The American Jobs Creation Act of 2004 provides an income tax deduction for taxpayers involved in domestic production activities. Crops and livestock produced in the U.S. qualify as domestic production activities. The domestic production activities deduction (DPAD) for tax years beginning in 2005 and 2006 is limited to the smallest of:

1. 3% of qualified production activity income (QPAI),

2. 3% of taxable income of a taxable entity or adjusted gross income of an individual taxpayer (computed without the DPAD), or

3. 50% of the FormW-2 wages paid by the taxpayer during the year.

The deduction increases to 6% for tax years beginning in 2007, 2008 and 2009. It further increases to 9% for tax years beginning after 2009. Thus, businesses have the opportu- nity, and an increasing tax-saving incentive, to adapt their business to take advantage of this deduction.

This deduction is computed and is taken as an adjustment to income on Form 1040. Thus, the deduction is for income taxes only and does not reduce earnings from self-employment. The Form 8093 combines the income and expenses for sole proprietorships and pass-through entities with the DPAD from distributions from agricultural or horticultural cooperatives to the taxpayer.

To qualify for the DPAD, a farm operation must have paid Form W-2 wages that are subject to federal income tax withholding requirements. Many farms may find that they can make legitimate wage payments to family members (spouses and children age 18 and older) and qualify for the deduction.

Families with farm losses may also find it difficult to qualify for the deduction, especially for tax years beginning after June 1, 2006 when wages received as an employee are not considered in computing qualified production activity income. Cash rent landowners are receiving payments for the use of real property rather than the production of personal property and are not eligible for the deduction. Share-rent land- owners will generally not qualify for the deduction because of the Form W-2 wage limitation.

Qualified Production Activities Income

Qualified production activities income, commonly referred to as QPAI, is equal to domestic production gross receipts (DPGR) minus the cost of goods sold, other deductions and expenses directly allocable to such receipts, and the share of other deductions and expenses not directly allocable to such receipts. Qualifying activities include cultivating soil, raising livestock, and aquaculture, as well as storage, handling and other processing (other than transportation activities) of agricultural products.

For many farmers, their QPAI will be equal to the sum of net income reported on their Schedule F and net gain from the sale of raised livestock reported on Form 4797. However, there a number of possible income items which may be excep- tions to this, as explained below. Receipts excluded from DPGR for farmers are also discussed. The cost allocation method used may also affect the QPAI and DPAD for the taxpayer.

Domestic Production Gross Receipts

Domestic production gross receipts (DPGR) are generally the receipts from the sale of qualified production property. For cash basis farmers, this would be the receipts from the sales of livestock, produce, grains, and other products raised by the producer. DPGR includes the full sales price of livestock (like feeder livestock) and other products purchased for resale. Gains from the sale of raised draft, breeding, and dairy livestock reported on Form 4797 also qualify as DPGR.

Sales proceeds from livestock purchased for draft, breeding, or dairy purposes would probably not qualify unless the taxpayer had purchased the animals as young stock and had a significant role in raising them. There is a safe harbor established for a significant role if direct labor and overhead expenses are 20% or more of the unadjusted depreciable basis in the qualified production property. Thus if a producer purchased an animal for $1,000 and spent $200 or more in labor and overhead expenses on the further growth and development of the animal, he or she would be generally considered to have a significant role in raising the animal.

Government subsidies and payments not to produce are substitutes for gross receipts and qualify as DPGR. Thus, subsidy payments that are directly linked to production, such as the loan deficiency payments (LDPs) and countercyclical payments, would qualify. Direct payments under the 2002 Farm Bill would be classed as a subsidy. Payments under the Conservation Reserve Program (CRP) are related to past production and are clearly a substitute for gross receipts. Crop and revenue insurance payments received would also be included in DPGR.

Gains from the sale of land, machinery, and equipment are excluded from DPGR. Rent received from land is specifically excluded from DPGR. Custom hire income (e.g., combining, spraying, trucking etc.) reported on Schedule F is also excluded from DPGR. Government cost-sharing conservation payments and stewardship and incentive payments probably do not qualify. Because a custom livestock feeder does not have the benefits and burdens of ownership of the animals, the receipts would not qualify as DPGR.

If less than 5% of total gross receipts from items that are not DPGR, a safe harbor provision allows a taxpayer to treat all gross receipts as DPGR. For example, a farmer has non-DPGR income of $5,000 from planting the neighbor’s no-till soybeans. As long as qualifying DPGR exceeds $95,000, the farmer can include the $5,000 as part of his or her DPGR, and no allocation of costs is necessary. If qualifying DPGR is $95,000 or less, then $5,000 custom hire income must be kept separate and expenses allocated between DPGR and non-DPGR activities, as discussed later. In computing the 5-percent limit, gross receipts from the sale of assets used in a trade or business, such as machinery and equipment, livestock, and other business assets, are not reduced by the adjusted basis of business property. However, for assets held for investment purposes, only the net gain is included.

To determine QPAI, the farmer’s DPGR are reduced by the appropriate costs. If items purchased for resale (e.g., feeder livestock) are included in DPGR, the cost of these items is deducted. Directly allocable and indirectly allocable deductions, expenses or losses related to the items included in DPGR are deducted. For a farmer whose entire crop sales receipts qualify as DPGR, or who qualifies for the 5% safe harbor, QPAI would be computed by subtracting the allowable expenses and QPAI would be equal to net farm income on Schedule F. If the farmer also had gains from the sale of raised livestock on Form 4797, QPAI would be the sum of net income from Schedule F and the gain from livestock reported on Form 4797.

