The new tax act substantially revised the tax rules that apply to business owners. In this article we will focus on those provisions that impact dental practices and consider how practice owners can benefit from those changes.
There are three major areas of substantial tax revision that we will explore:
- C-Corporation Tax Rate Reduction
- Fast Write-Off Depreciation and Expensing Rules
- Qualified Business Income Deduction
C-Corporation Planning Considerations
Prior to the new tax act and reduction of the corporate tax rate to 21%, this author has felt it ill-advised for a dental practice to be taxed as a C-corporation because of the 35% personal service tax rate on corporate profits and the double taxation of profits paid out to the owner/shareholder (first at the corporate level and second at the individual level). In addition, when C-corp practice owners sell their practice, they have had to get creative with the sale structure in order to avoid the double taxation on the gain from selling their practice, which routinely exceeds a million dollars.
With the reduction of the corporate tax rate to a flat 21%, there is a new call to examine whether or not it makes sense for a dental practice to be tax-structured as a C-corporation. I have given that question considerable thought. In general, for most practices the answer is still no; C-corp structure does not make sense. However, in some very narrow and specific situations, temporary C-corp structure does make sense. Being taxed as a C-corporation would allow the practice owner to accumulate cheaper after-tax capital for equipment purchases, or for a major office remodel, or to open or acquire an additional practice and/or to payoff existing practice debt.
For example, with broad strokes, the following fact pattern may make sense to temporarily convert to C-corporation status.
- Company is currently structured as an S-corporation
- In 2018 the Company spends $400,000 on new equipment and office remodel
- Owner’s W-2 compensation is $250,000
- Practice profit net of owner’s compensation but before depreciation is $200,000
- The Company borrowed $400,000 on a 5-year loan to pay for the equipment and remodel. Annual debt service is $94,000.
- In 2018 the Company claims 100% bonus/Sec. 179 depreciation of $400,000 for the new equipment and leasehold improvements.
- The practice remains an S-corp for 2018 in order to pass through the depreciation deductions for the new equipment and TI’s to the owner in order to benefit the owner’s personal taxes.
Converting to C-corp status in 2019 would allow the practice to generate after-tax profits at a 21% tax rate to pay back the bank loan versus after-tax profits personally at a 32% tax rate or higher.
The key for this strategy to work is corporate profits should be/need to be un-sheltered by depreciation deductions.
In this example below, we are comparing the tax outcomes of a practice continuing as an S-corporation (or PLLC) to the same practice that temporarily converts to C-corporation status. Translating the tax scenario above to numbers, we get the following outcome:
1 Assume entire $400,000 depreciation pass-through is limited by stockholder’s tax basis which will suspend or spread the utilization of the deduction over multiple years.
This strategy assumes converting back to S-corporation status after the loan is paid off and after waiting the minimum 5-year waiting period required before re-electing S-corporation status.
One negative in the tax scenario above is the corporation is accumulating profits net of tax and net of debt service totaling $64,000 annually, or $320,000 over the 5-year C-corporation period. Distributing this money out to the stockholder as dividend distributions will trigger tax at 15%, totaling $48,000. Dividend income in the example above would also be subject to the 3.8% Net Investment Income Tax of $12,160. Netting these additional taxes against the savings noted above still results in an overall tax reduction of roughly $50,000 ($109,000-$48,000-$12,160).
This is an over-simplified example to demonstrate a potential situation where a temporary conversion to C-corp status may make sense and disregards the impact of the new Qualified Business Income Deduction. In other words, situations with higher or lower taxable income will totally change the tax outcomes and the decision process to continue as an S-corp or convert to a C-corp, especially if you benefit from the new Qualified Business Income Deduction. My point is you need to entertain C-corporation taxation very carefully and with thoughtful and cautious guidance from your professional tax advisor.
Depreciation and Expensing Rules
The new tax act has greatly enhanced the depreciation and expensing rules for capital expenditures (equipment and tenant improvements).
First year expensing under Sec 179 allows the write-off of qualifying property in the year such property is placed in service up to an annual limit of $1.0 million, subject to phase-outs that don’t apply to the typical dental practice.
Qualifying property includes equipment, furnishings, computers/electronics, software and leasehold improvements – pretty much anything a dental office would acquire.
