Tax Reform! How Physicians and the Self-Employed are Affected
A tax break!
With the passage of the tax reform bill, most (but certainly not all) Americans will be paying a lower percentage of their income in taxes for at least the next eight years. I don’t plan to discuss the societal pros, cons, or politics, but I would like to address the immediate ramifications as it applies to many high-income professionals like you and me.
How Might You Be Affected by Tax Reform?
Among the highlights from the perspective of this married, part-time anesthesiologist:
- The new 24% bracket extends all the way to $315,000 for married filing jointly (MFJ). Many physicians and other entrepreneurs and professionals will have taxable income in this range. Under the old brackets, the 33% bracket started at $233,000 and the 28% bracket at $153,000. That’s a huge difference.
- The child tax credit now applies! It used to phase out from a MAGI of $110,000 to $130,000 for MFJ filers. I’ve never seen a child tax credit for my 7 and 9 year old boys. Now, the phaseout starts at $400,000 and the credit is $2,000 per child. That’s worth $4,000 a year in this house.
- The Pease limitation is gone! The repeal lowers the marginal tax rate for many households by about 1%. In effect, the Pease limitation was a surtax disguised as a limitation on itemized deductions. I was subject to this in the past; now it’s gone.
- The AMT will affect far fewer people. I believe I’ve paid the AMT every year that I’ve been a full-time anesthesiologist.
- The ACA individual mandate for health insurance is repealed in 2019. One can choose a plan that wouldn’t have qualified, such as many “catastrophic coverage” plans without being subject to a penalty. This could be significant for aspiring early retirees feeling priced out of the exchanges.
- The estate tax exemption is doubled to over $22 Million for couples.
- State and Local Tax (SALT) deduction limited to $10,000. This will affect many negatively, but I was used to paying the AMT and getting no deduction for SALT. Unless you plan to itemize with an additional $14,000 or more in deductions, you won’t benefit from the potential deduction, anyway.
There’s a lot more in the legislation that may or may not apply to you, and I would encourage you to read Michael Kitces’ breakdown at Nerd’s Eye View (love that blog and blog title) for additional insight.
To get a rough estimate of the changes you can expect to your taxes under the new plan, plug some numbers into this Tax Reform Calculator from CalcXML. I can expect to save about $8,000 a year, with half of that coming in the form of new-to-me child tax credits.
There’s one more piece of this puzzle that could greatly benefit those with businesses in which they are self-employed, including those of us in “service businesses” like physicians. This aspect hasn’t been well described in the media, but a savvy physician really dug into this “pass-thru deduction” and graciously granted me the remainder of this article.
Yes, it is described in the legislation as a “pass-thru” deduction as opposed to “pass-through,” although there are also references to pass-through entities. There is also a “look-thru” rule for foreign corporations. I cannot confirm that the document also contains emojis and several instances of “lmfao.”
This started as a forum thread on the White Coat Investor forum, and has been further developed at my request. Thank you, Dr. Elseroad!
Many Self-Employed Doctors to get a Pass-Thru Deduction
By Stanton Elseroad, MD
Disclaimer: Do your own homework. That’s what I did. Read the actual tax bill Part 2 on pages 23-49. Like the physicians in the WCI network, I am not a financial professional. I am only an EM doc, so I did this research for my family. All numbers are for married individuals which are most often halved for singles. Any limits provided are for 2018 tax year and not for the taxes due April 17, 2018. K = thousand to avoid trailing zero confusion. If you don’t trust my interpretation of the legalese, read Michael Kitces’, the financial advisor to the financial advisors.
tl;dr (Too Long; Didn’t Read) Summary
Independent contractors and business owners with personal gross income less than a half million will likely receive this new tax deduction next year without changing anything, saving up to $15,120!
Didn’t they exclude all doctors?
No, there is a limitation but not an exclusion if you are part of a high-income family and own a business in the service industry. If you are an independent contractor (paid 1099), in the eyes of the IRS you own a business. Physicians are one of the primary targets of this limitation on the service industry, but the average physician falls under it. The limitation is $315k of taxable income with a phaseout by $415k.
Don’t stop reading here if you make a half million. (But if make much greater than a half million your service income is likely excluded — sorry WCI! — and should see next section for some considerations.) Key word is TAXABLE which means after all deductions except the one in this discussion. The three main types are (in likely ascending order of size for a doctor):
1. Business Expenses on Schedule C including home office, supplies, and travel expenses.
2. Itemized Deductions on Schedule A including state taxes (income+sales+property $10k max, sorry CA/NY/NJ/DC), mortgage interest (limited to $750k homes for future purchases) and charitable contributions (up to 60% of income).
