With the enactment of Tax Cuts and Jobs Act of 2017, dentists who meet certain income-based criteria can qualify for lower tax rates. Though the new law is terrific for traditional sorts of businesses, when it comes to dentists and other professionals, the benefits will be more limited — but still possible in many cases.
The new rules, contained in new tax code section 199A, introduce the concept of “qualified business income” (QBI). QBI refers to profit generated from a pass-through entity (such as a dental practice structured as a sole proprietorship, S corp, partnership or LLC). Pass-through entities are not subject to income tax. Rather, the tax consequences “pass through” to the business owners and are reflected on their individual income tax returns. Under section 199A, a pass-through business owner who meets the specified qualifications can claim a tax deduction on his or her personal income tax return equal to 20 percent of his or her QBI.
Though they are technically classified as tax deductions, these changes have the effect of lowering the tax rate on QBI. If a taxpayer is in the 37-percent bracket and gets a 20 percent deduction on his next dollar of earned income (for example, $1 of QBI), then he will pay an effective tax rate on the QBI of only 29.6 percent. The lower rate is beneficial for those who qualify, but the category of who can claim this deduction is subject to some major restrictions.
Two Types of Businesses — QTOB and SSTOB
The new concept of qualified trade or business (QTOB) refers to any business that is not a “specified service trade or business” (SSTOB) or does not perform services as an employee. Examples of SSTOBs are doctors, lawyers, accountants, actuaries, performing artists, consultants or financial experts — any business where the principal asset is the reputation or skill of one or more employees. Dentists are clear examples of SSTOBs.
If you own a QTOB, you can claim the QBI deduction and potentially lower your tax rate. Even though most SSTOBs cannot claim the QBI deduction, there are some cases in which the individuals who own them can.
The Rules for Specified Service Trades or Businesses (SSTOBs)
Dental practices fall squarely under the definition of SSTOBs, which, under section 199A, do not qualify for the pass-through tax deduction. However, SSTOBs can qualify depending on the taxpayer’s taxable income.
If the SSTOB owner’s taxable income is $157,500 or below (single), or $315,000 or below (married filing jointly), they can still qualify as if they are operating a QTOB. A dentist with taxable income below these numbers will enjoy the deduction. Most practice owners won’t qualify, but others, such as doctors with modest practices and high overheads, may.
If the owner’s taxable income is above $207,500 (single) or $415,000 (married), then they will not get a pass-through income tax deduction.
And if the owner’s taxable income is between $157,500 and $207,500 (single) and $315,000 and $415,000 (married), then the owner’s ability to claim the pass-through deduction is quickly phasing out as income hits the top end of the range.
To reiterate, many dentists won’t benefit from the new QBI deduction. If you own a practice structured as a sole proprietorship, S corp, partnership or LLC, and your taxable income is over $207,500 (single)/$415,000 (married), you continue to be taxed as before, albeit at lower income tax rates. Associate dentists who are employees in practices will receive no benefit.
With this in mind, here are some planning opportunities that may still permit you to take advantage of the new pass-through deduction — even if you own an SSTOB or you are a non-owner associate employee:
- Very large practices may benefit by forming their own dental support organization (DSO). The practice of clinical dentistry subjects you to the harsh SSTOB treatment. But, you could make a case that a management company (owned by the doctor) that provides ancillary business services to the dental practice is not in the business of providing clinical dentistry. The DSO is a qualified trade or business (QTOB). The doctor would pay themselves a reasonably modest salary in the dental practice. They’d then form a new DSO structured as an LLC. The practice would pay the DSO as much as it could justify based on the services the DSO performs.
Since the pass-through deduction is the lesser of either 20 percent of the DSO’s income or 50 percent of the allocable W-2 wages, the DSO will have to pay out W-2 wage income to its employees. The non-clinical employees in the dental practice can be hired by the DSO and paid their W-2 wages by the DSO.
- Own your office building in a pass-through entity. The goal here is to make the real estate entity the QTOB. If your practice is paying a high enough rent, it will generate QBI in the real estate company. A real estate company does not need to pay substantial W-2 wages for the owner to claim the pass-through deduction. The deduction in this case would be the lesser of either 20 percent of QBI or 25 percent of wages plus 2.5 percent of the purchase price of the property.
- If your taxable income is below $207,500 (single)/$415,000 (married), recharacterize your “employment” agreement as an “independent contractor,” and become a Schedule C sole proprietor. As a sole proprietor, you will have no W-2 earnings that would take away from your valuable QBI. All of your earnings are QBI, so you can maximize your tax deduction.
If you are an associate, be aware that your employer may balk at this on the advice of their CPA or attorney. Worker misclassification is a hot-button issue with the IRS, and the employer may be concerned about an audit and possible penalties.
Most dentists will save on taxes thanks to tax reform. The across-the-board reductions in the individual income tax rates will overwhelm the well-publicized negatives such as the near-elimination of the state and local tax deduction. The biggest change our firm was hoping for was to lower the tax rate on pass-through business income to the same lower tax rate of 21 percent that applies to C corporations. While that didn't happen (especially for professional businesses), there are still several opportunities for the savvy dentist to take advantage of what the new law now offers.
Brandon S. Collier, JD, LLM, is an attorney who provides tax and business planning services to the dental profession through Collier & Associates Inc., a law and consulting firm representing doctors in all phases of their careers. He is the editor of the Collier & Associates doctor’s newsletter. For more information, visit CollierAdvisors.com.