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Domestic Production Activity Deduction Repealed For Tax Years After 2017 Under TCJA

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Under the new tax law, the Tax Cuts and Jobs Act (TCJA), Section 199 - the domestic production activities deduction (DPAD) was repealed for tax years beginning after 12/31/17.

What Follows is the Old Law (2017 and Prior Years)

The domestic production activities deduction (also referred to as the manufacturer's deduction) was 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 income from:

• Qualified production activities, or
• Adjusted gross income (AGI) 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 may not be counted as wages.

Where to Claim the Deduction

• Individuals claim the deduction on Form 1040, line 35.
• C corporations claim the deduction on Form 1120, line 25.
• Form 8903 is used to figure the deduction by individuals and C corporations.

Qualified Production Activities Deduction Percentages

The following are the deduction percentages for tax years 2005 through 2015:

• 2015: 9%
• 2014: 9%
• 2013: 9%
• 2012: 9%
• 2011: 9%
• 2010: 9%
• 2009: 6%
• 2008: 6%
• 2007: 6%
• 2006: 3%
• 2005: 3%

Limitations

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 or the taxable income limitation for C corporations
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:

• The manufacture of tangible personal property.
• The production of sound recordings and certain films.
• Software developed in the U.S. whether purchased off the shelf or downloaded, including video games.
  • Generally, the term "software" does not include fees for online use of software, fees for customer support, and fees for playing computer games online.
• The production of electricity, natural gas, or water.
• Selling, leasing, or licensing items manufactured, produced, grown, or extracted in the U.S.
• Selling, leasing, or licensing films produced in the U.S.
• Construction in the U.S.
  • Construction includes both erection and substantial renovation of residential and commercial buildings.
• Engineering and architectural services relating to a construction project performed the the U.S.

Not Qualified Production Activities

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

• 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.

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.
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)

Deduction Limitations for individuals

The deduction for 9% of qualified production activities income may not exceed adjusted gross income (AGI) for:

• Sole proprietors
• Owners of partnerships
• Owners of limited liability companies treated as sole proprietorships, partnerships, or S corporations
• S corporations (converted from C corporations).

In addition to the AGI limitation, the deduction may not exceed 50% of wages paid during the year.

Limitations for C corporations

• The deduction may not exceed 9% of taxable income.
• In addition to the taxable income limitation, the deduction may not exceed 50% of wages paid during the year.

Claiming the Deduction

• Individuals claim the deduction on Form 1040, line 35
• C corporations claim the deduction on Form 1120, line 25
• Form 8903 is used to figure the deduction by individuals and C corporations.

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:

• Tax years beginning before May 18 2006:
  • All wages may be used in determining this limitation.
• After May 17, 2006:
  • Only those wages paid that are allocable to domestic production gross receipts can be used for purposes of determining this 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 than the first method 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.

• 2% shareholders of an S corporation:
  • Health insurance premiums paid on behalf of or reimbursed to 2% S corporation shareholders are included in Box 1 of Form W-2 as wages and are subject to federal income taxes.
  • However, such premiums are not included in Box 3, social security wages, or Box 5,  Medicare wages. In other words, such premiums are only subject to federal income taxes but not social security or Medicare taxes.
• Employees of an S corporation who are not 2% shareholders:
  • Health insurance premiums paid on behalf of employees who are not 2% shareholders are not included in box 1, 3, or 5 of Form W-2. In other words, such premiums are not subject to federal income taxes, social security taxes, or Medicare Taxes.

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.

STEP 1: Determine the domestic production gross receipts percentage (DPGR percentage):

• Assume gross receipts (GR) of $100,000
• Assume the portion of gross receipts that represents domestic production gross receipts ( (DPGR) is $75,000
• Therefore, the DPGR percentage = 75% ($75,000/$100,000)

STEP 2: Using your DPGR percentage (STEP 1), compute your expense allocations:

• Cost of Goods Sold (COGS): Assume your total COGS is $40,000. Therefore, COGS allocable to DPGR is $30,000 (75% x $40,000)
• Wages: Assume total gross wages paid during the year is $25,000. Therefore, gross wages allocable to DPGR is $18,750 (75% x $25,000)
• Other Expenses: Assume total other expenses is $5,000. Therefore, total other expenses allocable to DPGR is $3,750 (75% x $5,000)

STEP 3. Compute Your qualified Domestic Production Activity Income (QDPAI):

To compute your qualified domestic production activity income (QDPAI) you must subtract the total allocated expense amounts of $52,500 (STEP 2) from DPGR of $75,000 (STEP 1). The difference of $22,500 is your QDPAI

STEP 4. Determining Your Tentative Deduction

• Multiply your QDPAI of $22,500, by the applicable deduction percentage for the tax year to determine your tentative deduction. Your tentative deduction is the amount subject to limitation.
  • The various deduction percentages starting from tax year 2005 are:
    • 3% for tax years 2005 and 2006
    • 6% for tax years 2007 through 2009
    • 9% for tax years 2010 and after
• Limitations:
  • Individuals compare the tentative deduction amount to adjusted gross income reported on Form 1040 figured without the domestic production activities deduction (DPAD).
  • C corporations compare the tentative deduction amount to taxable income reported on Form 1120 figured without the DPAD.
  • Next, compare your tentative deduction amount to wages allocated to DPGR for the year. The deduction may not exceed 50% of wages allocable to DPGR paid for the tax year
  • For tax years 2007 through 2009 the deduction may NOT exceed: 6% of adjusted gross income for individuals (6% of taxable income for C corporations) .
  • For tax years after 2009, the deduction may NOT exceed 9% of adjusted gross income or individuals (9% for C corporations)..

Keep in mind, you must have paid employees during the year to get this deduction. Independent contractors that you paid don't count as employees.

STEP 5: How to Claim the Deduction:

• Individuals claim the deduction on Form 1040
• C corporations claim the deduction on Form 1120

Note:

For partnerships, LLCs treated as partnerships, LLCs treated as S corporations, and S corporations that were converted from C corporations, gross receipts, cost of goods sold, and related expenses from qualified production activities are allocated to each owner on his annual Schedule K-1. 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.