116: Dental Financial Planning: Turning Chaos into Financial Freedom - Part 6

Hey, everybody. Welcome back. It's Wes Reed, cpacfp. It is a Saturday morning and I am hours away from embarking on a trip to Europe, first time in my life. And so I am knocking out a few podcast episodes. So we continue the sequence of two episodes per week. That's what we aspire to here at Practice CFO with our Dental Boardroom podcast. So let's carry on. So we just got done talking about in the last episode, the cost structure and breakeven levels. Pop quiz. What were the three breakevens as I defined them, they were, number one, your practice breakeven, your practice break even covers your fixed costs and your variable costs and your debt. Number two, your living budget breakeven that covers that level of collections, not only covers your fixed and variable costs, but it also covers what you need to live on and pay your taxes today. And the third break even. My favorite break even is the financial independence break even. That is the break even that not only are you covering your fixed and variable costs, paying yourself today, paying your taxes, but you're also setting aside money on your personal balance sheet to pay yourself in the future. That is financial independence break even. Now, what is the additional amount you need to layer on every month into your personal balance sheet in order to become financially independent? Well, that depends on how you define financial independence. Which was earlier in this series. Remember, the series was, number one, it's really four simple things. Financial planning for dentists. Number one, assemble your team, your A team, meet with them, have a cadence, a management process in the way you run your business as the CEO of the business. Number two, develop a personal financial plan for financial independence. That was step two, really authoring what kind of life you want, what kind of life you want. I mean, particularly as it of course, relates to money. And so much of the things we want to do in life are funded by money. And unless you essentially want to live on the beach with a sleeping bag and bum food off people, you basically need to have a certain amount of resources to take care of yourself. Beyond that is really a function of your preferences, your goals. Is it travel? Does that mean a lot to you? Is it having a really nice second home? Does that mean a lot to you? Is it some really nice cars? Is it golfing a lot? Is it fashion handbags? What is it? What means a lot to you? Now, I won't get into the philosophy around what drives true sort of happiness or joy. I'll leave that one to you to think about. But I will put an endorsement on experiences and relationships. Experiences and relationships. And truth is, you actually don't need to have a bazillion dollars to have a incredibly fulfilling life through experiences and relationships. And you can learn on faith in there if you're a person of faith. But it really doesn't require a huge amount. It doesn't. However, I admit there are things that I want to do. Like I'm about to leave on what's a fairly expensive trip to Europe, and I have never done this before. But I've decided that I want more experiences in my life. Helping my kids through some of their college costs is also a priority for me as well. And I gotta admit, I love to have a little house somewhere up right next to my brother in the northern parts of Washington. He lives on an island called Anacortes up in the San Juan Islands, and I would love to have a small second home right up there. It's beautiful. The scenery is beautiful. Be with my brother. I deeply love again, relationships, relationships, relationships. That's what I'm finding as I get older. It's relationships and the quality of those relationships that just seem to drive happiness home. I love it. So financial independence is break even. If you have done a good financial plan and you take that financial plan which will say how much you need to set aside every month to your financial goals, you give that to a good business planner and CPA and maybe, maybe they can back in through your taxes, debt, fixed costs, variable costs. Ultimately, what do you need to collect every year? What do you need to collect every month in order to satisfy those three breakevens, Practice breakeven, Living budget breakeven and financial independence breakeven. So here at Practice cfo, here's my sales pitch. That's what we do. That's why we exist, is we start with the end in mind, out of life, what do you want? And then we work our way backwards into a deeply, deeply committed and organized financial plan. Inside and outside of Are you looking.

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The Practice Most of the work, most of the hard work I'll say happens on the inside of the practice where all your overhead is, where your practice acquisition debt is or build out debt, equipment debt, all that debt, your 401k might be in there. This is where so much of the tax planning needs to take place is on the inside of your practice. So the business financial planning is the most important part of the overall process. When it comes to the technical side of financial planning for a dentist, it's on the business side. I would say we spend 75% of our time with our clients focusing on the business. The here, the now. This year, cash flows, taxes, 401k, defined benefit plan budgets, all of that, growing your top line, all of that. That's where we spend 75% of our time knowing that if we have a healthy cash flow in the practice then we can feed out to your personal life what you need today and what you need in the future. And that's where we spend probably 25% of our time is really doing a personal financial plan. Talking about your personal spending and needs in a very real way in the here and now. All right, let's now carry on to the next part of the process. Did I, did I remind you of all four sequences of the steps in the financial planning sequence? I think I did. Your team, your personal financial planning, your business financial plan to support your personal financial plan. And then you revisit, monitor, revise. Those are the four steps. All right, let's go on to the business planning. So we are in step three. Create a business financial plan to support your personal financial plan. And there were various steps in this reiterating what those steps are. They are organize your practice financial reports. That's your monthly P and L and other reports. Understand your breakeven. That's what we just talked about. Complete a tax plan as we're going to talk about today.

