Many taxpayers in the restaurant industry may not be aware that they may qualify for a significant tax deduction available under section 199.
Fully phased in for tax years beginning in 2010 and thereafter, section 199 provides a permanent tax deduction (the “domestic production activities deduction” or “DPAD”) to taxpayers deriving income from qualified production activities occurring in the United States.
The DPAD is computed as the lesser of the following three amounts:
- Nine percent of the taxpayer’s qualified production activities income (“QPAI”)
- Nine percent of taxable income for the year
- 50 percent of the taxpayer’s W-2 wages related to the qualifying production activities
QPAI is principally net taxable income derived from qualifying activities, equal to the excess of the taxpayer’s domestic production gross receipts (“DPGR”) over the sum of the cost of goods sold (“CGS”) and other expenses, losses or deductions that are properly allocable to such receipts.
While many taxpayers tend to think the DPAD only applies to traditional manufacturers, the benefit may be available to a number of other industries as well.
Section 199 broadly defines manufacturing to include activities such as making tangible personal property from new or raw material: processing, manipulating, refining or changing the form of an article; or combining or assembling two or more articles.
This definition can include the preparation of food and beverages, as such activities typically involve combining various articles to make a distinct finished product.
However, section 199 specifically excludes gross receipts of the taxpayer that are derived from the sale of food or beverages prepared by the taxpayer at a retail establishment from DPGR.
A retail establishment is defined as tangible property at which retail sales are made that the taxpayer owns, leases, occupies or otherwise uses to sell food or beverages to the public.
Furthermore, a facility that prepares food and beverages for take-out service or delivery is considered a retail establishment for purposes of section 199.
Accordingly, a restaurant that prepares food onsite from start to finish or a caterer may not qualify for the benefit.
Restaurants may still benefit from the section 199 deduction to the extent any portion of the food preparation occurs at an off-site facility. For example, many chain restaurants use a central kitchen to prepare food products and ship them to its various locations for final preparation and sale to the customer.
For these restaurants, the gross receipts attributable to the food preparation occurring off-site can be treated as DPGR, with the remaining gross receipts attributable to the on-site preparation of the meal treated as non-DPGR.
Off-site preparation of beverages also benefits under the same principle.
In a 2004 conference report discussing the various applications of section 199, Congress noted that although a beverage prepared at a retail establishment, such as a cup of coffee, would not qualify under section 199 in its entirety, a component of the beverage may be treated as qualifying property.
For instance, if a portion of the coffee was prepared off-site, such as roasting the coffee beans, then that specific portion could qualify for the deduction.
A taxpayer’s off-site facility is not a retail establishment if the taxpayer only uses it to prepare food or beverages for wholesale.
Additionally, a retail establishment does not include the bonded premises of a distilled spirits plant or wine cellar or the premises of a brewery (other than a tavern on the brewery premises).
Thus, any gross receipts derived from products produced at such locations and sold to customers (whether the sales occur on-site or off-site) can qualify as DPGR.
Qualifying activities for purposes of the DPAD are wide-ranging and applicable to taxpayers in numerous industries, including the restaurant and beverage sector.
As the rules under section 199 can be quite complex, it is prudent for taxpayers to work with their tax advisers to obtain a thorough understanding of the facts at hand in order to determine whether they may qualify for the incentive.
Note also that taxpayers may amend prior year returns (to the extent such years remain open under the statute of limitations) for any unclaimed section 199 deductions, further increasing their cash tax savings and reducing their effective tax rates.