Business Deductions

Quick Links

Hot Topics

Need Some Deductions for 2012?

Don't overlook these!

10 Oddball Tax Deductions

11 Most Overlooked Tax Deductions

Updated for 2012

What is the Domestic Production Activities Deduction?

The domestic production activities deduction (also referred to as the manufacturer's deduction) is a provision enacted in the American Jobs Creation Act of 2004 (P. L. 108-357) which was signed into law by President Bush on October 22, 2004.

The deduction is a fixed percentage of...

  1. income from qualified production activities or
  2. adjusted gross income for individuals (or taxable income for C corporations)

whichever is lower.

Individuals and corporations may claim the deduction for qualified domestic production activities.

You must have paid wages to employees to claim the deduction. Payments to independent contractors (Form 1099-MISC) may NOT be counted as wages.

Background:

What spurred the American Jobs Creation Act was the World Trade Organization's ruling in January 2002 that the extra-territorial income exclusion (referred to as the ETI) of prior law (which was effective October 1, 2000), was a prohibited export subsidy.

The ETI provided a tax incentive for export sales. Exporters could exclude 15 to 30 percent of export sales income from U.S. taxation.

The domestic production activities deduction replaces the former foreign sales corporation (FSC) and extraterritorial income regimes (ETI) in Section 144.

Congress enacted Section 199 as part of the American Jobs Creation Act of 2004.

Section 199 introduced a phased-in deduction for income attributable to domestic production activities.

The phase-in for the deduction began in 2005 and continued through 2010 (see deduction percentages below).

Qualified Production Activities Deduction Percentages

For 2011, the deduction percentage is 9%.

Here are the deduction percentages for prior years:

Note: After multiplying Qualified Production Activities Income by the applicable rate, the result is subject to two limitations:

  1. The adjusted gross income limitation for individuals (taxable income limitation for C corporations) and
  2. The wage limitation

If no wages are paid for the year, no deduction is permitted.

Qualified Production Activities

The following activities conducted in the United States qualify for the domestic production activities deduction.

Not Qualified Production Activities

The following lines of business are specifically excluded from claiming the domestic production activities deduction:

Safe Harbor

As the name of the deduction indicates, it is limited to activities in whole or significant part in the U.S.

Under a safe harbor, a taxpayer is treated as having manufactured, produced, grown, or extracted property in significant part within the U.S. if direct labor and overhead costs incurred within the U.S. account for at least 20% of the total cost of the property.

Domestic Production Gross Receipts

If your gross receipts include domestic production gross receipts (DPGR) and foreign production gross receipts you must determine the portion of gross receipts that represents domestic production gross receipts.

You can use any reasonable allocation method.

Figuring the Domestic Production Activities Deduction

To calculate the deduction:

  1. Begin with domestic production gross receipts (DPGR)
  2. Next, determine qualified domestic production activity income (QDPAI) by reducing DPGR by:
    • Cost of goods sold allocable to DPGR
    • Wages allocable to DPGR
    • Other expenses directly related to DPGR
    • An allocation of indirect expenses to DPGR.
  3. Multiply QDPAI determined in # 2 by the applicable percentage (which depends of the tax year)
  4. Compare the amount determined in #3 to the following two amounts to determine the deduction limitation:
    • Adjusted gross income on Form 1040 for individuals (or taxable income on Form 1120 for C corporations)
    • Wages paid during the year to determine the deduction limitation (remember, if no wages were paid then no deduction is allowed)

Limitations for individuals:

Limitations for C corporations:

Claiming the Deduction

Wage Requirement

If no wages are paid during the year, no deduction is allowed. In other words, you must have employees to qualify for the domestic production activity deduction.

W-2 wages include both taxable compensation and employee contributions to 401(k) plans (elective deferrals).

To determine the 50%-of-W-2-wages limitation:

Allocating W-2 Wages, Cost of Goods Sold, and Other Expenses

There are three methods for determining W-2 wages.

  1. The Unmodified Box Method:
    • This method looks at Form W-2, Box 1 and Box 5 and uses the lesser of the amounts in Box 1 or Box 5 of Form W-2.
  2. The Modified Box 1 Method:
  3. The Tracking Wages Method

The second two methods are more complex and can be found in the instructions to Form 8903. (Unlike the Unmodified Box Method, the other two methods don't take box 5 into account. Take a look at page 8 in the instructions for how to do the computation under each method.

Health Insurance Premiums for 2% S corporation Shareholders:

Health insurance premiums paid for S corporation 2% percent shareholder/employees are treated differently than health insurance premiums paid for regular S corporation employees who are not 2% shareholders.

See IRS Pub 15-B, page 7.

Example

The following example demonstrates how to figure the domestic production activity deduction including the allocation of expenses using the Small Business Simplified Overall Method.

1) First, determine the domestic production gross receipts percentage (DPGR percentage).

2) Next, using the DPGR percentage determined in #1, compute the expense allocations:

3) Now, subtract from DPGR (#1) the allocated amounts determined in #2 to compute your qualified domestic production activity income (QDPAI):

4) Multiply QDPAI ($22,500, determined in #3) by the applicable deduction percentage to determine your tentative deduction (the amount subject to limitation).

The deduction percentages are:

The tentative deduction for 2007 is: $1,350 (6% x $22,500).

5) Limitations:

First, compare the amount determined in # 4 ($1,350) to your adjusted gross income reported on Form 1040 figured without the domestic production activities deduction (DPAD)

Next, compare the same amount ($1,350) to wages allocated to DPGR for the year.

For tax years 2007 through 2009 the deduction may NOT exceed:

5) Claiming the deduction.

Note: For partnerships, LLCs treated as partnerships, LLCs treated as S corporations, and S corporations that were converted from C corporations:

In other words, the domestic production activity deduction is not taken at the entity level for the above entities; it is claimed at the individual level.

The elements needed to compute the deduction are provided to each owner by the entity on Schedule K-1.