Notwithstanding the elimination of many favorite tax deductions, the DC's own practice can be the best tax shelter possible.
Many of the tax advantages available to small business have been retained under the tax reform acts and intelligently operating, the practice can yield numerous tax shelter opportunities if proper planning is utilized.
Some of the measures a DC might consider taking would be to split income among family members, to position himself in his enterprises so that deductible tax losses are created to offset income from the salary taken from the practice, converting what would be ordinary earned income into not taxable or deferred income, or to receive benefits from the practice which constitute tax free fringe benefits. Additionally, the DC might use income earned in his practice to pay for personal expenses otherwise non-deductible, and to shift income into a tax year which would result in lower tax.
Splitting Your Income From the Practice Among Family Members
Let us suppose the DC's income is at high rate or 33% federal. Suppose, hypothetically, the DC's spouse would not otherwise work and would stay home to take care of the children. Because the spouse and children, if they were earning income, would most likely pay tax at a lower tax rate due to the fact that the level of income is lower, it might make sense for the DC to split the income earned from the practice among the family members.
For example, what if the DC's children are old enough to answer the telephones at work or do general clean up? If their income is each $3,000 per annum, they would receive the standard deduction and pay no tax, and the money could be utilized for what it would otherwise be utilized for including college, an automobile and other appropriate expenditures.
In other than a professional practice, one method to bolster this deduction would be to give away some of the stock in the family corporation to children and spouse in which it could then clearly be asserted that this was not a sham device simply to save taxes, but people being paid through, perhaps, an S corporation, their appropriate percentage of the earnings of the company.
Because the stock of a professional corporation should not be owned by the children, a method to solve this problem might be to give business assets to a mildly taxed family member or a trust created for that family member. The business then leases back the assets from the trust or the family member at fair market rent. In this manner, the professional corporation could deduct the lease payments and the trust would earn income on the lease payments and obtain depreciation deduction on the assets.
In short, utilize family members to achieve significant tax shelter benefits. The business can deduct the salaries. If the children are under 18, the children do not have to pay social security taxes, and understand that even if children earned over $3,000, because the income is earned rather than unearned, it should not be subject to the "kiddie tax" and would, therefore, be taxed at their own rate (probably 15%) which is still much under the DC's tax rate.
The DC might contemplate owning another business to generate additional tax losses, and the splitting of the stock for reasons indicated above would not be prohibited in a non-professional practice.
In order to achieve the maximum benefit, the DC would not want to incorporate but should utilize an entity in which the business loss is passed through, be that a sole proprietorship, subchapter, S corporation or partnership.
Be prepared to argue with the IRS that your new business enterprise is truly a business enterprise and not just a hobby. The enterprise must engage in "for profit" in order to generate deductible losses.
To beat the IRS in its own game in terms of its argument that you are attempting to deduct expenses from a hobby, try to operate at a profit three out of five years and secondly, operate the business professionally by keeping accurate records.
The Conversion Process
There is a little understood set of rules which would enable a personal service corporation to store up to $150,000 in the corporate bank account at the end of the calendar year and not pay taxes on it in that tax year.
The DC's corporation could theoretically store up to $150,000 until a tax advantaged method to extract the money could be discovered.
Great caution has to be taken, however, because the DC would need to document on the corporate minute books that there is a valid justification for holding this money in a true business purpose. Otherwise the IRS might classify the money as being held in a personal holding corporation and being fully taxed as undistributed profits.
Fringe Benefits to the DC
There are many fringe benefits which can be realized by the DC without having to pay tax on them.
Pension plans, for example, are an excellent method to extract money from the practice in a tax-free way. The DC's corporation would make a contribution to the pension plan for all the employees (of which the DC is one) and deduct the amount to be contributed which reduces the available dollars to be taxed. The employee is not taxed on the money as well.
The DC would need to accomplish a cost benefit analysis to ascertain if the total amount to be contributed on behalf of all employees versus what the DC individually benefits is worthwhile.
In my opinion, the smaller the operating staff of the professional corporation, the more beneficial such a program might be.
Even with a company pension plan, this may be supplemented by an employee stock ownership plan (ESOP) or profit-sharing plans in which instance the professional corporation would expend some of the corporation's profits and purchase a block of a corporation's stock in the account for the employee (probably not allowable in professional services corporations). The employee would not report taxable income and the stock or profits would be held in a tax exempt trust which invests the capital tax-free and just in the same manner as a pension fund. The employee pays taxes on the taxable income when he withdraws from the balance after retirement begins.
There are also salary reduction plans (also known as the 401K Plan).
What occurs here is that the employees take a reduction in salary but yet wind up with more money under the program.
If this method was to be utilized, the employee would choose to set aside up to 15% of compensation into a savings trust with the employer then contributing a matching amount. The maximum amount the employee is allowed to defer is regulated. The cash in the account is invested and accumulates in a tax deferred manner and the employee is taxed only when the money is withdrawn.
The employee receives a deduction since he doesn't receive the money at the present time.
What about the DC himself who is an employee of his professional corporation?
There are additional benefits available to the DC such as accident and health plans with expenses being deductible by the corporation, with the employee having not taxable income, group term-life insurance where the DC's corporation can provide up to $50,00 worth of insurance protection tax free.
Deducting Expenses Which Would Otherwise Be Personal
As has been illustrated by the recent trial of Leona Helmsley, one must do this correctly.
The logic is that activities undertaken by an individual are either personal activities or business activities and the more one can connect the expenditures to business activities, the more likelihood those expenditures will be deductible.
As has been discussed in an earlier article, the utilization of a company vehicle can be an extremely valuable fringe benefit, particularly when the use of that vehicle entails the payment of insurance, gasoline, repairs, etc.
With respect to the amount the company vehicle is used for personal use, that is proportionately incomed to the DC, but if the DC keeps detailed records, hopefully he will withstand an audit.
There are many other personal expenses which can be legitimately paid by the corporation and deductible by the corporation, such as for various club memberships, publications, seminars, and all the DC must accomplish is to find a reasonable explanation as to why this is a necessary expense for the business to expend on behalf of the DC.
Another area is travel and entertainment. The professional corporation might be able to take certain deductions for travel and entertainment expenses of the DC, but a great deal of thought needs to be given as to how to justify these deductions, in advance, and it would be wise for the DC to make sure that there are business discussions which take place and that they are specific business discussions where the DC can document exactly what was said and by whom. There needs to be meetings at these locations and notes should be taken of what occurs at the meetings.
Certainly the DC should discuss how to accomplish this with his tax adviser.
Deferral of Income
Sometimes it is wise at the end of the year to defer what earnings might be received by the corporation until the following year, depending on the tax rate in a particular year. With respect to those bills which were going to be sent to the patients or the insurance companies, sometimes it is wise to wait until the new year to do that.
Acceleration of Expenses
Suppose at the end of the year it turns out that there is a substantial amount of cash on hand.
Perhaps the DC might consider late in December acquiring considerable quantities of supplies and services which will be needed during the next year and pay for these items in the given tax year.
