The Most Overlooked Tax Mistake in Dentistry Excess Distributions

Welcome, everybody, to another episode of the Dental Boardroom podcast. It is May 13th today. This is the week of the CD8, the California Dental Association. I'm here in California. It is a huge convention. Those of you who attend it know that there are a lot of dentists and there are what feels like just as many vendors, and I will be there, has one of them Practice CFO and Practice Orbit. We'll both have boosts there. And I am speaking on the subject of buying a dental practice, on the subject of selling a dental practice, and on the subject of financial planning for existing practice owners who are neither buying or selling a dental practice. So I'm pretty excited about this week and always great things that come out of the CDA convention. Excited to go. All right. On today's subject list is something that dentists face often in their taxable situation. It is called excess distributions. Excess distributions. Have you heard of that term before? Maybe you heard your CPA talk about excess distributions. These are not good and they come with a what I just call a penalty tax. And so if you are a dentist and you are an S corporation, I really want you to listen up, really want you to listen up, because this is something that you have to constantly wrestle with. And if you understand what it is, I think you can wrestle more effectively to avoid getting hit with this penalty tax. If you are a partnership, this is probably less applicable, although it could be, and I'll explain later why. And if you're a sole proprietor, this is not applicable at all. But most of you RS corporations, and even those of you who are partnerships, set up as a 1065 partnership, usually, not always, but usually your attorney or accountant or both will recommend that as a partner in the dental practice, you have your own wholly owned, 100% owned S Corporation, and that that S corporation then owns your share of the partnership. Whether that's 50, 50, 60, 40, 70, 30, doesn't matter. That's usually the proper setup. It's called a partnership of corporations. It creates a lot of flexibility on how you distribute profits out of the dental practice and also how you can run personal expenses through your own S corporation without it being skin off the back of your partner. So that's a clean setup. So even if you are a partner, if you own your partnership interest through a wholly owned S corporation, then this podcast still applies to you. Now, you may say, hey, Wes, I'm an LLC and or not an S corp. Well, most of you who are LLCs are filing an S Corp tax return. You are an S Corp it's just at the state level. Some states allow you to structure yourself legally as a limited liability company or llc. And the reason why you do that is because there's lower, there's lower requirements on the administrative side of the entity as corporations just have more work to them. You have to keep corporate minutes. A lot of times they have more difficult filing with the Secretary of state where LLCs tend to be a little bit easier. Easier that way. But at the end of the day, they all file the exact same tax return. And it's called an 1120s. 1120 is a corporation. S is sort of a small business corporation. An 1120s which most of you listening in if you own a dental practice, are set up as an S corporation. Now a lot of states don't allow an llc. California, you have to be a professional corporation. So you're just straight up an S corp. That's how you're organized at the state level. But again, if you're confused about that at all, just look at your business tax return. And if at the top it says 1120s, then you know you are filing as an S corporation. Or just ask your accountant. All right, I want to go into this thing called excess distributions, which is a prolific subject of conversation as advisors and financial planners for our dentist that we have to educate them to understand because if not managed carefully, you will owe extra taxes and extra taxes get you behind and sometimes it spirals downward. And especially if you're a newer dentist who just bought a dental practice, you are highly susceptible to having what are called excess distributions. And I'll explain why. But even if you're a longtime practice owner, if you just did a build out or you're constantly buying new equipment, things that you depreciate or take a Section 179 deduction on, guess what? You too may have issues with what's called basis or excess distributions. Are you looking to buy or sell a dental practice? If you're a seller, how do you find a strong list of potential buyers? There's no MLS or Zillow for dental practice sales. In such a fragmented market, many dentists selling their practice feel discouraged. That's why I built practiceOrbit.com practice orbit is modernizing how dental practices are bought and sold. It's a platform technology. Y' all know them. Zillow, Airbnb, Uber, and OpenTable, just to name a few. These technologies do two things. First, they help match buyers and sellers by centralizing the marketplace. Second, once the match between buyer and seller is made, these technologies help them navigate the sale to a successful close. Here are a few of the features inside a Practice Orbit users can determine a reasonable sale price for practice in just minutes. All they need is the most recent business tax return. Practice owners can use the directory to find important service providers like practice brokers, attorneys, accountants and bankers. Practice owners and their brokers can invite those service providers into the platform so all parties are coordinating the sale together. Practice owners will have a beautiful digital listing of their practice like a home on Redfin. And importantly, the listing will be anonymous and personal information like your address, name and pictures are only released after an NDA is signed and approved by you or your broker. Practice buyers can create saved searches to be auto notified when new listings come on the platform that fit their desired specialty and location. And hey, dental practice brokers, you can list all your practices on the site for free. By doing so, you'll get access to Practice Orbit's large pool of buyers, all of whom have created profiles and saved searches to be auto notified of when new listings come for sale. You can use the platform to introduce your listings to a targeted set of buyers. Additionally and optionally, you can use the platform tools such as a built in NDA, a customizable loi and a workflow tool to navigate the sale from LOI to closing. In fact, you can manage all your listings on the system from listing the practice to NDA to loi and finally to closing the deal. Create your free account today at www.practiceorbit.com so there are certain terms I'm going to want you to know here because to understand what are excess distributions you need to understand certain terms that we use in the tax space for S Corporation owners. One of them is called basis. I'm going to talk about what is your tax basis. Number two is what's called a loan to shareholder. And then also I'm going to be talking about the risks with this issue of excess distributions. Risks that could lead to an IRS audit. And once the IRS weasels its nose in your door, guess what? A lot of times they start looking at the entire engine, not just one area. So the loan to shareholder and this excess distribution things thing, we got to have this under control. And I'll tell you what, if you don't plan with your CPA and understand what it is as you pull money out of your core incorporation into your personal checking account, if you're not careful, your CPA probably is not going to be ahead of this and you're going to find out after the fact. Why? Because as I've said before, CPAs are phenomenal historians, but they are