A special deduction authorized by Section 199 of the tax code is available for domestic production activity expenses. But like many other write-offs, the Section 199 deduction — also called the “domestic production activity deduction” (DPAD) — is being permanently eliminated by the Tax Cuts and Jobs Act (TCJA), beginning in 2018.
However, the Section 199 deduction can still be claimed on 2017 returns being filed this year. In addition to C corporations and pass-through business entities, a self-employed taxpayer can deduct qualified expenses above-the-line on Line 35 of Form 1040.
Be aware that the rules under Section 199 are complex. For starters, the deduction is equal to 9 percent of your “qualified production activities income” (QPAI). QPAI is generally equal to domestic production gross receipts (DPGR), minus the sum of:
- Cost of goods sold that are allocable to DPGR;
- Deductions, expenses or losses that are properly allocable to DPGR; and
- Other expenses, losses or deductions that are not properly allocable to DPGR or another type of income.
For this purpose, domestic production gross receipts include 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 U.S. No deduction is allowed for foreign-produced products.
However, other limits spelled out in Section 199 may apply. For instance, if your business’s taxable income before the DPAD is lower than its QPAI, the deduction is claimed as a percentage of the taxable income. Also the annual deduction is limited to 50 percent of the W-2 wages paid by the business.
The DPAD is also referred to as the “manufacturing deduction” because it is often claimed by manufacturers and others in a related business. But its reach is further than many people think. For example, the list of "qualified production activities" eligible for the Section 199 deduction includes, according to Delap LLP, the following:
- Manufacturing based in the U.S.;
- Selling, leasing, or licensing items that have been manufactured in the U.S.;
- Selling, leasing, or licensing motion pictures that have been produced in the U.S.;
- Construction services in the U.S., including building and renovation of residential and commercial properties;
- Engineering and architectural services relating to a U.S.-based construction project; and
- Software development in the U.S., including the development of video games.
On the other hand, the deduction is specifically excluded for certain activities, including construction services that are cosmetic in nature (e.g., painting); leasing or licensing items to a related party; and selling food or beverages prepared at a retail establishment.
Note that the TCJA preserves other above-the-line tax deductions for self-employed individuals, including the 50 percent deduction for self-employment tax, the deduction for health insurance and the deduction for certain qualified retirement plans. But the DPAD is going off the books.
Because of the repeal on the DPAD deduction, the IRS advised not to use Form 8903 to claim the DPAD for 2018 or later years.
This article is part of a series titled Vintage 2017 Tax Deductions, which focuses on the key deductions your clients may be able to claim under the new tax law.
