To offset the FSC/ETI exclusion — which allowed the United States to income from experts at a lower rate than other business income before the World Trade Organization ruled it “impermissable” — the IRS announced a new corporate tax deduction, “Income Attributable to Domestic Production Activities” for qualifying domestic manufacturers.
Originating with the American Jobs Creation Act of 2004, IRS Code Section 199 permits taxpayers who obtain income from “qualifying production activities” to deduct a percentage of this income, provided a “significant part” (equal to 20 percent of the cost of goods sold) of the production is performed in the United States.
Exceeding its original intent, the new manufacturing deduction is more acquiescent than its forerunner, welcoming all U.S. manufacturers. This generosity has proved costly. The most expensive section of the act, Section 199, carries a hefty $76 billion price tag, $26 billion more than the cost of the FSC/ETI exclusion.
It’s an investment many hope will be counterbalanced with new jobs and domestic economic growth.
The new deduction introduces a 3 percent corporate tax rate reduction, previously set at 35 percent. The reduction is scheduled to incrementally increase, reaching 9 percent when completely implemented in 2010. Qualifying taxpayers can claim a percentage of the year’s qualified production activities income or its taxable income, whichever is less. However, this deduction is restricted to 50 percent of W-2 wages for that same year.
Attempting to respond to previous ambiguities surrounding the provisions of this deduction, the IRS has issued Notice 2005-14. The notice outlines four applicable categories and advises on the deduction calculation for domestic production gross receipts, cost of goods sold allocation, other deductions and period costs, and other notable provisions.
Identifying and segregating qualifying domestic production gross receipts, at the item level, is the first step. While not expressly stated, the notice demands this level of detail because it limits the deduction to the production costs of the actual property, eliminating the service elements eligibility.
Consequently, taxpayers are required to segregate the property’s production elements from any embedded service component. In cases where the service components are a vital part of the production process, and thus cannot be separated, or amount to less than 5 percent of total income, the IRS has waived this requirement. If all facets meet the criteria of production procedures, all gross receipts from the sale are eligible for the deduction.
Next, identifying cost of goods sold requires allocating costs with associated revenue using the same methodology applied when allocating qualifying domestic production gross receipts. If cost of goods sold cannot be determined, the notice does allow the taxpayer to apply another reasonable method to quantify qualified activities.
For assigning other deduction and period costs, whether expenses or losses, to the revenue, the notice provides guidance utilizing the rules set forth under Regulation §1.861-8. The regulations outline comprehensive classification rules for allocating gross income expenses and grant flexibility for unclassified expenses that are accurately assigned to the gross income.
In addition, for small taxpayers (averaging under $25 million in annual gross receipts over a three-year period), the notice stipulates deductions can be calculated using a standard percentage — total of qualifying production activities divided by the total of all sources.
Other notable provisions ratified with the notice’s institution include forbidding the inclusion of Internet-driven software as qualified income and permitting income generated from real estate construction sales, provided the contractor is identified in a North American Industry System and the real estates value has been removed from qualified gross receipts.
As outlined in Notice 2005-14, the IRS has tackled many of the ambiguities regarding Section 199 deduction eligibility; still, it has yet to conclude the debate surrounding proper calculation methods and the ownership of work-in-process related to contract manufacturing arrangements. However, aware of the remaining uncertainty, the IRS is working on standardizing these guidelines, as well.
Reach Lou Miller, CPA, at (574) 236-8661 or [email protected].
