The Private Physician Practice’s Early Planning Considerations Under the New Tax Law

The implementation of Pub. L. No. 155–97, referred to as the Tax Cut and Jobs Act of 2017 (the “Tax Act”) on December 22, 2017 represents one of the most fundamental shifts in the taxation landscape since 1986, the last major recodification of the Internal Revenue Code of 1986, as amended (the “Code”). How quickly the Tax Act became law surprised many, and left tax advisors scrambling during the holiday season, answering questions from curious clients while still having to deal with last minute 2017 tax planning and spring 2017 tax due dates under the old regime.

With the lowering of the federal corporate income tax rate to 21%, for example, a majority of physician practices (typically structured as “pass-through”) entities questioned whether they should direct their tax advisors to convert to a “C” corporation for federal income tax purposes. For better or for worse, larger non-service providing corporations stand to receive the most tax savings under the Tax Act, while larger specialty physician practices benefit less.

In response to the common refrain that physicians should hear from qualified tax advisors this early in the lifetime of the Tax Act, in general, major restructurings of private physician practices should be avoided until their tax advisors can carefully evaluate the new laws in the context of their specific clients’ practices. One major caveat is that as of the date of this article, beyond the text of the Tax Act, administrative guidance is only now trickling in on various Tax Act provisions that sorely need guidance. Newly defined terms within the Tax Act, for example, have only general definitions that the Internal Revenue Service (“IRS”) will almost certainly further refine, expand, or limit, in subsequent administrative rulings and notices.

For these reasons, quickly changing the form of the physician practice should be avoided. There will be no “one size fits all” structuring solution for an existing physician practice. What is important is that physician practices be aware of the new concepts created by the Tax Act that will have impact on their final tax bill. This article seeks to introduce physician practices to key provisions¹ under the Act, maximizing awareness when consulting with tax advisors for tax planning.

New Tax Rate Considerations

1. Individual Rates

Clearly the major accomplishment of the Tax Act was the overall reduction in tax rates; which take effect now in 2018, and expire after 2025. Already as of the date of this article, payroll withholding is being adjusted to take into account reduced individual tax rates. The following chart shows the individual rate brackets in effect for 2018. On an annual basis, the IRS will use the Consumer Price Index (CPI) to adjust the rate bracket’s income amounts to account for inflation.

See Table 1 for the 2018 federal individual tax rate table (which would apply to physicians structured as sole proprietorships, as well as non-capital gain distributions and “pass through” ordinary income from physician practices, with taxable wages.²).

Table 1.

Individual Tax Brackets and Rates, 2018³

Rate	For Unmarried Individuals, Taxable Income Over	For Married Individuals Filing Joint Returns, Taxable Income Over	For Heads of Households, Taxable Income Over
10%	$0	$0	$0
12%	$9,525	$19,050	$13,600
22%	$38,700	$77,400	$51,800
24%	$82,500	$165,000	$82,500
32%	$157,500	$315,000	$157,500
35%	$200,000	$400,000	$200,000
37%	$500,000	$600,000	$500,000

2. Corporate Rates

The new “C” corporation tax rate is now a flat 21 percent, with no graduated corporate tax rate schedule and, importantly, no flat 35 percent “personal service corporation” tax rate that would apply to physician practices structured as “C” corporations under the rules in place prior to the Tax Act.⁴

This rate would apply to any net income of a “C” corporation that remains after paying practice expenses, including compensation. The emphasis here is that the 21% rate applies to “net income” of the “C” corporation – there still must be salary and other compensation paid to the physician before arriving at net income. The salary and other compensation (such as bonuses) will be taxed at the higher individual tax rates even aid within a “C” corporation. Historically physician practices structured as “C” corporations would zero out net income anyway by maximizing the compensation deduction. So, while in concept the 21% tax rate for “C” corporations is attractive, the actual benefits may be limited for many physician practices already structured as “C” corporations.

Moreover, the traditional disadvantages of the “C” corporation remain. There is still double taxation of any net income paid out as dividends; and, for any early stage business, net losses are trapped in a “C” corporation (rendering any pass-through of losses to shareholders impossible except through sale or liquidation).

New Tax Deduction for “Pass-Through” Entities (non-“C” corporation entities and sole proprietorships)

Since “C” corporations have a major reduction in the tax rate to 21 percent (down from the previous highest marginal rate of 35 percent), the Tax Act implemented a new 20 percent “qualified business income” deduction, or the “QBI deduction.”⁵ In principle, at least, the QBI deduction was intended help put on a more equal standing, tax-wise, the sole proprietorships, partnerships and limited liability companies (“LLCs”) and “S” corporations (called “pass-through” entities”) which do not have benefit of the low 21 percent tax rate applicable to “C” corporations. Generally, pass-through entities can take this new QBI deduction against their taxable net income (although not, unfortunately, against their net income for self-employment tax purposes). As will be seen below, while the new QBI deduction is a consideration for the physician practice, its utility is still in doubt.

