Reducing the overall effective tax rate may improve the competitive position of U.S. business taxpayers in the global market place. The deduction may be of particular benefit to Northeast Ohio labor-intensive businesses that have experienced severe competition from overseas manufacturers that have a lower overall cost structure.
Section 199 lowers the overall effective tax rate on U.S. production income by permitting a tax deduction equal to a certain percentage of the lesser of one of the following:
- A taxpayer’s qualified production activities income (QPAI)
- Taxable income for the tax year
The term QPAI is defined in the IRC as an amount equal to the excess (if any) of the taxpayer’s domestic production gross receipts (DPGR) for such taxable year, over the sum of the following:
- The cost of goods sold allocable to such receipts
- Other deductions, expenses or losses directly allocable to such receipts
- A ratable portion of other expenses not directly allocable to such receipts
The IRC defines DPGR as gross receipts that are derived from the following activities:
- Lease, rental, license, sale, exchange or other disposition of qualifying production property that was manufactured in the United States, any qualified film produced by the taxpayer, or electricity, natural gas or potable water produced by the taxpayer in the United States
- Construction performed in the United States
- Engineering or architectural services performed in the United States
The deduction is applicable to a significant number of business taxpayers who may not fall under the common definition of manufacturing. Arguably, every taxpayer should consult with a tax adviser to review the new Section 199 provisions to determine if they qualify.
Section 199 is quite broad and complex. Consider the following example.
Company XYZ manufactures plastic lumber. The company recognizes $5,000,000 in QPAI from the sale of plastic lumber in 2005 and $4,000,000 in taxable income. The maximum Section 199 deduction Company XYZ can claim for tax year 2005 is $120,000 (i.e., $4,000,000 the lesser of QPAI or taxable income times 3 percent, the maximum deduction percentage for 2005). Company XYZ’s effective tax rate declines to 31 percent from 34 percent (assuming no other permanent deductions) because of this new deduction.
The deduction is phased-in over a five-year period, climbing to 6 percent from 2007 to 2009, and reaching 9 percent after 2009.
Under the example above, the permanent deduction would equal $360,000 (i.e., $4,000,000 times 9 percent) when fully phased-in beginning in 2010. The effective tax rate declines to 25 percent, which helps improve the competitive position of many U.S. taxpayers doing business throughout the world.
In an effort to encourage domestic employment, Congress also included an additional limitation on the amount of the permanent deduction on an annual basis. The amount of the deduction for any taxable year may not exceed 50 percent of the W-2 wages of the employer for the taxable year:
Continuing our example above, if the same taxpayer reported $500,000 of W-2 wages in 2005, the deduction would not be affected because the regular calculation results in a lower overall deduction ($120,000 versus $250,000 $500,000 payroll times 50 percent). However, in 2010, if payroll remained at $500,000, the deduction would be limited to $250,000.
The example illustrates that labor intensive businesses shouldn’t have a problem with this limitation; however, businesses that have automated their operations - at the expense of domestic employment - may be subject to the 50 percent of W-2 wage limitation.
Michael R. Milazzo is a Certified Public Acountant with Skoda, Minotti & Co. Reach him at (440) 449-6800 or email@example.com.