How to design your Payroll as a Dental Practice Owner

Welcome back, associates. Today we're going to be talking about establishing your payroll. A strategically optimized payroll design is an instrumental component in carrying out your retirement tax and personal financial plans. As a practice owner, you have a lot more flexibility in how you manage your own payroll. And today we we're going to start with the key components of your payroll design. First, we have your gross wages. And on the surface it may be one that seems pretty straightforward. But the real question is how much in gross wages do we actually pay you? Second is your federal income tax withholdings. No matter where you live in the United States, you're going to pay some federal income taxes, or at least we hope so, because we want you to have some positive income. Third, unless you live in a state that doesn't charge income taxes, you're also going to have some state income tax withholdings. Next, most of you will have a non taxable distribution component to your payroll structure. This part of your payroll design isn't directly subject to income taxes or FICA taxes. And lastly, in order to properly design your payroll, you have to know what your cash flows of the practice are and how to manage your payroll design to be conducive to to your global cash flow plan. And next we're going to get into more detail on how we determine the appropriate amount of gross wages. When you're establishing your gross wages, there are a few important things to consider. You may at first ask yourself, why do I even need to pay myself a salary at all? I mean, after all, every dollar I pay myself via W2 salary, I, I have to pay 15.3% in FICA taxes on top of the income taxes I already owe. It's absurd. Well, the IRS has combated that urge by mandating that you pay yourself a reasonable salary. Yet they don't necessarily do a great job at defining or quantifying what reasonable is. And there are a few schools of thought out there on how to quantify a reasonable salary. But the one that consistently passes the smell test and the one that we actually use here at Practice, cfo is using half of your net business income before considering yourself and the W2. So we're going to first talk about a practice that doesn't have a 401k plan as an example, and one that will solely focus on estimated net business income for the year before paying a W2. And a lot goes into projecting your net business income for the year. For example, you have to have a good idea of how much you're going to produce, what your overhead is going to be in order to meet that production, how much interest you're going to pay on your debt, and how much depreciation and amortization you're going to have from the practice purchase or any new equipment that you've recently purchased subsequent to the acquisition. If you're not a CPA or a finance professional, estimating all of these things timely and accurately may feel overwhelming in a tall feat. It's not impossible, but it's more difficult, especially as you're in the operatories.

Once you've estimated your net business income for the year before factoring in your W2, you're going to want to pay yourself approximately half of that amount in gross wages. This has the benefit of keeping your FICA taxes as low as possible without failing to meet the IRS reasonableness test for W2 wages and failing to meet the IRS reasonableness test can trigger not only an income tax audit, but also a payroll tax audit. Payroll and income tax audits open up a lot of liability for missed underpayments, plus the accrued interest and penalties. Bottom line is the government wants you to fund your share of the Medicare and Social Security taxes, and we want to make sure you're on the right side of any gray area penalties and interest on avoidable areas. Crush your retirement funding opportunities and your timeline to financial independence and we're going to avoid those the best that we can. Next, let's talk about a practice that actually does have a 401k. Now most of you will have a full 401k which includes a safe harbor match and a profit sharing component because you're going to have great practice to fund that and we'll focus on that in a moment. But let's first focus on a 401k plan that only has the match component and the match component. As you may remember from our conversation of the differences between a W2 and independent contractor, a match component matches the only matches if the employee actually contributes to the plan and they will match them 3% dollar for dollar and 50% for the next 2%. Aka if an employee contributes 5% of their salary, you're going to match them 4% and the same goes for yourself and your elected deferrals that you contribute in the plan. You will be able to also match yourself and increase your own personal contributions, your retirement plan and increase the amount of tax deductions that you're going to get.

Relative to that as well.

