This is part two in a series that examines how tax reform impacts businesses and individuals operating in the dental industry. The series will be released over the next several months and will provide explanations and insight into the changes being made and how those affected can maximize the benefits of these changes. The first topic is the qualified business income (QBI) deduction. In August, the Treasury Department issued proposed regulations covering many aspects of the QBI deduction. These rules are complex and we recommend discussing any tax planning strategies with your tax advisor prior to making any changes.
Overview: Beginning in 2018, taxpayers may be eligible for a 20 percent deduction on QBI from a partnership, S corporation or sole proprietorship. The deduction is calculated at the individual level and taken by the taxpayer on their individual tax return. The deduction is subject to limitations based on wages paid by the business generating the QBI, or wages plus a capital investment element for the business. The QBI deduction is also subject to phaseout for taxpayers engaged in specified service trades or businesses (SSTBs), which include medical and dental practices. The phaseout is based on the individual’s taxable income reported on federal Form 1040.
Qualified business income: QBI is defined as income or loss from any qualified trade or business during the tax year. QBI does not include interest, dividends, capital gains/losses or compensation paid to the taxpayer from the practice through wages or guaranteed payments.
Deduction phaseout: For taxpayers at or below the section 199A taxable income thresholds ($157,500 for single filers, $315,000 for joint filers), income from an SSTB is eligible for the deduction. Above these amounts, the deduction is phased out over a range of $50,000 - $100,000. Taxpayers with taxable income that exceeds $207,500 (individual) or $415,000 (joint) are not eligible for the section 199A deduction on their SSTB income.
Wage limitation: The QBI deduction the taxpayer will receive is limited to the lesser of 20 percent of QBI or 50 percent of the taxpayer’s share of qualified wages paid by the qualified trade or business. Qualified wages include those subject to withholding (W-2 wages including officer wages), elective deferrals and any deferred compensation paid in that tax year. This limitation applies when a MFJ taxpayer’s taxable income is in excess of $315,000 ($157,500 for single filers).
Unadjusted basis of property limitation: QBI that does not have a wage component in relation to its activity (for example, self-rental income-producing property) is still eligible for a 20 percent deduction; however, the deduction is limited to 2.5 percent of the taxpayer’s share of unadjusted basis immediately after acquisition (UBIA) of qualified property. This limitation applies when a MFJ taxpayer’s taxable income is in excess of $315,000 ($157,500 for single filers).
Tax planning opportunities: The following strategies outline ways that practice-owning dentists may benefit from the QBI deduction and, as a result, lower their overall federal taxes when filing their annual returns. Please note that the following strategies are not exclusive to all dental practices and that taxpayers should consult with their tax advisor before implementing any new strategies.
Restructuring owner compensation: Wages paid to S corporation shareholders and guaranteed payments paid to partnership members are not eligible for the QBI deduction. By reducing compensation, owners can effectively shift income from non-QBI to QBI, increasing the amount of income eligible for the deduction. This shift can provide an effective tax savings of 4.8 percent (this assumes the taxpayer is below the SSTB phaseout threshold of $315,000 and in the 24 percent tax bracket, 20 percent QBI deduction multiplied by MFJ taxpayers’ tax rate of 24 percent).
In order to reconcile for the decrease in personal cash flow from reducing compensation, tax-free cash distributions can be taken out of the practice. However, it is important to understand that owner compensation cannot be eliminated completely as owners need to be paid “reasonable compensation.” Regulations require that owners be paid a salary which is reasonable based on their duties and the value of services provided to the company. If you pay yourself an unreasonably low amount, the IRS may attempt to reclassify distributions received as wages, which eliminates the tax benefit and could subject you to interest and penalties.
Cash balance retirement plans: Given the new QBI deduction, cash balance plans may be an attractive option for dentists who have taxable income at or just above the phaseout threshold and have available cash flow to fund additional retirement contributions. Cash balance plans are used as an add-on to a 401(k) plan and may allow dentists to contribute higher amounts toward their retirement while receiving a deduction to their business income. Due to the involvement of an actuary, these plans carry higher yearly costs than a standard 401(k). However, in the right circumstance, the tax savings will outweigh the cost and allow practice owners to maximize their net worth. If you have cash flow that could be utilized to fund additional retirement contributions and are at or near the income thresholds, we recommend discussing this type of plan with your tax advisor.
Increase investments in business capital: Taxpayers who exceed the deduction phaseout threshold and are not eligible for any QBI deduction can utilize accelerated depreciation methods, such as 100 percent bonus or section 179 expensing, to reduce their overall taxable income. The taxpayer will receive a tax savings from not only the accelerated depreciation deduction, but also the QBI deduction.
An MFJ taxpayer has taxable income of $430,000. Of this, $250,000 is net income from a dental practice and the remainder is wage income. The taxpayer does not qualify for any QBI deduction because his taxable income is above the $415,000 limit. However, after consulting with a tax advisor, the taxpayer purchased $120,000 of equipment for the dental practice and fully expensed the items under section 179. The reduction of taxable income drops the taxpayer below the limitation phase-in threshold, allowing for a QBI deduction of $26,000 ($250,000 practice income, less $120,000 section 179 expense = $130,000 x 20 percent). The total reduction to taxable income is the equipment write-off of $120,000 plus the QBI deduction of $26,000 or $146,000 in total. The tax savings on the $146,000 reduction to taxable income would be $38,900 or 32.4 percent of the equipment purchase price of $120,000. As a reminder, this is only the federal tax savings.
Conclusion: With the implementation of tax reform, dental practice owners have multiple ways in which they can maximize their QBI deduction. The strategies above may not be applicable to all taxpayers within the dental industry. We recommend discussing these topics with your tax advisor.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
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