If you have a business that involves producing and selling goods, and have employees in the United States who help you do so, you may qualify for the domestic production activities deduction. This deduction, though little known and rather complex, can be worth a lot. And even small businesses can take advantage of it.
What It Is
The domestic production activities deduction, which went into effect in 2005, is intended to give a tax break to businesses that hire employees to produce goods or engage in certain other manufacturing or production activities within the United States, rather than farming out the work overseas.
To qualify for the deduction, your business must engage in “domestic production activities.” These consist of the followin activities.
- Any sale, lease, rental, license, exchange, or other disposition of tangible personal property, computer software, or sound recordings that you manufactured, produced, grew, or extracted, in whole or in significant part, within the United States.
- Construction performed in the United States—including both new buildings and substantial renovations of existing buildings. However, rental income from real property isn’t eligible for the deduction.
- Engineering or architectural services performed in the United States for construction projects in the United States.
- Films and videos you produced if at least 50% of the production work was performed in the United States. (Sexually explicit films and videos are excluded.)
- Electricity, natural gas, or potable water you produced in the United States. (IRC Sec. 199.)
The first category above—the tangible personal property category—is by far the broadest and most inclusive. If you produce any tangible personal property “in significant part” in the United States and later dispose of it by sale or otherwise in the course of your business, you may be entitled to a deduction. According to the IRS, “significant part” means that the labor and overhead incurred in the United States was at least 20% of the total cost of the property. (IRS Notice 2005-14.)
Tangible personal property is any tangible property other than land, buildings, and structural components of buildings, including: clothing, goods, food, books, magazines, newspapers, production machinery, printing presses, transportation and office equipment, testing equipment, display racks and shelves, neon and other signs, hydraulic car lifts, and automatic vending machines.
Many businesses other than traditional manufacturers fall under this broad definition. Almost any activity relating to manufacturing, producing, growing, extracting, installing, developing, improving, or creating tangible personal property qualifies for the deduction. This includes making tangible property from new or raw material, or by combining or assembling two or more articles.
Example: Sophie owns a crafts business. She has two employees who make leather belts from raw leather Sophie purchases.The belts qualify as tangible personal property produced in significant part in the United States. Sophie’s activity qualifies for the domestic production deduction.
Design and development costs, including packaging, labeling, and minor assembly operations, are not domestic production activities. Also not included is personal property you lease, license, or rent to a person related to you. The deduction also does not apply to income derived from the sale of food and beverages you prepare at a retail establishment.
Amount of Deduction
The deduction is 9% (2014) of the income you earn from your domestic production activities. Income means your gross receipts from a production activity reduced by the cost of goods sold and related expenses, including the cost of production and a portion of your indirect expenses such as rent.
However, the domestic production activities deduction is intended to encourage businesses to hire more employees in the United States and thereby benefit the American public. Thus, a business can qualify for the deduction only if it has employees. For example, if you have a one-person business and do all the work yourself or use independent contractors to do the work you don’t do, you get no deduction because you have no employees.
If you have employees, you can get the deduction if you meet all the other requirements. However, it cannot exceed 50% of the total wages you paid to employees engaged in domestic production activities.
Example: Assume that Sophie from the above example generates $10,000 in domestic production activity income in 2014. She paid her employees $2,000 in wages to produce this income. Sophie can take a domestic production activities deduction of $900 ($10,000 x 9%). However, if she had paid her employees only $1,000, her deduction would be limited to $500 ($1,000 x 50%)
Obviously, you can increase your deduction limit if you hire more employees instead of doing work yourself or hiring independent contractors. But the value of the deduction may not justify the increased expense of having employees.
There is one more significant limitation on the deduction: It may not exceed your adjusted gross income if you’re a sole proprietor or the owner of an LLC, partnership, or S corporation. If you own a C corporation, the deduction may not exceed the corporation’s taxable income. Thus, businesses that don’t earn a profit and pay no taxes get no domestic production activities deduction.
Get Professional Help
If you want to take this deduction, seek guidance from a tax professional. It may increase your bookkeeping and accounting burdens. It could also subject you to the uniform capitalization rules. (IRC § 263A.) These rules prevent you from taking a current business deduction for the direct, and some indirect, costs incurred in production activities. Thus, for example, you could be prohibited from currently deducting all or part of your labor and overhead costs. Instead, you recover the costs through depreciation, amortization, or deducting the cost of goods sold when you sell or otherwise dispose of the property. This can take much longer than obtaining a current deduction.