Frederick J. Sitzberger

The American Jobs Creation Act of 2004 has created a new tax deduction for businesses that engage in production activities in the United States. This deduction will provide a significant tax break for many businesses.

The new deduction for domestic production activities is available to corporations and individuals for taxable years beginning after December 31, 2004. Qualifying businesses are allowed to deduct a percentage of their “qualified production activities income” (QPAI) from taxable income (for corporations) or adjusted gross income (for individuals). The deductions are as follows:

Years

% of QPAI

2005 and 2006

3%

2007, 2008, and 2009

6%

2010 and thereafter

9%

The deduction will also be effective for state tax purposes, although it remains to be seen whether any states decide to “decouple” from the federal deduction in order to avoid a loss of business tax revenue. According to the Wisconsin Department of Revenue, the state of Wisconsin usually waits until later in the year to make decisions, and as of yet, the American Jobs Creation Act has not been adopted.

The determination of whether you will qualify for the deduction depends on the nature of your business. The most important and difficult thing to determine is a taxpayer’s domestic production gross receipts (DPGR). Certain business activities are expressly listed in the legislation and the gross receipts from those activities are considered DPGR. They are as follows:

  • Any lease, rental, license, sale, exchange, or other disposition of:

– Qualifying production property that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States.

– Any qualified film produced by the taxpayer

– Electricity, natural gas, or potable water produced by the taxpayer in the U.S.

  • Construction of real property or substantial renovations performed in the United States
  • Engineering and architectural services performed in connection with U.S. construction.

DPGR does not include, however, gross receipts from:

  • The sale of prepared food at a retail establishment
  • Property leased to a related party
  • The transmission or distribution of electricity, natural gas, or potable water
  • The performance of services

The first category of economic activity qualifying for the deduction, which should benefit the most businesses, is also the category that will be the most difficult to apply. The IRS recognized that certain areas required further definition and, therefore, released Notice 2005-14 which is intended to provide interim guidance regarding the new deduction while the regulations are being written. The IRS has stated that the “qualifying production property” that is eligible for the new deduction includes: (1) tangible personal property, (2) computer software, and (3) certain sound recordings.

Once DPGR is known, a taxpayer’s QPAI can be found. QPAI is determined on an item-by-item basis and is calculated as follows:

Domestic production gross receipts (DPGR)

– Cost of goods sold

– Directly allocable expenses

– A ratable share of the taxpayer’s unallocated expenses

Qualified production activities income (QPAI)

x Applicable rate of deduction

= Qualified production activities deduction*

* Limited to 50% of W-2 wages

In general, gross receipts and costs for the year must be properly recognized using the taxpayer’s accounting method for federal income tax purposes and if a taxpayer exclusively manufactures qualifying production property in the U.S. and has no other income, QPAI should be equal to taxable income.

In keeping with the legislation’s theme of job growth, the actual deduction is limited to 50% of the taxpayer’s W-2 wages paid to employees for the taxable year. This can be complicated because the definition of W-2 wages takes many factors into consideration and there is no one box on Form W-2 that meets the definition of W-2 wages for this deduction. There are three methods that can be used to determine W-2 wages, and you should speak with a tax advisor for assistance in utilizing one of the methods for the calculation. Because the underlying theme of the legislation is to encourage U.S. job formation, this limitation could prevent businesses that rely primarily on contractors, or require only a small employee base, from taking full advantage of the new deduction.

As you can see from above, the new deduction is broad in scope and has the potential to reduce the taxes of many businesses. It also contains many traps, but with proper planning, most businesses and individuals that are involved in production and have employees can benefit from this deduction. Businesses should structure their activities so that they take maximum advantage of the new law. A coordinated approach to tax planning will allow many businesses to become more competitive.