Can Locums Doctors Qualify for a 20% Tax Deduction?

The new tax bill has become law and accountants are eagerly poring over the details, dissecting it for loopholes. One of the biggest giveaways is to small businesses, allowing a 20% deduction for income that is passed through (called “pass-thru” in the law) to the individual. It’s called Section 199A, and I expect that this will become a household name as famous as the 401k. The intent of the addition is to benefit small businesses (larger ones tend to go for C-corp style taxation) that employ the bulk of Americans but would otherwise be penalized at higher individual tax rates versus C-corps. To avoid incentivizing too many of these entities to be forced to convert to C-corps, it was decided to offer some token tax cut to pass through businesses. Ron Johnson largely pushed this addition through by himself, given slim margins for Republicans in the Senate.

Remember, this website isn’t interested in debating the ethics of the law or the politics behind its passage or ramifications. Rather, we want to be more practical (or nakedly capitalist if you will) – can I exploit this loophole for my own gain? This will be a more fine tuned analysis geared towards medical professionals, due to my own expertise in this area, but the principles are largely applicable to other professional service businesses as well.

To qualify, first you must be taxed as a pass through business. This includes:

  • Sole proprietors. If you’re taxed by filling out Schedule C reports of your 1099 independent contractor income, you count in this category. It’s the default if you haven’t gone out of your way to form a more advanced business structure.
  • Partnership. Basically a few sole proprietors working together on the project, each owning a portion of the firm. Each passes through income proportionally. Note that a married couple can be counted as a sole proprietor because they file together.
  • S-corp. This is where things get fun. This business model can scale as big as you want. You have all the responsibilities of a big corporation in terms of payroll, offering 401k, health benefits, getting a corporate board, and filing quarterly tax payments. It’s a big setup and reporting hassle and can be expensive to maintain. Luckily there are software packages out there that can make it easy for you to create one.
  • LLC status is a legal distinction that doesn’t matter to the IRS.

Contracted physicians (this includes the locums category) tend to be either sole proprietors or S-corp. Many have opted for the latter because you can choose to structure some income as wage income (W-2) and the rest as a pass through business distribution that is not subject to payroll tax. The IRS closely scrutinizes the proportion that is in each category to prevent people underpaying themselves and taking almost everything as a distribution. The generally accepted principle is that your income should be close to the national average for your profession and the type of work you do. Given the high incomes of physicians, this won’t save you anything in Social Security (unless you work part time) once you pass the income limit, but it will only save you the 2.9% Medicare portion of payroll tax that is applied to all earned income. It’s up to you to determine whether the tax savings outweigh the setup and maintenance costs as well as tax reporting hassles.

When crafting this carve out, politicians were careful to limit its benefits to favoured categories of individuals. They like businesses that own real estate, employ people, and invest in capital equipment. They most definitely did not want this loophole to benefit high income professionals who don’t employ others. Politically that would be depicted as overly favouring the rich, who presumably don’t need this loophole. Thus the law featured two “tests” – the income test and the profession test.

The Income Test

If you’re single and your total taxable income (this includes all other investment, side job, and interest income) is less than $157,500, great! You can take this deduction no questions asked. If you’re married, the same limit is $315,000. Mind you, if your income is higher than this threshold, it doesn’t mean you can’t take it. Rather, there’s a phase out period up to $207,500 for singles and $415,000 for married individuals. The phase out is essentially linear. What it means is if your income is above the phase out thresholds, you can’t use *any* of this 20% deduction. It doesn’t mean that you can still deduct the portion that’s under $315,000.

Ironically, this creates significantly negative incentives around the phase out line where one’s marginal tax rate goes up temporarily to ~50-60% because of rising brackets and losing benefits. Greg Mankiw may chime in in five years and say that it’s a “upper middle class” income trap with bad incentives.

Don’t fret if your income is above either threshold (lucky you!). Remember this test just wants to check your total taxable income. Anything that reduces this number can make you thin enough to squeeze under the bar and claim the deduction. This includes SEP-IRA, 401k, and business expenses, all of which reduce what’s visible as taxable income.

