I've been getting hammered with questions about the new tax law and forums are aflame with discussion about it. So although I generally favor “ever-green” content, I guess I'll have to write about this and do it sooner rather than later. This will be a long post; it won't cover every single change out there, but it will cover the most important ones to you. There will be at least one follow-up post about it as well.
The Politics Behind the Tax Cuts and Jobs Act
First things first, in order for you to understand what happened, we'll have to address the politics of the situation. I'm hesitant to do so because political discussions tend to generate more heat than light, but without at least briefly outlining what happened, a lot of the changes don't make sense. There is no more political topic than tax law changes. It is the ultimate political topic. A political topic is one in which reasonable people can disagree on the best thing to do. In this respect, the Republicans won the overall war, but the Democrats won the PR battle. Apparently they managed to convince Americans that most of their taxes are going up. According to a recent Vox poll, only 14% of Americans believe they'll see a tax cut. That number is probably closer to 86%, but most Americans, including many financially savvy doctors on this site, don't actually understand how the tax bill works. Will the tax bill for some people go up? Yes, but it is a very small percentage, and they're in all of the tax brackets (and mostly in high tax, high COLA states.)
The second aspect of politics that you need to understand to “get” what happened is that the Democrats decided not to work with the Republicans and the Republicans decided not to work with Democrats. So that means the Republicans had to get all of the votes required to pass this things themselves, a bit like when PPACA was passed after the 2008 election. Unlike back then, however, the Republicans didn't have a filibuster-proof majority in the Senate. That means they had to pass the law in the Senate under special provisions that allowed them to pass it with a simple majority. These “Byrd Rules” (i.e Reconciliation) were key to why some things happened and some things did not. This caused some desired changes to be left out or compromised on because they simply couldn't be done under the Reconciliation process. The most important of these was the “sunsetting” of many of the tax cuts in 2027, similar to what happened with the Bush tax cuts. Republicans don't actually believe that a future Congress will let them sunset. They think they'll be made permanent. I think it's hilarious that any politician or American would ever call any tax law “permanent.” This portion of the law combined with a lack of understanding of the tax code is what allowed Democrats to win the PR battle. Democrats could point out that the corporate tax cuts were “permanent” but the individual tax cuts were “temporary.” Well, 10 years is about as permanent as tax law ever is anyway. We'll see in ten years.
The third aspect to understand is that some Republican senators had to be “bought off” to pass the law. This sort of thing isn't uncommon, and used to be far more common before all the anti-pork rules were passed and the 24 hours news cycle and social media put Congress under a microscope. Law-making is a sausage factory. It's not something you want to watch. So you end up with a promise to Senator Collins to do some work on health care, you end up with ANWR being opened to oil development to get Murkowski's vote, you end up with a larger child tax credit to get Rubio and Lee etc. You also ended up with a compromise $10K state income/property tax deduction to get some of the Blue/High Tax state Republicans on board instead of eliminating that completely.
All of those compromises really watered down the tax reform aspect of the package. A major goal of Republican leadership was to simplify the tax code, i.e. Tax Reform. The main concept behind tax reform is dramatically lowering tax rates across the board, but eliminating a lot of the deductions. Theoretically, that reduces the time and expense we all spend suffering through our tax code. There were a few minor reforms, but not nearly as many as I would have liked to see and as near as I can tell, the Republican leadership and President Trump (who wanted us to be able to do our tax returns on a postcard) would have liked to see. Everyone has a pet deduction and doesn't want to lose it, but taken together, all of our pet deductions have made a monstrosity. This is all politics. We all want government to do more for us, but we don't want to pay for it. We'd all rather spend someone else's money.
Finally, it must be acknowledged that there is a philosophical difference between the parties. One believes firmly that you can better decide what to do with your money than government can and generally advocates for a less progressive tax code. The other party believes that a larger government can make life better for all of us and advocates for a more progressive tax code. It should be no surprise to any of us when that first party is in power and passes laws that the code becomes less progressive and when the second party is in power and passes laws that the code becomes more progressive. That's just politics. As President Obama famously said, “Elections have consequences.” This election did have the interesting effect of seeing Democrats posturing as deficit hawks, the usual position of the Republicans. But again, that's just politics. When Democrats want to spend more, the Republicans scream about the deficit. When Republicans want to cut taxes, the Democrats scream about the deficit.
With that lengthy explanation of the politics behind all of this, let's leave politics behind for the rest of this post (AND THE COMMENTS SECTION–I'll be deleting all comments related to politics there.) But I think it really is critical to have a basic understanding of the politics of the process to make any sense of the rest of this. Now take a deep breath, realize that your political opponents are your fellow Americans with a simple difference in opinion rather than Nazi stormtroopers or Communist fools, and let's talk about how this will affect the financial lives of doctors.
