Despite the economic slowdown, manufacturing continues to play an important role in the American economy. Congress, concerned that U.S. manufacturing was lagging behind foreign imports that in many cases benefited from foreign countries’ subsidies and undercut U.S. producer prices, offered tax relief with the domestic production activities deduction. Since 2004, Sec. 199 has allowed as a deduction a percentage of qualifying production expenses, with “production” defined broadly and requiring only that it take place “in significant part” within the United States. 1
After starting at 3% of such costs, the deduction increased to 6% for tax years 2007–2009 and is 9% for 2010 and following years. It is designed to be the equivalent of a 3 percentage point reduction in the effective tax rate for U.S. manufacturers. 2 The amount of the deduction is limited to 50% of the taxpayer’s W-2 wages attributable to domestic production gross receipts.
Because the domestic production activities deduction replaced the former foreign sales corporation and extraterritorial income provisions of the Code, U.S. manufacturers who did not benefit from those provisions’ export tax benefits may overlook it. The domestic production activities deduction is available to a wide variety of U.S. taxpayers, not just those who export their products. This article describes eligibility for the deduction, its limitations, and how it is calculated.
To be eligible for the Sec. 199 deduction, taxpayers must have qualified production activities income (QPAI), 3 which is defined as domestic production gross receipts (DPGR) for a tax year minus cost of goods sold and other expenses, losses, or deductions allocable or properly attributable to those receipts. 4 DPGR comprises receipts obtained from the lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP), any qualified film, or electricity, natural gas, or potable water produced by the taxpayer in the United States. DPGR may also be derived from construction of real property or engineering/architectural services in the ordinary course of business in the United States by taxpayers that actively conduct a trade or business of construction or engineering/architectural services, respectively. 5
QPP is property produced by manufacturing, producing, growing, or extracting (MPGE) activities performed in whole or in significant part within the United States. 6 QPP consists of:
- Tangible personal property;
- Any computer software; and
- Sound recordings. 7
Under Regs. Sec. 1.199-3(e), MPGE activities include:
- Manufacturing from scrap, salvage, or junk material as well as from new or raw material;
- Processing, manipulating, or refining;
- Changing the form of the property;
- Combining or assembling;
- Cultivating soil;
- Raising livestock;
- Mining minerals;
- Storage and handling activities connected with certain agricultural products; and
- Installing QPP, if the taxpayer also engages in other MPGE activity with respect to the QPP.
MPGE activities do not include:
- Minor assembly; and
- Installation of QPP, if no other MPGE occurs with respect to the QPP.
Safe harbor: If the combination of direct labor and overhead used in MPGE activities totals 20% or more of the QPP’s cost of goods sold (COGS) or, in a transaction without COGS (such as a lease, rental, or license), the direct labor and overhead total 20% or more of the unadjusted depreciable basis in the QPP, the taxpayer is deemed to have engaged in MPGE activities to produce QPP. 8
Before computing the Sec. 199 deduction, the taxpayer should determine if the entity is a member of a new attribution entity created by Sec. 199: an expanded affiliated group (EAG). Having made this determination, the taxpayer can calculate the two components of the Sec. 199 formula:
- Taxable income, as modified by Sec. 199 criteria; and
EAGs generally follow the rules of Sec. 1504, governing affiliated groups, except that “50%” is substituted for “80%.” 9 In effect, the EAG can encompass a larger group of entities than the normal rules of attribution. Exhibit 1 illustrates the EAG relationship compared with a Sec. 1504 affiliated group. Each EAG member must be engaged in the actual conduct of a trade or business. All EAG members must be considered in the Sec. 199 deduction. In effect, Sec. 199 becomes a consolidated deduction subject to allocation.
