Implications of the New Tax Law: Practice Structures & Personal Tax Issues
February 15th, 2018
James R. Malone, Jr.
When Congress makes major changes to the Internal Revenue Code, the impact ripples through the economy. As business owners, doctors in private practice understandably wonder what the implications of the recent federal Tax Cuts and Jobs Act are, and this post is designed to offer an introduction to some of them.
Basics for Businesses:
Certain aspects of the new law are quite clear:
- Entertainment expenses are no longer deductible.
- Meals provided to employees for the employer’s convenience are only 50% deductible, and that deduction will end in 2025.
- More equipment can be expensed (up to $1 million) rather than depreciated, making equipment acquisitions more attractive.
- For very large practice groups (over $25 million in revenue), there will be limits on the deductibility of interest.
Implications for Practice Structures:
The new law has significant implications for the tax structure of practice groups. Most practices are taxed as a pass-through entity, typically a partnership, an S Corporation, or a limited liability company (“LLC”) that is treated as a partnership for tax purposes. The law creates incentives to consider either restructuring an existing pass-through entity to maximize certain benefits of the new law or converting a pass-through entity to a C corporation, in view of the low corporate rate of 21%. Those types of changes, however, should be approached with caution.
Scenario 1: Restructuring Partnerships and Other Pass-Throughs.
The changes for pass-through entities have received significant coverage, as they create a deduction for the owners of a pass-through entity of up to 20% of their “qualified business income.” Effectively, that lowers the tax rate applied to that income.
- One problem for doctors, lawyers, and accountants is that deduction begins to phase out at a relatively low level, $157,500 in the context of an individual return. (By comparison, architects and engineers do not face this low threshold.)
- In a pass-through practice group that owns a building and equipment, some advisers may suggest that the members create a second pass-through entity to hold the building and the equipment and then lease those assets back to the practice group. The rental payments (if reasonable) would be business deductions for the practice group, lowering the members’ income from the practice group. Meanwhile, the members’ income from the partnership holding the building and equipment would be qualified business income, and their deduction for this class of income would not be subject to the limit that applies to their income from the practice, which would lower their tax bill.
That approach has two problems:
- First, restructuring a business solely for tax reasons is risky: In the scenario outlined above, the IRS would likely disregard the second partnership for tax purposes, because there was no business reason for the changes. The income would all be treated as if it came from the medical practice and the members would then face significant additional tax liability, plus penalties and interest. In contrast, a similar structure adopted in forming a practice group, merging two practice groups, or because a practice group was acquiring or refinancing a building might pass muster.
- Second, the relevant provision has a short shelf life; it will expire at the end of 2025.
Scenario 2: Switching to a C Corporation.
Before this law passed, business lawyers had a simple rule: Don’t form a C corporation unless you have to. This was because income was taxed twice, once at 35% for the corporation and then again at individual rates when distributed to the owners.
The combination of the lower corporate rate and preferential individual tax treatment of dividends could make C corporations attractive. But converting an existing practice group to a C corporation should be approached with caution:
- First, as discussed above, changes adopted solely to lower taxes may not be respected by the IRS.
- Second, state tax law plays a role. If the practice is in a state where the corporate tax rate is higher than the individual rate, the tax savings from converting a practice may not be all that significant.
- While the corporate rate of 21% is theoretically permanent, this was not a statute that reflects a bipartisan consensus. Changes in Congress could mean future changes in the rate.
- Corporations have operational requirements under state law that exceed those applied to partnerships and LLCs. If the additional formalities are not observed, the owners of a practice might face personal liability for mistakes made by someone else in the practice group.
Personal Tax Issues:
Turning to the personal side of the ledger, a key issue is the limitation on the deductibility of state and local taxes, which are now capped at $5,000 for an individual taxpayer. For physicians in high-tax states, the cap on that deduction may limit the benefit of the lower federal rates.
Estate planning documents should be re-examined. The new law doubled the amount that could be passed on to heirs without any estate tax, which is known as the unified credit. While that change is taxpayer-friendly, it has consequences. Wills for high-net-worth individuals often provide for the heirs to receive the entire unified credit amount and the balance to go to the surviving spouse, who has the benefit of an exemption. The doubling of the amount of the unified credit may create a windfall for heirs while leaving a surviving spouse with far less than anticipated.
Doctors and practice groups should contact their tax advisors for guidance on their respective situations. Any major changes to a practice’s structure should be weighed carefully.
Of necessity, this post is written in very general terms, which means it is not a substitute for legal advice aimed at a particular practice group’s situation. It is also not intended to create an attorney-client relationship.