The 10 Biggest Legal Mistakes Physicians Make That Lead to Excessive Federal Income Tax Liability

Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)

Download Free 646 Page E-book: The Biggest Legal Mistakes Physicians Make and How to Avoid Them

Executive Summary

Each year, many physicians pay unduly excessive federal income tax because the tax laws are highly complex and can be difficult to apply in specific situations. By having a general understanding of some basic tax rules and various traps for the unwary, physicians can avoid paying excessive federal income tax.

Mistake 1 Not Taking Advantage of the Higher Expensing Limit

The 2003 tax act increased the amount that business taxpayers may elect to take as an expense deduction for the purchase of tangible personal property used in the business. An expense deduction lowers taxable income by an immediate tax write-off, instead of depreciating the amount of the expenditure over the life of the property. The amount of the deduction has been increased to $100,000, but the deduction is totally phased out if investment in property for the tax year exceeds $490,000.

Action Step Physicians should manage their investments in office equipment to take full advantage of the increased expense deduction. They should consider advancing or delaying purchases of office equipment around year-end to obtain the maximum deductible amount.

Mistake 2 Assigning a High Value to a Covenant Not to Compete

Physicians who sell the assets of their medical practices are often asked to sign a covenant not to compete with the buyer of the practice. These covenants can last for a number of years and cover a designated geographic area. The amount of the purchase price that is allocated by the physician to the value of the covenant not to compete will be taxed to the physician at ordinary income tax rates (35%). However, the amount of the purchase price that is allocated to the goodwill of the practice will be taxed at capital gains tax rates (15%). This means that for every thousand dollars of purchase price that is allocated to goodwill instead of to a covenant not to compete, the physician will net additional cash of $200 through tax savings.

Action Step Physicians should negotiate with the buyer of their practice for a written allocation of the purchase price that minimizes the value of the covenant not to compete.

Mistake 3 Not Understanding Qualified Dividends

The 2003 tax act reduced the tax rate for “qualified dividends” to the applicable long-term capital gains rate. As such, dividends that were previously taxed at a rate as high as 35% may now be taxed at a rate as low as 15%. A “qualified dividend” is a dividend from most domestic and foreign stocks, but does not include amounts paid by real estate investment trusts (REITs) or amounts paid on preferred stocks. Also, to be entitled to treat the dividends as qualified, a taxpayer must hold the stock for more that 60 days within a 120-day window that surrounds the stock’s ex-dividend date.

Action Step Physicians who buy and hold investments will not have much difficulty following the qualified dividend holding period rules, while physicians who are active stock traders should invest in personal finance software program that can track the details of their investments.

Mistake 4 Not Bunching Up Deductions

Physicians typically expend considerable amounts for professional association fees. While these amounts are generally deductible for tax purposes, the deduction is limited to the amount of the fees paid during the year that exceeds 2% of the physician’s adjusted gross income. That threshold can be difficult to reach. For example, if a physician has an adjusted gross income of $200,000, only the amount of professional fees paid in excess of $4,000 will be deductible. Physicians should bunch deductions into a single tax year to exceed the minimum requirement.

Action Step Physicians should consider prepaying deductible expenses by December 31 of the year in order to exceed the floor on deductible amounts.

Mistake 5 Not Keeping Adequate Records

A general rule of the tax code is that deductions are allowed a matter of grace and that the burden is on the taxpayer to prove that they are entitled to the deduction. As such, physicians should always keep receipts, records, statements, and checks that support their deductions. The documentation should be kept for three years from the due date of the return or the date on which the return was filed, whichever is later. After three years, the Internal Revenue Service can assess a taxpayer only if it can be proven that the taxpayer committed fraud with respect to filing his or her tax return.

Action Step Physicians should separate out and save receipts, records, and checks by deductible category.

Mistake 6 Not Owning a Home

The tax laws are undeniably skewed in favor of home ownership. Interest paid on mortgage loans and home equity loans are deductible on tax returns. Also deductible are property taxes paid during the year. Additionally, upon purchasing a home, taxpayers are allowed to fully deduct any points charged by the lender, whether it is the buyer or the seller who actually pays the points.

Physicians who use a portion of their house as a home office can depreciate that portion of the house and deduct the amount of utility costs and homeowners insurance that relate to the use of the home office. The biggest tax benefit to home ownership by far is that if the home has been lived in for at least two of the last five years as a primary residence, then the gain recognized on the sale of the house will be totally excluded from income and never taxed.

Action Step Physicians should buy a home.

Mistake 7 Failing to Deduct Moving Expenses

Physicians often relocate for employment opportunities. If the costs of moving to a new locale are not reimbursed by an employer, the physician may be able to deduct the moving expenses on a federal tax return. To take the deduction, two tests must be met: first, the new office must be 50 miles farther from the old home than was the physician’s old office; and second, the physician must work at least 39 weeks during the immediate 12 months after the move. Moving expenses include the cost of moving of household goods, mileage, and lodging.

Action Step Physicians should keep track of all unreimbursed moving expenses incurred in relocating for employment.

Mistake 8 Failing to Pay Attention to the Alternative Minimum Tax

The tax cuts of 2001 and 2003 magnified the risk that physicians will be hit by the alternative minimum tax. The AMT is a parallel tax system to the regular federal income tax designed to make sure that taxpayers do not pay too little tax. The AMT has its own rates and rules on deductions and add-backs. Physicians will pay to the government the greater of either their regular federal tax liability or their AMT tax liability. The likelihood of being subject to the AMT increases as a physician’s income increases. If an AMT liability is due and the physician has not paid enough in taxes throughout the year (either through withholding or by making estimated tax payments), the physician may be subject to penalties and interest.

Action Step Physicians should consult with their tax professional and inquire about their susceptibility to the AMT.

Mistake 9 Not Tracking Tax Basis in Investments

A physician’s original tax basis in investment assets is generally the amount paid for the investment. The basis is increased by the amount of any commissions or fees incurred in consummating the purchase. If investment property is inherited, however, the physician’s tax basis is the fair market value on the date of the decedent’s death. If dividends and capital gains paid on the investment have been reinvested, then the tax basis of the investment is increased for these amounts because they were taxable to the physician in the year reported.

Action Step More investment companies are tracking taxpayers’ basis in their investments. However, good practice is to maintain all account statements that detail any activity with respect to the investment.

Mistake 10 Failing to Hire a Tax Professional

Physicians should hire a qualified professional to advise them on tax matters. The tax laws are vastly complex, and there is generally no benefit to physicians in spending their time attempting to learn tax law. Also, because the incomes of physicians are typically well above the median income level, applying the tax laws to physicians becomes even more complex, since many tax deductions and credits may either be unavailable or substantially limited.

Action Step Physicians should seek recommendations from colleagues for a qualified tax professional.

Conclusion

Physicians who understand some basic tax rules and principles will generally pay less in federal income taxes.

Additional Resources