Don’t Overlook Your Section 199 Domestic Production Activities Tax Deduction

ScheinIf you have CAD/CAM equipment in your practice, you should be sure to calculate your potential section 199 tax deduction. The tax savings could be significant!

The Section 199 deduction (also referred to as the domestic manufacturing deduction, U.S. production activities deduction, and domestic production deduction) is a tax break for businesses that perform domestic manufacturing. It was established by the American Jobs Creation Act of 2004 in an effort to help create jobs, reduce foreign outsourcing, and make domestic manufacturers more competitive.

The deduction was phased in starting in 2004 with a 3% deduction on qualified production activity income, and has now graduated to a 9% deduction as of 2010.

There are three different ways to calculate the deduction:

The Section 861 Method – This method requires that you separate all revenue streams by type, then allocate all expenses by both revenue stream and location of the expense incurred. This would be VERY time consuming for the typical dentist, and would negate much of the benefit of the deduction.

The Small Business Simplified Overall Method – This is the simplest method, but would rarely produce the maximum tax deduction for a dental practice. Under this method, total practice deductions are ratably apportioned between manufacturing revenue and non-manufacturing revenue based the relative ratio to gross receipts. For example, assume a practice has annual collections of $1,000,000 and total expenses of $700,000 for a net income of $300,000. If revenue from manufacturing crowns is $200,000 (20% of collections), then the expenses allocated to manufacturing are $140,000 ($700,000 X 20%). The Qualified Domestic Production Income of $60,000 ($200,000 – $140,000) times 9%, then yields a section 199 deduction of $5,400.

The Simplified Deduction Method – Under this method, the cost of the crowns milled, or items manufactured, must be calculated, but all other expenses can be ratably apportioned using the same percentage calculation in method 2. To calculate the cost of the crowns, you must calculate the portion of W2 wages that should be allocated directly to the time spent deriving that revenue. You also have to calculate the actual direct costs of the crown, or other items manufactured. For example, assume the same practice above. Also assume that they did 200 crowns that were manufactured in house. If the expenses for the ceramic blocks, milling coolant, diamond milling burrs, glaze, stain, cement, etc. totaled $7,500, and the chairside assistant’s W2 wages for the year were $30,000, with 15% of her time spent assisting during those crown procedures, then direct labor costs were $4,500, and total direct manufacturing costs were $12,000 $($7,500 + $4,500). The rest of the practice overhead would be allocated by the same 20% above. This method then yields a section 199 deduction of $10,422. (See the chart that follows)

Since there have been no IRS court cases involving dentists who took the manufacturing deduction, and were challenged, there is no clear guidance or guarantee that this interpretation of the rules would be supported under audit.

But given the broad definition the IRS has been following for other industries, it seems clear that using your PlanScan system to manufacture ceramic crowns, inlays, onlays and veneers would qualify.

I’ve heard from other aggressive dentists that they feel that there are many other potential manufacturing income procedures. They have taken the position that exposing an un-exposed film to X-rays, in order to create a custom image, constitutes manufacturing. Some felt that bending straight wires in to arched wires for ortho treatment constituted manufacturing income.

But when you look back at the original intent of the law, it’s not clear that those activities would have ever been easy to outsource to a foreign supplier, or activities that the dentist wasn’t already doing as part of treatment; whereas investing in CAD/CAM technology, and avoiding the potential of outsourcing to a foreign dental lab clearly align with the intent of the law.

So talk to your tax professional about the activities in your practice that do qualify as manufacturing, but don’t overlook the possible tax savings from section 199.