Allocating Costs

Farmers can use the Simplified Overall Deduction Method to apportion the cost of goods sold (items purchased for resale) and other deductions between DPGR and other receipts based on relative gross receipts. For example, Ima Producer has $85,000 of crop sales and $15,000 of custom work income for total Schedule F receipts of $100,000. Ima’s DPGR would be $85,000, 85% of total receipts. If Ima’s total Schedule F expenses were $60,000, 85% of the Schedule F deductions, or $51,000 could be allocated to qualified production activities. Ima’s QPAI would be $34,000, (her $85,000 DPGR minus the $51,000 allocated cost).

Computation of the Deduction

The domestic production activities deduction for 2005 and 2006 is computed as the smallest of:

1. 3% of QPAI,

2. 3% of adjusted gross income (AGI), or

3. 50% of Form W-2 wages paid during the year.

For an individual taxpayer, AGI would include other taxable income and deductible losses. For purposes of the 3% limitation, AGI is computed without the DPAD deduction. Note that the 3% of QPAI and AGI limits increase to 6% in 2007 and to 9% in 2010.

Example: Joe Farmer operates as a sole proprietor and has gross farm receipts of $250,000 from the sale of crops and livestock. All of Joe’s receipts qualify as DPGR and he has Schedule F expenses of $200,000, including $10,000 of Form W-2 wages for part-time help. Joe has net farm income of $50,000 on Schedule F and his QPAI is also $50,000. Assuming Joe’s AGI is $50,000 or more, his 2006 domestic production deduction would be the lesser of $1,500 (3% of $50,000 QPAI) or $5,000 (50% of $10,000 W-2 wages). For 2007, Joe’s deduction would double to $3,000.

For some farm situations, the domestic production activities deduction can be limited by Form W-2 wages. For example, assume Joe’s wife, Mary, provides the part-time help on the farm and is not paid. Income and expenses, other than hired labor, are the same as in Example 3. Joe’s QPAI would be $60,000 and Form W-2 wages are $0. Joe would not qualify for the domestic production deduction.

Joe could reasonably compensate Mary for her work on the farm and qualify for DPAD. If Joe paid Mary $8,000, his QPAI would be $52,000 and he would qualify for a $1,560 DPAD. Mary’s wages would be subject to social security taxes, but Joe’s earnings for self-employment tax would be reduced by the amount of the wages paid. In 2007, the domestic activities production deduction increases to 6% of QPAI or $3,120 which is still less than Form W-2 limitation. Some farms will need to make adjustments in W-2 wages to qualify for the maximum DPAD.

Wages paid in commodities, wages paid to a child (under the age of 18) of the proprietor (or a child of all of the partners), and compensation paid in nontaxable fringe benefits are not counted in determining the Form W-2 wage limitation. For tax years beginning after May 17, 2006 only those wages allocable to DPGR activities are qualified wages for the 50-percent of wages limitation.

Some Planning Opportunities

The DPAD for individuals is taken on Form 1040, and this provides some potential planning opportunities for only the 2005 and 2006 tax years.

Instead of being limited to receipts of a business, the methods of allocating costs discussed above can be used for the gross receipts of taxpayer on Form 1040. This may allow some taxpayers to qualify for a DPAD, or increase the amount that can be claimed as a DPAD in 2005 and 2006. Being able to claim a DPAD or a larger DPAD deduction may make filing an amended 2005 return worthwhile for some individuals.

Considering other receipts on Form 1040 might allow a farm to avoid a loss for DPAD purposes in 2005 or 2006. For example, including wages from an off-farm job could offset a Schedule F loss. Considering capital gains from the sale of farm land in determining the AGI might also create or increase DPAD. The 50-percent of W-2 wages paid and 3-percent of AGI limitations do still apply in determining the DPAD.

For tax years beginning after June 1, 2006, compensation received by an individual for services performed as an off-farm employee is not considered gross receipts for purposes of computing QPAI.

 

Pass-Through Entities

S corporations, partnerships and other pass-through entities do not pay income tax, and income and expenses flow through to the share- holders or partners. Limitations are applied at the shareholder, partner or similar level for both QPAI and Form W-2 wage allocation. An individual who has been allocated QPAI from a pass-through entity is also treated as having been allocated Form W-2 wages paid from that entity in an amount equal to the lesser of:

1. The owner’s applicable share of such wages paid, or

2. Two times 3% of the entity’s QPAI allocated to the owner for tax years beginning in 2005 and 2006.

For tax years beginning after May 17, 2006 the QPAI limit on the wages that are allocated to the owner of an entity is repealed. Thus, QPIA for the entity wage limit will not need to be calculated for 2007 and later years for calendar year taxpayers.

Summary

The new domestic production activities deduction is intended to stimulate employment in the U.S., but does not require taxpayers to increase the amount of labor hired. Many farmers will be eligible for this new deduction, although some may want to make wage payments to their spouse or their children 18 years of age or older to have qualified Form W-2 wages. Cash rent landowners are not eligible for the deduction and share-rent land- owners will generally not qualify for the deduction because of the Form W-2 wage limitation.

The deduction starts out at the smallest of:

1. 3% of qualified production activity income,

2. 3% of adjusted gross income, or

3. 50% of Form W-2 wages paid.

However, the limits of the percentage of income increase to 6% in 2007 and to 9% for 2010 and later years. Taxpayers will want to maintain their eligibility for the maximum deduction possible.