The Domestic Production Deduction and Sole Proprietors

By Wayne Wells and Thomas Zupanc

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JANUARY 2008 - The Domestic Production Deduction (IRC section 199) was created by the American Jobs Creation Act of 2004 (PL 108-357, 188 Stat. 1418) and amended by the Gulf Opportunity Zone Act of 2005 (PL 109-359, 119 Stat. 25) and the Tax Increase Prevention and Reconciliation Act of 2005 (PL 109-222, 120 Stat. 345) as a substitute tax benefit for export tax credits that had been declared illegal by the World Trade Organization. Although designed primarily for large businesses, the deduction can provide significant tax savings to small businesses, including sole proprietors. Although sole proprietors face special limitations, they can also benefit from certain opportunities.

The Deduction

The gross receipts from the sale, lease, rental, licensing, exchange, or disposition of qualified production property [IRC section 199(c)(5)] are called domestic production gross receipts [DPGR; IRC section 199(c)(4)(A)(i)]. Qualified production property includes property the taxpayer manufactured, grew, produced, or extracted; it also includes film production, sound recordings, discs, tapes, recordings, motion pictures (excluding sexually explicit pictures) on film or videotape, electricity, natural gas, and potable water. DPGR also include gross receipts from construction of real property in the United States, and engineering or architectural services performed in the United States for construction of domestic real property [IRC section 199(c)(4)(A)(ii) and (iii)].

Qualified production activity income (QPAI) [IRC section 199(c)] is computed by deducting cost of goods sold, and direct and indirect production expenses from DPGR. QPAI is essentially the net income from the qualifying activities (see the calculation in the Exhibit).

QPAI is then compared to the taxpayer’s taxable income. The lower of the two figures is then multiplied by the applicable percentage in effect for the applicable tax year. For 2005 and 2006, the percentage was 3%; for 2007, 2008, and 2009 it is 6%; and for 2010 and beyond it will be 9%. Therefore, even if the taxpayer’s qualifying business is profitable, as measured by QPAI, the taxpayer’s taxable income may limit the amount of the deduction.

The sole proprietor’s extra costs of recordkeeping (distinguishing DPGR from other gross receipts; distinguishing DPGR direct and indirect costs from other costs; and calculating the correct portion of DPGR indirect costs) may reduce or even exceed the tax savings, especially before the 9% rate is in effect. For a sole proprietor, these recordkeeping costs will represent a greater proportion of the tax savings than they will for larger businesses.

The calculations for all taxpayers are performed on Form 8903. For a sole proprietor, this deduction is reported on line 35 of Form 1040, not on Schedule C.

The special rules that apply to sole proprietors regarding taxable income and W-2 wages, although complicated, provide both limitations and opportunities.

Special Rule 1: Taxable Income. For sole proprietors, a special rule applies when comparing QPAI to taxable income. Adjusted gross income (AGI) is substituted for taxable income when calculating that individual’s deduction [IRC section 199(d)(2) and Treasury Regulations sections 1.199-1(a), (b), and 1.199-8(b)]. According to IRC section 199 and the regulations, the individual’s AGI is determined after applying IRC sections 86 (including Social Security and Tier 1 railroad retirement benefits), 135 (excluding income from U.S. savings bonds redeemed and used to pay higher education tuition and fees), 137 (exclusion of adoption assistance program), 219 (deduction for retirement savings programs), 221 (deduction for interest on education loans), 222 (deduction for qualified tuition and related expenses), and 469 (passive-activity losses and credit disallowance), but not taking into account the IRC section 199 deduction.

It is difficult to understand why the statute and the regulation defining AGI specifically mention items that are already automatically included in the calculation of AGI but omit any mention of other items of income and above-the-line deductions that are also necessary to calculate AGI, such as moving expenses and alimony deductions [IRC section 199(d)(2) and Treasury Regulation 1.199-1(b)(1)].