The Profession Test

If you make more than the income cutoffs, you can benefit from the law if your business fits into one of these categories:

  1. Anyone who is in the business of being an employee (yes, being an employee is considered being in a business), and
  2. Any “specified service trade or business.” 

The IRS will spend several years filing lawsuits and refining this broad definition, but for now you can consider that if your business features your skills and services as opposed to owning property and selling goods, you’re one of the undesirable types. You will fail the profession test. Law, medicine, “consultant” and accounting are some of the professions that are explicitly mentioned as failing this test.

Somehow there are exceptions for architects and engineers. No one knows why but presumably their professional societies lobbied hard.

The Recap

So for our locums physician to take advantage of this benefit, he or she needs to satisfy the income test, because we know that medicine will surely fail the profession test. This is easier to do if you work in one of the lower paying specialties, work part-time, and are married. For our friends with S-corp setups, since the income test evaluates you on your overall income, it doesn’t matter if you slice your earnings as salary or a business distribution, they both will be counted for purposes of the limit. This obviates a big advantage of S-corps relative to sole proprietors.

Some of the more astute readers will note that there is another test called the W-2 test, which is supposed to limit abuse by preventing really high income people from quitting their jobs and becoming a consultant working the same job. Forbes explains better than I can:

I’m a partner at a BIG, PRESTIGIOUS ACCOUNTING FIRM. I am also, however, an employee; one who collects a wage. Now, let’s just assume that my annual wage is $800,000 (it is not). With the new rules coming down and offering a 20% deduction against my income, what would prevent me from quitting my current gig, and then having my firm engage the services of “Tony Nitti, Inc.” a brand new S corporation I’ve set up specifically to facilitate my tax shenanigans? Now, my firm pays that same $800,000 to my S corporation, and my S corporation simply allows that income to flow through to be as QBI. I, in turn, take a 20% deduction against that income, reducing my income to $640,000. See the problem?

My role at my firm hasn’t changed. I provided accounting services before, I provide accounting services now. But before, I was receiving wages taxed at ordinary rates as high as 37%. Now, by converting to an S corporation and foregoing wages in favor of QBI, I am now paying an effective rate on that income of only 29.6% (37% * 80%). That’s not fair, is it? Compensation for services should be taxed at the same rate, whether it’s coming to me as a salary or flow-through income.

To prevent these abuses, Congress enacted the W-2 limitations. Because, in my example, Tony Nitti, Inc. does not pay any wages, in both scenarios my limitation would be a big fat ZERO, meaning I get no deduction. Like so:

My deduction is the LESSER OF:

  1. 20% of $800,000, or $160,000, or
  2. The GREATER OF:
    1. 50% of W-2 wages, or $0, or
    2. 25% of W-2 wages, or $0, plus 2.5% of the unadjusted basis of the LLC’s assets, or $0, for a total of $0..

It’s a lot of calculation and looks complicated, but we can actually disregard it all as this limitation will only come into play if you fail the income test. Since we’ve already determined that a physician who fails the income test will automatically fail the profession test and be prohibited from taking the deduction, we shouldn’t even worry about this section.

As Forbes explains:

Section 199A(b)(3)(A) provides that if your TAXABLE INCOME for the year — not adjusted gross income, not QBI, but TAXABLE INCOME — is less than the “threshold amount” for the year, then you can simply ignore the two W-2-based limitations. The “threshold amounts” for 2018 are $315,000 if you are married, and $157,500 for all other taxpayers. These amounts will be indexed for inflation starting in 2019. And quite obviously, you determine taxable income WITHOUT factoring in any potential 20% deduction that we’re discussing here.

The Payoff

Phew. You’ve waded through all of the above because you’re eagerly salivating over seeing how much you can save on your taxes, right?! Let’s crunch some numbers.

Our example physician is married, works as a contractor (paid as 1099), and is set up as a sole practitioner (in the end, S-corp calculations won’t be too different from this) for simplicity’s sake. Assume no kids. This person is based in Texas and to avoid troublesome state income tax calculations performs contract work in Washington, Nevada, Texas, and Florida only. Yearly income starting in 2018, the first year the new law will apply, is estimated to be $400,000.