historians. And as a historian, you're not planning for the future as much. Now, some CPAs do a pretty good job at jumping in and doing a forecast and helping you understand where you might be running into landmines around your cash flows, such as excess distributions. I believe that every CEO of their dental practice, that is all you all listening to me. I think that you need to understand this term. Now, I'm not trying to make you a tax professional or an accounting professional, none of that, but I don't want you to pay unnecessary taxes. And so this is one of those, I think, key terms or key concepts in the realm of taxes that I do think you should know about. You do not need to know the tax code, but there are certain segments that very much apply to you as a dental practice owner that I do think you should understand. And this is one of them. All right, so let's dive in. I am sharing my screen for those of you who want to go and subscribe to our YouTube where you can see a visual as I talk through this. But for those of you, most of you who are listening to it on your iPhone or your Android or on your desktop are probably just listening in. So I will narrate this as carefully as I can. What are distributions in an S Corporation? Let me talk at a very basic level here. In the corporate world, you have two types of corporations. I mean, two main types. In the for profit area, you've got C Corporations and you have S Corporations. C Corporations are all the big ones on the S&P 500 or the Dow. All the big companies, all the name brands you've heard of, they're all C Corporations. Why? Because that's the only structure you can have, really, on the public exchanges if you want to issue shares out to the public. And that is how C Corporations are done. So C Corporations are taxable corporations that issue dividends to the shareholders, which may be the executive team and employees through stock options, but also people like you and me who might own shares in, let's say, Apple, for example. We're all shareholders and we all get dividends, and that's one way that we get our return on investment. Now, S Corporations are for, generally speaking, smaller businesses. Most dentists are set up as S corporations. Without going into too much detail, the reason why most dentists are not C corporations is because C Corporations are subject to double taxation. The C Corporation itself pays corporate taxes. Then it distributes its net profit after the taxes to its shareholders in the form of dividends. And dividends are taxed. Well, if the C corp is taxed and the shareholder is taxed, that's double taxation. That is bad. That's. As a dentist, you want to avoid double taxation. You want single taxation. And S corporations are what are called floater entities, which simply means they flow the profits from the corporation out to you personally on your 1040 tax return through a document called a K1C. Corporations don't have K1s, only S corporations do. And that K1 is then added to your W2 and whatever, whatever other forms of income you have, and it aggregates to be your taxable income and you pay taxes on it, but the corporation is not paying taxes on the net profit. That's the difference. That's why it's called a flow through, because it flows through the profits out to you where they are taxed once on your personal 1040. And single taxation is better than double taxation. Hence most of you are set up and filing as an S corporation. Now, as an S corporation, you can take money out of your corporation in two ways. You know, you have a corporate checking account, maybe that's set up at Wells Fargo or B of A or Provide or Huntington or a local bank, whatever, pnc. But it's at a US Bank. But it, but it's at a conventional bank. And you have a business checking account. And you know, especially if your personal checking account is at the same bank, you can literally in 30 seconds go and transfer money from your business checking account to your personal checking account. And I always say the business is just one pocket on the individual. The personal side is the other pocket. It's all one person as a flow through S corporation. And that's why you don't have to have necessarily a system or plan on how and when you transfer money from your S corporation to your personal account. And the problem with that is, is that dentists tend to just transfer money at will without a great plan or system around that. And it gets them into trouble with excess distributions. So I'm going to dive more into explaining how that happens. But it's important to understand that distributions from an S corporations are. When you. From an S corporation is when you transfer money out cash or property and it goes to you, the shareholder that's transferring cash to your personal checking account. If you transfer it out. Who knows, if you have an X ray machine, you sell your practice, but you want to keep the X ray machine and you transfer it out of your corporation. I don't See that? But I'm trying to give you some examples. Anything that you transfer out of ownership of your S corporation's tax ID is a distribution. And now a minute ago, I never finished the two ways that a business owner transfers money out of their corporation to them personally. One is through the distributions I talked about. And of course the other is simply payroll. You have to pay yourself a paycheck as an employee of your own corporation. So those are the two methods. There technically is a third way that you dentists take distribution distributions from your corporation. It's when you make personal purchases through your business checking or credit card account. So if you pay, for example, your pool guy or your pool girl to come and clean your pool and you pay them with a check from your business account, that, sorry, but that's a distribution. That is not a tax deductible expense. Now, on another podcast, we could talk about how you rent out your house for 14 days to you personally or how you take a home office deduction. We are aggressive in all of those things as long as you can legitimize them with some doc, some basic documentation and whatnot. But some things are crossing the line, such as running your pool guy through this, the corporation. So if you did that, that cost is going to be classed as a distribution, even though it wasn't actually a cash distribution to you personally. So those are really the three ways that you have these sort of personal or value transferred out of your corporation to you personally as a direct transfer, as W2 payroll, or as running personal expenses through your corporations. Those are all essentially reducing this thing called your basis. Okay, so going on a little bit more on this subject, I have on my PowerPoints that distributions are not taxed if those distributions are less than your existing stock basis in your corporation. Now, I know you're thinking at the moment, you're thinking, wes, I'm a dentist, I don't need to learn what stock basis is. Actually, this is one of those things I think you do need to understand and it's not terribly complicated. And. But any income that does come out to you, I want to reiterate, is taxed at the individual level. There is no corporate level tax unless you're in California, which likes to slap a 1.5% tax on the net income of the corporation, because that's California getting its hand in the cookie jar in any way that it possibly can. Most states do not charge a penny on S corporation income at the corporate level. Again, it all flows out on your 1040 and you pay for it there. All right, let's go back to the stock basis thing. What is S Corp basis? Think of your business as a piggy bank. And in that piggy bank, you have the slot at the top that you're putting money in, filling it up, and then you have that little thing you unplug under the belly