Determine your appropriate W2 payroll for the year. That is assuming you are a C corporation, which if you are a single doctor, you absolutely should be. And if you're a partnership, your ownership in that partnership should be through a wholly owned S corporation. I had a whole series on partnership financial planning and partnership structuring and financial concepts back in, I think the 70s of my podcast, if in numerical order, if you're interested, go check that out. But if you are a single doctor owning your practice, unless you're say 6, 700,000 collections or less where you can be a sole proprietor, you absolutely above that amount should be a corporation, an S corporation. Now, in your state you may be able to be set up as an llc, a pllc. There's different sort of state designations when it comes to the actual title of formation and the liability protection you get out of that. But since we're on the subject of taxes today, I'll explain this. When it comes to the irs, the IRS doesn't even know what an LLC is. That's a little bit tongue in cheek. But they don't have a LLC tax return. They don't. There is simply.

A corporation tax return. And a corporation can be S or C. Small businesses are going to be S. There is a partnership tax return and there is a sole proprietor as well. The sole proprietor goes actually just on the 1040 tax return. And then there are different tax returns for states and trusts and charities and things like that, which I'm not going to get into. But for a dental practice owner, it is. Your three options are sole proprietor, S Corp, C Corp, or partnership. That's it. Those four don't ever be a C corp. Period. End of story. Never. Never. Partnership. Yes, always if you are more than one owner and S Corporation. Yes, always. If you are a single owner or your partnership, your S corporation owns your share of the partnership. Those are the primary tax structures for a dental practice owner. And again, if you're an S corporation, you are required to pay yourself a W2 as an employee of your own corporation. And I'm going to explain that a little bit later. Many of you listening to this are seasoned vets and are going to understand that concept, so I won't spend too long on it. I have other podcasts dedicated entirely to the concept of how much to pay yourself as a W2 employee, and I am going to just address that briefly again here shortly. All right, number five in the phase three, Develop a business financial plan. Number five is to complete a cash flow projection and allocate any surplus cash. Or what I like to call surplus capital is really the more technical use here. So organize your practice reports, understand your breakevens, complete a tax plan, determine your W2 payer for the year and then complete a cash flow projection and allocate surplus capital so that those are the steps of the business financial plan. And we are in Number three, Complete a tax tax plan. So let me head on over here. Those of you on YouTube are following along and I will explain for the rest of you. All right, number three, Complete a tax plan. I don't actually have a lot of visuals on this one, so this one's pretty much just me talking. And I want to start this off by emphasizing that there is a process to tax planning. Just like there is a process to doing a root canal or a restoration with initial X rays, clinical treatment, discussion, doing the work, collecting. There's a process. There's a process around good tax planning as well. It's not actually a single event or act or just one strategy of a few checkboxes or a few forms. That's not tax planning. Tax planning is a subset of financial planning. And financial planning is a comprehensive game plan for your full cash flow, end to end, from the moment it hits your bank account in your business, checking to the time that it goes out to pay the various vendors, the bank, the tax agencies, yourself, et cetera. Planning for all of that, top to bottom. And then within that you start to see where your opportunities are for tax planning. It's like you got to get all the pieces of your 3,000 piece puzzle on the table and you start to organize these things by color. You start to get a good idea of generally where they are and you start piecing this thing together. And the more you piece it together, the more you get clarity. And the more you get clarity, the more decision making, better decision making you can have. That's what tax planning is. It needs to be done within a comprehensive understanding of the cash flow. And this is why CPAs will give you some, some basic tax planning advice. Some of the common tax planning advice is on your level of your W2 relative to your profits on your K1. They will also talk to you about how much depreciation you can take. They may give you some advice about what you can or can't run through the business. Most CPAs are ultra conservative on keeping a division between personal and business. I am way more strategic and intentional around that to try to maximize deductions. And I will, I will talk about that a little bit. But the tax, the tax planning is, it's looking at. Those are some of the main things that a CPA will do. But they're not really getting into the deep trenches of cash flow. So here is the process. Number one is some time. So number one is in the, in the beginning of the year, you can look at your P and L for the full prior year and.

