How can a physician prepare their business for a tax-free retirement?
Tax planning for retirement may look slightly different every few years, as laws and regulations change in individual states and on a federal level. In part one of this series, we talked about the potential effects on taxes of the 2020 election, an overview of the history of tax rates, and where rates are likely to go in the future. We also covered individual options for creating a tax-free retirement.
In part two, we’ll be covering key tax strategies to create a tax-free retirement—but on the business side of the equation.
Essential business tax strategies
The right strategy will be based on your unique business situation, and not all of these options will make sense for your medical practice.
Consider adding or establishing the following:
- A family management C corporation with fringe benefits to your medical practice S corporation
- A 1202 intellectual property corporation
- A restricted property trust
- A closely-held insurance company owned by a Roth IRA/401(k) plan
- Selling your practice or other appreciated assets to a family endowment plan
- A practice management S corporation owned by an employee stock ownership trust
We’ll briefly walk through each of these scenarios to cover how they work and the benefits.
Family management C corporation with fringe benefits
When you decide to add a family management C corporation with fringe benefits, you can realize these advantages:
- Tax-free fringe benefits to owner-employees
- Taxable income will be shifted into the 21% income tax bracket
Basically, you would have a tax-deductible management fee paid by your medical practice—the S corporation—that goes into the C corporation. Then that amount goes back into the medical practice as tax-free fringe benefits.
If your practice has these expenses and you don’t take advantage of this structure, you’re essentially leaving money on the table.
1202 intellectual property corporation
This provision allows shareholders of qualified small business stock owned for at least five years to exclude up to $10 million of capital gains upon the sale. The tax law was expanded to include 100% of capital gains.
The medical practice creates a tax-deductible IP licensing fee, then lease that IP from the IP company. This stream of income is then capitalized for purposes of valuation when the practice gets sold.
Restricted property trust
This option doesn’t work for everyone because the minimum contribution in a restricted property trust is $50,000, and you have to commit for at least five years.
But it has significant benefits. The total net tax-deductible contributions go into the restricted property trust, and the trust then provides tax-free income in retirement. It also comes with a self-completion benefit, where your family will receive a whole life death benefit if you die before retirement age.
If you need life insurance, this is an ideal way to get it because you can deduct a portion of the premium.
Closely-held insurance company owned by Roth IRA/401(k)
In this situation, the medical practice pays a premium to the insurance company each year, calculated at the lesser of 10% of gross revenues or up to $2.3 million per year. Then, if you don’t file a claim, the money turns into a surplus.
The insurance company invests that surplus. And when you no longer need the insurance company in retirement, you liquidate it down to a Roth IRA. Starting at age 59 ½, you can pull all the money out completely income-tax free.
This is one of the best strategies out there for tax-free retirement income.
Selling your practice or other appreciated assets to a family endowment plan
This option allows you to make tax-deductible contributions, plus the money grows tax-free, the long-term distributions are tax-free, and those dollars are outside of a taxable estate—so you avoid estate tax, as well. You can control all the investments and own 100% of the voting interest. A donor-advised fund that you control owns the non-voting interest.
This strategy has a variety of potential uses, including:
- Alternative to funding an IRA
- Tax-free sale of real estate
- Sale of stock options
- Pension add-on
- Asset protection
- And many more
Here’s how it works: say you’re going to contribute your goodwill or nonclinical assets into the family endowment plan. You get back a 100% voting share, with the non-voting share going to the donor-advised fund. After the sale, 99% of that capital gain from the asset’s sale is allocated to the donor-advised fund, a tax-exempt entity.
So, you get a charitable deduction—which is limited to 30% of adjusted gross income but can be carried over for five years—equal to the fair market value of the non-voting interest in the donor-advised fund. Whatever the gain is, it’s not subject to capital gains tax. Now, that money is available to reinvest in pretty much any vehicle.
Practice management S corporation owned by an employee stock ownership plan or trust
In the employee stock ownership plan (ESOP) scenario, you determine a management fee to pay the S corporation—up to 30% of gross revenue. This works a lot like the family endowment plan in that the money you put there can be used for a variety of purposes or investments. The cash goes into the S corporation tax-deductible, and the employee stock ownership plan owns it.
Generally, you as the physician will be considered the highly compensated employee (HCE). If it is a partnership, there may be multiple HCEs. But you will retain 70% of the net economic effect of that plan, and non-highly compensated employees (NHCEs) would get 30%.
You have full access to how that money is invested and used for financing, future acquisitions, buy-sell purposes between partners, and more. If you make an outright sale to the ESOP someday (rather than family endowment), the capital gain on the deal would be deferred as long as you sell over 30% of the practice and roll that money over to qualified replacement securities. These could be privately or publicly traded stock or bond portfolios.
Working with tax professionals
As a physician, one or more of these strategies will apply to your business when you have income you want to shelter for retirement purposes.
But navigating all these tax scenarios isn’t simple. Work with the professionals at Physicians Tax Solutions to ensure you’re doing everything you can to pave the way for a tax-free retirement.
Physician Tax Solutions supports busy medical practitioners with proactive strategies and full-service tax preparation services that dramatically reduce tax bills. Contact us online or by calling 1-855-693-7829 to start saving today.