In a 401k match plan, it is very similar to the first payroll gross wage example that we went over where we're going to look at half of your net business income as a proxy for how much wages we need to pay you. The only difference here is, is that we're going to have a match component that is going to be attributed to the staff. It's a deduction in your business. And you're also going to have a match component that's for you and your family. If we have family on your 401k plan as well. Those two expenses reduce your business net income, which then subsequently reduces the amount of W2 that we actually have to pay you. So there's two savings here that are happening. We are being able, we're able to lower our W2 to avoid excess FICA taxes even more. And then we're also able to lower our total global income, which effectively lowers our total income taxes. So two great tax savings opportunities here by having a match plan, or any 401k plan for that matter. But in this particular example, now when you have a full 401k profit sharing plan, you're really tied in terms of how much you need to pay yourself W2. And with this type of plan, we need to pay you as of 2020, $285,000 and of W2 salary. And the reason for paying yourself that amount is because we want your plan from an actuarial standpoint to not be what they call top heavy. And when a plan becomes top heavy, you end up paying a disproportionate amount to your staff relative to your benefit. But by paying yourself 285,000, we ensure that the that the contributions that you're allowed to contribute are the maximum amount that are allowed to go through the profit sharing and safe harbor buckets, which in 2020 is $37,500, in addition to the 19,500 in elective deferrals that goes through payroll. So next let's look at an example using the same numbers that we have been using in the Dr. Devlin example. We're going to continue to use those here and we'll look at how Dr. Devlin would evaluate his financial situation in order to determine a reasonable salary. Starting with his core business operations. At the top, we see that collections for the year were 1,350,000. And between his labor, supplies, labs, marketing and administrative expenses, Dr. Devlin's overhead was 854,000, leaving him with net operating income of 400.

Moving down, we see that Dr. Deblin has a loan for his CEREC, his CBCT, and for his scanners, for tax purposes, we can only deduct the interest, only the interest portion of those loans, not the principal. So in this year, Dr. Devlin has $20,947 in interest expense, but he actually only has $0 in depreciation amortization, which indicates that Dr. Devlin most likely took a Section 179 deduction at some point when he purchased those equipment in year one. Which is why we're not seeing a depreciation and amortization while he's still paying these debt payments on his loan. That's one primary reason as to why we would see that. Now lastly, we're going to look at the owner expenses that can be run through the business. So to arrive at what we call net business income and what we're going to use to establish your W2. Now, for Dr. Devlin, you'll notice owner W2 reads A0, and the Dr. Devlin estimated net income for 2020 is.

$439,553, of which we need to pay Dr. Devlin roughly half and roughly half is 214,000. Now, most of you will be on a semi monthly payroll cycle, in which case you will have 24 payrolls. Payroll runs for the year or two per month. So we forecast out your payroll design for the year and then we divide that Payroll design by 24 pay periods to get the payroll design that you're actually going to enter into your payroll software. Now, I prayed to CFO for our clients. We are carrying out and facilitating the actual entering and building the payroll designs with the payroll company. But if you're working with your own payroll company, then this is how you would calculate that to enter into the system. Now, if you happen to be on a bi weekly schedule, which is pay periods every other Friday, you're going to take our forecast as seen here and you're going to divide that by 26, because there's 26 pay periods and a bi weekly schedule. So now that we've determined our gross wages, let's circle back to our tax projection tab before moving into the rest of the payroll design.

