Is your business taking full advantage of the Domestic Production Activities deduction?

This deduction – which can be as much as 9 percent of your U.S.-based business activity profit – is available to virtually every small business in the manufacturing industry.

A company engaged in the following business activities may qualify for the Domestic Production Activities (DPA) deduction. The items on this list are called “qualified production activities” (QPA):

• Manufacturing based in the United States
• Selling, leasing or licensing items that have been manufactured in the United States
• Selling, leasing or licensing motion pictures that have been produced in the United States
• Construction services in the United States, including building and renovation of residential and commercial properties
• Engineering and architectural services relating to a U.S.-based construction project
• Software development in the United States, including the development of video games

The DPA deduction is limited to income arising from qualified production activities in whole or significant part based in the United States.

Under the “safe harbor” rule, businesses can take the deduction if at least 20 percent of the total costs are the result of direct labor and overhead costs from U.S.-based operations.

If any part of manufacturing or production activities is outside the United States, the business must use either the safe harbor rule (at least 20 percent of total costs are from U.S.-based production activities) or allocate costs using the facts and circumstances of the business.

The following lines of business are specifically excluded from claiming the DPA 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

The key to figuring the Domestic Production Activities deduction is to examine “qualified production activities income.”

Qualified production activities income (QPAI)

– Qualified production activities expenses

= Qualified production activities net income

X The QPA deduction amount of 9 percent

= The Tentative QPA Deduction

The qualified production activities deduction is all income arising from qualified production activities.

For a company with only one line of business, QPAI will be the same as gross income. For companies with multiple lines of business, income will need to be allocated. The same is true for qualified production activity expenses, which are all expenses directly related to the qualified production activities.

The dollar amount of the DPA deduction is limited. The deduction cannot exceed adjusted gross income (for sole proprietors and owners of partnerships, S corporations, LLCs) or taxable income (for C corporations). The deduction cannot exceed 50 percent of W-2 wages.

If you engage in contract manufacturing, you can claim the DPA deduction only if you have the benefits and burdens of ownership of the property while manufacturing activity occurs.

Which party in a contract manufacturing situation has the benefits and burdens of ownership is a factual question. The parties cannot designate by contract which one is entitled to the DPA deduction.

If a company enters into a contractual arrangement with a nonrelated party to perform some or all of the manufacturing activities, the following is a three-step process to determine who has the benefits and burdens of ownership.

Step 1: Review Contract Terms

• Which party had title to the work-in-process?
• Which party had risk of loss over the work-in-process?
• Which party was primarily responsible for insuring the work-in-progress?

Step 2: Analyze Production Activities

• Which party developed the manufacturing activity process?
• Which party exercised oversight and direction over the employees engaged in the manufacturing activity?
• Which party conducted more than 50 percent of the quality control tests over the work-in-progress while the manufacturing activity was occurring?

Step 3: Evaluate Economic Risks

• Which party was primarily liable under the “make-good” provisions of the contract – for example, the warranty, quality of work, spoilage, overconsumption or indemnification provisions?
• Which party provided more than 50 percent, based on cost, of the raw materials and components used to produce the property?
• Which party had the greater opportunity for profit increase or decrease from production efficiencies and fluctuations in the cost of labor and factory overhead?

Many taxpayers have overlooked this deduction, so if you think your activities may qualify, contact your tax adviser.