Domestic Production Activities Deduction

General Overview of the Domestic Production Activities Deduction (1)and Analysis of When Receipts Derived In Whole or In Part From Timber Qualify as Domestic Production Gross Receipts.

WARNING: The following is a preliminary analysis by Professor Hoover. It has not been reviewed and should not be taken to represent the law.

The structure of the U.S. tax system is considered by analysts to put U.S. corporations at a competitive disadvantage compared to those in other taxing jurisdictions. Over the years a series of income tax provisions (2)were added and then revoked to level the playing field. These changes were required as part of the various rounds of international trade negotiations. The American Jobs Creation Act of 2004 replaces the extraterritorial income exclusion (ETI) with the Domestic Production Activities Deduction (DPAD), Internal Revenue Code Section 199. This new deduction is easily defined, but the determination of the various components is not. This summary provides only a brief summary of Sec. 199. The primary purpose of this summary is to start a discussion of how Sec. 199 applies to timber transactions.

General Structure of the Deduction

Taxpayers may qualify for a deduction or adjustment to gross income equal to the lesser of 3 percent (3)of their taxable income, or their qualified production activities income (QPAI). The deduction cannot exceed 50 percent of the taxpayer's W-2 wages paid. For tax years beginning after May 17, 2006 wages attributable to domestic production gross receipts must be used to determine this limit, not all W-2 wages. (4)

Definition of taxable income. For a business taxable income for purposes of Sec. 199 is domestic production gross receipts minus associated expenses. Adjusted gross income is used to make the calculation if the taxpayer is an individual. For many taxpayers the need to separate in accounting records revenue and expenses associated with qualifying domestic production activities from those not qualifying, additional accounting costs may be incurred.

Definition of qualified production activities income (QPAI). This is the taxpayer's domestic production gross receipts (DPGR), reduced by the amount of (1) the cost of goods sold, (2) other deductions, expenses and losses, that are directly attributable to the DPGR's.

Definition of W-2 wages paid. These are wages and benefits reported on Form W-2, Wages and Tax Statement issued for employees and officers of a corporate taxpayer under common law rules defining employment. As noted above, for tax years beginning after May 17, 2006 wages attributable to domestic production gross receipts must be used to determine this limit, not all W-2 wages.

Example 1. Mr. Brown, operating as a sole proprietor, owns a 620 acre tree farm from which he occasionally sells standing timber. He also has a mini-mill used to produce lumber from his timber and from logs purchased from nearby landowners. He sells the lumber to a concentration yard. He also retails air dry lumber to local craftsmen. In 2005 his gross receipts from the sale of lumber totaled $120,000. His expenses totaled $95,000 of which $24,000 was Form W-2 wages for part-time labor. All wages were incurred for the production of logs and lumber. His net income is $25,000, which is his qualified production activities income. His income from other sources totals $32,000, making his adjusted gross income $57,000 ($25,000 plus $32,000). His domestic production activities deduction is $750, 3 percent of $25,000.

Example 2. Assume the same facts as example 1, except that Mr. Brown did almost all of the work himself. He paid only $1,000 in W-2 wages. Fifty percent of these wages is $500, which is less than the $750 domestic production activities deduction. In this case, his DPAD is $500.

Domestic Production Gross Receipts (DPGR)

Domestic production gross receipts are those derived from one or more of the following:

  1. The lease, rental, license, sale exchange or other disposition of qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States. Qualifying production property is tangible personal property, computer software, and sound recordings.
  2. Any lease, rental, license, sale exchange or other disposition of any qualified film produced by the taxpayer.
  3. Any lease, rental license, sale exchange or disposition of electricity, natural gas, or potable water produced by the taxpayer within the United States.
  4. Construction performed in the United States, including activities directly related to the erection or substantial renovation or residential and commercial buildings and infrastructure.
  5. Engineering or architectural services performed in the United States for construction in the United States.

Application to Timber.

Income from the sale of forest products is included in the first category, i.e. receipts from the sale of tangible personal property. The receipts from the sale of products processed from timber, such as logs, lumber, pulpwood, veneer, etc. which are clearly tangible personal property, also quality as DPGR. The question is when, if ever, receipts from the disposal of standing timber are included.