We're looking at the same tax projections as before, but now we have the addition of the gross W2 wages of 214,000 and the corresponding payroll taxes of $11,469. Which leaves us with our new business income estimate of 214,084. Now remember, your W2 is also an expense to the corporation. So the more you pay yourself in W2, the less your business income is going to be. Now there are benefits to keeping your net business income higher under the new tax code, aside from the FICA tax savings. Right? Lower W2, higher business income, lower W2 equals lower FICA taxes. Higher business income is also a fairly good thing to have as long as you're within the phase out ranges under the new tax code because you get a qualified, what's called a qualified business income deduction or QBI for short. And Wes is going to cover this in detail in our tax module. Just know you're going to get a 20% deduction on that net business income number. So the higher that it is, the higher the deduction becomes. Alright, so now that We've established a W2 and computed the associated payroll taxes and arrived at our true net business income, we can compute what our total federal and state taxes are going to be. And we know that both your W2 and your net business income are going to transfer over your personal 1040 tax return where ultimately are going to form your taxable liability for the year. And in this example, your total income from your business is 50,428,008. Four, which is just your W2 plus your net business income. In order to keep this module dialed in, you're going to have to trust me that the tax estimates here on this 428,000 are accurate. Of course there are a lot of other things to consider before arriving at your true taxable income. But if you can get to this point, you've solved 75% of the tax puzzle. And as a CFO advisor, what I do for my clients is I get your global income numbers, every form of tax deduction under the sun and then we are throughout the year strategically planning so that we meet these certain income thresholds or deduction thresholds so that we're maximizing our withholding or maximizing our deductions and maximizing our tax plan in a way that keeps more after tax dollars in your pocket. Now our next example is establishing a payroll Design with the 401k match only plan. Here you can see we've compared to our first what we compared our first example. And these amount represents how much the doctor had to contribute for the staff at 4000 and how much he contributed for themself at 6000 to the 401 match component. And our gross W2 here, because this is what we're solving for, is still zero. And we see that our estimated net business income is $429,553. And remember, because we don't have a 401 profit sharing plan. Only a match plan. We don't actually need to default to that 285,000 as I mentioned previously, in order to maximize the 401 benefits for the doctor. Now let's look at the payroll design.

209,000 is approximately half of the estimated net business income after factoring in the staff and the Dr. 401k withholdings. And you'll also notice here that our taxes are considerably lower. And that's because in addition to the $10,000 deduction we discussed for the plan contributions, you will notice that Dr. Devlin also gets to contribute the max elected deferrals at least as of 2020 of 19,500. And that's an additional 29,500 in total tax savings thanks to the addition of this 401k plan. And you can see the resulting tax savings here compared to our original example. Alright, so let's circle back again to our tax projections tab and see how this all flows through. Now we have the addition of your W2 and payroll taxes. And I want you to notice that our gross W2 is almost identical to our net business income, which is exactly what we want to see. And you know, it can be plus or minus a couple percentage points. But really this is, in a perfect world, the most ideal. In our next example, we'll look at a plan with the 401 profit sharing component being added and what that looks like.

