For the first time, U.S. businesses will be able to write off expenses related to “qualified domestic production activities.” The so-called “manufacturing deduction” (or Sect. 199 deduction) is available even to many companies that wouldn’t normally consider themselves “manufacturers,” maybe even yours.
What’s new? Just in the nick of time, the IRS published proposed regulations that explain the ins and outs of this new deduction. (REG-105847-05) Those regulations expand and clarify guidance initially issued by the IRS last February (IRS Notice 2005-14). See the box below for links to both documents.
Advice: To take maximum advantage of the deduction on your 2005 return, cherry-pick the guidance from each of those documents that best suits your business. The IRS says you can rely on either document until final regs are issued sometime in 2006.
Before we look at those new rules, let’s examine the basics of this new deduction.
Beginning with 2005 tax returns, certain businesses can take a “domestic-production activities deduction” for gross receipts derived from the sale, lease or rental of tangible personal property assets (clothing, goods, food, software, etc.), as long as the product is manufactured in “significant part” in the United States.
A qualifying business can deduct 3 percent of the lesser of its taxable income from domestic production activities or its taxable income. The deduction percentage will increase to 6 percent in 2007 and then top out at 9 percent in 2010. Thus, if your company is taxed at the top 34 percent corporate rate, the deduction will eventually translate into an effective tax rate cut of about 3 percent.
The annual deduction is limited to 50 percent of the W-2 wages you’ve paid.
Here are some key points covered in the new proposed regulations:
Qualified production activities income. The regulations explain the method for calculating “qualified production activities income” (QPAI), including how to match income and expenses. For example, if gross receipts and corresponding expenses occur in different tax years, your accounting method will determine when the receipts and expenses should be taken into account.
However, you still need to determine QPAI on an item-by-item basis … a bit of a pain.
Tip: If your company’s whole product doesn’t qualify as an item, you can treat any qualifying part of the product as an item for QPAI. So, you may need to segment product parts to increase your deduction. W-2 wage limits. Payments to independent contractors and guaranteed payments made to partners aren’t included when calculating
W-2 wages. Also, the new rules prohibit the same W-2 wages from being claimed in different tax years or by different taxpayers. (That creates a disincentive to outsource more production- related work.)
Domestic production gross receipts. The new regulations also establish standards for calculating “domestic production gross receipts” (DPGRs). You can use any reasonable method of allocating gross receipts.
Construction activities. Under the new rules, you can qualify for the Section 199 deduction for construction activities if you meet certain standards established by the North American Industry Classification System (NAICS). The new rules let you qualify even if the construction activity isn’t your primary business activity.
Tip: If gross receipts from your non-construction activities comprise less than 5 percent of the total gross receipts from a particular construction project, all of the project’s gross receipts count as DPGRs from construction. So, stay within the 5 percent limit when possible.
Engineering and architectural activities. For engineering and architectural firms, only services relating to real property can qualify for the Section 199 deduction. The new rules specifically require businesses performing these types of services to be regularly engaged in the business according to the NAICS codes.
Bottom line: The new manufacturing deduction rules are complex, so the best approach is to huddle with your tax expert. Then, you can apply the preferred rules to your business.
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