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Domestic Production Deductions

| July 25, 2012

A little known income tax deduction is available for businesses involved in domestic manufacturing activities. Basically, the deduction is for 9% of net income from qualified production activities subject to some limitations.This deduction is most often seen in the oil and gas exploration industry, but is also available for farms and ranches. The deduction is limited to 50% of wages paid, so farms not paying wages subject to payroll taxes will not qualify. However, if you operate a small farm or ranch, report a profit for the year and issue a W-2 to one or more employees, then this deduction could be of significant benefit to you. One way to qualify for the deduction, and also to reduce your self-employment tax burden, would be to pay reasonable wages to your children if they work on the farm.As an example, a small farmer with net income of $20,000 and wages paid of $5,000 would receive a Domestic Production Deduction of $1,800. In a 25% tax bracket, this saves the farmer $450 in income tax. This deduction is not available for self-employment tax purposes.Unfortunately, we see a number of self-prepared returns claiming this deduction when it does not apply. This seems to happen most often on returns prepared using Turbo Tax and requires an immediate amended return to remove the deduction prior to IRS rejection and the addition of penalties due to understatement of income.As you would expect, there are numerous complications concerning this deduction that require attention in arriving at the precise amount. In addition, this is a deduction that has been designated by the IRS as an area of particular attention, so the return upon which it is claimed should be in good order.