Preparation is all around us, in everything we do inlife. But in terms of tax preparation, we tend to adhereto another p-word—procrastination—when it comes toour due diligence. And that tendency can be costly.
"Many physicians that we encounter underestimatethe importance of having their books and records ingood shape prior to our arrival," said Barbara Smith,CPA, CVA, and a tax partner with Cherry, Bekaert &Holland. "In addition, many contact us too late to doproper planning." Smith points out the value of contactingyour tax preparer during the fourth quarter to ensurethat there is time and opportunity to implement savingsstrategies. And there are many strategies to consider.
Surveying the Options Available
To begin easing into the tax preparation process,physicians need to engage in proper year-end planning.Smith believes that this should be undertaken by all medicalpractices, regardless of size. When meeting with a taxadvisor, reliable and current financial information shouldbe available. In addition, the practice owner should beready to discuss the business outlook for the remainderof the year. This combination of reliable information andforecasting, Smith says, is essential to making sounddecisions. "It allows for projections of cash receipts andcash disbursements for the remainder of the year, as wellas discussions regarding other steps that can be taken tominimize tax impact," she points out.
William Perez, CPA, a former IRS tax specialist, andthe tax planning guide for About.com, agrees thatphysicians should review their personal and businessfinances focusing on tax savings. "Several smart taxstrategies can be implemented before the end of the yearto help keep the tax burden at a minimum," Perez says.
Physicians should check their expense account. If theyare part of a large group practice or employed by a hospital,they should seek reimbursement from theiremployer for job-related expenses, such as continuingeducation, reference books, and journal subscriptions.Reimbursements are tax-free to the employee and avoidthe 2% adjustment of gross income limitation on jobexpenses on their Form 1040.
Physicians who own and operate their own businesses"should examine their profit and loss statement andestimate their tax bill," Perez advises. "If the business hassubstantial profits, the physician can decide to boostbusiness expenses, pay out bonuses to employees, or purchasecomputers, software, or other assets to boost theirSection 179 deduction." Business owners should alsopay attention to their retirement plan, Perez adds. Theycan decide to boost the company's matching contributions,thereby increasing their business expenses andhelping their employees save for retirement.
Funding your retirement plan is one ofthe most important things youcan do to lower your taxesand provide financial security.However, many physiciansfail to maximize their contributions.Maxing out yourretirement contributions immediatelyreduces your taxableincome and provides tax-deferredgrowth of your savings. Anothergood reason to max out every year isthat physicians will be eligible for matchingcontributions from their employer. Matchingcontributions, like the employees' contributions,will not be taxed until the funds are withdrawnin retirement.
"To the extent that it can be handled within theirbudget, we recommend that every participant maximizecontributions into their retirement plan," saysMark Heffernan, CPA, CFP®, PFS, principal with theMoneta Group. "At minimum, we recommend contributingthe percent that will allow participants toreceive the full level of the employer match."
When it comes to funding retirement plans, varioustax amounts and limits have increased slightly for2006. According to Perez, the limitation on itemizeddeductions has been slowly decreasing over the pastcouple of years, so physicians who itemize will findtheir allowed deductions are slightly higher.
For example, the limit for a defined-contributionplan is $44,000, an increase over 2005 of $2000. Anemployee can now elect to defer up to $15,000 in a401(k) plan. Employees over age 50 can defer an additional$5000 per year. For Savings Incentive MatchPlan for Employees, the maximum deferral for 2006 is$10,000, and $12,500 for employees over age 50.
If physicians are considering starting a new defined-benefitplan in 2006, the plan should be establishedprior to the year's end. Defined-benefit plans are retirementplans that allow higher savings than defined-contributionplans, like 401(k) and simplified employeepension IRA plans. The annual benefit limit fordefined-benefit plans for 2006 is $175,000. However,with the higher dollar limits come several drawbacks.
"The business must fund the retirement savingseach and every year," Perez says. "So, practices withunsteady cash flow might not be able to commit to adefinite level of retirement funding. Also, defined-benefitplans have significant administrative costs.But for highly profitable businesses, establishing adefined-benefit plan can supercharge retirement savingsfor their employees."
Heffernan points out that in recent years defined-benefitplans seem to be growing in popularity amongprofessional firms such as physician groups. "This isespecially true with relatively small groups when theprincipals tend to be slightly older and highly compensated,while the support staff tends to be younger withlower compensation levels," Heffernan explains.
