Tax Planning Issues Facing Dental Laboratory Owners
Staying abreast of the latest developments in tax law is crucial
By David J. Kramer, Esq, CPA; and Bruce Bryen, CPA, CVA
In January 2017, a new President and Congress were sworn in, and major changes to tax law certainly can be expected as a result. However, no significant changes were made to tax law for 2016 and 2017 other than inflation-adjusted limits on some deductions and the extension of tax incentives that had been set to expire. In the coming months, particular attention should be paid to new tax legislation that could impact which form your business should be operated under, and transactions that should be completed before the end of this year.
Tax Considerations in Choice of Entity
Several choices exist for how to designate a dental laboratory. The primary choices are either a corporation or a limited liability company (LLC). The taxation under each type of entity differs. The choice of entity should be examined relative to your individual income tax situation, so consultations with a tax advisor are especially important.
Identifying as a corporation is usually not advantageous due to the potential for double taxation. Net income is taxed at the corporate level and is also taxed at the shareholder level if a dividend is paid. Also, for a startup company that has net losses in its early years, those losses cannot be used by the shareholder.
To alleviate this problem, one may file an election with the Internal Revenue Service to be designated an S corporation. An S corporation is considered a pass-through entity, which means that income and losses pass through to the individual shareholders in proportion to their ownership interests. Income and losses are reported on the shareholder’s individual income tax returns. This may be tax beneficial in the early years of the business when losses may be expected due to significant equipment purchases.
In order to deduct losses from an S corporation, you must have basis in the stock and debt of the entity. It is very important that the capital and debt structure of the business is reviewed by your tax advisor so that you can avail yourself of any losses being distributed to you by the entity.
An LLC is an attractive alternative to a corporation. It gives you liability protections like a corporation would but provides more flexibility in its operation. For example, an S corporation can only make cash distributions to shareholders based on their ownership percentage, but an LLC can make disproportionate distributions. Also, there is a limit on the number of S corporation shareholders, but there is no limit on the number of LLC owners.
Similar to an S corporation, an LLC can be treated as a pass-through entity whereby its income and losses are passed through to each owner as determined by its operating agreement. However, unlike an S corporation, income distributed to active LLC members will be subject to self-employment taxes (Social Security and Medicare).
Tax Benefits on Acquisition of Equipment
Equipment purchased for the laboratory can be deducted through depreciation or an expense election. For new property purchased in 2017, bonus depreciation of 50% of the cost of acquiring the equipment is allowed as a deduction. The balance of the purchase price is deducted over a period of generally 5 to 7 years based on the type of item acquired. There are no income limits on bonus depreciation, so significant equipment purchases could create a business loss available to offset taxable income from other sources, such as wages or investments.
Another option in deducting the cost of new or used equipment purchased is electing under Internal Revenue Code Section 179 to expense the entire amount of the acquisition cost. In 2017, the limit on the deduction is $510,000; it was $500,000 in 2016. So, if you purchased $700,000 of equipment, you could elect to expense $510,000 and the balance of $190,000 would be depreciated.
Unlike bonus depreciation, you cannot reduce net income below zero when utilizing the Section 179 deduction. Any excess deduction can be carried over to subsequent years. Whether you should use bonus depreciation or the 179 deduction depends on your current and projected future income. Your tax advisor should be able to determine which option provides the optimum tax result.
Retirement Plans for Laboratory Owners
It is never too early to begin saving for your retirement. As a laboratory owner, you have many types of retirement plans available to meet your retirement goals. The plan you choose will ultimately depend on how large your business is and how much you are comfortable contributing.
The easiest plans to administer are employer-sponsored IRAs, which include the Simplified Employee Pension IRA (SEP IRA) and the Savings Incentive Match Plan IRA (SIMPLE IRA). The SEP IRA is easy to set up and is best if you have only a few employees. You make a contribution to each employee’s retirement account (including your own) of up to 25% of compensation. The maximum contribution is $54,000 in 2017 ($53,000 for 2016). You are not required to make a contribution every year, but you must contribute the same percentage for employees that you contribute for yourself.
A SIMPLE IRA allows employees (and you as the business owner) to contribute up to 100% of compensation through salary deferral, which cannot exceed $12,500 for 2017 and 2016. A catch-up contribution of up to $3,000 is allowed for those over age 50. You as the employer must match your employees’ contribution up to 3% of their compensation, or contribute 2% on behalf of all eligible employees.
A widely used retirement plan is a 401(k). There are variations of this type of plan that include a solo 401(k) and a safe harbor 401(k) profit sharing plan.
Solo 401(k) plans are for single-employee businesses (owner-operator) and may also include a spouse if employed by the business. A solo 401(k) plan may allow for larger annual deductible contributions than other plans. Between the deferral of income by the employee/owner and the employer contribution, a $54,000 maximum contribution ($60,000 for those ages 50 or older) is allowed in 2017 ($53,000 and $59,000, respectively, in 2016).
Safe harbor 401(k) plans require that employer contributions are vested immediately. This means that employees can withdraw all the money in their retirement account when they leave your laboratory, no matter how long they have been employed. The trade-off is that the plan is easier to administer.
With a safe harbor 401(k), an employee may defer up to $18,000 of compensation ($24,000 if age 50 or over) in 2017 and 2016. You as the employer must either match each employee’s deferral contribution 100% up to the first 3% of employees’ compensation plus 50% of the employees deferrals on the next 2% of compensation, or you may choose to make a 3% non-elective contribution for all eligible employees. The maximum contribution (employer plus employee) cannot exceed $54,000 ($60,000 if age 50 or over) in 2017 ($53,000 and $59,000, respectively, in 2016).
The most beneficial retirement plan for an older owner is usually a defined benefit pension plan. This plan obligates the employer to pay employees a specific benefit for life beginning at retirement. The amount of the benefit is based on such factors as age, earnings, and years of service. There is no contribution limit with these plans. Older employees and higher compensation will lead to a larger employer contribution.
Defined Benefit Plans are great for owners who are older than their employees. These plans can even be set up for a laboratory with a single employee.
In choosing the right retirement plan, it is important to not focus only on the contributions required by each plan, because the contributions are income tax deductible. As such, the tax benefit may offset the contributions allocated to your employees. For example, if the total contribution is $50,000 and you are in the 39.6% tax bracket, the tax benefit is $19,800. If the contribution allocated to your employees is less than or equal to $19,800, the tax benefit funded that contribution.
It is still early in 2017, so this is the optimal time to plan for the year. Keep in mind that proper tax planning considers not only the current year but projects the effect on future years. This makes it all the more important to consult with your tax advisor before choosing the appropriate plan.
David J. Kramer, Esq., CPA, is a Partner and Director of Tax Services Department at Robin Kramer & Green, LLP in Fort Washington, Pennsylvania; Bruce Bryen, CPA, CVA, is Principal of Robin Kramer & Green, LLP.