Modified Taxable Income
For corporations, taxable income for Sec. 199 purposes is determined without regard to the Sec. 199 deduction. In the case of corporate alternative minimum tax, alternative minimum taxable income will be used in place of taxable income. 10
For individuals, adjusted gross income is substituted for taxable income in the Sec. 199 calculation. For this purpose, adjusted gross income is determined before applying Sec. 199 and after applying:
- Sec. 86: Social Security benefits;
- Sec. 135: Income from U.S. bonds used to pay higher education tuition and fees;
- Sec. 137: Adoption assistance programs;
- Sec. 219: Qualified retirement savings;
- Sec. 221: Interest on education loans;
- Sec. 222: Qualified tuition and related expenses; and
- Sec. 469: Passive activity losses and credits. 11
QPAI consists of DPGR for a tax year minus COGS and other expenses, losses, or deductions allocable or properly attributable to those receipts. 12 Taxable receipts and expenses are to be allocated in a “reasonable” manner to produce income attributable to QPAI.
A reasonable method of allocation has the following characteristics:
- Whether the taxpayer uses the most accurate information available;
- The relationship between gross receipts and the method used;
- The accuracy of the method chosen as compared with other possible methods;
- Whether the taxpayer uses the method for internal management or other business purposes;
- Whether the method is used for other federal or state income tax purposes;
- The time, burden, and cost of using alternative methods; and
- Whether the taxpayer applies the method consistently from year to year. 13
Exhibit 2 gives an example of the QPAI computation. The QPAIs in this example total $1,165 (QPAI 1 + QPAI 2).
Taxpayers with Oil-Related QPAI
Sec. 199 defines “oil-related qualified production activities income” as the QPAI attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product derived from these substances. 14 For tax years beginning after 2009, if a taxpayer has oil-related QPAI, the Sec. 199 deduction is reduced by 3% of the lesser of:
- The taxpayer’s oil-related QPAI for the tax year;
- The taxpayer’s QPAI for the tax year; or
- Taxable income (determined without regard to Sec. 199). 15
In the Exhibit 2 calculation, if QPAI 1 were oil related, the Sec. 199 deduction would be reduced by $10 (rounded), which is 3% of the lower of QPAI 1 ($325), the total QPAI ($1,165), or total taxable income ($1,800).
Understanding DPGR is critical for the W-2 wage limitation because the Sec. 199 deduction is limited to 50% of the taxpayer’s W-2 wages attributable to DPGR activities.
Gross receipts are receipts for the tax year, as recognized by the taxpayer’s normal method of accounting as used for income tax purposes. 16 They are determined on an item-by-item basis rather than by department, plant, or product line. 17 For this purpose, “items” are those goods offered for sale in the normal course of a taxpayer’s trade or business. If property is sold by weight or volume, industry custom will determine the item. 18 For engineering, architectural, or construction activities, any reasonable method may be used to determine an item. 19
For purposes of Sec. 199, gross receipts include:
- Income from services;
- Income from investments;
- Interest, dividends, and other such items, regardless of whether received in the taxpayer’s ordinary course of business; or
- The amount of sales tax collected, if the tax is imposed on the seller and not the purchaser of the goods or services.
Gross receipts exclude:
- Principal received on payment of a liability;
- Proceeds from a nonrecognition transaction (e.g., Sec. 1031), except for the gain;
- Sales tax received from customers, if the tax is legally imposed on the purchaser and the seller is merely a collection agent; or
- The sale of food and beverages prepared by the taxpayer at a retail establishment. 20
The taxpayer must allocate receipts between DPGR and non-DPGR using a reasonable method of allocation. 21 The term “reasonable” implies that the information is readily available and that the taxpayer can identify DPGR without “undue time and expense.” This allocation is necessary because W-2 wages must be apportioned between activities relating to domestic and nondomestic production. The allocation affects the limitation by imposing a ceiling for the Sec. 199 deduction.
If the taxpayer’s accounting method recognizes partial advance payments as income, use of historical data in subsequent years constitutes a reasonable method. However, if historical data are updated, those revisions must be reflected in the Sec. 199 calculation in the year of update and thereafter. 22
A taxpayer using the percentage of completion method must be able to substantiate that the DPGR/non-DPGR allocation is reasonable. 23
De minimis rules exist for determining DPGR. If less than 5% of gross receipts are non-DPGR, the taxpayer may generally treat all receipts as DPGR. If 5% or more of gross receipts are non-DPGR, the taxpayer must allocate receipts between DPGR and non-DPGR. 24
The following rules are used to determine the entity level for gross receipts allocation:
- If the taxpayer is a member of an EAG but not a member of a consolidated group, determination is made at the corporate level.
