The domestic production deduction was created to encourage manufacturing and production within the U.S., and it provides a substantial business deduction equal to 9% (up from 6% in 2009) of the lesser of:
- the taxpayer’s net income from qualified production activities or
- the taxable income (modified adjusted gross income for individual taxpayers) without regard to this deduction for the tax year.
The deduction is further limited to 50% of the W-2 wages of the employer for the tax year allocable to the activities eligible for the deduction.
Domestic Production Activities – Although the definition of “domestic production activity” is a little elusive, it generally does not include retail sales or purely service activities. Among the more common eligible activities are:
- manufacturing and production activities in whole or in significant part within the U.S.,
- construction of real property in the U.S., and
- performance of engineering or architectural services in the U.S. in connection with real property construction projects in the U.S.
The following example, one that was used in a Congressional hearing, does a good job of defining what is and is not a qualified domestic production activity: Suppose you are a baker and in the business of producing donuts. Some of the donuts you sell retail directly to the consumers, and some you sell in bulk to hotels and restaurants. The production costs of the donuts sold at retail do not qualify for the deduction, while the costs associated with the wholesale sales to the hotels and restaurants do.
Computing the Deduction – The following is an example of how this deduction works: Suppose your business manufactures a product that you wholesale to retailers. Your net income from sales of that product for the year is $800,000, and the wages you paid to your employees to manufacture that product totaled $200,000. Your deduction for 2010 would be the lesser of 9% of the $800,000 in revenue or 50% of the $200,000 wages. Thus, the domestic production activities deduction for your business would be $72,000 (.09 x $800,000). The deduction is allowed for both regular and alternative minimum tax purposes.
Who Gets the Deduction – This deduction is allowed to all taxpayers, including individuals, C corporations, farming cooperatives, estates, trusts, and their beneficiaries. The deduction is allowed to partners and owners of S corporations (not to partnerships or the S corporations themselves) and may be passed by farming cooperatives to their patrons. And, despite the deduction’s history, it is fully available to taxpayers who do not export.
The foregoing is only an overview of this deduction. If you have questions related to how the domestic production deduction might apply to your specific circumstances, please give this office a call at 888-564-5777.