Taxable Talk

Thanks to Joe Kristan of Roth Tax Updates, here is some more information on the Domestic Production Activities Deduction, aka the Deduction from Hell. The draft form is available online here. A much more technical introduction to the proposed regulations, written by Elizabeth Askey of Pillsbury Winthrop Shaw Pittman LLP is available here. Joe Kristan’s in-house presentation on Section 199 is here. And the proposed regulations are available here.

As an aside, I’m not in despair over this deduction. As I was telling friends over dinner this past weekend, Congress continues to mandate full employment for tax preparers. It’s a pity that Congress does this by making deductions unnecessarily complex.

Hat Tip: Joe Kristan, Roth Tax Updates

Not many small businesses do their own tax returns. If they do, they’re likely to “enjoy” Form 8903, “Domestic Production Activities Deduction.” By the way, this form is not yet on the IRS’ website. The draft version of the form has only 19 lines, and looks deceptively easy.

It’s not.

It’s going to make tax preparers get gray hair. Luckily, I already have gray hair so that’s not an issue….

Let’s take a look at how this deduction “works” (all sarcasm intended). You own Widgets, Inc., and you manufacture widgets, and sell them. Your plant is in the United States.

So yo enter your receipts on line 1, your cost of goods sold on line 2, your direct and indirect deductions, to get your “qualified production activities income (QPAI).” This is then compared to your income limitation, which is 3% of the lesser of the QPAI or the taxable income for the taxable year (without regard to this deduction). Additionally, the deduction is limited to 50% of the wages paid by the taxpayer to employees during the tax year. Thus, self-employed manufacturers do not get this deduction.

That’s the simple case.

Now, let’s assume that this same company has two plants, one in Irvine and one overseas in China. Both plants produce the same products, and there’s nothing to distinguish the widgets made in China from those made in Irvine.

This new deduction holds only for the products produced in Irvine, so you will have to perform an allocation (presumably based on number of units produced in each plant). This is the not-so-simple case.

Now, let’s look at a much more realistic case, one that I’ll have to face. A company has two plants, one here in California and one overseas. They make a variety of products, and also perform services (repairs, consulting, field service, etc.). The products made here and the products made overseas are distinguishable, but are freely interchangeable. The company has never tracked product sales by location of manufacture (they do track it for quality control purposes).

In order to determine the correct deduction, I’ll have to:
—allocate between the manufacturing and service businesses;
—allocate between the products manufactured domestically and internationally; and, finally,
—allocate the domestic salaries by services and manufacturing.

Now, let’s make this more confusing. Some services do qualify, courtesy of effective lobbyists, such as architectural and engineering services. Newspaper production qualifies. Unfortunately, tax preparation services do not qualify. Software development qualifies but software support doesn’t. Restaurants don’t qualify but food preparation done for wholesale does qualify.

I’m not looking forward to my first venture in preparing a return with this deduction. IRS guidance is forthcoming, but it hasn’t been released (yet). The IRS does have a brief overview of the deduction. Notice 2005-14, which gives the IRC on this deduction (§199) is here. Professor Maule previously commented on this deduction.