Tax and Healthcare Legislation Creates Opportunities, Pitfalls

The impact of the American Taxpayer Relief Act of 2012 and the 2010 healthcare reform legislation might not be fully appreciated until you file your 2013 income taxes. And if you’ve already filed, you probably realize that the word “appreciate” is not used in a positive light.

“[Physicians are] going to be shocked and amazed,” says Nick Jovanovich, a tax attorney with the Florida business law firm Berger Singerman.

For example, the 2012 Tax Act retains the higher individual income tax rates that provide for a maximum rate of 39.6%. Also starting in 2013, individuals with income above certain amounts will be subject to a phase out of itemized deductions, as well as a phase out of the personal exemption.

In addition, the 3.8% Obama surtax on net investment income levied by the healthcare legislation means that capital gains of 15% are now taxed at 18.8% and capital gains of 20% are now taxed at 23.8% for persons whose modified adjusted gross income exceeds a certain dollar amount. This surtax creates additional complexities for individuals, estates and trusts.

“Physicians will certainly be much more cognizant of this going forward,” Jovanovich says.

Going forward

Jovanovich is quick to point out that all is not gloom and doom.

For example, prior to the 2012 tax act, transfer tax (estate, gift, and generation-skipping taxes) exemptions were scheduled to revert back to $1 million with a maximum transfer tax rate of 55%. The 2012 tax act capped the maximum transfer tax rate at 40%, extended the $5 million per person transfer tax exemption (indexed for inflation) and extended portability for estate and gift taxes, which allows unused exemption amounts to carry over to the surviving spouse resulting in a $10 million exemption for couples. As such, more couples are focusing less on estate tax savings strategies and more on asset protection planning and income tax planning.

“In prior years before we had a higher exemption amount and before we had portability, we would have put assets equal to the husband’s exemption amount in a credit shelter trust created by him, and the wife’s exemption amount in a credit shelter trust created by her, and the excess over the exemption amount would pass into a marital trust,” Jovanovich explains. “But now with higher exemption amounts and portability, for couples whose total assets are less than the combined exemption amounts, we can have a structure where the husband leaves his assets directly to his wife, and the wife directly to her husband, without any transfer taxes.”

As a result of the changes, heirs inheriting a property may be able to avoid or significantly reduce income taxes on the sale of the property.

Protecting the practice

On the medical practice side, Jovanovich says it’s important for physicians to have an appreciation for how their practices are structured.

All too often physicians still operate their practices as sole proprietorships, which offers no asset protection, while others are operating their practice through an S corporation. The problem with an S corporation, he points out, is that the S corporation stock may be attached/levied upon by the shareholder’s creditors. If the practice were owned by an LLC or a professional limited liability company (PLLC) owned by more than one member, then just like a limited partnership, there would be charging order protection.

“Many physicians think that if you form an S corporation that it has to be formed as a corporation for state law purposes,” Jovanovich says. “Oftentimes their accountant advises them to form an S corporation so that they can pay themselves a relatively small salary (which is subject to payroll taxes), while at the same time taking out a larger share of the profits as a K-1 distribution, free of payroll taxes.”

Jovanovich says that physicians who wish to form an S corporation that will be owned by more than one person should consider forming an LLC or PLLC, instead, and filing an election with the IRS to treat this entity as an S corporation for tax purposes.

Physicians who have existing S corporations owned by more than one person may want to consider converting their S corporation into an LLC or PLLC that is taxed as an S corporation. Properly structured, this conversion can be accomplished income-tax free. Physicians will end up with an LLC/PLLC for state law purposes, which may provide them with charging order protection, but for tax purposes the practice is treated as an S corporation.

“You do that by filing a conversion document with the state plus a certain tax election with the IRS to treat the successor LLC/PLLC as a corporation for tax purposes,” Jovanovich explains. “There’s no reason to have an S corporation when you can accomplish the same tax goal by forming an LLC taxed as an S corporation, while at the same time achieve non-tax benefits in the form of charging order protection for multi-member LLCs.”