Benefits and Burdens of the Domestic Production Activities Deduction
by Michael J. Devereux II, CPA
Mueller Prost PC
Enacted in 2004, the Domestic Production Activities Deduction (DPAD)1 is generally nine percent (9%) of a taxpayer's qualified production activities income (QPAI or qualifying income) for the tax year.2 The DPAD is designed to be the economic equivalent of a three percent (3%) reduction in tax rate on qualifying activities. This article will focus on how the DPAD applies to the various revenue streams of plastics processors, addressing qualification requirements of sales related to parts and molds, as well as determining which party is eligible for the deduction in instances of multiple parties' involvement in the same economic activities.
Basics of the deduction
Qualifying income is equal to the taxpayer's domestic production gross receipts (DPGR or qualifying sales), net of allocable expenditures. Qualifying sales are those sales from the manufacture, production, growth or extraction of qualifying production property in whole or in significant part by the taxpayer in the United States (US). In addition, the DPAD cannot be greater than that taxpayer's taxable income (or adjusted gross income) or 50 percent of the W-2 wages paid related to the activities giving rise to such deduction.
- Most US manufacturers engage in qualifying activities. That said, taxpayers should not assume that all net income is qualifying income. For a taxpayer with qualifying activities, the following steps should be taken to compute its DPAD:
- Determine the amount of qualifying sales (domestic production gross receipts).
- Net allocable expenses against qualifying sales to determine qualifying income (qualified production activities income).
- Multiply qualifying income by nine percent (9%).
- Determine the taxable income (or adjusted gross income) and 50 percent of W-2 limitations.
The DPAD equals the smallest of nine percent (9%) of qualifying income, nine percent (9%) of taxable income or 50 percent of the W-2 wages paid related to the activities giving rise to the DPAD.
Considering the various revenue streams of a plastics processor
Taxpayers must determine whether sales are qualifying on an item-by-item basis. The term "item" means the property held for sale by the taxpayer in the normal course of business. Therefore, plastics processors must first determine the "item" being sold. Taxpayers must consider the facts and circumstances in order to determine their item(s). Some considerations include the following:
- Does the taxpayer sell plastics parts only?
- If the taxpayer is selling the production mold to the customer, is the mold sold as part of its sale of plastic parts or is the mold held for sale as a separate item?
- Does the taxpayer provide services for additional consideration that would be determined apart from the sales of goods?
- If the mold is a separate item (product), was the mold manufactured "by the taxpayer?"
The answers to these questions may determine which sales are qualifying domestic production gross receipts and which are not. Taxpayers must keep books and records capable of determining which items are qualifying sales.
Multiple parties involved in the same economic activity
IRS treasury regulations provide that only one party may claim the DPAD with respect to any qualifying activity performed in connection with the same qualifying production property.3 That is, the item must be manufactured (1) by the taxpayer (2) in whole or in significant part within the US. This does not mean that multiple parties cannot have qualifying income for different stages in the economic activity. Rather, meeting these two requirements allows taxpayers to claim the DPAD for their stage within the overall economic activity.
If one taxpayer performs a qualifying activity pursuant to a contract with another party, then only the taxpayer who has the benefits and burdens of ownership of the qualifying production property is treated as engaging in qualifying activity.4 Determination of which party has the benefits and burdens of ownership is based upon the facts and circumstances, and taxpayers should consider which party has the following: the risk of loss, title of the work in process (WIP), control over the production process, liability with respect to "make good" contractual provisions and an opportunity to benefit financially from increased efficiencies in the production process.
An item is treated as manufactured in whole or in significant part by the taxpayer if the manufacturing activity performed by the taxpayer is substantial in nature, taking into account all of the facts and circumstances, including the relative value (i.e., cost) added by the taxpayer.5 Taxpayers looking to determine whether the manufacturing activities are substantial in nature with respect to an item in a more objective manner may rely upon the safe harbor provided in the Treasury Regulations. If the direct labor and overhead added by the taxpayer account for 20 percent or more of the taxpayer's cost of goods sold related to the item, the taxpayer is deemed to have manufactured the item in significant part.6
Plastics processors must look to the relationships with both customers and vendors to determine whether another party has the benefits and burdens of ownership. For instance, an original equipment manufacturer (OEM) may contract with a plastic injection molder for the production of a plastic part. The plastic injection molder may contract with a third-party tool maker for the production of the mold used to produce the part. In this common set of facts, which parties are entitled to the DPAD and for which items? Again, taxpayers must look to the facts and circumstances in order to determine whether each item is manufactured by the taxpayer in whole or in significant part. Some considerations include the following:
- Is the mold a product held for sale to the OEM once the processor meets functional specifications (e.g., making the mold an item or component thereof), or does the processor retain ownership of the mold that is used in the production of the plastic parts, thereby making the mold a cost allocable to the plastic parts?
