Medical practices have many legal tax-reduction strategies available to them and the strategies are not limited to the ultra-rich.
Running a medical practice usually means high income. Of course, that also implies more significant tax obligations. The truth is, although your taxes may be quite high, medical practices have many legal tax-reduction strategies available to them. Many believe that only the uber rich can afford the strategies developed by tax specialists and attorneys. However, the tax code is available to everyone to navigate and reap the savings benefits if you are willing to take the time to learn the strategies and how to implement them properly.
The good news is there are a few strategies you can start implementing right now. Here are some of the ways you can approach your medical practice’s taxes going forward.
Proper entity selection
One of the most basic but most important choices you can make for your practice is the choice of entity. Your entity selection will be determined by who the owners of the business will be and how the profit will be taxed in your practice.
The right entity choice depends on a few factors:
Below are options available to medical practices, as well as their major benefits and drawbacks. Remember, depending on the state your practice operates in, some of these options may not be available to you.
A sole proprietorship is often chosen by medical professionals because it’s simple and inexpensive to set up and maintain.
As a sole proprietor, you pay income tax at your ordinary rate and self-employment tax on 100% of the profit from your business. Being self-employed means you are responsible for all of your Social Security and Medicare taxes (15.3% of your gross pay) with an additional 0.9% Medicare tax if your income is more than $200,000 filing as single or $250,000 if filing jointly. You do not take a W-2 salary.
Although sole proprietorships are easy to administer, they create unlimited individual risk for you as the owner and they tend to be audited more frequently by the IRS than partnerships, S-corporations or C-corporations. Even if you create a single-member limited liability company (SMLLC), as a physician, you will not be able to avoid personal liability.
Partnerships are pass-through entities. The partnership’s tax return acts as an information return, and the income and losses pass through the entity and into the owners’ personal tax returns.
Similar to sole proprietorships, 100% of partnership profits will be passed to the owners and taxed at the ordinary rate subject to self-employment. You do not take a W-2 salary. You must choose the partnership option if you have more than one owner, which in some states can include your spouse.
You still have liability issues with a partnership unless you choose to be a limited liability company (LLC), but, again, as physicians the LLC protections do not apply to you.
Like partnerships, S-corporations are also pass-through entities where any income or losses are generally taxed at the entity level. It is important to note some states will impose an entity level tax.
Where S-corporations differ from partnerships and sole proprietorships is in the way they are taxed. You are required to take a reasonablesalary, which will be subject to Social Security and Medicare taxes. However, any profit above your salary is considered a distribution and not subject to Social Security and Medicare taxes. This can be a significant tax savings depending on your circumstances.
Although there are tax savings with an S-corporation, they are more expensive and time-consuming to administer. They also require you to be on payroll and limit the types of ownership.
A C-corporation is a standalone entity that protects against most business risks, except malpractice, for which you would still require insurance. However, it can protect you from general business liabilities. C-corporations are easy to transfer via corporate stock and well understood governance laws. If you plan to have outside investors in your medical practice, this form of entity would be ideal.
C-corporation profits are taxed at the entity level. You receive a W-2 salary from the business, and if you take any profits from the business they are treated as dividends and taxed at dividend tax rates. This causes the same profit to be double taxed. C-corporations are more expensive and time-consuming to administer.
Contributing to a retirement plan is the easiest and most direct way to lower your taxes. By contributing to a pretax retirement plan, you receive a deduction for the contribution. As a result, you pay less on taxes because the contribution lowers your taxable income. It’s important to note that there are limits to how much you can contribute to your retirement depending on the type of plan and whether you are the employee or the employer.
Another advantage of contributing to a retirement plan is that you may pay a lower tax rate at retirement than when you put the money into the retirement account. Your retirement savings are tax-deferred, which means you do not pay taxes when you contribute to your retirement and it will grow tax free. When you are required to take it out, you will have to pay taxes on it at the time of withdrawal.
