The Tax Cuts and Jobs Act (the “Act”) made many changes to the Internal Revenue Code which have the potential to impact physicians. One of the more substantial changes is the Qualified Business Income Deduction (“QBI Deduction”). The Act now permits the owners of businesses taxed as pass-through entities (such as S corporations) to deduct up to 20% of the “Qualified Business Income” from such entity from the owner’s taxable income. The deduction is effective beginning on January 1, 2018 and expires on December 31, 2025. As a result of this new opportunity to reduce an owners’ taxable income, some physician practices may find it advantageous to reorganize as an S corporation in order to benefit from the QBI Deduction.
Unfortunately for physicians, certain service industries are excluded from taking advantage of the QBI Deduction unless the individuals have taxable income less than a defined “Threshold Amount.” Healthcare is one of the industries that is subject to this exclusion (your Houston Harbaugh attorneys can empathize as the legal profession is also subject to this exclusion). In order to capitalize on the exception to this exclusion, shareholders in a physician practice electing to be taxed as an S corporation must have taxable income equaling less than $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly.
Should a physician have taxable income that does not exceed the Threshold Amount, the QBI Deduction is equal to 20% of the taxpayer’s Qualified Business Income from his or her physician practice. Therefore, if a physician practice has shareholders who earn less than the Threshold Amount, it may make sense to consider electing S corporation status (provided the practice meets the other requirements for S corporation status). Because the QBI Deduction is a personal tax deduction, it is not necessary that all shareholders in a practice have taxable income which is less than the Threshold Amount.
While the relatively low Threshold Amount will make the QBI Deduction unattainable for many physicians, an annual salary in excess of the Threshold Amount does not automatically make a physician ineligible for a QBI Deduction. This is because the Threshold Amount only applies to taxable income. There are ways to reduce taxable income which could make a physician eligible for the QBI Deduction, even if his or her salary exceeds the Threshold Amount. For example, contributions to qualified retirement plans reduce taxable income. Thus, a contribution to a qualified retirement plan could actually make an otherwise ineligible physician eligible for the QBI Deduction. For example, assume that a married physician filing jointly who is an owner in an S corporation has wages of $250,000, QBI of $200,000, and taxable income of $415,000. The physician is not entitled to any deduction based on QBI. If, however, the physician contributes $100,000 to a cash balance pension plan, his taxable income would be reduced to $315,000. Assuming that the contribution comes out of the QBI, the remaining QBI would be $100,000, and the physician would be entitled to a deduction of 20% ($20,000). So, the pension contribution would reduce taxable income by $120,000 ($100,000 + $20,000). We note that the $100,000 contribution to the plan will eventually be taxed, upon distribution from the plan.
In summary, physicians should consult with their attorneys and accountants to determine whether it makes sense to consider reorganizing as an S corporation to take advantage of the QBI Deduction. Elections for the current year must be made by March 15, 2018.