Computing the Domestic Production Activities Deduction for Passthrough Entities

Editor: Howard Wagner, CPA

Expenses & Deductions

The domestic production activities deduction (DPAD) has provided a substantial tax benefit to manufacturers and other qualifying businesses since it first became effective in 2005. Computing DPAD generally is straightforward for C corporations once a business has identified its expanded affiliated group and qualified manufacturing activities. However, some unique issues can arise when computing DPAD for a passthrough entity.

Background

The DPAD was enacted as part of the American Jobs Creation Act of 2004, P.L. 108-357. It provides a federal income tax deduction equal to 9% of the lesser of taxable income or qualified production activities income (QPAI). (The DPAD was phased in at lower rates for years before 2010.)

The DPAD reduces both regular and alternative minimum taxable income, but it cannot create a loss and is limited to one-half of domestic production W-2 wages paid. C corporations claim DPAD as a deduction on their return. Passthrough entities such as S corporations and partnerships do not claim the DPAD when computing taxable income. Instead, they provide the information required to compute the DPAD as a footnote on Schedule K-1, Shareholder’s [Partner’s] Share of Income, Deductions, Credits, etc. The taxable income limitation is applied at the shareholder or partner level, so each passthrough owner is required to separately compute the DPAD on its income tax return.

Suspended Losses

Because the DPAD can be used only by taxpayers with income, many businesses do not calculate DPAD in years when there is a tax loss. Passthrough entities that fail to compute the DPAD in loss years risk reporting incorrect tax in the current year or future years when the DPAD is claimed by a passthrough investor with suspended losses from basis, passive, or at-risk limitations. If a passthrough investor has any losses or deductions suspended during the current tax year due to basis or at-risk limitations, passive activity limitations, or any other applicable Code provisions, the DPAD regulations require the portion of the loss that is a qualified production activities loss (QPAL) to be separately tracked (see Regs. Secs. 1.199-5(b)(2) and (c)(2)). The QPAL is then carried forward along with the suspended loss, and the QPAI is reduced in the year the loss is eventually used.

Example 1: In year 1, taxpayer A receives a K-1 showing a loss of $2 million from passthrough activity X. None of the loss can be used in the current year due to a passive activity loss limitation. All of the suspended loss is considered QPAL. A does not use any of the QPAL from activity X in year 1 to compute the current-year DPAD because the loss is suspended under the Sec. 469 passive activity rules.

A must then track the amount of suspended QPAL or QPAI and include it in the calculation of the DPAD for the year in which the suspended losses are allowable. If all the income from an activity is qualified, computing the proportionate share of allocable losses or deductions for successive years is simplified.

Example 2: Continuing with the previous example, assume that in year 2, activity X passes through $3 million of passive activity income, all of which is QPAI. Taxpayer A is allowed to use $2 million of suspended losses from year 1 to reduce taxable income from activity X to $1 million under Sec. 469. Although A reports QPAI of $3 million from activity X, it is allowed to use QPAI of only $1 million because the suspended QPAL from year 1 must be used to reduce QPAI in the year the suspended losses are used.

If A did not have suspended QPAL from year 1 and the DPAD was not limited by either W-2 wages or the ­taxable income limitation, A would have a DPAD of $270,000 ($3 million QPAI × 9% DPAD rate). However, because the QPAL reduces the current-year QPAI to $1 million, A can claim a DPAD of only $90,000 ($1 million QPAI × 9% DPAD rate).

The computations are more complicated, however, if only a portion of the income from an activity is QPAI.

Example 3: In year 1, taxpayer B has a suspended loss of $1.5 million from activity Y, none of which can be used in the current year because of basis limitations. However, activity Y reports a QPAL of only $750,000. In year 2, B reports $1.5 million of taxable income from activity Y and fully uses the suspended loss of $1.5 million. B reports $1 million of current-year QPAI from activity Y. B’s combined adjusted gross income (AGI) from all sources is $1.5 million.

If B does not properly adjust the year 2 DPAD calculation for the year 1 QPAL, the taxpayer would incorrectly report a DPAD of $90,000 (9% × [the lesser of AGI, which is $1.5 million, or current-year QPAI, which is $1 million]). However, because B fully used the suspended loss from year 1 that had an associated QPAL of $750,000, B has QPAI of $250,000 ($1 million of current-year QPAI 2 $750,000 QPAL). Accord­ingly, B is entitled to a DPAD of only $22,500 (9% × $250,000).

Passthrough Entity With No Taxable Income

A different question arises if a taxpayer has a loss from a passthrough entity that is nonpassive under Sec. 469 and that has both an allowable loss and QPAI.

Example 4: Taxpayer C receives a Schedule K-1 from an S corporation that operates two divisions, one engaged in manufacturing that qualifies for Sec. 199 and a retail division that does not qualify for Sec. 199. The manufacturing division is profitable and reports taxable income and QPAI totaling $500,000. The retail division reports a loss of $750,000, for a net taxable loss from the S corporation of $250,000. Assume the loss is not limited on the owner’s return.

If C has income from other sources, such as wages or other activities, the QPAI from the S corporation may allow the taxpayer to claim a DPAD despite reporting a net loss. For example, if other income increases C’s AGI to $400,000, the taxpayer will be allowed a DPAD of $36,000 (9% × [the lesser of AGI, $400,000, or QPAI, $500,000]).

Passthrough entities with a QPAL can also affect the computation of DPAD.

Example 5: Taxpayer D receives a Schedule K-1 from an S corporation with a loss of $200,000 and another Schedule K-1 from a partnership with income of $600,000. If D is allowed to deduct the entire $200,000 loss in the current year, it will need to know the QPAI and QPAL associated with both the S corporation and the partnership. Because taxpayers are required to compute DPAD on an aggregate basis for all of their activities, passthrough entities cannot assume they do not need to compute DPAD in a loss year.

Conclusion

The DPAD continues to offer significant tax savings for qualified domestic manufacturers and other eligible businesses. However, investors in passthrough entities need to be careful when computing the DPAD to take into account the effect of suspended losses and other income they receive outside the passthrough entity. In some cases, taxpayers may need to proactively ask for information from a passthrough entity to compute the DPAD if the information is not provided on Schedule K-1. Passthrough entities also should consider whether any of these fact patterns might require them to provide DPAD information to shareholders in loss years.

EditorNotes

Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.