When a Practice adopts a 401 profit sharing plan and and maximizes that benefit. As you can see here, I've added these deductions to the safe harbor and profit sharing sections of the plan of 10,000 and 30,000 for the staff and the doctor respectively. You'll also notice how the amount that the doctor contribute relative to the staff greatly increases with this plan design, but so does the amount of cash that it takes in order to properly fund it. So the question isn't is a profit sharing plan right for my practice what? But rather when is it right for my practice? And the when is satisfied when you have enough cash flows to meet your personal spending budget, the overhead of your practice, and the cash flows necessary to fund the 401k plan. And under this plan we have estimated net business income before the Dr. W2 of $399,553. And we know in order to keep your plan optimized, we we need to pay you a W2 salary of 285,000. Here we see what a $285,000 salary looks like each pay period as well as the total taxes owed after adopting the plan, the taxes again are considerably less and the elected deferrals stay the same. Under both the match and profit sharing plan, the difference lies in the safe harbor and the profit sharing buckets where the doctor is able to contribute more for themselves. Circling back again to the tax rejections after building in the Gross W2 and the associated payroll taxes, we have a complete picture of what our estimated taxable situation will be from your dental practice. Okay, next we're going to look at how to pay taxes. Estimated total global taxable income for the year is going to be very handy in determining not only how we're going to pay our taxes, but where. And the where is are you making quarterly estimated tax payments or are you withholding taxes each pay period through payroll? Or perhaps are you doing both when paying taxes? There are, like I mentioned, two ways to do this. You can pay your taxes through payroll, or you can pay them through estimated payments, or maybe potentially even a combination of the two. But there's some important things to know in terms of how you can either pay yourself, depending on your income, 110% of your prior year's taxable liability. Now that can be 100% of your prior year taxable liability. But for most of you practice owners, your income is going to be high enough where it has to be 110% of your prior year taxable liability. And most CPAs, you know, general CPAs on the block, what they're going to do is going to take 110% of your prior taxable liability. They're going to break up into four payments. They're going to say, hey Doc, at the end of Q1, at the end of Q2, 3 and 4, I need you to make these payments. And all they're saying is if you pay this 110% of your prior year tax liability in these four equal installments without being late, you're not going to incur interest or penalties. But at the end of the year, your taxable situation could be drastically different. Hopefully it's a little higher because you're producing and collecting more. But what that CPA did not do for you is help you understand how you're going to what you're going to owe in taxes for the current year and how that differs from what you're paying in from an estimated payment standpoint. So that's one way to calculate your estimated payments that you might see from a cpa. Or the second way is they will take they will Try to do 90% of your current year's estimated taxable liability. Now, this is a little bit of a better way to do it, but it takes a lot more preparation, which is why most CPAs that are, you know, strictly historians revert to, because it's easier just to look at what you did before and just give you four payments and whereas actually sitting down with you throughout the year and estimating your income for the current year takes a little bit more work and therefore less likely that you're less likely to find that. Now at practice cfo, what I do with my clients, because we meet so frequently and so much is involved in the tax planning process throughout the year, because January through December 31st is when a tax return is billed, not at January 1st, when you're handing all of your tax receipts and documents to your CPA to prepare your taxes. At that point, it's too late to maximize some of the opportunities that you have. So here, what we do at practice CFO is I'm estimating your tax liability not at 90% for the current year, but hopefully at 100%. We're going to pay those payments through payroll, each pay period throughout the year. So, so that when you look at your bank account balance at any point in the year, you know through and through that that cash is after tax dollars that belongs to you to invest or pay your business overhead for working capital needs and to fund your future.

I mean, that's one of the key components of a successful cash flow plan is having a good strong understanding of what your true cash flow surplus is and what your true cash after tax cash balance is at any given point in time. Now, one of the other benefits of paying your payroll taxes, your income taxes through payroll rather than estimated payments is that for whatever reason, we have other cash flow priorities in the beginning of the year or maybe midway through the year that where we maybe turn taxes off or down to account for these other cash flow demands. But then we, you know, by the end of the year, By Just by December 31, the last payroll run, we've made up any missed tax payments by doing it through payroll. We are not subject to interest and penalties or late penalties by doing that. But however you do it through estimated payments, and we say, let's say you miss Q2 estimated payment, but you make Q3 and Q4 because you missed Q2, you will be subject to interest and penalties on that missed estimated payment. So there are definitely some benefits to paying them all through payroll. Now, what I hope for all of you is that at some point you're going to make too much money for us to fund all of your taxes through payroll without subjecting you to additional FICA taxes that are unwarranted. And at that point, we'll probably do a combination of both. We'll do estimated payments, but we'll also pay taxes through payroll to keep an even keel. Okay, so next, the next points in order to understand how to establish your payroll is what is your true personal spending budget? And does your cash flows for your practice, are they sufficient enough to pay yourself each month?

And what is your net W2 portion in relation to your distribution? If it's low, will this cause basis issues? Are you projecting a taxable loss in your practice? If so, what are the sources of income, if any, that we want to be able to use this loss in the current or future year? And what we're saying here guys, is, you know, in your payroll design I mentioned earlier, there's a non taxable distribution component to that payroll design. And that non taxable distribution component really just serves to meet your personal spending budget needs. Because your W2 in relation to your taxes is going to regenerate a net check. That net check likely isn't enough to cover your personal spending budget. So we add in this non taxable distribution to make up the rest, so that every pay period, you're getting the amount that you need in order to pay your living expenses. But on the flip side, and on the positive side, the reason why we'd like to do it this way is it has the effect of keeping you from a psychological standpoint, emotional standpoint, to stay on a budget. And by staying on that budget and not going back into the business bank account or the business piggy bank, so to speak, and pulling out surplus dollars in excess of that budget, it helps to keep your entire ecosystem of cash flow planning in line and, and.

