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The Deduction for Qualified Production Activites

By Peter Jason Riley

The massive tax law passed in 2004, the American Jobs Creation Act , continues to work its way into the lives of many businesses as its provisions become effective and the IRS issues interpretative rules and regulations to govern its details. One of the major new business tax breaks in this category is the generous deductions allowed to domestic manufacturers. For 2005-2006, the deduction (commonly called the "manufacturing" deduction) equals 3 percent of the lesser of qualified production activities income or taxable income. The percentage rises to 6 percent in 2007-2009 and finally to a hefty 9 percent in 2010 and thereafter.

The domestic production activities deduction, as it is formally called in the Internal Revenue Code, is broad reaching and covers considerably more than what is traditionally considered "manufacturing." For example, construction, engineering or architectural services, film production and agricultural production are all entitled to a share of the deduction as well as the manufacture of products.

To assist taxpayers with navigating the complex and still-unfamiliar requirements of this deduction, the IRS recently issued guidance addressing substantive and procedural rules applicable to those who wish to claim the deduction.

The all-important computation. Pursuant to the IRS guidance, qualified production activities income must be determined on an item-by-item basis, rather than on a transactional or product basis. "Qualified production activities income" in turn is equal to your domestic production gross receipts, reduced by the sum of:

  1. the costs of goods sold that are allocable to such receipts;
  2. other deductions, expenses, or losses that are directly allocable to such receipts; and
  3. a proper share of other deductions, expenses, and losses that are not directly allocable to such receipts of another class of income.

You must determine the portion of your total receipts that are domestic production gross receipts. The method used to determine these receipts must be reasonable and accurately identify gross receipts derived from:

  1. any lease, rental, license, sale, exchange or other disposition of qualifying production property which was manufactured, produced, grown or extracted by you in whole or in significant part within the U.S., any qualified film produced by you, or electricity, natural gas or potable water produced by you in the U.S.;
  2. construction performed in the U.S.; or
  3. engineering or architectural services performed in the U.S. for construction projects located in the United States.

The IRS will consider a number of factors in determining whether or not your method of allocating these receipts and nonqualifying receipts is reasonable, including whether the most accurate information available is used, and the time, burden and cost of using other methods.

The guidelines generally provide that gross receipts derived from the performance of services (except for engineering or architectural services) are not qualifying receipts. However, gross receipts from a qualified warranty and a de minimis amount of gross receipts from embedded services for each item of property (in the case of a lease, rental, license, sale, exchange, or other disposition) may be included in domestic production gross receipts.

A safe harbor is provided for taxpayer-employers whose gross receipts are primarily domestic production gross receipts. If less than 5 percent of your gross receipts are from non-qualifying receipts, then you are not required to allocate gross receipts.

The guidelines also clarify the definitions of "gross receipts," "manufactured, produced, grown or extracted," "by the taxpayer," "in whole or significant part," "United States," and "derived from the lease, rental, license, sale, exchange, or other disposition of qualifying production property."

It's all about U.S. jobs. You may recall that the deduction is limited to the lesser of the applicable percentage of qualified gross receipts or 50 percent of the W-2 wages paid by you as an employer during the tax year. Underlying the justification for the manufacturing deduction is not to reward the manufacture of any particular product but rather to keep and increase U.S.-based jobs. Therefore, if your manufacturing process is so mechanized that your labor costs are minimal, you won't be able to claim the full percentage otherwise allowed for the deduction.

"W-2 wages" are defined as the sum of the wages and elective deferrals that must be reported on Forms W-2, Wage and Tax Statement, with respect to your employment of employees during the calendar year ending during your tax year. The new guidelines provide three methods for computing W-2 wages that offer manufacturers in certain industries a welcomed degree of flexibility.

Special rules for partners and S corp shareholders. If the business entity in which the qualified domestic production activity takes place is a partnership or an S corporation, special pass-through rules apply. The deduction is determined at the partner or shareholder level in the case of a partnership or S corporation. Items attributable to the qualifying production activities of the partnership or S corporation pass through to the partner or shareholder according to the economic arrangement of the owners. It is, then, up to each individual partner or shareholder to aggregate items allocable to the pass-through entity's qualified production activities, expenses directly incurred by the partner or shareholder that are allocable to the pass-through entity's qualified production activities, and items allocable to the partner's or shareholder's other qualified production activities.

If you have any questions about how this deduction applies to you, or about the computations under the recently-issued IRS guidance, please contact our office at your convenience.


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