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June 03, 2008

The riduculous but useful Section 199 tax break - a 6% deduction for "production" income that is intended to aid manufacturers - prompts an interesting reader question (modified for my convenience).


I found & read your good stuff on Section 199. If a dentist has a machine that manufacturers crowns (which the dentist then inserts) does this qualify (by the dentist manufacturing the crown, they are not outsourcing the function to a dental laboratory).

Lets say the dentist has taxable income of $600,000 & $100,000 comes from manufacturing the crowns. How would his lower tax rate work?

First, it would appear that making the crowns qualifes as manufacturing. Lets start with a quick review of the weird alphabet soup of Section 199:

MGPE = Manufactured, Grown, Produced or Extracted
QPP = Qualified Production Property
DPGR = Domestic Production Gross Recipts

The deduction is 6% of taxable income from "qualified production property," which includes items "mantufactured, grown, produced or extracted" by a taxpayer.

So, to the regulation (Reg. 1.199-3(e); emphasis mine):

(e) Definition of manufactured, produced, grown, or extracted--(1) In general. Except as provided in paragraphs (e)(2) and (3) of this section, the term MPGE includes manufacturing, producing, growing, extracting, installing, developing, improving, and creating QPP; making QPP out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles; cultivating soil, raising livestock, fishing, and mining minerals. The term MPGE also includes storage, handling, or other processing activities (other than transportation activities) within the United States related to the sale, exchange, or other disposition of agricultural products, provided the products are consumed in connection with or incorporated into the MPGE of QPP, whether or not by the taxpayer. Pursuant to paragraph (f)(1) of this section, the taxpayer must have the benefits and burdens of ownership of the QPP under Federal income tax principles during the period the MPGE activity occurs in order for gross receipts derived from the MPGE of QPP to qualify as DPGR.

So if a dentist makes and "installs" his own crowns, it would appear that the income from both the manufacture and the "installation" should qualify. This example from the regs seems on point:

...Y manufactures the replacement parts it uses for the reconstruction and refurbishment of customers' tangible personal property. Y has the benefits and burdens of ownership under Federal income tax principles of the replacement parts during the reconstruction and refurbishment activity and while installing the parts. Y's gross receipts derived from the MPGE of the replacement parts and Y's gross receipts derived from the installation of the replacement parts, which is an MPGE activity pursuant to paragraph (e)(3) of this section, are DPGR (assuming all the other requirements of this section are met).

So what does this mean in example? In the simplified example, $100,000 of taxable income is from "manufacturing" the crowns, so the taxapyer would get a $6,000 Section 199 deduction (100,000 x 6%). But it gets much more complicated. A few of the factors that apply in real life:

- What is the "taxable income" from the manufacture and installation of the crowns? You have to allocate overhead costs between other dental income and services.

- Unless the dentist is practicing as a schedule C sole proprieter, you have to determine who the "taxpayer" is that gets to take the Section 199 deduction. If he is a C corporation, he may have to withdraw all of the income from his professional corporation as salary or pay a 35% tax starting with the first dollar of income. Since the Section 199 deduction would be based on taxable income at the P.C. level, the deduction would be zero because there would be no corporate taxable income after salary.

- If the dentist practices in an S corporation, he has to deal with the usual juggling of salary that S corporation professionals must deal with. If he pays himself too little salary, he can look forward to a battle with the IRS.

- Would the IRS accept "installing" crowns as a manufacturing process, rather than a service?

In an ideal world, there would be no Section 199 deduction; it makes no sense in a modern economy to try to draw neat borders between "manufacturing" and "services." Even if you could, why is it somehow morally better to make money running a foundry rather than, say, saving lives by doing surgery?

But we go to war with the tax code we have, and I get to charge for applying it, so think about it - you may be a "manufacturer" without realizing it. If so, you'd be foolish to pass up the deduction.

Flickr image courtesy Mr.Thomas

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I have a client that just purchased a very expensive piece of equipment to produce her own crowns. How does the cost of the equipment come into play? Since it is only used for that one purpose would it be a part of COGS for the year purchased?

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