In addition to the increased limits for Sec. 179 expensing, taxpayers can take advantage of 100% first-year bonus depreciation through 2022. Bonus depreciation is scheduled to be completely phased out between 2023 and 2026.
The net result for the next five years is Congress created a belt and suspenders write-off system that will allow the typical dental office to write-off 100% of their capital investment in equipment, technology and tenant improvements in the year placed in service, if desired.
With the various elections allowed when claiming Sec. 179 or bonus depreciation, we have great flexibility structuring the utilization of depreciation deductions.
On the surface one might think substantial (one-time) depreciation deductions are a huge tax benefit. They are a benefit, but if not used wisely, they may be hugely under-utilized. In other words, utilizing depreciation deductions to offset 37% tax dollars versus 15% tax dollars is clearly more valuable.
As it applies to dental practices, mapping out a plan that utilizes depreciation deductions for substantial capital investments against high tax rate income is obviously the smarter tax strategy to implement versus simply maxing out the deduction in year one.
Qualified Business Income Deduction (QBID)
The QBID has commonly been referenced in the financial press as the pass through income deduction. The deduction applies to all Qualified Business Income (QBI) generated from S-corporations, partnerships/PLLC and Schedule C entities (proprietorships and single-member PLLC).
The QBID is one of the tax law provisions that sunsets or expires in 2025. The QBID is also one of the key new law revisions that have many unresolved questions which will require interpretive or regulatory guidance from the IRS and/or a technical corrections act from Congress.
The Qualified Business Income Deduction is a fairly complex set of tax rules once you get into the details.
The general framework operates as follows:
- The deduction is equal to 20% of the taxpayer’s Qualified Business Income earned in a qualified trade or business. Suffice to say, the net income from a dental practice is considered qualified business income.
- Qualified Business Income is:
- Schedule C net income
- S-corp K-1 net income after deduction of owner’s W-2 compensation
- Partnership/PLLC K-1 net income without inclusion of owner’s guaranteed payments
Note that Schedule C filers are not penalized by a deduction for owner’s compensation. This is an area of disparity that the tax advisor community expects further guidance from the IRS and/or a technical corrections act by Congress.
Note that S-corp owner’s compensation and partnership/PLLC owner’s guaranteed payments (terminology that means compensation; typically a partner’s production based pay/allocation before remaining profits are allocated based on ownership percentages) factor into the calculation of Qualified Business Income. The higher owner’s compensation is results in lower QBI and vice versa. For S-corporations, working owners are required to be paid reasonable compensation which should be equivalent to what a non-owner would be paid for performing the same duties. There is no similar mandate to pay reasonable compensation in the partnership/PLLC tax arena. As noted above, Schedule C filers are not required to deduct an amount for reasonable owner’s compensation when calculating Qualified Business Income. The point is that the QBID has created some very significant, but probably unintended, uneven playing fields between S-corporations, multi-owner partnership/PLLC’s and Schedule C taxpayers. Historically, the tax rules have been designed to result in parity from one type of taxpayer to the next. That is clearly not the case for QBID as currently drafted, so regulatory guidance or a statutory fix from Congress is needed to resolve the flaws with the implementation of the Qualified Business Income Deduction.
- Some rental activities may qualify for the QBI deduction whether or not reported by a pass through entity or reported directly on Schedule E in an individual’s income tax return (i.e. rental income from self-rental of office to the dental practice). This is an area that needs further IRS guidance. Commentary from the “deep thinkers” suggest the taxpayer must be actively involved in the management of the rental activity in order to qualify for the QBI deduction versus being a completely passive investor that has hired out the property management to an independent company.
- Specific service businesses, including dental, are phased out or ineligible for the QBI deduction depending on the taxpayer’s level of taxable income.
The Tax Cuts and Jobs Act has made the most significant overhaul of our taxing system in over 30 years. We have covered three of the major law changes that impact dental practice owners. Yet many questions remain to be answered in order for professional tax advisors to properly guide their clients through the maze of the new rules. The IRS has the Herculean task of providing guidance for a host of new and changed statutory provisions. As a result, it will take time before we are able to sort out how best to implement and take advantage of planning strategies to the fullest benefit. Stay tuned!
This article highlights some of the key provision of the 2017 Tax Cuts and Jobs Act. This information is intended to be general in nature. Readers should consult with their professional tax advisor to assess their specific tax situation and determine the suitability of various tax planning strategies.
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