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.
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. >:(