In this scenario, the tax deduction can be significantlylarger than would otherwise be availablethrough a defined-contribution plan. Although morecomplicated and costly toadminister, in certain situations,the negatives of defined-benefitplans are more than outweighedby the benefits.
"We recommend consultationwith a qualified pension expert inorder to determine if the demographicsof your practice make the defined-benefitplan the right choice for your particularsituation," Heffernan says.
If a physician is charitably inclined, they shouldconsider gifting appreciated securities to their favoritecharity. If this strategy is utilized, it is important tostart the process early enough so that the transactionwill be completed by year-end.
"This is a win-win situation for both the donorand the charity," Heffernan says. "For example, aphysician donates a stock or a stock mutual fund initiallyvalued at $10,000. At the time of the gift, thestock/mutual fund was worth $20,000. The physicianis entitled to a charitable deduction for the fairmarket value of the security (ie, $20,000) withoutincurring capital gains tax, assuming it has been heldfor at least 12 months. The charity benefits from thefull $20,000 and is not required to pay tax when thesecurity is sold. Assuming the physician likes thesecurity and does not want to part with the asset,they can turn around and repurchase the same stockwith the cash that would have otherwise been donatedto the charity. In essence, the donor maintainstheir position in the security and increases the costbasis to $20,000—vs $10,000—thereby reducingfuture tax when the security is ultimately sold."
Perez also suggests that physicians who own andoperate their own practice should consider the legal,financial, and tax advantages of their form of business.That's because practices with a significant charitablecomponent may find it advantageous to operate as a501(c)(3) nonprofit organization. Other practices maybenefit from the flat 35% tax rate on personal servicecorporations, while some may find it advantageous touse an S-corporation structure.
"I mention 501(c)(3) organizations for a specificreason," Perez says. "Tax-exempt organizations areeligible to have two types of retirement plans—a401(k) or 403(b) plan plus a Section 457 deferred-compensationplan. And employees are eligible to contributeto both plans, offering them the ability to deferup to $30,000—for 2006—per year. It makes sense toreview the form of business every few years with yourattorney and tax professional."
As touched on earlier, structuring business financesto obtain the maximum Section 179 deduction is stilla great tax strategy. Bob Tilson, of Tilson FinancialGroup, explains that typically, if property for businesshas a useful life of more than 1 year, the costmust be spread across several tax years as depreciationwith a portion of the cost deducted each year.But there is a way to immediately receive theseincome tax benefits in 1 tax year.
"The provisions of Internal Revenue Code Section179 allow a sole proprietor, partnership, or corporationto fully expense tangible property in the year it ispurchased," Tilson says. "And tax law changes overthe past few years have made this option much moreappealing by dramatically increasing the amount thatcan be written off immediately."
Changes first made in 2003 and then extended in2006 mean that businesses can write off more of theircapital expenditures through 2009. Enhanced Section179 expensing now is at the base level of $100,000,with that level indexed for inflation for the last severalyears. This is four times more than the previouslaw's limit of $25,000. In addition, the investment limitationalso has been increased to more than $400,000and it, too, is indexed for inflation.
"These changes mean that in 2006, a business canexpense $108,000 in capital expenditures up to anoverall investment limit of $430,000," Tilson says.
Making Order from Chaos
Staying organized, experts agree, is perhaps the mostimportant tax planning strategy of all. Physicians needexcellent bookkeeping practices, not just to pay theleast amount of tax, but also to understand how theirbusiness is doing and to stay on top of insurance claims.
"Treat your financial statements and tax returns thesame way you would handle patient files," Perez suggests."In particular, keep all business and payroll taxreturns for at least 7 years, keep receipts for largeexpenses and business assets along with your taxreturns, and keep extensive documentation of yourinvestments in the business. When physicians startthinking about selling their practice, they will need tofigure out how much money they have invested in thebusiness over the years. So having all that informationin one place will make the process much easier."
Perez also urges physicians to schedule an appointmentwith their tax accountant and review their profitand loss, balance sheet, and other financial records.
"Often, your tax accountant will be able to suggestsome year-end tax moves that you might have overlooked," Perez says. "One of the biggest opportunitiesat the end of the year is to review employee salariesand compensation. Many times we can decide on raises,bonuses, more fringe benefits, or higher matchingcontributions to a retirement plan depending on howthe business is doing."
Take the time now to make sure that financialbooks and records are correct and accurate. This willensure the most efficient tax preparation possible. Andif you find that you are having trouble with thisprocess, seek help prior to year-end. A little preparationnow will go a long way toward peace of mindwhen it comes time to file your income tax during thefirst quarter of 2007.