Manufacturers may be well familiar with a rule that allows them to exclude income created on U.S.-made goods. But recent changes expand it to contractors, engineers and architects.
What if I told you there was a tax deduction that you were missing? Would you be interested? What if the tax deduction was equal to 9% of your net income? Well, there's a deduction called the domestic production activity deduction, or “DPAD,” that is missed by many taxpayers.
The DPAD came into existence as part of the American Jobs Creation Act of 2004. Prior to the DPAD, the tax code allowed for an extraterritorial income exclusion “ETI” for sales of U.S. manufactured goods overseas. The World Trade Organization ruled that this provision violated agreements concerning export subsidies and in response, Congress repealed the ETI and enacted the DPAD.
The DPAD is aimed at the original benefactors of the ETI — manufacturers. But Congress expanded the new deduction to a few other beneficiaries: contractors, engineers and architects.
To be eligible for the DPAD, property has to be produced in whole or in part inside the United States. Property is considered produced inside the U.S. if direct U.S. labor and overhead costs equal or exceed 20% of the total cost of the property.
Generally, a qualifying business can deduct 9% of the qualified net production income.
To qualify for the DPAD, a business has to produce tangible personal property, computer software, or sound recordings. Prepared food and beverages produced at a retail establishment do not qualify, nor does property leased, licensed or rented to a related party. Also added to the definition of qualified property is the construction of real property located in the U.S. and engineering and architectural services performed in connection with U.S. real property construction.
While most manufacturers are aware of the DPAD, many contractors, engineers and architects are not.
Eligible real property consists of:
Residential or commercial buildings;
Permanent structures (docks and wharves);
Permanent land improvements (swimming pools and parking lots); and
Infrastructure (roads, sewers, sidewalks and power lines).
Qualified construction income does not include activities such as hauling trash and debris or delivering materials, even if these activities are necessary in the construction process. Any substantial renovation of real property is considered qualified construction.
Engineers and architects who provide services in regard to real property construction are also eligible for the DPAD. Income from providing the following services is considered qualified income:
Design and supervision of construction; and
Aesthetic and structural design.
A general contractor building a commercial building for a customer on the customer's land would qualify for the credit. If the contractor has net profit on the job of $200,000, a DPAD of $18,000 would be available to reduce taxable income for the contractor. Because Congress wanted to encourage job growth, the deduction is further limited to 50% of wages paid. To take the entire $18,000 deduction, the contractor would need to have at least $36,000 in W-2 wages. The deduction is also limited to taxable income from the activity. The deduction itself will not produce a loss and will be limited to taxable income.
Contractors are eligible for the deduction if they can prove their work adds value to real property, extends the life of real property, or transforms the use of the property. Repairs do not qualify and the distinction between repairs and improvements can be a source of disagreement between the taxpayer and the IRS. Contracts should be evaluated individually to determine if the DPAD criteria is met and only those contracts can be used for the computation of the deduction.
For example, an HVAC contractor generally does a variety of different jobs: installation of new systems in residential and commercial projects, repair of existing HVAC units, and preventative maintenance services. Of these activities, only the installation of the new HVAC systems would be eligible for the DPAD. The computation of the DPAD in this situation would be complex because of the necessary allocations between qualified and non-qualified income.
Because of the complexity of the computation, the IRS has judged the DPAD to be a compliance risk and designated the deduction as a Tier 1 audit issue. What this means is that you can take the deduction, but need to make sure your documentation is in place because of the risk of scrutiny by the government.
The DPAD is a generous deduction that is given to U.S. producers of property to encourage domestic manufacturing and production. If your business meets the criteria, you should take advantage of this deduction. Just make sure your documentation is in order in case the IRS asks to take a look.
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]