Qualified Business Income Deduction: Considerations for Medical Practitioners
The Tax Cuts and Jobs Act, signed into law by the President on December 22, 2017, allows individual taxpayers to take a deduction equal to 20% of the taxpayers qualified business income. Qualified business income is generally income from a partnership, S-corporation, or sole proprietorship in which the taxpayer is an owner. In the case of certain service businesses, however, the ability to take the deduction phases out for taxpayers with taxable income over $157,500 for individuals and $315,000 for joint returns. Many physicians are likely to be subject to this limitation.
For income from service businesses, the phase-out begins at $315,000, and once a taxpayer’s total taxable income reaches $415,000 for joint filers (and $207,500 for individual filers), then the 20% deduction is fully phased-out. Taxable income includes not only the business income, but any other income the taxpayer (or the taxpayer’s spouse) receives.
The deduction is available for tax years beginning on or after 2018 and expires after 2025.
- A doctor, who is a joint filer, receives a K-1 from a medical entity for $300,000 and his/her spouse has $200,000 of wages. The doctor will have $50,000 of itemized deductions. Because the doctor’s taxable income is over $415,000, the doctor will not be able to take advantage of the 20% deduction. If taxable income had been between $315,000 and $415,000, the doctor would have received a partial deduction.
Taxpayers outside of service businesses with taxable income above the threshold amounts mentioned above are subject to different limitations. For those taxpayers, the 20% deduction may not exceed the greater of: (a) 50% of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. Under the signed law, qualified property means tangible property used in the business where the property has not been held beyond its prescribed depreciable life.
- A taxpayer operates a sole proprietorship that sells medical equipment (i.e., not a service company). The company is not subject to the limitations related to service companies, but is potentially subject to the limits based on W-2 wages and/or assets. The company purchases a piece of medical equipment for $100,000 and places it in service during 2018. The income from the business is over $415,000. Assume the business has two employees and W-2 wages for 2018 totaling $75,000. The 20% deduction cannot exceed the greater of: (a) 50% of W-2 wages, or $37,500, or (b) the sum of 25% of W-2 wages ($18,750), plus 2.5 percent of the unadjusted basis of the medical equipment immediately after its acquisition: $100,000 x 2.5% = $2,500. The amount of the limitation on the taxpayer’s deduction for 2018 is $37,500 which is the greater of (a) or (b).
For physicians with taxable income below the thresholds, the 20% deduction will most likely be a tax benefit. Physicians with taxable income above $315,000 (joint returns) will have a harder time fitting into this rule. Some are suggesting that taxpayers establish separate Management Service Organizations (MSOs) or the spinoff of one or more ancillary activities in order to report income in a non-service entity. By doing that, a taxpayer would be able to subject a portion of its business income to the 20% deduction. For example, if a taxpayer with $415,000 of qualified business income were able to move $100,000 of the qualified business income into a non-service entity, the taxpayer would receive a deduction of $20,000 (20% x 100,000). In that fact pattern, the taxpayer would still receive no deduction for the $315,000 of service business income because its taxable income is over $415,000. However, it is unclear whether such ideas (i.e., setting up a MSO) would achieve the intended benefit. The IRS will likely provide rules detailing how the new law should be implemented, or the IRS might rely on existing rules to prevent perceived abuses. For example, the IRS could apply existing analogous rules that treat related groups of companies as a single company for certain purposes. If those rules are applied, forming the MSO would not have the intended benefit.
What Does CohnReznick Think?
The creation and structuring of an MSO or the creation of spinoff entities must be done carefully and in compliance with existing medical industry standards, guidelines, and regulations, which may vary from state to state. As noted above, establishing an MSO and allocating some non-service income – depending on how the IRS interprets the new tax law – might not result in the intended tax benefit. CohnReznick is monitoring these discussions to determine whether the IRS will allow such a conversion, or whether there is an alternative option. Until the IRS releases more definitive information, it might be risky to incur the costs of setting up a separate entity, only to later discover that it must be dissolved.
CohnReznick’s Medical Industry team, working together with you and your legal team, can help you navigate through these issues. Should an MSO be the right fit for your practice, we can assist in implementing and achieving an appropriate and effective structure.
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Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.