of the piggy bank, and the money comes out. The IRS does not let you take out of your piggy bank more money than is in the piggy bank. Now, I know what you're thinking, Wes. How can I possibly pull out more money from my piggy bank if there's no money in there? That doesn't make sense. Well, here's a key concept. The income that the IRS considers as income on your tax return, your business tax return, is different than the cash flow income, net income that hit your bank account. Those are not the same. And this is the main reason why dentists get into trouble. There's cash in their bank account, and they think they can pull it out when to the irs, the piggy bank is empty and you can't pull it out. And if you do, the IRS slaps you with a penalty tax called excess distributions tax. And as the name indicates, these are distributions that are in excess of something. Excess distributions. They are distributions in excess of what? Of your basis. And your basis, again, is the income that you put inside of that piggy bank. There are the following ways of putting money inside your piggy bank. That is creating basis. Number one, if you take money from your personal account, personal checking account, and you drop it in your business checking account, that's called an owner contribution or a capital contribution contribution. You will hear it from time to time. A capital contribution, that is adding money to your piggy bank. That makes sense. The other way to add money in your piggy bank is simply you have profits. So every dollar that comes in from insurance or patients and hits your business checking account is creating basis. And so if you had a million dollars of collections for the year, you just added a million dollars to your piggy bank, that is basis. A million dollars of basis. So let's say you contributed $100,000 from your personal account to your business account, and you had a million dollars of collections, you added to your basis $1.1 million for the year. Because capital contributions from your personal account and income, or that is collections, they're all the same when it comes to basis. It's all adding basis. And basis is good because basis allows you to pull money out of your corporation without being taxed. On it. That's good. Now, what reduces your basis? Well, we already talked about distributions. When you take those distributions or you transfer that money from your business checking account to your personal checking account, that is a reduction of your basis. Also, all of your overhead is a reduction to your basis. Your labor costs, your labs supplies, your facility costs, your marketing costs, your administrative costs, your pay through payroll to yourself. That's all a reduction to your basis. And at the end of the year, let's say you made a million dollars in, in collections. And let's, let's remove the hundred thousand dollar contribution. You did not contribute anything from personal account to your business accounts. You made no capital contributions. It's very rare that dentists ever do so. That's understandable. But you made a million dollars in collections, a nice round number. And your overhead before paying you, let's say, was 600,000. So that's $400,000 a basis you created during the year. But now you paid yourself a W2 of 200,000. Now you're at 200,000 left in basis. Now, let's say you pulled out as a distribution, which is simply a transfer from your business checking account to your personal checking account. Let's say you pulled out $200,000. What's your basis? Zero, if you follow that math, which is pretty simple. Million dollars in collection. Great. You just added a million dollars of basis. You put it in that piggy bank account. But then you paid your labor, which labs, supplies, facility, marketing, admin, all that is money coming out at the bottom of the Piggy Bank. That's $600,000. You're left with $400,000. You also paid yourself a W2 payroll for the year of $200,000. That brings your basis down to $200,000. And you made a distribution by transferring money from your business checking your personal checking of $200,000. Why? Because you're sitting on $200,000 in your account. Theoretically, on December 31st, you didn't take any distributions during the year. You had a million dollars in collection. You, your overhead was $600,000. You paid yourself $200,000. So you're sitting on $200,000 in your business checking account on December 31st. And you go and you pull it out and so your basis is now down to zero. Are you good? The answer, you would think, is yes, because you put a million in, you took a million out. The answer is no, you're not good. And let me explain why. This is the problem. You think you're good because there's cash in your business checking account a little bit more than you need to cover your ongoing expenses. And so you pull it out. It's even worse when you pull it out when you need it for your ongoing expenses. And then your credit card exceeds your checking account balance in your business and now your negative cash balance. And that's not a good place to be either. Do you ever feel lost in your practice finances? And how about your personal finances? Ever wonder where your hard earned money goes and why you're not seeing the financial progress you've worked so hard for? If so, listen up. As a dental CPA and financial planner, I've created our company Practice CFO just for you. With almost two decades of experience, Practice CFO integrates great CPA services like accounting and tax with customized financial planning, both business and personal. Think of it this way. Our dental focused CPA services give us the extra raise we need to clinically plan your global finances and be effective financial planners. It's a highly customized approach we call the CFO model. Historically, having a CFO or chief financial officer was an advantage of large corporations only. 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So why are you not good? In my example where you made a million dollars in collections and you pulled out a million dollars from overhead paying yourself and the $200,000 distribution, you're at zero. The reason why is because your taxable profit to the IRS is reduced by some things that are not actually cash flow. And the two main ones that cause people problems is depreciation, which is the biggest culprit and the second is amortization. And they're both essentially the same thing. Except depreciation is when you buy that equipment, you buy those dental chairs, you buy that CAD cam, you buy that X ray machine, you do a build out, you do a renovation, all that stuff. Those are fixed assets. When you buy those, most of you are financing them. And so you're not really coming out of pocket. Little by little you are on the loan payments. But when you buy, let's say you bought a CAD cam for 100 grand, using nice even numbers here. You bought it for 100 grand, you put it into service. Your, your, your CPA wants to look like a hero. So what does your CPA do? They take a full 100% deduction on that CAD CAM through what's called a Section 179 deduction, which all that is doing is it's taking what would be the normal depreciation of that CAD CAM over five years, where you're essentially deducting 20,000 per year for five years, which equals the price, $100,000. Now, it doesn't work in a linear way like that, but just to drive my point home, that's how normal depreciation works. You buy a CAD cam, you don't get to deduct it all in year one. You deduct it over its sort of useful life per the irs. And so you deduct it little by little and reduce. So think of it this way. You, when you bought that CAD CAM for a hundred thousand dollars that you financed with a bank on day one, there's no change to your basis. Nothing went in the piggy bank. Nothing came out of the piggy bank. However, in that year.