Executed properly so that your financial independence goals are met on time. Basis is one of the more complicated areas of the tax code. And Wes is going to go over a lot of what basis, the details of what makes up basis. But quickly, at a high level, you create basis every single year. If you generate net income in your business, that is one way. The second way is if you contribute personal money from your personal bank account in the business account, that is considered an owner contribution, and that also increases your basis. But if your net income is artificially low due to depreciation amortization, then you're not creating basis, but you're taking distributions each pay period. And Distributions decreases your basis. And the IRS says if you distribute money that is in excess or more than what you've established in basis, then you're supposed to pay a capital gains tax rate of 15 or 20%, depending on your ordinary rate bucket on those excess distributions. Now, there are ways to get around that to some extent, but inevitably if you continue on that path, there's nothing that we can or anyone can do to keep you from paying those capital gains taxes at some point in the future. And Wes is going to do a great job of talking about basis and loan to shareholder in a future module, which you'll find out exactly how those things are intermingled and how they will reduce one another and how they reverse themselves naturally over time. As long as you have a strong business.

Tying personal spending budget back into your global cash flow plan what you're seeing here is how we're going to analyze not only the business component of your practice, but also the personal spending component. This is what we call the global cash flow projection view or perspective. And at the top, we're starting with business collections from your practice, as we always do. And then we're going to go through the main overhead categories as we always do, to get to core business income before any debt or personal spending is factored in. And then we're going to come down, we're going to take out your debt payments. And in a cash flow view, the debt payments that you're seeing here include both principal and interest because this is not a profit and loss statement for taxes. This is a true cash flow view. And this is how we tie in balance sheet and P and L into one view so that you can truly see the changes from your bank account balance in the beginning to the end of the month. And the next section is going to be personal Dr. Cash flows, essentially how we manufacture your payroll design to pay your taxes and your personal spending budget. And after that we factor in any 401 contributions that need to be made to the profit to the profit sharing or safe harbor buckets because those are not done through payroll, which is in the top line of the owner salary line item there, so that has to be taken out subsequently and then also any doctor perks. So doctor perks are going to range from health insurance premiums that you pay to the business auto, any business meals that you run through the business. So truly personal expenses in nature, something that would otherwise be once you got your net check from the business would come out in the form of a personal expense. But because you're a business owner, you have the luxury of including those as a business expense and why we're showing them here. So when we get to this place we want to look at. Alright, so we're paying ourselves $15,000 a month in personal spending and.

We have a residual profit left over. Is that residual profit enough surplus to not only Fund 401, but then to also fund other avenues in life? You're going to need that excess surplus to hopefully pay down student loans and other things other than just funding a 401k plan. And most likely, unless you're starting at 30, 31 years old, a 401k plan alone isn't enough to get you to financial independence in a timely manner where you're going to need taxable brokerage accounts, Roth, iris, all of this ecosystem of investment.

Real estate included, potentially even that are going to make up a strong portfolio for you to become financially independent. And this is the view where we're going to assess whether or not you are spending too much on the personal side or if we have a true business cash flow problem and there's potentially business strategic overhead changes that we need to make. We need to increase hygiene production. Dr. Production within the hygiene. Do we need to increase our, our perio maintenance that are coming through there? What can we do to bring new patient flow in? All of this sort of comes together in this view. And if personal spending ends up being the issue, that's the conversation that we start to have. And guys, that is our module on payroll design and how to structure your payroll. I hope you enjoyed it. I enjoyed being here and giving you the, giving you the spiel. Stay tuned for our future modules. I'll see you very soon.