Domestic Production Activities Deduction Chapter 7 pp. 213-243 2016 National Income Tax Workbook™

Domestic Production p. 213 Activities Deduction Terminology Computing the Deduction Limitations on the Deduction Amount Reporting the Deduction on Form 8903 Pass-Through Entities Agricultural & Horticultural Cooperatives Specific Industries

DPAD p. 214 Domestic Production Activities Deduction Tax years after 12/31/2004 Increasing rate – top at 9% since 2010 DPAD = smallest of 9% taxable income from QPAI 9% taxable income without DPAD 50% of W-2 wages attributable to DPGR Allowed for both regular and AMT tax See Acronyms listed – p. 214

QPAI pp. 214-215 Qualified Production Activities Income QPAI = Domestic Production Gross Receipts (DPGR) less: Items directly allocable to DPGR Cost of goods sold Deductions, expenses, losses Ratable portion of items not directly allocable to any class of income

DPGR p. 215 Domestic Production Gross Receipts DPGR = gross receipts from lease, rental, license, sale, exchange, other disposition of Qualifying production property (QPP) manufactured, grown or extracted (MPGE) by TP, in whole or significant part, in the U.S. Film production in certain circumstances Electricity, natural gas, or potable water produced by the TP in the U.S.

DPGR p. 215 Domestic Production Gross Receipts Includes receipts from: If construction T or B: Construction or substantial renovation of real property in U.S. If engineering or architectural T or B: services performed in U.S. relating to construction of real property Self-constructed property used by taxpayer Business interruption insurance proceeds & payments not to produce (if DPGR substitute)

DPGR pp. 215-216 Domestic Production Gross Receipts Excludes receipts from lease, license, or rental for use by related person Embedded Services Generally, services do not qualify as DPGR If services part of regular product price & not sold without product, some services in DPGR Example 7.1 AC delivery fee in product price Example 7.2 AC delivery fee separately stated

DPGR p. 216 Domestic Production Gross Receipts De minimis exceptions If embedded services < 5% of gross receipts, can include in DPGR N/A if service amount separately stated If non-DPGR receipts < 5% of total gross receipts, can include in DPG

QPP p. 216 Qualified Production Property Tangible personal property (TPP) Other than land, buildings, computer software, sound recordings, qualified films, electricity, natural gas, or potable water Computer software Sound recordings

MPGE p. 216 Manufactured, Produced, Grown, Extracted Manufacturing, producing, growing, extracting, installing, developing, improving, creating QPP Making QPP from scrap or new materials or by combining 2 or more articles Cultivating soil, raising livestock, fishing, mining Installing QPP is in another activity with the QPP Storage, handling or other processing activities connected with certain agricultural products

pp. 216-217 MPGE Does not include Transportation Packaging, repackaging, labeling, or minor assembly of QPP QPP installation if no other MPGE for the QPP Example 7.3 – More than just repackaging Example 7.4 – Service not MPGE Example 7.5 – Assembly process = MPGE

p. 217 IRS Guidance on MPGE LB&I on retail activities not = MPGE: Cutting blank keys to customer specs Mixing base paint & paint coloring agent Applying cake decoration if not baked where sold Applying gas to ag products to affect ripening Storing ag products to extend shelf life Maintaining plants and seedlings

pp. 217-218 Installation Activities Qualifies as MPGE if: TP manufactured, produced, grew, or extracted the QPP and During installation, TP had benefits & burdens of QPP ownership or is treated as meeting ownership rules of government contracts Example 7.6 Install of purchased parts Example 7.7 Install of Manufactured parts Prop Regs – If QPP MPGE, install is MPGE

p. 218 MPGE by the Taxpayer Business with ownership benefits & burdens during MPGE activity gets DPAD Example 7.8 Fast Car contracts with Bob to build race car Fast Car owns car at all times → gets DPAD Example 7.9 Printer produces ads using ADVO specs but with materials it purchased – DPAD → printer

