How Doctors can Reduce their Tax Liability by Taking Advantage of the Qualified Business Income Deduction
Benjamin Dailey, Partner, Tax & Business Services
Healthcare professionals such as physicians and dentists were excluded from one of the biggest tax deductions contained in the Tax Cuts and Jobs Act of 2017 (TCJA) – the Qualified Business Income (QBI) Deduction. But there are still good tax saving opportunities for business owners who are willing to plan.
The TCJA brought about some of the biggest changes to the tax law in over 30 years. Corporations had their tax rate cut from 35% to 21%, while individuals received a modest reduction in tax rates of 2-4%. But with careful planning, a medical practice has the opportunity to utilize a special deduction to unlock an additional 10% tax savings.
The accountants at Marcum have been working with healthcare providers and related businesses to help them take full advantage of tax planning opportunities since the new tax law took effect. We want you to understand why your current business structure may no longer be ideal and what you need to know in order to evaluate the potential benefit of a change.
Most doctors will not benefit from corporate tax cuts.
Doctors who take most of their business profits as salary are not seeing significant tax savings from the TCJA tax cuts. In fact, some of the changes, such as the loss of the state income tax deduction and home equity interest expense, frequently result in a higher overall tax burden, even with the rate reduction. The new slightly lower individual tax rate is applied to a much higher tax base after the loss of itemized deductions. In the end, the loss of itemized deductions hurts more than the 2-4% rate reduction helps.
Practicing physicians commonly operate through professional corporations (PCs). A PC is a special type of corporation owned by a licensed doctor(s). Although PCs qualify for the lower 21% tax rate available to all corporations, very few of these corporations actually pay tax. Most PCs pay out all the corporate profits to the doctors who work in the practice.
Paying out corporate profits as compensation makes those profits subject to higher individual income tax rates as well as payroll taxes. When the business pays out all corporate profits to individuals, it is effectively taxed as a pass-through entity. This is the most tax-efficient way to plan for a corporation, but the result could be even better if the business took the step to change its legal structure to become a pass-through entity (an LLC or S corporation).
The Opportunity: Change your legal entity to get the Qualified Business Income Deduction.
In order to provide some benefit to non-corporate businesses, the TCJA introduced the QBI, a 20% Qualified Business Income deduction. Unfortunately, doctors and other medical service providers were left out of the best tax break available to individuals in the new tax law. There was a broad exclusion from this new deduction, prohibiting it for any business that performs services in the field of health. But like any tax law, there are numerous exceptions to the general rule.
Marcum has helped countless businesses evaluate their current structures in light of the tax law changes. These are some of the things we look at when reviewing a business structure that may no longer be optimal. We think everyone would benefit from reviewing the following and discussing it with their partners:
- Exceptions to the exclusion: Not every medical business is excluded. There are a wide range of medical businesses that are not excluded from the QBI deduction. This includes sales of medical devices and pharmaceuticals, operating nursing and assisted living facilities, or making products. There may be multiple lines of business that should be considered separately to determine if they are eligible for the deduction. Consider reviewing this with your CPA to take a fresh look at sources of revenue and allocations of costs.
- The income threshold: Even if the business income is not eligible for the QBI deduction, there is still a chance some owners can achieve the tax savings. The 20% deduction is available to all taxpayers with incomes below $426,600 ($213,300 for single taxpayers). In a practice with a number of doctors earning close to the threshold amount, there is an even greater potential for tax savings. This is determined at the individual level, so each owner needs to consider the taxable income on his/her 1040 and plan together with the other partners in the practice to get the best outcome for everyone.
- Cash basis accounts receivable: Medical practices that operate as corporations usually use the cash method of accounting. This delays taxation until the revenue is collected, but in a change of entity, there needs to be a plan to collect outstanding balances and wrap up the old company. This is also a great time to review A/R aging and update your procedures manual for billing and collections.
- Loss of tax-free fringe benefits: There are many fringe benefits offered tax-free to C corporation owners that would be taxable to LLC or S corporation owners. Each medical practice has to weigh the benefit of the 20% QBI deduction against the loss of tax-free fringe benefits.
- Reinvesting in the practice: It is important to review your budgets including planned capital improvements and long-term debt repayment schedules. Paying the lower corporate tax may be a good option if the business needs to use after-tax cash to pay for things that are not currently tax deductible. Keep in mind that there is an accumulated earnings tax which may apply to a corporation if it has more cash than the business reasonably needs.
Medical practices that take advantage of the QBI deduction stand to get as much as a 10% tax rate reduction over those that do not. There are real tax saving opportunities to unlock if you take a little time to review how your practice operates. Consult your Marcum professional, your attorney, and practice management advisors to understand the benefits.