Corporate Tax Reform
The biggest changes in the tax code are changes to the corporate tax code. I'll gloss through these because they don't have as direct of an effect on your life as the changes to the individual tax code. There is a major political argument here between the two parties. Republicans believe lowering the tax burden on corporations will help the American economy. Democrats see it as a giveaway to the wealthy. A bit of perspective on this topic. First, corporations are us. Just like raising tariffs to pay for government is just a different way to tax us (raising the cost of what we buy), taxing corporations is just a different way to tax ourselves. You can charge tariffs, tax corporations, or tax individuals. It's really all the same. If one method results in a more efficient way to accomplish what needs to be done, wonderful. But neither politicians nor economists can agree on this topic and I'll be honest, I have no idea what the right combination of tariffs, corporate taxes, and individual taxes is. There is no doubt that taxing corporations less makes our tax system LESS progressive, since wealthier people tend to own a larger percentage of corporations. But those are also the same people paying most of the individual tax burden.
The main changes here are lowering the maximum corporate tax rate from 35% to 21%, eliminating the corporate Alternative Minimum Tax (AMT) and making it more advantageous for corporations to bring money that has been kept overseas back to the US. These changes should show up in your portfolio as better returns on your stocks. This is likely a major reason for the excellent stock market performance in 2017. I still don't see a good reason for doctors to form their own C corporations. Even if you're only paying 21% on your corporate tax returns, you're likely going to be paying 23.8% on the dividends from that corporation. 44.8% is definitely more than the top individual bracket.
Pass-Thru Entity Deduction
This topic is of sufficient importance to physicians that I will be hitting it in its own blog post coming up, but we'll hit it briefly today. It isn't just C corporations that are getting a break. It is also pass-thru entities such as sole proprietorships, partnerships, LLCs (taxed as sole proprietors, partnerships, or S corps), and S Corps. The idea here is that you get a deduction for a portion of your business income. That is NOT the income you pay to yourself as salary. It's the rest of it. Many docs and other small business owners have been doing this for a long time in order to save payroll taxes by taking an “S Declaration” (turning a C corp or an LLC into an S Corp for tax purposes.) You split your profits into salary and distribution and only pay payroll (SS and Medicare) taxes on salary. Well, now that pass-thru business income (both salary and distribution) qualifies for lower income taxes too. Basically, you get the lower of 20% of the business income or 50% of what you paid in salaries as a deduction. So, for example, if WCI, LLC makes $1 Million and pays $300K in salaries in 2018, then it's deduction would be the lower of 20% * $1M = $200K or 50% * $300K = $150K. Given our 37% bracket, that deduction would be worth 37% * $150K = $55,500 off of our tax bill. Actually, it's even smaller than that. That 20% number isn't calculated on the business's gross profit, but on your taxable income. Complicated, I know, but suffice to say there will be some deduction there.
Unfortunately, Congress hates doctors. Don't feel too badly. It also hates lawyers, accountants, and financial advisors (but not engineers or architects or bloggers.) These “service businesses” have this deduction severely limited. As long as your taxable income is under $157,500 ($315,000 married) you're fine. You take it just like non-service businesses. Between $157,500 and $207,500 ($315K-415K married) of taxable income, it phases out. Above $207,500 ($415K) you don't get ANY deduction, even on the first $207,500 ($415K) of pass-thru income. So lower paid doctors, lawyers, accountants, and financial advisors are likely to see a deduction, but higher paid ones will not. It's going to be a major tax preparation hassle going forward and will make it a little harder to do your own taxes. Which will cause more docs to hire accountants. Which will cause the accountants to make more money. Which will cause them to be phased out of this break too. One vicious circle.
[Update: Note this section has been updated since publication (and may see more updates as we all figure this out.)]
Higher Standard Deduction
Let's get into the stuff that is a little easier to understand. The standard deduction is rising from what would have been $6,500 ($13,000 married) to $12,000 ($24,000 married.) That's a good thing for tax reform and is good tax policy. More people will take the standard deduction and not have to track all the Schedule A (itemized) deductions. In fact, my family will be using the standard deduction in 2018 (probably only for 2018 though) after “bunching” property taxes and charitable contributions into 2017. Overall, estimates are that 70% of taxpayers will take the standard deduction in 2017 and 90% will do so in 2018.
No More Exemptions
Exemptions are now gone. Basically they were rolled into the standard deduction. If you had three family members or fewer, you come out ahead. Four or more, you're now coming out behind on that point, unless you're a high earning doctor [AGI of $261,500 ($313,800 married)] and were phased out of those deductions anyway. So low earning doctors with large families are hurt by this. Low earning doctors with small families and high earning doctors were helped by this. It's probably good reform though as it simplifies things.