Perhaps the explanation is simple: The rules governing the IRC section 199 deduction are still in the development stage. Early in 2005, the IRS issued Notice 2005-14, a 100-page document that raised questions and criticisms. In October 2005, the IRS followed up with 136 pages of proposed regulations that significantly altered rules in Notice 2005-14 and added more. Extensive final regulations were issued on June 19, 2006 (IRB No. 2006-25, June 19, 2006, 26 CFR 1.199-1, et seq.), clarifying many issues but promising further modifications and clarifications.

For the time being, the 2006 instructions for Form 8903 simply state that the taxable income limitation for the IRC section 199 deduction for sole proprietors is replaced by the taxpayer’s AGI from Form 1040, line 37. (The 2007 instructions have not been released yet.)

It is conceivable that a sole proprietor may have QPAI from a profitable business but would still be limited or prohibited from taking the deduction because of the AGI limitation. For example, the existence of net operating losses carried forward from a previous year, Schedule E losses from rental property, farm losses, another Schedule C venture that creates a tax loss, moving expenses, alimony payments, higher education expenses, other above-the-line deductions, or a combination of the above losses and expenses could reduce the sole proprietor’s AGI and limit the deduction. Furthermore, a spouse’s above-the-line losses or expenses on a joint return could also create low AGI and limit the deduction. There are no rollover or carryover provisions in the statute that would allow the sole proprietor to use one year’s deduction in a later year in which AGI is no longer a limitation.

On the other hand, it is also conceivable that a sole proprietor may have QPAI from an unprofitable business but could still be allowed to take the deduction. For example, this would occur if a sole proprietor runs a business that produces DPGR and QPAI but also has a service component that is unprofitable. The net effect could produce a low profit or even a loss on Schedule C. Nevertheless, if the sole proprietor is diligent in his recordkeeping so that the DPGR, cost of goods sold, direct expenses, and indirect expenses can be related to QPP, then there will be QPAI and the sole proprietor can still take a section 199 deduction. Many items of the sole proprietor’s AGI unrelated to the business, such as capital gains, wages from other employment, or pension payments, could greatly increase the potential section 199 deduction, even if the Schedule C shows a loss or a small profit.

For example, Kim’s sole proprietorship consists of a bakery and retail food sales. Assume the (wholesale) bakery DPGR are $700,000, and after cost of goods sold, direct expenses, and a ratable portion of indirect expenses are subtracted, there is $100,000 of QPAI. W-2 wages related to DPGR are substantial. Also assume the retail food sales loses $1 million after taking into account its cost of goods sold, direct costs, and the ratable portion of indirect costs. The Schedule C shows no profit, but there is still QPAI, so the section 199 deduction could be taken, up to $6,000. Kim will not be able to take much of the section 199 deduction if her AGI is low. However, if she has any other income, or if she files a joint return and her spouse has any other income, their AGI will be higher and the section 199 deduction could approach $6,000.

Special Rule Number 2: W-2 Wages. The section 199 deduction is also limited to 50% of the W-2 wages paid by the taxpayer allocable to DPGR. The lower the taxpayer’s W-2 wages, the lower the potential deduction.

Under the Tax Increase Prevention and Reconciliation Act of 2005, the definition of W-2 wages is limited to include only those W-2 wages that are properly allocable to DPGR. Thus, if a taxpayer has employees whose activities are devoted to providing services or to other activities that do not create DPGR or QPAI, those W-2 wages are not counted in the total amount of W-2 wages, which could reduce the deduction.

W-2 wages include more than gross salaries or wages, however. The definition of W-2 wages includes not only the total amount of wages as defined by IRC section 3401(a) but also the employees’ total elective deferrals under IRC sections 402(g)(3) and 457, and designated Roth contributions, as defined in IRC section 402A. Some of these common elective deferrals include contributions to 401(k) retirement plans, section 403(b) salary reduction agreements, section 408(k)(6) salary-reduction simplified employee pensions (SEP), section 457(b) plans, and section 408(p) savings incentive match plan for employees (SIMPLE) accounts.

