The Best Approach to Funding Specialty School Costs with Tax-Deductible Dollars
August 2016Education Planning Saving/Paying for College
Specialty dental school costs are continuing to soar, with some programs costing $80,000 or more annually. Prior to The Great Recession, most doctors were funding 100% of their children’s education costs from their personal funds. Recently, more children are sharing in the cost, often paying 25%-50% of the total through working, student loans, scholarships, and/or grants. Paying the remaining balance with tax-deductible dollars can save the doctor’s family thousands annually, as discussed below.
Practice Continuing Education Expenses
Section 162 of the tax law allows a deduction for continuing education expenses. Unfortunately, dental school expenses are not deductible, since they qualify the doctor for a new profession (dentistry). Fortunately, the IRS has ruled (Revenue Ruling 74-78) that post-graduate dental specialty training costs are fully deductible, since they improve job skills, but don’t qualify the doctor for a new profession, since no additional license is required to provide dental specialty services.
In order for the practice to deduct specialty school expenses, the student (doctor’s child) must be employed by the practice. Fortunately there are a number of important job duties the child can perform that can justify employment and the related salary paid, such as practice marketing, including website design/upgrade, social media, generating reviews (Google), and even producing video testimonials.
How much salary should the child be paid? The goal is to shift the maximum amount of income to the child that will be tax-free (as shown below), with the balance paid by the practice as tax deductible continuing education.
Paying $12,000 ($1,000 a month) is optimal tax-wise, satisfying the IRS test that pay be reasonable in exchange for the services rendered, while minimizing federal and state payroll taxes. The child should use the net salary proceeds to pay for the specialty school tuition, in order to qualify for the Lifetime Learning Tax Credit, discussed below.
As you can see, the child can report income of $26,438 and owe $0 in federal income taxes, if properly structured. If the child is 24 or older, the “kiddie tax” does not apply, so that all income shown on the child’s return will be taxed at his or her rate. $12,000 of the $26,438 in federal income would come from the salary earned, while the remaining $14,438 should come from the child’s share of family limited partnership (FLP) or a limited liability company (LLC) income generated by renting the office building/equipment to the practice, or operating a lab and/or records business.
|Total Income Child (Single)||$26,438|
|Tax Rate - Single||$2,000|
|Lifetime Learning Tax Credit||($2,000)|
|Net Tax Due||$0|
Lifetime Learning Tax Credit
In order to achieve the $0 tax result, the child must qualify for the Lifetime Learning Tax Credit. The credit is allowed for 20% of the first $10,000 of qualifying educational expenses, with a maximum credit of $2,000 annually.
Since the credit is phased out at higher income levels (modified adjusted gross income (MAGI)) greater than $65,000 if single; $130,000 if married), the credit is not available for high income doctors, but can be claimed on the child’s return. In order to do so, the child must be claimed as a dependent on his own return, and not on his parents’ return.
Optimizing the Tax Benefit
Assuming the child’s specialty school expenses are $80,000 a year (including living expenses), it should be funded as follows to generate the maximum tax savings:
|Total Specialty School Cost (including living expenses)||$80,000|
|Child Responsibility (25%)||($20,000)|
|Amount Paid by Practice as Continuing Education||($33,568)|
|Amount of Income Shifted to Child’s Return Tax-Free; Composed of:|
Share of FLP/LLC Income $14,438
Traditionally, doctors have paid for their children’s education costs with after-tax dollars. As a result, doctors in the 50% marginal tax bracket would have to earn $120,000 before taxes, to have $60,000 left over after taxes to pay for the cost of education. Funding with tax-free dollars as discussed above, can save the doctor $60,000 annually!
The McGill Advisory content is provided for informational purposes only and does not constitute legal, accounting, or other professional advice.
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