Child Tax Credit Increase
This one helps those low earning doctor families with lots of kids. The credit is increased from $1,000 to $2,000 per child under 17. This more than makes up for the loss of exemptions, since the phaseout for this credit was also dramatically increased. The phaseout was at $75,000 ($110,000 married) in 2017. Now it is at $200,000 ($400,000 married.) So lots of doctors that didn't get child tax credits in the past, now will. Unfortunately, it wasn't indexed to inflation. That's bad policy and has caused many issues in the past, particularly with the AMT.
There's a new “dependent credit” too. It's only $500, but it's better than a kick in the teeth. It includes your parents and college students.
Schedule A Changes
A lot fewer people will be itemizing in 2018. Part of that is due to the higher standard deduction. But another part is due to the fact that lots of Schedule A deductions were reduced or eliminated. Let's go through the major deductions there:
- Medical/Dental Expenses: No change (but few doctors could take this one anyway as it had a 10% of income floor). Actually, there was a slight change. It was decreased to 7.5%, but only for 2018.
- State Income Taxes: Combined with property taxes and limited to $10K. A dramatic decrease for most doctors.
- Property Taxes: Combined with state income taxes and limited to $10K. A decrease for some doctors in high tax states.
Sales Taxes: Gone completely. Some doctors in income tax-free states lose out here.- Mortgage Interest: Slightly limited. Instead of being able to deduct interest on up to $1M in mortgage debt, now you can only deduct up to $750,000. Old mortgages are grandfathered in. This will affect a few docs in high cost of living areas.
- Home Equity Loan Interest: Eliminated. No grandfathering.
- Charitable Donations: No real change. In fact, it gets slightly better as you can donate up to 60% of your income and deduct it instead of the previous 50%.
- Miscellaneous deductions: Severely limited or eliminated completely. This includes tax prep fees, advisory fees, trustee fees, unreimbursed employee expenses, and casualty losses among others. These were always subject to a 2% of income floor, so the truth is that few doctors had enough here to get a deduction. This is honestly good tax policy as it simplifies things quite a bit. Sorry if your pet deduction got euthanized.
AMT Will Hit Fewer Individuals
One of the biggest disappointments of this tax reform effort was that the AMT for individuals wasn't eliminated completely. Leaving it was a bad policy decision. It makes the tax code far more complicated. The good news is that it will hit fewer of you. The exemption amount was raised from $55,400 to $70,300 ($86,200 to $109,400 married) and more importantly, the phaseout of that exemption doesn't start until $500,000 ($1M married.) That number used to be $123,100 ($164,100 married.) Bottom line? If you have always paid AMT in the past, you very well may not in 2018, especially with your state income tax deduction so limited. Unfortunately, you (or more likely your tax software) will still have to run the numbers to know.
Bracket Changes
The most significant change that will affect everyone (and will likely lower the overall tax bill for most) is the change to the ordinary income tax brackets. Basically, your entire tax burden gets lowered by around 3% of your taxable income. Ignoring the political decision of whether the tax code should be more or less progressive, I was disappointed to see the five-bracket system originally proposed by the House plan be dropped from the final law. That would have been some serious tax reform and good policy. We still have seven brackets, but at least you'll pay less in taxes. Here's what they look like:
As you can see, what was 15% is now 12%, what was 25% is now 22% etc. The 35% bracket is now MUCH bigger. The overall effect is that marginal tax rates are lower for everyone except those in the 10% bracket. This is the main change that is going to result in most doctors and (most American taxpayers) paying less in tax. Anyone arguing against that point probably doesn't actually understand how taxes work.
Pease Phaseout Gone
Another benefit for well-paid doctors (and a good reform/simplification) is that Donald Pease will no longer be famous. The Pease phaseouts were basically a stealth 1% bracket that began at a taxable income of $261,500 ($313,800.) I hated this law, and not just because it raised my tax bill. It was poorly written as a phaseout of itemized deductions, when in reality it was just another tax bracket. If you want a more progressive tax code, just increase the tax rates. Don't make things complicated. Combined with the new top bracket, this basically reduced the federal tax rate on your 500,000th earned dollar for the year by 3.6%, from 41.5% to 37.9% (the 0.9% is the PPACA tax.)
Less Inflation Adjustment
Another minor change to the tax brackets is that they won't quite keep up with inflation. This bill changes the inflation measurement used to increase the brackets (and other tax policies) from “traditional CPI-U” to “chained CPI-U.” Economists argue about which is more accurate, but the new one is usually lower than the old one. That means a slight tax increase is now baked into the tax code every year.
