The new tax code contains a 20 percent tax deduction for small businesses, but dentists who earn too much are excluded from taking it. Here’s what you need to do to take advantage of the deduction.
How Does the Pass-Through Tax Break Work?
For dentists, the calculation is simple. If your taxable income is below a certain level, you receive a deduction equal to 20 percent of your share of profits from your practice. The only exception is that the deduction can’t reduce your taxable income below zero.
There are other limitations, but they generally don’t apply to dentists. Dentists are mostly excluded from taking the deduction at income levels where the other limitations are in effect.
Why Are Dentists Excluded?
Under the law, dentists are considered a specified service trade or business. Congress excluded service businesses from the deduction to prevent W-2 wage earners from reclassifying themselves as an independent contractor to take advantage of the deduction.
However, service businesses are not excluded below certain income levels.
What Are the Income Limits?
Dentists qualify for the full 20 percent deduction if their taxable income is up to $157,500 for single filers and $315,000 for joint filers. This is your individual taxable income from line 43 of your Form 1040, so it is based on your own share of your practice’s profits, not your practice’s total profits. It also includes any other wages, business income or taxable investment income you may have.
Dentists with taxable income above the first threshold and up to $207,500 ($415,000 if married filing jointly) receive a reduced deduction. As your income approaches the upper limit, your deduction is reduced toward zero. However, there is a secondary calculation that may slow the phaseout of the deduction if you pay enough in W-2 wages.
If your taxable income exceeds the $207,500/$415,000 limit, you are fully excluded from the deduction as a service business.
How Do You Get Around the Income Limits?
Smart tax planning may help you to qualify for the deduction if you are near the cutoff.
The easiest move is to reduce your taxable income by contributing to a deferred-tax retirement account. For 2018, the individual contribution limit for a 401(k) increases to $18,500, and the total contribution limit (including employer contributions) for a 401(k) or SEP IRA increases to $55,000.
If you have investments in taxable accounts, you may consider using tax-exempt municipal bonds or tax-efficient index funds to reduce your dividends and capital gains income.
Changing your dental practice’s business structure may be more difficult. The most obvious potential strategy is to convert to an S-corporation so you can pay yourself W-2 wages. However, W-2 wages
- still increase your taxable income,
- do not receive a 20 percent deduction, and
- reduce your business profits on which you can receive a 20 percent deduction.
An S-corporation makes the most sense when you are in the $157,500 to $207,500 (double if joint filing) phaseout range and may need W-2 wages on your books to increase your potential deduction. However, since that income range is so small and dentists do not qualify at higher income levels, the potentially minimal tax savings may not be worth the move – especially if you aren’t sure your income will remain within that range.
What Should You Do?
One final note is to consider the tax effects for all of your partners. Even if you can’t personally claim the deduction, know that converting to an S-corporation may still help your younger partners.
Other than that, schedule a meeting with your team and CPA to review your practice’s financials and see what moves may be available to you.