Domestic Production Activities Deduction

 

What is Domestic Production Activities Deduction? 

The Domestic Manufacturing Deduction also referred to as DPAD or the Section 199 deduction is a tax deduction for businesses that perform manufacturing and other qualified production activities in the United States and Puerto Rico [US-based].  It was established in 2004 by the American Jobs Creation Act of 2004 to increase the investment in domestic manufacturing facilities. 

What lines of business qualify for the dedication?

The following lines of business qualify for the Domestic Production Activities Deduction. They MUST be US-based:

• Manufacturing and production
• Selling, leasing, or licensing items that have been manufactured
• Producing or growing agricultural or horticultural products
• Marketing US-based agricultural or horticultural products
• Mineral extraction
• Oil-related production activities.  This includes production, refining, processing, transportation, or distribution of oil or gas, or any primary product from oil or gas
• Production of electricity or water
• Qualified film production
• Selling, leasing, or licensing motion pictures that have been produced in the United States,
• Construction services including building and renovation of residential and commercial properties
• Engineering and architectural services
• Software development, including the development of video games.

The following activities do not qualify

·        Sale of food and beverages prepared by the taxpayer at a retail establishmen

·        Transmission or distribution of electricity, natural gas, or potable water

·        The lease, rental, license, sale, exchange, or other disposition of land.

·        Construction services those are cosmetic in nature, such as painting

·        Leasing or licensing items to a related part

What entities qualify for the dedication?

·        Corporations, both “C” and “S” corporation

·        Partnerships and Limited Liability companies

·        Sole Proprietorships

·        Agricultural Cooperatives

What are the tax savings? 

The tax savings is a tax deduction equaling to the lesser of

·        Nine percent of NET Qualified Production Income

·        Nine percent of taxable income, without regard the DPAD

Also, the deduction cannot exceed fifty percent of W-2 wages and reportable commission paid to employees that contribute to the qualified activities.

Qualified Production income is the net of gross income from the qualified production activities less all expenses directly related to the qualified production activities.  For a business with only one line of business, the expensed deducted will be the same as total expenses. For businesses with multiple lines of business, income and expenses will need to be allocated.

General Rules and Safe Harbor

The Domestic Production Activities Deduction is limited to income arising from qualified production actives in whole or significant part US-based. Under a "safe harbor" rule, businesses can take the deduction if at least twenty percent of the total costs are the result of direct labor and overhead costs from US-based operations.

If any part of manufacturing or production activities is outside the United States and Puerto Rico, then businesses must use either the safe harbor rule or allocate costs using the facts and circumstances of their business.

Cautions

The DPAD is considered a Tier 1 audit issue by the IRS and requires additional due diligence to ensure compliance and substantiation of company practices.  Tier I audit issues are of “high strategic importance” to the IRS and have a significant impact on one or more industries. Tier I issues may involve a large number of taxpayers, a significant dollar amount, a substantial compliance risk or high visibility. Issues will be placed in this category if the IRS has an established legal position or directive out on the issue.  In other words, if you take the DPAD, it could be a “red flag” for audit.  Normally if a taxpayer is honest and follows the rules, with transparency, an audit should not deter them from taking appropriate tax deductions.  The DPAD rules are complex and time consuming, if the deduction is calculated incorrectly or lacks substantiation, your business could face additional taxes, penalties, and interest.  Thus it is imperative that you seek proper tax advice from a CPA or tax attorney.

Applicable tax codes 

(1)   Internal Revenue Code § 199

(2)   Internal Revenue Code § 927(a)(2)(C)

(3)   Internal Revenue Code § 1382(b)(c)

(4)   IRS Regulation § 1.199

(5)   IRS Proposed Regulation § 1.199(3)(f)(3)

(6)   IRS Instructions for Form 8903

Summary 

Many small business’s has traditionally over looked a potential this very important tax deduction.  Even though there are a set of complex rules, at nine percent of NET income from qualified production activities, businesses are unnecessary leaving money on the table by not taking advantage this tax deduction.  According to Paul Schlather, a senior tax partner with PricewaterhouseCoopers' Private Company Services practice, “while Section 199 comes with a very complex set of rules, chances are small businesses will qualify for the deduction much easier than the rules depict".

 

Is Your Company Leaving Tax Deductions on the Table?

If your company participates in a manufacturing or production process, you might be leaving money in the table

There is a deduction for the sale, lease/rental or license of production activities, officially called the “domestic production activities deduction”.  It is also called the “Section 199” or “DPAD”.  The deduction is the lesser of 9% of net qualified production activities income, 9% of taxable income or 50% of W-2 wages paid by the company to domestic production employees.  The deduction cannot reduce net income below zero, but it can be used against the AMT.  However many states including California, New York and Oregon do not allow the deduction.

The deduction is limited to production activities in the US and is available for the following:

(1)  Oil & gas production

(2)  Agricultural processing (i.e. farmers) including cooperatives

(3)  Manufacturers

(4)  Construction

(5)  Engineering

(6)  Architecture

(7)  Computer software production

(8)  Motion picture production

(9)  Music production

The following example was used in a Congressional hearing defines what is and is not a qualified domestic production activity:  “Suppose you are a baker and in the business of producing donuts. Some of the donuts you sell retail directly to the consumers, and some you sell in bulk to hotels and restaurants. The production costs of the donuts sold at retail do not qualify for the deduction, while the costs associated with the wholesale sales to the hotels and restaurants do”.

The deduction is not limited to just the manufacture or producer, but is also available to companies who outsource the manufacturing or production.  However only one company can take the deduction.  In this case, things can get a bit complicated for the company that takes the deduction and must provide documented proof of the following:

(1)  A statement that explains the basis for the taxpayer's determination that it had the benefits and burdens of ownership in the year or years under examination

(2)  A certification statement, using an IRS form, signed by both companies

If you have already taken this deduction or thinking you should, be warned this is an area the IRS loves to audit.

Please call this office if you wish more information