Recently issued guidance, including final Regulations issued in 2006, help clarify some of the issues related to the calculation of the deduction The 2004 act repealed the Foreign Sales Corporation-Extraterritorial Income (FSC-ETI) regime and implemented a new domestic production activities deduction.
Section 199 was the Act’s most significant provision for U.S. manufacturing companies. It contained a new domestic production activities deduction that partially replaces the FSC-ETI regime. The phased-in deduction is generally equal to:
l Three percent of the taxpayer’s “qualified production activities income (QPAI) ” for tax years beginning in 2005 and 2006
l Six percent of such income for tax years beginning in 2007-2009
l Nine percent of such income for tax years beginning in 2010 and thereafter.
The deduction is limited to 50 percent of annual W-2 wages allocable to the domestic manufacturing activities. For corporate taxpayers that are members of certain affiliated groups, the deduction is calculated by treating all members as one taxpayer and then allocating the deduction in proportion to each member’s QPAI share. The deduction is allowable for calculating alternative minimum taxable income (including adjusted current earnings), and special rules apply to partnership, S corporation and farm cooperative income.
U.S.-based manufacturers are eligible if their domestic production gross receipts are derived from any lease, rental, license, sale, exchange or other disposition of qualifying production property that is manufactured, produced, grown or extracted in whole or in significant part within the United States. Qualifying production property includes tangible personal property as well as U.S. construction, domestic film and sound recording, engineering and architectural, computer software and railroad roadbed expenditures.
A qualifying reduction would work this way: Assuming a 34 percent flat rate on corporate taxable income, a corporate taxpayer with $1 million of QPAI in 2007 would pay $340,000 in tax without the U.S. production activities deduction, but only $319,600 with the deduction computed as 6 percent of QPAI. The effective tax rate is reduced by about two percentage points.
This deduction applies only to companies paying W-2 wages. For pass-through entities such as partnerships, LLCs and S corporations, the QPAI is calculated first at the entity level. Qualifying wages are also determined at the entity level. The deduction is then calculated at the owner level.
Weighing entity structure, personnel and tax options can be complicated. Partnerships face eligibility challenges because the IRS states that an individual cannot be a partner and a partnership employee. Companies relying heavily on contract labor may want to hire more full-time workers. Taxpayers involved in multiple pass-through entities may want to combine some entities or restructure operations. Sole proprietorships may want to incorporate.
Another major challenge is determining allocation of deductible revenue in multiple-activity operations. For example, certain businesses are involved in manufacturing some components of their products in the United States but import the remaining components. The U.S. Treasury Department provides guidance for allocating revenue and costs. A safe harbor is provided when conversion costs (direct labor and related factory burden) incurred in the United States account for 20 percent or more of the total cost of goods sold.
The 2004 law and recently issued guidance now provide a solid framework from which U.S. manufacturers can enhance their tax deductions. Experienced tax advisors can guide companies toward those benefits.
Jeff Sanders is a certified public accountant and tax partner at Weaver and Tidwell, L.L.P., in Dallas. He can be reached at 972.490.1970 or at firstname.lastname@example.org.