The seed for this legislation was the decision by the World Trade Organization in January 2002 that the Extraterritorial Income Exclusion (ETI) provided to U.S. taxpayers under the Internal Revenue Code constituted a prohibited subsidy under international trade agreements.
As a result, the European Union began imposing multimillion dollar sanctions in March 2004, and it was projected that U.S. businesses would have faced $475 million in tariffs by March 2005 if the ETI rules were not effectively replaced. The new act repeals the ETI provisions on a phased-in basis, with 80 percent of the benefit retained in 2005 and 60 percent retained in 2006.
In its place is a new Domestic Production Deduction. It only indirectly impacts taxpayers formerly benefiting under the ETI subsidy, as the benefit is not based on export activity but rather on domestic production. As such, any taxpayer, even those with no international activity, may qualify for the new deduction provided he or she engages in qualifying domestic production activities.
Congress has defined qualifying production activities very broadly. Many taxpayers will be pleasantly surprised to find that their business activities will qualify. For example, construction activities performed in the United States will qualify, including activities directly related to the erection or substantial renovation of residential and commercial buildings and related infrastructure. Engineering and architectural services performed in connection with construction projects will also qualify.
The new deduction will be phased in beginning in 2005 and be fully implemented in 2010. The tax incentive yielded by this new deduction will effectively reduce the top tax rate applicable to qualifying income from the current 35 percent to 31.85 percent (33.95 percent for 2005 and 2006). Taxpayers eligible for the new deduction include C and S corporations, LLCs, partnerships, estates and trusts, as well as sole proprietors.
The new deduction will add an incremental layer of complexity to the tax system. It is capped at 50 percent of W-2 wages paid during the year, and calculations are to be carried out by including all members of an affiliate group.
In general, the deduction is equal to a percentage of qualified production activities income or taxable income, whichever is lower. Initially, the percentage will be set at 3 percent for 2005 and 2006, increasing to 6 percent from 2007 through 2009 before increasing to 9 percent in 2010.
"Qualifying productions activities income" is defined as equal to the difference between domestic production gross receipts and the costs of goods sold, as well as the direct and indirect costs allocable to the production of such receipts.
It is in carrying out these calculations that the rubber hits the road in regard to potential complexity and controversy with the IRS. Maximizing tax benefits from the new deduction will typically heavily rely on maximizing qualifying receipts while minimizing the offsetting costs that are allocated to same. Terms such as "domestic production gross receipts" will likely give rise to lengthy, and in many cases, confusing regulations and other pronouncements from the IRS, as well as an entirely new area for litigation in the courts.
It is not too early to begin to consider planning opportunities that may impact the available deduction. For example, the new deduction will represent one more factor favoring the choice of S (pass-through) corporation over C (regular) corporation structure.
In a C corporation environment, owners often resort to salary as a means of sharing corporate profit while avoiding a second level of tax that would otherwise arise on corporate dividends. Owner salaries, however, will potentially reduce the available deduction compared to a comparable S corporation business paying relatively lower salary to its owners (with the owners receiving nontaxable distributions to make up any difference).
Recordkeeping is often the Achilles' heel of taxpayers having disputes with the IRS. Maximizing the new manufacturer's deduction could require modification or tightening of internal accounting and reporting procedures with a focus upon identification of qualifying activities and their related income and costs.
Michael Viens, CPA, is a director specializing in tax, CBIZ Accounting, Tax & Advisory Services, Philadelphia/Plymouth Meeting. CBIZ, a publicly traded company and the 10th largest accounting firm nationally (Accounting Today), provides a wide range of assurance, tax and consulting services to small and mid-sized companies. Reach him at email@example.com or (610) 862-2204.