pp. 218-219 MPGE by the Taxpayer Government contracts MPGE treated as taxpayer’s activity even if title required to be transferred prior to completion MPGE in whole or significant part w/in U.S. 50 states, D.C., U.S. territorial waters and seabeds and subsoils of any waters adjacent to U.S. territorial waters over which U.S. has exclusive exploration/exploitation rights Puerto Rico if U.S. taxed & before 1/1/2017

p. 219 “In Whole or in Significant Part…” Substantial in nature test – factors of: Relative value added Relative cost Nature of the activity Nature of the property Example 7.10 – Figure 7.3 Assembles purchased parts into an auto Substantial in nature = in significant part met

pp. 219-220 “In Whole or in Significant Part…” Safe harbor test TP’s direct labor & overhead costs for MPGE of QPP in U.S. ≥ 20% of QPP’s COGS or No COGS, TP’s direct labor & overhead total ≥ 20% of QPP unadjusted depreciable basis Example 7.11 Foreign parts $75, US labor $25 (25% of total) Example 7.12 Ex. 7.10 with labor of $3,000 Foreign parts $10,250, US labor 23% of total

p. 220 Computing the Deduction DPAD = 9% x lesser of QPAI or taxable income QPAI = DPGR less COGS, expenses losses allocable to DPGR COGS include: Costs allocated to inventory under § 263A Costs allocated to inventory under general inventory valuation rules – includes LIFO Basis of noninventory if sales $ in DPGR

pp. 220-221 Computing QPAI - COGS DPGR & non-DPGR? - must allocate Reasonable method consistently applied Small Business Simplified Overall Method DPGR COGS = COGS x (DPGR/Total GR) Average annual gross rec ≤ $5M for prior 3 yrs Farmer not required to use accrual Average annual gross rec ≤ 10M & cash o.k. Example 7.13 – Figure 7.4

p. 221 Computing QPAI - COGS Example 7.13 – Figure 7.4 Builds custom pianos + tuning, repair services Average GR prior 3 years of $5,000,000 Small business method for COGS $2,290,000 x (3.500K/3.880K) = $2,065,722 QPAI = $ 1,434,278 (3,500,000 – 2,065,722) Specific identification method QPAI = $1,400,000 (3,500,000 – 2,100,000)

pp. 221-222 Computing QPAI – Other Costs Other deductions/costs allocable to DPGR I.R.C. § 861 method More accurate but complex - costs may exceed benefit of using Small business simplified method (SBSD) or Allocated based on DPGR/Total GR Simplified deduction method

p. 222 Computing QPAI – Other Costs Simplified deduction method If average annual GR ≤ $100M or total assets end of current year ≤ $10M Extends small business method to other deductions allocation for those $5M to $100M Must use chosen method for all deductions May switch methods year by year May use statistical sampling for allocations

pp. 222-223 Computing QPAI - Other Losses § 165 allocable to DPGR if property is QPP Example 7.14 Casualty – factory – ($50,000) If TP built it: Allocable to DPGR If TP purchased it: not allocable to DPGR NOL (DPAD not in NOL carryover/back) NOL not included in QPAI computation NOL part of DPAD taxable income limitation Example 7.15 and 7.16 Effect of NOL

pp. 223-224 Rules for Expanded Affiliated Group Expanded Affiliated Group (EAG) = 1 corp Apply § 1504 using > 50% in lieu of ≥ 80% Aggregate all taxable income/loss, QPAI and W-2 wages, remove GR from related entities Membership in EAG determined daily Member part year, has two DPAD amounts

pp. 224-225 Wage Limitation DPAD may not > 50% W-2 wages properly allocable to qualifying production activity Example 7.17 – Creating Wages for DPAD $80,000 net – No wages DPAD: $80,000 x 9% limited to -0- Hires wife – salary $15,000 DPAD: $65,000 x 9% or $5,850 (< $7,500) Balance with FICA & additional Medicare cost

p. 225 Wage Limitation Wages from flow-through with a qualifying production activity flow to owner – may make Schedule C or F DPAD allowable Example 7.18 Schedule F net of $150,000, no employees 10% interest in PS with qualifying activity $15,000 income, $30,000 wages share DPAD: $14,850 (165K x 9%) Limit: $15,000

