Section 199 deductions: the basics — Business Management Daily: Free Reports on Human Resources, Employment Law, Office Management, Office Communication, Office Technology and Small Business Tax Business Management Daily
On their 2006 returns, companies may deduct 3 percent of the lesser of their qualified production activity income (QPAI) or their taxable income. The deduction percentage will increase to 6 percent next year; then 9 percent in 2010. QPAI is based on domestic production gross receipts (DPGR) from qualified activities.
In no event can your annual Section 199 manufacturing deduction exceed 50 percent of the W-2 wages paid during the year.
For partnerships, S corporations and LLCs, the partners or shareholders are treated as having been allocated their proportionate share of the pass-through entity’s income.
Update: The new tax law—the Tax Increase Prevention and Reconciliation Act—modifies the deduction cap. For tax years beginning after May 17, 2006, the deduction is limited to wages deducted in arriving at QPAI. Partners and shareholders will be allocated only those wages paid to determine QPAI.
The rules for this calculation are spelled out in separate regulations. (IRS revenue procedure 2006-22)