Now is the time for year-end Tax Planning

Physician's Money Digest, November 2005, Volume 12, Issue 15

Being prepared is not a new credo. The Boy Scoutsof America teach young men the importance of planningahead and being prepared, especially during outdoortrips and activities. The Red Cross cautions thatdisaster can strike quickly and without warning, as wehave all learned in the wake of Hurricane Katrina.

Being prepared, therefore, is a concept that appliesto many venues and many walks of life. So it makessense that when it comes to income tax filing, beingprepared is just as important a lesson. "Accountantsdon't expect to get a perfect set of books,"explainsBill Smith of CBIZ Accounting, Tax, and AdvisoryServices. "But if they're organized, it helps tremendouslybecause it allows the physician to get a betterunderstanding of their current financial situation.Without that kind of organization, tax advisors aregoing to ask questions that the physician might nothave the answers to."

Planning for the Future

Smith points out that there's still time to get organizedand take steps to maximize your 2005 tax filingnext spring. But the longer you wait toward the end ofthis calendar year, the fewer options you will have.

With time winding down on 2005, Mark Beefe,CPA, with the Wealth Enhancement Group, suggeststhat physicians really should be working with a qualifiedtax preparer who does tax projections rather thansimply preparing tax returns. "If I was working with aclient, I would not only be doing an income tax projectionfor 2005, I would be doing one for 2006," Beefe explains. "Because if something material is goingto change in 2006, I really need to know that now inorder to advise the physician what to do for theremainder of 2005."

The reason for the advance planning is what Beeferefers to as "this nasty little tax" called the alternativeminimum tax (AMT). Beefe explains that the AMT wasset up by Congress in 1969 as a penalty tax for the ultrarich who were using all sorts of tax shelters to reducetheir income to next to nothing. Basically, the AMTrules determine a minimum amount of tax that individualsof certain incomes should be required to pay. If youare already paying at least that much in taxes because ofthe regular income tax, you don't qualify for the AMT.However, if your regular tax falls below the minimum,you make up the difference by paying the AMT.

"The problem is that the IRS gives you an exemptionof $58,000 [for a married couple filing jointly]when you calculate the AMT," Beefe explains."That's going to expire at the end of 2005 and bereduced to $42,000. The other problem is that whenCongress reduced the income tax rates for regulartax purposes, it never made a corresponding adjustmentto the AMT rates. The AMT is still at 26% and28% today, yet ordinary tax rates have droppedfrom a high of 39.6% to 35% as the top tax rate thisyear. And all the rates have dropped correspondingly,so many of our middle income tax payers andabove are ending up with AMT on their tax returns."

Beefe explains that the AMT has changed a lot oftraditional thinking when it comes to income taxpreparation. The old rule of thumb was to acceleratedeductions into the current tax year, such as paying allof your state income taxes in 2005, or doubling upyour real estate tax to get a double deduction, thusdriving your tax liability down as low as possible.However, those deductions are not allowed for theAMT. As a result, you could find that you don't receiveany tax benefit for making those payments. Worse yet,you could trigger the AMT. According to Beefe, thatcould mean anywhere from a couple of thousand totens of thousands of dollars. It highlights the importanceof being prepared and projecting ahead.

Defined Benefit Plans

The national trend in recent years has been for thedecline of the defined benefit plan, not to be confusedwith a defined contribution plan, such as a 401(k).But recent changes in the law have made definedbenefit plans a bit more attractive. However, DavidDanziger, founder and principal of the Law Officesof R. David Danziger, says that word hasn't spreadabout this new opportunity. "The greatest tax shelteringopportunity for physicians is to consideradopting a defined benefit plan," Danziger says. Hepoints out that a 50-year-old who sponsors a definedcontribution plan is limited to $46,000 a year.However, in a defined benefit plan, the physician-sponsorcan shelter $150,000 or more.

Danziger explains that the rules for contributingto a defined benefit plan are really the same as witha defined contribution plan. As long as the plan isadopted before the end of the year, contributors cantake until the due date of their tax return the followingyear to make the contribution. For a professionalcorporation, that would be March 15, 2006, for2005 income tax filing.

The start-up process is quite simple, Danzigersays, and it starts with obtaining a plan illustration."Talk to a firm that provides defined benefit plansand show them your census of employees," Danzigerexplains. "How much do they earn? How old arethey? How long have they worked for the company?Ask the firm to develop a design illustration. If thedesign looks good, the implementation of the plan isreally quite easy."

