United States: Double-Dipping Deductions With DPAD

Last Updated: August 15 2016
Article by Karl Heafield and Stanley Rose

Manufacturing has long been considered the backbone of our country's industry. It is vital to a country's prosperity, in part because most manufacturing endeavors support a number of related manufacturing, service and other industries as well. Congress recognizes the value of manufacturing, and has long known that favorable tax rules can effectively encourage and reward certain activities and behavior. The purpose of this article is to describe one such tax break that was designed primarily for manufacturers: The Domestic Production Activities Deduction. It is a very potent benefit that indirectly allows certain outlays to be deducted twice.


The Domestic Production Activities Deduction ("DPAD") was introduced in 2004 with the creation of Internal Revenue Code Section 199. While it was established to encourage manufacturing, its history is a little more complex than that. Since the early 1970s a number of tax benefits were rolled out in succession, each one replacing its predecessor, in an effort to reduce taxes on U.S. exporters and reduce trade deficits. Those benefits included qualification as a Domestic International Sales Corporation ("DISC"), categorization as a Foreign Sales Corporation ("FSC"), and allowance of a deduction known as the Extraterritorial Income Exclusion ("ETI"). For various reasons, the tenure of each of these benefits was shortened by complaints by domestic companies and, more significantly, by the World Trade Organization and European Union, which argued that the rules violated international trade agreements by unfairly subsidizing U.S. – based companies. DPAD, therefore, is the fourth of these benefits, but to assuage the international community concerns, Section 199 provides significant benefits to all qualifying activities – not just those who export. (This makes it harder to argue that it was designed as an unfair export subsidy.) While DPAD has its detractors, it seems to have ruffled fewer feathers than the regimes it replaced.


Many pages of Internal Revenue Code and Treasury Regulations have been written to describe DPAD and clarify its reach and limitations, and the following is merely a simplified overview. Basically, a taxpayer who is engaged at least in part in qualifying production must separately compute the net income from that activity. For a taxpayer who does nothing but qualifying production, no such separation is needed. But for many taxpayers, a non-qualifying activity – like repairs or service work, for example – are also undertaken. Those taxpayer must segregate their revenues and direct expenses, and allocate indirect expenses, to arrive at the net income earned from qualifying activities, known as Qualified Production Activities Income ("QPAI"). Much of the guidance in the Treasury Regulations addresses various methods of cost allocations, but the general guidance allows for "any reasonable method."

Once that breakout is accomplished to produce the qualifying net income (QPAI), the deduction itself tentatively is equal to 9% of that amount. However, two additional limitations exist. First, if QPAI is higher than the company's total net income (a situation that would exist if non-qualifying activity operated at a loss), the deduction cannot exceed 9% of net income. Also, to encourage domestic employment, another limitation is based on wages, preventing the deduction from exceeding 50% of the taxpayer's W-2 wages paid in that tax year. These limitations can be summarized by stating that the deduction itself is equal to the smallest of:

  1. 9% of a year's domestic production activity income,
  2. 9% of a year's overall taxable income, or
  3. 50% of that year's W-2 wages that relate to the qualifying activity.

The math behind this deduction reveals just how potent this benefit can be. All of the costs that are incorporated into the QPAI base already were deducted as a component of the company's net income. With the inclusion of this deduction, those deductions are essentially duplicated, to the tune of 9% of the qualifying activity. For a company that does nothing but manufacture, only 91% of its income will be taxed – dropping the effective tax rate by several points.


General qualification

The DPAD benefits generally apply to:

  1. Construction of real property in the U.S.,
  2. Engineering and architectural services that support construction of real property in the U.S., and
  3. Sale, lease, or licensing of:
    1. Qualified film, but only if at least 50% of the compensation related to the film was paid for services performed within the U.S.,
    2. Electricity, natural gas or potable water produced in the U.S., and
    3. Tangible personal property, software, or audio recordings that are produced, manufactured, grown, or extracted in whole or in significant part within the U.S.

Note that qualification under any of the alternatives depends on some (and in some instances, all) of the activity being undertaken within the U.S., which is consistent with its description as a "domestic" benefit.

