Taking Advantage of the Deduction for Domestic Production Activities

The domestic production activities deduction was created to encourage manufacturing and production within the U.S., and it provides a substantial business deduction equal to 9% of the lesser of:


The deduction is further limited to 50% of the W-2 wages of the employer for the tax year allocable to the activities eligible for the deduction.

Domestic Production Activities – Although the definition of “domestic production activity” is a little elusive, it generally does not include retail sales or purely service activities. Among the more common eligible activities are:

• Manufacturing and production activities in whole or in significant part within the U.S.,
• Construction of real property in the U.S., and
• Performance of engineering or architectural services in the U.S. in connection with real property construction projects in the U.S.

The following example, one that was used in a Congressional hearing, does a good job of defining what is and is not a qualified domestic production activity: Suppose you are a baker and in the business of producing donuts. Some of the donuts you sell retail directly to the consumers, and some you sell in bulk to hotels and restaurants. The production costs of the donuts sold at retail do not qualify for the deduction, while the costs associated with the wholesale sales to the hotels and restaurants do.

Example of how the deduction is determined – ABC, Inc. produces widgets in the U.S. that it wholesales to retailers. The company’s revenue from the sale of the widgets is $2 million, with a manufacturing cost of $950,000. ABC, Inc. also has $1 million of income from widget repair services. The total “W-2” wages for the year were $400,000, of which $150,000 is properly allocated to the widget manufacturing costs and the balance used to provide the repair services. The deduction would be determined as follows:


Of course, the deduction on ABC Inc.’s tax return will be limited to the company’s taxable income. This example is rather a simplistic illustration of how the deduction is determined. In actual practice, inventory, cost of goods, determination of qualified production wages, and so on all have rules, procedures and complications of their own. However, the deduction can be very beneficial and well worth the added accounting. In fact, most taxpayers who qualify for the deduction are required to claim it, even if the administrative costs of applying the law and regulations outweigh the benefit of claiming the deduction.

Who Gets the Deduction – This deduction is allowed to all taxpayers, including individuals, C corporations, farming cooperatives, estates, trusts, and their beneficiaries. The deduction is allowed to partners and owners of S corporations (not to partnerships or the S corporations themselves) and may be passed by farming cooperatives to their patrons. And, despite the deduction’s history, it is fully available to taxpayers who do not export.

The section above is only an overview of this deduction. If you have questions related to how the domestic production deduction might apply to your specific circumstances, please give this office a call.

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