By Adam Cmejla, CFP®
April 24, 2019
Unless you’ve filed for an extension, by the time you’re reading this article your 2018 business tax return has already been filed.
This is the likely scenario of many readers: You have an established practice, cash flow is solid, and your CPA is advising you that your tax bill for 2018 is going to be higher than you anticipated. You start looking for ways to minimize your tax bill for 2018 only to realize that the only arrow that’s left in your quiver is to make a profit-sharing contribution to your practice’s retirement plan.
If you’ve filed for an extension, then this strategy is still alive and well for you for tax year 2018, provided you have ample cash flow. If you’ve already filed, then take this opportunity to be proactive in your strategy for 2019, and determine if planning to make a profit- sharing contribution is a viable option for you.
Making a profit-sharing contribution is a strategy that I talk to practice owners about once their practice is “cash flow rich.” The characteristics of a practice that is making profit-sharing contributions is one where the following boxes can be checked:
• The practice has minimal debt service.
• The owner/doctor is drawing a comfortable salary from the practice.
• There are no planned major expenses or upgrades in the coming year that would require a significant cash outlay.
• Most importantly, the owner/doctor doesn’t “need” the net profits of the practice to sustain their personal quality of life. The profits of the practice are the “cherry on top of the sundae” and the entrepreneurial reward for being a business owner.
If you meet these criteria, consider the following truths about the one-of-two-things that will happen to the net profits of your practice: you can either have those profits flow through your business return (assuming you file as an S-corp) and onto your personal return, and have them taxed at your personal tax rate today, or you can choose to defer that tax liability by paying yourself (and your team) in the form of a profit-sharing contribution.
As with all financial matters, the variables at play here are abundant, and the information we’ll soon discuss should not be used solely in your decision-making process. Be sure to consult your professional team to help you make educated and informed decisions.
The rest of this article will look at a hypothetical, but detailed, example of these two choices.
Taking vs Sharing the Profits
Should you decide to share the profits of your practice, one of the jobs and duties of your TPA (Third-Party Administrator) is to help you understand how much of the profits you’ll have to share with your team. This is why making sure that your plan design serves you as the practice owner in the best way possible is an important component. Having the right plan design allows you to keep as much of the profits as you can as the owner of the practice. (Side note: if you’re interested in hearing a thorough discussion on retirement plan design options, check out this episode of our podcast called “The Dose” (newly renamed/rebranded “20/20 Money”).
Profit-sharing contributions are tax deductible on your business return and are accounted for on line 17 of Form 1120S (Subchapter S corporation tax return).
Consider the following data from an established and profitable practice that has a 401(k) New Comparability Profit-Sharing Plan with a 3 percent non-elective match formula:
As we can see, this practice has two owners and seven team members. In this example from 2018, the goal of the practice owner was to get to the maximum amount they could contribute into their retirement plan, otherwise called the “415 limit.” The 415 limit is the maximum amount that anyone can put into a qualified plan through all contributions: their own deferrals, company match and profit-sharing contributions. For 2018, that number was $55,000, and because this doctor is over the age of 50, she can make an additional $6,000 catch-up contribution.
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Based on the data, for the doctor-owner to max out their limit, they need to get an additional $31,100 into the retirement plan by making a profit-sharing contribution. (The other $29,900 has been contributed through their own deferrals and the company safe harbor match).
However, the Department of Labor (DoL) and the IRS put rules around “sharing the wealth.” In other words, the owner-doctor can’t just make the contribution and keep 100 percent of the profit-sharing contribution for themselves without sharing the profits with their “rank and file” team members.
As we can see, based on DoL rules, for the doctor to max out her plan, she needs to make a total profit-sharing contribution of $42,584, of which she’ll keep $31,100. Put another way, she’s able to keep 73 percent of the profits for herself while sharing the other 23 percent with her team,which presents the following mathematical decision point: Is this owner’s personal combined tax rate (federal and state) higher or lower than the amount that she would have to share with her team? If it’s higher, it would behoove her to make the profit-sharing contribution. If it’s lower, she would keep more dollars by having them flow through to her personal return and keep it for herself.
However, in my opinion, this is a very myopic way to evaluate this decision point. First, we’re forgetting the fact that the money that is being put into the profit-sharing plan is going to be invested for the long term. Even in this example of a doctor-owner over the age of 50, this person still has a 30+ year investment horizon, so we have to assume a growth rate for those funds.
Second, the doctor may well be in a lower tax bracket in retirement than they are right now in their peak income/earning years. Therefore, deferring the tax liability until a later time, at which point they will take distributions at a lower tax rate, may be advantageous and worth considering.
Positive Impact on Employee Morale
More importantly, though, we have to consider the effect that sharing the profits can have on team morale and buy-in to the mission and goals of the practice. Show me an owner who invests (literally and figuratively) in their team and I’ll show you a practice that has low turnover and productive, happy and loyal team members. The byproduct of this can translate into providing a great patient experience, which helps patient retention, business success and a lower-stress work environment.
Our happiest clients are those who own well-established, well-run practices…and one of the ways they have these kinds of practices is by minimizing team turnover.
Here’s an important point, though: Making profit-sharing contributions is difficult to do if you aren’t able to satisfy my last and most important characteristic that I mentioned in the beginning of the article–making sure that you don’t need the profits from your practice because “lifestyle creep” in your personal life demands that you siphon off every available dollar for your own personal consumption.
How do you prevent that from occurring? By being a good steward of the business and wealth you’ve created…and by having a trusted team of advisors guide and coach you on how to create a sound personal and professional plan.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a free copy of his “Top Five Tips to Financial Freedom” visit https://bit.ly/2Mo3NV8 and check out the “20/20 Money” podcast wherever you find your favorite podcasts to get more tips on making smart, informed financial and business decisions.