I want to talk a bit about a crazy business tax loophole called the DPAD, or Sec. 199 deduction, that’s available to but that often isn’t used by Washington small businesses.
The 9% Loophole
The loophole in question lets a domestic manufacturing business (and a variety of other domestic businesses as well) whack 9% off the business’s income.
For example, if your business earns $100,000, the deduction means you don’t get taxed on $9,000 of that income. That might save you as much as $3600.
If your business makes $1,000,000, the deduction means you don’t get taxed on $90,000. And that might save you as much as $36,000.
But here’s something that small businesses especially need to know. Your Sec. 199 deduction can’t be larger than 50% of your business’s W-2 wages.
In other words, you need $2 of W-2 wages for each $1 of DPAD you want to claim. To take a $90,000 deduction, for example, you need your business to show at least $180,000 of W-2 wages.
I’m going to talk a bit more about this important-for-small-business issue in a few paragraphs, but let me identify who potentially can use the loophole.
Which Manufacturers Benefit
In a nutshell, the Sec. 199 deduction or DPAD loophole benefits businesses that manufacture, produce, grow or extract property “in whole or in significant part” with the United States. The acronym DPAD actually stands for “domestic production activities deduction.” (See the instructions form used to claim the deduction for a longer list by clicking here.)
So if you’re making stuff in China and then reselling it in the United States, you don’t get the benefits of the loophole. Sorry.
Furthermore, the logic of the loophole is that Congress wants you to be employing Americans. Clearly, this deduction rewards businesses that make stuff and employ people within the US.
And then a last point, you don’t necessarily need a traditional rustbelt-style manufacturing business to qualify for the DPAD loophole.
Not just traditional manufacturing companies, but a lot of other “we make stuff” businesses qualify, too. Of course Boeing qualifies. But software companies like Microsoft and also potentially the kid next door qualify. And so do film companies, oil and gas companies, construction companies, engineering firms, architects, and a handful of other specialty firms, too.
A Final Caveat
Unfortunately, and this is my final point, small businesses sometimes aren’t organized in a way that allows for the deduction.
Remember that a firm needs $2 in wages to get a $1 of deduction. This means that any very small business which would otherwise qualify doesn’t get the deduction if the business doesn’t have employees. Say the firm operates as a one-person sole proprietorship or an LLC partnership with working partners but without W-2 employees.
Fortunately, there’s an easy workaround when the W-2 wages limit kicks in for these types of super-small firms: Even one man proprietorships or two partner businesses can opt to be treated as a regular corporation or subchapter S corporation.
That decision will mean that some of the business’s profit will get treated as W-2 wages. And that W-2 wages treatment will give the business’s owners access to this great loophole.