You get $20,000 of depreciation. And so let's say you paid $10,000 in a loan, but to the IRS, you deducted $20,000 of depreciation. @ the end of the year, you're sitting on an extra $10,000 in cash over what the IRS considers as your net income because the loan payments were less than the depreciation. This is really important, the depreciation. When you buy this equipment in the first three years, you're deducting most of it with the IRS on your tax return, which is like money coming out of the bottom of that piggy bank, but actual money coming out to pay back the bank is less than the money coming out of your piggy bank. And it creates this false conception in your head that you have extra cash laying around to pull out of your practice and go spend personally. Well, it's even worse if your CPA takes a 179 deduction, a section 179 deduction, and deducts 100% of that CAD CAM of $100,000 in that first year, which they can do, and they. Most CPAs do that by default because it makes them look really good, because your taxes drop a lot and you will get a tax refund in many cases. The problem is if your piggy bank just saw $100,000 come out of the bottom of it from this 179 depreciation. But you didn't actually see a hundred thousand dollars go out of your business checking account because let's say you only paid 10 or 15,000 on the loan that year. Suddenly you have 80 to 90 thousand dollars of cash sitting in your business checking account. That to you feels like profits from operations that you can then go pull out of your business. But to the IRS, no, you can't do that because that 179 depreciation dropped your net income by a hundred thousand dollars. So your Piggy bank saw $100,000 go out. So you need to look at that piggy bank as if it's sort of a simulated account, a simulated cash flow. It's not actual cash flow. Because the irs, what the IRS calls your net income is different than your cash flow net income, taxable income is different than cash flow net income, primarily because of this issue around accelerated depreciation. When you buy equipment, amortization is similar, except amortization is for intangible assets, which only happens when you buy a dental practice. When you buy a dental practice, most of the price generally is for the intangible asset, which is the brand of the practice. It's what keeps your patients coming back. It's the reputation. It's all that you can't touch it. And most of the time, 80% of the purchase price of dental practice goes to Goodwill, and that's deducted over 15 years.

So that's also can be a reason. But the primary reason, to be honest, is depreciation because you're not deducting a whole lot of income amortization from year to year, it's deducted over 15 years, and usually the loan is over 10 years. So in many cases it's the opposite with amortization. But depreciation is it that that is a problem. Now also, when you buy a practice, a lot of times the bank will drop $50,000 of cash in the buyer's corporate checking account as working capital. Or some of you have gone out and taken a equity cash loan on your practice. It's like a HELOC or home equity line of credit where you use the equity in your house to get cash to go buy a boat. Well, oftentimes dentists will do something similar. They will use the equity in their practice to get a loan. Oftentimes they'll use that as a loan, as a down payment on a building that they're buying their space, that they may be Buying, which is not held the building is not held in their S Corporation. It's held in a separate taxable entity. So that equity cash loan is treated as a distribution. So let's say you take out $200,000 to put down on buying your building, and you use your equity of your practice, the loan is to your practice, and then you pull out the 200,000 as a distribution and you use that in a separate transaction to buy the building. And so that 200,000 is a distribution. But it's not like that 200,000 was created from income or you didn't put that in out of your personal pocket. So it doesn't create basis. Whenever you get cash from a bank for working capital or to take out of the practice for something else, that is not creating basis, but you just made the distribution which lowers your basis. So I hope you follow that when you get that loan from the bank, you're not adding money in the piggy bank, which gives you basis, but you are pulling money of the piggy bank, which is a distribution. And that is another reason why oftentimes we pull more money out of our corporation than our tax basis, which causes this excess distributions. Now, the IRS says in your basis you cannot go below zero. And if you go below zero, then that is exactly what causes the excess distribution. Okay? So bottom line, excess distributions are distributions that exceed your basis in the corporation that exceed what's in the piggy bank as defined by the irs, not your business checking account. It's what the IRS says your basis is, not your business checking account. That's why you have to be very careful that just because you have extra cash in your business checking account does not mean it's okay to take that out. And that's where it gets a little complicated, depending on how much depreciation or 179 deduction your CPA took. And that's what creates the precarious situation and why you need to talk with your CPA about what your basis is. And are you running the risk of pulling money cash out. So if you say, I'm going to go pull out $50,000 because I need to pay for my child's college tuition payment for the next couple years. And you go pull that out without talking with your CPA, you may end up owing 15 to $20,000 on that $50,000 as a penalty tax. That's in addition to the income tax. So that's why you got to be really careful about this. Now, how exactly is it taxed? It is taxed Both federal and state. From a federal standpoint, it's taxed as what's called capital gains. Many of you know that. And capital gains can be short term or long term. Short term capital gains are when you hold an asset for less than a year and then you sell it. And that is taxed at whatever your ordinary tax rate is. And ordinary tax rates go all the way up to 37%. Long term capital gains go up to 20%. So long term capital gains are better. So at least the excess distributions are taxed at the lower long term capital gain rates of Usually for most dentists it's 20. If you're in a really low tax bracket, it could be 15, but for most