Can You Qualify for Greater Manufacturing Tax Deductions?
Reducing taxes is always a topic of interest among US businesses. If you’re a manufacturing company, make sure you take advantage of the Internal Revenue Code Section 199 Domestic Production Activities Deduction (DPAD.) DPAD’s generous tax deductions make it an appealing option for American manufacturers looking to maximize their income.
What is DPAD?
In 2004, Congress enacted the DPAD as a way to provide tax relief for manufacturers in the U.S., no matter where the goods are sold, and to ensure jobs remained onshore. Subject to certain limitations, manufacturers are allowed a deduction equal to the lesser of:
- 9% of the taxpayer’s qualified production activities income (“QPAI”);
- 9% of the taxpayer’s taxable income for the year; and
- 50% of the taxpayer’s W-2 wages for such year that are properly allocable to domestic production gross receipts (“DPGR”)
QPAI includes receipts from products that have been manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole, or in significant part, within the United States. In addition to traditional manufacturing, activities can include the production of qualified films, utilities, software development, and U.S. real property construction.
The deduction is not limited to corporations, but rather any entity engaging in these activities. Pass-through entities should provide information regarding DPAD on the K-1s issued to shareholders, partners or members.
Detailed calculations are required to arrive at net QPAI. Simply put, after determining the domestic production gross receipts (DPGR), subtract the cost of goods sold, direct expenses and a ratable portion of indirect expenses allocated to these gross receipts (IRC Sec 199(c)(1)).
The challenge is in the allocation of the DPGR and the costs. In order to capture the information necessary for the computation and to maximize your deduction, a modification to your current accounting system may be needed.
The Recent Evolution
Since its issuance, DPAD has been causing an array of confusion among taxpayers and enforcers alike. There has been recent debate between the IRS and district courts over what manufacturing activities are eligible under Section 199. So the looming question is, at what point can a business claim that they are manufacturing?
The loose interpretation of what falls under manufacturing, producing, growing or extracting (MPGE) has catalyzed a slew of businesses claiming to fall under the manufacturing umbrella.
The Wins for Manufacturers
With uncertainties as to what qualifies under MPGE, there have been two recent district court cases ruling against the IRS in favor of businesses claiming repackaging as a qualifying activity.
Dean, Houdini Inc.
Houdini Inc., a company that created gift baskets and gift towers from various items from multiple suppliers, claimed that their use of an assembly line to change the form and function of the various items into one new product fell under the qualifications set forth by DPAD. The IRS fought the claim by saying that minor assembly or repackaging does not qualify as a MPGE activity.
The courts ruled in favor of Houdini, declaring that the assembly line changed the form and function of the various items in its production process. As a result, the IRS released Proposed Reg. Sec. 1.199-3(e)(5) that declared the following activities as non-MPGE: packaging, repackaging, labeling, or minor assembly, by way of adding examples to the existing regulation to help narrow the scope.
Precision Dose Inc.
Days later, another court case arose. Precision Dose, Inc., a company that creates single-dose medications from bulk, was denied their refund under DPAD by the IRS. Precision argued that their product, although derived from bulk items, was unique due to their complex production process. The IRS refuted the claim stating that Precision was merely repackaging and labeling an existing product and therefore failed to qualify as MPGE.
The courts ultimately ruled in favor of Precision, stating that their “complex production process,” which included research, product testing, and unique mixing, qualified them as creating a “distinct” final product. The IRS dropped their appeal.
What Does this Mean for Me?
The arguments formed in both Dean and Precision Dose, Inc. serve to provide insight on the various ways in which a business can make the most of DPAD. While neither labeling nor repackaging alone directly qualify, persuasive arguments can be made for businesses that engage in additional processing activities.
If you are uncertain whether activities qualify as MPGE or repackaging, note certain key aspects of the "complex" production processes that the courts found persuasive:
- The processes relied on assembly line workers and machines;
- The form, purpose, and resulting demand of the final products were distinctly different from their initial parts;
- Subassembly of the items into the final form did not constitute a majority of the process;
- Thorough market research of the product;
- Extensive testing of the product.
In response to the court decisions, the IRS published proposed and temporary regulations on December 16, 2015 (REG-136459-09) to better define and provide guidance on the DPAD provisions. These regulations, which will be effective when published as final, remain at odds with the recent court decisions as the IRS is seeking to administratively strengthen its position on DPAD. In light of the developing guidelines and DPAD’s evolving nature, it is beneficial to stay to up to date on provisions to ensure that your business’ activities are compliant. Note some of the proposed changes below:
- Under the current IRS regulations, only one taxpayer is allowed to claim a DPAD benefit from the manufacturing of a product – the taxpayer that has the benefits and burden of ownership. The proposed regulations would rather state that if a qualifying activity is performed under contract, then the party that performs the activity gets the deduction. This could be a significant change for contract manufacturers that have not previously received a DPAD deduction and their customers who have the benefit and burden of ownership who have received the deduction.
- The proposed regulation also clarifies which manufacturing activities qualify for DPAD. They reaffirm their position that standalone packaging or testing do not qualify for DPAD.
- The proposed regulations clarify that a taxpayer must engage in construction activity to qualify for DPAD on an item-by-item basis, so this would have to be looked at for each job. For companies doing any construction management activity, this may limit the DPAD on those jobs.
- The regulations also update the definition of substantial renovations of real property to conform to the tangible property repair regulations released in early 2015. The proposed DPAD regulation refers back to the repair regulations to determine what the unit of property is for the 30%-40% test. The current definition for substantial renovations is the renovation of a major component or substantial structure or real property that increases the value or the property, prolongs the useful life, or changes its use.
If you have questions about your qualifications for the DPAD, or need to file an amended return to claim DPAD, it’s a good idea to consult with your accountant or a financial consultant.
Donna Holm is a senior tax manager at Sensiba San Filippo. She specializes in closely- held businesses, corporations and partnerships. She has experience in both domestic and international finance in a variety of industries, as well as the owners/founders in the high net worth space. Donna can be reached at (408)286-7780 or at [email protected].