- If the taxpayer is a member of a consolidated group, determination is made at the consolidated group level.
- If the taxpayer is an S corporation, partnership, trust, estate, or other pass-through entity, determination is made at the passthrough entity level.
- In the case of an owner of a passthrough entity, determination is made at the owner level, taking into account the gross receipts of all the owner’s trades or businesses, including the passthrough entity. 25
DPGR generally does not include any gross receipts of the taxpayer derived from property leased, licensed, or rented by the taxpayer for use by any related person. An exception occurs if QPP or qualified film is leased or rented to a related taxpayer and in turn is leased or rented for ultimate use by an unrelated party. In that case, the gross receipts will qualify as DPGR. The same exception would also apply to a qualified film that a taxpayer licenses or relicenses for ultimate use by an unrelated third party. 26
A qualified film is any motion picture film or videotape in which 50% or more of the total compensation relating to its production is for services performed in the United States by actors, production personnel, directors, and producers. The term includes copyrights, trademarks, or other intangibles of the film. The methods and means of distributing a qualified film do not hinder the Sec. 199 deduction. 27 Qualified films do not include films depicting actual sexually explicit conduct. 28
W-2 Wage Limitation
The wages comprising the 50% limitation must be attributable to DPGR and must have been correctly reported to the Social Security Administration within 60 days of the due date to qualify for Sec. 199. W-2 wages include wages actually paid, elective deferrals actually made, 29 deferred compensation actually deferred under Sec. 457, and designated contributions to a Roth IRA made after December 31, 2005. 30 “Correctly reported” includes being reported on Forms W-2, Wage and Tax Statement (or W-2c, Corrected Wage and Tax Statement), and W-3, Transmittal of Wage and Tax Statements (or W-3c, Transmittal of Corrected Wage and Tax Statements). 31
If an original payroll tax return is filed within 60 days of the due date and a corrected return is timely filed, W-2 wages will consist of the amounts shown on the corrected return. If the original return is timely filed but the corrected return is filed later than within 60 days of the due date, any increases will not be considered for Sec. 199 purposes, but any decreases must be taken into account. If the original return is not timely filed within 60 days of the due date, the amounts on a corrected return are disregarded for Sec. 199 purposes. 32
Originally, all W-2 wages were included in the 50% limitation. After May 17, 2006, wages included only the compensation allocable to DPGR. A taxpayer may use any allocation method as long as it is reasonable. 33 The effect of this change is to lower the ceiling of the deduction.
If the employer listed on the W-2 form does not have control of the payment of wages, or if the taxpayer is paying wages as an agent of another taxpayer, those wages will not be counted as W-2 wages for purposes of Sec. 199. 34
In a short tax year, only the wages actually paid, elective deferrals actually made, 35 and deferred compensation actually deferred under Sec. 457 during the short year may be counted for Sec. 199 purposes. 36
In the event of an acquisition or disposition of a business or major portion of a business, wages will be allocated between the predecessor and successor businesses. 37 Duplication of wages between tax years or different taxpayers is not permitted. 38
For taxpayers having a noncalendar-year end, the term “W-2 wages” means wages paid during the calendar year ending during the taxpayer’s tax year, as stated in Regs. Sec. 1.199-2(e)(1). A taxpayer may determine the amount of W-2 wages that is properly allocable to DPGR for a tax year by multiplying the amount of W-2 wages for the tax year by the ratio of the taxpayer’s wage expense included in calculating QPAI (as defined in Regs. Sec. 1.199-1(c)) for the tax year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or adjusted gross income, if applicable) for the tax year (Regs. Sec. 1.199-2(e)(2)(ii)).