of you it's 20%. Now at the state level, that all depends on your state. If you're in California, it's going to be 10%. Most states don't distinguish between your long term capital gains rates and your ordinary tax rates. Ordinary is just what you pay on your W2, on your K1 income, yada yada. All that's taxed at your ordinary tax rates, which go from zero all the way up to 37 and a half percent. Let me just check on something there. All the way to. Yeah, there's 10, 12, 22, 24, 32, 35 and 37%. Those are the stairs in the tax code in the tax bracket. And those do get higher because the top four buckets are at 22, 24, 32, 35 and 37. That's the top five buckets are higher than the long term capital gain rates. And so you would prefer any taxed, if you are taxed at least to be at the long term capital gain rate. But keep in mind that these excess distributions are on top of what are your income taxes. So this is not a good thing. This is truly a penalty tax. Now again, I said most states don't have a long term capital gain rate separate from their ordinary rates. It's just whatever the state tax rate is. In California, that is roughly around 10%, 8 to 12% depending on where you are. So you add those two together and you're looking at somewhere around 30 to 32% on that excess distribution. That ain't good. And sometimes dentists are caught unexpecting, not expecting this at tax time and they're like, hey, I thought I was paying my quarterly estimates or paying, paying my taxes through my payroll and I thought I was good. Why do I Suddenly now owe 25 grand? Well, let me explain, Doc. This is your CPA it's because you remember that cone beam that you bought? You know, we took a 179 deduction on that and it dropped your basis so much that you didn't have room to take out all those distributions, which you did. And those distributions are causing this excess distribution tax. Well, crap. Why didn't you tell me that ahead of time? Can we go back? Do we amend the corporate tax return to not take the Section 179 deduction on that cone beam? Then you got to go through all those hoops. That's why you want to be ahead of this. Okay, so now we know what are excess distributions, how they relate to that basis, anything above the basis, any distribution above the basis creates these excess distributions. And then they're taxed at these rates. Why do dentists often have this? Well, this is mainly because dentists are capital intensive businesses. You're having to buy those dental chairs, you're having to buy those TVs in your room, those monitors. You're having to buy the computers throughout your office, you're having to buy the CAD cam or the X ray machines, you're having to do the build out all of those things cause depreciation. And whenever your CPA accelerates that depreciation, or even if they don't, if the loan term is longer than the depreciation schedule, you end up reducing your tax basis faster than the cash flow to pay for those things. And. But most CPAs, again, they're accelerating their depreciation through Section 179. And also this thing called bonus depreciation where they're shoving all that deduction in the current year and then your basis goes way down and then you pull out cash thinking it's okay. So this is why high cash flow still allows for large distributions even when your basis doesn't allow it. And let's now go on to what do CPAs often do to skirt around this excess distribution tax? If you're looking on my screen at the top, it says loan to shareholder. Loan to shareholder. So asking you who's the shareholder of your S Corporation? Most likely it's only you. Every once in a while I'll see a spouse on there too. But most likely it's only you. And most likely there's somewhere around 1,000 shares or 10,000 shares. You'd have to go back to your original documents on that. Or if you're an LLC, it's interest, not shares, but you own it 100%. And so you are the shareholder of your corporation. And so what we often do we CPAs get a little sneaky on this. And we're like, okay, I know you don't want to pay the $20,000 excess distribution tax. Let's go ahead and call your distributions. Let's say you took out $60,000 in distributions for the year. Let's go ahead and call that a loan. This is a loan from the corporation to you, I. E. A loan to shareholder. Well, guess what? This is literally on your tax return. If you look right here on my screen, for those of you can, I'm showing schedule l of your 1120s tax return. This is just a few pages down from the main page. It's on page four and row seven, this is the 2024 version, row seven, loans to shareholder. Loans to shareholder. So the IRS, their system can flag that immediately and automatically doesn't even need human involvement to be flagged. Now what some CPAs will do is they might get really aggressive, but this is probably crossing the line is they will take that loan to the shareholder and they'll bury it. They'll bury it not in row seven, loan to shareholder, but in the general loan, but somewhere else in here like under other current assets, which is the row above it, or nine other investments. They'll sort of bury, bury it in these other schedules so it doesn't automatically flag. But if a CPA were audited, if an IRS came to review the CPA firm's returns and they see that that is a clear problem and that's going to stir up some trouble between the CPA and the irs. And the IRS may decide that you're the type of CPA that leads to tax evasion with your, your clients and then they'll go through all of your clients books. And so here at practice cfo, yes, we toe the line, but we gotta be careful not to cross the line because we don't want the IRS coming through all of our clients books, obviously. So it's a bit of a delicate balance. It's like the Federal Reserve has a dual mandate to keep unemployment low and to prevent inflation. It's a dual mandate. We have a dual mandate. Reduce your taxes, but avoid an IRS audit. And the loan to shareholder increases the chance of an IRS audit. So although we're willing to allow some reclassification of those distributions from being originally a distribution to changing them and calling them a loan, which therefore allows you to avoid paying the excess distribution tax. That's good. We saved paying the excess distribution tax, but now we got this loan to shareholder and, and it could raise A concern. So I'm going to talk about that a little bit more here in a moment. But that's what