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Debra Mitchell
Debra Mitchell

Taking advantage of the domestic production activity deduction

It's not just for manufacturers—various taxpayers may find that they are eligible for this valuable deduction.

July 26, 2012
by Debra A. Mitchell, CPA

Qualified taxpayers are able to take advantage of the domestic production activity deduction (DPAD). This deduction—also called the manufacturing deduction or the Sec. 199 deduction—replaced former foreign sales corporation and extraterritorial income provisions of the Code, so taxpayers who did not benefit from those provisions’ export tax benefits may overlook it. However, the DPAD is available to a wide variety of U.S. taxpayers, not just those who export their products.

The deduction is limited to 9% of the lesser of qualified production activities income (QPAI) or taxable income for the year. When the deduction was created in 2005, it was 3%. It increased to 6% in 2007, and has been 9% since 2010 (Sec. 199(a)). This percentage is reduced for oil and gas activities (Sec. 199(d)(9)).

Adjusted gross income is substituted for taxable income for individuals, estates, or trusts (Sec. 199(d)(2)). The deduction is calculated and reported on Form 8903, Domestic Production Activities Deduction, or on Schedules K-1 for passthrough entities.

The deduction is further limited so that it cannot exceed 50% of allocable W-2 wages. Wages for this purpose include amounts reported on Form W-2, Wage and Tax Statement, along with deferred compensation such as deferrals for 457, 401(k), 403(b), SIMPLE, and SEP plans (Sec. 199(b)).

QPAI

QPAI equals domestic production gross receipts (DPGRs), reduced by cost of goods sold, and other deductions, expenses, and losses allocable to the receipts (Sec. 199(c)(1)).

As the name implies, DPGR applies to domestic operations and consists of:

  • Gross receipts from lease, rental, sale, exchange, or disposition of qualified production property (QPP) which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States. QPP is normally tangible personal property, but it also includes computer software and sound recordings. It does not include land, buildings, or structural components.
  • Construction or substantial renovation of U.S. real property.
  • Engineering or architectural services for U.S. construction projects (Sec. 199(c)(4)).

DPGR does not include activities that are:

  • Exclusively sales of property; or
  • Exclusively services, with the exception of construction, engineering, or architecture.

Allocation of receipts

Any reasonable method may be used to allocate gross receipts between DPGRs and non-DPGRs. Taxpayers are required to use the specific identification method if the amounts are readily available and the method would not cause the taxpayer to incur any undue burden or expense. There is a de minimis exception when less than 5% of total gross receipts is from non-DPGRs. In this case, there is no requirement to allocate gross receipts (Regs. Sec. 1.199-1(d)).

Allocation of costs

When determining QPAI, taxpayers need to determine the allocable portion of cost of goods sold along with the allocable portion of other expenses, losses, and deductions. For taxpayers that have no non-DPGRs, all cost of goods sold would reduce their QPAI. Other taxpayers should use a reasonable method of allocation. These methods could include allocating expenses based on gross receipts, units produced, or total production costs. Taxpayers should keep in mind that if costs can be specifically identified without undue burden or cost, this method should be used. The method for allocation of cost of goods sold should be consistent with method of allocation of gross receipts, unless there is support that a different method is more accurate (Regs. Sec. 1.199-4).

Three methods may be used to allocate deductions. They are:

  • Sec. 861 method;
  • Simplified deduction method; and
  • Small business simplified overall method (Regs. Sec. 1.199-4).

A taxpayer may change which method it uses from year to year.

Sec. 861 method

The Sec. 861 method is the most costly and cumbersome calculation. Under this method, a taxpayer must allocate and apportion its deductions using the allocation and apportionment rules provided under the Sec. 861 regulations. Any costs that are not directly allocable need to be apportioned. This method does result in more accurate calculations, but the simplified methods are often used because of this method’s recordkeeping burden.

Simplified deduction method

The simplified deduction method may be used by taxpayers with average annual gross receipts of $100 million or less or total assets of $10 million or less at the end of the year. Under this method, allocable deductions are calculated by multiplying deductions by the ratio of DPGRs to total gross receipts. It differs from the small business simplified overall method in that it may not be used for cost of goods sold.

Small business simplified overall method

Certain taxpayers may use the small business simplified overall method. Several limits apply for using this method, and the following taxpayers qualify:

  • Taxpayers with average annual gross receipts of $5 million or less;
  • Certain farmers who are not required to use the accrual method; and
  • Certain taxpayers with annual gross receipts of $10 million or less who are eligible to use the cash method of accounting.

Under the simplified overall method, allocable costs are calculated by multiplying cost of goods sold and other deductions by the ratio of DPGRs to total gross receipts.

Passthrough entities

In the case of passthrough entities, the DPAD limitations are applied at the shareholder, partner, or member level (Sec. 199(d)(1). Therefore, entities are required to present information that allows calculation of the limitations at this level. There are two methods for providing this information, as follows:

  • Entities that qualify to use the small business simplified overall method or simplified deduction method may calculate QPAI and W-2 information at the entity level and pass through this information only; or
  • Entities can pass through separate information so that the deduction may be calculated at the shareholder, partner, or member level.

Other issues

The DPAD applies in calculating both the regular tax and alternative minimum tax (AMT). However, for corporate taxpayers, the taxable income limitation of Sec. 199(a)(1)(B) for AMT purposes is calculated based on alternative minimum taxable income instead of regular taxable income (Sec. 199(d)(7)). The DPAD has no effect on shareholder or partner basis (Regs. Sec. 1.199-5(c)(1)(i)).

The DPAD, if applicable, can provide tax relief to various taxpayers. The recordkeeping may appear to be burdensome, but the use of simplified methods provides relief in this area. While the name may suggest that it is a manufacturing deduction only, various taxpayers may find that they are eligible for it.

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Debra A. Mitchell, CPA, MBA, MST, is a principal with Braver PC Accountants and Advisors in Providence, R.I.