How To Operate A Lab Business For Maximum Tax Advantages
With the 2013 tax hikes, many doctors are in or near the 50% combined marginal federal and state income tax bracket. As a result, legitimate methods to shift taxable income to lower bracket family members are increasingly important.
In addition to shifting earned income to lower brackets through employing the doctor’s children, we recommend that doctors shift unearned income (rents, dividends, interest, capital gains, etc.) as well. The preferred method of shifting unearned income is through establishing a family limited liability company (LLC) or family limited partnership (FLP) so the doctor can generate substantial tax savings while still maintaining control through their status as managing member or general partner.
Once established, the doctor can transfer his personally-owned office building and/or equipment into this entity, and thereafter lease the property back to his corporation at the highest reasonable rental rate. We’ve also helped many doctors establish and operate a family lab, x-ray, and records business through a LLC/FLP, using the steps outlined below to further increase tax savings.
Once established, we recommend that doctors transfer the vast majority (typically 95%) of the non-managing ownership interests in the LLC/FLP to their college-age children, in order to shift taxable income to their returns. Distributions from the family LLC/FLP, along with their practice salary, should be used first to fund college expenses, with the balance coming from the child’s Coverdell Savings Account (CSA) and Roth IRA.
If the transaction is properly structured, the child’s share of the LLC/FLP profits will be taxed on the child’s tax return. However, all unearned income in excess of $2,100 annually is taxed at the parent’s rate, if the “kiddie tax” rules apply. However, if the college-age child generates at least 50% of their support (net of scholarships received) from their own earnings, the “kiddie tax” does not apply and all unearned income, including the LLC/FLP income, will also be taxed at the child’s rate, which is at a 10%/15% federal income tax rate up to $37,450 of taxable income in 2015.
Furthermore, transferring personal investments into the LLC/FLP can also reduce or eliminate the 3.8% Medicare payroll tax on the doctor’s personal investment income that would otherwise apply. Also, transferring appreciated stock or real estate into the LLC/FLP prior to sale can also eliminate federal income taxes on the capital gains and dividends, since a 0% tax rate applies for those in the 10%/15% tax bracket.
This strategy also represents an excellent estate planning tool, since 95% of the assets owned by the LLC/FLP, and all future income derived therefrom, will not be included in the doctors’ taxable estate at death. Furthermore, this is also an effective means of building up family assets that are protected from malpractice and other creditors’ claims.
Once the child begins college, she should pay 100% of her support from her own funds, which includes her practice salary, LLC/FLP income, capital gains and dividends, and distributions from the CSA and Roth IRA. Since the child, rather than the doctor, is paying for all college and personal living expenses, the doctor can no longer legally claim the child as a dependent on his return. However, no tax deduction will be lost here, since personal exemptions for high income doctors have been phased out.
Since the parent is no longer legally entitled to claim the child as a dependent, the child can claim an exemption deduction for herself on her tax return, equal to $4,000 in 2015. Utilizing the personal exemption and standard deduction ($6,300 in 2015) further reduces the income taxes due on the child’s return during each year in college.
Education Tax Credits
The American Opportunity Tax Credit (AOTC) provides a tax credit of up to $2,500 for each of the first four years of college. Since these tax credits are phased out for doctors whose adjusted gross income (AGI) exceeds $80,000 if single and $160,000 if married, most high income doctors will be unable to use them. However, this tax credit can be claimed by a child on his or her tax return, offsetting most, if not all, of the income taxes otherwise due.
Properly Operating the Lab Business
While many doctors transfer the ownership of their office building into an LLC/FLP, a lab business has an added advantage of flexibility. Lab operations can commence or increase as the doctors’ children reach college age and later be scaled back or stopped altogether when their education is completed.
The following steps should be taken to properly operate the lab business:
1. The LLC/FLP should apply for and receive an Employer Identification Number (EIN) from the IRS as well as any state tax numbers.
2. The LLC/FLP should establish a bank account in its name, using the new EIN assigned to it. The doctor should contribute sufficient capital (usually $5,000) in order to fund the initial capital contribution.
3. The lab partnership should then purchase all of the lab equipment at its fair market value from the doctor’s practice, in exchange for cash or promissory note.
4. The lab partnership should then purchase all necessary supplies such as plaster, impression material, acrylic, and other items to be used in the lab business. The lab partnership should thereafter pay all supply bills directly to the suppliers.
5. The practice should bill the lab partnership on a monthly basis for rent, based upon the number of square feet utilized by the lab, and for a prorata share of utilities, property taxes, and building insurance.
6. In order to avoid the cost of an extra payroll, additional payroll taxes, and related payroll tax returns, the practice should bill the partnership for the use of all lab employees on a monthly basis. Rather than attempting to trace the direct employee cost involved, the practice should bill the lab partnership for 120% of the hourly wage rate paid to the lab employees in order to cover payroll taxes, fringe benefits, and retirement plan contributions made on their behalf.
7. At the end of each month, the lab partnership should invoice the practice for all study models, appliances, and other products produced by the lab partnership for the use of the practice. The price at which to bill these items should be the highest commercial prices available according to published price lists. The lab partnership should solicit commercial price lists every year for lab services and products, and adjust their prices annually as this data is received.
8. At the end of each year, the lab partnership should distribute all or part of its annual profits to its partners in proportion to their ownership interests, unless there are business reasons for retaining profits within the business such as the purchase of new equipment, expansion, or investment.Back
The McGill Advisory is designed to provide accurate and authoritative information with regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal or accounting advice or other expert assistance is required, the services of a competent professional should be sought.
Copyright © 2018 John K. McGill & Company, Inc. All Rights Reserved.