CHAPTER 10
Personal Taxes
The only thing that hurts more than paying an income tax is not having to pay an income tax.
Lord Thomas R. Duwar
Taxes are a fact of life in the United States. As the government provides more services for the population, it requires more money to do those services. Government services may primarily be considered entitlements (such as welfare and Social Security), probably because those items are often in the news. However, governments at all levels provide many other services used by everyone, including military protection, the road system, primary education, the university system, air traffic safety, and restaurant safety inspections. Because of these varied services, taxes to pay for them are also varied and substantial. Box 10.1 shows how much someone might pay in total taxes (actual and hidden). Given this considerable tax liability, dentists must manage their tax liability effectively.
The single most significant item of tax expense for most Americans is the personal income tax. This chapter discusses personal income taxes, how the taxes are calculated, and what can be done to reduce this tax burden. The federal government levies the most significant portion of income tax. Many states also have separate income taxes. As a rule, states with income taxes follow the format of federal forms reasonably closely. Some states use the same form, applying different percentages for the taxes. Most states have a few differences in state‐specific municipal bonds and other state‐specific initiatives. Some cities, counties, and other municipalities also have income taxes. These vary tremendously. Some cities call them “occupational taxes”; some call them “sinking fund taxes” (because they often retire sinking fund debt). Regardless of the name, they are a form of income tax.
Remember, tax laws frequently change as different political parties with different agendas are elected. This chapter is intended as a general primer on personal taxes, and we present information that we believe will not change significantly soon. Each state (and many municipalities) taxes income and property in addition to the federal government, and we cannot cover all of those in this book. Practitioners should check with their accountant or tax advisor concerning current federal and state tax laws and their application to their situation.
Most dentists have their accountants “do their taxes” (calculate and prepare reporting forms). If dentists understand the basics of tax law, they can give their accountant complete information and make more informed decisions regarding their tax status.
FEDERAL INCOME TAXES
Federal income taxes are due on any money someone makes during the year. This income can be earned income or from investments (unearned income). Dentists in a proprietorship business determine their profit or loss from operating their business on a separate form (Schedule C) and then bring that profit or loss to the personal tax form (Form 1040). If someone owns a corporate or partnership practice, they must file returns for those entities, bringing their taxes owed to their personal tax form. If someone is a non‐owner employee of a practice, they will have a simpler time computing personal taxes because they do not have to report the practice information.
INCOME
The Internal Revenue Service (IRS) develops and implements tax laws for the federal government. The IRS has a simple rule concerning whether money made is income or not for tax purposes. It considers any money made to be taxable income unless there is a specific waiver for that type of income in the tax codes.
Taxpayers are generally taxed on available income, regardless of whether it is actually in their possession. This means that someone pays tax when the value changes hands. The income is available to them if they have received a check, regardless of whether they cash it. By the same reasoning, a dentist pays no income taxes on accounts receivable because they are not income until the money is received.
Taxes are owed only when the income is realized. For example, someone buys 100 shares of XYZ stock at $10.00 per share. If the price goes to $25.00 in the first year and $35.00 per share in the second year, they pay no tax until they sell the stock. If the stock is sold in the fourth year for $55.00 per share, they pay tax on the appreciated value (55.00 − 10.00 = $45.00 per share) in the fourth year.
The IRS has many ways to check that someone reports all their income. Be sure to report all income. However, a few specifically designated types of income are exempt from income taxes. Some common sources that are non‐taxable income include:
- Inheritances and gifts.
- Scholarships and grants (for tuition and fees, not living expenses).
- Disability insurance payments (if the premiums were paid with taxed money).
- Many employer‐provided insurances.
- Life insurance payouts.
- Municipal bond interest.
Earned Income
Earned income is money that comes from personal effort. It is also called ordinary income. This may be through a 9–5 job, consulting, or freelancing. It can be wages, salary, commission, tips, many benefits, or self‐employment. This is usually the primary income for working people.
The form of the income is immaterial. (It does not have to be cash.) If a dentist barters a crown for a house‐painting job, they have received income, according to the IRS. That person should record as income the value of the house‐painting job, and the painter should similarly include the value of the crown in their income.
Taxpayers must pay two types of taxes on earned income: income taxes and Social Security/Medicare (also called FICA, payroll, or SETA). They pay income taxes on all earned income, and Social Security taxes (currently 12.4%) are paid yearly on earned income up to a specified limit, which changes yearly. The Medicare tax portion (currently 2.9%) applies to all wages (no upper limit). If someone is employed, their employer pays half of this tax, but a person must pay the total amount if they are self‐employed.
Unearned Income
Unearned income is any money that someone does not earn from their active work. It is often called passive income since they do not actively work to earn it. They may make money through investments, savings, rental property, or a business in which they do not actively participate.
Unearned income is taxed differently from earned income, depending on the type. The IRS still considers it as income and usually taxes it at the standard rate. However, certain types (dividends and capital gains) are taxed at lower rates. Unearned income is not subject to Social Security/Medicare taxes. However, as a rule, the unearned income also does not qualify as compensation that someone can contribute to a tax‐advantaged retirement plan (such as an Individual Retirement Account, IRA). Alimony is an exception to this rule.
The characterization of income (and therefore its tax treatment) gets very complex when someone owns a business and works for the business (as in a dental practice). They must work closely with their accountant or tax advisor to comply with current laws and regulations.
Some common sources of unearned income include:
- Interest in savings accounts.
- Capital gain when investments are sold.
- Dividends from investments.
- Rental (property) income.
- Distributions from most retirement accounts.
PERSONAL DEDUCTIONS
Deductions are IRS‐defined expenses subtracted from income before calculating the tax owed. Some deductions are personal, and some are for business. (In this chapter we only discuss personal deductions.) The IRS has a rule similar to the “income rule” for deductions, and it considers no expense to be deductible unless it has expressly granted deductibility in the tax codes. (Just because someone believes an expense should be deductible does not make it so.) A dentist may need to prove the amount and necessity of this expense to the IRS, so keeping excellent records that include a description of the deduction, a receipt, and a canceled check or another payment record for the item is always a good idea. A canceled check, by itself, is not enough documentation.
BASIC PERSONAL TAX FORMULA
Box 10.2 provides a basic tax formula. Dentists need to understand the components of this formula to understand how to reduce tax liability. This is for personal (not business) tax, which will be covered in Chapter 17. Net income from the practice becomes personal gross income for tax purposes.
- Total (gross) income
Gross income is all the money someone makes in a year. It includes income and wages, tips, profits from a business, such as a dental practice, tax refunds, rental income, or any other form of income. Earned income (from working) and unearned income (from investments) are both income for tax purposes, although the IRS treats them differently in specifics of the tax code.
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