p. 225 Taxable Income Limitation Deduction limited to 9% of the lesser of: Qualified Production Activities Income (QPAI) or Entity taxable income without the DPAD Individuals: limitation = AGI after applying §§ 86, 135, 137, 219, 221, 222, 469 AMT: Allowable for AMTI but not in AMTNOL Individual: Same DPAD as for regular tax Corp: 9% x lesser of QPAI (reg tax) or AMTI

pp. 226-227 Reporting DPAD on Form 8903 Joint return – combine items for Form 8903 Example 7.19 Schedule C: Figure 7.5 LLC: $3,000 QPAI and $1,000 wages share 1099-PATR, box 6: $850 share of DPAD AGI $65,000 Figure 7.6, page 227, Form 8903

pp. 228-229 Pass-Through Entities DPAD computed at partner or s corp SH level using allocated items from the entity If basis, at-risk or passive limitations apply only proportionate share of each DPAD item used In year items allowed, use in DPAD comp Combine DPAD items from the entity with those of qualifying activities on owner’s return DPAD does not reduce basis in PS or S corp

p. 229 QPAI Determined @ Entity Level Some S corps or PSs may determine QPAI Allocate QPAI and W-2 wages to K-1s SH/PN cannot recalculate using another cost allocation method Entities eligible to compute QPAI § 861 partnership Eligible widely held pass-through entity Eligible small pass-through entity

p. 229 QPAI Determined @ Entity Level § 861 partnership ≥ 100 PNs each day, ≥ 70% qualifying PNs Not manager, < 5% interest, no material part. Eligible widely held pass-through entity S or PS, average GR ≤ $100M in 3 preceding and total assets ≤ $10M end of current Has DPGR, COGS & deductions ≤ $10M Owners every day: individuals, estates, QSST No one owns > 10% (prof/cap int., shares)

p. 229 QPAI Determined @ Entity Level Eligible small pass-through entity PS or S corp qualified for small business simplified overall method Has DPGR & total costs of ≤ $5,000,000 If PS, does not have ineligible PN or an EAG PS as a PN

p. 230 W-2 Wages & QPAI - Entity Level Rev. Proc 2007-34 provides rules Must account for separately and nonseparately stated items Must include income items the inclusion of which is normally determined at PN/SH level Must subtract expense items which the expense or capitalization is determined at PN/SH level Must disregard any limitation on deductions applied at PN/SH level

p. 230 W-2 Wages & QPAI - Entity Level Must account for expenditures for certain tax preferences w/optional write-off without regard to any PN/SH election Must disregard any expenditure that the PN/SH could elect as deduction or credit Must compute and account for any depletion under § 613A, without regard to any PN/SH level limitations

p. 230 W-2 Wages & QPAI - Entity Level Must take into account increase/decrease in basis of PS assets under § 743(b) Must exclude any entity items allocated by an eligible § 861 PS to a PN that is not a qualifying PN QPAI will be < zero if entity’s DPGR is not > entity’s items deducted for QPAI

p. 230 Entity Level – Cost Allocations Eligible § 861 PS must use § 861 method Eligible widely-held pass-through entity must use simplified deduction method Eligible small pass-through entity must use the small business method

pp. 230-231 Entity Level – Cost Allocations Example 7.20 Small Business Method $2,000 gross receipts ($1,000 of DPGR) $900 COGS (includes $400 W-2 wages) $800 in other deductions DPGR exp = $850 [(900+800) x 1,000/2,000)] QPAI = $150 ($1,000 - $850), $75 to each PN PN: DPAD = $75 x 9% or $6.75 (Wage limit = $100)

p. 231 Entity Level – Cost Allocations Example 7.21 Simplified Deduction Method 2 PNs: 50/50 but wages 80/20, other 20/80 $8,000 gross receipts ($6,000 of DPGR) $4,000 COGS ($3,500 allocable to DPGR) $3,000 other deductions ($2,000 marketing wages, $1,000 other expenses) Eligibility for Simp Ded Meth at PN level Cindy has $1,000 other GR, $200 wage exp.