DPGR's must be from the lease, rental, license, sale, exchange or other disposition of tangible personal property. DPGR does not include revenue from the sale, exchange, or other disposition of land. (5) Generally the Internal Revenue Code and the courts look to applicable state law to determine the classification of property. The IRS apparently hopes to develop through regulations guidelines that are consistent among all states for purposes of Sec. 199 (6). This may be possible in the case of section 631(a) since the same party is involved on both sides of the accounting transaction. Thus, the IRS's proposed position on section 631(a) is likely to stand up under review, i.e. any section 1231 gain under a section 631(a) election does not qualify as DPGR's under section 199.

The IRS has not to my knowledge addressed the much more complex issue of when, if ever, section 1231 gains realized from section 631(b) disposals would qualify as DPGR's under section 199. Although, it can generally be stated that timber is real property when sold with the land, the multitude of contractual arrangements used to sever interests in standing timber, and differences in state real property and contract law, will make it difficult for the IRS to generalize. Clearly when severed to produce logs, timber is converted to tangible personal property. The question then is whether real or personal property has been disposed of under the various forms of contracts and methods of disposal. In most cases this is determined by when title to the timber transfers from the buyer to seller, but in some states transfer of title and of equitable ownership are not simultaneous.

In addition to the multitude of possible contractual terms and variations in state law, the issue of when an economic interest is retained may again come into play (7). There is a continuum of possible contractual relationships between an owner of timber in fee and a second party. At one end a grantor severs all interest in the timber while retaining the land, creating a separate estate in the timber. At the other end of the continuum the fee holder contracts for logging services and sells the logs produced by the contractor. The issue that will have to be addressed by the IRS is where along this continuum a taxpayer's interest in timber is converted under the applicable property and contract law from real to tangible personal property.

The following series of examples presents the likely application of section 199 to the basic ways in which timber can be disposed of. However, involuntary conversions are not considered. Example 5, granting a contract right to cut, is the most ambiguous. An example for a lump-sum disposal under section 1221 is not presented because section 199 only applies to the actual conduct of a trade or business (8).

Example 3 - Lump Sum Sale of Timber. The Smiths own and operate a 300 acre tree farm from which they sell standing timber under lump sum contracts, so-called timber deeds. Under the terms of the contract the buyer takes title to the standing timber under the provisions Uniform Commercial Code as adopted by their state. They report the gain on these disposals as Sec. 1231 long-term capital gain. For purposes of IRC Sec. 199 the Browns have disposed of real property. As such the gain on the timber does not qualify as DPGR. The buyer of the timber is a logger who is the owner of the timber and produces logs and merchandises them to various mills and brokers. The logs are tangible personal property and as such revenue from the log sales receipts is DPGR.

Example 4 – Logging Services Contract. The Browns in example 1 learn about the domestic production activities deduction and decide to change their business practices to qualify for the deduction. Instead of selling timber on the stump they contract with a logger to produce logs for them. The contract is for logging services with the Browns retaining all rights to the logs until they are delivered to buyers. The Browns merchandise the logs themselves. They pay the logger a fixed fee per unit volume of logs produced. Since the Browns are selling logs, tangible personal property, the receipts from log sales qualify as DPGR. The fees received by the logger for services rendered do not qualify as domestic production gross receipts for purposes of the logger's tax return.

Example 5 – Contract Right to Cut. The Browns in example 1 dispose of their timber by granting the logger a contract right to cut timber on the logger's own account. They are paid a per unit royalty based on the log scales conducted when the logs are delivered to the mills and brokers selected by the logger. Under some circumstances the royalty payments to the Browns may qualify as DPGR in some states(9). If they do the Browns would report the gain from the disposal of the timber as a long-term capital gain under Sec. 631(b) and 1231. Since the logger has an economic interest in the timber under the contract right to cut agreement, receipts from the sale of the logs also qualifies as DPGR for purposes of the logger's tax return.

