The domestic production activities deduction (DPAD) allows taxpayers to take a deduction which equals 9 percent of the lesser of their taxable income or their income resulting from qualified production activities for the tax year. Taxpayers may qualify for this deduction if they in whole or in significant part manufacture, produce, grow, construct, engineer, or conduct other activities within the Unites States. Activities that are merely sales or service-related generally do not qualify for this deduction.
A taxpayer must meet certain tests to qualify for this deduction. The first test determines if the taxpayer has made a significant contribution to the production of the product. The activity must be substantial in nature where at least 20 percent of the taxpayer’s total costs must go to production. A taxpayer engaged only in packaging, labeling, and minor assembly would not meet the requirements to be eligible for DPAD.
Subcontracting of the process to another taxpayer may not meet the requirements of ownership of the property being produced. The general rule looks to who bears the benefits and burdens of ownership of the property while the activity occurs.
The second test determines if the activity took place in the United States. The term “United States” includes the 50 states, the District of Columbia, and territorial water of the United States. It does not include possessions and territories of the United States, except for a special rule for Puerto Rico. Taxpayers who import part of their production from foreign activities would need to determine if the production in the United States is significant enough to fulfill the requirements to qualify for DPAD.
Gross receipts must be from qualifying production activities derived from the sale, lease, rental, license, exchange, or other disposition of property that meets the requirements of the tests for DPAD. Receipts such as interest, dividends, receipts in the performance of services or resale of purchased product, among other receipts, would not be eligible for the deduction.
The DPAD may apply to many activities and entitle taxpayers to an additional deduction when computing their taxable income solely based on their current business activities. This deduction is allowed to all taxpayers – individual, C corporations, estates, trusts, trust beneficiaries, and owners of partnerships and S corporations. The deduction effectively reduces the income-tax rate on domestic production activities, which was the intent when the law was enacted in 2005 in the hope of providing jobs.
The IRS has issued much guidance in this area, including several revenue procedures and various sets of regulations. These rules render assistance involving the computation, including determining if a particular activity is eligible for the deduction, how to compute the net income from activities that are eligible for the deduction, and how to determine the deduction when there is income from both eligible and ineligible activities. Although the rules are complex and numerous in determining the eligibility of the taxpayer for this deduction, the effort involved after the initial determination provides an added tax savings benefit to taxpayers.
Allison J. Shoemaker can be reached at Email or 215.441.4600.