You can use that as your starting point to forecast out your current year. You can just assume this new year is going to be last year plus 3% because I raised my UCRS a little bit or the insurance companies allowed an increase to the fee schedule. Whatever, it's going to be pretty consistent from year to year. And you have a, you probably don't have your tax return yet done in January or February. You definitely aren't going to have your 1040 unless you have an absolute superhuman CPA because the IRS doesn't even open their filing window until late January, sometimes early February. And so you're probably not going to get your, you're not going to know what your ultimate tax liability for the prior year was until at best it's going to be probably around March. So we, some of our clients who are in need of getting a tax return done right away because they're trying to buy a house or for whatever reason, or some of our largest clients where we absolutely need the tax return done ASAP.

We'll have some S Corps and some 1040s done in February, but most of them start to roll out S Corps really aggressively late February, finishing up a lot of our S Corps in March. And then we really pivot after March 15th when the is the first deadline for S corporations, then you got one month to try to get the 1040 personal tax returns done by April 15th. Now, the vast majority of business owners extend their tax returns so they don't file on their Corporation's returns on March 15. They will extend and then they will extend their 1040 from April 15, the extension date, the final due dates, the extended due dates are September 15th for corporations and October 15th for individuals. And partnerships are also on. I think they may have changed this, but partnerships historically have been October 15th as well, sorry, September 15th as well. And the reason for having the business tax return due date before the personal tax return due date seems pretty obvious because it is you need to have that K1 as a business owner from your S corporation or partnership in order to do your 1040. Meaning you can't do your 1040 tax return until your business tax return is done. Therefore, the IRS expects business tax returns done to be sooner to dish out those K1s for S corporations partnerships to the CPA to then be able to do the 1040. So that's why the sequence is what it is. Now. A lot of people think oh well then why do I even need to worry about figuring out my tax liability making any final payments by April 15th if we can extend and have all the way until October 15th. The reason why is even though the IRS allows you to extend to 15 file the return the physical, well it's not physical, the digital return these days they it doesn't mean that the IRS is letting you extend the due date of your payments or amounts owed. This is why CPAs have to do an estimate. They have to look at your the prior year data and they have to try to get some information about your personal situation. If the CPA is doing the accounting in house within their company like practice cfo, if they're doing the accounting in house, then they have the financial statements through December 31 and will be able to therefore get.

Almost a perfectly accurate extension of the S Corporation tax return. Now that said, the one big variable with S Corporation tax returns is the fact that if you have a 401k or a few of you may have a defined benefit plan, cash balance plan, but if you have a 401k, a lot of times you don't know exactly what the final top off amount the final contribution is to your 401k until you get what's called a contribution letter and back from the third party administrator or tpa. So I'm going to Double click on this just for a sec. Your 401k has to be tested every year. Now all, pretty much all of our clients have a 401k and we do the year end work to gather the census data and information to then hand off to the TPA. We are not a TPA practice CFO, but we do work very closely with two TPAs and we then we do the interaction with the TPA so the doctor doesn't have to. We give them the census, we go over the design. Here's what we're trying to do. Tpa, we want to maximize the safe harbor and the profit share on this 401k. We've got the spouse on payroll in order to contribute into this. And then we will work with the tpa, they'll give us some scenarios, scenario one, two, and sometimes even a third scenario. And then we come back to the doctor and, and we look at the cash balance and we look at how much they're going to owe in taxes because this all relates to each other and we will recommend a certain amount. Now what I usually say is if you have sufficient cash above your working capital needs, then I like to drop a lot into that 401k because for most doctors, every dollar they put into the 401k at that time is getting somewhere around a 35 to 47% income tax deduction. It's a significant reduction on taxes. The more that you can put into your 401k. Now I get it, you don't see that money now. And so it may not feel as valuable, but the reality is it's hugely valuable because not only is it going to save you a dramatic amount in taxes, it's also going to grow. Tax deferred. And if you look at the science of compounded growth, tax deferred significantly propels the rate of compounding. And that's why tax deferral is so valuable. And a lot of times I have a doctor say, yeah, but Wes, I'm gonna have to pay taxes on it at ordinary rates when I pull it out down the road. Well, that's true, but if you can let this sit for 15 years, 20 years, 25 years, the compounding effect just dwarfs the fact that you are going to have to pay taxes when you pull it out. But remember, it saved you taxes today when you're likely in a higher tax bracket than you are at that point. I'm sort of riffing here, but I want to keep going on this a little bit. And this is sort of the conversation I will often have with people is people will say, well yeah, but Wes, in the future tax rates are likely going to be higher and that could be very, very true. There are two reasons why your tax rates for you personally will be different in the future.

