[Editor's Note: This guest post is an interview of Diane Kennedy (USTaxAid.com) by real estate investor and physician Dennis Bethel (NestEggRx), who is a previous advertiser here at WCI. Dennis sent me this excerpt from the interview as a guest post as he thought it might be useful to WCI readers. I agreed. I have no current financial relationship with either of them.]
Diane Kennedy is a best selling author, CPA, tax-strategist, business consultant, and educator who owns www.ustaxaid.com. While I had read many of Diane’s books, I didn’t meet her until I was a few years post-residency and realized that I had a tax problem.
Despite hiring a local CPA, I was paying excessive amounts of taxes. Even worse, every time I suggested a way to reduce my tax burden it was rejected off hand. Taxes were easily my biggest expense and I had a sinking feeling that I was overpaying. When I discussed the topic with my colleagues, they were in the same boat. That’s when I turned to Diane.
Diane reviewed my taxes and informed me that I was overpaying significantly. She helped me right the ship and my annual tax savings funded my yearly SEP-IRA contribution with money left over. In fact, on average Diane saves her clients $28,000 a year. Consequently, I thought interviewing Diane would be helpful to the White Coat Investor readers. Diane, graciously let me interview her on March 11, 2015. A portion of the transcript is below:
NestEggRx: I got an email last year from an Ob/Gyn lamenting his tax burden. He said he had already paid $65,000 in federal taxes and got a letter that he owed more. What percentage of doctors do you see that are paying more tax than they need to?
US Taxaid: Easily 95% of the doctors that I consult with are overpaying. They typically are looking for a CPA with a tax strategy viewpoint as they know something is wrong and that they need to do things differently.
To compound that issue, taxes are so much worse today. Take for example the new Medicare surtaxes on W-2 income and the 3.8% tax on passive income. Also note that the top federal tax bracket is now 39.6%. I call this a sneaky tax, because many people believe that it is only a 4.6% increase over the previous top bracket (35%). However, when you do the math (4.6 / 35) you actually get just over a 13% increase in tax. Additionally, what used to be typical deductions are phasing out. When you combine all of this, high-income doctors are just getting slammed.
NestEggRx: I couldn’t agree more and I fear that it’s getting worse. Merritt Hawkins (one of the leading physician recruitment companies) does an annual study that has clearly documented a trend toward hospital employment. That report shows that while only 11% of recruitment in 2004 was for hospital employment, it has climbed to a whopping 64% in 2014. Regrettably more and more doctors are receiving W-2 income instead of 1099 or K-1 income…..and W-2 income means higher taxes doesn’t it?
US Taxaid: That is a great question, because unfortunately the consequences of being an employee are tough. You simply don’t get the same deductions. Let me share with you a case study I did a few years back. I looked at the taxes of a guy who made $50,000 a year as an employee. The following year, he took a similar position as an independent contractor for the same $50,000.
When it was all said and done, he paid almost $10,000 less in tax. The difference was that he was able to take write-offs that he couldn’t take as an employee. The list of deductions that are legal and possible go on-and-on, but they are unavailable to W-2 employees. Now I know that doctors typically make significantly more money than that, however, the tax-savings that are possible from 1099 income versus W-2 income is scaleable. [No, I have no idea why someone with a gross income of $50K is paying even $10K in taxes (since the federal tax liability for a family of four with a gross income of $50K is $1488 without any creative tax strategizing), nor how someone in that income range can reduce their taxes by 20% of their gross income without significantly affecting their lifestyle.-ed]
Now just to throw out a possible solution to this dilemma, I know a lot of physicians that are doing more than one thing. Some do things like clinical trials, expert witness, consulting, and various other jobs that could create 1099 self-employment income. If that is the case, then you can become eligible for all of those deductions.
NestEggRx: Let me ask you a question about two areas of potential deductions that I see as viable for many physicians – home office deductions and owning a car through a corporation. I know several doctors who are reluctant to utilize these, what are your thoughts?
US Taxaid: I run into these questions all of the time. The fear of the home office deduction stems from a somewhat famous 1993 case that was brought before the US Supreme Court. In that case, Dr. Soliman, an Anesthesiologist, was denied the home office deduction. However, Congress essentially nullified that decision in 1997 when they passed new law.
In order to legally take this deduction, you simply must comply with two rules – the space must be exclusively and regularly used for your business. Exclusively means that it can’t be the kitchen counter or a corner of the dining-room table. Instead, it should be an extra room, the basement, or some other separate space. Regularly means that you routinely do business related tasks from that office space and that can be as simple as checking emails or reviewing diagnostics. Consequently, the home office deduction post-1997 really is a non-issue as far as an audit red flag.
On the other hand, the vehicle can be a red flag depending on how you report it. You see, you are suppose to keep track of the mileage driven for business related tasks. As far as the IRS is concerned, no small business uses a vehicle for 100% business purposes. They believe you use that car for personal reasons too. So if you try to report 100% business use, then yes it can be a red flag. You are much better off taking less than 100%.