- If the mold is sold to the OEM, does the contract between the OEM and the processor bundle the mold and parts into one item, or may the OEM purchase the mold in a separate transaction and, subsequently, be free to use a different processor to produce the parts?
- If the mold is a separate "item" and a third-party toolmaker manufacturers the production mold to the processor's specifications, does the third-party tool maker or the plastics processor have the benefits and burdens of ownership during the manufacturing process of the mold?
- If the third-party tool maker is determined to have the benefits and burdens of ownership during the manufacturing of the production mold, does the plastics processor's direct labor and overhead account for at least 20 percent of all the costs allocable to the mold?
In most instances, the plastics processor will have the benefits and burdens of ownership related to the manufacturing of the plastic parts. Generally, plastics processors can benefit significantly from reducing cycle time, scrap or press downtime.
Clearly, if the plastics processor manufacturers its own molds, it has the benefits and burdens of ownership during its manufacturing process. However, processors using third-party toolmakers will need to examine their contracts to determine which party has the benefits and burdens of ownership or if their direct labor and overhead account for at least 20 percent of the cost of the molds to determine whether the mold may be treated as qualified production property.
IRS issues directives helping taxpayers determine benefits and burdens of ownership
In order to reduce ambiguity in contract manufacturing arrangements, the IRS has issued three directives to help taxpayers determine which party has the benefits and burden of ownership during the manufacturing of an item.
The first directive identified three steps to determine which party has the benefits and burdens of ownership.
Step 1: Contract Terms
- Does the taxpayer have title to the work-in-progress (WIP)?
- Does the taxpayer have risk of loss over the WIP?
- Is the taxpayer primarily responsible for insuring the WIP?
Step 2: Production Activities
- Does the taxpayer develop the qualifying activity process?
- Does the taxpayer exercise oversight and direction over the employees engaged in the qualifying activity?
- Does the taxpayer conduct more than 50 percent of the quality control tests over the WIP while the qualifying activity was occurring?
If the taxpayer answers "yes" to two answers in each step, the taxpayer has the benefits and burdens of ownership during the manufacturing activity. If not, taxpayers must proceed to Step 3.
Step 3: Economic Risks
- Is the taxpayer primarily liable under the "make good" provisions of the contract (for example, the warranty, quality of work, spoilage, overconsumption or indemnification provisions)?
- Does the taxpayer provide more than 50 percent, based on cost, of the raw materials and components used to produce the property?
- Does the taxpayer have the greater opportunity for profit increase or decrease from production efficiencies and fluctuations in the cost of labor and factory overhead?
If the taxpayer answers "yes" to two of the answers in Step 3, the taxpayer has the benefits and burdens of ownership during the manufacturing activity.
In superseding the first directive, the second directive provides that both the taxpayer and the counterparty agree at the outset of the manufacturing activity which party has the benefits and burdens of ownership.
The third directive clarifies the second directive related to taxpayers already under IRS examination and the removal of an attestation provision of the agreement with the counterparty suggested in the second directive.
The final directive makes clear that if the parties have not agreed, it should not be presumed the taxpayer does not have the benefits and burdens of ownership. Rather, the IRS must examine the facts and circumstances to determine which entity has the benefits and burdens of ownership for purposes of the DPAD.
Author's Observation: While the first directive was superseded, the questions identified in each step are helpful to taxpayers in determining whether they have the benefits and burdens of ownership during the manufacturing process, based upon the relevant facts and circumstances.
The DPAD is an extremely beneficial provision of the internal revenue code for taxpayers in the plastics manufacturing industry. Careful consideration of the requirements and questions posed in this article will help taxpayers ensure they are calculating the proper amount of DPAD, as well as help establish procedures that substantiate such positions in the event of an IRS examination.
- This provision of the code goes by many names, including, but not limited to, the Code Section 199 deduction, the manufacturers' deduction and the US production deduction.
- The deduction was phased in over time with the deduction equal to three percent (3%) of QPAI in tax years beginning in 2005 or 2006; six percent (6%) of QPAI in tax years beginning in 2007, 2008 or 2009; and nine percent (9%) of QPAI in tax years beginning in 2010 and thereafter.
- Treasury Regulation §1.199-3(f)(1)
- Treasury Regulation §1.199-3(f)(1)
- Treasury Regulation §1.199-3(g)(2)
- Treasury Regulation §1.199-3(g)(3)