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New Rules Clarify, Modify the Domestic Production Deduction

The Domestic Production Deduction (DPD) was passed as part of the American Jobs Creation Act of 2004 and became effective for years beginning on or after Jan. 1, 2005. Congress mandated that the Treasury Department provide guidelines within 90 days after the bill's passage, even though congressional members themselves had not yet read the provisions.

In January 2005, the Treasury Department met this deadline by releasing Notice 2005-14, despite its advice during the bill's debate that many provisions were unworkable, undefined and would be extremely complex for taxpayers to follow and tough for the IRS to audit. The Treasury Department issued proposed regulations later in 2005, which for the most part, followed many workings of the earlier notice.

Many rules and definitions provided by the Treasury Department were based on its interpretation of the law with little, if any, guidance from Congress. The Treasury actually performed an admirable job in providing rules in such a short time frame, especially since many terms were not previously defined under the Internal Revenue Code.

However, many practitioners questioned whether the Treasury Department had the legislative authority to issue many of the rules and administrative convenience shortcuts provided in Notice 2005-14 and Proposed Regulations.

GO Zone Act clarifies, amends the DPD

Shortly after the proposed regulations were issued, Congress passed the Gulf Opportunity Zone (GO Zone) Act of 2005 (the Act), primarily to provide relief to victims of Hurricanes Katrina and Rita. The Act provided several clarifications and changes to the DPD, many of which were retroactive to the start of that regulation.

The GO Zone Act: 

• Codified a requirement that wages used in the "wage" limitation for the DPD must be filed on Form W-2 to the Social Security Administration within 60 days after the extended due date of Form W-2. Thus, if the wages are not reported, the taxpayer has no "wages" to claim.
• Stipulated that domestic production deduction gross receipts (DPDGR) do not include gross receipts with respect to land
• Clarified that, with respect to construction, engineering or architectural services related to the DPD, the taxpayer must be in the business of providing construction, engineering or architectural services, although that does not have to be the taxpayer's primary business (i.e., one-time services will generally not qualify)
• Made it clear that the DPD is calculated at the individual level (or that of the ultimate owner), not at the flow-through level. Each ultimate owner must consider his respective share of items from the flow-through entity.
• Stipulated that for purposes of calculating the DPD for alternative minimum tax (AMT) purposes, the additions or subtractions of Sections 56 through 59 are not considered. Basically, all AMT adjustments do not change the DPD as determined for regular tax. The only difference is that the taxable income limitation is based on alternative minimum taxable income or alternative minimum adjusted gross income for individuals.

TIPRA creates more rule changes

Shortly before the DPD final regulations were issued, Congress again passed some rule changes. The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) is effective for tax years beginning after May 17, 2006 (first effective for calendar year 2007 taxpayers).

TIPRA will require a more stringent definition of allowable wages for use in the wage limitation under the DPD. Such wages are required to be incurred with respect to a DPD activity. Prior to this change, the wage limitation included all wages incurred in a business activity. However, TIPRA also removes the limitation on wages to taxpayers from flow-through entities. The old law provided allowable wages from a flow-through entity could not exceed twice the qualified production activity income.

The Treasury Department, after reviewing comments, complaints and suggestions to the proposed regulations, adopted several administrative relief provisions. One of the more significant was the allowance of the simplified deduction method for businesses with average annual gross receipts under $100 million, rather than $25 million.

The prior rules required complex cost allocation methods for taxpayers with more than $25 million in prior average revenues. The new rules allow expenses other than the costs of good sold to be allocated proportionally between domestic production gross receipts (DPGR) and non-DPGR revenue.

An extremely beneficial change for certain construction contractors is allowing many of their material costs to be included as DPGR. The final regulations reversed the Treasury Department's prior stance in requiring contractors to have manufactured the materials used in the construction process for such receipts to be counted as DPGR.

Example: A plumber has been hired by the general contractor to provide and install certain plumbing fixtures in a new building project. Under the prior regulations, if the plumber did not manufacture the plumbing fixtures, the receipts allocated to the plumbing fixtures did not qualify as DPGR, even though the receipts allocated to his services would. Under the final regulations, if the fixtures provided by the plumber become part of the structure constructed, receipts allocated to the fixtures and services will qualify as DPGR.

Taxpayers are required to use the final regulations for tax periods beginning on or after June 1, 2006. Earlier application is allowed. However, if any part of the final regulations is used, such as the simplified deduction method for businesses with less than $100 million, but more than $25 million in average annual gross receipts, all of the final regulations must also be used.

Questions about the DPD?
Contact Mike Calahan at 312/980-2996.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.