1. QBI Caveat #1 – Difficulty in QBI Deduction Calculation

While the principle of the QBI deduction is commendable; its application is not because the mechanics, limitations, thresholds, and definitions surrounding the QBI deduction are not simple and will create headaches for tax compliance, as well as challenges for the IRS in its administration. If simplification was a goal for the Tax Act, that goal was missed. As will be seen in the discussion below, the majority of larger private physician practices will be unable to use the QBI deduction for the medical service-providing aspect of their business.

The QBI deduction is calculated, very generally, as the lesser of (i) 20 percent of a taxpayer’s “qualified business income” from the pass-through entity (including a sole proprietorship); or (ii) the greater of (a) 50% of W-2 wages or (b) 25% of W-2 wages plus 2.5% of the “unadjusted basis of the taxpayer’s assets.” These amounts are determined, in the case of a taxpayer that is a part owner, with reference to the allocable share of such amounts (not the whole).⁶

The “qualified business income is trade or business income, and is intended to exclude investment income such as dividends and capital gains. Moreover, “trade or business income” does not include W-2 wages paid to an owner as an employee (which is usually seen in the context of “S” corporations). And the QBI deduction cannot exceed 50 percent of the total W-2 wages paid by the business.⁷

2. QBI Caveat #2 – Physician Practices Generally Excluded

The emphasis here on the above QBI deduction explanation, is “very generally.” The actual QBI deduction is more complicated than in the brief description above, and even once the calculation is nailed down, the QBI deduction is not going to be available to most physician practices! This is because of a key exclusion (with its own exceptions). The QBI deduction is not available to more profitable physician practices because “specified service trade or businesses” are excluded from taking it. These “specified service trade or businesses” include the performance of services in the fields of health, law … accounting, actuarial science, performing arts, brokerage services, or “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of it employees.”⁸ As such, physician practices, where medical services are performed, are largely ineligible to take the QBI deduction. The rationale here is that such service providers, if able to easily take the QBI deduction, would simply be able to convert wages that they would otherwise get as an employee (taxed at the higher individual rates) into essentially the tax-favored corporate rates.

As a concession to smaller family and rural practices, however, the QBI deduction is still available for even owners of specified service trade or business if their taxable income is less than $315,000 (for joint filers) or $157,500 (for single filers).⁹ Those practices (typically small sole proprietorships or disregarded professional limited liability companies) should have their tax advisors pay particular attention to the QBI deduction. There is a phase-out as the taxable income exceeds those thresholds, such that the QBI deduction is completely phased out at $415,000 for joint filers or $207,500 for a single filer.

3. QBI Caveat #3 – Clarifying Regulations that May Close Loopholes May be Forthcoming; Consider Non- Tax Reasons for Any Restructuring

Now, given the complexity of the QBI deduction, what are the practical aspects that the private physician practice should focus on? A caveat is that because no clarifying regulations have been issued, the IRS may see early proposed strategies as loopholes and shut them off. Some options make sense from a non-tax, liability protection standpoint, so to the extent a physician practice contains fixed assets of significant value, such assets, such as real estate or investment property, would be better off in a non-practice entity. The physician practices should balance the additional complexity created by separation of entities (especially with multiple owners and governing documents) and decide whether some tax savings and liability separation is worth the considerable administrative expense.

A. Consider separation of any non-medical practice components of the physician practice into separate entities. Larger physician practices may have sources of revenue that are not tied to the provision of physician services. Development of intellectual property, teaching/writing, surgery center development, real estate, equipment purchase/leasing, might be considered as activities that should be separated out from the physician practice businesses to take advantage of a potential QBI deduction. Naturally, there are liability reasons to do this as well, if not already done.

B. To the extent that the income level of a physician may be under the $415,000/$207,500 thresholds described above, pay particular attention to the timing of deduction and recognition of income to ensure the benefits of the QBI deduction will be taken. Invest in quality tax professionals to ensure the correct calculations are made in obtaining this QBI deduction. Particularly in the case of solo family practitioners which may purchase its own real estate and pay a fair market rental value to a wholly-owned real estate entity.

Specific New Provisions of Interest to the Physician Practice

1. Cash Method Changes

A key change that will impact many larger private physician practices is the ability to use the cash method of accounting for its practice. Previously, corporations, partnerships and LLCs must use the accrual method of accounting if they exceed $5 million in average gross receipts for the prior 3 taxable years. That $5 million threshold has been increased considerably to $25 million; moreover, this rule applies regardless of entity structure or industry.¹⁰ Practices with significant timing issues between billing and actual receipt may consider whether deferral of income tax recognition to cash will be worthwhile (keeping in mind accrued expenses may not be currently deducted under the cash method). Changes in accounting method require a formal request be made with the IRS, via “Form 3115.”

