What is the Section 199 Deduction?
by Melissa Merrick | Rex Miller, CPA
Team Members of the Manufacturing & Distribution Services Group
The Section 199 deduction (also referred to as the domestic manufacturing deduction, U.S. production activities deduction, and domestic production deduction) is a tax break for businesses that perform domestic manufacturing and certain other production activities. It was established by the American Jobs Creation Act of 2004 in an effort to ease the tax burden of domestic manufacturers and as a result make the investment in domestic manufacturing facilities more advantageous.
In past years, Section 199 provided either a three percent (2004-2006) or six percent (2007-2009) deduction on the lesser of qualified production activity income or taxable income for the year. The deduction became fully phased in at nine percent for tax years beginning in 2010 and thereafter; hence, more businesses may find it worthwhile to calculate and substantiate the deduction.
What activities are eligible for the Section 199 deduction?
Per Section 199, domestic production gross receipts (DPGR) can be derived from the following qualifying production activities as long as they are conducted in whole or in significant part within the U.S.:
- The manufacture, production, growth, or extraction by the taxpayer of tangible personal property. This encompasses all tangible personal property (except land and building), computer software, and sound recordings.
- The production of qualified film
- The production of electricity, natural gas, or water
- The construction of real property
- The services of architecture/engineering
DPGR resulting from the property produced must be owned by the producer taking the deduction (i.e. the production of property that is owned and under contract by someone else would generally not be eligible).
How is the Section 199 deduction calculated?
The deduction is limited to the income produced by the above qualifying activities. Income from qualified production activities is calculated as domestic production gross receipts (DPGR) less cost of goods sold and other expenses that are directly allocable to production of DPGR. Income and expenses that are not directly related to qualifying activities will need to be backed out of the calculation for qualified production activity income. After the lesser of the DPGR or taxable income is multiplied by the applicable percentage (9% for 2010), the deduction is further limited to 50% of Form W-2 wages allocable to DPGR.
The Section 199 deduction is allowed for both regular and alternative minimum tax for individuals, C corporations, farming cooperatives, estates, trusts, and their beneficiaries. The deduction is also allowed at the partner, member, and owner level for a partnership, LLC, and S corporations, respectively. Businesses should also be aware that the Section 199 deduction does not always apply at the state level. As of the beginning of 2010, 22 states (including Indiana) have departed from the federal deduction.
The following are some examples of how the Section 199 deduction would be calculated in certain circumstances:
Example #1: For the year ended December 31, 2010, John Doe Manufacturing Company (a C-Corp) had taxable income, all from qualifying manufacturing activities, of $1 million and paid $100,000 in W-2 wages.
Example #1 Solution: John Doe will be entitled to a Section 199 deduction of $50,000 due to the 50% limit of W-2 wages. If the W-2 wages had been greater than $180,000, the deduction would have been $90,000 [$1 million X 9%].
Example #2: Same facts as #1 ($180k W-2 wages), except John Doe Manufacturing Company is a S-Corp, with John Doe owning 60% and Jack Doe owning 40%.
Example #2 Solution: The deduction passes through to the shareholders, with John receiving $54,000 and Jack receiving $36,000 of the deduction.
Example #3: Same facts as #2, except that John takes a $108,000 distribution and Jack takes a $72,000 distribution. No W-2 wages are paid.
Example #3 Solution: A Section 199 deduction can not be taken because W-2 wages were not paid.
What are some specific applications of the Section 199 deduction to the Manufacturing Industry?
Qualified production property (QPP) includes all tangible personal property, except land and buildings, and includes computer software and sound recordings. Qualified manufacturing activities will include those which, manufacture, produce, develop, improve, install, grow, extract and/or create the qualifying production property. Even those processes that use scrap, salvages, or junk material (instead of new or raw material), may be eligible. Such produced material will be eligible if it is processed, manipulated, refined, or altered such that the materials form is changed or the material is combined/assembled into two or more articles or materials. Furthermore, manufacturing components that will later be used by another party for manufacturing or product activities will be considered eligible.
It is also worth noting that food processing activities at wholesale can be considered as DPGR as long as they do not consist of food and beverages being prepared at a retail establishment.
Our Manufacturing & Distribution tax experts would be happy to talk with you further on this increasing tax deduction (we don’t get to use the words ‘increasing tax deduction’ very often).