Domestic Production Activities Deduction
In the past, the United States (US), like many other countries, created tax incentives to promote exporting. However, the World Trade Organization ruled that most of these tax incentives favored US producers, discriminating against foreign competitors, so the US enacted the domestic production activities deduction (DPAD) in 2005 that applies to most producers of goods within the US, whether they export their goods or not. The deduction was intended to promote production of goods within the US, to increase employment, and to decrease the exporting of jobs to cheaper labor markets overseas. Consistent with these objectives, there is no deduction for businesses without employees.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, the Domestic Production Activities Deduction has been eliminated, starting in 2018 for taxpayers other than C corporations and 2019 for C corporations.
The DPAD is 9% of qualified production activity income, equal to the gross receipts from qualified production minus the expenses for creating the product. The deduction is available under both the regular and the AMT tax systems.
Only qualified producers can claim the deduction — those who are:
- selling, leasing, or licensing items manufactured, produced, grown, or extracted in the United States
- cultivating soil, raising livestock, fishing, and mining minerals
- storing, handling, and performing other activities related to the sale of agricultural products as long as the products are used in the qualified production of goods, whether by the taxpayer or by others
- selling, leasing, or licensing films — but not sexually explicit films — produced in the United States, where at least 50% of the compensation is paid to actors, producers, directors, and service personnel for work within the United States
- construction of residential and commercial buildings, including substantial renovation that incurs costs that must be capitalized
- however, rental income from real property is ineligible for the deduction
- engineering and architectural services for contract construction projects in the United States
- the development of software, including video games, but not for fees that are charged for customer support, playing computer games online, or for the online use the software.
- the production of electricity, natural gas, or potable water
- making tangible property from new or raw material, or by combining or assembling 2 or more articles, such as a craft business.
The following do not qualify:
- cosmetic activities related to construction, such as painting
- the sale of food or beverages prepared in a retail establishment, but a business that produces food or beverage for sale in other retail establishments can claim the deduction
- leasing or licensing to a related party
To claim the deduction, a significant amount of the production activity must occur within the US. Although there is no bright line defining a significant amount, there is a safe harbor that will apply if the labor and overhead costs of manufacture, production, growth, or extraction of the property within the US are at least 20% of the total cost of goods sold. (Internal Revenue Bulletin - February 14, 2005 - Notice 2005-14) However, if the 20% test is not met, an activity can still qualify for the deduction based on facts and circumstances.
Uniform capitalization rules (IRC §263A) may prevent taking the deduction for some production activities. Instead, these costs may have to be recovered through depreciation, amortization, or deducting the cost of goods sold when the property is sold. However, most small businesses will not be subject to the uniform capitalization rules.
Allocating Qualified Income and Expenses to Domestic Production Gross Receipts
The DPAD can only be deducted against qualified production activity income (QPAI), which is income earned from qualified production activities. Domestic production gross receipts (DPGR) are the gross receipts from qualified domestic production activities, so QPAI equals the DPGR minus the deductions, expenses, losses, and cost of goods sold allocated to the qualified production activity. If the business has both domestic and foreign operations, then any reasonable allocation of income and costs to qualified domestic activities can be used.
QPAI = DPGR – Qualified Production Activities Expenses
Domestic Production Activities Deduction = 9% × QPAI
The DPAD is figured on Form 8903, Domestic Production Activities Deduction. Gross receipts is reduced by the cost of goods sold and related expenses including direct costs of production plus a portion of indirect expenses, not including design and development costs, packaging, labeling, or minor assembly operations.
There is also a de minimis rule: no allocation is necessary if gross receipts from nonqualified domestic production activities are less than 5%, thus allowing all gross receipts to be treated as qualified. Likewise, if gross receipts from services are less than 5% of the gross receipts from the property.
There are 2 limitations to the deduction:
- the deduction cannot exceed adjusted gross income for sole proprietors and owners of business entities nor the taxable income for C corporations
- the deduction cannot exceed 50% of W-2 wages, including taxable compensation and elective deferrals, such as contributions for 401(k) plans.
The wage limitation applies to W-2 wages on domestic production activities allocated to the business's DPGR. For business entities, the wage limitation equals 50% of the wages that the business allocates to the qualified production activity. W-2 wages does not include self-employment income, payments to independent contractors, or guaranteed payments to partners. The deduction cannot be used to calculate a net operating loss.
Several states, including California and New York, do not allow the domestic production activities deduction. Owners of business entities claim the deduction on their personal returns, so the business entity must allocate gross receipts, cost of goods sold, and related expenses for the qualified production activities to each of the individual partners, members, or shareholders. In determining the limitation of W-2 wages, the allocation must be the lower of the owner's allocable share of wages or 2 × 9% of production activities income for the tax year.
