Qualified Production Activities Income (QPAI)

Four tips to easy computation.

July 31, 2007
by Jan Skelton, JD/LLM

Reader Note: This article has been excerpted from Jan Skelton’s course manual Section 199: Benefiting From the Production Activities Deduction.

Section 199 provides a deduction in the amount of a percentage of the lesser of Qualified Production Activities Income (QPAI) or taxable Income. QPAI also is referred to as “qualified income.”

The deduction is phased in as ETI benefits phase out. For tax years beginning in 2005 and 2006, the deduction is equal to three percent of a taxpayer’s income from domestic production activities. The percentage increases to six percent for years beginning in 2007 through 2009, and reaches nine percent for tax years beginning in 2010 and thereafter.

Amount of the Deduction
Year Percentage of QPAI or Taxable Income
2005 and 2006 3 percent
2007, 2008 and 2009 6 percent
2010 and thereafter 9 percent

When fully implemented, the nine percent deduction will be equivalent to a rate reduction for corporate taxpayers in the maximum 35 percent marginal tax bracket of 3.15 percentage points on their income from domestic production activities.


During 2006, ABC Company, a U.S. corporation that is not part of an Expanded Affiliated Group (or EAG), engages in activities that generate QPAI of $1,000 and reports taxable income of $1,500 before taking into account any allowable Section 199 deduction.

Before consideration of any limitations on the Section 199 deduction, ABC Company determines that its Section 199 deduction will be $30 (3 percent x (lesser of QPAI of $1,000 or taxable income of $1,500)).

The amount of the Section 199 deduction is limited to 50 percent of W-2 wages.

Basics of QPAI Computation

The following discussion provides a basic overview of the computation of the new deduction. In later chapters, each component of the computation will be explored in greater detail.

Step 1: Identifying Qualifying Activities

The first step of the calculation involves the identification of revenue earned from qualifying activities. This is essentially gross receipts that are derived from the:

  • Lease, rental, license, sale, exchange, or other disposition of:
  • Any tangible personal property,
  • Software,
  • Sound recording,
  • Film, or
  • Utilities

that were produced in significant part within the United States,

  • Construction services performed in the United States, or
  • Architectural or engineering services performed in the United States for United States construction projects.
  • Observation

    The activities substantially overlap with the activities that benefited from the FSC and ETI regimes. For FSC and ETI purposes, however, the produced property had to be exported, and the architectural and engineering services had to relate to a non-U.S. construction project, whereas, under Section 199, such services must relate to a U.S. construction project. Thus, it is important to keep in mind that many taxpayers that did not qualify for FSC and ETI benefits (e.g., because they did not export) will be eligible for Section 199 benefits.

The May 2006 Final Regulations clarify that any ETI exclusion does not reduce taxable income for Section 199 taxable income limitation purposes, even though the excluded amount is taken into account in determining QPAI.

Once the taxpayer has identified the qualifying activities, it must allocate its gross receipts between qualifying and non-qualifying activities. The receipts allocated to qualifying activities are the Domestic Production Gross Receipts (DPGR) that are eligible for the Section 199 deduction. Thus, Step 1 involves the identification of activities and allocation of receipts. For most companies, this step will represent the majority of the work of computing the Section 199 deduction.

Step 2: Allocation of Cost of Goods Sold
In this step, a taxpayer must determine the portion of its cost of goods sold (COGS) that is allocable to the qualifying revenue. The COGS refers to the tax cost of goods sold rather than the book cost of goods sold. This means that in determining COGS, tax concepts such as the uniform capitalization rules must be taken into account.


Some commentators expressed concern that the October 2005 Proposed Regulations were not clear regarding whether the COGS attributable to DPGR was determined using the methods of determining COGS used for book or tax purposes. The preamble to the Final Regulations explains that the Proposed Regulations clearly state that it is the method of determining COGS used for tax purposes, and the Final Regulations contain the same rule as the Proposed Regulations. Thus, whether a taxpayer is applying the Proposed Regulations or Final Regulations, the taxpayer must use its tax method of determining COGS.

Step 3: Allocation of Below-the-Line Expenses
In the last step in determining QPAI, the taxpayer’s qualifying gross income (that is, revenue minus COGS) is further reduced by allocable below-the-line period expenses. Specifically, the expenses that are directly allocable (such as sales and marketing expenses) as well as expenses that are apportionable (such as general and administrative expenses) are required to be allocated between qualifying and non-qualifying receipts.


The calculation essentially requires building a separate statement of profits and losses (P&L) for domestic production activities. This often will require data that companies typically do not accumulate.

Many companies viewing themselves as “traditional manufacturers” may be under the impression that QPAI will equal taxable income and, thus, the Section 199 deduction will simply be taxable income times a percentage. However, guidance under Section 199 provides a number of rules that refine the computation of QPAI. Accordingly, many traditional manufacturers will find that their QPAI does not equal taxable income and may be required to build a separate P&L for their domestic production activities.

Step 4: Limitations
At this point, the taxpayer has calculated QPAI. The Section 199 deduction (or QPAI deduction) generally is equal to QPAI times the applicable percentage, which is three percent for tax years beginning in 2005 and 2006 (increasing to 6% for tax years beginning in 2007). There are, however, two important limitations: One for taxable income and another for W-2 wages.

The taxpayer first must compare its QPAI to taxable income and multiply the lesser of the two by the applicable percentage. The deduction then is equal to the lesser of (1) that amount or (2) 50 percent of the taxpayer’s W-2 wages for the year.

Taxable Income Limitation

The Section 199 deduction actually is equal to the applicable percentage times the lesser of a taxpayer’s QPAI or its taxable income. The taxable income limitation will affect companies that are profitable as to their qualified production activities, but that are unprofitable as to their non-qualifying activities.


Warm Company, a U.S. corporation that is not part of an Expanded Affiliated Group (EAG), manufactures scarves (qualified production property) and acquires mittens for resale (non-qualifying property). During 2010, Warm Company generates $2,000 of taxable income and QPAI from the sale of the scarves. Sales from mittens result in a taxable loss of $250. Warm Company’s Section 199 deduction will be $157.50 (9 percent x (lesser of QPAI of $2,000 or taxable income of $1,750)).

The taxable income limitation also will affect a taxpayer with a net operating loss (NOL) deduction. If a taxpayer has an NOL and also has no alternative minimum taxable income, the taxpayer will have no Section 199 deduction for that year due to the taxable income limitation.

W-2 Wage Cap

A second limitation limits the amount of the deduction to 50 percent of a taxpayer’s W-2 wages paid during the calendar year that ends within the tax year.

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Copyright © 2007 by The American Institute of Certified Public Accountants, Inc.

Jan Skelton, J.D., LL.M, is a principal in the Federal Tax Practice of Deloitte Tax LLP and is the author and video moderator of the AICPA continuing professional education course: Section 199: Benefiting From the Production Activities Deduction.