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Domestic Production Activities Deduction

Tree Farmer Magazine: January/February 2006 - Volume 25 No. 1

NOTE: For the most current analysis of the Domestic Production Activities Deduction click here!

The structure of the U.S. tax system puts U.S. corporations at a competitive disadvantage compared to firms in other countries. Over the years a series of income tax provisions 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 Sec. 199, added by P.L. 108-357).

Before bothering you with the details of new tax provisions I usually wait until the IRS has clarified how they apply to tree farmers, but the law is in effect for 2005 tax returns and temporary regulations have been issued (NPRM REG-105847-05, 2005-7 I.R.B. 498). Thus, the train has left the station and you may want to get on board, but talk to your tax advisor first.
You can turn the page now if your tree farm isn't a business and you don't pay wages. But, if you're open to restructuring your operation, read on. Here's what I think I know so far.

What's the Benefit?
You may qualify for a deduction or adjustment to gross income equal to the lesser of 3 percent of your taxable income, or your so-called qualified production activities income (QPAI). The rate of the deduction increases to 6 percent for the 2007 to 2009 tax years, and 9 percent thereafter. However, the amount of the deduction cannot exceed 50 percent of the W-2 wages you paid to employees or company officers. This deduction also applies to the calculation of the alternative minimum tax.
Definition of taxable income. For a business taxable income is gross receipts minus expenses. Adjusted gross income is used to make the calculation if the taxpayer is an individual.
Definition of qualified production activities income (QPAI). This is the taxpayer's domestic production gross receipts (DPGR), another term we need to discuss, reduced by the amount of (1) the cost of goods sold, and (2) other deductions, expenses and losses, that are directly attributable to the DPGR's.
Definition of W-2 wages paid. These are the wages that must be reported on the Form W-2's employers file with the IRS and give to their employees.

Let's start with a straightforward example.

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. 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 form 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
The challenge is to define domestic production gross receipts DPGR). These are receipts derived from 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. There are several other categories of receipts that qualify, but they don't apply to tree farms.

Application to Timber. Income from the sale of forest products constitute receipts from the sale of tangible personal property. The question is when receipts from timber are included. DPGR's must be from the sale of tangible personal property. Thus, the major criteria is when the owner of timber has sold or otherwise disposed of tangible personal property. To some extent this is determined by state law, however, it appears that the IRS hopes to develop through regulations guidelines that are consistent among all states for this purpose. In all states timber is real property. When severed to produce logs, the 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.

Consider the following series of examples based on the ways in which timber can be disposed of. This set does not include involuntary conversions.

Example 3 - Lump Sum Sale of Timber. The Smiths own and operate a 300 acre tree farm from which they occasionally sell standing timber under lump sum contracts. 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 long-term capital gain on their Form 1040, Schedule D. For purposes of the DPAD 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 produces logs and merchandises them to various mills and brokers. The logs are tangible personal property and as such the log sales receipts of the logger are DPGR.

Example 4 — Logging Services Contract. The Smiths in example 1 learn about the domestic production activities deduction and decide to change their business practice to qualify for the deduction. 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 fee for services received by the logger do not qualify as DPGR for the loggers 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 scale conducted when the logs are delivered to the mills and brokers selected by the logger. The royalty payments to the Browns qualify as DPGR. Thus, the Browns can report the gain from the disposal of the timber as a long-term capital gain under Sec. 631(b) and 1231. They can also claim the DPAD. 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 loggers tax return. It appears that receipts from timber classified as Sec. 1221 property, even if sold under a pay as cut contract, would not qualify under Sec. 199 since the Internal Revenue Code limits DPGR to the actual conduct of a trade or business. Note: My conclusions in this example hinge on the payments for timber qualifying as receipt of royalties.

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 qualify 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 as possible of their gain on the timber 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. Receipts from the sale of the lumber and logs would qualify as DPGR. Note: The disqualification of 631(a) gains is specifically mentioned in the IRS's introduction to the proposed regulations.

I'll keep you posted as we sort through the regulations and discuss their application to timber with the IRS.