Keeping More of Your Hard-Earned Money

By Sam Martin, MBA (tax), CFP®, CPA

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Beyond the overhead of your practice, the next largest expenses in life may well be income and FICA taxes—generated from your practice, other personal assets such as real estate, and of course, your investments.

New Tax Increases
The tax landscape has gotten tougher in recent years with the implementation of new tax increases in 2013 and implementation of taxes embedded in the Affordable Healthcare Act. Here is what you are facing as a successful dentist:

1. Net Investment Income Tax: New 3.8% net investment income tax—a FICA tax on unearned income to the extent of the lesser of unearned income or your Adjusted Gross Income (AGI) in excess of $250,000 (joint). This applies generally and broadly to interest, dividends, rents, royalties, income from passive activities, and most capital gains.

2. Medicare Tax portion of FICA: Also at AGI of $250,000 (joint) or more, a new .9% add-on to the 2.9% Medicare tax portion of FICA kicks in —bringing the total Medicare rate on salary or self-employment income to 3.8%.

3. Itemized Deductions and Exemptions: When Adjusted Gross Income exceeds $300,000 (joint), you begin to lose the benefit of your itemized deductions and your personal exemptions. A stealth tax of 1-2%.

4. Tax Rate Increase: The top tax rate that had been 35% for quite some time has been kicked up to 39.6% on taxable income exceeding $466,950 (joint —2016).

5. Long-Term Capital Gains Tax Rate Hikes: Long-term capital gains tax rates that had been zero and 15% prior to 2013 are now zero on the first $75,300 (joint) of taxable income, 15% for taxable income over $75,300 and less than $466,950 and 20% thereafter. Since most capital gains are subject to the 3.8% FICA tax where Adjusted Gross Income exceeds $250,000, we now have no less than five capital gains brackets: Zero; 15%, 18.8%, 20% and 23.8%.

Many, most or all of these tax increases hit successful dentists right where they live, and we have seen the bottom line increase in tax from slight to $25,000 plus in a single typical year.

Tax Deductions & Savings Strategies Even More Valuable
Every tax deduction or savings strategy you know about, and some you don’t, just became more valuable. When tax rates go up, tax savings techniques become more valuable. Every dollar deducted keeps more money in your pocket than previously. Putting your tax plan into writing as a part of your overall financial plan means you are much more likely to carry it out—much more likely to capture the savings that, in turn, help to fund your long-term goals.

We know what we want to accomplish and we may know how we want to accomplish it—now let’s determine the most tax-efficient way to do so.

A Few Ideas for Tax Savings Your Practice Plan
Investing in your practice is more than important—it is crucial. Work up a five-to-ten year plan for improving your practice. You will need the help of your “team” to put this together. Your dental CPA can help you with the cash flow projections, tax savings and strategy of the plan. Your equipment specialist can assist you with how to effectively spread out and prioritize your upgrades. Your designer/architect can assist with remodel plans. To the extent your plan includes adding new technology to the practice, include in it the time and money to obtain expert training for you and your staff. There is a lot of potential productivity to be had from upgrading your office—but you only optimize this when training is embraced. There may be many other team members to consider given your particular goals.

Save Taxes by Investing in Your Practice
The tax savings from investing in your practice can be quite substantial. Congress has now made “permanent” the Section 179 Equipment Expensing Election at $500,000 and has also given us a few more years to use the alternative “First Year Bonus Depreciation.” Mixing and matching these deduction opportunities can be part of a tax optimization plan—taking advantage of the deduction over one, or in many cases, several years to optimize the tax bracket within which we are taking the deductions.

Retirement Plan
No doubt a big part of your financial plan (you know, the comprehensive one that is in writing and that you review with your advisor once or twice a year) is your retirement accumulation savings plan. Since you need to save, the question becomes—what is the most cost-effective way to do so?

Income Tax Deductions & Deferrals
Generally, the first place we look is to see if we can save on a tax-deductible basis. The reason we look for tax deductibility is that we expect the vast majority of dentists will be in significantly higher income tax brackets during their careers than in retirement. Or think of it this way: If you can obtain an income tax deduction and deferral by taking money from one pocket and putting it into another pocket—why not? We do need to explore the cost benefits of the plan—which is discussed below.

Most Common Plan Types and Funding Amounts
The grid below is a great place to start as the amount of available cash flow needs to be matched to the plan. If you are just starting out and you cannot afford to put away more than $5,500- $11,000, then funding either tax-deductible IRA’s or Roth IRA’s may be the best choice. If you can put away $30,000-$40,000, a SIMPLE-IRA plan might be a good fit for the time being. If you have the ability to fund $50,000-$60,000—a 401(k) plan might be the ticket.

Catalyst Q3 2016_office design_p3-01Higher Funding Needs
For funding needs beyond this, a 401(k) plan can be accompanied by a discretionary profit sharing plan that will allow you to fund up to $53,000 ($59,000 if 50+) for just yourself—plus whatever your spouse may qualify for, if applicable. Beyond the 401(k)/profit sharing combination, there is the defined benefit plan—including the increasingly popular cash balance plan that could add another $100,000-$200,000 to the funding. In any case, there is a plan type that will match up with your funding needs and ability.

