The Domestic Production Activities Deduction is a tax incentive for businesses that produce goods in the United States. It was enacted in 2005 to encourage US-based production and decrease the importation of goods. It is a tax deduction for certain business activities conducted primarily in the U.S., as defined by IRC Section 199. It provides:
- A deduction of 3 percent in the first year.
- 6 percent in the second.
- 9 percent in the third.
This deduction is part of the American Jobs Creation Act of 2004. It is covered by Internal Revenue Code Section 199, and IRS Proposed Regulations 1.199. The DPAD is available to most businesses that manufacture, grow, extract, develop, or improve goods, primarily in the United States. It is particularly beneficial to oil and gas producers but can also benefit information technology and construction firms.
For a business to qualify for the DPAD, it must have qualified production activity income (QPAI), which is the gross receipts from domestic production activities minus the cost of manufacturing and other expenses. There are many limitations on QPAI, including the requirement that a significant amount of the production activities be performed in the U.S. Some businesses are ineligible for the DPAD, such as restaurants and retail food operations. But if you sell products produced in the United States, such as coffee beans or cheesecake, then the DPAD might help you reduce your taxes.
How to Claim Domestic Production Activities Deduction?
To claim the DPAD, a significant portion of the manufacture, production, growth, or extraction must take place in the United States. This includes the sale, lease, rental, license, exchange, or other disposition of tangible personal property, computer software, and sound recordings produced, grown, or extracted in the U.S. However, no bright line defines a significant amount, and an activity can qualify based on the facts and circumstances. The IRS has determined that an activity will qualify if the labor and overhead costs of the property’s manufacture, production, growth, or extraction are at least 20% of the total cost of goods sold.
Many of the most valuable companies benefit from this deduction, including information technology firms, construction firms, and mining operations. These firms capture two-thirds of the value of the DPAD, while manufacturers capture about a third. The DPAD is applied to businesses that have employees and is calculated on Form 8903 for individual tax returns or on line 25 of Form 1120 for corporations. It is applied to the income of owners, partners, members, or shareholders that allocate gross receipts, cost of goods sold, and related expenses for qualified production activities to each owner’s allocable share of wages.
- A DPAD can be calculated for business entities by multiplying the QPAI by a DPAD rate of up to 9%. The deduction cannot exceed 50% of the W-2 wages paid to employees allocated to a qualified production activity.
In addition to the DPAD, some states allow an income deduction for certain domestic production activities. For example, California allows a 9% deduction for qualified construction activities, and New Jersey allows a 9% deduction for eligible home-based craft businesses. The DPAD is an ineffective, overly complicated, and distortionary policy that does little to support domestic manufacturing or increase employment, and its repeal would be the best way to promote American production and job creation.
Domestic Production Activities Deduction Repeal
In 2004, Congress passed the Domestic Production Activities Deduction (DPAD), which offered a 9% deduction on income for small businesses that produce goods in the U.S. Instead of moving overseas to take advantage of cheaper labor and easier supply chains, many businesses took advantage of DPAD as a way to stay in the U.S. However, DPAD was phased out in the tax reform bill signed into law in December 2017, replacing it with the qualified business income deduction. The new deduction allows sole proprietorships, S corporations, and partnership owners to claim up to 20% of qualified business income, subject to certain limitations. Businesses can still claim this deduction for their 2017 and earlier tax returns.