If you retire before age 72 (the age at which you’re required to start taking distributions from your retirement account) you can take advantage of lower tax rates and start taking the retirement contributions earlier so their distributions are spread out over more years. Once you are 59½, there is no penalty for taking money out of your retirement account.
You also can convert pretax retirement to a post-tax retirement account, known as a Roth account, by paying tax at lower rates between retirement and age 72. This can be a significant strategy for saving money and legacy planning.
Despite the direct tax benefits of retirement plans, there are a few things you need to think about when choosing the type of retirement plan for your practice:
If you think a retirement plan makes sense for you, do so with the assistance of a tax or financial adviser.
Hiring family members in your practice allows you to shift income from your higher tax bracket to their lower tax bracket and create a deduction of their wages through your business. This gives you the opportunity to teach your children about handling money or to save for their retirement or education. Or, if you have parents you regularly support, you can hire them in your practice and write off their support as wages.
If you have a sole proprietorship or partnership, you can hire your children and you do not have to pay Social Security or Medicare taxes on their payroll. However, if you have an S-corporation or C-corporation, you will have to pay payroll taxes. In addition, when hiring a spouse, you can contribute more to their retirement based on the compensation they earn in your business. This can add up to more tax savings.
This is a fairly easy tax strategy, but you must follow a few rules. Any family member you hire must have a legitimate job in your practice and be paid a reasonable wage. It is important to document their job responsibilities and duties as well as open a separate bank account in their name.
Many medical practices build a large collection of medical equipment. This creates an opportunity to use the equipment in a gift-leaseback, which effectively replaces the current salary of a family member. Typically, you would use this strategy to support a parent or child. You need to determine the fair market value of the equipment and the fair rental value of the equipment. A gift of the equipment is transferred to your family member and then the family member leases the equipment back to your business. This creates a rental deduction for the business, the family member receives income/support and you avoid payroll taxes on the family member’s salary. Family members can also continue to depreciate the equipment to help lower their taxable income.
It’s important to note that you need to do a proper appraisal of the equipment and have a rental agreement in place with your family member.
Hidden business deductions
Lastly, there are several deductions available to your medical practice that you might not know about.
The Augusta Rule is otherwise known as the 14-day rental rule. The rule allows you to rent your primary residence (not a rental property) for up to 14 days per year without paying any tax on the rental income on your individual tax return regardless of how much you make. You do not receive any deductions for the time your home is rented. This can be done if you have a home near major sporting events or even rent your home to your business. You need to document the business purpose of the rental, such as corporate meetings, and charge a reasonable rental rate (similar to hotel rates).
A health savings account (HSA) is one of the ultimate tax-efficient ways to save. HSA contributions are contributed tax free, grow tax free and are distributed tax free if used for qualified medical expenses. In order to qualify for an HSA, you must meet the qualifying limits.
It’s important to note that you can pay for your medical expenses out of pocket and hold onto the receipts until you are ready to take the money out of the HSA. This could be later in retirement years, which allows the HSA funds to grow more quickly and gives you some extra tax-free income.
Own your building?
Do you own the building your medical practice is in? As a bonus, you can consider a cost segregation study.
Cost segregation studies break down a structure into various depreciable components that have shorter depreciable lives. This allows the owner to accelerate depreciation instead of the whole building being depreciated over a 40-year period.
Depreciation of property value is one of the more complex deductions. But having a cost segregation study done can uncover new tax-savings opportunities. These studies normally cover things you can’t calculate on your own such as structural element, land improvements on the structure’s exterior and construction expenses.
In general, these studies need to be completed by experienced firms. The American Society of Cost Segregation Professionals website has more information.
As we all know, different diagnoses require different approaches and every business has a unique financial situation. Therefore, depending on the characteristics of your business and on the plans that you have for your future, it is always wise to consult with a qualified tax or financial adviser before moving forward with any of these strategies.
Alexis E. Gallati, EA, MBA, MS Tax, CTP, is the founder and lead tax specialist at Cerebral Tax Advisors and the author of “Advanced Tax Planning for Medical Professionals.”