Avoiding Common Tax Errors

by Richard A. Blum, CPA, JD, LL.M. Senior Tax Manager, Elliot & Warren, PLLC

Having reviewed hundreds of tax returns for doctors over the last several years, we have noticed several recurring tax errors. These tax errors can significantly increase your tax liability and, therefore, should be avoided. They include the following:

• Travel and Entertainment Expenses - Many tax returns lump together expenses for travel, meals, lodging, entertainment and continuing education into one category called "travel and entertainment". Consequently, the doctor's CPA mistakenly deducts 50% of this amount, even though some of these expenses are 100% deductible. For example, expenses for business travel, lodging and continuing education are 100% deductible. In addition, expenses for recreational, social (including meals) or similar activities primarily for the benefit of staff employees are also 100% deductible.

  This error can be avoided by having the doctor's financial statements and tax returns be prepared using separate expense classifications for "travel and lodging", "continuing education", "employee benefits" and "meals and entertainment". Only the "meals and entertainment" expenses would be subject to the 50% deduction limitation.

• Accrual Tax Basis - Many tax preparers mistakenly believe that all incorporated doctors are required to use the accrual method of accounting for tax purposes. Under the accrual method, the doctor is required to report income as services are billed, even though collections may be months away and even in the following tax year. Similarly, the accrual tax basis requires that expenses be deducted when bills a re received, rather than when they are paid. Generally, the use of the accrual method results in doctors reporting taxable income much earlier than would be the case if they were using the cash method of accounting, thereby increasing the corporation's tax liability. In many cases, there is a significant annual acceleration of taxable income that has yet to be received, thereby resulting in large tax liabilities.

  The tax law generally prohibits corporations from using the cash method of accounting. However, there is an exception to this general rule that allows professional corporations with average annual gross receipts of $5,000,000 or less to use the cash method of accounting. Under this exception, the corporation's average annual gross receipts for the three prior tax years must be $5,000,000 or less. Under the cash accounting method, income is reported only as collected and expenses are reported when bills are paid.

• Use of Corporate Fiscal Years - Professional corporations are allowed to use a fiscal (non-calendar) tax year, although the tax law places limitations on those doctors who do so. For instance, these fiscal year corporations are required
  to pay out a pro rata share of the doctor's salary during the period beginning on the first day of the tax year and ending on December 31st. Failure to comply with this minimum distribution requirement can lead to disastrous tax results, with the corporation postponing part or all of its corresponding deduction to its next fiscal tax year.

  In addition, such fiscal year corporation's net operating losses may not be carried back and are only allowed to be carried forward. This limitation often prevents doctors from using current year corporate net operating losses to get an immediate refund of prior year corporate income taxes paid.

  Therefore, since there are substantial tax traps in maintaining the corporation's fiscal tax year, it is advisable that doctors change their corporate tax year to December 31st.

• Business Automobiles - Many doctors' tax returns fail to deduct business car expenses. Specifically, many CPAs overlook the tax benefits available for business use of certain sport utility vehicles, vans and trucks with loaded gross vehicle weight greater than 6,000 pounds. If these vehicles are used more than 50% for business purposes, they avoid the luxury automobile excise tax, avoid the luxury automobile yearly depreciation limitation and allow utilization of the $25,000 section 179 expensing election. Furthermore, these automobiles would be eligible for the 30% bonus first-year depreciation deduction under the new tax law enacted in 2002. Consequently, the depreciation deductions are greatly accelerated resulting in significant tax savings.

• S Corporation Election - Before making an S corporation election on behalf of your corporation, the CPA must do proper planning to avoid adverse tax consequences. For instance, in the absence of proper tax planning, a corporate level tax is imposed on accounts receivable and other built-in gains when a regular C corporation converts to an S corporation.

  Such tax planning to avoid the built-in gains tax may include creating a built-in loss prior to S corporation conversion. This can be accomplished by paying out a bonus equal to the receivable value during the first two and one-half months of the S corporation's initial tax year. Please note that the declaration of the bonus prior to the conversion should be shown in the corporate minutes.

• Charitable Contributions - Many corporate tax returns show significant amounts of charitable contributions which are disallowed on the tax returns under the 10% limitation rule. Under this rule, the charitable contribution deduction for corporations is limited to no more than 10% of the corporation's taxable income. To avoid this limitation, the doctor may consider whether he expects to receive some future benefit from the expense, in which case they can be properly classified as "advertising and promotion" which would be 100% deductible. If not, the doctor should make the charitable contribution personally and deduct it on his individual income tax return.

• Retirement Plan Funding - The tax law allows a deduction for many retirement plan contributions made as late as the due date of the return (including extensions). Therefore, many CPAs erroneously advise the doctors to make the required retirement plan contributions on the latest possible date thinking there is no benefit to early funding. However, these CPAs fail to realize that funding retirement plan contributions as early in the year as possible maximizes the tax-deferred accumulation and is therefore highly recommended.