The American Jobs Creation Act, signed into law in 2004, includes a tax benefit for certain domestic production activities. Designed to aid small U.S. manufacturers that are engaged in domestic production, the tax deduction can benefit a wide swath of businesses ranging from software firms to construction companies.
“The legislation enhances the ability of certain domestic businesses to compete in the global marketplace,” says Valerie Colin, senior vice president of Gumbiner Savett Inc.
Smart Business spoke with Colin about the domestic production activities deduction and how to take advantage of the tax credit.
What is the domestic production activities deduction?
An eligible taxpayer is allowed a deduction for tax years beginning in 2005 or 2006 equal to 3 percent of the lesser of the taxpayer’s qualified production activities income for the tax year or the taxpayer’s taxable income (adjusted gross income in the case of an individual). The deduction increases to 6 percent for tax years beginning in 2007, 2008 and 2009 and to 9 percent for tax years beginning after 2009. The deduction is subject to a 50 percent wage limitation. Every business in the manufacturing industry should be looking at this as a tax deduction.
Why was this tax deduction adopted?
This legislation was a part of the American Jobs Creation Act of 2004, which enacted IRC section 199, a new tax deduction, related to domestic production activities. The legislation replaced the export tax benefit that was ruled inconsistent with U.S. obligations under various international trade agreements. It is available to all U.S. taxpayers that qualify whether their sales are domestic or foreign because the deduction, for the most part, is based on where the goods and services are produced rather than sold. The legislation repeals the Extraterritorial Income regime effective for transactions after Dec. 31, 2004, with certain transition rules.
What activities qualify for the deduction?
The tax deduction targets manufacturing and production activities within the United States. It incorporates a very broad definition of manufacturing. The act extends the definition of manufacturing and production to benefit handlers of agricultural products, software companies, film production, construction companies, engineering firms, architectural firms, and electric, gas and water companies in addition to typical product manufacturers.
How is qualified production activities income calculated?
Qualified production activities income (QPAI) is an amount equal to the excess (if any) of the taxpayer’s domestic production gross receipts (DPGR) over the sum of: (1) The cost of goods sold (CGS) allocable to such receipts and (2) other expenses, losses or deductions, other than the domestic production activities deduction, that are properly allocable to such receipts.
For a business with only one line of business, QPAI will be the same as gross income, CGS will be the same as total cost of goods sold and other expenses will be the same as total expenses. For businesses with multiple lines of business, these amounts will need to be allocated.
In what ways has Congress eased the burden of calculations for small manufacturers?
There are a couple of simplified formulas that smaller taxpayers may use. There is something called a ‘simplified deduction method’ to allocate and apportion deductions between DPGR and non-DPGR, assuming some of your product is imported or produced overseas or you have multiple lines of businesses, some of which qualify and some of which do not. This is available to taxpayers with average annual gross receipts of $25 million or less. The average is based on the three taxable years prior to the current year.
In addition, there is a ‘small business simplified overall method’ to allocate the CGS and deductions based on relative gross receipts. These further simplified computations are available to those with average annual gross receipts of $5 million or less.
How can a business best take advantage of the credit?
If a company is a widget manufacturer producing all if its goods in the U.S., it’s very simple. For 2008, assuming there’s a profit, the deduction would be 6 percent of the net income before the deduction. Simply put, if the net income before the deduction were $100,000, the deduction would be $6,000, therefore, the taxable income would only be $94,000. In this example, the total wages would also need to exceed $12,000 since the deduction is limited to 50 percent of wages. The deduction requires information to be reported on Form 8903. When a company has several different types of activities, some of which involve U.S. manufacturing, some outside the U.S., etc., it is best to consult with your CPA.
Once you understand the ins and outs of what qualifies and how the allocation formulas work, you may be able to restructure some of your operations or materials purchases to maximize the deduction by increasing the percentages of domestic activities. The more complicated the business, the more likely some additional cost accounting mechanisms may need to be implemented to capture the most deductions.
VALERIE COLIN is senior vice president of Gumbiner Savett Inc. Reach her at (310) 828-9798 or firstname.lastname@example.org.