3. 1040 Gross Income Adjustments (the big ones on the 1040 itself) including i401k ($55k max), HSA ($6.9k max), health insurance premiums (usually >$10k these days), and half of self employment tax (already at $9.7k if at >$127k income, paying the Social Security max tax).
A married independent contracting doctor who is a WCI disciple could have $82k in 1040 deductions alone before Schedules A & C. Let’s say a family is super safe and too worried about IRS audits so they claim no business deductions (C) and opt not to itemize (A), you then could add the new higher standard deduction of $24k to equal $106k deductions. So this family would need $521k of gross income ($415k+ $106k) before being completely phased out of this new deduction.
Considerations if you are not eligible despite your deductions:
All of a sudden, every business is going to claim they don’t serve anyone. If you are a real estate business (like our president himself), you could receive an unlimited deduction, even unlimited with respect to the Alternative Minimum Tax. And somehow architects and engineers finagled a last-minute exclusion from the service definition. Where was the physician lobby?
Or those making more than half million — I am talking to you, surgical subspecialist — could consider becoming a C Corporation with the new 21% flat tax but more expensive administrator burden.
How is the pass-thru deduction calculated?
It’s the least of the following 3 calculations:
1. 20% of your taxable income. If the majority of your income is from your business and you are not a dividend-heavy S Corp, this will be applicable to you.
2. 20% of your total business income. If your service business is a side gig and your main job does not generate too much income to hit the limitation described above, this will be applicable to you. For those with service S Corps this EXCLUDES wages.”3. 50% of your nonservice S Corp W2. This does not apply to those with only doctor income. Those below the taxable income limit are exempted from this wages calculation and those above the taxable income are excluded from this deduction.
If you pay yourself less than 40% of your nonservice business profits (ie >60% dividends), this will be applicable to you. This is because 50% of W2 on 40% of all = 20% on all income (Calculation 1). As someone who lives in a state that adds an extra S Corp tax, it was not advantageous to use this to circumvent Medicare taxes.
For those doctors in a service S Corp, no changes will change their ability to get this Pass-Thru Deduction since this is based completely on the taxable income limit. I see this as guidance written into the code for those who use nonservice S Corps to be more reasonable.
For those who are reading this and are not business owners, this W2 is not the same as the one you get from your employer and this article is not for you. For those pass-thru businesses with sizeable depreciable assets such as real estate or machinery, there is an alternate calculation of 25% of the W2 plus 2.5% of unadjusted basis that can be used if larger than 50% of the W2.
Ironically, those nonservice businesses without W2s or depreciable assets above the taxable income limit such as a married sole proprietorship with a taxable income >$415k would get no deduction and will likely be advised to setup an S Corp if the setup costs were less than the tax savings but I doubt few of these exist since the FICA exemption on the dividends should already make an S Corp useful.
How do you figure the max allowable Pass-Thru Deduction tax savings?
For married filers, $315k of taxable income * 20% deduction = $63k deduction * 24% tax bracket that encompasses it all = $15,120 in tax savings.
How do you figure the phaseout?
You lose 15.12 cents per dollar earned over $315k until it’s all gone at $415k of taxable income (after all other deductions). Don’t worry about each cent though since the IRS rounds to whole dollars on everything. In other words, you lose 1% of the savings per $1k over $315k.
Example: After all deductions, this family’s taxable income is $365k, $50k over the limit, so they have a 50% reduction in the deduction savings to only $7,560 ($15,120/2).
How does this change the effective marginal tax rates?
By taxable income (post all other deductions)
$165k to $315k: 19.2%
$315k to $400k: 47% (32% + lost deduction)
$400k to $415k: 50% (35% + lost deduction)
$415k to $600k: 35%
For every dollar earned of taxable income from $400k to $415k you only get to “keep” 50 cents! If you include FICA taxes, you keep less than half even before state taxes! It is not very encouraging to work another shift in December if you get to keep less than half of your compensation.
If you have taxable income of $315k between $415k you could consider adding more charitable giving at near half the cost to you.
Examples of the Pass-Thru Deduction
PoF: Thank you, Dr. Elseroad for the detailed explanation of this impressive new deduction that will benefit self-employed physicians and bloggers, among others.
While you digest what you’ve just read, I’ll try running through a couple purely hypothetical examples.
