Physicians are mostly employees of large corporations; however, even within that employment model, multiple streams and forms of income can exist. Additionally, income from investments, either passive or active, can flow to the physician in many forms, which can be difficult to understand and manage. Tax planning is an important exercise to many physician households, as income tax is often the biggest hurdle each year.
By examining your sources of income, you can be more educated in how to plan and ultimately set your expectations on what is possible for lowering your tax burden. In this particular article, I have created a Pros and Cons list for the following types of income:
- W-2 Employee Wages
- 1099 Contractor/Ownership Income
- Passive Income, focusing mostly on real estate
- Portfolio/Investment Income
- Hobby Income
Each one of these income sources are siloed from each other, so you can’t take a loss from one source of income and deduct it against another (some exceptions do exist). Here is a quick summary of what’s good and bad for each income source.
W-2 Employee Wages:
This is probably the most pertinent income I see in the physician community; however, W-2 wages are usually mixed with other kinds of income as well. When it comes to W-2 employee wages, there are three advantages that no other type of income has.
First, taxes are estimated and withheld from the paycheck. Federal, state, and local income taxes are all withheld, if applicable. This results in a net income, which makes most tax filing experiences much more palatable than any other income source.
Second, the responsibility to pay FICA taxes (Social Security and Medicare) are divided evenly between the employee and employer. Social Security imposes total a tax of 12.4% of your income up to the first $147,000 of earnings, and Medicare imposes a total tax of 2.9% of your entire income. Being a W-2 employee requires your employer to pay half of this tax, often referred to as payroll tax. As such, roughly 6.2% of your income (up to $147,000 of earnings for 2022) and 1.45% of your entire income is due to the government to provide Social Security and Medicare benefits, and your employer has to come up with the other half of your FICA taxes.
The third major benefit to W-2 wages is having access to your employer’s benefits. Benefits may come in the form of retirement plans, health insurance, disability insurance, etc. Some of the benefits may be paid for by your employer entirely, not at all, or somewhere in between, but by having W-2 wages, you have access to most of the benefits provided by the employer.
The biggest downfall of having W-2 wages is that there are such limited tax deductions to bring the taxable wages down. The standard deduction was just raised with the introduction of the Tax Cuts and Jobs Act in 2017, yet the ability to itemize deductions still exists (if itemizing allowable deductions is more beneficial than the standard deduction), but other than funding retirement plans and itemizing deductions in years where charitable donations were high or medical bills were extraordinary, there is no concrete method to reduce taxable income. The best thing to do with W-2 income is to fund retirement plans when offered and make sure you’re withholding the proper amount of taxes. The IRS has a tool available to the public to measure this.
1099 Contractor/Ownership Income:
Whether it be moonlighting income, private practice income, or owning a small business outside of medicine altogether, some or all the collected revenue might be paid in the form of 1099 income. One of the biggest advantages of active 1099 income is the ability to reduce your taxable wages through business tax deductions. This could be in the form of purchasing tools, books, and supplies that are necessary and reasonable to continue your job, or it could be from marketing, payroll, and rents to keep the lights on. Whatever it is, just remember to keep your receipts and have access to solid tax advice!
Another advantage to ownership income, if you have ownership duties, is the freedom to choose the direction you want to take your clinic, company, or business. It may be from voting rights, leadership authority, or being solely at the helm of the business, you can shape both your patient experience and employee culture from the ground up. While this is an advantage to some, it’s a serious disadvantage to others, depending on their goals, strengths, and personalities.
One more advantage is that 1099 income is cheaper to hospitals and entities than W-2 employee wages. With 1099 income, there are no benefits or payroll taxes included, so there can be significant financial incentives to hire contractors vs. employees. If you are negotiating a salary with a hospital, and they want to pay you as a 1099 contractor, you can remind them how cheap your salary is because there is not any other baggage attached the salary! Also, if you’re looking to hire someone into your own practice and want to “test them” before hiring as an employee, use them as a contractor first for a test run.
Social Security and Medicare taxes can be a huge disadvantage. Unlike the W-2 wages, where you equally split the obligation of your Social Security and Medicare taxes, as a 1099 contractor or employer, you are both the employer and the employee, so you get to pay both halves. This translates to up 15.3% of your wages being gobbled up with FICA taxes. This tax is called the self-employment tax. The good news is that there are currently ways to reduce the self-employment tax burden by taking on the proper corporate structure or tax election. If you incorporate as an S-Corp or live in a state that allows LLCs to be taxed as an S-Corp, you can use that S-Corp election to pay yourself a reasonable salary and then take the company profits as distributions. The reasonable salary will require Social Security and Medicare taxes, but the ownership distributions will not. As long as this strategy is allowable, this disadvantage can somewhat be minimized, but it’s still a disadvantage nonetheless.
