A little known tax deduction, Section 199 could save some convenience stores money—if they know what to look for.
By Mark E. Battersby, Contributing Editor
Can a convenience store convince the Internal Revenue Service (IRS) that they are “manufacturers” or engaged in “qualified production activities?”
Given our complex and often confusing tax rules, it may be possible for some activities that constitute convenience store operations to qualify for a unique tax deduction equal to 9% of their income from some operational activities.
A tax deduction created to make U.S. exports more competitive can include not only manufacturers, but almost every business engaged in “qualified production activities.” The rules are complex, but know that this deduction is being overlooked by a surprising number of convenience store operations and businesses.
Because the Section 199 tax deduction—also referred to as the domestic manufacturing deduction, U.S. production activities deduction and domestic production deduction—was intended to encourage businesses to hire more employees.
Currently, Section 199 allows a deduction equal to 9% of the lesser of (A) the “qualified production activities income” (QPAI) of the business, or (B) the operation’s taxable income for the year. This is a tax break pure and simple and any convenience store operation with QPAI can take a tax deduction of 9% from net income if it qualifies.
QUALIFIED ACTIVITIES
Qualified production activities include manufacturing, producing, growing and extracting interests, tangible personal property, computer software and sound recordings, and the construction and substantial renovation of real property including infrastructure.
Within those broad categories, a range of activities are eligible. Processing of food products for sale at wholesale is an eligible production activity for example, but preparation of food and beverages for retail sales.
Where a business produces a product and sells it in its own retail outlets, the retail sale can qualify as part of the production process. It breaks the chain of qualifying production if within those retail outlets; the business further processes the product immediately prior to sale, especially if the business prepares a food or beverage for consumption.
Which raises the question: When a fast-food restaurant sells a hamburger is it providing a “service” or is it combining inputs to “manufacture” a product?
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 produced by others.
ALWAYS A LOOPHOLE
Many businesses fall under the broad definitions in Section 199. Almost any activity relating to manufacturing, producing, growing, extracting, installing, developing, improving or creating tangible personal property qualifies for the deduction. This includes making tangible property from new or raw material, or by combining or assembling two or more articles.
The so-called “Starbucks Footnote” that was included as part of the Section 199 legislation’s House-Senate Conference Committee report provides an insight. Lawmakers noted that food processing can qualify as a production activity, but doesn’t cover activities carried out at retail establishments.
Lawmakers noted the taxpayer “may own facilities at which the predominant activity is domestic production … and other facilities at which [the taxpayer] engage[s] in the retail sale of the taxpayer’s produced goods and also sell[s] food and beverages.”
As an illustration, Congress cited a taxpayer buying coffee beans and roasting and packaging them at a facility. The taxpayer then sells the roasted coffee through unrelated third-party vendors as well as at its own retail establishments. Thus, according to Congress, the gross receipts from the sale of the roasted coffee beans are qualified domestic production gross receipts.
While roasting and packaging coffee beans obviously qualifies the taxpayer for the manufacturing deduction, keep in mind that the taxpayer also sells brewed coffee and other foods at its retail establishments.
Lawmakers concluded that gross receipts from the sale of brewed coffee and other foods do not qualify as domestic production gross receipts. The taxpayer may allocate part of the gross receipts from the sale of the brewed coffee as qualified domestic production gross receipts to the extent of the value of the roasted coffee beans used to brew the coffee.
WRITE-OFF
Calculating the Domestic Production Activities Deduction can be simple or complex, depending on the nature of the business. The key to figuring the Domestic Production Activities Deduction is to examine “qualified production activities income” (QPAI) and set limitations. In other words, the more complicated the business, the more complicated the math for calculating the Domestic Production Activities Deduction.
The Section 199 deduction is the least of three amounts for 2014 and beyond:
• 9% of Qualified Production Activities Income (“QPAI”) for the taxable year,
• 9% of taxable income for the taxable year, or
• 50% of the qualifying W-2 wages for the taxable year.
ELIGIBILITY
Who is eligible for tax deductions under Section 199? In general, any corporation, partnership, individual or other business entity may claim this deduction provided it is for a qualified production activity. Although Section 199 doesn’t apply to sole proprietors, the tax benefit can be passed through to individuals by entities such as Subchapter S corporations, partnerships and limited liability companies not taxed as corporations.
SAVINGS
Once a convenience store operation or business identifies its qualified production activities, it calculates domestic production gross receipts (DPGR) and allocates them between qualified and nonqualified production activities. Then the business similarly allocates the cost of goods sold.
The resulting qualified production activities income (or taxable income, if lower) is multiplied by the applicable percentage. The resulting deduction is further limited to 50% of the operation’s Form W-2 wages allocable to DPGR.
Safe Harbors: Under a unique “safe harbor” rule a business can take the deduction if at least 20% of their total costs are the result of direct labor and overhead costs from U.S.-based operations. Of course, if any part of manufacturing or production activities are outside the U.S., then businesses must use either the safe harbor rule (at least 20% of total costs are from U.S.-based production activities) or allocate costs using the actual “facts and circumstances” of their business.
Simplified Deduction Method: The simplified deduction method may be used by businesses with average annual gross receipts of $100 million or less or total assets of $10 million or less at the end of the year. Under this method, allocable deductions are calculated by multiplying deductions by the DPGR (domestic production gross receipts) ratio to the total gross receipts of the operation. It differs from the small business simplified overall method in that it may not be used for cost of goods sold.
Small Business Simplified Overall Method: Certain taxpayers may use the small business simplified overall method. Several limits apply for using this method, and taxpayers qualify if:
• Taxpayers with average annual gross receipts of $5 million or less; and
• Certain taxpayers with annual gross receipts of $10 million or less who are eligible to use the cash method of accounting.
Under the simplified overall method, allocable costs are calculated by multiplying the cost of goods sold and other deductions by the ratio of DPGRs to total gross receipts.
This deduction doesn’t apply to income derived from:
• Activities not attributable to the actual conduct of a trade or business;
• The sale of food and beverages prepared at a retail establishment;
• Advertising and product-placement; or
• The lease, rental, license sale, exchange, or other disposition of land.
Every business, whether small or large, that might conceivably be engaged in “manufacturing” or “domestic production activities,” should consider the Section 199 deduction.
Obviously, professional assistance will be necessary to determine eligibility as well as for computing the allowable deduction. However, today’s 9% Section 199, domestic production deduction warrants another look by those who may have passed originally.
