An Overview of the Domestic Production Activities Deduction
This deduction is still available in certain tax years
Certain companies were able to take a 3 percent deduction for U.S.-based business activities between 2005 and 2017. That's can add up to a very nice tax break for small businesses.
"Every small business in the manufacturing industry should be looking at this as a tax deduction. 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," according to Paul Schlather, Independent Director of Stonebridge, Inc.
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.
Now fast forward 14 years. You'll recall that Congress was busy 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 Rules were changed and a handful of tax breaks were added, but many were repealed as well.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 Dec. 31, 2017 as the TCJA became effective on Jan. 1, 2018. But businesses can still claim it on their 2017 returns, even if they must file amended returns to do so.
And it might not be gone forever. The TCJA expires at the end of 2025 so it's possible that fresh life might be breathed back into the DPAD at that time.
Here's what you need to know whether you're looking back or looking forward.
The Basics of the Section 199 Deduction
Businesses with "qualified production activities" can take a tax deduction of 3 percent from net income. That's the easy part. The more complicated the business, the more complicated the math for calculating the domestic production activities deduction.
In a nutshell, businesses engaged in manufacturing and other qualified production activities must implement cost accounting mechanisms to make sure that their tax deductions are accurately calculated.
What Are Qualified Production Activities?
A company engaged in the following lines of business can qualify for the domestic production activities deduction. The "qualified production activities" eligible for claiming the deduction under Internal Revenue Code Section 199 include:
- 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 percent 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 the 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 percent
equals the tentative QPA deduction
Of course, now you have to identify each of these terms.
Qualified Production Activity Income (QPAI)
Qualified production activity income is just what it sounds like—all income resulting from qualified production activities. This will be the same as gross income for a business that engages in only one line of business, but businesses with multiple lines of businesses must allocate their incomes.
Qualified Production Activity Expenses
Qualified production activity expenses are all expenses directly related to the 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 cannot exceed adjusted gross income for sole proprietors, partnerships, S-corporations or limited liability corporations and it cannot exceed taxable income for C-corporations. Nor can the deduction exceed 50 percent of W-2 wages paid out.
"The rules are simplified for small businesses in a single line of business," according to Paul Schlather. Make sure your business qualifies under the qualified production activities rules, then take 3 percent of net income. Compare the 3 percent figure to adjusted gross income and 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.
Where to Claim the Deduction
Businesses must complete IRS Form 8903 to claim the deduction for years prior to 2018.