Computation of the Deduction
To compute the Sec. 199 deduction, the taxpayer determines the lesser of QPAI or taxable income, as modified. The smaller number is then multiplied by the appropriate percentage:
- 3% for tax years beginning in 2005 or 2006;
- 6% for tax years beginning in 2007, 2008, or 2009; or
- 9% for tax years beginning in 2010 and thereafter.
This result is then limited by 50% of W-2 wages attributable to DPGR.
Example: In 2010, A Corp. has taxable income of $210,000, QPAI of $145,000, and DPGR wages of $26,000. The Sec. 199 deduction would be $13,000 ($145,000 × 9% = $13,050, limited by $26,000 × 50% = $13,000).
Had the year been 2007, the applicable percentage would have been 6%, and the Sec. 199 deduction would have been $8,700 ($145,000 × 6% = $8,700). The wage limitation of $13,000 would have been irrelevant. Exhibit 3 shows a Sec. 199 computation.
Allocation of the Deduction
Pending the issuance of regulations, the allocation of the Sec. 199 deduction is based on each EAG member’s portion of QPAI. 39 See Exhibit 4, adapted from the regulations.
This article presents an overview of the domestic production activities deduction. In addition to the statute, nine regulations spell out in detail topics such as expanded affiliated groups, domestic production gross receipts, qualified production activities income, special rules for agricultural and horticultural cooperatives and passthrough entities, and the W-2 limitation (both before and after May 17, 2006).
Practitioners should be aware of the Sec. 199 deduction and be comfortable with its calculations so clients can take full advantage of its provisions. In some cases, refinements will have to be made to the taxpayer’s accounting system in order to capture the required data—e.g., DPGR versus non-DPGR and the related wages.
1 Sec. 199 was enacted by the American Jobs Creation Act of 2004, P.L. 108-357, and modified by the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222.
2 Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress (JCS-5-05) (May 2005).
3 Sec. 199(a).
4 Sec. 199(c)(1).
5 Sec. 199(c)(4)(A).
6 Sec. 199(c)(4)(A)(i)(I).
7 Sec. 199(c)(5).
8 Regs. Sec. 1.199-3(g)(3)(i).
9 Sec. 199(d)(4)(B).
10 Sec. 199(d)(6)(B).
11 Sec. 199(d)(2).
12 Sec. 199(c)(1).
13 Regs. Sec. 1.199-4(b)(2)(i).
14 Sec. 199(d)(9)(B).
15 Sec. 199(d)(9)(A).
16 Regs. Sec. 1.199-3(c).
17 Regs. Sec. 1.199-3(d)(1).
18 Regs. Sec. 1.199-3(d)(2)(ii).
19 Regs. Sec. 1.199-3(d)(2)(iii).
20 Regs. Sec. 1.199-3(c).
21 Regs. Sec. 1.199-3(d)(1).
22 Regs. Sec. 1.199-1(e)(1).
23 Regs. Sec. 1.199-1(e)(2).
24 Regs. Sec. 1.199-1(d)(3).
25 Regs. Sec. 1.199-1(d)(3)(i).
26 Regs. Secs. 1.199-3(b)(1) and (2).
27 Sec. 199(c)(6).
28 Sec. 199(c)(6) excludes property subject to the record-retention requirement of 18 U.S.C. §2257, which applies to various products that contain “visual depictions . . . of actual sexually explicit conduct.”
29 See Sec. 402(g)(3).
30 Regs. Sec. 1.199-2(e)(1).
31 Regs. Sec. 1.199-2(a)(3)(i).
32 Regs. Secs. 1.199-2(a)(3)(ii) and (iii).
33 Regs. Sec. 1.199-2(e)(2).
34 Regs. Sec. 1.199-2(a)(2).
35 See Sec. 402(g)(3).
36 Regs. Sec. 1.199-2(b).
37 Regs. Sec. 1.199-2(c).
38 Regs. Sec. 1.199-2(d).
39 Sec. 199(d)(4)(C).
Phillip Schurrer is an instructor in accounting and taxation at Bowling Green State University in Bowling Green, OH. For more information about this article, contact Mr. Schurrer at email@example.com.