An Overview of the Domestic Production Activities Deduction
The Basics of the Section 199 Tax Deduction
Certain companies have been able to take a 3 percent deduction for U.S. based business activities since 2005. "Every small business is 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 small businesses will qualify for the deduction much easier than the rules depict," according to Paul Schlather, Independent Director of Stonebridge, Inc.
The Basics of the Section 199 Deduction
Businesses with "qualified production activities" can take a tax deduction of 3 percent from net income. 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 will have to implement cost accounting mechanisms to make sure their tax deduction is accurately calculated.
Qualified Production Activities
A business engaged in the following lines of business may 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 domestic production activities deduction 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 take 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 domestic production activities deduction can be either ridiculously simple or enormously complex, depending on the nature of the business. The key is to examine "qualified production activities income" (QPAI) and the limitations.
Domestic Production Activities Deduction Calculation
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
Qualified Production Activity Income (QPAI)
Qualified production activity income is all income resulting from qualified production activities. For a business with only one line of business, this will be the same as gross income. For businesses with multiple lines of business, income must be allocated.
Qualified Production Activity Expenses
Qualified production activity expenses are all expenses directly related to the qualified production activities.
For a business with only one line of business, this will be the same as total expenses. For businesses with multiple lines of business, income must be allocated.
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, or taxable income for C-corporations. The deduction cannot exceed 50 percent of W-2 wages.
"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 will not qualify for the domestic production activities deduction if it has zero net income or zero W-2 wages.
Where to Claim the Deduction
This deduction was part of the American Jobs Creation Act of 2004 and is covered under Internal Revenue Code Section 199 and IRS Proposed Regulations 1.199. The Domestic Production Activities Deduction is discussed in JK Lasser's Your Income Tax, Chapter 40.23, and JK Lasser's Small Business Taxes, Chapter 21.