Tax Savings: The 20 Percent Qualified Business Income Deduction
A useful option for new or start-up orthodontic practices, as described by Cain Watters Investment Advisory Services.
Although the Qualified Business Income (QBI) deduction has been around since the new tax law passed in 2018, it’s still one of the areas where CPAs get a lot of questions. As a quick refresher, this attractive deduction allows flow through entities, such as S Corporations, partnerships and Schedule C filers, to exclude up to 20 percent of the flow through income from the taxpayer’s taxable income.
It’s important to keep in mind that orthodontists fall under a “specified service business” making this deduction not applicable for most orthodontists. To take advantage of the QBI deduction, taxable income must be below the $329,800 threshold. This limitation allows a dental professional to be able to take full advantage of the 20 percent QBI before any phaseouts. A phaseout of the deduction occurs up to $429,800 of taxable income.
For a new orthodontist opening a start-up practice, the QBI deduction may not be the first thing considered but, the steps taken early in the process will play an important role in the amount of deduction taken in the coming years.
Although most solo doctor orthodontic practices ultimately elect to be taxed as an S-corporation, it may not be the right choice for a start-up practice. By selecting to file on your Schedule C (likely as a single member LLC or sole-proprietorship) the full amount of your income will be subject to the QBI deduction – as opposed to an S-corporation, which must remove the portion the doctor pays him or herself through salary.
Ideally this entity structure would be kept for the first few years in practice until income exceeds $429,800 phase out deduction. For example:
Practice Collections – Year 2: $500,000; Year 3: $750,000
Practice Overhead – Year 2: $350,000; Year 3: $487,500
Doctor Personal Expense – Year 2: $20,000 Year 3: 20,000
Doctor Salary – Years 2 and 3: 0
Doctor Flow Through Year 2: $130,000; Year 3: $242,500
QBI Deduction – Year 2: $19,300; Year 3: $41,300
In this example this start-up doctor was able to generate a total QBI deduction of $56,700 over the first two profitable years in practice. This results in total taxes saved of $11,400, by not making an S-election.
As the practice continues to grow you will start to phase out of the QBI deduction. In the example below the doctor is completely phased out of the QBI deduction in the fourth year of practice.
Year 4 Year 4 Revised
Practice Collections – Year 4: $1,200,000; Year 4 Revised: $1,200,000
Practice Overhead – Year 4: $720,000; Year 4 Revised: $720,000
Doctor Personal Expense – Year 4: $20,000; Year 4 Revised: $50,000
Retirement Plan – Year 4: 0; Year 4 Revised: $90,500
Doctor Salary – Year 4 and Year 4 Revised: 0
Doctor Flow Through – Year 4: $460,000; Year 4 Revised: $339,500
QBI Deduction Year 4: 0; Year 4 Revised: 60,500
An important concept for a young orthodontic practice owner to understand is the relationship between production and collections. By understanding this relationship, you can begin to understand what the cash flow of the practice will look like in the following year.
The owner of this practice may not have felt ready for a retirement plan in the fourth year, but the growth in production in year four would show the increase in practice collections in year five. As a Schedule C filer this doctor could fund the retirement plan as late as October 15th of the following year and still have the deduction applied to year 4. In addition to the added retirement plan, additional “perks” could be added to help bring income below the phase-out threshold.
By making these changes, this doctor added in retirement savings and additional tax-deductible perks. All of these expenses would be saved at this doctor’s marginal bracket. These perks save the doctor $28,900 in taxes. In addition to the tax savings by running these new expenses through the practice, this doctor also has now dropped under the QBI phaseout limit allowing them to receive a $60,500 QBI deduction, saving this doctor an additional $14,500 in taxes.
These simple changes can add up to large savings in the early years in the practice when cash flow is paramount. Having an advisor that understands the growth of a young orthodontic practice and can direct these decisions can help ensure there are not tens of thousands of dollars left on the table.
For personal questions or guidance, reach out to the CWA team at cainwatters.com/contact.
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