Physician C-corporations are subject to a 35% federal tax rate on their earnings at year end. The common tax planning technique that is used to zero out earnings after all expenses are paid, is to issue bonuses to the physicians. However, in many cases, there is no cash left to pay these bonuses. This is typically due to several reasons.
The C-corporation pays non-deductible expenses that use cash, but do not create a tax deduction. These expenses can include the 50% of non-deductible meals, club dues, penalties, and federal income taxes. Timing differences between use of cash and tax deductibility can also occur. These would include payment for depreciable assets in full before the tax deductible depreciation is utilized, as well as charitable contributions, or business investments that do not generate tax deductions commensurate with the cash investment outlay.
The difference between cash on hand and the bonus amount necessary to zero out income is usually covered by one of two sources — a line of credit borrowing, or the bonus monies being immediately loaned back to the corporation. Neither is a desirable outcome.
With the banking industry in its current state, lines of credit often require personal guarantees, plus the costs of borrowing the money. Any personal loans need to be documented with a note including interest at a stated interest rate.
There are several techniques that can be utilized to reduce and even eliminate the growing disparity between cash and the year end bonus amount; thereby reducing the need for borrowing and loans.
Review your charitable contributions. Charitable contributions are only deductible to the extent that they exceed 10% of taxable income (IRC §170(b)(2)). If there is no taxable income, these contributions become non-deductible expenses. These expenses can be turned into deductible expenses if they can be classified as goodwill advertising that can be expected to result in future financial gain. Many payments for fundraising contributions can result in future referrals, thereby being a form of advertising (100% deductible) and not a charitable contribution limited to 10% of taxable income. Of course, the ordinary and necessary business expense rules would apply.
An alternative to the corporation making the payment would be to have the shareholders make the contributions personally to deduct on their own personal tax returns; thereby removing this expense from the corporation.
For the non-deductible expenses that cannot be eliminated (e.g. club dues, 50% of meals and entertainment, and penalties), allocate them to the shareholders and include them in their individual paychecks. This tactic moves these expenses from being non-deductible to being deductible as wages. Although the shareholders are now paying taxes on income they did not receive, it helps to relieve the borrowing requirement for the corporation.
Besides tax planning purposes, these ideas also help in generating a stronger shareholder equity amount on the balance sheet, rather than having the deficit grow larger each year. By eliminating the differences between taxable income and book income (usually a book loss to arrive at a low or zero taxable income), the corporation’s retained earnings can stop decreasing every year due to these differences.
If this disparity between book and taxable income is not addressed, the gap between cash and profits will continue to grow, as will the credit line requirement or physician loans back into the practice. Proper planning is required to budget and anticipate each year’s activity so as not to get caught off guard at year end.
Kathryn M. Walsh, CPA, JD is a senior manager with Godfrey Hammel Danneels & Co., PC. She has over 20 years tax and accounting experience with a demonstrated expertise with physicians and physician groups. Kathryn can be reached at (586) 772-8100.
Godfrey Hammel Danneels & Co., PC is also a proud member of the National CPA Health Care Advisors Association. HCAA is a nationwide network of CPA firms devoted to serving the health care industry. Members provide proactive solutions to the accounting needs of physicians and physician groups. For more information contact the HCAA at firstname.lastname@example.org.