After much anticipation, the Treasury Department has finally come out with regulations clarifying the 20% pass-through deduction affecting dental practices and their DSO’s.
As most of you know, much has been written about how this new tax law could provide a potential windfall for S Corporations, Partnerships and Sole Proprietorships (e.g. pass-through entities). This was an actively discussed issue at the Dykema Definitive DSO Conference where I was a participant on the expert tax panel this past July.
It has been well documented that to the extent the taxable income of an owner of a dental practice formed as a pass-through entity exceeds $415,000, such owner will not able to obtain this special deduction equaling 20% of the net income of the practice. This is because certain professional service firms are deemed a specified service trade or business (SSTB) and are not eligible to claim this deduction. The question was how are dental support organizations (DSO’s) viewed relative to this tax benefit?
Here is the bottom line
To the extent that the DSO and dental practice (PC) have common ownership, whereby ownership of 50% or more exists among the same group of entities and 80% or more of the revenue from the DSO comes from the commonly owned PC’s, the DSO is viewed as a SSTB and is not able to take advantage of the 20% pass-through deduction. So the question begets, how does one view common ownership?
Brothers and sisters, children and parents, spouses, and Corporations and Partnerships that are owned by the same people are viewed as commonly owned. Here is an example of a common DSO/PC structure. Two brothers own a DSO equally, while one of the brothers is a dentist who owns a 100% interest in the PC. The DSO derives 100% of its income from the PC. As a result of this relationship the DSO is viewed as a SSTB and is unable to take advantage of the 20% deduction.
While this eliminates many DSO’s from obtaining this tax benefit, it clarifies opportunities for the Investor/Private Equity based DSO as more often than not, common ownership is less than 50% and/or less than 80% of the revenue of the DSO is received from PC’s where greater than 50% common ownership exists.
Let’s look at the following example:
Dr. Jones owns 100% of a PC A and 51% of a DSO. Dr. Smith owns 100% of PC B and 0% of the DSO. Each PC generates 50% of the DSO’s revenue. The net income earned by the DSO on PC B’s practice is eligible for the 20% deduction while the net income earned on PC A’s practice is not eligible due to common ownership.
Wait there’s more
There are a few more caveats.
To the extent that the DSO provides consulting services to any practice whereby such services consists of providing professional advice and counsel to assist the practice in achieving its goals and solving its problems, such services are considered disqualified from claiming the 20% deduction due to the nature of this type of service.
In addition, there is still a lack of clarity due to an overlap of service offerings in the fields of accounting and financial services as the DSO often provides accounting and bookkeeping services as well as providing advisory services regarding valuations, mergers, acquisitions, dispositions and restructurings.
While it is clear that the services referred to above are disqualified if offered by a traditional accounting or financial services firm, it is not as clear if they are provided by a DSO.
The good news is that payment processing and billing analysis is not deemed a disqualified service.
Thus it is critical for the DSO to maintain accurate records so that it can properly track the revenues and expenses of these disqualified services.
However, to the extent that these disqualified services are less than 10% of the total combined revenue of the combined businesses (5% for businesses whose combined revenues exceed $25 million), such income is considered incidental and does not need to be carved out for purposes of calculating the pass-through deduction.
How does the deduction work?
If your DSO qualifies for this benefit your deduction can not exceed the greater of:
1. 50% of the W-2 wages with respect to the qualified trade or business (W-2 wage limit), or
2. The sum of 25% of the W-2, wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”. Qualified property is defined as meaning tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.
As you can see, there are various complications in analyzing and evaluating these relationships in order to determine whether one can claim this valuable benefit while the interpretation of this new law will continue to evolve.
For more information please feel free to contact our offices.