To fit under the threshold, we maximize our SEP-IRA contributions, which are $54,000. We accumulate $22,000 in deductible business expenses. Then we also take the standard deduction of $24,000 for a married couple. That leaves us with $300,000 exact in visible taxable income. All of it is eligible for the 20% deduction.

Let’s use Marketwatch’s calculator to calculate our total tax under the new bracket system for 2018:

  • $40,179 for federal income tax
  • $0 state income tax
  • $15,958.8 Social Security (double because of 1099)
  • $12,114 Medicare (including surtax)
  • Total of $68,251.8

For comparison, if we earn that $300,000 as W-2 income (employed physician), our total tax will be:

  • $60,578 for federal income tax
  • $0 state income tax
  • $7,979.4 Social Security
  • $6,633 Medicare (including surtax)
  • Total of $75,190.4

There is a net savings of $6,938.6 with business income as opposed to wage income. The numbers are close but not exact, since the business owner will be able to deduct business expenses and half of the payroll tax that the W-2 earner can’t itemize.

I haven’t included calculations for S-corp owners because there are complex rules depending on how much you take as W-2 salary and how much is a distribution. The same thresholds apply, and you are only allowed the 20% deduction on the portion that is a distribution.

 

(Much of the details are from the source text, as well as Forbes Tax Geek and Evergreen Small Business)

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Don’t Do Something, Just Stand There

Another week, another all time in the stock market. North Korea’s saber rattling and the devastation wrought by the hurricanes don’t seem to have put a dent in the market’s relentless ascent. Furthermore, with this being the “most hated” bull market in history (or so they all say), things don’t seem primed for a major collapse. A mild pullback on the order of 5-10%? Sure, perhaps it will happen within the next year, but a major recession doesn’t seem to be in the cards.

What’s the best mentality for an average investor to have? The same as always – don’t change your long-term strategy due to short-term circumstances. Ignore the noise going on around you and robotically invest what you won’t touch in the next 5-10 years. The mantra that my mentor in medicine told me, which brings “do no harm” into the modern world, is encapsulated by the title of the post. Sometimes it’s simply better to do nothing than to react like a jumpy cat to every slight movement.

Take this advice of this article for instance:

“If you don’t want to invest in equities because you fear a market crash, then you should never be in equities, because equities always crash,” Ritholtz said, speaking at Morningstar’s annual ETF conference.

He noted that there was a bear market in equities—defined as a 20% drop from a peak—every five years, on average, although the recent market environment has been bereft of even much smaller declines. Current valuations have led to concerns that such a crash could be imminent, but “If you’re under [the age of] 50, you should be rooting for a market crash, because it would be nice to have a 20% discount and then 20 years to compound that discount.”

He added, “there’s no escaping this: markets go up and down, that’s what they do. But if you’re still worried, you should significantly lower your expectations for future returns” by buying safer—but lower growth—alternatives. He noted that over the past century, U.S. stocks have returned about 10 times what Treasurys have, although they also experienced numerous massive selloffs over that time, something the government bonds hadn’t.

“The risk you assume when you buy equities is that there will be a significant drawdown in the 20 to 30 years you own them. But you get rewarded for that risk. Treasurys don’t have the same kind of drawdowns, but don’t deliver the same kind of returns.”

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To Buy or Not to Buy at Market Highs

There is always a bit of fear when evaluating buying in at all time highs. The sentiment is understandable. Everyone is afraid of buying in at a market peak and eating the recession that follows. After all, after almost a decade of uninterrupted growth, aren’t we due for a downturn?

However, the data analysis (done by someone else!) and existing scholars such as Tobias Moskowitz supports momentum investing. In other words, when the market or an individual stock is rising, it’s more likely than not to keep rising than to suddenly reverse.

Applied to current market highs, I would still encourage ordinary people to invest their new capital in accordance with prior allocation ratios, to achieve a healthy rebalance despite stock market highs. More likely than not, the market will be even higher (even after adjusting for inflation) in the next decade. If prior trends hold, we may be on the cusp of a 1-2 decade run of sustained all time highs.

