In 2004, Congress introduced the Domestic Production Deduction (the DPD) to encourage U.S. manufacturing and certain other "production" activity.
At the time of enactment, there was a decidedly lackluster reaction to the new incentive: the new provisions were complex, the computations and reporting could be difficult and the tax benefit often appeared relatively small or non-existent. Flash-forward to 2010; the interest in Sec. 199 has swung dramatically upward and for good reason. The DPD can produce both significant tax savings and a meaningful reduction in a company's effective tax rate; however, it can also result in unexpected tax assessments, penalties and interest for those taxpayers who claim the benefits of Sec. 199 too liberally. Let's review why.
An Overview Of The Domestic Production Deduction (Section 199)
Sec. 199 came into law on the heels of decades of incentives intended to reward those U.S. businesses that exported products overseas. Those incentives - which date back to the 1960s and included Domestic Sales Corporations, Foreign Sales Corporations and the Extraterritorial Exclusion Regime - often came under attack by the international community as unfair U.S. government subsidies of U.S. businesses. With the advent of the new millennium, Congress was less concerned with encouraging foreign export and much more concerned with the continuing exodus of U.S. jobs (particularly in manufacturing) to other countries. Thus, Sec. 199 was enacted to encourage the retention and growth of U.S. manufacturing without regard to whether the output of those manufacturers was exported out of the country or consumed domestically.
America's industrial backbone needed support and Sec. 199 was intended to provide it. Sec. 199 accomplishes this objective by effectively reducing the income tax assessed on the profits of targeted industries, principally manufacturing, construction and natural resource extraction (oil and gas, mining, forestry, etc.). For good measure, software developers, filmmakers and music publishers were also tagged to benefit from the new incentive. "Production" was to be rewarded while service, retail and distribution businesses generally were not. In 2005, qualifying taxpayers could take a deduction up to three percent of taxable income attributable to production activities. After the full phase-in of the DPD benefits in 2010, qualifying taxpayers could expect a deduction up to nine percent of taxable income. To ensure that the incentive produced the desired U.S. job growth, Congress limited the deduction to 50 percent of the wages of the taxpayer's employees (initially all employees; later amended to include only those employees involved in the production activity).
This all seems attractive enough for U.S. taxpayers who fall within the targeted industries and, for many, the benefit is relatively easy to obtain. A significant number of small to midsize U.S. manufacturers conduct all of their operations within the United States, derive all of their recurring operating revenues from the sale of the products that they produce, and have little or no unusual income or expense items that might raise issues in the course of the computation. Certain de minimis rules often could be applied to prevent small amounts of nonqualified income from complicating the computation. If these companies operated as C corporations, the process of obtaining the DPD could be a simple one. But what about other types of corporate entities?
The Challenges And Complexities Of Section 199
Many small to midsize manufacturers operate as S corporations, partnerships and LLCs with multiple owners. Because the DPD is computed at the taxpayer level, those entities cannot do the arithmetic to compute the deduction for the owners. Instead, they pass selected information out to each of the owners who must combine that information with similar information provided from other pass-through entities in which they have an ownership interest to compute the DPD to be reported on their individual returns. Because flow-through entities cannot presume to know whether or not the owners would take the deduction, such entities are required to provide the information to the owners notwithstanding how small the final numbers prove to be. This is not an elective provision as to those entities. When Sec. 199 was first enacted, delays in getting the requisite information, inconsistent formats as to its presentation and confused K-1 recipients were the order of the day. Structures involving multiple tiers of flow-though entities as well as trusts and estates added further challenges.
For larger and more complex businesses, other challenges in computing the deduction quickly become apparent. Many of these challenges arise from the concern of Congress that Sec. 199 might benefit taxpayers for whom the benefit was not intended. To prevent this from occurring, Congress introduced an alphabet soup of new acronyms (MPGE, DPGR, QPAI, etc.) as well as principles not found elsewhere in the tax code. This led to a great deal of computational complexity.
Even at the most elementary level, consider the following:
• Domestic: Must be made in the U.S., right? Yes, although nearly 80 percent of the cost of a finished product could be produced overseas and still meet the safe harbor to qualify as domestic production. Further, 80 percent or more could be produced overseas if the taxpayer could successfully argue that the U.S. production was nonetheless "substantial" in nature.
• Production: So services are not rewarded, correct? Generally, but services that are "embedded" in the products can also qualify. Additionally, certain architectural, engineering and construction services qualify for the deduction.
