The Tax Cuts and Jobs Act (TCJA), signed into law in December 2017, may have significant business implications for optometrists who are business owners. Regulations that will dictate how the law is interpreted by the Internal Revenue Service (IRS) have been proposed. Although the regulations have not been finalized by press time, the principal stipulations of the law that affect optometric business are known, and prudent planning may yield substantial tax savings. (Final regulations may be found at www.irs.gov/tax-reform once finalized.)
The following is a simplified optometrist’s view of the financial implications for small business owner-O.D.s. (A caveat: Prior to making any business decision, consultation with your tax specialist is strongly recommended.)
The purpose of the TCJA was to give small business owners a tax break in the form of a 20% reduction in taxable income to promote jobs creation, primarily in business sectors engaged in the production or sales of manufactured goods. This legislation gives small business owners a similar tax break to what “C” corporations currently enjoy. However, most service-related enterprises (e.g. health care, accounting, legal, etc.) were excluded. These service industries are termed “Specified Service Trade or Business” (SSTB) in the accounting vernacular. (See “Glossary” for other terms used throughout this article.) This might make one think optometrists will not be able to take advantage of the new tax break; however, as Lee Corso from ESPN would say, “not so fast, my friend.” In fact, many optometrists may be able to take advantage of the tax break and dramatically reduce their tax burdens. There are two scenarios under which optometrists will be allowed the tax break, explained in the following paragraphs.
SCENARIO 1: PERSONAL TAXABLE INCOME IS WITHIN RANGE
The first scenario is the easiest to understand. It is based on the taxable income reported on your personal tax return. If taxable income on your personal Form 1040 is under the threshold income level, your business does qualify for a 20% reduction in your taxable income through the TCJA, regardless of your status as a SSTB or non-SSTB profession. The taxable income should be found on line 43 of your 1040 in 2017, and, if you file jointly, the threshold is $315,000. If you file singly, or as head of household, the threshold is $157,500. If your taxable income is above $415,000 filing jointly or $207,500 filing singly or as head of household, you do not qualify for the tax break. If your taxable income is between the $315,000 and $415,000 ($157,500 and $207,500 filing single), the tax reduction is pro-rated. (See “Sliding Scale” table for examples of the proration.)
For example, if you have $300,000 in taxable income on line 43, you qualify for a 20% reduction in your qualified business income (QBI). Profits derived after all expenses, including your personal salary, are deducted from your business income. These K-1 profits are usually reported in lump sum (if you have multiple businesses, such as an LLC that rents your office to your practice and a separate entity for your optometric practice, the net income from the two K-1s would be totaled) on line 17 in 2017 of your personal 1040. Of course, Form 1040 is subject to change every year, so K-1 profits may show up elsewhere in the future. In the example, if you have $100,000 on line 17, this represents your QBI and will result in a $20,000 deduction from your taxable income ($100,000 multiplied by 20%). If your marginal tax rate is 25%, you will have a tax savings of $5,000 ($20,000 multiplied by 25%).
SCENARIO 2: THE WHOLE BUSINESS IS CLASSIFIED NON-SSTB
Now, for scenario two. If your taxable income is greater than $315,000 on your personal tax return (Form 1040, line 43 in 2017), then your business activities may allow you to participate in the tax savings; however, you must have enough revenue in non-SSTB-related activities to qualify.
The key here is whether your business is considered SSTB or non-SSTB. What does that mean? Simply put, sales of ophthalmic goods are non-SSTB, while professional services (e.g. eye exam fees) are SSTB. The proposed regulations state that if more than 90% of your revenue is derived from sales of ophthalmic goods, you will be considered non-SSTB and, therefore, able to apply the tax break. (Remember, these are proposed regulations, so the 90% number is subject to change and will not be set in stone until the regulations are finalized.)
DEFINITIONS AND DESCRIPTIONS of terms and documents you will need to fully understand this article:
→ TCJA: The Tax Cuts and Jobs Act is the new tax law that may reduce your taxable income up to 20%.
→ SSTB: The Specified Service Trade or Business are service industries, including optometry, excluded from the tax breaks as a class of business, but that may qualify under certain circumstances.
→ FORM 1040: This is the personal tax return.
→ FORM K-1: This is a summary of business income that results from the net profits of sole proprietorships, “S” corporations, LLCs, LLPs and partnerships. The net profit from these is reported on form 1040 as income.
→ TAXABLE INCOME: This is the net income after deductions and exemptions reported on Form 1040. This is the amount that personal income taxes are based on.
→ QUALIFIED BUSINESS INCOME (QBI): This is the net profit from sole proprietorships, “S” corporations, LLCs, LLPs and partnerships reported on Form K-1. This is the net after all expenses, including wages paid to the owner.
