The new tax law, The Tax Cuts and Jobs Act of 2017 or TCJA, brought on many changes that greatly affect physicians. Some are clearly negative, including the $10,000 limitation on the itemized deduction for state and local taxes and the elimination of personal exemptions, while others provide relief, such as the lifting of the overall limitation on itemized deductions (the Pease Limitation) and the changes that largely make Alternative Minimum Tax extinct.
However, the most intriguing planning opportunity is the Qualified Business Income (QBI) deduction available to partners in a partnership, S-corporation shareholders and sole proprietors. You may have heard that those in the business of healthcare are excluded from this opportunity, and this is correct, with one important caveat. That is, if your taxable income is between $315,000 and $415,000 married filing joint (MFJ), or between $157,500 and $205,500 for single individuals, you can take this deduction regardless of your profession. While many physicians’ incomes from pass-through businesses exceed these ranges, remember that these measures are of taxable income, so don’t give up hope and read on.
Overview of the Qualified Business Income Deduction
In 2017, Congress lowered tax rates for corporations taxed as C-corporations from graduated rates topping out at 35% to a flat rate of 21%. At the same time, there was a feeling in Congress that other forms of business should also share in the savings and thus the QBI deduction was born. Generally, net taxable income of a sole proprietorship, partnership or S-corporation business qualifies, except that certain businesses, including healthcare, were excluded. If eligible, a deduction of 20% of QBI may be taken by owners of these “pass-through” businesses. While income from healthcare businesses is not eligible, a special exemption applies for taxpayers regardless of the industry if their taxable income (before the deduction) is under $415,000 MFJ/ $205,500 Single. Note that the ability to take the deduction phases out, under a complex set of rules, for taxable income between $315,000 and $415,000 MFJ, or $157,500 and $205,500 for Single individuals.
Strategies to maximize the Qualified Business Income deduction
There are several issues to consider:
- Consider segregating into separate entities: Segregate non-healthcare businesses into separate entities that may qualify for the QBI deduction. These might include, for example, moving all equipment to a separate entity that leases the equipment back to the physician practice. Note here that there are other limitations on the QBI deduction that will need to be considered, such as the level of salary expense and capital investment.
- Evaluate salary vs. pass-through income: An owner’s salary or guaranteed payment income is not QBI. Therefore, owners with the potential to take the QBI deduction should try to shift their income from the business away from salary and guaranteed payments in favor of income that passes through to them via distributions through their Schedule K-1. Note, however, that the IRS will be watching to make sure that salaries and guaranteed payments to owners are reasonable in comparison to market-based compensation for the services that the owners perform in the business.
- Consider ways to reduce the owner’s taxable income: Remember, taxable income is Adjusted Gross Income less itemized deductions, so this typically involves increasing itemized deductions. As there are now limits on medical, state and local tax deductions, and miscellaneous itemized deductions have been eliminated, the focus is now on charitable contributions. Generally, taxpayers may claim cash charitable deductions of up to 60% of their Adjusted Gross Income. Therefore, for example, if Adjusted Gross Income is up to $787,500, then a 60% charitable deduction will bring taxable income down to $315,000, allowing an MFJ taxpayer to then take the full 20% of QBI deduction.
Below are 3 opportunities in the charitable deduction area:
1.) Donor-Advised Funds (DAF):
A donor-advised fund is an account set up with an investment provider that allows an individual to make a substantial contribution in one year to a DAF account and take a charitable deduction for this contribution, and then advise the investment provider as to which charities and amounts to give the account funds in the future. This allows a large deduction to be taken now and a more normal level of giving to the selected charities over time. Note that once placed in the account, funds cannot be returned to the donor.
2.) Georgia Education Expense Credit and Rural Hospital Credit funds:
Georgia law contains two unique opportunities to donate money to charities and receive not only a federal charitable contribution but also a direct dollar-for-dollar Georgia income tax credit as well. This allows taxpayers the unique benefit of “paying” their Georgia taxes while deducting these payments not on the limited (up to $10,000) state and local tax deduction line but on the much higher limited charitable contributions line on their federal income tax returns.
Beware though: Although Georgia’s funds existed before the TCJA was enacted in 2017, since then, many states have enacted charitable funds designed to help their state’s citizens pay their state’s taxes and get around the $10,000 limit on their federal return. As a result, the IRS announced recently that only investments in these funds prior to August 27, 2018 will qualify for the federal charitable deduction.
3.) Conservation easements:
Conservation easements allow a charitable deduction for landowners that agree to restrict future development of their land in perpetuity. The deduction is for the difference of the value of the land between “highest and best use” before and after the restriction is placed. The opportunity to take this deduction has been greatly expanded with the recent popularity of syndicated partnerships that acquire the land on behalf of many partners and pass through the charitable deduction on a Schedule K-1. The deduction is often 4 to 4 ½ times the amount invested by the partner, generating significant tax savings. This type of charitable deduction is limited to 50% of Adjusted Gross Income.
Note: These conservation easement investments carry inherent risks. The IRS may challenge whether the specific technical requirements were met to claim the charitable contribution and may attack the valuations of the property as being unreasonable. Only investors with a high tolerance of risk and net worth should contemplate such investments, and only if entering with eyes wide open as to the possibility that the deduction may be reduced or eliminated. Indeed, the IRS has stepped up audits in this area and have labeled certain syndicated conservation easement partnerships as tax shelters requiring enhanced disclosures.
While the new tax law presents challenges, there is no better time than now for physicians and other high-income healthcare professionals to consult with their tax advisors to plan and take advantage of all the opportunities that may now be available to lower their tax obligations. Please contact Moore Colson for more information.