Marriage Penalty Decreased
There is still a marriage penalty in that 35% bracket, but the overall effect of the marriage penalty is decreased. It maxes out now at $8K in taxes. That's good news for two physician families.
529 Account Changes
529 plans can now be used for K-12 expenses. That's good news for those of you with kids in private school. Now you can put the money in a 529 and pull it out the next day to pay high school tuition and maybe get a state income tax break on it. Not sure it will have a huge effect since most of those who can afford to put kids in private school were already getting the maximum 529 state income tax break as they saved for college. Note that there was originally talk of this including home-schooling expenses, but that was taken out in the end. Now there is one less reason to use a Coverdell ESA.
PPACA Taxes
There was no change to the 3.8% tax on investment income for high earners nor any change to the 0.9% tax on earned income for high earners. The penalty for not buying health insurance, however, is gone. You still need health insurance (and are technically still legally required to buy it) so this probably won't affect you much. There may be some less expensive (and less comprehensive) policies coming back on to the market though. I'm still wrapping my head around how this is going to change the health insurance and health care landscape in this country, but I think it will have a huge effect over the next few years.
Long-Term Capital Gains/Qualified Dividends
No significant changes here that are likely to affect readers of this site. There was some talk of some changes that would make tax-loss harvesting trickier, but those were not included in the final bill.
Estate Tax Exemption Amounts Doubled
The estate tax exemption amounts have been doubled. They are now $11 Million ($22 Million married.) Few doctors had to pay federal estate tax in the past, and it's even fewer now. It is still indexed to inflation (good policy.) Be aware your state exemption may be MUCH smaller than the federal exemption.
Alimony Tax Treatment Reversed
In what may be the worst possible policy change in the bill, those of you who pay alimony can no longer deduct the payment. Basically, now you pay for your ex-spouse's taxes on that alimony payment. In essence, it is a tax on divorce since that tax arbitrage (between the higher earning spouse and the lower earning spouse) no longer exists. One more reason to follow the One House, One Spouse rule. The only good news is that if you're already paying alimony, you're grandfathered in. Better not renegotiate that agreement though.
Deferred Compensation
There has been a bit of a crackdown on deferred compensation plans like 457(b)s. Expect to see a lot of changes here in the next year or two if you have one of these plans. The distribution options are going to become less attractive such that many doctors will opt to invest in taxable instead of using a 457, and might even regret using a 457 in the past. I'm still wrapping my head around what these changes are going to mean, but you may wish to put any 457 plan contributions off until the end of 2018 when things become more clear.
Loopholes
One person's pet deduction is another person's loophole. Here is a list of loopholes that made the cut and a list of those that did not:
Made the cut:
- Tax-credit for electric vehicle
- Schoolteacher deduction
- Elderly and dependent care credit
- Adoption assistance credit
- Increased business auto deduction (makes leasing less attractive)
Didn't make the cut:
- Moving expenses deduction
- Business entertainment expenses
This post is long enough, so I'll stop here. We've hit the high points and discussed how they will affect you. If you love reading about this stuff, you might want to check out what the rest of the WCI Network is saying about the tax plan:
PoF's Take: Tax Reform! How Physicians and Self-Employed Are Affected
PIMD's Take: How The New Tax Plan Affects the High-Income Physician
What questions do you have about the new tax laws? Comment below, but be aware we're not going to have a political discussion in the comments section of this post. You can go do that at Fox News or the New York Times if you want. It'll be deleted here.
A question on 529 plans for K-12 spending – can the money be used to purchase educational materials/expenses during this time? I am thinking things like a computer, calculator, etc. but also possibly things like a school-related trip that may require additional funding?
“There may be some less expensive (and less comprehensive) policies coming back on to the market though.”
Although the ACA individual mandate was repealed, that did not change the ACA requirements that are needed to be able to sell an individual or small group plan. Plans will still have to include the essential health benefits and cannot deny for pre-existing conditions, etc. So there is nothing in this that would allow for less comprehensive policies at this time.
But those catastrophic and short-term plans already exist and you can have them and pay the ACA penalty at the same time.
Next year, you can continue to violate the mandate, have a non-ACA-compliant insurance plan, and not pay a penalty.
Interesting. If that is the case (and I’m just taking your word for it) then it shouldn’t change much. Maybe they can sell it as something other than health insurance.
I’ve got a great guest post on the topic to be published next month.
Honest question here:
“I was disappointed to see the five-bracket system originally proposed by the House plan be dropped from the final law. That would have been some serious tax reform and good policy.”