Passive income, such as rents from real estate, is reported in 1099s, but since it’s passive income, you can’t do much with losses, like you can with other income (more on that later). You would incur losses if the mortgage, taxes, insurance, and maintenance costs are greater than the rents collected for a year. More specifically, I’m referring to collecting rent, not buying and selling real estate (again, more on that later). There are some instances where collecting rent can be considered active income, but it generally takes a lot of work (literally!) to be granted that status. You likely need to prove that you are actively managing properties, and if you’re not really actively managing properties, then it’s difficult to prove that you are.
The biggest advantage to passive income is that you received money without having to go to the hospital and practice medicine. Another advantage is there are no FICA taxes due with passive income because passive income is technically unearned income.
Passive income is a great insulator against needing to “show up” at the hospital. Since the income is unearned income, the income, in the absence of expenses, just seems to show up in a quality passive investment. This kind of income is often referred to as “mailbox money”, because for many individuals prior to electronic banking, paychecks of this kind just showed up in the mailbox each month. In addition to this, passive income is a great addition for retirement.
One of the downfalls to this kind of investment is often costly. Once the cost is recovered, the investment can provide significant benefits, but there’s risk involved if something goes awry during the cost recovery period.
There are a few layers of income from portfolio/investment income, which is also reported in various forms of 1099s. Portfolio/investment income is income received from company ownership or from selling an investment for a profit. The investment could be a security, such as a stock, or it could be real estate, such as rental house.
Let’s discuss the dividend income first. Depending on what kind of security the dividend came from will determine the resulting tax impact. If you purchase a stock from a US-based company which pays a dividend considered to be a qualified dividend, you get a tax break as a result. An ordinary dividend would flow into your highest income tax bracket, which could be as high as 35%; however, a qualified dividend is taxed at 15%-20%, depending on your income level. Additionally, there are some dividend payers that aren’t taxed at all, such as municipal bonds. All dividend income will be treated as passive income, but there will be various levels of taxation, depending on the source.
The next form of portfolio income is taxation from capital gains and capital losses, which has both benefits and drawbacks. All income regarding capital gains is derived from capital assets. To trigger a capital gain or loss, an asset must be sold for a profit or a loss. A capital asset may be a stock, bond, real estate, NFT, artwork, or any other asset that holds a value. The capital gains rate is determined by the amount of time the asset was owned. If an asset was owned for one year or less, the tax rate is determined to be your highest income tax rate (up to 35%!) and is referred to as short-term capital gains, and if the asset was owned for more than a year, the capital gain tax rate is given a discount to 15%-20%, depending on the amount of income (from any source) for that year; this is called long-term capital gains tax.
If an asset is purchased and sold for a loss, that loss can offset other capital gains, dollar-for-dollar. If there are no more capital gains to offset with the losses, then up to $3,000 of the loss can be deducted from your earned income! This is one of the exceptions of siloed income sources affecting other income. If there are capital losses exceeding $3,000, then the remaining loss can be carried forward to future years indefinitely until there is no remaining loss to deduct.
One of the biggest drawbacks in capital gains taxation is that it can be complicated and confusing. There are plenty of nuances, exceptions, and qualifiers when determining capital gains tax. Additionally, if you have a high income, you can be subject to the net investment income tax (NIIT), which is a 3.8% additional tax imposed to capital gains and dividend income for high income earners.
Hobby income is derived from earning income from a hobby without a profit motive. There can be quite a lot of gray area in determining hobby income from earned income. The rules of a profit motive are generally to be profitable at least once every five years, and the income source needs to be derived from a business activity, not a leisure activity. If you have hobby income, your expenses and losses cannot be deducted against the income.
The ultimate advantage of hobby income is that you are doing something you love, and it happens to generate income. There was a famous court case of John Sernett, a Sprint race car driver, who had significant losses while racing at a high level. Without a clear business plan, he couldn’t convince the tax court that he had a profit motive, although he kept thorough records. He was forced to pay a significant amount of tax resulting in the loss of hundreds-of-thousands-of-dollars of tax deductions.
The negatives around hobby income are that there is no protection whatsoever from taxes on income reported. You pay income tax on hobby income, even if there was significant expenses or losses to provide the income. In many cases, it would be better to have no income at all (so there is no tax), and just expense your hobbies and passions in your free time; however, if you can pass your hobby income as having a profit motive, then you get funding and tax benefits to do what you love. Unlike earned income, hobby income is not subject to FICA taxes.
There are many forms of income tax, and if you have income beyond W-2 employee income, it can become complicated. Depending on the situation, qualified tax advice might be extraordinarily helpful to: 1) make decisions about your future endeavors, and 2) make sure you are up to speed with the necessary tax laws to stay compliant. Careful tax planning beyond proper compliance is also critical to planning for your future. When analyzing your current and future endeavors, taxes should almost never be the primary factor when making these decisions; however, taxes should almost always be considered.