The Section 199 deduction (aka U.S. production activities deduction, the domestic manufacturing deduction and domestic production activities deduction) is intended to be a tax break to encourage domestic manufacturing. In fact, it’s often referred to as the “manufacturers’ deduction.” However, this potentially valuable tax break can be used by many other types of businesses besides manufacturing companies.
Everyone wants to avoid paying taxes, which means maximizing deductions and reducing taxable income. The deduction is allowed for both the regular tax and the alternative minimum tax for individuals; C corporations; farming cooperatives; and estates, trusts and their beneficiaries. The deduction is also allowed to partners and the owners of S corporations (not to partnerships or the S corporations themselves). However, the deduction might not apply at the state level, since as of December 31, 2016, 28 states have decoupled from or have significant adjustments to the section 199 deduction.
Section 199 Deduction Overview
Under current law, qualifying businesses can claim the Section 199 deduction based on 9% of their qualified production activities income (QPAI). The deduction is also limited to 50% of W-2 wages paid by the taxpayer that are allocable to domestic production gross receipts.
This deduction is available to traditional manufacturers, but businesses engaged in activities such as construction, engineering, architecture, computer software production and agricultural processing also may be eligible.
The deduction can be used against the alternative minimum tax, but isn’t allowed in determining net self-employment earnings and generally can’t reduce net income below zero.
Calculating the Section 199 Deduction
To determine a company’s Section 199 deduction, its QPAI must be calculated. The rules are complex, but QPAI is generally equal to domestic production gross receipts, minus the sum of:
- The costs of goods sold that are allocable to domestic production gross receipts (DPGR);
- Deductions, expenses or losses that are directly allocable to domestic production gross receipts, and
- Certain other deductions, expenses and losses that are not directly allocated to domestic production gross receipts or another class of income.
For this purpose, DPGR includes gross receipts derived from the sale, exchange, lease, rental, licensing or other disposition of qualified production property. The property also must be manufactured, produced, grown or extracted, in whole or in significant part, in the United States.
There are other limits. For instance, if your company's taxable income is lower than its QPAI before the Section 199 deduction is calculated, the deduction is claimed as a percentage of the taxable income. Further, the annual deduction is limited to 50 percent of the W-2 wages your company pays. This can be a major obstacle for manufacturing firms operating in a cost-efficient manner.
Other considerations to consider, if one taxpayer performs a qualifying activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership during the period in which the qualifying activity occurs is treated as engaging in qualifying activity.
Nevertheless, the Section 199 deduction represents a significant tax break for qualified manufacturing firms. If your company is in the top tax bracket for 2016, a 9% deduction amounts to an effective tax cut of more than 3%.
Calculating the Section 199 Deduction
Generally, calculating the deduction involves the following five steps:
- Identify areas of potential qualified production activities. Assess whether the manufacture or production of tangible personal property occurred domestically and then determine if a product is held for sale, lease or license, or if it involves another aspect.
- Figure out the DPGR. Allocate gross receipts between qualified and nonqualified activities. Gross receipts should be allocated and apportioned at the item level.
- Allocate cost of goods sold to DPGR between qualified and nonqualified activities.
- Allocate and apportion below-the-line expenses. Unless the firm is eligible for a simplified deduction method (see right-hand box), it must allocate and apportion certain deductions using the principles of section 851 (specifies apportionment of certain items of gross income and deductions to sources within the US), including charitable contributions, research and development expenses, corporate and selling expenses, general and administrative expenses and interest.
- Calculate the deduction. Use sales and cost-of-sales data derived in steps 2 and 3, and taxable income data derived in step 4. The net taxable income of the qualified products should be aggregated and presented on the consolidated calculation by entity schedule. The lesser of the qualified production activities income (QPA) or taxable income is then multiplied by the applicable percentage to determine the deduction, which is limited to 50% of wages paid to the taxpayer's employees reported on Form W-2 during the calendar year ending during the tax year and that are allocable to DPGR.
Due to the complicated nature of the Section 199 deduction, you face potential pitfalls, as well as tax-saving opportunities. In addition, calculations may be affected by assumptions or reliance dating back to years when the deduction equaled a lower percentage of QPAI. Some calculations have been rolled forward for several years and have not been updated.
7 Steps to Maximize Your Section 199 Deduction
With the increase in tax dollars at stake, you can be sure that the IRS is paying closer attention to the Section 199 deduction than in previous years. As a result you should ensure that you have the supporting documentation and that can withstand an IRS audit on this issue. With that in mind, here are seven steps that may help maximize the deduction.
- Bulk up DPGR. Frequently, taxpayers fail to properly identify all the items that may qualify as DPGR, resulting in a lower Section 199 deduction. It is important for all company departments to understand the impact of their revenue streams, especially if you are not necessarily considered a "traditional" manufacturer.
- Make sure direct expenses are matched to DPGR. For various reasons, a taxpayer may fail to properly match direct expenses to DPGR. This could cause an incorrect amount to be assigned to items producing QPAI. The net effect is a reduced QPAI and a lower deduction.
- Make sure that indirect expenses are properly matched to DPGR. This is a common problem for taxpayers eligible for Section 199 deduction. It may be difficult to assign indirect expenses, especially corporate, selling and administrative expenses, to items relating to QPAI. Accordingly, the deduction may be reduced or eliminated.
- Timing is critical. At the end of the year your firm may be able to time certain items to your tax advantage. For instance, if your enterprise is in danger of being limited by the 50 percent rule for W-2 wages, it might be able to accelerate amounts before year end. Similarly, if a deduction would be lowered due to the limit for taxable income, you might bring more income before the close of the tax year, when possible and feasible.
- NOL carryback and section 199 interplay. Companies may elect to carry back net operating losses (NOLS) up to two years, which may affect their taxable income and consequently their section 199 deduction. The companies should evaluate whether recomputing the section 199 deduction for the carryback year is required - for example, if the amount of the deduction depends on whether it was based on taxable income or QPAI.
- if taxable income is less than QPAI, then the NOL carryback would reduce taxable income and the amount of the Section 199 deduction in the carryback year.
- If QPAI is less than taxable income, the section 199 deduction would not change in the carryback year, unless QPAI exceeds taxable income after applying the NOL carryback.
- Allocation of noncompensatory expenses under Section 861. Examples of noncompensatory expenses may include warranties, bad debts, legal settlements and environmental remediation.
- Section 481(a) adjustments. A taxpayer that changes its method of accounting must properly allocate the resulting section 481(a) adjustment (to prevent omission or duplication of items) between DPGR and non-DPGR in determining its section 199 deduction. Common examples of a section 481(a) adjustment may include changes in accounting in regard to depreciation, amortization and repairs.
Important: Don't make the mistake of assuming that the Section 199 deduction is locked in at a certain amount or rely on your company's previous history. With professional guidance from your tax adviser, analyze the situation and make the appropriate year-end moves.
Manufacturing Deduction - Simple Does It
The Section 199 deduction calculation is complex, but there are two simplified methods a small firm may be eligible to use for allocating and apportioning expenses.
- Firms with less than $5 million of average annual gross receipts and firms using cash-basis accounting can allocate all expenses, including cost of goods sold, to DPGR and non-DPGR based on the ratio of each to total gross receipts.
- Firms with less than $100 million of average annual gross receipts or $10 million of total assets at the end of the year can determine the amount of cost of goods sold to allocate to DPGR. Then all other costs may be apportioned between DPGR and non-DPGR based on relative gross receipts.
Contact Paul Burris to learn whether this potentially powerful deduction could reduce your business’s tax liability when you file your 2016 return. Paul Burris can be reached at email@example.com or call 615-309-2348.