Healthcare and Tax Reform: What We Know Now
Since the Tax Cuts and Jobs Act (TCJA) was signed into law seven months ago, many healthcare professionals have been wondering how the new law will impact the industry and what steps they should take now to prepare. Though the Internal Revenue Service (IRS) is still issuing guidance on the new law, this article summarizes the key provisions and the implications for those practicing in the healthcare industry.
The 20 Percent Pass-Through Deduction
Those earning income via pass-through entities (i.e., sole proprietorships, partnerships, limited liability companies, and S corporations) may be entitled to a new deduction on “qualified business income.” The deduction can be as high as 20 percent, but several limitations and exclusions may apply, which could decrease the benefit. For instance, many service businesses, including healthcare services, are not considered “qualified businesses.” As a result, these businesses are generally not entitled to the deduction. However, there is an exception for taxpayers reporting less than $157,500 of taxable income on their individual tax return ($315,000 for those who are married filing jointly). This means owners of pass-through entities – including healthcare service businesses – will be entitled to the full 20 percent deduction on “qualified business income” if their taxable income is below this threshold. Taxpayers with taxable income in excess of this threshold will either receive a limited deduction or will be fully ineligible for the deduction. Taxpayers reporting taxable income between $157,500 and $207,500 ($315,000 and $415,000 for those who are married filing jointly) will be entitled to a partial deduction, and taxpayers with taxable income exceeding $207,500 ($415,000 for those who are married filing jointly) will generally not be entitled to a deduction on any portion of healthcare service income.
As an additional limitation, taxpayers exceeding the $157,500 ($315,000 for those who are married filing jointly) taxable income threshold may be limited to 50 percent of allocable W-2 wages paid by the pass-through entity or, alternatively, 25 percent of allocable W-2 wages paid by the pass-through entity plus 2.5 percent of allocable qualified property held by the pass-through entity.
Healthcare services generally do not qualify for the 20 percent deduction (unless below the aforementioned income thresholds). But, to what extent can healthcare professionals separate nonservice lines of business from the overall business operation? For instance, can pharmaceutical drug trials, clinical lab operations, drug administration, or retail sales be accounted for separately, and further, do they represent a business activity that is not related to healthcare services? If so, a deduction would be permitted with respect to these lines of business even though the overall business operation, the provision of the healthcare service, is typically disqualified. If taxpayers are not permitted to segregate lines of business within an entity, will they instead benefit by creating separate entities to operate nonservice businesses?
Additional questions arise with respect to income earned from self-rented real estate and ambulatory surgery centers. Will income from these sources be treated as healthcare service-related and thus ineligible for the deduction? Additional opportunities may arise in situations where packaged or bundled pricing is offered. Are healthcare professionals permitted to allocate more of the fee to facility/equipment use and away from the medical service itself? Guidance from the IRS is likely forthcoming, but in the absence of such guidance, reasonable arguments could be made to support these positions.
As previously stated, the extent to which taxpayers will be able to separate lines of business (either within a single entity or with separate entities) is unclear. Although the IRS has yet to issue guidance, taxpayers should speak with their tax advisors to ensure they are positioned to maximize the deduction. Careful consideration should be given to any position that serves to utilize the deduction within the healthcare industry; taxpayers should be aware of the associated risk and should work in combination with their advisor to ensure the position is well documented and in accordance with relevant guidance.
Business Interest Limitation
The TCJA imposes a limitation on a taxpayer’s ability to deduct business interest expense. Under the new law, a taxpayer will only be able to deduct business interest up to 30 percent of the business’s adjusted taxable income, which is generally taxable income with an addback for interest, depreciation, and amortization. Any disallowed interest deductions may be carried forward to future tax years. Businesses with average annual gross receipts of $25 million or less are exempt from this limitation. (Related entities are required to be aggregated for purposes of the $25 million exemption.) This limitation may particularly impact healthcare businesses with encumbered real estate, especially when such real estate is isolated in a separate entity.
Under the new tax law, 100 percent of the cost of qualified property placed in service after Sept. 27, 2017, and before Jan. 1, 2023, may be expensed. Beginning in 2023, the bonus depreciation amount will begin to phase out. It is important to note that used property will now qualify for bonus depreciation. The new law also allows businesses to claim up to $1 million, adjusted for inflation, of Section 179 deductions each year on qualifying property.
Meals and Entertainment
The TCJA eliminates the 50 percent deduction allowed for entertainment, amusement, or recreation expenses. However, there are certain exceptions to this rule. One significant exception is for recreational or social activities primarily for the benefit of the employee. For example, holiday parties, annual picnics, or employee outings would all continue to be deductible entertainment expenses.
Food and beverage expenses incurred in the course of business remain 50 percent deductible in large part but also received noteworthy changes. Under the previous law, meals provided to employees for the convenience of the employer were 100 percent deductible. However, under the new law, the deduction for these meals is limited to 50 percent. At this point it is unclear whether food and beverage expenses incurred in connection with an entertainment event (e.g., hot dogs purchased at a baseball game) would be nondeductible as an entertainment expense or whether they would be 50 percent deductible as a food and beverage expense.
Due to the changes in the treatment of meals and entertainment expenses, the best practice is to create a general ledger account for entertainment expenses and another account for food and beverage expenses. This will allow the nondeductible entertainment expenses to be easily identified.
The tax law limits or completely eliminates several deductions previously allowable to individual taxpayers. For example:
- Moving Expense Deduction: The deduction and tax-free receipt of reimbursement of moving expenses incurred when starting a new job has been suspended. Healthcare providers who offer to reimburse moving expenses in order to attract physicians will need to report the moving expenses on the physicians’ W-2 wages as compensation.
- Itemized Deductions: Taxpayers who may have historically itemized deductions, but have less than $24,000 of itemized deductions, may now likely take the standard deduction instead. This means that these taxpayers will not receive a tax deduction for their charitable giving. One strategy to retain the tax benefit of charitable giving is to give more but less frequently. For example, if you wanted to donate $10,000 over the next two years, you might be better off giving the full $10,000 in either year as opposed to $5,000 each year. This is because the $10,000 donation might push you over the standard deduction, whereas $5,000 may not be enough to reach this threshold. The same effect can be achieved via a donor advised fund. (The benefit of the donor advised fund is that you would be able to direct charitable giving yearly but still get the up-front tax deduction when assets are deposited in the fund).
- Miscellaneous Itemized Deductions: All miscellaneous itemized deductions subject to the two percent floor have been suspended. Examples include unreimbursed employee expenses, investment expenses, and tax preparation fees.
- Mortgage Interest Deduction: The mortgage interest deduction debt limitation was reduced from $1 million to $750,000. Interest on debt incurred prior to Dec. 15, 2017, is grandfathered and will still be subject to the higher $1 million limitation. Additionally, under the new law, the deduction is limited to home acquisition indebtedness. Mortgage interest paid on home equity indebtedness is no longer deductible unless the debt would otherwise qualify as acquisition indebtedness.
For more information on how the TCJA could affect you and your healthcare business, we encourage you to contact your KSM advisor.
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