Of course, there are some caveats. One is that thecontributions are not as flexible as in a 401(k) plan.In a defined benefit plan, the physician-sponsormakes a commitment to continue contributing at aset level of funding for at least the next 3 years.Danziger suggests that for physicians with a steadyincome stream, this should not become a problematiccommitment. In addition, physicians need to beaware of possible changes in employee demographics,because that can have an impact on the cost ofthe contributions.

According to Danziger, perhaps the nicest featureof defined benefit plans is that contributions are shelteredfrom the AMT. "Some physicians have a sidebusiness," Danziger says. "They may be a partner ina practice but have self-employment income fromanother source. Or they may receive income fromserving as an expert witness or conducting studies.Often this side income is not needed for family support.A defined contribution plan limits the contributionto 25% of income. That's the most that can bededucted. But the defined benefit plan would allowthe entire income to be sheltered. So it's a great wayto reduce income that's exposed to the AMT."

Like-kind Property Sidestep

As the calendar year draws to a close and the realestate market is still hot, physicians might be thinkingabout selling their current vacation home or the rentalproperty they own. That could trigger what JohnMangham, CPA, refers to as a taxable event. There isa process, however, that will allow you to circumventthat taxable event. It's a section of the tax code calledthe 1031 exchange, otherwise known as a like-kindexchange. "The strength of this code is the definitionof like-kind," Mangham explains. "It's very broad."

Suppose you have a rental house that you'veowned for a number of years. You may have paid$100,000 for it 10 years ago, and over the years ithas doubled in value. On the day that you go to sellthe rental house, the IRS says you have a taxableevent. However, if you structure the sale of the rentalhouse with the purchase of a replacement property,the IRS will give you a safe harbor provision indicatingthat you have deferred the taxes on the sale of thefirst property by acquiring a second one of equal orgreater value.

"The key phrase is that the like-kind provisionallows you to buy any kind of real estate as long as itis held for investment," Mangham explains. "Thereplacement property could be another rental house,a condo at the beach, an office building, or a piece ofland. It can be residential, commercial, or agricultural.As long as the primary purpose of buying theproperty is to hold it for investment, that propertyqualifies for a 1031 exchange."

The flipside of what you can buy is what you can'tbuy, Mangham says. For example, you cannot purchasea property and move into it as your residencebecause then it becomes a personal use property. Inaddition, a boat does not qualify because it's not realestate. However, if a physician owns a small officebuilding where their practice is located, the officebuilding can be sold and several rental houses can bepurchased in its place. The reverse is also true. Aphysician can sell a beach house and expand theirpractice by investing the money in a medical officefacility. "There are plenty of physicians who are realestate investors," Mangham explains. "It creates astream of income without having to go to the officeevery day. The concept of like-kind is so broad, I liketo say you can go anywhere in the domestic UnitedStates that you want to go with a 1031 exchange."

Covering the Bases

There are still several other avenues physicians cantake advantage of before the 2005 calendar yearexpires. The first is to maximize your 179 deduction—the deduction that allows you to expensedepreciable property. "In 2004, the amount you couldexpense was $102,000, and it will go up for 2005," Smith says. "If you have business equipment needsthat you can foresee over the next 6 to 12 months,you should accelerate buying and write it off now."

Maximizing contributions to your retirement planis a standard approach, but Smith says physiciansshould also consider a review of their retirement plan.He explains that it's important to make sure the practiceis set up in such a way that they're able to takemaximum advantage of retirement planning.

For physicians contemplating college for their children,a 529 plan is a fantastic resource, Smith says.Charitable giving should also be considered, and it's agood time of year to examine your investment portfolio."Many investors have capital losses that are beingcarried forward even now from when the markettanked in 2000 and 2001," Smith states. "With capitallosses, you can only deduct them up to capital gainsplus $3000. If you've got capital gains in your investmentsand you have capital loss carry-forwards thatyou weren't able to fully utilize, it's a great idea to closeout of some of those investments, roll them into somethingelse, and take advantage of the gain tax-free."

Smith also urges physicians to think about taxplanning year-round rather than during the fourthquarter of the tax year. The benefits are far greater inthe long term if you think things through and pursuewhatever the plan might be.