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Little Known Tax Deduction for Dentists and Orthodontists

08/11/2016  |  By: Sarah Oakman, Manager, Tax

Most doctors probably don’t think of themselves as being in the manufacturing business, but if any of your dental practice’s revenue is coming from the on-site production of crowns, in-lays and other restorations using CEREC or other CAD/CAM technology then, according to the IRS, you can take advantage of a federal tax deduction called the Domestic Production Activities Deduction (DPAD). The IRS ruled that the milling process used to shape the materials for proper fitting is what qualifies as manufacturing. In addition, doctors who are deriving revenue from retainers, appliances or other items produced in an in-house lab are also eligible for the deduction.

A recent District Court case (United States v. Dean, No. 11-01977 (C.D. Cal. 2013) has further expanded the deduction’s application to assembly line activities that only repackage various items or materials, none of which are produced on-site, to create a final assembled or “repackaged” product. The Dean case focused on the activities of a gift basket company; which involved purchasing various items from third parties and combining these items together in gift baskets or towers. The court concluded that the company’s production process created gift baskets or towers that were “distinct in form and purpose from the individual items.” The company’s activities “transformed into a gift” individual items that would typically be purchased separately as ordinary groceries. Similarly, orthodontists placing brackets and wires to begin patient treatment are combining two or more purchased raw materials and using those to form a new item which is “distinct in form and purpose from the individual items.”

How Does It Work?

The deduction is equal to 9% of the Qualified Production Activities Income (QPAI), or taxable income if lower. QPAI is the net income from eligible activities after deducting the related overhead costs. IRS regulations provide three methods to calculate those costs.

A practice with average gross receipts of $5 million or less can use what’s known as the Small Business Simplified Method. Under this method you would apply an average overhead rate to determine the related net income (QPAI). While this method is the easiest to calculate, it doesn’t always provide the best result since many times the qualifying activities (crowns, in-lays, etc.) have higher profit margins than other procedures performed in the practice.

The Simplified Method is available to practices with average gross receipts of $100 million or less and total assets of $10 million or less. Under this method, material costs are separately stated and all other expenses are subject to the average overhead rate. This method is beneficial where the actual cost of materials used in the production process is small compared to other procedures.

The IRS also allows the related overhead costs to be calculated in any manner that makes sense economically. Under this method, all material costs and other deductions are analyzed in order to identify the related overhead costs. No average overhead rate is applied.

Under all three methods, the deduction cannot exceed 50% of the W-2 wages related to the production activities. Since the doctor, lab technician, administrative staff and others may all be involved to some extent in the production process, percentages should be applied to those wages depending on the degree of involvement. By doing this, your deduction is less likely to be reduced by the 50% wage limitation.

The calculations for the DPAD can be complicated and may require a skilled tax professional to help make final determinations, calculations and proper documentation for the deduction to stand up to IRS scrutiny. That being said, if you think your practice is involved in any of the qualifying activities mentioned, it is definitely a deduction worth looking into as you could be missing out on thousands of dollars in tax savings for your practice.

Little Known Tax Deduction for Dentists and Orthodontists