A Tax Planning Primer Tips for the Practice and Individual Practitioner — Part I

Tax planning for doctors who are owners of their medical or dental practice takes place at two levels, i.e. the practice entity level and the individual level.

Regardless of the type of entity, planning is important because it impacts what the doctor is ultimately going to owe in taxes at the individual level. Professional corporations or PCs are subject to federal income tax at the rate of 35{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} on taxable income unless the corporation has elected to be taxed as an S corporation. Taxable income of S corporations, general partnerships, sole proprietorships, and limited liability companies (LLCs) generally are passed through to and taxed to the individual owners on their individual income tax returns. This article is intended to provide some tax planning and financial concepts that should be adopted in a coordinated effort between doctors and their accounting firms, and should begin well before the 11th hour of the tax year-end.

Don’t Bonus Out Everything

Most small- to medium-sized medical and dental practices are on the cash/income tax basis of accounting versus the accrual basis of accounting. Accordingly, most doctors’ concept of tax planning is to bonus out all available cash before Dec. 31 (or the tax year-end).

The problem with this oversimplification is (a) it doesn’t always work, (b) it can create a cash flow nightmare for the business office, and (c) it usually impairs the long-term financial well-being of the organization. The most effective tax planning balances the financial needs of the practice with that of the individual doctors. It also involves giving consideration to business decision-making throughout the year, which may impact current as well as future tax years. We recommend two rules of thumb. First, maintain a cash balance at least equal to two weeks of annual operating expenses. This is in addition to special accounts used during the year to accumulate cash for funding the practice’s annual retirement plan contribution.

Second, leave a taxable profit equivalent to 5{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of net income before doctor compensation. You may pay some income tax but consider it a necessary business expense to maintain an adequate level of liquidity. It is worth noting that there is little difference between the corporate and individual tax rates, so basically the same dollars would be paid in regardless of whether the profit is left in the corporation or bonused out. The most successful practices follow these two rules of thumb.

Doctor and Staff Bonuses

This is an obvious tax-planning measure at the practice level. It is also the most direct way to reward hard work and to motivate future effort. The downside to this is that it drains the practice of cash, which may be needed to meet payroll and other practice expenses in the following month. Practices on the cash/income tax basis of accounting can’t deduct accrued payroll for tax purposes, so it must be paid before the tax year-end.

There are a couple of ways to deal with the cash-flow problem. The business manager or administrator should compile a list of expenses, including payroll, that need to be paid in the first two weeks of the following year, as well as a conservative estimate of cash collections for the same period. To the extent you haven’t got enough cash to cover this, you can borrow on your line of credit. Every practice should have an established line of credit with a bank to meet short-term cash deficits during the year. Don’t wait until you need to borrow to go to the bank — it may be too late to get the loan processed.

Another option is to have the doctors loan back to the practice their net bonus checks. Of course these are loans that need to be repaid. They effectively use collected revenue of future periods to pay bonuses of the current year.

Deferral of Income

There are times when income should be accelerated to take advantage of lower tax brackets. Also, low reimbursement levels have motivated doctors to maximize billing and collection efforts. However, in the last month of the fiscal year, practices on the cash/income tax basis of accounting can defer recognition of income until the following month, within reasonable limits. If done on a consistent basis from year-to-year, this can result in a tax savings that does not impair the cash flow needs of the practice. This would make your business manager very happy.

Acceleration of Expenses

As with the recognition of income, there are times when it may make sense to defer expense recognition. However, the acceleration of expenses is generally the objective at year-end. Generate a list of all outstanding bills and a list of those expected in the following month. After paying all bills in-house for operating expenses, you can accelerate payment of some expenses, within reason. Examples are malpractice insurance premiums, rent, medical and office supplies, and interest on debt service. These are usually expenditures that would be made in the following month anyway and therefore should not negatively impact cash flow.

Maximize Retirement Plan Contributions

Individual and group practice retirement plans are the single most valuable tax planning vehicle available to doctors today. Changes in ERISA and tax legislation have made these plans more flexible and cost-effective than ever before. The current individual funding limited for a typical defined contribution plan is $44,000 for 2006. If you have attained age 50 or older in 2006, you can add an additional $5,000 to this limit for a total of $49,000. This is the combined amount of individual income deferral and entity-level contributions. The individual elective deferral portion of this is $15,000 or, if you are age 50 or older, $20,000.

This vehicle not only reduces current taxes at the practice level, but defers taxes at the individual level until retirement and possibly beyond. It makes good business sense as well as tax sense because employees have an increasing awareness of the importance and value of this benefit. It also provides financial security for doctors and staff alike.

Another unique feature of practice retirement plans is the ability to accrue and deduct the amount of the current year’s contribution while not having to actually fund it until two months after the tax year-end, or the due date of the practice tax returns, including extensions.

