The Domestic Production Activities Deduction
The Domestic Production Activities Deduction – also known as the manufacturing deduction or the Section 199 Deduction – was created as part of the Jobs Creation Act of 2004 to promote competition in the global marketplace. The deduction gives domestic manufacturers a tax incentive for conducting certain domestic production activities in the U.S.
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Businesses engaging in qualified production activities can take a tax deduction of 9% of their qualified production activities income (QPAI) or their net income. The deduction cannot be greater than 50% of W-2 wages.
“The deduction equals 9% of the lesser of: (a) qualified production activities income; or (b) taxable income for the taxable year. However, the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. Qualified production activities include manufacturing, producing, growing, and extracting tangible personal property, computer software, and sound recordings, and the construction and substantial renovation of real property including infrastructure. The production of certain films is also a qualifying activity as are certain engineering or architectural services.” – IRS.gov
The Safe Harbor Rule
Under the safe harbor rule, businesses can claim the deduction if at least 20% of the total costs are the result of direct labor and overhead costs based in the U.S.
Qualified Production Activities
The qualified production activities under Internal Revenue Code Section 199 include:
- Manufacturing based in the United States,
- Selling, leasing, or licensing items that have been manufactured in the United States,
- Selling, leasing, or licensing motion pictures that have been produced in the United States,
- Construction services in the United States, including building and renovation of residential and commercial properties,
- Engineering and architectural services relating to a US-based construction project,
- Software development in the United States, including the development of video games.
Non-qualified production activities include:
- Construction services that are cosmetic in nature, such as painting.
- Leasing or licensing items to a related party.
- Selling food or beverages prepared at a retail establishment.
Calculating the Deduction
Qualified Production Activity Income (QPAI)
The total income generated from qualified production activities. This will be the same as gross income for businesses with only one line of business. For businesses with multiple lines of business, income will need to be distributed accordingly.
Qualified Production Activity Expenses
All expenses directly related to the qualified production activities This will equal your total expenses for businesses with only one line of business. For businesses with multiple lines of business, income will need to be distributed accordingly.
Qualified Production Activities Income (QPAI) minus (-) Qualified Production Activities Expenses equals (=) Qualified Production Activities Net Income times (x) The QPA Deduction Amount of 9% equals (=) The Tentative QPA Deduction.
The Domestic Production Activities Deduction is one of the most beneficial, yet missed tax deductions in the U.S. tax system.
According to Paul Schlather, a senior tax partner with PricewaterhouseCoopers’ Private Company Services practice, “every small business in the manufacturing industry should be looking at this as a tax deduction. While Section 199 comes with a very complex set of rules, chances are small businesses will qualify for the deduction much easier than the rules depict.”
Contact a Swanson Reed specialist to find out more information.