Why would a 5 bracket system been materially different than a 7 bracket system? Why do we even have discrete brackets anyway? No one that I know of is computing their taxes for a given income by hand, but rather using the IRS table or a computer program. Given that this is the case, why not make it a smooth gradation such that the marginal rate on each additional dollar (or 100 dollar increment, whatever is the table format’s resolution) is different than the last? It’d be no harder to compute practically.
(Yes, I do understand how brackets work, but am rather focusing on your comment of why 5 would be better than 7.)
Interesting idea. That would make it VERY hard to do your taxes by hand. And now you know someone who has done it by hand. Many times.
No it wouldn’t. You could just reduced it to a single equation. Just plug in your taxable income and it would spit out a number. It might be more difficult for someone who isn’t very bright to understand, but to actually perform the calculation would be trivially easy. Even by hand.
You calculate the taxes due for an AGI by hand in the sense of going through each bracket and multiplying the applicable amount by the rate for said bracket down to the one below it? (Why would you do this?) Or do you look up the taxes due in the IRS table? If the latter then it’d be equally as easy under my infinite* marginal rates system.
* infinite in the sense that income could be infinite, but with quanta determined by the IRS table resolution.
IRS tables, which apparently are in $50 increments, so there you have it: https://www.irs.gov/pub/irs-dft/i1040tt–dft.pdf
The IRS doesn’t publish tables for the incomes I’m interested in! Yea, I literally do it by hand all the time. Actually, I can do it in my head. Married couple taking standard deduction in 2017- first $20K at 0%, next $18K at 10%, next $50K at 15%, next $75K at 25% etc.
I really think that’s an interesting idea to do taxes that way, but I can’t imagine it would sell to the American people.
On the surface, the act seems to help physicians who are married more than the single ones. Almost all of the MFJ former 28% and 33% brackets become lower at 24% and 32%. Meanwhile, roughly the top half of the single former 28% bracket becomes higher at 32% and virtually all of the former 33% becomes higher at 35%. Kitces has a good graphic comparing marginal rate changes. When I ran the cumulative tax due, from about $375k to $450k for singles, the act causes slightly higher taxes, and from about $200k to $375k, it’s $3k or less of savings. Still crunching numbers on SALT caps (bad) and AMT changes (good). Regardless, seems I should climb into the new 37% bracket (and get a lobbyist)!
Yea, I thought that was a bit odd. I’m not sure if a lobbyist or a spouse would be cheaper.
[Post deleted.]
Thanks for this awesome summary, Jim. You keep serving your readers well. Amazing. If I were in your shoes I would rest on my laurels and not keep working so hard. Hmmm, maybe that is why I’m not in your shoes…..
At any rate, this was timely. I had considered prepaying my property tax. I’m reducing my federal withholding on a W-4 today. I was also deciding about my 457 contributions for 2018 so all this was very helpful.
I think I will set a goal in 2018 to keep my income below $315K or so. That 24% bracket looks nice to me. I will have to slash my income a lot to get there but given my changes at work, I might just make it. To quote a famous recent post I read, “Work less, smile more!”
It’s funny that you, me, and likely others are thinking about reducing work output to get to a “sweet spot” as to taxes paid.
My non-physician friends are appalled that I might simply choose to work less even though I am able and in my peak earning years in a field with a shortage of physicians (psychiatry).
I have been saying for years that my marginal dollars (moonlighting weekends and holidays) are not worth the stress. In fact, if they were not reduced by my SEP, I would think even less of their worth after taxes. I take heart in that my SEP IRA will likely end up funding 5 years of retirement by my age 62.
I can only talk about taxes with other docs. Everyone else I speak to thinks we should be soaked and abused by taxes. At present, taxes are my number one expense. They exceed retirement savings (about $60K a year goes into my 401K and SEP) and they also exceed my total monthly fixed expenses.
If you add in social security, self employed taxes, Medicare, state taxes, the amount is something like $13,000 a month!
Atlas shrugged eh? As the marginal tax rate goes up and the marginal utility of wealth goes down, nobody should be surprised to see people decide not to work. As rational homo economicus, do what we’re incentivized to do.
Taxes are by far my largest expense. I haven’t done my 2018 taxes, but I expect to pay about 3 times what I spent on EVERYTHING ELSE (not counting giving and saving) in taxes. You would be nuts to think that doesn’t disincentivize work. I’m actually pretty amazed just how many entrepeneurs out there are still busting their butts despite already having “enough.”
Of course, it’s all a first world problem and one I’m glad to wrestle with. I was reading Unbroken last night and how the freed American POWs in Japan were sharing their air-dropped food with the Japanese civilians who were just as hungry as they were!
