The Effect of the 2018 Tax Law
This deduction was originally part of the American Jobs Creation Act of 2004. It was covered under Internal Revenue Code Section 199 and Internal Revenue Service (IRS) Proposed Regulations 1.199. Then, in 2017, Congress began negotiating and finalizing new tax legislation. The result was the TCJA, which made sweeping changes to U.S. tax law. Rules were changed, and a handful of tax breaks were added, but many were repealed as well. The domestic production activities deduction (DPAD) was one of those to be eliminated. It expired on December 31, 2017, as the TCJA became effective on January 1, 2018. The DPAD might not be gone forever. Other tax breaks eliminated by the TCJA have been revived by subsequent legislation, so the DPAD could be revived similarly.
The Basics of the Section 199 Deduction
From 2004 through 2017, businesses with “qualified production activities” could take a tax deduction of 9% from the annual income they earned through those activities. The deduction was simple in theory, but the more complicated the business, the more complicated the math becomes for calculating what was a qualified production activity. In a nutshell, businesses that engaged in manufacturing and other qualified production activities had to implement cost accounting mechanisms to make sure their tax deductions were accurately calculated.
What Are Qualified Production Activities?
A company engaged in the following lines of business could qualify for the domestic production activities deduction. “Qualified production activities” eligible for claiming the deduction under Internal Revenue Code Section 199 include, but aren’t expressly limited to:
Manufacturing based in the U.S. Selling, leasing, or licensing items that have been manufactured in the U.S.The production of potable water, natural gas, and electricity in the U.S.Film and movies that were produced at least 50% in the U.S. Construction services in the U.S., including building and renovation of residential and commercial propertiesEngineering and architectural services relating to a U.S.-based construction projectSoftware development and sound recordings made in the U.S.
General Rule and Safe Harbor
The DPAD 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 takes place outside the U.S. The safe harbor rule applies if at least 20% 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:
Advertising and product placementLeasing or licensing items to a related partySelling food or beverages prepared at a retail establishment
Figuring the Tax Deduction
Calculating the DPAD can be either ridiculously simple or enormously complex, depending on the nature of the business. The key is “qualified production activities income” (QPAI) and its limitations. The equation works out like this:
Limitations
The dollar amount of the domestic production activities deduction is limited. The deduction can’t exceed adjusted gross income for sole proprietors, partnerships, S-corporations, or limited liability corporations. It can’t exceed taxable income for C-corporations, nor can the deduction exceed 50% of W-2 wages paid out to employees by any company. Oil companies had to reduce their deduction by an additional 3%.