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Sure. Number one is your income level will be different in the future. After retirement, theoretically your income level will be a lot lower. And if your income level is lower, you're going to be taxed at a lower rate. However, there's a second reason for a change in your tax circumstance. The tax brackets themselves change and you have no control over that other than your tiny little one vote that you make for the President. He usually dictates what these tax code changes are.

And they may lower the brackets or they may raise the brackets. They may change the rates, or they may change the new tier at which you enter a rate. Think of the tax bracket or the tax scale. This progressive tax scale is like stairs. You've probably heard me say this many times. If you listen to me a lot, the stairs and on the first stair it's 0% up to about $15,000 of income. You don't have to pay a single dollar in taxes. Federally speaking state you may, but federally you don't. Then the next stair after 50,000 and that stair will go from 15,000, I don't know, let's say up to about 35, 40,000.

That portion of your income for the year is that that next step, that next interval of income is taxed at 10% and then the next 30 or 40,000 is taxed at 12%. And those stairs keep going up and there are, if you count zero as a stair or the base, the first stair is at 10%. There are 1, 2, 3, 4, 5, 6, 7 stairs, the 10% bracket, the 12% bracket, the 22% bracket, the 24% bracket, the 32% bracket, the 35% bracket, and the 37% bracket. 1, 2, 3, 4th, 5, 6, 7. Now, most of you doctors are above the 24% bracket federally. And you hit that when you have $206,700 of taxable income. Now that's not necessarily your W2 or even the sum of your W2 and K1. That is your taxable income. So that's after certain deductions for itemized deductions, for example, or what's called a qualified business income deduction. There's some deductions you have in your 1040 that you are lowering what is your sort of gross take home income in order to get to your taxable income. And your taxable income is then entered into this sort of stairs, this tax bracket. And your first 15,000 is taxed at nothing. Your next 20 or 30,000 is taxed at 12% on and on and up. When you get to $206,700 of taxable income, you are now in these sort of, you're getting into the larger brackets. You're now at 24% federally. Now remember, you got to add on whatever your state is, if you're in a state like California where at around 70, $80,000, you hit the their near top bracket pretty quick. That's at 9.3%. You got to add that 9.3%. Whatever your state tax is, whatever that is in Arizona, I think it's like 3.5% or so. Pennsylvania, I think it's 3.01%. And sometimes they're just flat taxes. Sometimes they're also stared or tiered or progressive brackets like the federal bracket is. But you got to layer those two things on top of each other to get your true marginal income tax rate. Now, some of you are in a state like Tennessee or a state like Washington where you don't have an income tax. However, as a business owner, you're the one who pays the taxes needed for that state to offer all the public benefits that it does. So business tax owners are. Business owners are disproportionately carrying the state tax load in those states. And so that's why a lot of times you hear people just all excited for living in tax free states like Texas or Florida, Tennessee, Washington, Alaska. These states where there's no income tax. If you're an employee, that's fantastic. You have. You completely escape the cost of providing the benefits of.