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Secrets to Successful Investing

It feels like we’re always hammering the same points on investing over and over again. Don’t watch your portfolio. Stop tracking the market’s daily gyrations. Focus on the long term. Stay diversified. Don’t try to stock pick or market time. Stick with the asset allocation determined earlier and rebalance. Stick to these tried and true principles based on solid research and you’ll be fine.

Sometimes, we feel that we can be exceptional or lucky and we try for the moon. Humans are poor learners from others’ failures, and rather learn best from a strongly emotional personal experience (like a major loss in the market due to a self-inflicted error). I believe everyone should learn that by starting out playing single stocks with small amounts of play money, ideally earlier in life rather than later, so we can quickly return to the right path having learned our lesson in a way that sicks.

In other words, use the “the martyr system” to your advantage, letting the hippocampus impart the long-term financial scars from personal failures that will leave lasting memories of what not to do.

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No Regrets

My last post touched briefly on the nature of regret in missing out (selling too soon, buying in too late). However, this is not a healthy mindset to have. As Marketwatch pointed out today, very few people have the intestinal fortitude to ride out the market’s gyrations and hold for the 10+ years needed for wealth to compound exponentially. How many of us would have sold out during one of the times when bitcoin or Netflix crashed >50%?

This Morningstar article serves as a reminder that we are our own worst enemies:

Well, it’s really about the target-date funds because they are sort of the confluence of good behavior. In other words, they are boring funds. You’ve got tremendous diversification. They don’t cause fear or greed. They are just boring. But then the other part of it is, in 401(k)s where you see nearly all the target-date money, people are investing every paycheck very steadily. So, they are also kind of shielded from the ups and downs of the market. So, if you go back to ’08, ’09, 2010, people just kept steadily investing, people generally did not panic in their 401(k)s, and so that meant you are really buying low and then staying with it to see those benefits. So, if you think about it, target-date is kind of the intersection of good funds and good investor behavior and it kind of suggests where we might want to go as an investing group as a whole because this is where things really work well.

The best returns actually came from disciplined boring investing. As Monevator likes to say, keep investing as boring as watching paint dry, so you won’t be tempted to buy and sell all the time. As another former mentor once told me, “Don’t just do something, stand there!” That is really the approach to take when investing.

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Take More Risk in Tax Advantage Accounts

The Bond King Bill Gross likes to philosophize about profound emotions such as joy and melancholy in his investment rants, and this post is driven in part by the emotion of regret seeing Bitcoin hit all time highs, and even surpassing the price of gold.

Such is the case for many in my field. When I was finishing my last year at Berkeley, I came upon news reports of the fancy new cryptocurrency idea called Bitcoin. Independently at the same time, so did my fiancee’s brother, childhood friend, and cousin-in law (all techies). We didn’t think much of it, and as risk averse as I was, I didn’t even bother putting $50 or so of play money into there. If I did, it would be worth almost a million! Similarly, my fiancee’s aunt regrets not buying Apple stock when it was down in the dumpster right before Jobs took over (seriously, most smart money was on the company going bankrupt, not staging a phoenix-like revival).

While we can all regret not doing the most “optimal” thing (life doesn’t have a save/reload button) in hindsight, we can also never with certainty predict what the future will hold. What we can do, and it will sound boring, is to make sure we have the right types of investments in the right places, and to stay allocated to assets in a way that allows us to sleep well at night. If we do dedicate a small (e.g. 5%) portion of our portfolio to lottery ticket bets on small cap stocks, that’s fine. Just make sure to do it in the tax advantaged section of the portfolio.