Example 6 – Vertically Integrated Business. The Browns in example 1 decided to expand their business by doing their own logging and processing the grade logs through their own mini-mill and selling green and air dry lumber. They sell their low grade logs to a nearby pallet and firewood producer. Receipts from the sale of lumber and logs qualifies as DPGR.

Example 7 - Elect to Treat Cutting as a Sale. The Browns believe that they can get top dollar from their timber only by merchandising it themselves. Therefore, they contract with a logger to produce logs under a logging services contract. They instruct the logger to sort logs at the log landing according to their criteria. They identify buyers for each batch and contract with truckers to deliver them to the appropriate buyer. The Brown's believe that it's in their best interest to report as much of their gain on the timber as possible as capital gains. Therefore, they elect to treat the cutting as a sale under Sec 631(a) and report the gain as a Sec.1231 transaction. The long-term capital gain under 631(a) does not qualify as DPGR since it is for the disposal of real property (10). Receipts from the sale of the lumber and logs would qualify as DPGR.

1 Code Sec. 199, added by P.L. 108-357, American Jobs Creation Act of 2004. The IRS provided preliminary advice on 1/19/05 in Notice 2005-14, I.R.B. 2005-7. Proposed Regs. were issued 10/21/05. Final Regs. were issued 6/16/06 in T.D. 9263, IRB 2006-25 effective 6/1/06, however, see Reg. 1.199-8(i) concerning application of proposed or final regulations.

2 These were domestic international sales corporations (DISC), foreign sales corporations (FSC) and the extraterritorial income exclusion (ETI).

3 3% for the 2005 and 2006 tax years, 6% for 2007 to 2009 tax years, and 9% thereafter

4 Tax Increase Prevention and Reconcilation Act of 2005, P.L. 109-222, Act Sec. 514(c)

5 Code Sec. 199(c)(4)(B)(iii), added by P.L. 109-135

6 This conclusion is based on the IRS's response to a comment on Notice 2005-14 on Section 102(c) of the American Jobs Creation Act of 2004 that allows a taxpayer to revoke an election under section 631(a). In rejecting the commentators suggestion that section 199 should apply to any section 1231 gain resulting from an election under section 631(a), the IRS noted that timber is real property, not tangible personal property.

7 Recall that under section 631(b) it is no longer necessary to retain an economic interest in timber disposed of to qualify it as a section 1231 gain or loss.

8 IRC Section 199(d)(5).

9 To qualify the royalty payments would have to be considered to be from the lease or rental of tangible personal property, section 199(c)(4)(A)(i)(I) and 199(c)(5)(A). This may be possible under the applicable property and contract law in some states.

10 Proposed Regulations, NPRM REG-105847-05, Supplementary Information, Summary of Comments on Notice 2005-14 (2005-7 I.R.B. 498), Revocation of Election Under Section 631(a): "Section 102(c) of the Act allows a taxpayer to revoke an election under section 631(a) to treat the cutting of timber as a sale or exchange. Any section 631(a) election for a taxable year ending on or before October 22, 2004, may be revoked under section 102(c) of the Act for any taxable year ending after that date. In addition, any election under section 631(a) for a taxable year ending on or before October 22, 2004 (and any revocation of the election under section 102(c) of the Act), is disregarded for purposes of determining whether the taxpayer is eligible to make a subsequent election under section 631(a). A revocation under section 102(c) of the Act will remain in effect until the first taxable year for which the taxpayer makes a new election under section 631(a).

Commentators suggested that, if a taxpayer makes an election under section 631(a), section 199 should apply to any resulting section 1231 gain. A taxpayer that makes an election under section 631(a) reports the difference between the fair market value of the timber cut and its actual cost as section 1231 gain. The proposed regulations do not adopt the suggestion because timber is real property, not tangible personal property, and the cutting of timber does not qualify under section 199(c)(4)(A)(i)(I). (emphasis added) In the case of a taxpayer who does not make an election under section 631(a), or a taxpayer who revokes an election under section 631(a) pursuant to section 102(c) of the Act, the cutting and sawing of timber produces lumber which qualifies as tangible personal property. The gross receipts derived by a taxpayer from the sale of lumber it produces qualify as DPGR (assuming all the other requirements of section 199(c) are met)."