General disqualification

There are several items DPAD specifically does not apply to, and the reason for disqualification does not relate to the product, but instead relates to another aspect of the description – the taxpayer's "activity" relative to the product. For instance:

  1. The sale of food or beverages prepared by the taxpayer at a retail establishment generally does not qualify. However, growing vegetables or manufacturing processed food generally does qualify. (Incidental retail sales are sometimes permissible – such as a small retail outlet that generates modest sales at a manufacturing facility from which most of the product is shipped wholesale.)
  2. The mere transmission or distribution of electricity, natural gas or potable water does not qualify – but the production or extraction of it, as noted above, does qualify. (Integrated producers who both produce and deliver must allocate their revenues and costs between such activities, because only the production activities qualify.)
  3. The sale or leasing of land does not qualify – but the sale or leasing of construction on that land often does qualify.

Situational qualification

Generally minor assembly, packaging or labeling do not solely qualify as production for purposes of the DPAD. (And of course, the law helpfully does not define these terms, leaving significant ambiguity.) However, it does provide that if such activities are undertaken by the same taxpayer as part of broader activity that does qualify (true production), these otherwise non-qualifying tasks can be treated as qualifying. By example, if Taxpayer 1 produces property but then sells to Taxpayer 2 to assemble, package, and label; Taxpayer 1 may utilize DPAD if it otherwise qualifies, but Taxpayer 2 cannot. If Taxpayer 1 instead handles all of the assembly, packaging and labeling on its own, its related "core" production activities favorably taint the assembly, packaging and labeling; allowing them to be included as qualifying activities.

Sometimes a contractor will undertake an activity on behalf of another taxpayer, and the contractor's activity is of a qualifying nature. However, the Treasury Regulations limit the DPAD benefits to the party who bears the "benefits and burdens of ownership" of the underlying property. For this reason, it is possible that an otherwise available deduction will not exist for any party, or will be significantly reduced. A scenario in which this is likely to happen is explained in the "wage limitation" section below.


Congress clearly wanted to limit the Section 199 deduction to endeavors that employ U.S. workers. This is evidenced by some of the law's restrictions. As noted above, regardless of net income or qualifying domestic production activity income, the benefit is limited to 50% of wages. Specifically, this is limited to wages reported on the taxpayer's own Forms W-2. Compensation paid to independent contractors does not qualify, and generally amounts paid to contracted employees fail as well. Additionally, only wages paid for work related to QPAI qualifies. If a taxpayer has two lines of business, and only one qualifies for DPAD, its wages paid for non-qualifying activity must be excluded from the 50% test.

The wage limitation and "benefits and burdens of ownership" rule may work together to deny a deduction to all parties who are involved with otherwise qualifying activity. A common scenario may involve a contractor. The contractor collects fees that do not constitute wages. The other party to the contract – the true manufacturer – likely retains the benefits and burdens of ownership. If much of the labor is accomplished by the contractor, the manufacturer may be left with little or no W-2 wages, which are needed to obtain the deduction. The contractor may use employees and issue W-2s, but without benefits and burdens of ownership it cannot obtain the deduction. In this not-too-uncommon case, DPAD slips through the cracks for both parties. This lost deduction should be considered by parties who have the opportunity to hire and use their own employees in lieu of using contractors.


DPAD is available to many forms of business. The party claiming the deduction (whether a corporation or individual) reports it, and supporting calculations, on Form 8903. For C-corporations and proprietorships, the deduction is utilized directly by the entity/individual who undertook the qualifying activity. For flow-through entities like S-corporations, LLCs, and partnerships, most of the underlying calculations are done at the entity level, and each owner's share of the components that yield the benefit are reported to the owners on Schedule K-1, along with the "routine" items of income and deduction that accompany a K-1. The owner uses that information to populate Form 8903, allowing qualifying deductions to become a component of his or her Form 1040.

DPAD can be used to reduce income for purposes of both regular tax and Alternative Minimum Tax ("AMT"), but under the latter regime the deduction is recomputed and limited to 9% of alternative minimum taxable income. DPAD cannot be used if doing so would increase or create a net operating loss.


Since its introduction, the Domestic Production Activities Deduction has provided what often is a very significant benefit to a large number of taxpayers. It truly does allow what essentially is a second deduction related to costs already deducted. Its broad definition of what qualifies as "production" suggests that many taxpayers should investigate whether this opportunity exists for them.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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