Standard portfolio theory suggests that we should make sure that our money is invested in the way that takes advantage of legal tax shelters to our benefit, as much as possible. Just to recap, there are in general three big categories of holdings: taxable, pre-tax 401k/IRA, and Roth 401k/IRA. Here’s what we should put in each:

  • Taxable: The goal here is to hold for as long as possible and to minimize the number of transactions and income generated, since each sale can generate a huge tax bill for capital gains. The best choice is a low fee total stock market index fund (Vanguard, iShares, and Schwab are all good choices) that is held and not sold until death. Then we can take advantage of the tax free basis step up when we bequeath to heirs. The small amount of dividends generated is taxable, yes, but at a much lower rate than the marginal rate. Bond holdings should be in tax-free municipal bonds as much as possible, doubly so if you’re in a high tax bracket.
  • Pre-Tax: We have to pay tax on the whole thing anyway but not until we cash the money out from the account. That quirk makes pre-tax accounts ideal for traders, stock pickers, and market timers who move in and out of positions with regularity. It’s also a good place to stash taxable bond funds and high dividend funds that throw out a lot of periodic income.
  • Roth: This is where you should make your highest risk “lottery” type bets. Let’s say you could (and want to) invest in bitcoin, startups in their infancy, micro cap stocks, penny/value stocks, turnaround stories, Greek bonds on the verge of default, and foreclosed homes. You would do so here. The bigger the potential gains, the better it will be. Whether you stumble upon a 10-bagger or 100-bagger doesn’t matter. You won’t pay any tax on it at the end.

So in summary, you want to use the right tool for the job. A balanced portfolio should consist of stock funds, bond funds, and maybe a dash of play money. Instead of making each tax category holding the same, we should concentrate our investments in the type of account that is best-suited from a tax perspective. Big gainers should be in the Roth, slow steady accumulator broad market funds should be in taxable, and income spewing investments in the pre-tax account.

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Passive Clearly Beating Active

These past few years have not been good to actively managed funds, or their managers. As this Morningstar article shows, funds are continuing to lose investor money and as a result, they have to lay off their fund directors. Shed no tears for them though, as they’ve had several years of high six figure+ income without providing a corresponding return to their investors.

Let Uncle Warren and Jack Bogle light the way. It’s no secret why the biggest indexer, Vanguard, is growing more than everyone else combined!

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The Few Proud Stock Winners

Remember my exhortation against stock picking, due to the few winners driving gains and the majority of stocks being meh or losers? This Morningstar article posted an insightful finding based on a recent study:

Half of U.S. stock-market wealth creation has come from 0.33% of listed companies.

Please note, that figure is not 33%. It is one third of 1%—one security out of 300.
Of the 26,000 stocks that appear in CRSP’s database, 86 provided half the aggregate wealth creation, 282 are required to reach the 75% figure, and 983 account for the full 100%. That is, after the 983 highest wealth creators, the remaining 25,000-plus securities are net neutral. Some made money for their investors, and some lost, but overall they were a wash.
Let’s re-emphasize. 86 stocks drove half of the gains of the market as a whole. If you were to randomly pick a stock to place your bets on, you would only have a 0.33% chance of picking a major winner. What’s the lesson, Morningstar?
In other words, do as your columnist prescribes, not as he does: Diversify. Widely and broadly.
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How the Wealthy Became Rich

The answer? It’s mostly through slow and steady investment.

The article defined wealthy as those with at least $3 million in investable assets, which is easily within reach.

According to the survey, more than three-quarters of the wealthy investors surveyed came from middle-class or lower backgrounds, and earned their wealth mostly through income from work and investing.

They took one of three basic paths to wealth: earning it; investing to get it, or becoming an entrepreneur. Only 10% attributed their wealth mostly to an inheritance. In short, the wealthy have worked their way to their enviable portfolios, and took a long time getting there.

Regardless of the asset (preferably stocks or real estate), diligent saving and investing over time will let anyone achieve great wealth.

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There’s a Reason They Promote Active Management

Just saw this ad on Morningstar:

marketwatch ad

Investors have started to wake up to the high fees and poor performance seen with active management, and as a result, big financial service firms are trying to stem the flow of money away from active funds to passive funds. As a result, they’ve ramped up advertising trying to sell potential customers with fear. “Now is a turbulent time,” they say. “In an uncertain world, it’s not good to be passive.” “Have an expert guide you.”

But really, if they have to work that hard to sell you on something, it’s probably a bad investment. Just remember: they’re worried about profit, not about working in your best interest. They (apart from Vanguard) have little incentive to sell you on low-margin passive products.

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