What seems to be the successful crunching of numbers at year end to forego any unnecessary payment of corporate income tax, may come back to bite you. Many unsuspecting medical practices may find themselves with a deferred income tax liability when the time comes to liquidate the practice.
According to a Medical Management Advisor (MMA) article written by PYA Principal Greg Gates, CPA, “Most medical practices prepare monthly financial statements and income tax returns based on the income tax method of accounting (some may refer to this as the cash method of accounting). One of the drawbacks of the method is that all too often a practice has unknowingly created a deferred income tax liability that the physicians and administrator (and perhaps even the CPA) are unaware of. Stated simply, a deferred income tax liability is the amount of federal and state income taxes that will be due in the event, and at the time, the practice liquidates.”
The scenario is most prevalent with C corporations, but any practice—from sole proprietorship to limited liability company to partnership or corporation—is subject to deferred income tax liability.
In the MMA article, Gates outlines the three main types of medical practice expenses:
Because the tax deduction for these types of expenses equals the amount spent, no deferred income tax liability is created.
For example, if a practice pays cash for a fixed asset, the money is spent more quickly than the practice can depreciate or amortize the fixed asset over its applicable useful life. However, according to Gates, “Over the useful life of the asset, the practice will get a tax deduction equal to the amount of cash spent. Accordingly a timing difference may create taxable income in one year but, at the end of the useful life, this timing difference will ‘correct itself’ and does not add to a deferred income tax liability.”
This type of expense creates the deferred income tax liability. Meal and entertainment expenses are good examples because most are only 50% deductible. Cumulatively, the difference between the expense and what can be deducted adds up. Other examples of non-deductible expense include corporate federal income tax, penalties, business gifts exceeding $25, social club dues, amounts paid to shareholders for stock redemptions, and most officers’ life insurance premiums.
It is important that practices are aware of what creates deferred income tax liability and that they review the liability with their tax advisors annually. Once it has been identified, the tax advisor can help determine ways to eliminate or contain it. Ignoring the liability will result in the practice incurring permanent differences each year, with the liability growing larger and larger. The last doctor to retire will bear the ultimate burden of the deferred liability.
Another consideration is buy-ins and buy-outs. Your tax advisor can make a calculation of the deferred income tax liability and advise a physician as to the amount of the deferred income tax liability (which should affect the amount of the buy-in or buy-out).
If your practice has questions about deferred tax liability, contact the expert listed below at PYA, (800) 270-9629.
WE ARE REQUIRED BY IRS CIRCULAR 230 TO INFORM YOU THAT THE FOLLOWING DISCUSSION WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, NOR RELIED UPON, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING ANY PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW. THE ADVICE WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED IN THE DISCUSSION. EACH TAXPAYER SHOULD SEEK ADVICE BASED ON ITS PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.