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Proprietorship The economic value of self-employment is quite significant: • Based on current income figures, an owner of a practice (solo) can expect to earn $1,000,000 more in income over 30 years than an employee; for partners, the difference is more than $2,000,000 in income compared to an employee • The owner of a practice has a valuable asset worth about $300,000 (based on average current income levels) that can be sold to finance retirement • Practitioners who own a building may rent or sell it at retirement to produce significant additional income There are five basic types of business organizations available: • individual (sole) proprietorship • general partnership • limited liability company (LLC) • professional association or corporation (PA or PC) • subchapter S corporation The choice of type of practice determines the cost, complexity, and administrative burden to be borne by the practitioner. Sole proprietorships are the easiest to form and operate, while corporations are the most expensive and time-consuming. The type of business organization influences income potential: on the average sole practitioners earn less than practitioners in partnerships or groups. According to the 2007 AOA Economic Survey (2006 data), mean net income was: --$175,329 for all self-employed optometrists --$134,094 for sole proprietors -- $176,944 for partners (2 optometrists) -- $179,205 for optometrists in group practices (3 to 5 optometrists). Business organizations also determine liability exposure: sole proprietors have the most exposure, while practitioners in LLCs, Subchapter S corporations, and PAs/PCs have the least. The basis for this difference is that in a sole proprietorship the optometrist and the business organization are merged—there is no separate business entity that is responsible for the optometrist. Retirement plans are also dictated, to some extent, by the choice of business organization. The type of plan to be used, its cost, and the benefits available are affected by whether a practitioner is incorporated or not, although differences have diminished greatly over the past few decades. Tax writeoffs and benefits are also dependent on the type of business organization that has been selected. Generally speaking, the more complex the business organization, the greater the availability and number of tax deductions that may be utilized by the business. Also, sole proprietorships, partnerships, LLCs, and S corporations pay no income taxes: professional associations or corporations do. Thus the choice of business organization is a key aspect of tax liability. Optometrists have traditionally been entrepreneurs who have tended to operate solo practices so that they could “be their own boss". However, with the increased emphasis on health care in optometry, the high costs of instrumentation and of operating an office, there has been a change away from solo practice and toward partnership. Still, according to the 2005 AOA Economic Survey, about 49% of optometrists in private practice are solo. Individual proprietorship remains the easiest, least complicated, and most direct choice of business organization. There are distinct advantages and disadvantages to this form of doing business. Advantages One person rule, with control over decisions and destiny. High long-term income potential and great equity potential. Independence, with control of the office schedule, time off, vacations, and similar matters. Choice of optometric specialties to be practiced. Disadvantages The pressure of all decisions and management and marketing responsibilities lies on the shoulders of the practitioner. Multiple financial risks and competitive challenges. Lower starting income, higher start-up costs are present. Lack of office coverage in cases of illness, vacation, time off, etc. Fewer specialties to offer. In an individual proprietorship, the individual and the practice are merged as one: there is no separate business entity, rather the practice is constituted in the person of the practitioner. All income is the individual’s income, all expenses are the individual’s expenses, and any profit or loss is reported by the individual. To begin a practice, the sole practitioner must: • have a state license • secure federal and state tax identification numbers • obtain a business license (required in most municipalities) • open a business checking account • enroll as a provider for Medicare, Medicaid, and third- party plans in the community • prepare the proper paperwork to begin withholding federal and state taxes • open an account in a federal bank for the deposit of federal taxes • obtain state sales or use tax forms for reporting of taxes (in states that tax ophthalmic goods) • notify insurers of the date that operations begin Liability for the practice rests solely on the shoulders of the proprietor, who is responsible for all contracts, tax matters, and legal issues (such as liability claims). The proprietor is individually liable for these matters and liable for the acts of employees as well. With respect to taxes, the income earned by the practice is taxed to the practitioner; the individual proprietorship pays no taxes. The profit (or loss) of the sole proprietorship is calculated on Schedule C, and the result is entered on Form 1040. The practitioner pays taxes on this amount, which also determines Social Security and Medicare taxes. Retirement Plans Retirement Plans should be initiated when starting into practice! Individual retirement accounts (IRAs) may be established regardless of any other type of retirement plan a practitioner may have. The types of retirement plans (such as IRAs) are discussed in Chapter 37 of the textbook. There are 5 types of IRA: • Traditional • Roth • Simplified Employee Pension (SEP) • Savings Incentive Match Plan for Employees (SIMPLE) • Educational (Coverdell) Traditional Individual Retirement Accounts (IRAs) • For 