40.25 Figuring the Deduction

To figure the domestic production activities deduction, start with domestic production gross receipts. If there are gross receipts from domestic and foreign production, you must make an allocation of gross receipts based on any reasonable method to determine qualified production activities income (QPAI).

Caution

Wage Limitation

For S corporations, only wages allocable to a shareholder (and not the shareholder’s personal wages) are taken into account for the limitation on the domestic production activities deduction. For both partnerships and S corporations, wages for the W-2 limit include only amounts paid to determine qualified production activity income.

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Reduce this amount by all of the following (based on your books and records if possible, or on any reasonable method):

• The cost of goods sold that is allocable to domestic gross receipts
• Other deductions, expenses, and losses that are directly allocable to domestic gross receipts
• An appropriate share of other deductions, expenses and losses that are not directly allocable to domestic gross receipts or another class of income

Limitations.

The deduction for 9% of qualified production activities income cannot exceed adjusted gross income for sole proprietors and owners of partnerships, limited liability companies, or S corporations (a taxable income limitation applies for C corporations).

The deduction also cannot exceed 50% of W-2 wages paid during the year to employees. W-2 wages include both taxable compensation and elective deferrals (e.g., employee contributions to 401(k) plans). It appears that all wages of a business, not just those related to domestic production, are taken into account for purposes of the 50%-of-W-2-wages limitation. There are three methods provided for determining W-2 income. One method looks to the lesser of the amounts in Box 1 or Box 5 of Form W-2, while the other methods are more complex; see the instructions to Form 8903.

Partnerships and S corporations.

The deduction is applied at the owner, not the entity, level. This means that the business must allocate on the owner’s Schedule K-1 gross receipts, cost of goods sold, and related expenses from qualified production activities to the owners, who then claim the deduction on their personal returns.