Kind of curious if we need to make a change. WCI or anyone else any thoughts? We are a C corp (C corp never paid any taxes since all the money was given as W2 salary). Our W 2 is in 450 to 500 range. Will it make a difference to convert our C corp to S corp, give 315K in W 2 and rest in S corp dividends? Will those S corp dividends qualify for lower 20 + 3.8% tax bracket?
Also I heard in order to change to S corp it has to be done within the first 2.5 months of the year, otherwise the election to S corp would be for the next year.
Thanks for the article.
Why are you asking this question now? Yes. It’ll help now. It would have helped last year. I would have helped 10 years ago. The reason is that you’ll save Medicare taxes on the distributions. Will it help MORE now? Depends on what you make and whether your business is a service business or not (I assume it is).
It’s beyond me why any doc would have a C Corp. Why do you have one? What advantage do you see there? Was something different in the past that made it more attractive?
Yes, S Corp election must be done early in the year. 2 1/2 months sounds right, but I don’t have that memorized.
The main advantages for a C corporation with a small ownership base are benefits flexibility (MERP, retirement plans), some add’l business deductions vs. other entities, issuing W2s (may or may not be considered a benefit) and using carry forward losses more easily. It’s much more complicated to use pass-through losses from a S Corp.
One significant advantage is for raising investment money, selling the business to someone willing to purchase the stock (long term cap gains) instead of purchasing assets or going public, but few share holders will ever utilize those features.
Let’s get specific. What deductions are you taking as a C Corp that I can’t take as an S Corp? Is that really worth paying all that extra Medicare tax?
And what retirement plan are you using as a C Corp that I can’t use as an S Corp?
Medicare tax is only 1.45% (Employee portion) if I am not wrong. if you get 150,000 in dividends, barely a saving of 2,175
You save both employer and employee portion of Medicare tax on distributions.
One of my favorites is MERP. Unlimited deductions without restrictions.
Ooops, just discovered you can’t edit replies. Didn’t get to mention the 7.5% threshold for S Corp medical deductions. That’s significant for doctor income ranges since it’s unlikely you’ll ever meet it. Not arguing against S Corp at all, but against the idea that a particular entity is always the right choice. At the times I owned them, each of the various flavors was the best for my situation at the time. My current company spent part of its life as an S Corp.
Here’s some good points about S Corp drawbacks:
https://bradfordtaxinstitute.com/Content/Is-S-Corp-Best-Entity.aspx
I’ve owned and reported income from self-employed, W2, LLCs, S Corp, C Corp and partnerships over the years, so the tax nuances tend to get jumbled together at this point along with tax code changes over the years. Picking an entity and totaling up deductions isn’t entirely about minimizing taxes which is implied when you’re asking about a 1-to-1 deduction comparison. That’s only one of many different factors going into the decision tree for picking an entity.
Shareholders? Thinking about going public? Liability issues? Other assets at risk? Outside funding? Assets being held in the entity? Purchasing real estate? IRS requirements for a particular business practice?
You asked specifically why a doc might use a C Corp over an S Corp. Let’s say you acquired a valuable patent or developed a clever surgical instrument and want to raise professional money to bring it to market. The only realistic choices are C Corp or an LLC. Taxes and deductions don’t come into the picture at all. It’s all about funding and shareholders.
Conversely, putting real estate into a S Corp is usually a bad idea because of tax consequences. It probably belongs in an LLC. Comparing deductions doesn’t matter if you might lose the entire capital gains exemption on a future sale.
Not sure that was what I meant when I asked why a doc would choose a C Corp. Sure, if he has a non-doc business. But I’m talking just a boring old physician practice.
“Even if you’re only paying 21% on your corporate tax returns, you’re likely going to be paying 23.8% on the dividends from that corporation. 44.8% is definitely more than the top individual bracket.”
It’s closer to 39.8% overall. You’re applying personal tax rates to the entire corporate profit.
$100 in corporate profits is subject to $21 (at most) in corporate taxes leaving $79 for dividends subject to the 23.8% (at most) in personal taxes. The after-tax income is around $60 or about the same as the new top brackets. Obviously, this a trivial example which probably applies to no one’s actual tax situation. Most non-doctor income folks would be paying 0% – 15% on dividends.
I’d also expect the 3.5% Obamacare tax to eventually disappear, so 23.8% could turn into 20%.
Fair enough on the math.
Not sure I agree with your last line though. I have no more reason to assume that tax will go down than go up. I think the best estimate of future tax law is current tax law, kind of like bond yields/returns that way.
El Presidente has three more years to actually repeal ACA. If that happens, my presumption is the tax used to fund the program would also be repealed. Raising it would imply an endorsement of ACA which seem unlikely. With that notable exception, I definitely agree with your thoughts about future tax law.