→ THRESHOLD INCOME LEVEL: This is the amount of taxable income that triggers the SSTB “test.” Under the lower limit, everyone qualifies for the exemption, above the upper limit, no one qualifies, and between the lower and upper, tax reduction is pro-rated.
The regulations also state that if there is common ownership between a service business (SSTB related) and a product business (non-SSTB), then the two businesses will be taxed as one entity. Therefore, there appears to be no tax advantage to splitting the optical goods business off from the professional business. If your practice management software or accounting software allows you to separate service-related revenue from sales of ophthalmic goods, you should be able to easily determine whether you meet the 90% cutoff. (Remember, the ratio to determine whether the business is SSTB or non-SSTB is not finalized at this time. The 90% is in the proposed regulations, which should be finalized by the end of this year.)
Assuming you pass the 90% test, your tax savings is calculated as in scenario one; however, it is reduced by the sliding scale (since your taxable income in this example is greater than $315,000 filing jointly). However, there is one more catch: The QBI deduction cannot be more than 50% of your annual wages, as reported on your W-2. For example, if your taxable income on line 43 of Form 1040 is $365,000, you get a 10% reduction in your K-1 profits on line 17 of Form 1040 (since $365,000 is halfway between $315,000 and $415,000). So, if you, again, had $100,000 on line 17 of Form 1040 (your QBI), your taxable income would be reduced by $10,000. This $10,000 is then compared to 50% of W-2 income reduced another 50% in this example because $365,000 is 50% on the pro-rated scale. In this example, $40,000 would be the cut-off W-2 wage because 50% of $40,000 reduced another 50% is $10,000 ($40,000 multiplied by 50% multiplied by 50%). As long as your W-2 salary is $40,000 or greater, your tax savings, assuming a marginal tax rate of 25%, would be $2,500 because the QBI in this example is $10,000. Note: This is a simplified version!
THE SLIDING SCALE is continuous from a 20% reduction in QBI down to no deduction. The table shows selected proration amounts; the QBI deduction may be extrapolated for other taxable income totals that fall between the top and bottom of the scale.
|FILING JOINTLY||FILING SINGLY||PRORATED QBI DEDUCTION|
PROACTIVE STEPS TO LOWER LINE 43
If you find yourself in scenario two, some business decisions may allow you to participate in the TCJA tax break or may allow you to gain a larger reduction in your taxable income. Anything you can do to lower your taxable income (line 43, Form 1040) will result in a larger tax savings. Purchasing equipment that qualifies for a section 179 deduction (e.g. camera, auto-refractor, OCT, corneal topographer) reduces your taxable income (but also reduces your K-1 profits, so the effect is not dollar for dollar) and may allow you a tax deduction that you would otherwise not be entitled to receive. For example, if your taxable income is greater than $415,000 filing jointly, buying a $50,000 camera would reduce your taxable income to $365,000, and you would qualify for a 10% reduction of your QBI, whereas not buying the camera would leave you over the threshold, resulting in no TCJA-related income tax reduction. Equipment purchases often qualify for a tax credit through the Americans with Disabilities Act as well, and this is in the form of a tax credit (i.e. direct reduction of your tax paid).
Another method to reduce your taxable income is to participate in a deferred income plan. Deferred income plans allow you to reduce your taxable income by shifting current wages into a savings plan that can be drawn on once you retire. Again, this might provide an additional benefit if it lowers your taxable income such that you become eligible for the qualified business deduction. If you know how to use a spreadsheet program, such as Microsoft Office Excel, it can prove very valuable to allow you to evaluate various scenarios to help you make the smartest business decision for your practice (as would consulting a tax specialist).
Since QBI is net profit after paying yourself a salary, some might suggest lowering your salary and, therefore, reporting a higher net profit, which will increase your QBI, leading to a larger tax deduction. This not necessarily sage advice for two reasons:
- Your W-2 salary drives any matching contribution amounts for 401k plans. Lowering your salary lowers the amount that can be put away for retirement.
- The IRS expects a small business owner optometrist to pay a “reasonable” salary. This is the more important reason. The IRS doesn’t specify how it defines “reasonable,” but, historically, it looks at salary surveys by region, as well as your historical tax records. Being the deer that wanders off from the herd is the fastest way to get the lion’s attention!
I hope the above summary and examples are helpful. Again, prior to making any major business decisions, I strongly recommend consultation with a tax expert who understands your business. OM
Updated: A previous version of this article incorrectly stated the percentage of revenue from ophthalmic goods in order to qualify as a non-Specified Service Trade or Business entity.