How much are you leaving on the table? Improving your practice’s after-tax financial efficiency
Thursday, September 19, 2013
Time is of the Essence
There is no better time than now over the last 30 years to focus on post-tax efficiency. As you likely know, when President Barack Obama signed the American Taxpayer Relief Act of 2012 in early January 2013, taxes increased on high-income taxpayers like many business owners and executives — in some cases dramatically. While the details of the "fiscal cliff" deal is a topic for another article, the important takeaways are:
1. Many doctors and healthcare executives now face a 50-plus percent marginal income tax regime, when all of the new tax increases are accounted for. Depending on the city/state where you live, tax rates are now between 45-55 percent, no less. Income tax planning is more important now than at any time in the last 30 years.
2. These higher rates will apply to more income, with the reinstatement of the itemized deduction limitations and the personal exemption phase-out.
3. Total taxes on long-term capital gains and dividends can now reach 23-33 percent when the new federal tax, healthcare reform tax and state and local taxes are assessed.
The Common Causes of Dollars “Left on the Table”
While the causes of “dollars left on the table” in a medical or dental practice can range from billing errors to unproductive employees, our expertise and focus is corporate structure, tax reduction and benefit planning. For this article, we will focus on three strategies for recapturing some of the funds left on the table:
1. Using the ideal corporate structure
2. Maximizing tax-deductible benefits for the practice owners and executives
3. Utilizing a captive insurance arrangement
The most important thing you can do is keep an open mind. Just because you have operated your practice a certain way for five, 10 or 20 years, you don’t have to keep doing the same thing. Changing just a few areas of your practice could recover $10,000 to $100,000 of “lost dollars” annually. Let’s explore the three areas:
1. Using the Ideal Corporate Structure
Choosing the form and structure of one’s practice is an important decision and one that can have a direct impact on your financial efficiency and the state and federal taxes you will owe every April 15. Yet from our experiences in examining over 1,000 medical or dental practices of our clients, many get it wrong. Here are a few ideas to consider when thinking about your present corporate structure:
A. You must avoid using a partnership, proprietorship or disregarded entity: These entities are asset protection nightmares and can be tax traps as well. Nonetheless, we have seen very successful practices operating as such. The good news is that those who run their practices as a partnership, proprietorship, or disregarded entity have a tremendous opportunity to find “dollars on the table” through lower taxes — especially on the 3.8% Medicare tax on income. This can be a $10,000-$30,000 per owner annual recovery.
B. If you use an “S” corporation, don’t treat it like a “C” corporation: We estimate that 60-70 percent of all medical and dental practices are “S” corporations. Unfortunately, many do not take advantage of their “S” corporation status — using inefficient compensation structures that completely erase the tax benefits of having the “S” in the first place. If your practice is an “S” corporation, you should maximize your Medicare tax savings through your compensation system in a reasonable way. This can be a $10,000-$30,000 per owner annual recovery for practices not properly structured.
C. Implement a “C” corporation: Once upon a time, “C” corporations were the most popular entity for U.S. medical and dental practices. Today, in our estimation, fewer than 15 percent of such practices operate as “C” corporations. Why? Because most doctors, bookkeepers and accountants focus on avoiding the corporate and individual “double tax” problem.
While this is crucial to the proper use of a “C” corporation, it is only one of a number of important considerations a doctor must make when choosing the proper entity. A common mistake is to overlook the tax-deductible benefit plans that are only available to “C” corporations. If you have not recently examined the potential tax benefits you would receive by converting your practice to a “C” corporation, we recommend that you do so. Utilizing benefit plans that only a “C” corporation can offer can create a $10,000-$30,000 per doctor annual improvement.
D. Get the best of both worlds — use multiple entities: Very few practices use more than one entity for the operation of the practice — and, if they do, it is simply to own practice real estate. While this tactic is also wise from an asset-protection perspective, its tax benefits are typically minimal, if any.
Successful practices can often benefit from a superior practice structure that includes both an “S” and a “C” corporation. This can create both tax reduction and asset protection advantages. If you have not explored the benefits of using both an “S” and “C” corporation to get the best of both worlds in planning, now is the time to do so. Utilizing a two-entity structure properly can create a $10,000-$40,000 per owner annual improvement.
2. Maximizing Tax-Deductible Benefits for the Doctors in the Practice
If you are serious about capturing “dollars left on the table,” tax-efficient benefit planning must be a focus. Benefit planning can definitely help you reduce taxes, but that is not enough. Benefit plans that deliver a disproportionate amount of the benefits to employees can be deductible to the practice, but too costly for the practice-owners. These plans can be considered inefficient. To create an efficient benefit plan, one may need to combine qualified retirement plans (QRPs), nonqualified plans and “hybrid plans.”
Nearly 95 percent of the practices who have contacted us over the years have some type of QRP in place. These include 401(k)s, profit-sharing plans, money purchase plans, defined benefit plans, 403(b)s and other variations. This is positive, as contributions to these plans are typically 100 percent tax deductible and the funds in these plans are afforded excellent asset protection. However, there are two problems with this approach: 1.) many QRPs are outdated; and 2.) QRPs are only one piece of puzzle.
First, most practices have not examined their QRPs in the last few years. The Pension Protection Act improved the QRP options for many practices. In other words, many of you may be using an “outdated” plan and forgoing further contributions and deductions allowed under the most recent rule changes. By maximizing your QRP under the new rules, you could increase your deductions for 2013 by tens of thousands of dollars annually, depending on your current plan.
Second, the vast majority of practices begin and end their retirement planning with QRPs. Most have not analyzed, let alone implemented, any other type of benefit plan. Have you explored fringe benefit plans, nonqualified plans or “hybrid plans” recently? The unfortunate truth for many doctors is that they are unaware of plans that enjoy favorable short-term and long-term tax treatment. These can have annual tax advantages that vary widely ($0-$50,000 per doctor) and also create significant long term tax value as well. If you have not yet analyzed all options for your practice, we highly encourage you to do so.
3. Utilizing Captive Insurance Arrangements
For practices with gross revenues over $3 million, a small captive insurance arrangement might be significant way to recapture “dollars left on the table.” Today, there are likely many risks in your practice that are going uninsured – from excess malpractice, economic risks, employee risks, and litigation defense risks from any number of audit or fraud claims. Like most doctor, you likely just save funds personally and hope that these risks don’t come to fruition. As a result of your de facto “self-insurance,” you are not taking advantage of the risk management, profit enhancing and tax reduction benefits that are available to you with a captive.
By creating your own captive insurance company (CIC), you can essentially create a pre-tax war chest to manage such risks. If structured properly, the CIC enjoys tremendous risk management, tax and asset protection benefits. The potential tax efficiency, in fact, can be in the hundreds of thousands of dollars annually. While an experienced law firm, captive management firm, and asset management firm are crucial, you as the captive owner can maintain control of the CIC throughout its life. It can then become a powerful wealth creation tool for your retirement.
Nearly every one of you reading this article would like to be more tax efficient, especially with a new higher tax regime in place for 2013 and beyond. We hope these new tax rules motivate you to make tax and efficiency planning a priority, so you too can recapture the “dollars left on the table.”
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