Tuesday, October 4, 2016
The Domestic Activities Production Deduction (DPAD) is a very complex provision and is codified at I.R.C. §199. Except for domestic oil related production activities the deduction is equal to nine percent of the lesser of the qualified production activities income (QPAI) of the taxpayer for the year; or the taxable income of the taxpayer (but in the case of an individual, this limitation is applied to AGI). The deduction can’t exceed 50 percent of the wages expense of the taxpayer. As a result, the taxpayer income limitation excludes taxpayers with current year net operating losses or with NOL carryovers that eliminate current year taxable income.
The deduction is allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings), however it is not allowed in computing self-employment income. It is also available to pass-through entities such as S corporations, partnerships, and estates or trusts, but the deduction is applied at the shareholder, partner or beneficiary level. S corporations and partnerships with qualified activities are required to separately pass through to each owner the share of QPAI and the corresponding Form W-2 wage amount, or corresponding detail information, to allow computation of the overall deduction at the Form 1040 level.
The patrons of an agricultural cooperative may not claim a DPAD with respect to income generated from sales to cooperatives or patronage dividend income. The cooperative may claim the deduction; the cooperative may choose to allocate the DPAD to the patrons. If so allocated, the patrons may claim the DPAD. DPAD allocated from a cooperative is not subject to the 50 percent of wages limitation.
The FICA wage expense is used for determining the 50 percent limitation. Thus, for farmers, neither ag wages paid in-kind nor wages paid to children under age 18 count toward the 50 percent limit. Thus, farm proprietors and partnerships that don’t issue W-2s cannot claim the DPAD (except that which is allocated from a cooperative).
QPAI is derived from domestic production gross receipts (DPGR) which includes gross receipts from various sources that are derived from the active conduct of a taxpayer’s trade or business. For example, gross receipts from growing and producing tangible property such as grain and livestock would count as DPGR. However, support/service activities including gross receipts from seed and/or chemical sale endeavors would not qualify as DPGR because manufacturing or growing is not involved. Similarly, gross receipts from services provided to others such as trucking, combining, spraying, plowing, etc., also would not qualify.
Other activities in the agricultural context that implicate DPGR include the following:
- Crop Insurance/FSA Subsidies. The proceeds from business interruption insurance, governmental subsidies, and governmental payments not to produce are treated as gross receipts that qualify for the production deduction. Accordingly, crop insurance and FSA subsidies qualify as production receipts.
- Sales of Productive Livestock. The sale of raised livestock as well as purchased livestock, further grown and held for resale, qualifies for the production deduction based on the “growing” definition of DPGR.
- Raised livestock. The regulations are silent on whether raised livestock that is placed into a breeding herd, and subsequently culled in later years after productive use as a breeding or dairy animal, qualifies as DPGR. However, based on the definition of DPGR arising from the sale of personal property grown by the taxpayer, and that there is no distinction in the DPGR rules requiring that the asset be held as inventory versus held for productive use, it would appear that proceeds from raised breeding and dairy stock would qualify as DPGR.
- Purchased breeding and dairy livestock. Purchased breeding and dairy stock that has been acquired as a mature animal, and held by the taxpayer for productive use, depreciated, and subsequently sold may not meet the “manufactured, produced, grown or extracted” (MPGE) definition. Further, the regulations specify that only one taxpayer can claim the deduction with respect to an item of tangible personalty.
- Hedging Transactions. Gains or losses from hedges qualify and count as DPGR if the hedge involves the purchase of supplies used in the taxpayer’s business, the hedge involves sales of stock in trade of the taxpayer or other property of a kind that would be included in inventory if on hand at the close of the taxable year, or property held for sale to customers in the ordinary course of the trade or business. If the hedge involves the purchase of stock in trade, inventory property or property held for sale, gains and losses are taken into account in determining the cost of goods sold.
- Storage and handling. Storage, handling, or other processing activities (other than transportation activities) within the U.S. related to the sale, exchange or other disposition of agricultural products qualify as DPGR, provided the products are consumed in connection with, or incorporated into the MPGE of qualified production property, whether or not by the taxpayer.
- Mineral interests. Gross receipts from operating mineral interests count as DPGR. Receipts from mineral royalties and net profits interests (other than those derived from operating mineral interests) are treated as returns on passive interests in mineral properties, with the owner making no expenditure for operation or development, and are not treated as DPGR.
Change in the Benefits and Burdens Test
Under the initial version of Treas. Reg. §1.199-3(f)(1), the taxpayer must bear the benefits and burdens of ownership and be the exclusive owner of the underlying property such that the taxpayer is the only taxpayer that could claim the DPAD. In contractual settings, several factors are important in making this determination – whether legal title has passed, how the parties treat the transaction, whether rights of possession are vested in the buyer, which party controls the production process, and whether the taxpayer actively and extensively participated in the management and operations of the activity, among other factors.
However, new temporary regulations became effective on August 27, 2015. Under these new temporary regulations, it’s now a question of which party performed the activity under the contract. The party that performs the activity gets the DPAD. This new interpretation does seem to run counter to the statute, and it will likely have an adverse impact on companies that outsource production domestically. That means that contracts will have to be renegotiated in some situations. There are numerous contract situations in agriculture that will be impacted by the new regulation, including livestock feeding arrangements. Feeding arrangements may qualify either way, however, if the custom feeder is responsible for providing the feed. In this situation, the feed is converted into a different product by the custom feeder, which is the manufacturing process that will qualify in the income of the custom feeder for the DPAD computation.
The DPAD is a complex tangled web of various rules. While it can provide a nice tax deduction for businesses that qualify, it would be simpler to eliminate it and reduce the tax rate applicable to corporations, sole proprietorships and businesses conducted in other forms.