By Sophia Bennett
One of the most talked-about components of H.R. 1, the 2017 tax reform bill, was the steep decrease in rates for pass-through businesses. Provisions in the bill would greatly lower taxes for small businesses, leaders boasted, which would encourage businesses to make new investments and hire more people.
There may be circumstances where switching a dental practice to a pass-through business makes sense. But it’s not a slam dunk, says Carly Carlson, CPA with Aldrich CPAs + Advisors LLP, which is based in Oregon but also has offices in Washington and Alaska. It’s important for dentists to check with their accountant and attorney before changing their legal structure.
What is a pass-through business?
A business set up as a pass-through doesn’t pay income taxes. Instead, all of the income is “passed through” to the owner’s individual tax return. They can be a partnership or S corporation.
“Historically pass-through businesses have been a preferential structure because the other option for a business tax structure is a C corporation,” says Carlson. “C corporations that provide services, like dental practices, were taxed at a flat 35 percent. There weren’t the graduated tax rates you see on the individual side. If there was any money left in the business at the end of the year, you, as the owner, either needed to take a salary or a dividend.” That sum was taxed a second time at the individual level.
This “double taxation” is what led to the creation of pass-through businesses in the 1950s. It’s long been a better deal for companies that didn’t need the benefits provided by C corporations. Even though the top individual rate was set at 39.6 percent under the old law, it was better than paying the 50 to 60 percent that some high earners faced under the double taxation system.
The situation for some pass-through businesses is looking even sweeter today thanks to the tax reform bill. “The IRS is now allowing what’s called a pass-through deduction,” says Carlson. “This deduction is up to 20 percent of the pass-through income. When we’re looking at this for our dentists and other clients, ideally what we’re saying is not only are we taking the lower individual rates, we’re only paying tax on 80 percent of the income that comes through.”
The law’s limitations
While this is celebration-worthy news for many companies, it’s important to understand that Congress placed some restrictions on who could benefit. “The main limitation is that the 20 percent deduction phases out completely when you have gross income on your individual return of more than $415,000 for married filing jointly,” says Carlson. “Once you’re above that, you no longer get the deduction.”
Since many dentists and other medical professionals are above that limit, becoming a pass-through business might not make sense. Ironically, it may be more beneficial to become a C corporation. The corporate tax rate is now 21 percent instead of 35 percent. That’s significantly lower than the individual rate of 37 percent that pass-through business owners who earn above $415,000 will be paying.
Before you call your attorney and request a change to your business structure, Carlson stresses that it’s important to discuss how the reforms will affect you and your business with your tax advisor. “This is the largest overhaul of tax law in more than 30 years,” she says. “It’s hard to just quickly look at something and say, ‘Yes, this is for sure what you should do.’ There are so many things that come into play. Unless you sit down with a tax professional and have them run the scenarios for you, you’re not going to get a good answer.”
The deadline to change your entity election type and benefit from its rates in the same year is typically March 15. But businesses that don’t change their structure now may be able to make a mid-year election and prorate income through the years, Carlson says. If you’re thinking about switching incorporation types, get in to see an accountant as soon as possible.
A trip to an attorney’s office comes next. Depending on the outcome of the entity type analysis, you may be required to file paperwork with several government agencies to change your structure, including the secretary of state and IRS. Ideally the attorney and CPA should work as a team to complete forms and create new documentation. If you don’t have an attorney your accountant should be able to recommend one. After that, your next trip to your accountant’s office might include a discussion about smart ways to invest some of your savings back into your business so you can continue to grow your bottom line.