An important new deduction for manufacturers and producers

By Lynne Walline, CPA, Sacramento, California.

If you produce a product, grow crops, construct or design buildings, or make almost anything else and you pay wages to employees, you’re likely to be eligible for a new type of deduction for 2005 and in the years to come.

On Oct. 22, 2004, President Bush signed the American Jobs Creation Act, legislation meant to encourage the hiring of American workers and reduce outsourcing to overseas labor. Among its provisions, the act created a new tax benefit that gives a break to nearly every kind of business that is engaged in production in the United States. This tax deduction (not a credit) begins in 2005 as a 3 percent deduction on income from qualified production activity and increases in two steps to a 9 percent deduction by 2010, when it will be fully phased in.

Who can take the deduction?

The American Jobs Creation Act deduction applies to just about any kind of company, small or large, that produces something, including those engaged in the following:

• Chemical manufacturing
• Publishing
• Motion picture and sound recording production
• Computer and electronic-product manufacturing (including software production)
• Utility production operations
• Petroleum and coal products manufacturing and other mining operations
• Beverage and tobacco products creation
• Construction
• Transportation equipment manufacturing
• Farming and other food manufacturing
• Wholesale and retail trade
• And various other businesses engaged in domestic production

You needn’t be a gigantic manufacturer to take advantage of the new deduction. A company that pays salaries to people making handicrafts is considered a producer under this act, as would be a video company that employs photographers or camera operators to manufacture images.

Excluded from eligibility for the deduction are most service industries, such as accounting; but two types of businesses previously considered services do qualify for the deduction as part of the production process: architectural firms and engineering companies. Most retail stores do not qualify — unless they manufacture the products they sell — and companies that engage only in packaging, labeling and/or minor assembly also do not fall under the provisions of this regulation. Contractors that construct buildings for other organizations qualify, but a company building a facility for itself does not qualify under the construction provisions.

Organizations that carry out both production and services can take the deduction for that portion of their business that involves production. Thus, a business that sells, installs and monitors security alarms qualifies for the deduction in relation to its income for installing its products, but not for the monitoring service.

How is the deduction is calculated?

The deduction applies only to companies that pay W-2 wages and only for production inside the United States. If more than 5 percent of production income derives from operations in a foreign country, that proportion is separated from the dollars considered for the new deduction. The tax break is designed to generate job creation within the United States.

After considering this requirement, we look at the domestic production gross receipts (DPGR), or the gross income for the company’s production in the United States for the year. The DPGR is adjusted by subtracting out the following:

• The cost of goods sold that is allocable to the DPGR
• Other general and administrative expense-type losses and expenses that also are allocable to DPGR
• A prorated portion of other deductions and expenses not directly allocable to DPGR

By factoring in these adjustments, we come up with the qualified production activities income (QPAI). This is the total on which the 3 percent deduction is based.

If a company finds that 100 percent of its activity is qualified, then the QPAI is the same as its net taxable income. So, for example, if that business had $1 million in gross receipts and a cost of goods that totaled $665,000, its QPAI would be $335,000.

This tax break is subject to a limitation, however. The deduction can be no more than the lesser of 3 percent of the QPAI or 50 percent of the W-2 wages paid during the calendar year. If the company in our example paid W-2 wages of $190,000 for the year, 50 percent of its wages would be $95,000. Three percent of its QPAI would be $10,050. So the 3 percent deduction would be based on the lesser figure — the QPAI, in this case. QPAI cannot exceed taxable income for the year. Qualified production activity deduction (QPAD) cannot exceed 50 percent of the W-2 wages paid to employees during the year. The deduction is permitted for alternative minimum tax purposes.

Although the 3 percent amount applies for 2005 and 2006, it increases to 6 percent in 2007 through 2009, and in 2010 it reaches the full 9 percent. So, again using our example, if wages and income remained constant, in 2007 the deduction would double to $20,100 (6 percent of $335,000) and in 2010 it would be triple the 2005 deduction, or $30,150 (9 percent of the QPAI).

Tracking and recordkeeping

Because the deduction is allowed only for production, companies would be well advised to segregate their costs for these types of activities. They should establish separate categories for the sales of items they produce and for other income received from services and similar nonproduction activity. Likewise, costs of goods should be tracked separately for those costs associated with the manufacture of products and those related to services.

Although taking this deduction may increase your chance of being audited by the IRS, you should not worry at all if you have the financial information to back up your return. Keeping good records of expenses that can be allocated specifically to production will help ensure a good outcome. Because of the complications of Internal Revenue Code section 199, you should consult your tax professional for guidance.

The deduction for America’s producers is a tax benefit that can be enjoyed all across the business community, from small start-ups to mid-size employers and large corporations. It’s one of those unusual opportunities for every company that innovates products and adds to our nation’s wealth to contain their costs while contributing to America’s job growth. In the years ahead, the American Jobs Creation Act tax deduction is likely to make an important difference in the hiring decisions of the country’s growing small businesses.

About the author

Lynne Forsyth Walline joined Chapman & Co., CPAs in 1984. She serves as audit principal. She provides clients with tax, management advisory, compilation, reviews and audit services. Lynne's clients are varied and include individuals, contractors, professional service companies, closely held entities and real estate developers. Prior to joining the firm, Lynne worked in private industry for a national contracting firm. Lynne earned a BA from California Polytechnic State University, San Luis Obispo. She completed her advanced accounting course work at California State University, Sacramento.

Professional Affiliations

• American Institute of Certified Public Accountants
• California Society of Certified Public Accountants - Currently serving as President for the Sacramento Chapter, co-chair of the Technology Committee of the Sacramento Chapter and member of the State Technology Committee.
• Sacramento County Taxpayers League - Past Treasurer
• American Society of Women Accountants - Past President of Sacramento Chapter

Note: This information is provided to you by third parties for informational purposes only and shall not constitute tax or legal advice. Microsoft has not checked or verified any of the information provided and makes no representations or warranties as to its accuracy. Each individual’s tax situation is unique and you should check with your accountant or other tax professional for particular advice on your situation.