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Take aim at Section 199 manufacturing deductions

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in Small Business Tax,Small Business Tax Deduction Strategies

Did you fail to qualify for the Section 199 “manufacturing” deduction in the past? Don’t give up.

Strategy: If at first you don’t succeed … try, try again. A business taxpayer who didn’t meet the requirements in a prior calculation might do so on a 2010 return. Best of all, the maximum deduction reached its high-water mark in 2010, so it’s more valuable than ever.

Here’s the whole story: Initially, the Section 199 deduction was limited to 3% of the lesser of a taxpayer’s qualified production activity income (QPAI) or taxable income. The maximum deduction percentage was then doubled to 6%. It’s been increased to 9% for 2010 and thereafter.

QPAI is equal to domestic production gross receipts (DPGR) from qualified activities minus expenses. Expenses include the cost of goods sold allocable to the receipts, allocable direct and indirect costs and a ratable portion of other costs.

Production activities must be performed in whole, or in significant part, in the United States. The annual deduction is limited to 50% of related W-2 wages.

Note: The Section 199 deduction can offset either regular income tax liability or the alternative minimum tax (AMT) for C corporations, individuals, farming cooperatives and estates and trusts. It may also be claimed by partners and owners of S corporations (but not the partnerships or the S corps themselves).

A business engaged in any of the following lines of business may qualify for the deduction:

  • Manufacture, production, growth or extraction of tangible personal property, computer software or sound recordings or qualified films
  • Production of electricity, natural gas or potable water in the United States
  • Construction services, including related engineering and architectural services performed in the United States.

Within each of these categories, a broad range of types of activities are eligible. Raw materials and finished products may be new or made from scrap, salvage or junk material. Manufactured components can be used by another party in subsequent activities. Processing and preparing food products for sale at wholesale is an eligible activity, but preparation of food and beverages for sale at retail isn’t.

Due to the complexity of these rules, taxpayers frequently fail to obtain the full benefit they are entitled to.

In addition, calculation methods may have been initiated when the maximum deduction percentage was only 3%.

In many cases, early calculations have been rolled forward for years without being updated to reflect changes, including the higher percentage amount.

5 steps in the calculation

1. Identify areas of qualified production activities. Determine if the manufacture, production, or development of eligible property occurred in the United States. Then evaluate whether a product is held for sale, lease or license or involves a hosting service.

2. Calculate the DPGR. Allocate gross receipts between qualified and nonqualified production activities.

3. Allocate the cost of goods sold to the DPGR. Divide production costs between qualified and nonqualified activities.

4. If necessary, apportion and allocate below-the-line expenses. Unless the taxpayer qualifies for a simplified deduction method (see box below), it must apportion certain items of gross income and allocate deductions to sources within the United States. (IRS Sec. 861)

5. Figure out the deduction. Use the sales and cost-of-sales data from Steps 2 and 3 and taxable income data from Step 4. The net taxable income of the qualified products should be aggregated for each entity. The lesser of the QPAI or taxable income is then multiplied by the applicable percentage (9% for 2010) to determine the deduction.

Tip: Nearly half the states have “decoupled” from the Section 199 deduction. Get assistance from your tax pro.

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