The domestic production activities deduction (DPAD), also commonly referred to as the manufacturers’ deduction or Section 199 deduction, provides a generous tax break for certain “domestic production activities.” Unfortunately, many businesses overlook this valuable tax break because they believe it’s only for manufacturers.
In fact, the deduction is available to a wide range of businesses, including construction companies, architects, engineers, software developers, oil and mining companies, agricultural processors, and producers of recordings and films. Now is a good time for businesses to revisit DPAD in light of temporary and proposed regulations that may affect their eligibility.
Calculating the DPAD is complex, but generally it’s equal to the lesser of 1) 9% (6% for “oil-related” activities) of a company’s income from qualified production activities, or 2) its taxable income. In addition, the deduction can’t exceed 50% of the company’s W-2 wages for the year that are attributable to domestic production.
To determine a company’s qualified income, start with its gross receipts from qualified domestic production activities and subtract the cost of goods sold and certain other costs allocable to those activities.
IRS offers guidance
The temporary and proposed regulations clarify a number of issues related to the application of DPAD. Here are some of the highlights:
Contract manufacturing. Which party to a contract manufacturing arrangement is entitled to claim the DPAD? Under current rules, the answer depends on which party enjoys the benefits and bears the burdens of ownership. That, in turn, depends on several factors, including which party retains legal title to manufactured property during production, which party controls the property and the process, which party bears the risk of loss or damage, which party receives profits from the property’s sale, and which party pays property taxes.
To eliminate the uncertainty associated with this analysis, the proposed regulations would establish a bright-line test under which the party that actually performs the activity would be entitled to claim the deduction.
Construction. Qualified production activities include those associated with the construction or substantial renovation of U.S. real property, including those “typically performed by a general contractor,” such as management and oversight of the construction process. The proposed regulations would clarify that a contractor whose activities are limited to approving and authorizing invoices and payments is ineligible for the DPAD.
Testing and packaging. Under current rules, qualified production activities may include testing of component parts, packaging, repackaging, labeling and “minor assembly.” The proposed regulations would exclude these activities if the taxpayer isn’t otherwise involved in manufacturing, producing, growing or extracting the property in question.
W-2 wages. The temporary regulations provide guidance on application of the W-2 wage limitation to taxpayers with a short taxable year. Wages are calculated on a calendar-year basis and there had been some uncertainty over the treatment of wages paid during a short tax year that didn’t include a calendar year end. The temporary regulations provide that wages paid to employees during such a short tax year are included for the purposes of the W-2 wage limitation.
The temporary regulations also clarify the treatment of wages when a business is acquired or disposed of during the year. If employees receive wages from two different taxpayers, those wages are allocated between the taxpayers based on the employees’ respective periods of employment with each taxpayer.
If your business has claimed the DPAD in the past, or if you think it may qualify in the future, talk to your tax advisor about how the temporary and proposed regulations will affect your eligibility and the size of your deductions.