Individual Retirement Accounts

In addition to entity-level retirement plans, you can contribute up to $4,000 in an IRA for 2006. If you have attained age 50 or older in 2006, you can add an additional $1,000 to this limit. Most doctors have entity-level retirement plans and/or have adjusted gross income in excess of amounts allowable to deduct their IRA contributions on their individual tax returns, but with the maximum federal income tax rate of 35{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} in 2006, it makes sense to contribute to a nondeductible IRA. Remember, you will get that deduction in the form of nontaxable distributions when you retire and begin drawing on your IRA.

Most doctors also have adjusted gross income in excess of limits which would otherwise allow them to have Roth IRAs. If you file jointly and your combined adjusted gross income (AGI) is over $150,000, your allowable Roth IRA contribution decreases to zero gradually when your AGI reaches $160,000. For an individual, the phase-out is between $95,000 and $110,000.

Purchase of Medical and Office Equipment

The timing of equipment purchases can impact the amount of the first year write-off you can get. Generally speaking, if more than 40{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of equipment purchases are made in the last quarter of the tax year, the first-year depreciation will be substantially reduced due to present tax law limitations. Keep in mind that the equipment must be “placed in service” by year-end, not in transit or sitting in a box.

A special rule explained at Internal Revenue Code Section 179 allows a 100{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} expense deduction for equipment purchased each year, regardless of which month the purchase is made, limited to the first $108,000 in 2006. If your purchases exceed the Section 179 limit, you should carefully choose which ones you elect to treat under Section 179. Generally, you want to expense those with the longer depreciable life to maximize the overall write-off to the practice. If cash is a problem, you can purchase the equipment by loan or credit card advance and still elect to take the tax deduction.

Be careful not to make equipment purchases in excess of $430,000 in 2006, if possible, because the Section 179 deduction will be reduced dollar for dollar in an amount by which your qualified purchases exceed this amount.

Pay Attention to Nondeductible Items

Don’t forget that the tax-planning process involves identifying expenditures that may not be deductible and therefore have to be added back to ‘book income’ to arrive at taxable income. These can be significant individually or in the aggregate. Examples are key personal life insurance payments, disability buy-out insurance, disability income insurance, charitable contributions, penalties, a portion of meals and entertainment, and some country club dues. The treatment of these may vary depending on whether the practice is organized as a sole proprietorship, partnership, S corporation, limited liability company (LLC), or a professional corporation (PC).

Run Tax Projections

Tax planning should encompass having your accountant run a projection of your income tax on current tax software. This accomplishes two things. First, it calculates any alternative minimum tax (AMT) that may be due. This is very important to the planning process. Second, nobody likes surprises come April 15. There is nothing worse than getting your income tax return a week before the filing deadline and finding out you have a huge balance due.

Avoid Underpayment Penalties

If you don’t pay the IRS enough during the year, through withholding or timely quarterly estimated tax payments, you could owe a penalty on the amount underpaid, which could be substantial. Generally, the underpayment penalty can be avoided by (a) timely payment of 90{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of the tax shown on the current year return, or (b) timely payment of 100{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of the tax shown on the prior year’s return. If your adjusted income in the prior year was in excess of $150,000 ($75,000 for a married person filing separately), the requirement to pay 100{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of the prior year’s tax changes to 110{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}.

W-2 Add-Ons and 1099 Information

As part of your year-end tax planning you should be assembling information that your accountant and/or payroll service will need to have in preparing your W-2 wage, withholding, and reporting statements. These include the taxable portion of certain business perks such as personal use of business-owned or leased vehicles, disability insurance premiums paid at the corporate level, which you elect to have reported in after-tax dollars, and self-employed health insurance premiums paid at the corporate level. For vehicles, you should list total miles driven during the year, commuting miles and business-use miles included in the total.
You will also need to list payments made to unincorporated independent outside vendors for services rendered such as transcription, maintenance, and bookkeeping. Also, rent payments and payments to lawyers for legal services need to be reported as well as interest paid to owners.

Doing this immediately after year-end will facilitate the timely and accurate filing of these forms.

Maximize Benefit of Capital Losses

At this writing, the stock market is on the upside. This may be a good time for individuals to sell off holdings that have dropped in value and have still not recovered. Capital losses are first offset against capital gains, but if selling these depressed holdings will generate losses in excess of your current-year capital gains, the first $3,000 of excess losses can be offset against your ordinary income that may be taxed at the highest rate of 35{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}, thus saving you over $1,000 in taxes.

In conclusion, tax planning is an integral part of running a medical or dental practice. It should not be done in a vacuum during the last few days of the tax year. To be most effective, it should occur throughout the year, in consultation with your accounting firm and attentive to the cash flow and other business aspects of your practice. In the next article we will cover tax law changes and tips to maximize tax savings beginning in 2007.

James B. Calnan, CPA, is partner-in-charge of the Health Care Services Division of Meyers Brothers Kalicka, P.C., Holyoke, Certified Public Accountants and Business Consultants; (413) 536-8510.