Business Taxes and Tax Planning
Over and over again courts have said that there is nothing sinister in so arranging one’s affairs so as to keep taxes as low as possible. Everybody does it, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands; taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere can’t.
Justice Learned Hand
U.S. Supreme Court, 1947
cash basis accounting
depreciation recapture rules
employee benefit programs
Employer Identification Number (EIN)
federal income taxes
Federal Insurance Contributions Act (FICA; Social Security)
Federal Unemployment Insurance Act (FUTA)
Form 1120: The Corporate Income Tax Form
Form W-2: Wage and Tax Statement
Form W-4: Employees Withholding Allowance Certification
I-9: Employment Eligibility Verification
legal and professional expenses
local income (occupational) taxes
marginal tax rates
meals and entertainment
pension plan contributions
returns and allowances
state income taxes
state sales and usage taxes
State Unemployment Insurance Act (SUTA)
unwithheld expenses for the employer
workers’ compensation insurance
This chapter presents the common taxes that businesses pay. Depending on the type of business entity that established, it will be reported to the government differently. The basic tax principles remain the same, regardless the entity. Income and deduction are reported, equipment depreciated, and employer-related taxes are paid. An accountant will complete forms and do other paperwork for the business owner. However, the business owner should understand the principles so that he or she can communicate effectively with an accountant and other advisors.
In this chapter only federal taxes are discussed. Many states and municipalities have similar, additional taxes if a person practices in their jurisdiction. These taxes also follow the same principles outlined here. The specific implementation of those principles and rules may differ. An accountant will help with these taxes as well.
Principles of Business Taxation
The principles of business tax planning remain the same from year to year. Specific rules, amounts, and thresholds change constantly. Some are pegged to the inflation rate. Congress changes others as they attempt to affect social policy and the economy. If the principles are understood, changes in specifics will make much more sense and will be easier for a person to use to his or her advantage.
The IRS has a simple rule concerning whether money made is “income” or not for tax purposes. They consider any money made to be taxable income unless they have made a specific waiver for that specific type of income in the tax codes. By this definition, almost any income gained by the dental practice is taxable. This includes collections from patient payments, money paid by insurance companies, capitation payments, interest or dividends earned, the gain from sale of assets owned by the practice, the value of trade or barter, and rebates. (This does not include money that the practice borrows.) Some business entities (C corporations) pay income tax on any profits in the business at the end of the tax year. Others (proprietorships, partnerships, S Corps, and limited liability companies [LLCs]) do not pay income tax, but let income and deductions flow through to the individual owners. These flow-through entities report to the IRS who received the profits for the year. The IRS then checks to be sure that the individual has claimed the right amount of income on his or her individual tax return.
After the practice pays for the costs of doing business, the money goes to the owner or employee of the business. The owner or employee then pays individual income tax on it. This includes profit from a proprietorship or partnership (self-employment income), wages paid from an employer (proprietor or corporation), bonuses paid, profit sharing, and sometimes excessive employee benefits. An individual must decide the type of income that is paid because the IRS taxes it all differently. Ordinary income is the same as earned income. This money is made by working. Income and self-employment (SETA) taxes are paid on earned income. Investment income (e.g., capital gains, interest, or dividends) are called unearned income. The IRS taxes it at a lower rate. Because it was not earned, Social Security or Medicare (or SETA) tax is not owed on this type of income. Tax laws and rates change frequently at the whim of Congress, specific rates will not be detailed in this text. Dentists should check with an accountant for the current tax rates.
Most dental practices fall under the cash basis accounting rules. This means that a person realizes income when he or she takes constructive receipt of it. Therefore, a person only pays tax when he or she has control of income and can use it for whatever purpose desired. For example, assume a patient has a bill for $1200. They pay $800 on December 31 of the year X1, and the remainder ($400) on January 2 of year X2. The dentist pays tax on $800 of income in year X1 and pays tax on $400 in the year X2, the year it was constructively received. By this definition, a person pays no income taxes on accounts receivable because they are not income to until patients pay them. (It is not income until the check crosses the receptionist’s desk.) A few large practices use accrual-based accounting rules. However, these rules cause income and expense recognition problems that do not favor the practice.
If a person sells a practice, or a component of the practice (such as dental operatory equipment), he or she receives money for the asset(s). The IRS calls this money either a capital gain or ordinary income, depending on the circumstances. The difference is important because different tax is paid on the two types of income. This leads to some obvious tax-planning issues. These are covered in different chapters of this text.
A deduction is an expense that is a cost of operating or maintaining the practice. A person may need to prove the amount and necessity of this business expense to the IRS, so he or she should keep a receipt and canceled check for the item. The IRS may also require that the person prove the other criteria listed previously, so he or she should be sure to keep excellent records. Canceled checks, by themselves, are not enough documentation.
The IRS considers no expense to be deductible unless they have specifically granted deductibility in the tax codes. For a business expense to be deductible, it must meet all of the following criteria:
The IRS expects everyone to follow these rules for deductions when they file their income tax for the year. However, the only way the IRS knows for sure that a person has followed th rules is if the IRS audits that person and finds a problem. Therefore, many taxpayers take a risk, get away with breaking the tax rules, and do not get caught. This is a risky practice. If the IRS catches that person, there are substantial fines, penalties, and interest payments. He or she might even receive a prison sentence for gross or willful tax cheating. The IRS recently increased the audit rate on high income individuals (such as dentists) decreasing the chance of getting away with breaking the law.
