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What is a Domestic Production Activities Deduction?

By John Lister
Updated May 16, 2024
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The domestic production activities deduction is a tax deduction in the United States. It allows companies involved in certain production activities to take a deduction from their income for tax purposes, thus lowering their tax liability. The deduction is designed to promote domestic production.

The level of the domestic production activities deduction has increased since its introduction. In the first tax year it took effect, 2004-5, the level was 3%. This increased to 6% from the 2006-7 tax year, and 9% from 2009-10.

The major qualifying activity for the domestic production activities deduction is US manufacturing. This includes sales, leases and licenses of any items manufactured in the United States. The deduction also includes construction services in the United States and engineering and architectural services that relate to a US construction project. The deduction also includes sales, leases and licenses of US-produced movies, and software development. Although the production of utilities like gas and electricity comes under the deduction, the supply and transmission do not.

While the Internal Revenue Service may be forced to make a judgment on some gray areas, there are two types of activities that are specifically excluded from the domestic production activities deduction. The first is purely cosmetic construction services such as painting. The second is the sale of food and drinks that are prepared at a retail establishment.

Calculating the deduction can be a complicated process, with restrictions on both the proportion of a company's income that qualifies, and the total amount of the deduction. If all of a company's manufacturing and production activities are conducted in the United States, all the related income qualifies. If any of the activities are conducted outside the United States, then the company must show that at least 20% of its total costs come directly from labor and overhead spending in the United States. If this is not the case, the company can only claim the deduction on the income that specifically results from US costs.

There are also limits on the deduction amount itself. In a sole proprietor business or partnership, the deduction cannot exceed the gross income of the owner or owners. In any business with employees, the deduction cannot exceed 50% of the total payments to employees, as stated on the W-2 return.

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