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Tax Cuts and Jobs Act brings reduced personal tax rates, brackets
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Are you ready for tax “reform?” Thanks to the just-passed Tax Cuts and Jobs Act, the tax rate for incorporated optometry practices and businesses will be reduced from its current 35% to 21% for the 2018 tax year and thereafter. Although the business tax cuts are, for the most part, permanent, the tax cuts for individuals are temporary, expiring in 2026.
Temporarily, optometric professionals should fare well under the Tax Cuts and Jobs Act (TCJA). While those in the service fields such as medicine, accounting and law may not do as well as others, everyone will benefit. Income rates are, for example, lower across the board. How much lower will, of course, vary with each optometrist’s personal and professional situation. Some will still pay higher personal taxes because of higher income and the loss of the deductions for state and local taxes.
The personal side of taxes
Some of the most widely discussed changes included in the TCJA are the reduced personal tax rates and the number of tax brackets (down to only seven in 2018). The TCJA lowered most individual income tax rates, including the top marginal rate, from 39.6% to 37%. In addition, the new law increased the standard deduction to $24,000 for joint filers, $18,000 for head-of-household filers and $12,000 for all others. That may seem generous, but the new law also eliminates the personal exemption.
Prior to the TCJA, 30% of taxpayers itemized their personal deductions instead of claiming the standard deduction. Today, many miscellaneous itemized deductions such as employee business expenses, tax preparation fees and investment interest expense have been eliminated. Personal theft and casualty losses, except those in federally declared disaster zones, have also been eliminated.
The so-called “SALT” deduction for state and local income taxes, sales taxes and property taxes may still be claimed, but only up to a combined ceiling of $10,000 ($5,000 for single filers). The interest on a home equity loan will no longer be deductible, while interest on a new home mortgage will be limited to the interest on a $750,000 ($375,000 for single filers) new mortgage taken after 2017.
Then there is the controversial new treatment of the income from so-called “pass-through” practice and business entities. While regular C corporations will be taxed at a flat 21% tax rate, the majority of those involved in small businesses and professional practices operating as pass-through entities will face new personal tax rates that may be higher than the corporate tax rate.
Pass-through practices, businesses
Whether it is two professionals working to run a more profitable enterprise, optometrists and optometry practices in a joint venture, a syndicate, a group or a pool with others, pass-through entities are an increasingly popular practice entity. In fact, many optometrists operate as or are involved in pass-through practices such as partnerships, limited liability companies (LLCs), S corporations and sole proprietorships, where income is passed to their principals who pay tax at the individual rate.
The TCJA created a 20% deduction that applies to the first $315,000 of income (half that for single taxpayers) passed through from an S corporation, partnership, LLC or a sole proprietorship. All practice entities meeting the income thresholds, regardless of whether or not they are service professionals, can take advantage of the 20% deduction.
The TCJA does, however, place limits on who can qualify for the pass-through deduction, with strong safeguards to ensure that so-called wage income does not receive the lower marginal tax rates. For pass-through income above the threshold level, the new law allows that 20% deduction, but only for business profits, reducing the optometrist’s effective marginal tax rate to no more than 29.6%.
In other words, that 20% deduction applies only to business income in excess of the limits that have been reduced by the amount of reasonable compensation paid the practice’s principal. Reasonable compensation has not been defined as yet.
Fringe benefit limits
Further limiting the options of optometry professionals working for their practice, the new law disallows deductions for entertainment expenses, eliminating the burden of attempting to prove whether such expenses are sufficiently business- or practice-related. The 50% limit on the deductibility of business meals has been expanded to include meals provided through an in-house cafeteria or otherwise on the premises of the optometry practice.
A practice’s deduction for fringe benefits such as transportation (eg, parking and mass transit) is no more, although such benefits received by an employee, even the practice’s principal, continue to be excluded from the recipient’s income.
Capital contributions
Capital contributed to or invested in an optometry practice, not only by its principals but also contributions made by others – even that contributed by a patient or potential supplier – was not considered to be income. However, the new law now clearly states that “contributions to capital” does not include any contribution in the aid of construction, any other contribution by a patient/supplier or any contribution by any governmental entity or civic group and must be treated as income.
If property is acquired by an incorporated practice as a contribution to capital and is not contributed by a shareholder, the adjusted basis or book value of the property is zero. If the contribution to capital consists of money, the new rules require the incorporated practice to first reduce the basis or book value of any property acquired with the contributed money within the next 12 months and then reduce the basis of other property held by the practice.
Affordable Care Act’s individual mandate
The 2010 Affordable Care Act – popularly known as Obamacare – contained a provision that required individuals to buy health insurance or pay a federal penalty. Thus, any individual who failed to buy health insurance was required to pay penalties of $695 (higher for families) or 2.5% of their household income, whichever was higher, but was capped at the national average cost of the most basic, low-premium, high-deductible plan. Fortunately, the new law repeals the penalties.
No deduction for fines, penalties, sexual harassment settlements
An optometrist or optometric practice is generally allowed a deduction for ordinary and necessary expenses paid or incurred in carrying on any trade or business. However, among other exceptions, there is no deduction for: any illegal bribe, illegal kickback or other illegal payment; certain lobbying and political expenses; any fine or similar penalty paid to a government for the violation of any law; and two-thirds of treble damage payments under the antitrust laws. Under the TCJA, no deduction is allowed for any settlement, payout or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.
Estate taxes
Ranking high on many optometrists’ list of concerns, the tax law applies a 40% levy on estates worth more than $5.49 million for individuals and $10.98 million for couples. The newly passed law provides immediate relief from the so-called death tax by doubling the exemption so it applies to fewer estates. The higher thresholds would sunset in 2026 and be repealed entirely after 6 years.
In a related area, the credit for estate, gift and generation-skipping transfer taxes has been increased to $10 million for decedents dying and gifts made after Dec. 31, 2017.
Many of the TCJA’s provisions impacting on the personal tax bills of optometric professionals are set to expire on Dec. 31, 2025. If no legislation is passed to extend the tax changes beyond that date, tax rates and exemption rules will revert to the 2016 levels of current law.
Additional changes
Obviously, there are many more changes contained in the massive TCJA. Many of those tax breaks and new restrictions will have a significant impact on optometrists, their practices and small businesses. S corporations attempting to convert to regular C corporations will face tougher, new rules; Section 199, the deduction for so-called domestic production activities, has been repealed; and partnerships will no longer automatically terminate upon the death or exit of a partner.
All-in-all, the TCJA appears to favor professional practices and businesses over individuals, with longer-lived tax savings. Even worse, with few exceptions, many of the personal tax breaks are only temporary, expiring after 2025. In my next column I will explore the impact of the TCJA on optometry practices and their principals.
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- Mark E. Battersby has been reporting on news and developments in the tax and financial arenas for more than 25 years. He can be reached at MEBatt12@Earthlink.net.
Disclosure: Battersby has no relevant financial disclosures.