The domestic production activities deduction, also known as “DPAD” or “Section 199 deduction,” is meant to encourage domestic production. This potentially valuable tax break can be used by many types of businesses, from manufacturing to farming.
Understanding the acronyms
Before trying to calculate the DPAD, it helps to understand the acronyms involved. One important factor is qualified production activities income (QPAI), which is the amount of domestic production gross receipts (DPGR) exceeding the cost of goods sold and other expenses allocable to that DPGR. Most businesses will need to allocate receipts between those that qualify as DPGR and those that do not unless less than 5 percent of receipts are not attributable to DPGR.
Farmers qualify for DPAD as producers of crops and from the sale of raised breeding, dairy or draft livestock. Apart from farming, DPGR can come from a number of activities, including the construction of real property within the United States. It also can result from the lease, rental, licensing or sale of other qualifying production property, such as machinery, office equipment or computer software. The main rule regarding any property is that it must have been manufactured, produced, grown or extracted in whole or “significantly” within the United States. While each situation is assessed on its merits, the IRS has said that, if the labor and overhead incurred in the United States accounted for at least 20 percent of the total cost of goods sold, the activity typically qualifies.
What are the limitations? The DPAD is limited to 50 percent of Form W-2 wages paid to employees and allocable to DPGR. Unfortunately, many farmers do not pay W-2 wages which disqualifies them from deducting at least 50 percent of W-2 wages under DPAD. You may be able to avoid this rule by making legitimate wage payments to family members including spouses and children over the age of 18. In addition, your farming operation may be financially stable enough to hire employees to complete tasks instead of hiring on a contract labor basis. In order to maximize your DPAD, you should ensure that 50 percent of W-2 wages reach at least 9 percent of the farm’s QPAI.
Simplifying the calculations
Although determining what costs are allocable to DPGR can get complicated, some smaller businesses can simplify their calculations. Under the Small Business Simplified Overall Method, costs are allocated between DPGR and non-DPGR based on relative gross receipts. This is the most common approach used by farmers
The Simplified Deduction Method, another method for calculating QPAI, can be used by most businesses whose assets are no more than $10 million, or whose average gross receipts do not exceed $100 million. This approach is similar to the Small Business Simplified Overall Method in that most expenses are allocated between DPGR and non-DPGR based on gross receipts. The allocation is not used for the cost of goods sold.
If your business can claim the DPAD, you may be able to deduct 9 percent from the lesser of your QPAI or taxable income. As such, it could boost your cash flow. Please contact a member of Yeo & Yeo’s Agribusiness Services Group for help with determining whether and how the deduction could work for you.