A sole proprietor who has no employees would not be able to take advantage of the IRC section 199 deduction, no matter how profitable the business is. For example, assume Jan Janssen, dba Beta Products, has DPGR of $1 million; the company’s cost of (qualifying) goods sold is $500,000; its direct costs are $250,000; and indirect costs are $100,000. Beta has QPAI of $150,000. If Jan’s AGI is $140,000 (maybe as a result of the company’s service business component, or because of above-the-line deductions), then Jan’s section 199 deduction based on income is $8,400 ($140,000 x 6%). However, if Beta has no employees, then there are no W-2 wages, and Jan gets no section 199 deduction. If Beta has employees but W-2 wages are less than $16,800, then Jan’s section 199 deduction is limited to 50% of the W-2 wages.

If it would be appropriate for other reasons, Jan may want to consider hiring employees to create a higher W-2 wage cap, but she must also consider that W-2 wages will create FICA liability and possibly other costs, and lower the amount of QPAI and AGI, all of which will have a direct effect on the section 199 deduction.

Using the Beta Products example, assume the same facts as above but assume an additional $10,000 of W-2 wages paid, plus $765 in FICA. Assume the W-2 wages and FICA are direct costs of DPGR. Beta Products will have direct costs of about $261,000, and QPAI of about $139,000. Jan’s AGI will now be about $129,000 (or about $139,000 if Beta’s new employee is Jan’s spouse and they are filing a joint return). The section 199 deduction is 6% of $129,000 ($7,740) or 50% of W-2 wages ($5,000), whichever is lower. The immediate tax benefit is a $5,000 deduction and lower self-employment tax on Jan, but Beta has FICA liability of $765 on the wages and possibly federal and state unemployment tax, workers compensation coverage, higher liability insurance premiums, or other employee-related costs, all of which will reduce cash, QPAI, and AGI.

The final regulations provide a potential significant opportunity for married taxpayers filing jointly: Taxpayers may take into account wages paid to their spouse’s employees in determining the amount of W-2 wages, provided the wages are paid in the spouse’s trade or business and properly allocated to domestic production activities [Treasury Regulation 1.199-2(a)(4)].

For example, assume Harvey and Wilma file a joint return, and each of them owns separate profitable businesses producing QPAI. Assume further that Harvey has no employees, and QPAI from his business is $100,000 this year. Assume Wilma’s QPAI from her business is $100,000 after taking into account the $30,000 of W-2 wages her business pays. Assume they have $200,000 of AGI on their joint return (without regard to IRC section 199). If Harvey and Wilma file a joint return, they are treated as one taxpayer for purposes of the W-2 wage definition. Harvey can take a $6,000 section 199 deduction, and Wilma can take a $6,000 section 199 deduction. Together, the section 199 deductions do not exceed 50% of the $30,000 of W-2 wages.

Potential Benefits

Although complex, the domestic production activities deduction provides a potential tax savings tool for sole proprietors who produce gross receipts by creating and profiting from the disposition of qualifying property or performing qualifying services.

The costs of recordkeeping for keeping track of DPGR, direct expenses, and the ratable portion of indirect expenses, especially in a “hybrid” sole proprietorship—with both qualifying and nonqualifying activities—can be disproportionately higher than they are for larger businesses. Sole proprietors must measure those costs against the savings that IRC section 199 can create.

Special rules in IRC section 199 on income and wages paid may limit or eliminate the ability of a sole proprietor to benefit, but the ability to use AGI toward the income limitation and to use a spouse’s W-2 wages paid toward the wage limitations may allow use of the deduction far in excess of the actual income derived from the business generating the qualifying property or services.


Wayne Wells, JD, LLM, is a professor of accounting, and Thomas Zupanc, JD, LLM, is an associate professor of business law and taxation, both at Saint Cloud State University, St. Cloud, Minn.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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