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Domestic Production Activities Deduction, otherwise known as DPAD, was enacted as part of the American Jobs Creation Act of 2004 (code section 199). With the purpose of providing a deduction for U.S. businesses, it simultaneously offset the repeal of a tax break for U.S. exporters. This deduction is allowed for both regular tax and alternative minimum tax (AMT) purposes.
Contrary to the history of its predecessor tax provisions, the DPAD is available to taxpayers who do not export. This includes individuals, both C and S corporations, cooperatives, estates, and trusts. Additionally, beneficiaries of an estate or trust and patrons of farming cooperatives can be allocated a share of the DPAD for each entity.
Most simply put – the DPAD allows a deduction of 9% of the total net income from eligible activities (phased in from 3% - 9% over the first five years it was in place). This is the economic equivalent to a 3% reduction in tax rate on eligible activities. For example, a tax rate of 22% on a business for eligible activities in a given year would effectively become 19%. But keep in mind that the deduction for any year cannot exceed the taxpayer's taxable income (or for individuals, cannot exceed adjusted gross income). Further, the DPAD is limited to 50% of the Form W-2 wages paid out to employees in the eligible activities.
Update: Effective for tax years beginning after December 31, 2017, the Section 199 Domestic Production Activities Deduction has been repealed as a result of the 2018 Tax Cuts and Jobs Act. However, there is a new Section 199A Qualified Business Income Deduction effective for tax years beginning after December 31, 2017, that may result in a larger deduction than the former DPAD. Please refer to the December 27, 2017, blog post Tax Reform in a Nutshell for more details on this new deduction.