There are several points to consider about deductions:
- Expenses in getting to be a practicing dentist (or any other new occupation) are not deductible. Therefore, expenses for dental education and first state board exam are not deductible. The IRS considers a specialty to be a new occupation, so those expenses are not deductible. (Dentists frequently challenge this point in the tax courts.) The costs associated with setting up a practice are deductible.
- Expenses incurred for maintaining an occupation or profession are a required expense of doing business and are, therefore deductible. Relicensure fees, continuing education expenses, dues, professional books, and publications are all deductible, once a person is a practicing dentist. He or she may deduct the costs of taking another licensing exam, after an initial license is earned.
- Business loan payments are not directly deductible. The interest paid on a business loan is a cost of business and therefore deductible. The principal portion of the loan payment represents a long-term asset. The value of the asset itself is deducted indirectly through depreciation.
- It never pays to incur an expense simply to “get a deduction.” If it is an expense a person would take anyway, then that expense should be structured so it is deductible.
- The first step in maximizing deductions is to learn which items are deductible, so as not to miss one or more authorized deductions. Examples of deductible and nondeductible expenses for the dental office are given in Table 11.1.
- The marginal tax rate influences the value of a deduction. A $1,000 deduction in the 15-percent marginal tax bracket translates into a $150 tax savings. Conversely, the expense only “costs” a person $850 (1,000 – 150) instead of the full $1,000. That same deduction in a 28-percent marginal tax bracket translates into a $280 savings.
- When establishing a checkbook register, a person should be sure to establish categories that are the same as appear on Schedule C. This makes tax time much easier in that he or she does not need to go back over all receipts and categorize them for tax purposes. They have already been allocated to proper categories and the year-end totals are used.
|Dental building||39 years|
|Leasehold construction||15 years|
|Office equipment||7 years|
|Office computers||5 years|
|Professional books||7 years|
|Office furniture||7 years|
|Any intangible asset||15 years|
Capital Assets and Depreciation
Some business purchases are assets that last for several years. These are considered “capital” assets of the business. As an example, a dental chair should last for several years, and a building for many years. Tax law says that because those capital assets have a lifetime greater than 1 year, the deduction for the expense of that item must be spread out over the estimated “useful lifetime” of the asset. (The IRS has a list that tells what the useful lifetime of most assets is.) If the IRS says that a dental chair should last 7 years, then logically one-seventh of the value of the dental chair should be deducted each year. Another way to think of depreciation is wear and tear on long-term assets. By this definition, the dental chair “wears out” over its useful lifetime of 7 years. It is written off over the same period.
Depreciation is the term used for hard, tangible assets. Intangible assets may also have a useful lifetime or wear out over time. A restrictive covenant that lasts for 3 years has a 3-year lifetime. Amortization refers to depreciation of these intangible assets. The idea is the same as depreciation. Depletion is similarly used for natural resources, such as timber or coal deposits.
Some points to consider about depreciation:
- Depreciation Form 4562 is the form by which the cost of assets that have a life span is deducted. This deduction starts the tax year the asset is placed into business service and occurs each year after that according to the depreciation law in effect in the first year. The IRS allows several accounting methods to set depreciation (wear and tear) on an asset. These methods include:
- As a rule, the alternative methods (2 and 3) speed up the deduction for depreciation over the straight-line method (1). A person gets a larger portion of the depreciation in early years, less in later years with these accelerated methods. A person does not need to know how to calculate these amounts, just that several methods exist that generally speed up the deduction.
- A person should discuss with his or her accountant whether or not to speed up depreciation deductions. The MACRS method loads the deductions much more heavily on the front end. That is fine if a person estimates that his or her income will be steady over the next several years. That person will gain more of the tax saving immediately. However, if income will be significantly higher in the future (as, for example with practice growth), he or she may want to defer those depreciation deductions until he or she is in a higher tax bracket, thereby getting more “bang” for the depreciation expense. In the straight-line method, the person is trading off the certainty of an immediate deduction for the possible higher value of a future deduction. That person might find that later in the asset’s life, he or she has a cash flow problem. He or she is still paying for the loan for the asset (primarily principal) although he or she has used all of the depreciation deduction for the asset.
- When a person puts an asset into service during the year affects how much depreciation that can be deducted in the first year. If an asset is bought in January, he or she gets to claim much more of a full deduction than if it is bought in December. The IRS also has several methods for calculating this amount. An accountant will do that. A business owner needs to be aware that he or she may not receive the entire deduction the first year when buying a large asset.
- Disposable assets (those used up within 1 year, such as dental supplies) are a deduction in the year purchased.
- Land does not “wear out” over time, so it can not be depreciated. Buildings do wear out over time. If a building and land are purchased, the appropriate percentages of the cost to each must be allocated, depreciating the building but not the land.
- A person may depreciate any piece of equipment that is purchased, even if it is used and someone else has already depreciated it. It is essentially “new” to that person and has a new useful lifetime for him or her. An asset may be depreciated as often as it is bought. The sale price determines how much depreciation can be claimed. The previous owner is subject to capital gain or loss, and recapture.
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