2. Completed Contract Method of Accounting

The Tax Act contains a bit of a windfall for some smaller construction industry taxpayers, which will also indirectly impact physicians engaged in construction projects with surgery centers and hospitals. Construction contractors who engage in projects that may take several years to complete will be able to defer recognition until a project is completed (using the “completion method of accounting”) as opposed to recognizing revenue over time (the “percentage of completion” method). The threshold for construction contractors to use the “completion method” was previously $10 million in annual gross receipts or under; that number has increased to $25 million.¹¹

3. Increased Section 179 Expensing

A significant boon for all business taxpayers is the ability to take a 100% “Section 179” immediate expense deduction, up to $1 million of eligible new property placed in service before January 1, 2023 (the previous limit was $500,000). Also, where previously, the Section 179 expense deduction “phase-out” threshold was $2 million (after which the Section 179 expense ability is reduced dollar for dollar) was increased to $2.5 million. In addition, certain improvements to non-residential real property, such as roofs, heating, ventilation, air conditioning, and fire and alarm projection now qualify for Section 179 expensing.¹² These all help reduce the cost of equipment and key property improvements for the physician practice.

4. Elimination of Non-Meal Entertainment Expenses/Limitation on Deductible Staff Awards

A tax break previously afforded to larger physician practices was the 50% deduction for entertainment costs for entertaining clients; this deduction was substantially rolled back and the only amount that may be deducted now is 50% of the costs for meals.¹³ This eliminates the ability to write off costs of sporting events, event tickets, and club dues. Office holiday parties may continue (no word on whether you can combine a party with a client event).

Staff fringe benefit rules are adjusted as well; employee achievement awards must be in the form of tangible personal property and not cash, gift cards, tickets, meals, lodging, or stocks and bonds.¹⁴ Practices with significant write-offs for staff awards may want to review its policies going forward.

Businesses may no longer deduct the cost of employee parking and transit passes, although employees who still receive the benefit do not have to recognize the cost as income.¹⁵

5. Litigation-Related Tax Changes

No physician practice ever wants to be hit with regulatory violations; however, in the event of such an unfortunate occurrence, the Tax Act has new provisions that the practice counsel should be aware of in structuring settlements. Previously, while fines and penalties paid to a governmental entity for any violation were not tax-deductible (punitive payments), compensatory payments, including False Claims Act and environmental remediation penalties, were deductible. Now, under the Tax Act, there is a general prohibition of tax deductions for any payments made to or at the direction of a government, governmental entity, or regulatory entity in connection with a violation of law or an investigation into a violation.¹⁶

The narrow exception for tax deductions that remain are for payments that constitute “restitution (including remediation of property) for damage or harm related to the violation or potential violation of law.¹⁷ Amounts paid for the costs of the investigation or litigation are not deductible. The amounts that constitute “restitution” must be identified in the relevant court order or settlement agreement, and the governmental entity or regulatory agency must file an information return with the IRS reporting the deductible amounts.

And in response to the #MeToo movement, the Tax Act prohibits any deduction for amounts paid for any settlement or payment relating to sexual harassment or sexual abuse, or any attorney’s fees related to any settlement or payment if such settlement or payment is subject to a confidentiality or nondisclosure agreement.¹⁸

Conclusion

The common refrain that the physician practice will hear from qualified tax advisors, following the passage of the Tax Act, should be to avoid major restructurings without careful consideration of all aspects of the practice. The most common question will be whether the more favorable “C” corporation tax rates will justify a change from pass-through status to that of a “C” corporation; but since the rates will generally only apply to income after payment of a reasonable salary, the benefits are not as clear cut as a straight up reduction. There is an old lesson in tax law classes – the “C” corporation is like a lobster trap – easy to get into, nearly impossible to get out of. Pass-throughs still contain more flexibility in operations and liquidation transactions, so currently, are still favored.

The QBI deduction is new, so most commentary suggests awaiting further analysis and IRS regulatory guidance before any major restructuring is done to attempt to take advantage of the new deduction (if at all possible). That being said, private practices with income that falls under the $415,000 joint filer/$207,500 single filer thresholds should take care to ensure their tax return preparers take into account this deduction when the 2018 returns are filed next year.

Finally, numerous other provisions discussed in this article will impact the physician practices to some extent, particularly with respect to the increased Section 179 expensing amount. This benefit will permit younger physicians to jump-start their practices by permitting significant capital investment with less of a tax burden than in prior years. While tax considerations are only one factor driving the business decisions of a physician practice, a good awareness of its changes will help physicians make appropriate decisions through 2018 and beyond.

Biography

Albert Lin, JD, LLM, is a partner in Austin, Texas, office of Husch Blackwell. The information contained in this article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and readers are urged to consult their own attorney concerning their specific situation and specific legal questions.

Contact: Albert.Lin@huschblackwell.com