DPAD = 9% of the Lesser of Taxable Income or Qualified Production Activities Income or 50% of Wages Allocated to Qualified Production Activities
Example: DPAD = $3 million of QPAI × 9% DPAD Rate = $270,000.
Example: a business has domestic production activity income of $100,000. Wages paid to employees that are allocated to the production activity equals $20,000. Therefore, the domestic production activities deduction would equal $100,000 × 9% = $9000. However, if only $8000 were paid for wages to produce that income, then the deduction would be limited to $8000 × 50% = $4000.
Small Business Simplified Overall Method for Allocating DPGR and Non-DPGR
Certain small businesses with average annual gross receipts not exceeding $5 million can use a simplified method for allocating cost of goods sold and related expenses between DPGR and non-DPGR by ratably apportioning the cost according to the proportion of DPGR over non-DPGR. Businesses that are qualified to use this simplified method must satisfy any of the following:
- average annual gross receipts for the preceding 3 years was $5 million or less
- if the business has not existed that long, then the average should be based on the duration of existence
- however, any short tax years should be annualized by dividing the gross receipts by 12, then multiplying by the number of months in the short tax year
- the business is not required to use the accrual method of accounting or it is a farming business
- the business is eligible to use the cash method of accounting under Revenue Procedure 2002-28, meaning that the business has average annual gross receipts not exceeding $10 million and is not excluded from using the cash method under IRC §448.
Excluded from using the simplified method are estates and trusts, and certain oil and gas partnerships and partnerships owned by expanded affiliated groups.
Example: Using the Simplified Method for Allocating DPGR and Non-DPGR
- No Net Operating Loss
- Total Gross Receipts = $1000
- DPGR = $750
- Cost of Goods Sold and Other Deductions and Expenses = $400
- DPGR Percentage = $750/$1000 = 75%
- Expenses Allocated to DPGR = $400 × 75% = $300
- QPAI = $750 – $300 = $450
Partnerships and S corporations that are small pass-through entities are permitted to use the simplified overall method to calculate QPAI at the entity level, then allocating the result to partners or shareholders. A small pass-through entity is one that satisfies all the following requirements:
- DPGR cost of goods sold and deductions, not including the net operating loss deduction, does not exceed $5 million
- one of the following requirements are satisfied:
- average annual gross receipts not exceeding $5 million for the previous 3 tax years
- it is engaged in farming, but it is not required to use the accrual method of accounting, or
- it can use the cash method of accounting under Revenue Procedure 2002-28
- if a partnership, then no partner is a qualifying in-kind partnership or an expanded affiliate group partnership (Regulations §§1.199-3(i)(7) - (8)).
Simplified Deduction Method
There is also a simplified deduction method that can be used to apportion deductions, losses, expenses — but not the cost of goods sold — between DPGR and non-DPGR by ratably apportioning the amount based on relative gross receipts. To be eligible for this method, business assets must not exceed $10 million by the end of the tax year and average annual gross receipts cannot exceed $100 million.
Example: Using the Simplified Deduction Method
- No Net Operating Loss
- Total Business Deductions, Expenses, or Losses = $400
- Cost of Goods Sold Allocated to DPGR = $240
- Total Gross Receipts = $1000
- DPGR = $600
- DPGR Percentage = $600/$1000 = .6 = 60%
- DPGR Expenses = $400 × 60% = $240
- QPAI = $600 – $240 = $360
The simplified deduction can be calculated at the entity level, then allocated to the business owners, but only if the entity is a widely held pass-through entity, defined as those partnerships or S corporations that meet each following requirement for the tax year:
- it satisfies the requirements, discussed above, for using the simplified deduction method
- it has DPGR
- total cost of goods sold plus deductions does not exceed $100 million
- all shareholders or partners are individuals, estates, or trusts during the entire tax year
- during that same year, no shareholder or partner, including any ownership interests held by related persons, owns more than 10% of the business entity.
If an estate or trust is eligible under the above rules, then it must use the simplified deduction method to allocate both indirectly attributable and directly attributable business deductions, expenses, or losses between DPGR and non-DPGR (Regulations §1.652(b)-3).
The DPAD is limited to the extent that losses and deductions are disallowed by any of the following provisions of the tax code:
- at-risk rules
- passive activity rules
- basis limits on a partner's share of partnership losses or on a shareholder's share of S corporation losses.
Any proportionate share of expenses that were disallowed because of the above limitations in the current year can be used to calculate the DPAD in a later tax year.