This specialized deduction is easily overlooked but can be a material benefit to your clients. Taxpayers who work more closely with their advisors can maximize the deduction.
The Section 199 deduction is claimed on Form 8903, the instructions of which estimate the time to learn about the deduction and complete the form at almost two days not counting recordkeeping time for the client or the accountant. So when the deduction is an issue for a particular client, keep in mind that the materiality and complexity are such that it may even affect the tax professional’s fee quote.
Accountants should also be advising clients on the type of recordkeeping needed to establish the domestic production activities deduction, DPAD. Consideration might also be given to the client using separate entities, one for qualifying activities and another for non-qualifying revenue, as a means of establishing a clearer path to measuring this important deduction.
This tax benefit focuses mainly on U.S. sellers of personal property and isn’t aimed at benefiting pure service providers. But service providers may be part of the process and qualify as part of the framework that benefits from this special deduction. Also, there are aspects of the real estate industry that qualify. Those who benefit from the deduction are a broader class than one might think from some brief summaries of the provision. As usual, it is up to the tax professional to dig into the details of the rules and relate them to their clients.
The DPAD is generally 9% of qualified production activities income but subject to a couple of important limitations based on income and wages.
The deduction cannot exceed 9% of taxable income, or adjusted gross income if an individual. So decisions about maximizing other deductions that reduce AGI can negatively impact this deduction.
Another important limitation is that the deduction cannot exceed 50% of wages, including flow-through wages from partnerships or other flow-through entities.
To the extent an individual’s taxable income consists of DPAD, it is generally a fair statement the deduction reduces the individual’s tax bracket to 91% of such rate; e.g., a high individual rate of 39.6% becomes approximately 36% as to qualifying income. If an individual’s tax rate were 25%, it would reduce the rate to a little under 23%.
The deduction is relatively significant. Over the years, the deduction has grown. The percentage deduction wasn’t always as high as the current 9%.
Guaranteed payments to a partner are deducted in arriving at qualifying income to the extent allocable to qualifying production activity income. The receipt of the guaranteed payment isn’t qualifying income to the partner. Guaranteed payments don’t count as wages for purposes of the wage limitation.
There are special adjustments for oil-related taxpayers.
Married taxpayers combine their figures on one Form 8903.
The rules are generally applied at the shareholder or partner level, but certain S corporation and partnership make calculations and allocations at the entity level. ( Instructions to Form 8903, p 1-2.)
Even exempt organizations may benefit; exempt organizations are generally limited to deducting 9% of their unrelated business income. (Instructions to Form 8903, p. 8)
The deduction isn’t per se subject to a cap, a maximum amount. Both small and large taxpayers can benefit. The law aims at providing an across-the-board incentive, tax relief rather than, as is often the case, providing relief for smaller taxpayers.
On individual returns for 2015, the deduction is claimed on line 35. The deduction is taken in arriving at adjusted gross income.
The deduction is aimed at increasing business activity whether sales are going to U.S. or international customers.
The DPAD, subject to certain rules, can also reduce the taxpayer’s alternative minimum tax
If a net operating loss is incurred in a particular year, the taxpayer wouldn’t have a DPAD in that year. This is because it is necessary to have positive adjusted gross income in the case of an individual, or taxable income in the case of a corporation, for there to be DPAD. But a net operating loss carrying to another year may affect the DPAD in such year. For example, it may reduce the 50% of AGI limit for an individual.
The basic idea for qualifying receipts is the sale of U.S. produced goods. The “production” in the title doesn’t limit the deduction to manufacturers.
The concept of U.S. produced goods isn’t as strict as one might anticipate. In general, there needs to be significant U.S. production but the rules are generally fairly liberal if there is an admixture of U.S. and foreign production activities. (Regs. 1.199-3(g)(3).
Qualifying income is termed domestic production gross receipts, DPGR. Sales tax collected is generally to be excluded from qualifying income. (Regs. 1.199-3(c).
In measuring domestic production gross receipts, the distinction is item by item, not division by division, etc. But there are such practical rules as allowing the taxpayer to treat all sales as qualifying if less than five percent are considered non-qualifying.
Qualifying income isn’t necessarily limited to outright sales but also encompasses income derived from “any lease, rental, license, sale, exchange, or (generally) other disposition …” of qualifying production property, as well as derived generally from construction activities as well as engineering and architectural services performed in the U.S. related to constructing real property in the U.S. (Regs. 1.199-3(a).)
The sale of electricity, natural gas or potable water produced by the taxpayer in the U.S. may qualify. (Regs. 1.199-3(a)(1)(iii).)
