Tax Reform for Dentists: The New 20% Deduction
Updated: Jan 11
The Tax Cuts and Jobs Act of 2017 was signed into law on December 22, 2017. This article discusses the repeal of Section 199, enactment of Section 199A, and how these changes directly affect dental practices. Instead of focusing on the logistics of the phase-out calculations, we’ll explore the larger picture. For simplification, the dollar amounts referenced here are for married taxpayers, but can be halved for single filers in most circumstances.
Sect 199: CEREC Machines
Previously, revenue from CEREC machines was used to factor the Domestic Production Activities Deduction (DPAD) under Section 199. The 2017 tax reform repealed Section 199 and therefore eliminated the 9% deduction from DPAD effective 2018. There has been discussion regarding ways to recharacterize this CEREC income to qualify under Section 199A, but recent IRS guidance (discussed later) has made this creativity unlikely to find success.
Sect 199A: The New 20% Pass-Through Deduction
Section 199A is a new, 20% deduction provided on the net income from pass-through businesses including S-Corps, sole proprietorships, partnerships, and limited rental activities. However, because dental practices are considered a “specified services trade or business” (SSTB), the 20% deduction may be diminished once the taxable income of married taxpayers exceeds $315,000. Once taxable income exceeds $315,000 for married taxpayers, the deduction is reduced based on a calculation involving wages and depreciable property. And when taxable income exceeds $415,000 filing jointly, no deduction is allowed for a dental practice’s SSTB income.
Ignore the finer details for a moment and focus on the following for joint filers. If taxable income for a married taxpayer is under $315,000, you get the 20% deduction on your business’ net income. If it’s over $315,000, your deduction may be limited. And if it’s over $415,000, your deduction may be zero.
The main issue is that your dental practice is considered a SSTB. A married taxpayer can have taxable income over $415,000, but at that point, the 199A deduction is only allowed on income from non-SSTB activity.
IRS Proposed Regulations
Since the tax reform was enacted in December 2017, many have speculated as to how the IRS will interpret the new tax code. Practice owners have likely heard potential strategies to circumvent the 199A phase-out limits, with the goal being the development of income from non-SSTB sources.
On August 8, 2018, the IRS finally released proposed regulations providing the first glimpse of guidance on Section 199A. These proposed guidelines take the wind from the sail of most of the proposed strategies.
Segregate Management & Lab Functions?
Before guidelines were released, some had suggested practice owners divide their practice into distinct functions, for example, segregating the administrative and in-house lab functions into separate corporations. The idea of the strategy was to create non-SSTB income eligible for the 199A deduction. The IRS’ proposed regulations discuss the idea and state, “Such a strategy is inconsistent with the purpose of Section 199A”, and the IRS has proposed a substance test. If a separate entity (e.g. practice management corporation) shares at least 50% common ownership and provides more than 80% of its product or services to a SSTB (e.g. your dental practice), the separate entity is also considered a SSTB.
Increase Rent on Self-Rentals?
Similarly, since the tax code as written allows the 199A deduction for rental activity, some suggested those who own their office building increase rent to push income into the non-SSTB. While the recent IRS guidance excludes most rentals that aren’t a “trade or business”, they made an exception for businesses directly rented to a commonly-owned trade or business. However, they clarified that if a SSTB rents from a commonly-owned rental, the rental is also considered a SSTB. In fact, the proposed IRS regulations specifically use a dental practice as their example! The net result is that taxpayers are mostly handcuffed by the income phase-out limitations previously discussed.
Other Means of Reducing SSTB Income
For taxpayer’s facing a 199A phase-out due to taxable income being too high, there are a couple of other strategies that can help those near the phase-out border. Owners with minor children would be wise to consider employing their kids to reduce the SSTB’s income. Certain married taxpayers may also consider filing separately to assist the 199A calculation. All taxpayers will have until the due date of their tax return to determine whether to profit share into the practice’s 401(k), and fully-funding the plan may significantly benefit an owner’s 199A deduction if they’re on the border of the phase-out.
The Section 199A deduction can allow for significant tax savings, although it may require proactive strategizing to ensure businesses are adequately managed each year. There are two important limitations to communicate: (1) the proposed 199A regulations were only recen