Sort of public benefits of roads and parks and school systems, not school systems, because that's actually paid by your property taxes. But you get to bypass paying for a lot of these benefits that fund the public area that you live in and not all. There are some state and local taxes that are very unique to given states like Pennsylvania. Pennsylvania has some unique local taxes and whatnot. But if you're in a lot of these states that don't have an income tax and you're a business owner, you have to pay this thing called a franchise tax. It's named differently in different states, but it's usually a percent of the either gross income or the net income in your business for that month. And every month you kind of got to log in and you got to make a payment or it could be done on the tax return itself. But it's important to understand that most of you are paying taxes at the state level. Most of you through an income tax, some of you through a franchise tax. And there's a few states where you just sort of escape it all altogether. All right, so at 206,700, you're now on the 24% tax bracket. Once you get to 300. This is married filing joint, by the way. If you're single, take half of this. It's pretty much half is the tier of income at which you're entering a higher bracket. At 394,600, you're in the 32% federal bracket. At $501,050, you're in the 35% tax bracket. And at 751,600, you are in this high, the highest tax bracket at 37%. And if you're in a state like California, you're going to be paying about another 10%. If you're above that 751,000, you're going to add roughly another 10% or so in California. And so you're at 47%. Once you get up past a million California, you're getting up to like 11% plus you're approaching 50%.

Now.

A lot of you are going to say, why would I even go into work if I'm literally giving up 50% of my hard earned income to the IRS? That just seems ridiculous. Well, a couple things to keep in mind. It's not like this is the main thing. It's not that 100% of your taxable income. Let's say you're making $800,000 taxable income. You got a thriving thing going on. Let's say that's the case. It's not that all $800,000 is taxed at 37%. No, the first $15,000 is zero. The next roughly 20, 30,000 is taxed at 10% and so on. So in all the income below $751,600, you're taxed at a rate lower than 37%. It's only dollars above that that are taxed at 37%. So you have to sort of blend them to understand what is your total. What, what's called effective tax rate. Marginal tax rate is the tax rate in that on that step that your income is on. And so if you're at 800,000, you're on the 37% step in my stair analogy. And so the effective tax rate is simply the total taxes you paid divided by your taxable income. So if you paid $100,000 in taxes and your taxable income was 400,000, then your effective tax rate is 25%. 100,000 divided by 400,000, which is 1 divided by 4. That is 25%. That's your true effective tax rate. Federally layer on state, which may be like 7 or 8% in California. And now you're at 32%. And now you got a good idea of my, of my total income, taxable income, I am paying in that case around 32% to federal and state. Now that doesn't factor in FICA taxes on your W2, that's Social Security, Medicare. That doesn't factor in property taxes, which is on your 1040 Schedule A. That, that doesn't factor in sales tax, which really for most of you is not a tax deductible. Paying your sales tax. And so when you lay on all these taxes, it starts to creep up there. And this is why taxes are a significant impediment to financial independence. And that's why having a good strategy around the way you weave your money throughout all of your vendors and your debt, your taxes, yourself, your retirement plan, investments, yada yada, the way you weave that and align all those levers really has a significant effect on how much friction you got to give up to the tax agencies. Okay, let's carry on now.

