One must follow a complex set of rules just to determine if the business qualifies. The level of complexity was such that in the past, many businesses that might have qualified didn’t bother to seriously look into it.
For budgetary reasons, the deduction has been gradually phased in since it was introduced. Beginning with 2010 tax returns, the deduction is fully phased in. This makes the potential deduction greater and harder than ever to pass up.
What qualifies for a production tax break?
What kinds of activities qualify? The business must make something that is “manufactured, produced, grown or extracted.” The product can be made out of scrap or new raw materials. In addition to making a new product from scratch, qualifying activities can include processing, manipulating, assembling, refining or changing the form of an item by combining or assembling two or more items and improving existing products.
In addition to U.S.-based manufacturing activities (from software development to tangible equipment), specific qualifying activities can include cultivating soil, raising livestock, fishing and mining minerals in the U.S. Even motion picture or video production can qualify when most of the compensation for services is for services performed in the U.S.
Other qualifying activities can include construction services for real property projects in the U.S., and civil engineering and architectural services relating to U.S.-based real property construction projects. Real property for this purpose includes residential and commercial buildings in the United States. Infrastructure (such as sewers and pipelines) as well as land improvements (such as sidewalks and parking lots) are considered real property for this purpose.
Some specifically excluded activities are transportation, packaging, labeling and minor assembly. Food preparation at the retail level does not count while food preparation at the wholesale level is a qualifying activity.
Who can claim?
Who can claim DPAD when subcontractors are used? The business entitled to claim the deduction is the business bearing the benefits and burdens of ownership of the property while the qualifying production activity occurs.
Here’s an example: Sellerco contracts with Subco to build a product that Sellerco will sell to its customers. Sellerco owns the product throughout the entire production process. Sellerco can potentially qualify for DPAD and Subco cannot.
Had the contract called for Subco to control the details of the manufacturing process and maintain the risk of loss with Sellerco paying Subco a fixed amount under the contract, Subco would have the benefits and burdens of ownership. In this scenario Subco can potentially qualify for DPAD and Sellerco cannot.
There are limits
The taxpayer’s production costs must be “in significant part” within the United States with respect to the qualifying property. While there is no strict definition of “significant,” a safe harbor of 20 percent or more of the taxpayer’s costs can generally be used. Essentially, the deduction is only available to the extent the production activity relates to U.S.-based work.
The deduction cannot exceed 50 percent of the company’s W-2 wages attributable to production activities. Noncorporate owners normally cannot be considered employees and do not receive W-2s. Therefore, a partnership, LLC or sole proprietorship that has all of its work performed by the owners or subcontractors normally cannot qualify for DPAD.
The deduction is only available in years the business has income overall and income from production activities.
Financial data related to qualifying production activities and nonqualifying activities must be segregated. This alone can be a burdensome project. The deduction is equal to the lesser of qualified production activity income or taxable income multiplied by 9 percent. When the entity generating the deduction reports its activity on the individual owner’s personal income tax return, adjusted gross income is used in the preceding formula instead of taxable income.
The DPAD rules are very complex with many more limitations and exceptions than there is space in this article to mention. However, the basics described above should give a business owner a feeling of whether further research into claiming DPAD is worth pursuing. For many, the tax savings will be very substantial and well worth the effort.