“More people will itemize and not have to track all the Schedule A (itemized) deductions.” I think that should be “less people will itemize” as the standard deduction is larger.
You’re right of course.
Wow, wish I heard that more!
You’re right. You’re right. You’re right.
Quick question. It is my understanding that the AMT is not going to change for the tax return for 2017 filed by April 2018. Per my CPA “A new tax law would indicate the tax year it takes effect. I didn’t see anything referencing 2017.” I have typically been hit with AMT and so it does not make sense for me to pay my real estate taxes ahead if I am going to hit the AMT.
That’s right. These tax changes refer to the 2018 tax year. The 2017 tax year is based on the old tax laws. That’s correct that it makes no sense to pre-pay if you pay under the AMT system.
Do you foresee medical service providers that are currently W2 employees restructuring themselves to be LLC or S-corp based on the recent tax policy changes? Is this materially better if they (household) is only making taxable income less than $$415K a year?
Yes. There is a tax break there so I do see this trend occurring this year. It’ll be a slow process as people learn about the tax break, and it won’t apply to the higher earners, and some are locked into contracts or aren’t willing to walk away from their employers and their employers aren’t willing to change.
Sadly, as an unmarried person taking home ~300k my rate will increase from 33% to 35%. Whereas if I was making the same amount but with a non-working spouse, my rate would drop from 33% to 24%…unless I’m misunderstanding the brackets posted here. Oh well, such is the single life for now.
Perhaps, but your expenses would likely make up for that 9% difference 🙂
You’ve heard of the “marriage penalty” before, right? That was decreased and when there are winners with tax changes, there must be losers. But even before, the best tax situation was being married to a non-working spouse.
Dang, upon looking further, it’s frustrating a married couple making up to 100k more than me will be paying LESS in taxes.
Yes, but if both work it’s actually more tax than if they weren’t married. We owed the IRS about 8k last spring because the taxes withheld from my and my husband’s salaries didn’t account for the other’s income which effectively pushes us up into higher brackets.
For what it’s worth. Got a response from spouse’s benefit manager about 457b, that their legal team has analyzed the final bill and sees no changes, including in distribution rules. Said original house plan would have basically shut done all NQDC plans including non-gvt 457b but that was stripped early on.
Best I can tell, most of this concern was sparked by a single paragraph in that long Kitces piece, but is not supported in the actual bill.
I’m going to keep contributing for now.
I really appreciate this post Jim.
[Political part of comment deleted.]
Another great article, Jim!
There seems to be some nuance to consider regarding home equity loan deductibility. Per Kitces’ discussion, it appears that both home equity loans and HELOCs where proceeds are used for home improvements will be treated as “acquisition debt” and will still be tax deductible.
I don’t think that’s true. I don’t think even home improvement home equity loans and HELOCs are deductible any more.
The Kitces post I referenced appeared to make a convincing case. https://www.kitces.com/blog/final-gop-tax-plan-summary-tcja-2017-individual-tax-brackets-pass-through-strategies/
I also found this online (not an endorsement of the firm):
“HELOC interest is still deductible if proceeds are
used for “acquisition indebtedness” (to build or
improve a primary residence)”.
http://www.lenoxadvisors.com/2018-tax-update/#.WkxIXCtlDYU
I guess we will have to see how IRS interprets.
You may be right. But I’ve definitely seem what appeared to be reasonably reliable sources taking the opposite position. There have been several things with this law that have taken a while to clarify. Might not be a great time to take one out until it is more clear.
Note, also, that if you’re 65 or older your standard deduction is $13,600 (single) or $26,600 (married). (Not a huge difference, but in my case – single with $10,000 SALT every year – it may make it worthwhile for me to “bundle” my charitable contributions starting in 2018.)
I bundled my charitable donations for 2018 into 2017 with a donor advised fund. Even though I will still be able to claim deductions over the standard deduction for the foreseeable future, my marginal rate will be dropping by 11% in 2018. You may still have a day or two to front load donations either directly or through a DAF if you are in a similar situation. You could donate in 2017 and then next in 2019.
First WCI, thank you for a great article – I’m not into politics and this article is a slam dunk unbiased masterpiece. I’ve been a silent reader for 7 years and thank you for everything you’ve done.
My w2 is $550k and medical device consulting through an LLC is about 250k. Would it help me to file my LLC as an s-corp? Would it help to take a salary rather than just pass through LLC style? Wife’s parents have been doing my taxes, not sure if we’ve been doing this right…
That’s very kind of you. Many others felt it was incredibly biased; although those people were found on both ends of the spectrum! I think you may benefit from an S corp for both your practice and your side gig. Taking distribution instead of salary would save medicare taxes.
