Section 199 repeal effective date clarified by IRS
The domestic production activities deduction (DPAD) under section 199 of the Internal Revenue Code has been an incentive for production activities in the United States since 2005. It is computed as the lesser of qualified production activities income (QPAI) or taxable income and is limited to 50 percent of Form W-2 wages attributable to domestic production. Although an S corporation or partnership may engage in domestic production activities, section 199(d)(1)(A) provides that the deduction is computed at the shareholder or partner level. The process for claiming the deduction is that the S corporation or partnership performs the computation of QPAI for its domestic production activities and reports the components to compute QPAI (i.e., income, gain, loss, deductions, cost of sales and gross receipts) to the shareholder or partner in a statement attached to Form K-1. Then the shareholder or partner takes those items into account and computes the DPAD on Form 8903 at the shareholder or partner level.
The DPAD has been repealed by the Tax Cuts and Jobs Act of 2017 (TCJA), so that no deduction is allowed for tax years beginning after 2017. A frequently asked question that has arisen is, “Can an S corporation with a fiscal year that begins in 2017 pass through QPAI information to an individual shareholder, and can that shareholder deduct the DPAD on his or her 2018 calendar year tax return?”
Since the DPAD is computed at the shareholder or partner level, it would seem that the only logical conclusion is that the deduction is not allowed to be taken on a 2018 calendar year individual return because the tax year began after 2017. However, reflecting an unusually taxpayer-friendly position by the IRS, we were surprised to learn that the recently issued draft instructions to the draft 2018 Form 1040 provides the following instruction for Schedule 1 – Additional Income and Adjustments to Income:
Schedule 1, Line 36. Add lines 23 through 35. The domestic production activities deduction (DPAD), for various trade or business activities conducted in the U.S., has been repealed for tax years beginning in 2018 or later. However, partners etc. of fiscal-year pass-through entities that have DPAD generated in a tax year beginning on or before Dec. 31, 2017 should enter their share of the entity’s DPAD on the dotted line next to line 36, identify it as “DPAD,” and include that amount on line 36.
As this instruction appears contrary to the statutory language in section 199, RSM investigated further and learned through IRS officials that their reasoning for allowing the DPAD in 2018 from a fiscal year pass-through entity was to balance out the transition rule from the initial enactment of section 199. Those rules provided that shareholders and partners were not allowed a deduction on their 2005 tax return for pass-through income from a fiscal year entity whose tax year began in 2004. We further learned that because the DPAD is now repealed, the IRS is not committing resources to issuing any further guidance in the form of Regulations, Rulings, Notices or other formal guidance.