Domestic Production Activities Deduction

Businesses with "qualified production activities" can take a tax deduction of 3% from net income. This is a tax break pure and simple. The more complicated the business, the more complicated the math for calculating the Domestic Production Activities Deduction. In a nutshell, businesses engaged in manufacturing and other qualified production activities will need to implement cost accounting mechanisms to make sure their tax deduction is accurately calculated.

Domestic Production Activities Deduction

A business engaged in a qualfying production activity is eligible to take a tax deduction of 3% in tax years 2005 and 2006. The deduction increases to 6% in year 2007, and 9% in year 2010.

Qualified Production Activities

A business engaged in the following lines of business may qualify for the Domestic Production Activities Deduction. These are the "qualified production activities" eligible for claiming the deduction under Internal Revenue Code Section 199:

• 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 US-based construction project,

• Software development in the United States, including the development of video games.

General Rule and Safe Harbor

The Domestic Production Activities Deduction is limited to income arising from qualified production activies in whole or significant part based in the United States. Under a "safe harbor" rule (IRS Proposed Regulations 1.199.3.f.3), businesses can take the deduction if at least 20 percent of the total costs are the result of direct labor and overhead costs from US-based operations.

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

Not Qualified Production Activities

The following lines of business are specifically excluded from claiming the Domestic Production Activities 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.

Figuring the Tax Deduction

Calculating the Domestic Production Activities Deduction can be either ridiculously simple or enormously complex, depending on the nature of the business. The key to figuring the Domestic Production Activities Deduction is to examine "qualified production activities income" (QPAI) and the limitations. I'm going to throw out several technical terms, and then explain how to figure the deduction step-by-step.

Domestic Production Activities Deduction Calculation

Qualified production activities income (QPAI)
minus Qualified production activities expenses
equals Qualified production activities net income
times The QPA deduction amount of 3%
equals The Tentative QPA Deduction

Qualified Production Activity Income (QPAI)

Qualified production activity income (QPAI) is all income arising from qualified production activities. For a business with only one line of business, this will be the same as gross income. For businesses with multiple lines of business, income will need to be allocated.

Qualified Production Activity Expenses

Qualified production activity expenses are all expenses directly related to the qualified production activities. For a business with only one line of business, this will be the same as total expenses. For businesses with multiple lines of business, income will need to be allocated.

Limitations

The dollar amount of the Domestic Production Activities Deduction is limited. The deduction cannot exceed adjusted gross income (for sole proprietors, partnerships, S-corporations, or limited liability corporations) or taxable income (for C-corporations). Also, the deduction cannot exceed 50% of W-2 wages.

Domestic Production Activities Deduction cannot exceed:

Adjusted Gross Income, or
50% of W-2 Wages paid out

Simplified Method

"The rules are simplified for a small business in a single line of business," according to Paul Schlather. Make sure your business qualifies under the qualified production activities rules, and then take 3% of net income. Compare the 3% figure to adjusted gross income and W-2 wages paid out. A business will not qualify for the Domestic Production Activities Deduction if it has zero net income or zero W-2 wages.

Where to Claim the Deduction

Businesses will need to fill out IRS Form 8903 (PDF). You can also download Instructions for Form 8903.

Tax Law

Internal Revenue Code Section 199, and IRS Proposed Regulations 1.199. This deduction was part of the American Jobs Creation Act of 2004.

Internal Revenue Code Section 199, and IRS Proposed Regulations 1.199. This deduction was part of the American Jobs Creation Act of 2004.

From the IRS

"For 2005 and 2006, the deduction equals 3% of the lesser of: (a) qualified production activities income; or (b) taxable income for the taxable year. However, the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. The deduction is phased-in; for 2007 through 2009 the percentage increases to 6% and for 2010 and after the percentage will be 9%.

Qualified production activities include manufacturing, producing, growing, and extracting tangible personal property, computer software, and sound recordings, and the construction and substantial renovation of real property including infrastructure. The production of certain films is also a qualifying activity as are certain engineering or architectural services."