As part of the American Jobs Creation Act of 2004 (the “2004 Tax Act”), Congress gave most companies engaged in production activities a real tax break. Beginning this year, eligible taxpayers will be able to deduct up to 3% of their taxable income for both regular tax and alternative minimum tax purposes. This deduction will grow to 9% in 2010, resulting in about a 3% reduction in the tax rate on income. All domestic production activities qualify for the deduction; eligible businesses include those involved in manufacturing, construction, architectural design or engineering, software development, music recording and making movies or TV shows, as well as producing and processing food. Of course, there are somewhat complicated definitions, limitations and restrictions. As always, it will be important to bring your accountant and other tax professionals into the loop early in order to maximize the benefits that will be available to you.
Several years ago, the so called extraterritorial income (ETI) tax incentives, given by the United States to taxpayers for exporting U.S. made products, were found to illegally subsidize U.S. taxpayers and violate international law. A major part of the 2004 Tax Act, which President Bush signed into law on October 22, 2004, was the repeal of the ETI regime. However, Congress noted that many European and other developed countries have lower effective corporate tax rates than the U.S. Accordingly, in the 2004 Tax Act, Congress included a provision that is intended to lower the effective federal income tax rate on domestic manufacturing and other domestic productive activities by providing for a deduction for any eligible activity, effective for taxable years beginning on or after January 1, 2005. When fully phased in, the deduction is intended to reduce the effective tax rate on the lucky activities included within its scope by about 3%. The deduction is available to individuals, C corporations, S corporation shareholders, partners and trusts and estates with “qualified production activities income,” and products need not be slated for export to qualify.
The Deduction for Qualified Production Activities
For 2005, the deduction (which is in new Section 199 of the Internal Revenue Code) equals 3% of the lesser of: (a) taxable income derived from a qualified production activity or (b) taxable income, for the taxable year. However, the deduction is limited to 50% of the W 2 wages paid by the taxpayer during the year. The 3% deduction increases to 6% in 2007. In 2010, when the deduction is fully phased in, the rate increases to 9%.
Qualified production activities are:
- The manufacture, production, growth or extraction in whole or significant part in the United States of tangible personal property (e.g., clothing, goods and food), software development or music recordings;
- TV, movie or video production, provided at least 50% of the total compensation relating to the production is for services performed in the United States;
- Production of electricity, natural gas or water in the United States;
- Construction or substantial renovation of real property in the United States, including residential and commercial buildings and infrastructure such as roads, power lines, water systems and communications facilities;
- Engineering and architectural services performed in the United States and relating to construction of real property.
Note that the only services that qualify are construction, architectural or engineering services. Income from other services, including transportation services, as well as medicine, law, accounting and most consulting, does not qualify for the deduction.
The deduction applies only to income from property manufactured, produced, grown or extracted in whole or in significant part within the United States. Property is produced “in significant part” in the United States if the U.S. activities are substantial in nature or if the labor and overhead costs incurred by the taxpayer in the United States for the property are at least 20% of the taxpayer’s total cost for the property.
If a taxpayer has satisfied the “significant part” test and other requirements, the deduction is a portion of the taxpayer’s profits from domestic production. For example, assume that a taxpayer purchases a motor and various parts and materials for $750 and incurs $250 in labor costs at its factory in the United States to make a lawn mower. The taxpayer also incurs packaging, selling and other costs of $20 and sells the lawn mower in 2005 for $1,120, to bring him a profit of $100. The lawn mower will be treated as manufactured by the taxpayer in the United States “in significant part” because the labor is more than 20% of total costs. The taxpayer’s domestic production activities deduction will be 3% of the taxpayer’s $100 profit on the lawn mower: that is, $1120-$750-$250-$20=$100 times 3%=$3. If the sale occurred in 2010 when the deduction is fully phased in, the deduction would be 9% of the taxpayer’s $100 profit on the lawn mower, or $9.