p. 231 Example 7.21 Partner Calculation Partnership Items (50% but 80% wages, 20% other) $1,250 DPGR gross income ($3,000-$1,750) $750 non-DPGR gross income ($1,000-$250) $1,800 deductions (wages $1,600 + $200) Cindy’s allocation of other items to DPGR (3,000/5000) x ($1,800 + 200) = $1,200 QPAI = 50 ($1,250 - $1,200), DPAD = $4.50 Wage limit: $540 50% x [60% x (1600+200)]

p. 231 Entity Safe Harbor – W-2 Wages Small Business Method Safe Harbor PS or S corp using small business method % wages allocable to DPGR = DPGR/Total GR Wage Expense Safe Harbor PS or S corp using § 861 method or simplified deduction method % wages allocable to DPGR = wages in QPAI/all wages for the year

pp. 232-233 Entity Allocating QPAI & Wages Partnership In same proportion as gross income or Allocate in proportion to profits interests Schedule K-1, Line 13 – Figure 7.7 S corp – in proportion to shareholder ownership Schedule K-1, Line 12 – Figure 7.8 W-2 wages for DPAD allocated in same manner as allocated to PNs and SHs for the year

p. 233 Agricultural & Horticultural Coops Can claim DPAD if MPGE agricultural or horticultural products If Coop marketing treated as having MPGE in US from QPP if patrons MPGE the QPP Nonexempt Sub T coops can exclude eligible distributions to patrons as patronage dividends or per-unit retain allocations Includes per-unit retain paid in money (PURPIM)

p. 234 Agricultural & Horticultural Coops Pass all/portion of DPAD through to patrons On Form 1099-PATR – patron claims Patron S corp or PS – separately stated item No wage limitation on passed thru DPAD Qualified products include fertilizer, diesel fuel, and other supplies used that are MPGE Example 7.22 Markets patrons’ corn: coop receipts = DPGR

p. 234 Agricultural & Horticultural Coops Example 7.23 Markets patrons’ corn GR $1,500,000, Wages $130,000 Pays patrons $370,000 = per-unit retain allocations paid in money on 1099-PATR Coop’s QPAI: $1,370,000 (1.5M-130K) May pass thru DPAD if qualified payment made to patron

pp. 234-235 Agricultural & Horticultural Coops Coop dividend paid deduction for patronage dividend is reduced by passed-thru DPAD Coop is allowed to claim passed-thru DPAD to avoid “taxable income” that was passed on If passed-thru DPAD later adjusted in audit, recapture at COOP level Example 7.24 $60,000 DPAD to patrons $1M taxable income, $1M patronage div. Coop: $1M - $940,000 - $60,000 = -0-

p. 235 Agricultural & Horticultural Coops To extent payments to patrons treated as PURPIM, not deducted for QPAI Must tell patrons amount of PURPIM Patrons cannot use PURPIM as DPGR Patron will need allocations for non-DPGR PURPIM in Box 3, Form 1099-PATR

p. 235 Computer Software Income from lease, rental, license, sale, exchange in US qualifies for DPAD Computer software – any program, routine, sequence of coding TP designs to make computer perform desired function Includes video game and rights to use software Does not include any TPP (diskette etc)

pp. 235-236 Computer Software Example 7.25 Software for video game, in U.S. Reproduces and sells on a compact disc Sale of both computer software and TPP Sales of both = DPGR as MPGE in U.S. Example 7.26 Software for video game, not U.S. Blue (not in US) licenses to Red (in U.S.) to manufacture and distribute Red must allocate – only sale of disc = DPGR

p. 236 Computer Software – Use Online Providing software for customer’s direct use while on internet is DPGR if The taxpayer or an unrelated person regularly leases, sells, or licenses basically the same in tangible medium or by Internet download Example 7.27 Payroll Software Provides access to customers on line for a fee Competitor sells substantially same on disk Gross receipts from online is DPGR