• Deduction: This should at least be clear, should it not? Sure, as long as one understands that the deduction is not necessarily computed by the entity that incurs the related costs. In the case of pass-through entities, it is computed by the taxpaying owner(s) or beneficiary instead. Further, regardless of who the taxpayer is, if that taxpayer otherwise has a loss from the activity generating the Domestic Production Deduction (either through current operations or due to a loss carryback or carryover), or if the taxpayer does not have U.S. payroll, then there is no DPD at all.
Deeper in the Sec. 199 regulations are a multitude of other complexities. The correct application of the rules can become much more difficult for taxpayers whose business models are even moderately complex and involve one or more of the following:
• Accounting systems that track revenue and expenses based on divisions, product lines and other broad criteria (as opposed to the "item" approach required in the Sec. 199 computation);
• A complex mix of qualifying and non-qualifying activities as to which revenues, costs and expenses must be allocated in some reasonable and manageable way; and in a manner that is not inconsistent with other allocations that the taxpayer may regularly make relative in managing its business operations; and in its approach to other allocations for tax purposes including those related to Sec. 263A or related to a foreign tax credit;
• Industries that "produce" - but not in the traditional manufacturing sense (software developers, construction companies, film and music businesses, printers, etc.) - that are subject to unique DPD issues;
• Shared production responsibilities through sub-contractor arrangements, whether acting as the sub-contractor or the customer of a sub-contractor;
• Provision of delivery services, installation services or warranties in connection with the produced property;
• Production of products with multiple components with only some produced by the taxpayer;
• Unusual or non-recurring types of income including Subpart F inclusions, litigation settlements, gains on the disposition of capital assets and others;
• Unusual or non-recurring types of expenses and expenses that may relate to the stewardship of or allocations of costs and revenue among subsidiary and affiliated businesses.
This is a lengthy list, but it is by no means an all-inclusive list of the potential sources of complexity.
After reading this discussion of challenges and complexities, the lackluster initial response from many U.S. taxpayers is understandable. However, as the deduction percentage increased from three percent of qualifying income to sixpercent and then in 2010 to a fully phased-in nine percent, both the current and cumulative benefits have become quite substantial. For many companies, the DPD has become the item that provides the greatest permanent tax benefit, and the item that has the most significant favorable impact on the effective tax rate reported in its income statement. The permanent cash flow savings from this benefit can quickly become quite sizeable.
Of course, with this heightened current and cumulative benefit comes the need to protect this cash and tax rate savings from challenge by the IRS. Pass-through entities are also appropriately concerned about the flow-through effect of adjustments to their owners and beneficiaries. Because the Sec. 199 deduction has been designated a Tier 1 audit issue for IRS examiners, a taxpayer that comes under examination and that has claimed a Section 199 deduction will be examined by the agent. Challenges of one year's computation may escalate to a review of other years. As part of the Tier 1 audit process, IRS examiners will likely issue standard Information Document Requests that focus on all aspects of the computations. Taxpayers must be prepared with workpapers that are responsive to these requests.
Further, analyses required under implementing accounting for uncertain tax positions (formerly known as FIN48) have appropriately become more rigorous to keep pace with the magnitude of the cumulative benefit. As a consequence, additional documentation of the DPD will likely be required in connection with financial audits as well.
Conclusions And Recommendations
The DPD represents a significant permanent tax savings for a very broad group of taxpayers. Most qualifying taxpayers are claiming some benefit from the DPD, but it is likely that all would benefit from a re-examination of the provisions and their application to their businesses. Have all of the issues and opportunities related to the identification of qualifying activities and the determination of the taxable income from those activities been properly understood and addressed, especially in light of the types of issues enumerated above? Have the mechanics of the computation kept pace with the evolution of the business and the current thinking as to the DPD? Have critical technical positions been appropriately analyzed and documented? Have the relevant records required to support the computation been properly maintained?
One should keep in mind that the computation of the Sec. 199 deduction is not a tax accounting method. As a result, a deduction from prior years can be adjusted through an amended return without requesting the permission of IRS. Also, the approach to the computation can change from year to year; however, to the extent that the underlying facts remain the same, a consistency to the approach from year to year enhances the likelihood that the approach would be deemed reasonable. As is the case with most tax incentives, a thoughtful and thorough analysis will be key in identifying opportunities to maximize the benefit, and comprehensive documentation will be key in sustaining the benefit.
David Freeman is a Managing Director in the Chicago office of WTAS, where he works principally with private and public companies as well as private equity firms. WTAS is one of the largest independent tax advisory firms in the nation, consisting of over 500 personnel located throughout the United States focused exclusively on providing a wide range of tax, valuation, financial advisory and related consulting services.