we tend to do. We reclassify it as a loan to shareholder. It avoids the capital gains taxes at the federal and state level and it now appears as a receivable. Now I would say that if the loan to shareholder or that distribution amount that was reclassified by your CPA as a loan, if it's less than six figures, that is 100,000, you're probably fine. I'd never had an IRS audit on loan to shareholders less than 100,000. Frankly, I've never had an IRS audit over this in general. But that's because we here at practice CFO meet three to four times a year with our clients. And one of the things we do in every visit is, is we look at the basis in the corporation and whether or not we're potentially exposed to excess distributions and then we have a real serious discussion around how to avoid it. So a lot of times when we get new clients, sometimes I've had a client come in with $800,000 of loan to shareholder and that's a problem. So one of the first orders of business with that client is unwinding out of that, which can be a bit painful doing that. That essentially means that that doctor was borrowing a bunch of money from a bank collateralized by the practice, pulling it out and spending it personally. And that's not good.

So if it's under a hundred thousand, you're probably fine. If it's above that, that's when I start to get a little worried. Now, what does the IRS check for if they do come knocking? What they're going to ask for is to know whether or not this is a legitimate loan or whether or not this is just a cover up for excess distributions is they're going to look, is there a loan agreement in place just like with the bank or for a car or whatever, is there a loan agreement in place that states the interest and what the repayment terms are? And are you actually repaying, are you personally repaying the corporation back for having lent you money? So you're going to look for all those things and if they're not there, if they're not in place, then guess what they're going to do? They're going to reclassify that loan to shareholder as either a taxable capital gain, excess distribution, or as compensation. Now between the two, you're going to want a taxable capital gain between the two because that's going to be taxed. Lower compensation is taxed at the ordinary tax rates, which are going to be higher. And it would also be subject to payroll taxes, which are FICA taxes, Social Security and Medicare, which are 15.3%. So that is a problem. We want to avoid that, but that's what the IRS will do. Now, if you have a loan agreement and you're actually making payments and it's at a market rate interest of, let's say, 5 or 6%, then you're probably good. The IRS will say, okay, all right, that does look like a legitimate interest rate loan. Even then, they may still decide to reclassify it. But I think you're pretty defendable if you have a legitimate set of loan terms and repayment occurring. So that's a risk. This is the risky side of reclassifying things as a loan. Now, what are some best practices? Dentists. How do we, how do we avoid getting in this, this trap? Because it really is a trap, especially when your supplier, and this is not to knock on suppliers, but suppliers are oftentimes very involved with the practice. They're, in some ways they can be really helpful giving insight or just trying to make sure you're stocked appropriately and never run out. So I'm not trying to knock suppliers here, but what suppliers often do is they will tell you to buy that equipment and then they'll quote you what is the true cost after taking a Section 179 deduction. So if it's a hundred thousand bucks for that piece of equipment, but they'll show you after the Section 179 deduction that it's only, let's say $55,000 out of your pocket and you get to finance 100% of it. And so you're going to get this huge tax deduction in year one. You finance it. No cash actually leaves your bank account. You get the equipment, you get, everything's looking great. Well, that's fine. But now you're exposed, most likely to excess distributions tax. And in future years, you're not going to get a tax deduction but you're repaying a loan and money going out to repay the loan that doesn't get a tax deduction. That's painful and it creates a tax trap. And at the end of the next year, your CPA is like, whoa, you're going to owe a ton of taxes because we took 100% of the deduction last year with bonus depreciation, or 179 when you bought that $100,000 piece of equipment. And so you need to go out and buy another $200,000 piece of equipment. So you rush, you buy it, you get it in service by December 31st, and now you're saved. The only problem is you don't have basis for it. So now your loan to shareholder goes from $100,000 up to 200,000, $300,000 because of that, because you were pulling out the cash, all spare cash in your business checking account throughout the year. And this is a death trap. It is a spiral that has caused some dentists to go bankrupt. And this is where you got to be really careful with when you buy things. And being lured in to the after 179 true cost of buying something by the sales rep. The true cost is a hundred thousand bucks. Yeah, you're going to get to deduct it like anything else, you're going to get to deduct your CPA costs, your front office costs, your hygiene costs, your supplies. You get to deduct all that stuff. The only difference with the 179 is when you buy equipment, normally you deduct it over five years. Now you get to front load it and you're deducting all of it in the first year. That's. That's all the 179 is. There's no magic to it. It's just a timing difference of when you get the tax deduction. And that timing difference on surface may sound good, but if you don't have basis to take that deduction when you financed the purchase of it, it's going to get you in trouble. Now, I always say if you bought it in cash, if you came out of pocket a hundred thousand bucks, you wrote a check, put it on credit card, whatever. If you could do it on credit card at a hundred thousand, you probably don't have that limit, but whatever. If you actually bought it in cash, then take a 179 deduction. In other words, align the deduction with the cash payment for that equipment and you're good. You're not going to run into basis issues if you do that. Because if you come out of pocket $100,000 to buy that piece of equipment, that's $100,000 you, you don't have to distribute personally to