The Part-Timer with a Side Gig
Let’s say there’s a part-time anesthesiologist with two children under 17 who works as a W-2 employee. He also has an online business that qualifies as a pass-thrubusiness in a non-service industry.
W-2 income is $250,000 and online income paid as a salary is $100,000 (wishful thinking). He is married, files taxes jointly, and there is no additional income. He deducts about $25,000 between a 401(k) and HSA and takes the new standard $24,000 deduction rather than itemizing.
Taxable income (before the deduction) is $301,000, well under the $315,000 mark at which the pass-thru deduction would phase out.
20% of the $100,000 online income taken as salary would be taken as a pass-thru deduction. In the 24% tax bracket, we take 24% of $20,000 to arrive at a savings of $4,800.
The CalcXML calculator bears this out. Comparing this anesthesiologist’s tax burden with a full-time anesthesiologist earning $350,000, we see that the latter would owe $57,719 whereas the part-timer with the same combined salaries owes $52,919, or exactly $4,800 less.
The Full-Time Locum
The locums doc could just as easily be any independent contractor who earns income on a 1099 rather than a W-2. She earns $350,000 reported on a 1099 and is married with two children.
Deductions include $55,000 into an individual 401(k), nearly $7,000 in the HSA, and the $24,000 standard deduction. She also deducts a total of $20,000 for health insurance for a grand total of $106,000 in above-the-line and below-the-line deductions.
Taxable income is $244,000, well under $315,000, so she can deduct 20% of her taxable income. The $48,800 deduction in the 24% marginal tax bracket is worth $11,700.
Interestingly, the calculator I used for the previous exercise does not account for the phase-out of the deduction that we believe starts at a pre-pass-thru-deduction taxable income of $315,000, but rather subtracts 20% of pass-through income regardless of the total income.
In her case, total income is $350,000, so the calculator will not give accurate results in this instance, but with the additional deductions plus the pass-thru deduction, I would expect her to owe in the range of $15,000 less than the W-2 employee.
Note that the W-2 employee will have a valuable benefits package, whereas the 1099 contractor will be responsible for her own benefits package, so we’re not exactly comparing apples and oranges. If you are paid on a 1099, expect to be paid a premium compared to taking an employed W-2 position for the same or similar job.
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I want to emphasize that these are preliminary calculations based on legislation with wet ink. The IRS will need to fully interpret and implement the new tax code to provide further clarity. CPAs will be busy, as will the self-employed business owners who will be operating for the first time under the Tax Cuts and Jobs Act.
As we receive more definitve information, I will update this post. I am sure you will have questions, and I’m quite sure we won’t have definitive answers, but together with our readership, we can come up with our best guesses based on what we’ve read and learned. I have a disclaimer that says I am not a professional in any business but medicine, and Dr. Elseroad makes the same claim. Please keep that in mind and consult a tax professional to address your specific concerns prior to making any changes related to what you’ve learned here.
Maximizing Sec. 199A Deductions Monograph
For a more thorough treatment of the pass-thru deduction, one of the nation’s foremost experts on small business accounting, Stephen L. Nelson of Evergreen Small Business has written a monograph on the topic, available for purchase and immediate download here.
The monograph, which runs roughly 100 pages, provides tax accountants and sophisticated taxpayers with all the information they need (dozens of simple examples) to start work on maximizing this tax planning opportunity, including:
- At the very start, a general high-level description of how deduction works to get up-to-speed ASAP
- Rich discussion about what counts as qualified business income (the income sheltered by the Sec. 199A deduction)
- How the “pass-thru” deduction works for different types of “pass-thru” entities including sole proprietors, partners and partnerships, S corporations, and rental property investors
- Which service businesses get disqualified and how disqualification works
- How to determine whether you should “un-incorporate” an S corporation… or revoke your Subchapter S election and operate as a C corporation
- A “baker’s dozen” of practical tactics for maximizing the deduction–starting in 2018!
- Checklist of steps taxpayers will want to take on their 2017 tax returns in order to be ready to maximize the deduction in 2018.
- Detailed discussion and examples of the rather complicated rules (including the “grain glitch” fix) for specified agricultural and horticultural cooperatives and their members
The monograph also includes two appendices… the first provides FAQs tax practitioners can share with their clients (via email or traditional letters) to help clients immediately understand the Sec. 199A opportunity… the second provides the text of the Sec. 199A law including the technical corrections. For more information, follow this link.
How will you fare under the revised tax code? Which changes will affect you the most, either positively or negatively? Will you benefit from the new Pass-Thru Deduction? Comment below!
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