Lessons learned in 2018 can help in 2019
Bruce Bryen, CPA, CVA
Because the new income tax law learning curve was not fully reached by most in 2018, many laboratory owners were introduced in a bad way to what the law encompassed. The outcome of their 2018 personal federal and state income tax return results were not what many had thought they would be. Astute planners are ahead of that shift in thinking in 2019 by meeting and spending time with their advisors so that 2019 tax filing does not resemble that of 2018. Some are even making plans for refunds or little to no tax to occur from filing the 2019 taxes as early as possible in 2020 and discussing methods for safety regarding those taxes. There are not many material approaches that can resolve the tax situation in favor of the entrepreneurial laboratory owner. Probably one of the biggest impediments that no one saw coming to the extent that it did was the change in the ability to deduct personal real estate taxes and mortgage interest payments to the fullest extent that they were allowed as in past years. Those items used to be part of the tax planning that went into overdrive for the laboratory owner who had middle to high income results consistently from year to year. The following paragraphs attempt to offer some creative ideas to change things for the better for the laboratory owner in 2019 and beyond in a cost-effective approach for business and personal taxes.
Benefits of Pass-Through Income
There are always items that can be deductible that are not significant in amount if some time is spent working on the ideas and exhaustive record keeping needed to support those deductions. The laboratory CPA can assist by offering ideas that create some deductions for things that are already being undertaken but not thought of because of that record keeping nightmare to protect the minor amount of deduction that these points may offer. Many of the items were not thought to be worthy enough because the deductions were not meaningful compared to the aggravation in detailing them carefully enough to be able to offer support for them to the laboratory CPA. Because high real estate tax write offs and high interest deductions for those with high mortgages are now gone, the laboratory owner wants to find some new deductions to offset those lost tax savings that came from those items being deductible. For those with pass-through entities—such as almost all business organizations except for C corporations—the implementation of an employer-sponsored qualified retirement plan now is one of the most material concepts to consider. It allows large tax deductions to the dental laboratory, and those will pass through to the owner of the laboratory on his or her personal federal and state tax returns if the business entity allows for that.
There are so many things to consider when discussing what each type of retirement plan does for the owner and employees in the way of tax deductions and government approved tax deferred savings. In the past, the cost of participation for each employee many times would convince the owner to defer the implementation of the retirement plan because so much of the deductible contribution would be allocated to the employees and not to the owner. Now with the loss of the large personal tax deductions for mortgage interest and real estate taxes, the cost per employee has actually decreased since without the retirement plan, the net income tax to the owner has increased. By tax affecting the cost of the employees’ contribution, there is a much smaller cost for the employees, and the owner’s allocation is much greater at a lesser cost compared to the past computations with the adoption of a qualified employer sponsored retirement plan. In an example using a $10,000 total deductible contribution where there may be 10 employees including the owner, each would receive an allocation of $1,000 ($10,000 divided by 10). Now with the various types of retirement plans available, if the owner is willing to spend some time and money with an accountant who understands retirement plan allocation, the $10,000 deduction may be allocated as $5,500 to the owner and the other $4,500 divided by the 9 other employees, or $500 to each. Also, if an employee leaves before he or she is vested, that employee forfeits his or her $500 to the other retirement plan participants in the pro rata share of their prior allocations. That means that the owner would receive $5,500 (of the $10,000) or 55% of the $500 forfeiture from that prior employee ($275.00). Each of the other employees would receive their share which would be $225 (of the $10,000) or 45% among the remaining eight employees ($225 divided by eight—$28.13 each). There is some rounding so four employees get $28.12 and the other 4 get $28.13. You see how this benefits the owner. What occurs effectively now is that the laboratory receives a deduction that it did not have before the implementation of the retirement plan in our example of $10,000 and 55% is allocated to the owner before any employee terminations. This deduction as it passes through to the owner’s personal federal tax return in a state like New York, New Jersey, and California would save the federal and state tax rates as well as the self-employment tax of 15.2% on the $10,000. The total tax savings to the owner would be over 50%, or at least $5,000 of the $10,000. The employee allocation would be $4,500. Therefore the tax savings of $5,000 is more than the employee cost and allocation of $4500.