2009, up to $5,000 a year may be placed in an IRA by employed or self-employed individuals under 50 years of age, and • An additional $5,000 may be contributed by a married couple filing jointly, even if there is a non-working spouse--$10,000 total. • For individuals 50 years of age and older, these limits are higher by $1,000 ($6,000 in 2009). Traditional Individual Retirement Accounts (IRAs) • The money placed into the IRA is invested and thus generates earnings. • The IRA's earnings are tax sheltered (not taxed) until withdrawn. • Withdrawals must begin between the ages of 59 ½ and 70 ½ years or a penalty will be imposed. • Withdrawals can also be made at death or disability without penalty. • Withdrawals can be held for 60 days when "rolling over" one IRA account to another IRA account. • IRAs can be used even if there are other retirement plans, regardless of type of business organization. Traditional Individual Retirement Accounts (IRAs) • Contributions to an IRA can be deducted from taxable income (and thus not taxed) if the taxpayer making the contributions is not covered by an employer-maintained retirement plan. • Thus a self-employed practitioner can make tax- deductible IRA contributions. • So can an employee (e.g., an associate). Traditional Individual Retirement Accounts (IRAs) • For 2009, if a taxpayer is covered by an employer- maintained retirement plan the taxpayer can deduct the IRA contribution in full if: -- the taxpayer is single and earns $55,000 or less; -- the taxpayer is married and the couple earns $89,000 or less. • If the taxpayer’s income exceeds these limits, IRA contributions can still be made (to an income ceiling), but they cannot be deducted in full. Traditional Individual Retirement Accounts (IRAs) • A partial tax deduction is permitted if: -- a single taxpayer earns more than $55,000 and less than $65,000 (example: if $60,000 is earned, $2,500 (50%) may be deducted) -- married taxpayers earn more than $89,000 and less than $109,000 (example: if $94,000 is earned, $3,750 (75%) may be deducted). Traditional Individual Retirement Accounts (IRAs) • For a married couple filing jointly, if the taxpayer is covered by a employer-maintained retirement plan, and the spouse is not, the spouse can contribute $5,000 to an IRA and claim it as a tax deduction if the adjusted gross income of the couple is less than $166,000. • A partial tax deduction is permitted if the couple earns more than $166,000 and less than $176,000 (example: if $173,500 is earned, $1,250 (25%) may be deducted). Traditional Individual Retirement Accounts (IRAs) • Penalty-free withdrawals before age 59 ½ are permitted for: – eligible higher education expenses; – unreimbursed medical expenses; – buying, building or rebuilding a first home (up to $10,000). • However, a 10% tax penalty may be imposed under other circumstances. Don’t underestimate the power of an IRA—to have a million dollar nest egg at retirement: • Start at age 25 • Contribute $5,000 a year for 40 years • That’s $200,000 worth of deductions • Assume 7% interest • Total is $1,068,047! • The key is to start early and use the power of compound interest Contributions to an IRA: Projected Growth* Period 5% Growth* 10% Growth* After 5 years $29,009 $33,578 After 10 years $66,033 $87,655 After 15 years $113,287 $174,748 After 20 years $173,596 $315,012 After 25 years $250,567 $540,908 After 30 years $348,803 $904,717 After 35 years $474,181 $1,490,634 After 40 years $634,198 $2,434,259 *calculated at $5,000 a year contributions At $10,000 per year, the 40 year returns are $1,268,397 (5%) and $4,868,518 (10%) Roth Individual Retirement Accounts • A Roth IRA is different from a traditional IRA in that contributions to a Roth IRA cannot be deducted from income. However, the account grows tax-free and withdrawals from the account are tax- free. • Also, there is no age restriction for contributions (which may continue as long as income is earned, whereas 70 ½ is the limit for traditional IRAs). • However, there are income limits that restrict eligibility for Roth IRAs. Roth Individual Retirement Accounts • For 2009, the annual amount that may be contributed to a Roth IRA is $5,000 for persons under 50 years and $6,000 for persons 50 years of age and older. This amount must be reduced by any contributions to a traditional IRA. • Contributions can be made for a non-working spouse as long as the income requirements are met; thus a married couple can contribute up to $10,000. Roth Individual Retirement Accounts • Individuals may contribute to a Roth IRA if they meet the following taxable income requirements (for 2009): -- for single taxpayers, an adjusted gross income of less than $105,000; a partial contribution is permitted if the individual earns more than $105,000 but less than $120,000 (example: if $112,500 is earned (50%), $2,500 may be contributed). -- for married taxpayers filing jointly, an adjusted gross income of less than $166,000; a partial contribution is permitted if the couple earns more than $166,000 but less than $176,000 (example: if $169,000 is earned (30%), $3,500 may be contributed). Roth Individual Retirement Accounts Distributions from a Roth IRA may be made without penalty after age 59 ½ , or before that age if for disability, death, or a qualified special purpose distribution. This latter category permits withdrawals to buy, build or rebuild the main home of a first-time homeowner ($10,000 limit). The power of a Roth IRA is demonstrated by my son Christophe’s “summer job” IRA: • Opened a Roth at age 15 years • Average contribution $2,000 • Pays minimal income tax • Will make contributions only through age 25 (11 years), then stop • Earning 9% interest (until 2008!) • At age 65 the total will be $1,202,384 • And it’s tax free when withdrawn! As of 2010, a traditional IRA can be converted to a Roth IRA regardless of income level. Before 2010, transfer of tax-deferred traditional IRA money into a tax-free Roth plan was