An Overview of the Domestic Production Activities Deduction
The DPAD is available for previous tax years and for some businesses
Certain companies were able to take a 3% deduction for U.S.-based business activities from 2005 through 2017. That could add up to a nice tax break for certain small businesses. Unfortunately, that was then and this is now.
The Effect of the 2018 Tax Law
This deduction was originally part of the American Jobs Creation Act of 2004. It was covered under Internal Revenue Code Section 199 and IRS Proposed Regulations 1.199. Then Congress began negotiating and finalizing new tax legislation at the end of 2017, and the changes made under the resulting Tax Cuts and Jobs Act (TCJA) were sweeping indeed.
Rules were changed and a handful of tax breaks were added, but many were repealed as well. The domestic production activities deduction (DPAD) was one of those to be eliminated. It expired on December 31, 2017 as the TCJA became effective on January 1, 2018.
Businesses can still claim the DPAD on their 2017 returns and for earlier years, but they must file amended returns to do so.
The DPAD might not be gone forever. Keep in mind that the TCJA expires at the end of 2025, so it's possible that fresh life might be breathed back into this deduction at that time, and some businesses manage to dodge the new TCJA rule.
The Basics of the Section 199 Deduction
Businesses with "qualified production activities" could take a tax deduction of 3% from net income through 2017. That's the easy part. The more complicated the business, the more complicated the math becomes for calculating the domestic production activities deduction.
In a nutshell, businesses that engaged in manufacturing and other qualified production activities had to implement cost accounting mechanisms to make sure their tax deductions were accurately calculated.
What Are Qualified Production Activities?
A company engaged in the following lines of business could qualify for the domestic production activities deduction. "Qualified production activities" eligible for claiming the deduction under Internal Revenue Code Section 199 include but aren't expressly limited to:
- Manufacturing based in the U.S.
- Selling, leasing, or licensing items that have been manufactured in the U.S.
- Selling, leasing, or licensing motion pictures that have been produced in the U.S.
- Construction services in the U.S., including building and renovation of residential and commercial properties
- Engineering and architectural services relating to a U.S.-based construction project
- Software development in the U.S., including the development of video games
General Rule and Safe Harbor
The DPAD is limited to income resulting from qualified production activities in whole or significant part based in the U.S. Businesses must use either the safe harbor rule or allocate costs using the facts and circumstances of their business if any part of manufacturing or production activities takes place outside the U.S.
The safe harbor rule applies if at least 20% of total costs are from U.S.-based production activities.
Non-Qualified Production Activities
The following lines of business are specifically excluded from claiming the domestic production activities deduction:
- Construction services that are cosmetic in nature, such as painting
- Leasing or licensing items to a related party
- Selling food or beverages prepared at a retail establishment
Figuring the Tax Deduction
Calculating the DPAD can be either ridiculously simple or enormously complex, depending on the nature of the business. The key is "qualified production activities income" (QPAI) and its limitations.
The equation works out like this:
- Qualified production activities income (QPAI) minus qualified production activities expenses
- Equals qualified production activities net income
- Times the QPA deduction amount of 3%
- Equals the tentative QPA deduction
Qualified production activity income will be the same as gross income for businesses that engage in only one line of business, but businesses with multiple lines of businesses must allocate their incomes.
Qualified production activity expenses are all expenses directly related to qualified production activities. This will be the same as total expenses for a business with only one line of business. Again, expenses must be allocated for companies engaging in multiple lines of business.
The dollar amount of the domestic production activities deduction is limited. The deduction can't exceed adjusted gross income for sole proprietors, partnerships, S-corporations, or limited liability corporations. It can't exceed taxable income for C-corporations, nor can the deduction exceed 50% of W-2 wages paid out to employees by any company.
The Calculation Simplified Method
The rules are simplified for small businesses in a single line of business. Make sure your business qualifies under the qualified production activities rules, then take 3% of your net income. Compare the 3% figure to your adjusted gross income and to W-2 wages paid out.
A business won't qualify for the domestic production activities deduction if it has zero net income or zero W-2 wages.
How to Claim the Deduction
Businesses must complete IRS Form 8903 to claim the deduction for years prior to 2018.
"Every small business in the manufacturing industry should be looking at this tax deduction," according to Paul Schlather, Independent Director of Stonebridge, Inc., in 2017. "While Section 199 comes with a very complex set of rules, chances are that small businesses will qualify for the deduction much easier than the rules depict."
And it's not too late if you overlooked this deduction on previous years' returns. Sole proprietors and single-member LLCs can amend their tax returns from past years using Form 1040X. C corporations can do so on Form 1020X, and S corps can amend returns using Form 1120S. Multiple-member LLCs and partnerships should use Form 1065X.
An Exception for Some Agricultural Businesses
The expiration of the DPAD wasn't entirely sweeping. In December 2018, the IRS announced:
"The repeal of section 199 for tax years beginning after December 31, 2017, does not apply to a qualified payment received by a patron from a specified agricultural or horticultural cooperative in a tax year beginning after December 31, 2017, to the extent such qualified payment is attributable to qualified production activities income with respect to which a deduction is allowable to the cooperative under former section 199 for a tax year of the cooperative beginning before January 1, 2018."
Consult with your tax professional if you're engaged in this type of cooperative and think you might qualify. You might still be able to claim this deduction going forward.