p. 236 Computer Software – Use Online Example 7.28 Inventory Control Software Provides access to customers on line for a fee No competitor sales of similar on disk Gross receipts from online is not DPGR All software games deemed substantially same Free download with fee for use, not DPGR R&E expenses for computer software & sound recordings included for substantial in nature & safe harbor tests (p. 219)

p. 237 Farming Qualifying production: producing, growing, cultivating soil, raising livestock, fishing, mining, storage, handling, or other processing activities in the US related to sale, exchange or other disposition of agricultural products (not transport) Must have ownership benefits & burdens while the producing or growing activity occurs Example 7.29

p. 237 Farming Example 7.29 $500,000 sale of raise grain $50,000 USDA subsidy (part for no crop) $40,000 insurance for hail damage to crops $10,000 custom combining services 1, 2 and 3 qualify as DPGR but not 4 As $10,000 < 5% of total → all treated as DPGR under de minimis rule (some exceptions apply)

p. 237 Construction of Real Property in US DPGR: proceeds from sale, exchange or other disposition of real property constructed by TP Real property: Buildings, inherently permanent structures, land improvements, oil & gas wells, infrastructure Construction: to erect or substantially renovate the property (increase value, prolong life, adapt to new/different use) Admin support services part of construction

pp. 237-238 Construction of Real Property in US Grading, demolition, clearing, excavating, painting, landscaping, hauling trash, delivering materials = construction only if connected with qualifying construction activity Construction T or B on a regular/ongoing basis Derives GR from unrelated by selling or exchanging constructed real within 60 months of completion date Can have DPAD without ownership of property

p. 238 Construction of Real Property in US Example 7.30 Substantial Renovation Rebecca owns building. – no DPGR if sold Steel hired as general contractor – has DPGR Air Repair hired for AC install – has DPGR

pp. 238-240 Construction of Real Property in US Example 7.31 DPAD and AMT Figure 7.9 – interest income < 5%, include Figure 7.10 – Form 8903 (p. 239) DPAD = $13,545 for regular tax AMTI DPAD: lesser of QPAI or AMTI x 9% 150,500 (QPAI lesser) x 9% or $13,545 50% of wages - $175,000 Rental of real property not eligible for DPAD

p. 241 Engineering/ Architectural Services Gross receipts = DPGR if services Relate to real property Are performed in the US and Are for construction projects in US Must be in the Tor B on a regular/ongoing basis NAICS code of 541330 (eng), 541310 (arch)

pp. 240-241 Food or Beverage Sales Retail establishment sales no DPGR Food and beverage prepared, sold, and served Take-out and delivery sales Wholesale food sales = DPGR Food & beverage held for sale by purchases Food manufacturer/processing yields DPGR Example 7.32 Coffee shop + Production GR from sale of beans roasted = DPGR

p. 241 Electricity, Natural Gas, & Potable H20 Lease, rental, license, sale, exchange = DPGR GR from production = DPGR GR from transmission and distributions NOT Natural gas: all activities in extracting and processing it to pipeline quality = production Potable water: acquisition, collection, storage of untreated, transportation to treatment facility, & treatment (but not storage after or delivery to customer)

pp. 241-242 Oil and Gas Industry Extraction process and sale of product = DPGR Activities related to drilling & generating IDC NAICS 213111 – drilling O&G wells NAICS 213112 – support – includes field services performed on contract/fee basis Oil-related activity DPAD reduced by 3% of least of: oil-related QPAI, QPAI or taxable income Oil-related QPAI = QPAI from production, refining, processing, transportation, distribution

p. 242 Oil and Gas Industry After 12/31/15, independent refiners allocate only 25% of transportation costs to QPAI Example 7.33 DPGR $400,000 Oil $300,000 Costs $100,000 Oil $75,000 ($50,000 trans) Pre 2016: DPAD = $20,250 300,000 x 9% less 3% x (300,000-75,000) Post 2015: DPAD = $22,500 337,500 x 9% less 3% x (300,000-25,000-12,500)

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