Cost Benefit
When you fund traditional or Roth IRA’s, there is no staff cost to consider. However, for all of the other plans mentioned, there are staff costs and some level of administrative cost. Administrative costs start out close to zero for a SIMPLE-IRA plan, are typically moderate with a 401(k) plan, and can be significant with a defined benefit plan. As we contemplate these plans, we can employ cost/benefit analysis to compare your tax savings to the associated staff and administrative costs.

Simple-IRA vs. Safe-Harbor 401(k)
For example, in a SIMPLE-IRA plan, the maximum staff cost is a 3% match—and the match is only for eligible staff members who participate by deferring their own dollars. This generally makes a SIMPLE-IRA plan cost effective for the owner. Safe Harbor 401(k) plans are similar to SIMPLE-IRA’s—but the staff cost can be slightly higher—either a 3% guaranteed contribution on behalf of all eligible participants or a maximum (up to) 4% match.

Choosing the Right Profit-Sharing Funding Method
When you begin adding in profit sharing, participant costs can jump up and, in some cases, depending on the demographics of your practice, might not be cost effective—but in many cases, choosing the right profit-sharing funding method can make the cost benefit quite advantageous.

Part of your ongoing financial planning should be to determine if your current retirement plan type and features (or lack thereof) are optimizing your cost benefit. We review this issue each fall and help clients determine if they have the right plan and plan features in place for the coming year.

 

Cost Segregation
If you have built-out or remodeled your office in the past 10-15 years, you will want to make certain that a cost segregation study has been completed. Generally, your contractor’s bill for the construction process defaults into the commercial real estate asset classification and will be deductible over either 39 years, or in more recent years, may qualify for the 15-year write-off. Either way, it is a lengthy or very lengthy time-period to recover your investment for tax purposes. A cost segregation study allows you to reclassify a significant percentage of the build-out

or remodel into much faster write-off classifications—five-year and seven-year, and in turn, qualify for first year bonus depreciation.

Retroactive Cost Segregation
With a retroactive cost segregation project, you determine the depreciation that should have been taken compared to the slower method depreciation you have taken and make a “catch-up” deduction in the current tax year. These can lead to significant one-time deductions—saving tens of thousands of dollars. To determine if applicable, have your detailed federal tax depreciation scheduled reviewed by your dental CPA. (Note: Our firm provides depreciation review on a complimentary basis).

Build-out or Remodel
Contemplating a build-out or remodel? Address the cost segregation aspect up front. This allows you and your cost segregation provider the ability to organize and capture relevant costs with your contractor before you break ground. Cost segregation also applies to buildings.

S Corporations
If you are not currently operating as an S Corporation, you should have your dental CPA prepare an analysis of the pros and cons for electing this status. For higher income dentists, S Corporations have traditionally been valuable in limiting the total amount of FICA tax paid. With the new Medicare taxes mentioned above, the savings have grown substantially.

In short, when you operate as an S Corporation, you have two types of taxable income as a result: Salary, which is subject to income and FICA taxes, and S Corporation income (profit) which you take from the corporation as a distribution (draw). S Corporation income is subject to income tax, but is not subject to FICA taxes, and is exempt from the 3.8% net investment income tax.

Paying Yourself a “Reasonable” Salary
The salary you pay yourself must be “reasonable” in the eyes of the Internal Revenue Service. This means you must pay “enough” to reasonably compensate yourself as a dentist. There are a number of ways to estimate this level of “reasonable.” One might take the U.S. Department of Labor Bureau of Labor Statistics national average general dentist salary (2015) of $158,310 and perhaps tack on a bit for management responsibilities. Or you might take 28% of your personal net production. In any case, you cannot pay too low or you risk additional tax, interest and penalties.

So, for example, if you are making $200,000, and paying a “reasonable” salary of $175,000, your potential savings are not much and would not warrant the added cost of filing an S Corporation return and the annual planning required to properly maintain an S Corporation. But at $300,000 plus, the savings nicely outweigh the added cost and hassle. (The higher the S Corporation income after deducting salary is the greater the amount of income you are receiving that avoids FICA tax and net investment income tax.)

Note: When contemplating a change to S Corporation status, you must also consider legislative risk (i.e. these rules could change in the future). Forming and/or electing S Corporation status should be undertaken with the guidance of your dental CPA and professional practice attorney.

Deducting What You Already Spend
Although some dentists are aggressive with their income tax deductions, most are not. In fact, most new clients that we encounter fail to document and deduct legitimate expenses they already incur. These fall into categories such as automobile, meals and entertainment, continuing education and travel. Knowing the rules for these deductions and keeping the appropriate documentation could be worth a few hundred to a few thousand dollars kept in your pocket each year. Even the occasional meal with your spouse where you update him or her on practice matters and plans can be 50% deductible—including a fine bottle of merlot—but you must follow the documentation rules.

Spend some time with your dental CPA after tax season to map out what potential deductions you are missing out on. Also develop a plan for how you will capture and store the required documentation to sustain the deductions if audited.

Spend Time to Plan Tax Savings
Those are a sample of the 40-some items we (and most likely other dental CPAs) look at when considering tax opportunities for dentists. The real point is—it’s well worth spending the time to plan your tax savings and after-tax returns. Keeping more of your hard-earned money in your pocket and out of the hands of the government, along with a strong cup of French roast, is what gets me out of bed in the morning.

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