not available if the adjusted gross income was $100,000 or more. That income limit has been removed. However, taxes must be paid on the previously untaxed amounts that are converted to the Roth IRA. But half the conversion costs can be paid as 2011 taxes, with the remainder paid in 2012. Simplified Employee Pensions (SEP IRAs) • SEPs are a form of Individual Retirement Account (IRA) usable by any type of business organization. • A self-employed practitioner who contributes to an SEP may deduct the amount contributed from taxable income. • For 2009, up to 20% of the practitioner's net income, to a maximum of $49,000, may be contributed each year to the SEP. Example: if net income is $245,000, the maximum contribution allowable would be attained, $49,000. Simplified Employee Pensions (SEP IRAs) • The percent to be contributed annually to an SEP is set by the practitioner and thus can be varied each year. • There is minimal cost and formality compared to other plans. • Like other IRAs, contributions are invested and produce earnings. • The earnings are tax sheltered until withdrawn. Simplified Employee Pensions (SEP IRAs) • Withdrawals from SEP IRAs must begin between the ages of 59 ½ and 70 ½ or a penalty will be imposed. • Withdrawals can also be made at death or disability before 59 ½ without penalty. • Withdrawals can be held for 60 days when "rolling over" an SEP IRA. Simplified Employee Pensions (SEP IRAs) • SEP IRAs may be established for employees. • The percent contribution is set by the employer. The amount contributed is a tax deductible business expense for the employer. • Vesting (the right to accrued earnings in excess of what has been contributed) is immediate (100% vesting). Example: an employee has contributed $10,000 to a SEP IRA, which has earned $1,000 in interest; if the employee leaves, the entire $11,000 account belongs to the employee. Savings Incentive Match Plans for Employees (SIMPLE) • A SIMPLE IRA can be established if there is no other retirement plan for employees. (An employee may still contribute to a personal IRA—but it cannot be a Roth IRA.) • Although intended as a benefit for employees, employers who are also employees (as in a PA/PC, S corporation) can participate in a SIMPLE IRA. • Under the plan, an employee may elect to place a percent of salary, not to exceed $11,500 per year (in 2009), into an IRA account. The employer also contributes to the plan. Savings Incentive Match Plans for Employees (SIMPLE) • One option is to make matching contributions. The employer matches the employee's contributions, on a dollar-for-dollar basis, from 1% to 3% of the employee's income. • Example: an employee earning $25,000 contributes 5% of salary ($1,250) to the SIMPLE IRA. The employer pays 3% ($750) as a matching contribution. The total amount contributed to the employee's SIMPLE IRA is $2,000. • The employee's contributions are excluded from gross income, and the employer's contributions are deductible as a business expense. Earnings are tax sheltered until withdrawn. Savings Incentive Match Plans for Employees (SIMPLE) • The other option is to make a non-elective contribution of 2% of the employee's income. • Example: an employee earning $25,000 chooses not to make contributions to the SIMPLE IRA. The employer pays 2% ($500) as a non-elective contribution. The total amount contributed to the employee's SIMPLE IRA is $500. • The employer's contributions are deductible as a business expense and are tax sheltered until withdrawn. Savings Incentive Match Plans for Employees (SIMPLE) • Persons who are age 50 or older can make "catch- up" contributions; for 2009 the “catch up” amount is $2,500, which means a total of $14,000 ($11,500 plus $2,500) can be contributed by employees 50 years and older. • Withdrawals from a SIMPLE IRA are subject to the same rules as for traditional IRAs (they can be made without penalty between 59 ½ and 70 ½). Education IRAs (Coverdell Education Savings Accounts) • Education IRAs are not retirement accounts; they are custodial accounts created for the purpose of paying “qualified” higher education expenses for the beneficiary of the account. • The beneficiary must be a child under age 18 years. • Like an IRA, the contributions are invested and provide earnings. Education IRAs (Coverdell Education Savings Accounts) • the definition of "qualified expenses" under an education IRA includes tuition, fees, books, supplies, and equipment incurred with enrollment in a secondary, public, private or religious school • room, board, uniforms, and transportation expenses which are required for enrollment in a secondary, public, private or religious school will be considered "qualified expenses" • computer technology, equipment, or services purchased for use by the account beneficiary (student) while the beneficiary is in school will also be considered "qualified expenses" Education IRAs (Coverdell Education Savings Accounts) • For 2009, a maximum of $2,000 per child may be contributed each year by single taxpayers with a modified gross income of less than $95,000, and a partial contribution may be made up to $110,000. For married taxpayers, the income limits are $190,000 to $220,000. Example: a partial contribution of $1,000 can be made in 2009 by married taxpayers with an adjusted gross income of $205,000. • Contributions to an Education IRA are not tax deductible but amounts deposited in the account grow tax-free until withdrawn. Education IRAs (Coverdell Education Savings Accounts) • Withdrawals used to pay for the qualified higher education expenses of the beneficiary are not taxed. • Contributions cannot be made after the beneficiary reaches age 18. • Any assets remaining in an Education IRA after education expenses have been paid can be withdrawn by the beneficiary by age 30, but will be taxed as income. • However, Education IRA assets may be transferred without penalty to another beneficiary who is a member of the family and under age 30.