yourself, which is what causes the excess distributions. All right? So best practices track your basis. I can't tell you how many times a new client comes to us and their prior CPA was not tracking their basis. The IRS doesn't require it to be reported annually. You have to track the Basis. Your CPA has to track your basis. That's really important. And, and so make sure your CPA is doing that. Ask them to show you. Show me my best. My basis schedule in the S Corporation, not, not my basis in the assets that I buy inside of the corporation. Like when you buy that $100,000 piece of equipment that gives you $100,000 of basis on that particular equipment and then you depreciate it. That's called inside basis. No, ask your CPA about outside basis, which is the basis in your corporation itself, that piggy bank I was telling you about. All right, Second best practice, avoid distributions exceeding your basis. So number one, track your basis and number two, avoid distributions exceeding your basis. Like I said with practice cfo, every quarter we have a, we have a super detailed, many layered and tabbed spreadsheet that we've created over the past 20 years that brings everything together from personal spending, needs, payroll, 401k, job debt, overhead, taxes, sort of brings it all together into one big puzzle on the table. And that's when we look at your basis and your distributions and we have that conversation. And so our clients generally don't have this issue. If the only time our clients have this issue is if we tell them, hey doc, you can pull out $3,000 a month, 5,000amonth, 10,000amonth, whatever it is. We tell them that their basis allows them to distribute, and then they don't obey that or listen to it and they go and distribute out every last dollar in their account. Above love what we guided them on. Then they're going to run into distribution issues. But we will never knowingly allow a doctor to get into excess distribution territory. All right. Third best practice for dentists on this issue. If you use a loan, if you do a loan to shareholder, you do need to document this. You do need to document that loan and actually be paying it back. If it's a 15, 20, 30, $40,000 loan to shareholder, you're probably fine. The IRS probably isn't come knocking on that. But if you get into 1000-002003-00000 plus loan to shareholder. Yeah, you want to get a loan document in place. And here at Practice cfo, for those of our clients who do do that, we will take care of that loan document process and set up a way to repay that. Now if you go to sell your practice and you have a loan to shareholder, it all goes away. Because when you sell your practice, you're going to have huge gains in your corporation from the sale of the assets. And that creates a massive, a massive amount of basis in your corporation. It's like dropping boatloads of money inside of that piggy bank. And now you can reclassify that loan as a distribution and you're going to be fine. Now you may say, well, Wes, then why do I care? Why do I care? Why don't I just let the loan to shareholder build up over the years and then when I sell my dental practice, I should be fine? Well, maybe. But the problem is, is if you're reporting to the IRS every year, a loan to shareholder, you're really increasing your chance of being audited. And for me, as a cpa, I can't allow that to happen because like the irs, if they're smart, the IRS will go auditing CPA firms, not the clients of the CPA firms. They'll go to the CPA firm where they think the CPA is being too aggressive with their clients, and then they'll go through all of that CPA's client's books. And I have seen that before, all their client list. And we do not want that again. It's a fine balance. I think we do. We're really focused on our dual mandate of keeping heirs away while also reducing taxes here at practice. Cfo, lastly, coordinate closely with your CPA on this issue. Extremely important. I'll add one more bullet point which isn't on the screen, which is this is the one that gets people in trouble the most is when you finance the purchase of equipment or a build out a renovation, whatever, whatever that is. When you take out a loan to buy something that becomes an asset on your balance sheet, that gets deducted through depreciation on your P and L. Be really careful with your CPA to avoid deducting all of that through accelerated depreciation, I.e. section 179 or bonus depreciation, and pushing you into negative basis. Again, you can't have negative basis, but it pushes you to zero. And then the rest you pay taxes on. So that is another best practice to talk with your CPA when you finance it. Every year that you find that, that you buy equipment, financed or not, you should have an intentional conversation around how that is going to be depreciated. You're going to front load it or not. And if you front load it, is it going to create excess distributions which then have to be reclassed as a loan to shareholder, which then is a problem and could get you audited. Have that conversation, please, with your cpa, Please, please. All right, One more Thing I think I want to share here is most of you are set up as S corporations, but like I said, some of you are set up as partnerships and some of you may be set up as sole proprietors. If you're doing less than say 500,000, 600,000 in collections per year, probably just be a sole proprietor. Yeah, you don't have, there's certain tax deductions you may not get and all that, but it's marginal and you won't have to pay all the costs of having a corporation. It's only one tax return. If you're a sole proprietor, it's on your 1040, what's called a Schedule C. Everything is cheaper as a sole proprietor, but it doesn't give you the strategies that S corporations can have to really save on taxes. And also of course, liability protection as, as well, some of you old timers might be sole proprietors too. It's an older school version, but none of this applies to a sole proprietor because the owner is the business. There's no differentiation between the two. So there is no such thing as distributions. If you're a sole proprietor, yeah, you're transferring money from a business checking account to a personal checking account. But to the IRS it's all a personal checking account because you didn't set up a separate entity. So it doesn't. None of this applies to sole proprietors. Now, if you're a partnership and you are not, you don't own your interest in