out of the question.

Update by Howie, December 2018: Unfortunately if you own real estate in a separate LLC/ entity, or create another non specified service business to try to make income eligible for the pass through deduction, there are severe limitations on if it will be eligible for the 20% pass through deduction.

The IRS provided clarification in August. There are rules to prevent “cracking”, or ways to strip money out of a specified service business (all docs are SSB and therefore have a total income limit from all sources for which the pass through deduction gets phased out at $315,000-415,000 for married filing jointly, half for single.
To make a long story short, if a business gets 80% of income from a SSB, then it’s not eligible for the pass through deduction if the two businesses have at least 50% common ownership. And if a business gets less than 80% income, then only the portion to the non affiliated group gets the pass through deduction.
Example:  Ho Sun leases 50% of his office to a podiatrist. He isn’t eligible to get a pass through deduction on the portion leased to his ophthalmology practice, but he is eligible to get a pass through deduction of 20% of profits leased to the podiatrist.
Of course, one way to get around this if you own your own practice is to get two unrelated individuals (not spouse) to own the LLC controlling the building so your ownership is 33%. But this probably isn’t worth it, due to the minimal tax savings compared to the cost and headaches of the legal fees and paperwork.

3. Change my practice into a C corporation

Since my professional S corporation has no chance of seeing any pass through deductions, I thought about converting to a C corporation instead. By doing so, I would pay the 21% corporate tax rate on all my earnings, and then just keep everything undistributed in my corporate account. Thus, avoiding the remaining 14.8 to 18.8% in capital gains tax. Then, I would let everything grow in some sort of investment vehicle. Sort of like an unlimited modified 401(k). Then, when I die, all the assets in the corporation would be passed down to my children, where up to $5.6 million dollars per individual (2018) would be tax free.

But alas, the elegance of the tax code strikes once again. Enter the accumulated earnings tax, where the IRS assesses a 20% tax on retained earnings considered beyond what is ordinary and necessary for business. As a personal service corporation, you can accumulate up to $150,000 in excess of any amount that is necessary to run your business. So, as a hedge fund, you can justify sitting on millions in dollars in stocks without incurring the accumulated earnings tax. However, as a medical practice, it’s kind of difficult to justify holding 1,000 shares of Amazon as an ordinary business expense. Hence, converting to a C corp is out as well.

As you can see, if you make over $415,000 as a couple or $207,500 as a single person, you’re pretty much screwed. Of course, no one’s going to feel sorry for you. Is it really worth all this corporate juggling and acrobatics to save $5,000? Probably not. As you can see, in conclusion, there really is no tax strategy for the high earning pass through entity in the Trump era. >:(

12 thoughts on “My Professional S Corporation Trump Tax Plan Strategy as a “High Income Earner”

  1. So knowing what you know now, if you had to do it all over again, would you consider starting up as a sole proprietor?

    • This is Howie. My understanding from going to OMIC lectures is sometimes if there is a suit filed due to negligent acts of an employee, the physician and the practice are both named. The physician individually is sometimes dropped but the corporation remains, because the basis of the suit was vicarious liability over the employee. If you do not incorporate this will not be possible.

      Settlements against an individual are reportable to the NPDB (National practitioners databank) while settlements for corporations aren’t.

      Some states have laws stating that the shareholders of corporations are liable for their employees’ vicarious acts, but this can be negotiated in a settlement if you incorporate.

  2. I considered all these options and as you said it’s not worth it. I decided to buy a lot of Realestate building and do a NNN DEALS and make my wife manage them as a real estate professional and do a coat segregation study to depreciate he building to set of my salary. This year I’ll be able to write $150k off from my salary.

    • This is Howie. We will have a post on cost segregation analysis. You are correct that this is a tax break now (time value of money)- but don’t forget at sale of the property the depreciation you take now is recaptured at 25% which may or may not be favorable depending on what tax bracket you’re in (it’s usually favorable for docs).

      I suppose you could continually do 1031 exchanges, bequeath the property to your heirs, and take advantage of the step up basis at death.

      But in my opinion (and I respect that others will differ) is that commercial real estate is most definitely NOT a passive investment- upkeep for the building, finding tenants, etc is work. And when it comes time to sell it depends on how the market is. If you have to sell in a bad market due to cash needs you may not come out ahead as much as you’d like.

      In addition to being illiquid, there isn’t much diversification in one single property (or a few) compared to the total stock market index fund.

      Yes there are some people who buy the right place at the right time and get rich, but there are others who barely break inflation or take losses. To each their own…

  3. I have struggled with all these same issues. I find that most cpas, even the ones that claim to be experts in medicine, tell me things that won’t make a difference. It is shocking to me how few cpas seem to know about the limit on retained earnings. One thing I have been kicking around: non qualified deferred comp. I would be a C corp and pay the 21% profit. Then I would fund a deferred comp for myself. You do have to pay payroll tax (here would only be the medicare most likely). The money is not deductible to the corp now but it would be when realized years later. I assume that means some year in the future I will start showing losses in the C corp? I am in my early 40s and figure I could ladder income for 10-15 years from now if I retire early and can’t access retirement funds anyway. Thoughts?

    • 1. Are you maximizing your 401k ($56k), Backdoor Roth ($11k married), HSA ($7k family), and 529 plans ($28k for two kids)? That would be $101,000 in tax advantaged accounts.

      2. If you are really maxing out all these accounts, and invest properly, you’re probably going to have at least $150,000 of income per year even if you retire super early. Therefore you’re taxed at about 15%. If you are taxed at the corporate level at 21% and then individual at 15% then it’s still a 33% tax (note: I’m not 100% sure if you would pay corporate tax as I’m not expert at this)

      3. Based on my limited understanding of non qualified plans, the company still must exist. Do you have partners who will continue the company and do you trust them to run the company the way you did? Will they sell to a larger group that might terminate the non qualified plan?

      4. Have you considered a defined benefit plan? If you have relatively few employees that are young compared to you this might work when you can defer $100,000 in the highest tax brackets. Charles Schwab has a proposal form you can fill out. Drawbacks are matching for employees is high, administrative costs are high. But this is asset protected where a non qualified plan isn’t.

      • yes on maximizing everything else. I am part of a large group practice without walls model partnership that is the main source of income. We have another organization that I do cash pay items through. I am trying to figure out a tax advantaged situation to save even more. I am not eligible for the pass through deduction. The 80/50 rules explicitly rule out the crack and pack. However I don’t think that would apply to a C corp since Uncle Sam will get his corp tax on this. So I could remove money from my partnership (where I have to pay medicare tax on distributions) and send it to another entity. I could keep the entity open even when it doesn’t have cash flow later correct?

      • The details are beyond my knowledge. My understanding is that you would still pay corporate tax the year the money is earned, but personal tax the year the company gives you the money. As I said my last comment after corporate tax you have 0.79 of every dollar and even if your tax rate is 15% (would imagine its higher if you’re maxing everything else and have post tax income, 0.79 times 0.85 is 0.6715, a 32.8% rate. That’s a tax arbitrage of 3.2% off the highest personal rates. If it’s worth setting up a non qualified plan all the power to you!

        This article states usually not best fit for small family businesses:
        http://fambizpv.com/articles/money_issues/nonqualified.html

        BTW most folks would love to have your problem; they don’t earn enough!😀

      • Also, there are “financial advisors” who are looking to steer you into these plans for their own benefit, by selling you insurance within a non qualified plan. I’m not saying that you shouldn’t get a non qualified plan, but find conflict free good advice.

        These same advisors often steer you into high load investments for 401k and IRA, but a 401k is still a good idea. Just buyer be aware!

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