Qualifying Retirement Plans
The type of retirement plan used in the example above is known as an employer-defined contribution plan. This means that the amount of the deductible contribution to the employer is defined; in this case, the amount taken as the deduction was limited to $10,000. Most employers are familiar with this type of plan which is commonly known as a 401(k) or profit sharing plan. The maximum annual deferral from each employee’s compensation is $18,500 except for workers at least 50 years of age; the latter can defer up to $24,500 of his or her compensation and not have that amount reported as income until he or she withdraws the funds from the 401(k) plan. The laboratory has an opportunity to deduct and contribute a set amount that is typically determined by an actuary (or by the laboratory’s accountant if they do that kind of work). Amounts can vary but $25,000 is not an unusual sum available for a laboratory owner to use in addition to his or her own deferral. In this example, if the laboratory owner is age 50 or older, $24,500 can be deferred individually, plus as additional 55% of the company-deductible contribution of $25,000 ($13,750) for a total to the owner of $24,500 plus $13,750, equaling $38,250. These are hypothetical amounts, so each laboratory owner should consult with his or her own advisors for more precise numbers. The amounts stated should give approximate financial insight into what these types of plans can do for a laboratory owner who adopts a defined contribution employer sponsored retirement plan.
Other Retirement Plans to Consider
The above type of retirement plan is good when there are a lot of employees, especially those who are older since the deductible contribution is defined and no more than the allowable amount is permitted to be deducted and paid into the retirement account by the individual and the owner. There is another kind of retirement plan know as the defined benefit plan. This is also an employer-sponsored qualified retirement plan where, instead of the contribution being defined as in the prior paragraph, the benefit is defined. This means that the amount that is paid to the retired participant in the plan is known and guaranteed by the sponsor of the retirement plan. An example of the way this retirement plan operates is as follows. An actuary is needed who typically sits with the accountant or other financial advisor for the laboratory and reviews the past few years profits and expected earnings in the next number of years as well. Based on the affordability, the design of the retirement plan can present a non-discriminatory deductible contribution of $125,000 or more per year, most of which will be allocated to the owner based on the fact that the owner probably has reported more earnings than any of the other employees. It is also based on the fact that the owner is probably much older than the other employees.
The defined benefit plan costs more than the defined contribution plan to implement and to administer since the defined benefit plan is based on an IRS-approved formula designed by the actuary with tremendous input from the accountant or other financial advisor who is very much involved with the laboratory finances and projections. Guidelines for the allocation of the annual deductible amount are based on the age of the participants in the plan and the “normal retirement” date of the participants. As an example, if the owner was 60 years old and the “normal retirement” date was 67, the retirement plan must receive enough in deductible contributions to pay the owner’s benefit that is defined by the plan design. Hypothetically, if the plan design was to give the participants the average of the three highest years’ salary as the benefit, and if the average of that amount was $200,000, the plan must have received at least enough over the 7 years of the age 60 year old to the “normal retirement” age of 67 to amass enough to pay out $200,000 per year with a minimum number of years of payment guaranteed. Think about how much is needed in the first 7 years of this plan’s existence and what needs to be earned from year to year to guarantee the $200,000 per year payment. Retirement dates can be extended, earnings are counted as are losses, and the guaranteed earnings of the plan are part of the design that is sent to the IRS for approval. If the thought of a massive deductible contribution per year is considered, that is correct. This type of plan is geared for the specific instance where profitability of the laboratory is needed, and excellent accountants and actuaries should be consulted and retained for the adoption of this type of plan.
About the Author
Bruce Bryen, CPA, CVA, is the principal in the firm of RKG Tax and Business Services, LLC, in Fort Washington, Pennsylvania.