The domestic production deduction (DPD) under IRC Section 199 did not appear to have a promising future when it was first introduced in 2005. Created as the centerpiece of the American Jobs Creation Act of 2004, the Section 199 deduction was derided by critics as being overly complex — a so-called accountants’ code section. In 2010 (and for years thereafter) it reaches its peak statutory deduction rate and completes its evolution into one of the largest permanent federal tax benefits available to taxpayers today.
The law was primarily designed to protect United States jobs and replace the extraterritorial income exclusion. It covers a broad range of production activities, including the manufacture of tangible personal property; the production of computer software, sound recordings and certain films; the production of electricity, natural gas, or water; and construction, engineering, and architectural services.
The DPD generally allows taxpayers to receive an additional deduction based on qualified production activity income (QPAI) resulting from domestic production. For all years after 2009, the deduction is limited to the lesser of:
- 9 percent of QPAI;
- 9 percent of taxable income; or
- 50 percent of the Form W-2 wages that are deducted in arriving at QPAI.
The crazy alphabet soup of key terms continues, with QPAI defined for any taxable year as an amount equal to the excess (if any) of the taxpayer's domestic production gross receipts (DPGR) for such taxable year over expenses (direct and indirect) that are allocable to such production receipts.
This edition of Tax Advisor Weekly focuses on two aspects of managing the deduction:
- Opportunities to increase the DPD benefit; and
- Documentation considerations for the deduction.
Opportunities to Increase the DPD Benefit
The inquiry as to whether there is any opportunity to increase the DPD should likely begin by focusing on the aspect of the calculation that is the limiting factor. If QPAI is the limiting factor, then taxpayers should review what has not been classified as DPGR to confirm no revenue streams have been overlooked. Also, directly allocable expenses should be reviewed to determine if they were improperly assigned to DPGR.
One area that often seems to be overlooked is DPGR associated with contract manufacturing activities in the United States. Taxpayers who rely on a contract manufacturer to perform their manufacturing may still be entitled to the deduction if they retain the benefit and burdens of ownership during the time that the production occurs. For example, many retailers and distributors have private label brands that may involve direct manufacturing relationships that should be considered for the DPD.
The concept of benefits and burdens has been addressed in a variety of other tax contexts. The courts have generally held that a determination of which taxpayer bears the benefits and burdens of owning property is a factual inquiry that is influenced by all of the surrounding facts and circumstances. Factors evaluated include:
- The intent of the parties;
- The party with whom legal title vested;
- The party that bears the risk of loss;
- The party with the right to possession, control, use, and enjoyment of the property;
- The party having control over decisions about disposition of the property; and
- The party having control over the details of the manufacturing process.
No single factor is determinative, so all must be weighed in determining whether a taxpayer is entitled to a deduction for manufacturing activities.
Taxpayers with installation and assembly activities should also take another look at the potential application of Section 199. There is a subtle distinction at best between assembly and minor assembly. What may appear to a service activity on the surface may actually meet the requirements for the deduction. These activities are specifically defined as production activities if the taxpayer performing the installation produces the item being installed and possesses the benefits and burdens of ownership during the installation period.
In addition to identifying additional revenue streams, taxpayers should consider whether they are appropriately allocating costs to DPGR. One significant opportunity area is covered in IRS Industry Directive #3, which addresses currently deductible compensation expenses that relate to prior period income. If a taxpayer has compensation related to prior period income, then the Section 861 allocation rules provide that such expenses should be allocated to non-DPGR in the current period. By reducing expenses allocated to DPGR, the QPAI amount is maximized.
Finally, if the W-2 wage limitation is the limiting factor, taxpayers should consider all three W-2 wage methods to determine if the optimal method is being used. In addition to maximizing the amount of W-2 wages by reviewing the three wage calculation methods, taxpayers should review their allocation of wages between DPGR and non-DPGR activities to ensure the allocation is appropriate. Both direct and indirect wage amounts should be allocated to DPGR (and non-DPGR) activities.
Documentation Considerations for the Deduction
The need for a well-thought methodology and proper documentation increased significantly when the DPD was designated a Tier 1 issue in December 2006. Although the deduction amounts were fairly modest in the early years, the IRS recognized that the law’s complexity had the potential to require substantial audit resources in an examination and that the benefit would grow significantly as statutory rates increased.
The IRS has created a Quick Reference Guide to Section 199 that outlines all guidance released to date on the DPD and summarizes the IRS protocols for a DPD review. As expected, the basic focus of an IRS examination will be:
- Do the activities included in the DPD qualify as a production activity?
- Are costs properly allocated to production activity?
- Does the revenue used in the Section 199 calculations tie to page one of the tax return?
For those taxpayers having difficulty managing the large volumes of data, Revenue Procedure 2007-35 provides guidance for determining when statistical sampling can be used for purposes of Section 199 and establishes acceptable statistical sampling methodologies. The guidance provides that factors used in determining whether a statistical sample is appropriate include the time required to analyze large volumes of data, the cost of analyzing data, the existence of verifiable information relevant to the taxpayer’s Section 199 calculation and the availability of more accurate information. Pursuant to this revenue procedure, statistical sampling may be used to:
- Allocate gross receipts between DPGR and non-DPGR;
- Determine whether gross receipts qualify as DPGR on an item-by-item basis;
- Allocate the cost of goods sold (COGS) between DPGR and non-DPGR; and
- Allocate deductions that are properly allocable to DPGR or gross income attributable to DPGR.
Many Section 199 provisions allow the taxpayer to make determinations based on reasonable methods. A reasonable method should begin with the books and records available in a taxpayer’s business, but taxpayers should consider whether more advantageous approaches are available given the flexibility extended by the regulations.
Alvarez & Marsal Taxand Says:
The DPD has finally reached its peak statutory rate and, for many taxpayers, has become their largest permanent tax benefit. However, many taxpayers have likely not taken a fresh look at the calculation since the statute was first enacted. Given the increasing benefits, it is prudent to take another look to ensure optimal methods are being used and proper documentation is being maintained.
Because of the large benefits available from the DPD, taxpayers should not lose sight of how other tax planning may affect the deduction. For example, if a taxpayer is subject to the taxable income limitation, a Section 481(a) adjustment (or any acceleration of expense or reduction to revenue) will likely affect the DPD. A similar consequence may result from the filing of net operating loss (NOL) carryback claims from 2009. To the extent taxable income is reduced, the carryback may result in lost Section 199 amounts in the earlier years.
The increasing size of the benefit will also likely bring increased IRS scrutiny. Taxpayers should be prepared to provide documentation that supports the identification of DPGR, the related COGS and the methodologies used to allocate other costs to DPGR and non-DPGR. Although the general view of the DPD seems to be that it is mainly an accounting exercise, the exercise must begin with a factual review of the types of activities ongoing within an organization. A strong understanding of the facts will enable a better assessment of revenue streams, as well as allow for better allocation of expenses.
As a final thought, the intended benefits of Section 199 have been somewhat limited in recent years because of the requirement that taxpayers have taxable income. It will be interesting to see if any legislative developments follow, since many companies targeted for this incentive are receiving no benefits from the current statutory design. Even the ability to carryforward QPAI to future periods would create an asset for many manufacturing businesses that desperately need help to remain competitive in the global market.
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