fully phased-in in 2010, taxpayers could take a deduction of 9% of the lesser of their qualified production activities income or taxable income. This deduction is an adjustment to income on the front page of the 1040, but in my experience, I seldom see the deduction being taken.
Why? It may be due to the complexity of the calculation, tax preparer unawareness or misunderstanding of what constitutes domestic production.
The calculation requires the isolation of qualified production activities income. The first step is to identify the gross receipts for the domestic production. Total receipts may include both domestic gross receipts and non-domestic gross receipts, and the tax regulations require the allocation method to be reasonable. The regulations offer guidelines to determine whether or not the allocation method is reasonable.
Transformation is a requirement of production. The four specific operations that represent transformation are: Manufactured, Produced, Grown or Extracted. Without one of these elements, production has not occurred.
Qualified production property includes tangible personal property, computer software and certain sound recordings. Tangible personal property includes all tangible personal property other than land or real property, and includes gas, chemicals and similar property.
Another element that is required in order to qualify as domestic production is “in whole or significant part” criteria. As a general guideline, if 20% or more of the cost of goods sold is made up of direct labor and
allocated overhead for domestic production, the activity would meet the criteria.
Once all elements are identified, Form 8903 is used to quantify the credit. Besides the income limitation, the credit is also limited to 50% of W2 income reported by the entity that was allocable to domestic production gross receipts.
Tax Preparer Awareness
Although the DPAD is a separate line item in the “adjustments to income” section of the tax return, tax preparers who are unaware of the credit may overlook it. Knowledgeable CPAs, enrolled agents and other preparers will increase their value to their clients by taking this and all available credits on their clients’ tax returns. Many times these credits flow to the 1040s from pass through entities on K1s from partnerships, S-Corps and similar entities.
What constitutes Domestic Production for purposes of the credit? Besides what is normally considered manufacturing, several other activities also qualify. For instance, many construction activities qualify as domestic production activities. The production of electric, natural gas and drinkable water in the United States is also domestic production for the purpose of determining the credit.
In conclusion, the DPAD can significantly impact an individual’s taxes. Tax preparers may better serve their clients by being aware of this complex topic.