The Code Sec. 199 Deduction
Code Sec. 199—enacted to help offset the repeal of a tax break for U.S.
exporters—provides a deduction for many U.S. businesses that's allowed for both regular
tax and alternative minimum tax (AMT) purposes. The deduction doesn't have an official
name. It's been called, among other things, “the U.S. production activities
deduction,” the “domestic production activities deduction” (DPAD), and the
“domestic manufacturing deduction” (DMD). For simplicity's sake, we're calling it the
Code Sec. 199 deduction.
The Code Sec. 199 deduction is allowed to all taxpayers—individuals, C corporations,
farming cooperatives, estates, trusts, and their beneficiaries. The deduction is allowed
to partners and the owners of S corporations (not to partnerships or the S corporations
themselves), and may be passed through by farming cooperatives to their patrons. And,
despite the deduction's history, it's fully available to taxpayers who don't export.
The Code Sec. 199 deduction equals a percentage of the net income from eligible
activities—6% for 2007-2009, 9% after 2009. However, the amount of the deduction for any
tax year may not exceed the taxpayer's taxable income or, in the case of individuals, the
taxpayer's adjusted gross income. When fully phased in, the deduction is designed to be
economically equivalent to a 3% reduction in the tax rate on eligible activities conducted
in the U.S. This means that if the tax rate on the business income from an eligible
activity would normally be, say, 36%, the Code Sec. 199 deduction would reduce it (when
fully phased in) to 33%. The reduction is smaller before 2010.
In addition, the amount of the Code Sec. 199 deduction can't exceed 50% of the “W-2
wages” (wages subject to income tax withholding, and certain deferred compensation) paid
to employees for the year that are allocable to the activities eligible for the deduction.
This means that businesses operated as sole proprietorships or partnerships with no
employees aren't eligible for the deduction. (To take advantage of the deduction, such
businesses can incorporate and pay W-2 wages to their principals.)
As noted above, the Code Sec. 199 deduction equals a percentage of the net income from
eligible activities. Among the more common eligible activities are:
the manufacture, production, or growth of tangible personal property, in
whole or in significant part within the U.S.;
the construction of real property in the U.S.; and
the performance of engineering or architectural services in the U.S. in
connection with real property construction projects in the U.S.
Purely sales activities aren't eligible for the deduction, nor are purely
service activities, except for construction, engineering, and architectural services.
Eligible manufacturing and production activities. A broad range of
activities qualifies as eligible manufacturing or production activities. The taxpayer's
raw materials and finished products may be brand new, or may be made out of scrap,
salvage, or junk material. Manufacturing or producing components used by another party in
later manufacturing or production activities are eligible activities, as are manufacturing
or producing finished items from components manufactured or produced by others.
The processing and preparation of food products for sale at wholesale is an eligible
“production” activity, but the preparation of food and beverages for sale at retail is
Generally, the taxpayer must own the property that it's “manufacturing or producing.”
The manufacture or production of property under contract for someone else who owns the
property isn't an eligible activity. (There are exceptions for some federal government
contractors—and this requirement doesn't apply to construction, architecture, or
Construction. Construction activities are eligible for the Code Sec. 199
deduction, but only if the construction is of real property performed in the U.S. The real
property may consist of residential or commercial buildings, permanent structures (like
docks and wharves), permanent land improvements (like swimming pools and parking lots),
oil and gas wells, platforms, and pipelines, and infrastructure (like roads, sewers,
sidewalks, and power lines). Real property doesn't include machinery unless it's a
“structural component”—for an example, an elevator. Examples of businesses
conducting eligible construction activities are residential remodelers, commercial and
institutional building construction contractors, foundation, structure, and building
exterior contractors, structural steel and precast concrete contractors, electrical,
plumbing, heating, and air-conditioning contractors.
Eligible construction activities don't include tangential services such as hauling trash
and debris, and delivering materials, even if the tangential services are essential for
Construction includes “substantial renovation,” but not decoration (or redecoration).
Engineering and architecture. Engineering and architectural services are
eligible for the Code Sec. 199 deduction, but only if they're performed in the U.S. for
real property construction projects in the U.S. Eligible engineering services include
consultation, investigation, evaluation, planning, design, and supervision of
construction. Eligible architectural services include consultation, planning, aesthetic
and structural design, and supervision of construction.
There's a lot more to the Code Sec. 199 deduction—for example, determining whether your
particular business activities are eligible for the deduction, how to compute the net
income from activities that are eligible, and how to determine the amount of the deduction
when you've got income from both eligible and ineligible activities. The statutory rules
are complicated, and IRS has issued voluminous—and equally complicated—guidance on