Leasing or licensing to a related party doesn’t ordinarily qualify but there are exceptions when the related party in turns rents, etc. to an unrelated party. (Regs. 1.199-3(b).)
Construction activities don’t require ownership of the property as is true, for example, of someone selling personal property. Such costs as landscaping and painting may not qualify as “construction.” (See Regs. 1.199-3(m)(3).)
In general, the concept of qualifying income excludes fees received by pure service providers – fees earned by doctors, lawyers, accountants, etc. Customer services, phone support, internet access fees for books, online banking, etc. also fall outside the “production” concept.
Income from the sale of food at a restaurant wouldn’t qualify, whereas taxable income related to the sale of food as a wholesale business would qualify. So the client’s books would need to distinguish food sales that are retail from sales that are wholesale.
Generally not qualifying are the sale and lease of land.
Advertising and product placement fees generally do not qualify, subject to some exceptions.
Another requirement is the income must be from a trade or business, such that sporadic activity may not qualify; similarly, hobby loss income doesn’t qualify.
The goal is to encourage U.S. production, and sales foreign or domestic count for purposes of this special deduction.
The main categories of qualifying income are: selling, leasing and licensing U.S. produced goods and motion pictures.
It includes construction activities in the U.S., including not only building but renovation of residential and commercial properties. It includes engineering and architectural services related to such construction.
It includes sound recordings. A film qualifies if 50% of the compensation paid to actors, production personnel, directors, producers is in the U.S.
In general, income from the sale, lease, other disposition of software developed in the U.S. qualifies, whether the software is purchased off the shelf or there is a download from the internet. On the other hand, the following don’t qualify: fees for the on-line use of software, fees for computer support, on-line services, fees for customer support, fees for phone services, and fees for playing computer games on-line. ((Regs. 1.199-3(e)(5), Example 8, 1.199-3(i)(6)(ii).)
Attaching items to a building doesn’t necessarily cause such items to lose their status as personal property whose sale constitutes qualifying income; e.g., machinery and signs attached to the building.
For purposes of this deduction, cost of goods sold includes the cost of goods sold to customers as well as the adjusted basis of non-inventory property disposed of in the trade or business. The method used for allocating cost of goods sold generally should follow the method used for distinguishing DPGR and non-DPGR. There’s a statement in the Form 8903 instructions that reads, “If you use a method to allocate gross receipts between DPGR and non-DPGR, the use of a different method to allocate cost of goods sold won’t be considered reasonable, unless it is more accurate.” (Instructions to Form 8903, p. 5.)
Expenses other than cost of goods sold may include wages directly related to DPGR, other expenses directly related to it, and indirect costs allocated to DPGR.
If no wages are paid, there is no deduction, so a sole proprietor with no employees doesn’t qualify.
There are some variations in measuring wages and choices of method that sum different boxes from the W-2.
The calculations basically involve determining the W-2 wages then the portion of such wages allocable to domestic production gross receipts.
There is a small business “simplified overall method” that can be used to measure other expenses and losses as well as the cost of goods sold. (See Regs. 1.199-4(f).)
The definition of a small business for purposes of this rule is generally gross receipts under $5 million, sometimes gross receipts under $10 million, and a farmer not required to use the accrual method of accounting. (See Regs. 1.199-4(f)(2); Rev. Proc. 2002-28 and page 5 of the instructions to Form 8903.)
Estates and trusts can’t use the small business simplified overall method.
The simplified overall method basically allocates based on relative gross receipts. The regulations also contemplate a “simplified deduction method” which contemplates a similar allocation based on gross receipts but that term excludes cost of goods sold. (Regs. 1.199-4(e).)
So there are efforts toward simplification and making the deduction more readily available, but the instructions to Form 8903 also discuss using statistical sampling methods, which is to say some efforts at quantifying the deduction may get quite complicated.
Conclusion: Plan for the Deduction
The nature of the deduction is such that the taxpayers who work more closely with their advisors are the ones more likely to benefit.
It is generally suggested that interim discussions and projections take place a few times during the year so that the different components, such as projected taxable income or adjusted gross income and/or limitations based on wages, may be understood and managed to the client’s best tax advantage in maximizing the deduction.
About the Author
J. Michael Pusey, CPA, MSA, is a senior tax manager with Rojas and Associates, CPAs, Los Angeles. He has over forty years experience in tax and finance. Mr. Pusey has written or contributed to four tax books, including an AICPA Tax Study, and a finance book. Mr. Pusey began his career with KPMG before working nine years in “national tax” for Laventhol & Horwath and Grant Thornton. He was V.P., Assistant Tax Director, Manager of Research and Planning for a NYSE financial institution prior to beginning his practice, then joining Rojas and Associates.