The American Jobs Creation Act of 2004 added Code Section 199, the domestic production deduction, into law. This new deduction was designed to encourage manufacturing activity in the United States. The great news is that this deduction is available to qualifying doctors, regardless of their business structure (S corporation, C corporation, unincorporated, or LLC).
Applying Section 199 to dentistry
The definition of manufacturing has been liberally construed, with the IRS even stating, "... Congress intended for the deduction under Section 199 to be available for a wide variety of production activities." In 2013, a judge in a California Federal District Court decision (US vs. Dean)ruled that even arranging wrapped candy bars and wine bottles into gift baskets constitutes "manufacturing" and thus qualifies for the Section 199 tax break.1
The product that is manufactured has to be tangible personal property. In other words, the patient needs to leave your office with a product. Application of the deduction for orthodontists relates to the manufacturing of their own appliances and retainers, as well as the inlays and onlays of the brace assembly process. General dentists can take the deduction for the manufacture of in-house crowns and other restorations using CAD/CAM technology. Products made by a third-party lab do not qualify. When you consider the calculation of the deduction, it is important to capture all related costs of wages (clerical and clinical), material, and overhead.
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RECOMMENDED: Confessions of a former domestic production activities deduction hater | Jean Patterson, CPA, CFE (DentistryIQ)
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Calculating the deduction can be tricky, as determining the input for the variables can make a huge difference in the result. So, here are the top five areas that will leverage the maximum deduction for you:
1. What qualifies as a manufacturing process? The process associated with in-house manufacturing of crowns, retainers, and braces may be more than just the time it takes to create the item. You and your CPA should thoroughly discuss all elements of the process so that the appropriate income generated by the process is used in the calculation.
2. How should my expenses be allocated? In order to reduce the administrative burden, the IRS allows small businesses, defined as businesses with average annual gross receipts of $5 million or less, to calculate income generated by the manufacturing process and then ratably apportion expenses without any other calculations. While this method is truly simple, it rarely gives the best result because crowns, for instance, have a higher profit margin than some of the other services provided by dentists.
3. Do I have to use a flat percentage rate for all my expenses? A second, simplified method of calculating the deduction (any business with annual gross receipts of $100 million or less and total assets of $10 million or less qualifies) allows the cost of materials to be separately stated and not subject to the same flat percentage as all other expenses. This method usually benefits the dentist because the actual cost of materials used for manufacturing retainers, for instance, is small compared to the other dental supplies purchased throughout the year. However, this method does not take into consideration how overhead is allocated and thus does not always result in the highest deduction.
4. How should I calculate my overhead percentage? The third method the IRS permits in calculating the Section 199 deduction is available to all businesses and allows overhead to be considered in any manner that makes sense economically. Your practice software has many of the numbers you need, so you and your CPA should work together closely to determine expense items that can be separately assigned and how best to allocate the remaining general overhead expenses. The time put in will normally pay off since using this method generally results in the largest deduction.
5. How do I determine the portion of wages that are a part of the manufacturing process? The Section 199 deduction is limited to 50% of the wages attributable to the activity. However, the dentist, a lab technician, a hygienist, and clerical staff may all be involved in varying degrees. Using a flat percentage of all wages will often not adequately reflect the appropriate wages associated with the process and will result in a smaller deduction.
In conclusion, a little time spent with your CPA may result in significant tax savings. The deduction is available, and you don't want to miss it!
John K. McGill, JD, CPA, MBA, provides tax and business planning exclusively for the dental profession and publishes the McGill Advisory newsletter through John K. McGill & Company, Inc., a member of the McGill & Hill Group, LLC.
Susan Harris, CPA, CFP, provides accounting and CPA services through Elliott Davis Decosimo, PLLC, affiliate of the McGill & Hill Group. The McGill & Hill Group is a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment advisory services. Visit mcgillhillgroup.com for more information.
Reference
1. United States v. Dean, 945 F. Supp.2d 1110 (C.D. Cal. 2013).
CaseText. https://casetext.com/case/united-states-v-dean-13. Accessed Sept. 20, 2016.