the partnership through your wholly owned S corporation. In other words, if you're not a partnership of corporations, then you have one benefit that an S corporation owner doesn't is any debt you have held in the partnership that creates basis. So if you bought a practice as a partner, that and you, you took out that loan to you personally, you get to use that as basis and therefore you have a. That loan essentially goes in your piggy bank account and that gives you this massive amount of basis which then allows you to pull money out. And so usually people that own their got a loan and bought into their partnership, that way they don't have excess distribution issues. However, if you own your partnership through your corporation, through your wholly owned corporation, then you're subject to all of the distribution rules around an S corporation. So that matters there. Okay, in summary, let's recap. Number one, dentists often face excess distributions due to non cash deductions, primarily accelerated depreciation, I.e. section 179 of bonus depreciation. Number two, summary S Corp basis is critical to determining tax Liability, please track your outside S corporation basis with your cpa. Number three, if you have to, you can reclassify the distributions that are in excess as a loan, but they need to be legitimized through a loan term and document and repayment plan. And lastly, be sure to coordinate with your cpa, Stay compliant, avoid audits and be successful. Now here at Practice CFO we are driving personal financial success. I will be doing a lot more podcasts in the future. On the personal side, as many of you know, we do two main things we help you as a CPA in business financial planning consultant, number one, and number two as your personal financial planner. And, and yes, some people don't want to have to move everything under one umbrella, which is our model. And yes, we require that. But the reason why is because it's my opinion that if you have a financial planner who doesn't understand the cash flows of your practice and maybe tries to plug in a 401k or tell you, hey doc, you need to save $10,000 a month and you'll be able to retire at age 63. Ready, go. I'll see you in six month. That's not great financial planning. That's telling you the obvious how much that you just need to save a certain amount. That's pretty easy to calculate. The difficult thing is how do you create the cash flow? Through budgeting overhead, through debt management, through tax minimization, and through good smart business cash flow planning in order to create that $10,000 a month to set aside for your future self to retire at age 63. That's true financial planning. And the main reason why so few dentists are able to retire at age 60, 60, you know, in their early 60s and maintain their lifestyle is because they had so much inefficiency in their financial ecosystem because they did not have good coordination around their bookkeeping, around their payroll, their taxes, their business planning and forecasting, their personal spending and financial planning. All of that need, it's all integrated, it's all related. Like one affects the other. It is a circular reference. All of these things are in Excel. There's literally this thing called circular reference where it won't let you run a calculation because it's running a calculation off one cell that's contingent upon the first cell that you're trying to run a calculation for. Now that might sound confusing, but basically you everything relates to each other and that's why you have to have good planning which evaluates all of the ecosystem and how it interplays with each other. And if you don't, you're going to have an inefficient system, I guarantee you. Your financial advisor may not be telling you the right amount for your W2 in your corporation. They might not be designing the 401k to correlate to your tax situation, your basis situation, your. Your payroll situation. And if you don't have that full X ray, you cannot give good, clean, optimizing advice around things like 401k design and funding. Same thing with a defined benefit plan. When and if a defined benefit plan, which is the most amazing tool ever, if it's right, if it's at the right time in your practice. None of this can happen correctly without a full panoramic view of the cash flows in and out of your practice. And that is why here at Practice cfo, we are strong believers that financial planning is best done on both the business and personal side. And I started Practice CFO to drive personal financial freedom. That's it. That's where I started it. Not to file a tax return, not to do monthly accounting statements. I think we do a phenomenal job at those. We put a lot of emphasis on. On very good CPA services, but only because it gives us the tools and the cash flow we need to help our doctors become financially independent. So if you ask Wes, why do you require everything? It's because that's our model and our mission. Financial independence. And without everything together in an integrated way, we're not able to do that effectively. And so, yep, unfortunately, I do need to understand excess distributions. I need to understand the tax code that relates to dentists. I need to understand all of the financial aspects of running a dental practice. I don't need to run the operations or talk about practice management consulting or scripting in the practice or insurance billing. That's for somebody else. My job starts when the dollar hits the bank account.

And I toggle it through, I plinkle it through your P and L and back to you personally. And ideally, to really set aside some good money to fund your future self. That is the mission of Practice cfo. Literally. Our mission is to make our doctor's journey remarkable, using their cash and their growth and their success to drive a fulfilling life. Thanks, everybody, for listening in to another episode of the Dental Boardroom podcast. If you hear this before the CDA or during the cda, it should probably release on Thursday. When the CDA starts, please come over to our booth. Practice cfo, Practice orbit. Two booths right. Right next to each other. Or come listen to my speaking. I'LL be speaking in the spot section of the vendor in the ven. In the massive vendor area on all three days. Buying a practice on Thursday, selling a practice on Friday and practice financial planning on Saturday. Love to see you there. Thanks, everybody. Until next time.