The Internal Revenue Code (“IRC”) section 199 Domestic Production Activities Deduction (“DPAD”) provides a tax benefit in the form of a current deduction for expenditures made in conducting certain, qualifying activities in the United States (“US”). As such, it allows for a double-dip in tax deductions of up to 9% of taxable income, subject to limitations.
Qualifying activities cover a broad range of industries. Domestic Production Activities include:
- The sale, lease, rental, license, exchange, or other disposition of tangible personal property, computer software, or sound recordings produced, grown, or extracted, in whole or in part, within the US.
- Construction performed in the US.
- New construction as well as substantial renovations of existing buildings can qualify.
- Engineering or architectural services performed in the US for US construction projects.
Films and videos
- Over 50% of the production work must be conducted in the US.
- Electricity, natural gas or potable water produced or extracted in the US.
Traditional manufacturers are clear candidates for the DPAD. In addition, any business that contributes value-added services to tangible or intangible property may be entitled to benefits. The DPAD is available at all stages of production, from the processing of raw materials through a product’s completion. Examples of ineligible activities are those that do not contribute to modifying the product such as packaging, labeling and minor assembly operations.
The rules for determining the deduction are subjective, complex, and contain a myriad of traps for the unwary. Advanta’s experienced DPAD specialists can assist you with:
- Developing a methodology for calculating the deduction, and/or
Reviewing existing methodologies for calculating the deduction to ensure:
- The proper application of the tax law, and that
- The maximum allowable benefit is obtained.
The DPAD is an area of focus with the Internal Revenue Service (“IRS”) and our professionals possess deep knowledge of the tax law and extensive experience and success working with clients with DPAD claims under IRS review.
The calculation of the DPAD is conceptually fairly simple. A calculation is made that is essentially a shadow income calculation (i.e., the calculation starts with a revenue figure from which certain expenditures are deducted in calculating ‘income’). This income amount is then factored against a statutory percentage to determine the potential deduction from taxable income. There are several limitations which must be adhered to as well.
The steps for calculating the deduction are as follows:
Bifurcate qualifying and non-qualifying activities.
Qualifying activity is the manufacture, production, growth or extraction (“MPGE”) of tangible personal property in the US.
- Generally, does not include activities conducted in US territories nor US possessions. (However, for tax years Starting tax years beginning before January 1, 2017, includes Puerto Rico.)
- Qualifying activity is the manufacture, production, growth or extraction (“MPGE”) of tangible personal property in the US.
Calculate Domestic Production Gross Receipts (“DPGR”)
- Starting with sales detail from the Trial Balance, Gross Receipts are identified on an item-by-item level as either related to qualifying activity or as non-qualifying activity.
- Allocate Costs of Goods Sold between qualified and non-qualified activities.
Apportion other costs between qualified and non-qualified activities. There are three allowable methods available to taxpayers.
The Simplified Deduction Method (Treas. Reg. § 1.199-4(e)(1))
- Available to taxpayers with average annual gross receipts of less than $25 million.
The Small Business Simplified Overall Method (Treas. Reg. § 1.199-4(f)(1))
- Available to taxpayers with average annual gross receipts of less than $5 million (and certain taxpayers eligible to use the overall cash method of accounting).
The IRC section 861 method
- Must be used by taxpayers not electing one of the simplified methods or ineligible to do so.
- Must be applied in a consistent manner with other methodologies utilizing Section 861 to allocate expenses (e.g., the Foreign Tax Credit)
- The Simplified Deduction Method (Treas. Reg. § 1.199-4(e)(1))
Determine Qualified Production Activities Income (“QPAI”)
- QPAI is the net of DPGR less allocated COGS and apportioned other costs.
- The lesser of QPAI and Taxable Income is factored by the appropriate percentage, currently 9%, to determined potential deduction.
Compare potential deduction to Form W-2 wages properly allocable to generating DPGR.
- Deduction is limited to 50% of such wages.
While conceptually simple, the calculation is subject to numerous pitfalls, limitations and subjective determinations. In addition, care must be taken to apply the law appropriately while ensuring that the maximum allowable deduction is claimed. The requirement to calculate the deduction at the item level can seem burdensome to businesses with many separate products. Advanta’s DPAD specialists have extensive experience with assisting businesses efficiently navigate the DPAD, maximize the tax benefits and provide a deliverable documenting the positions for future calculations and possible IRS examination.
There are many planning opportunities due to the complexities in this area. For example, Advanta reviewed calculations for taxpayers which are technically correct, however, changing several of the Sec. 861 expense allocations options significantly increased the deductions.
Taxpayers with a tax loss or no taxable income will often forgo calculating the DPAD for those years. However, it is important for pass-through entities to calculate the DPAD for each year or risk reporting incorrect tax information. The DPAD is calculated at the taxpayer level. Therefore, shareholders/partners need DPAD information from all of their holdings in order for them to accurately calculate their overall tax position.
Our DPAD specialists are well versed in:
- developing efficient methodologies for taxpayers new to claiming the DPAD,
- reviewing existing calculations and methodologies to ensure compliance with the relevant tax law and that the maximum allowable benefit is derived,
- documenting the support for the tax positions in a detailed report, and
- representing taxpayers under examination.
The DPAD is a substantial benefit to taxpayers but is an area of great subjectivity and complexity. Advanta’s professionals can assist your business in navigating the DPAD.