Great post and comment. The only new thing to me was the 457b treatment. I see the links posted and agree based on my own searches that 457 don’t seem affected. I have a 457 and will be leaving my job for a new job with another 457. I can’t rollover. The 457 issue is highly relevant to many Physicians. Thabks for the warning though, I will be sure to look out for this.
The bill is ‘reform’ in that taxes are lowered overall. It failed as ‘simplification’ by persisting 7 brackets and the AMT, to my disbelief.
I am baffled by the pass through entity changes, and was never that clear on S election anyway, and await further reading. Particularly as I move from w2 income towards ‘business’ income again.
I guess I always considered reform to mean simplification, not a change in the total tax revenue collected or a change in the progressivity of the system.
Got a chuckle out of the very first two posts being deleted after the warning.
Yes, it would be easier if they would have just sent an email. They weren’t terribly political comments, but it was pretty obvious to see which way this would go if I left them.
As a 2 MD family and high earner in a high tax state (CA), it appears that we will be one of those that has a net tax increase next year, mostly due to SALT changes. I am currently earning a very high 6 figures as a W2 hospital employee with a small amount (20k) side hustle from consulting. My spouse is currently an independent contractor making about 175k as a consultant to a large group, but they are interested in making her a full time W2 salaried employee with benefits.
1) With that in mind, is there any value with her staying an independent contractor? I assume that since our overall income is well beyond the phase out for the pass through benefit, there is no chance she can get that deduction. On the other hand, she can put away more tax deferred income in her solo 401k if she stays on a 1099. She would lose a 3% 401k match, insurance (I already have the family covered), and other benefits of being an employee. But wonder if it might be better for us one way or the other.
2) I could leave the hospital and try to set up my own solo practice. But based on my limited understanding, as a MD earning well above the pass through threshold, there is no real benefit for me doing that, correct?
Thanks to everyone for pitching in with thoughts, opinions, ideas, etc. on this site.
I’m so sorry about your tax bill climbing while most people are seeing their bill go down.
1. I think you’re right. I don’t see it helping much. Try to compare apples to apples and maybe it’ll work out better one way or the other. Personally, I like being self-employed. Obviously you need to be paid more if you’re self-employed than if you’re an employee where the employer is buying benefits and paying half the payroll taxes.
2. You mean will you get the pass-thru deduction? Doesn’t sound like it. Are there other benefits (and downsides) of self-employment? Sure.
This isn’t quite as simple as your questions seem to indicate you think it is. There’s a lot of moving parts there.
You already know about the Solo 401K. Another advantage to 1099 work is business deductions which are more generous than those available for W2 employees. Probably 20-30% of my annual “income” comes through deductions which would otherwise be lost, especially medical and travel related expenses.
Thanks so much, a real eye opener compared to some high level news articles. I don’t really see much simplification. The devil is in the details and from what I can see there are a lot of them no matter what your bracket or corporate organization. I’m on the low income end (roughly $160K gross) and organized as a C-Corp with W-2 salary reduction to result in a near break-even business income each year. Thought I would see about a 3% reduction in taxes due to my primary bracket rates lowering of 3% but a couple of big deduction deletions will probably result in slightly higher taxes for me. Loss of $8100 personal exemption for the wife and I as well as $5K in state sales tax (I’m in Texas) adds up to a $13K reduction in deductions and of course it will be much harder to itemize, possibly forcing me to take the standard deduction unless I really amp up the charitable giving. As it was in 2016 the sum of all itemized deductions with a large charity component was about $26K. I think it unfortunate to charities that donors won’t realize the tax benefit they once did, I will be giving more and paying more taxes the way it worked out. I’m afraid some won’t be able to afford previous patterns of charitable generosity since the deduction no longer starts with first dollar given. Also really disappointed that House version didn’t prevail as would have given more room to deduct down to a lower bracket. Oh well, gave up and went to a CPA three years ago, the trend will continue.
Interesting issue in an income tax-free state. I hadn’t really thought much about how the loss of sales tax deduction would hurt those folks.
I agree, that based on the discussions here, not sure any significant simplification happened. I think we can all agree that simplification is a desired outcome. And some people here will get slightly lower taxes, others will get slightly higher taxes. It does appear that the largest and most monetarily significant change, by far, was for large corporations. However, the change in handling ACA may actually, in the end, be the largest, but we don’t know yet.
This was a pretty good analysis of the new tax code.
Here is another analysis done by a CPA blogger:
http://www.moneyguy.com/2017/12/the-gop-tax-plan-what-does-it-mean-for-your-tax-bill/
What I find ironic is that we heard all about the House bill, all about the Senate bill, all about the reconciliation …. but very little about the new tax bill that actually passed.