So the cadence that I recommend here on getting a tax plan is in the beginning of the year, I think it's a great idea to. If you can meet with your cpa, it's going to be very difficult. You may not be able to do this. But it's important that your payroll, your W2 out of your corporation is structured in a way so that it is withholding property, a proper amount of taxes. And if you have a 401k, you are projected to fully fund your 401k. If you have a spouse on payroll, then the spouse's payroll try to get sort of the boat pointing in the right direction in the first month or two of the year to the extent that you can. A lot of times what happens is whatever your payroll structure was at the end of December just carries on in January. For a lot of you, though, if your payroll was above 176,000, what happens is if your payroll was above your own W2 was above that, then your FICA taxes got capped out. And FICA taxes are 12.4%. And so if you don't change anything and you were tapped out, let's say you paid yourself $200,000 W2 in the prior year when you had hit. It was right around SE. It was right around 170,000 or so. Last year when you hit that point, suddenly you got a bump in your net deposit in your personal checking account because you already satisfied the fica, the Social Security tax withholding, and that is no longer withholding, which means the amount you took home went up. But in January, guess what kicks back in? Everything that was sort of phased out in the prior year, like your Social Security tax payments. That kicks back in in certain states, like California, where you have a state disability income deduction, as well, an SDI deduction, which caps out pretty early, that kicks back in in January. So a lot of times in January, you'll see, suddenly your payroll drops out of nowhere. So what we do here at practice CFO is every January, we have from the prior year, meetings, let's say the last quarter of the year or so. When we met with clients, we projected out their taxes, we projected out everything we said, okay, in January, here's what the payroll update needs to be for the doctor and doctor, spouse and kids. If kids are on payroll, and we spend a good couple days just going through every client and updating them so that that boat, starting with the new year is pointing in the right direction, then fast forward, you get four, five, six months of P and LS and cash flow into the new year. Now you, now you have an ability to project out what the income and net taxable income will be in the new year. Now at practice, CFO, we work really, really hard to get as many tax returns done on time by the original due dates, by the original due dates of April 15th. Because if we do that, then it's so much easier and effective to do a tax plan for the new year when you know what your tax situation ended up being in the prior year. And this is why we definitely get out a lot more tax returns than your traditional CPA. We strive for about 50%. But for those of you that we extend, you just gotta be a little patient and empathetic with us. Because the IRS opens up their tax filing window in the beginning of February. We have like five weeks, five weeks to get the corporations done. And we have about 400 corporations and business tax returns that we have to do. And we've got a tax team of roughly six people. It's just a tremendous amount of work. And they're working pretty much 16 hour days consistently during really from about February 1st to April 12th. About. It's insane for my tax team. So we pump those out as much as we can. Because for us, it's not just about filing your tax return and you paying us for a tax fee. It's not about that. It's actually about the tax return being done so that we can do our financial planning for, for the new year. Because the CFO model is all about financial planning. And when we don't have a 1040 tax return done until October, it's kind of hard to tax plan and financial plan for the new year. That's why it's hugely important for us that we push out returns. And we're currently looking for a couple more tax people. I'll tell you what, since COVID there's been a mass exodus from the accounting and tax world because the government incentives around ERC and PPP and Eidl and the HHS grants that were made, all this government helicopter money that was just dropped in the economy to try to spur it on and get it through Covid was an absolute nightmare for us CPAs and we're having to amend a lot of returns because of the erc. Doctors are getting ERC still to this day. Four years, five years after Covid hit, some of them are still landing ERCs, which is forcing us to go back and amend tax returns from prior quarters. IRS guidance is notoriously and shamefully late for us Tax law changes. A lot going on. It's been for tax people it's been rough. It's been rough. And many of you know our tax director David Niddle who we all love and have a good friendship with. He left practice CFO to go start a Handel's ice cream shop in Arizona. That's right. Quite a career change there mid career. It was just kind of a bruiser these past five, seven years. And our senior manager in tax named Maya, who is awesome. She is such a great tax person. She's highly technical, very responsive. She's growing her team over there on our tax side. She's doing a great job at this. But it has been tough and the accounting industry has been in a little bit of a crisis top to bottom. From the big ones like Ernst and Young and Deloitte where I used to work at Ernst and Young, from those big ones all the way down to the small CPA firms there is just a significant struggle to get talent. That's why a lot of CPA firms are offshoring to the Philippines is sort of a big go to right now because there's some very confident competent accountants and CPAs in the Philippines. And with the proper technology and security, it's been almost a necessity for a lot of firms to be able to offer their accounting tax audit services at at least a modest cost in order to cover their own costs and have a reasonable profit as a CPA firm. That's what's going on. And so it's been very difficult to be able to get more tax returns out the door across the industry by the due dates of April 15th. Now we are trying to hire and I prefer to be over hired in tax if possible because I want to get more and more and more tax returns done on time. Now there have been some people have said well Wes, isn't it better to extend your taxes and file them later because it makes you less subject to audit risk because the IRS will audit the ones that are done first rather than the ones that are done last. There may be a little bit of truth to that, but the reality is it makes hardly no difference because the IRS is so dramatically behind and Doge filed and fired another 5,000 people at the IRS that they are, they are just not going. They are just the number of audits is so dramatically low that risks of an audit, the staffing is so low that the risk is pretty low of being audit not to say you won't, not say you won't. We've had a few people audited, but the chances are pretty low. And so it really doesn't matter. I would say always don't let the tail wag the dog. The dog is. Let's get your tax return done sooner so we can do good business and financial planning. Business. Financial planning for the new year. Okay. I'm debating whether or not to do an episode or just sort of wrap this one. I'm going to wrap this one up here. Actually. No, I'm going to park this. We are coming up on 40 minutes. I'm going to park this, come back to do another episode. Until then, have a great.