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Domestic Production Activities Deduction

There has been a little known or publicized tax deduction that is starting to make a difference in the tax planning of many small business owners and entrepreneurs.  It has been around since 2005, but has made a difference in the tax benefits of many small business owners in 2007. This “domestic production activities deduction” is applicable specifically to contractors, construction services, manufacturing companies, selling and/or leasing items that have been manufactured in the United States; engineering and architectural services relating to US based construction projects, and software development.

         Starting in 2005, certain companies can take a 3% deduction for US-based business activities, and 6% deduction starting in 2007. These qualified production activities can take a tax deduction of 6% from net income from 2007 through 2009, and 9% starting in the year 2010.

This is a very advantageous tax break. Although the math in computing this tax break comes with a set of complicated limitations involving W-2 wages paid, cost of goods sold analysis in relation to total sales and so on, this is very much a tax break “gimme” for those business which are eligible “qualified production activities”. The more complicated the business, however, the complicated the math in calculating the qualified production activities deduction. Basically, businesses engaged in manufacturing, construction services, and so forth, will need to implement cost accounting mechanisms to make sure their tax deduction is accurately calculated.

As with all tax deductions and tax breaks, there are limitations. The Domestic Production Activities Deduction is limited to income arising from qualified production activities in whole or a significant part in the United States. Those companies, which import a significant amount of their products from overseas, specifically would not be eligible for this deduction. Under this “safe harbor rule”, businesses can take the deduction if at least 20 percent of the total costs are the result of direct labor and overhead costs from US-based operations. If any part of manufacturing or production activities is outside of the United States, then businesses must use either the safe harbor rule (20 percent of total costs are from US-based production activities) or allocate costs using various facts and circumstances of their business.

The following businesses are specifically excluded from claiming this deduction:

a)                          Construction services that are cosmetic in nature, such as painting or home decoration;

b)                          Leasing or licensing items to a related party

c)                          Selling food or beverages prepared at a retail establishment.

Since the computation of this calculation is rather complicated, you should consult with your tax advisor about whether or not you are eligible for this tax deduction.

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