The old system of keeping mileage logs of your business driving can be onerous. However, there are some pretty cool apps that you can use on your smartphone now. Milebug and Mile Tracker are two examples. You simply turn them on when you are going off for business and turn it off when you are done. These programs use GPS to calculate your mileage and that is enough to prove that you have business use on your vehicle.
[Editor's Note: Remember that commuting isn't business use of a vehicle.]
NestEggRx: Given that doctors pay such high taxes, I guess the most important question is what are some of the best ways to reduce that tax burden and what investments stand out as having exceptional tax savings?
US Taxaid: Other than utilizing tax-deferred retirement accounts, it really has gotten down to just real estate. Certainly there are investments that are tax advantaged under the usual personal tax system. However, many doctors fall into the alternative minimum tax (AMT) and many of those investments are not AMT friendly. At their level of incomes, they need to look for deductions that work for both the personal tax and the AMT. Frankly real estate is the best thing going.
At the very least, real estate purchased well will likely provide one with an asset that increases in value and spins off cash-flow. Depreciation allows one to off-set that income and refinances allow one to harvest their equity without having to pay tax on it. So you have something that is going up in value, gives you tax-savings, and creates cash-flows. I don’t know of anything else that does all of those things.
NestEggRx: I’m glad you brought up real estate as I am clearly a huge fan of this asset class. Can you discuss the real estate professional designation?
US Taxaid: Yes, real estate professional status allows one to take their depreciation losses against their other income. There are some specific rules around these that include having 750 hours or more a year working in real estate including material participation. You also have to do more hours in real estate than in any other career. For that reason alone, the vast majority of working physicians would not qualify.
However, even without the real estate professional designation, owning real estate still has significant benefits. At the very least, developing streams of income that you don’t have to pay tax on is quite material. That is what you get with real estate. [Technically speaking, the income, if any, is only tax-free if your profit minus expenses, including depreciation, are $0 or less. And unless you exchange (rather than sell) the property, or hold it until death, that depreciation deduction is recaptured at the time of sale. Just because income comes from a real estate investment DOES NOT make it tax-free income. Real estate rents are taxed at your regular, marginal tax rate and long-term gains are taxed at capital gains rates. There are lots of “tricks” that can be used to help reduce the tax burden (such as depreciation) but in reality, most of these are actual costs to the investor and thus completely legitimate deductions.-ed] NestEggRx: Along these same lines, I’ve heard of another strategy that reduces physician taxable incomes using real estate without needing the real estate professional designation. Some of the doctors and dentists I’ve helped diversify into commercial multifamily real estate use income splitting to pay themselves. Part of their income gets paid as excess distributions via a K-1. When they invest passively into commercial multifamily real estate, they get the benefit of depreciation and accelerated depreciation from a cost-segregation study. Consequently, even though their real estate investments have made them money, they get the side benefit of a paper loss on their K-1 at the end of the year. They can then subtract those real estate K-1 losses against their K-1 gains in their profession and effectively reduce their tax. Couldn’t doctors or groups of doctors who own their own building use this same strategy to further reduce their overall tax from their medical and dental practices? US Taxaid: Absolutely, everything you just said is true. It is not uncommon for high earning doctors to take some of their income as excess distributions which helps to minimize employment taxes. Doctors can absolutely use the depreciation in their own office building to offset their K-1 gains to effectively reduce their income tax. In this scenario, they will likely be holding the building in an LLC instead of in their medical corporation….but yes, you can absolutely do that.
NestEggRx: Wow, that is huge.
US Taxaid: Yes, it really is. If you could save $30,000 a year in taxes, and in some of these really high income specialties it is not unheard of for us to save them as much as $50,000 a year….if they take that savings and put it into real estate annually, by the time they retire it is huge. The difference for themselves and their families is significant.
NestEggRx: I could talk real estate until the cows come home. However, let’s wrap this up with how tax strategists are different from your garden variety CPA?
US Taxaid: CPAs fall under a large umbrella. It’s a big group. There are CPAs that specialize in SEC work, or audits, or financial statements, and the list goes on. So first of all, you need to make sure that the CPA you’re working with is involved with tax primarily. Another important component, however, is a tax strategy.
Tax strategists tend to be more proactive. Certainly, we will talk to you about the previous year and get your return done. In general though, our main focus is going to be on what do we need to do this year and the year after so that you can pay less tax. Typically, one to five years is a minimum outlook for a tax strategist.
When you hear stories about guys like Buffett and other rich guys who have really minimized their tax burden, legally, they are able to accomplish this primarily by looking forward and mapping a winning strategy that allows them to take advantage of all the tax breaks available to them.
NestEggRx: Thank you Diane. It is always illuminating talking with you and I seem to always learn something new.
US Taxaid: It was my pleasure Dennis.
What do you think? Do you use a CPA or other tax preparation professional? Do you see someone you would consider a tax strategist? Why or why not? Comment below!