Understanding the "manufacturers' tax deduction"
How businesses can benefit from the latest tax deduction
By Allen Falke
Don’t let its name fool you: The so-called "manufacturers’ tax deduction" applies to a much broader range of industries than those traditionally associated with manufacturing. And your business could miss out by not claiming it.
Congress created the deduction in 2004 when it passed the American Jobs Creation Act. The act phased out the extraterritorial income exclusion (ETI), which had provided incentives to U.S. businesses to sell goods in foreign markets. Section 199 of the new act – better known as the "manufacturers’ tax deduction" – benefits a broader range of domestic businesses, and offer incentives to companies that manufacture, produce, grow, or extract property within the U.S. The definition of manufacturers is quite broad, and includes industries such as engineering, architecture, utilities, software, film production and construction.The deduction, which went into effect in January 2005, will reduce the top corporate tax rate from 35 to 32 percent, and can be claimed by all qualifying C and S corporations, partnerships, sole proprietorships, estates and trusts. It will be phased in over six years and applies to all gross receipts on qualified production not just from export sales. The 2005 to 2006 tax year deduction is 3 percent. It grows to 6 percent from 2007 to 2009, and 9 percent thereafter.
Although it reduces the tax rate, the deduction may create extraordinary administrative and recordkeeping tasks. Claiming the deduction is not a simple task and there are several steps that must be taken to effectively calculate a company’s deduction. The key is identifying and segregating profits received from U.S. manufacturing operations versus overall profits. To claim the deduction, businesses must be diligent about tracking and reporting costs incurred and income generated from their products and services, which can be challenging depending on the complexity of the business. A company must separately break out the profits generated by the foreign and domestic parts of its products or services and track those costs.
The purpose of the break out of profits is to determine whether the manufacture of the product is "in whole or substantial part" within the U.S. If so the entire gross receipts would qualify. To add further complexity if there are foreign tax filings, the entity must analyze its allocation of costs to properly allocate profits to foreign countries.
In addition, other business expenses such as salaries may reduce the deduction. When calculating the deduction, things like the CEO’s salary may also need to be analyzed with a portion of it being allocated to domestic production activities, a portion to foreign activities and possibly non-qualified domestic activities. Tracking these expenses and assigning a percentage to each activity can be difficult. Businesses must have a system in place that can analyze total revenue and expenses and determine what qualifies.
That being said there are easier options available. For certain taxpayers, simpler methods of calculating the deduction, namely the Small Business Simplified Overall Method or the Simplified Deduction Method, are available.
Calculating the deduction
The deduction is calculated based on income from qualified production activities (QPAI), which starts with the taxpayer’s domestic production gross receipts. That number is reduced by the sum of the cost of goods sold allocated to those receipts; other expenses and losses directly allocated to such receipts, and; a ratable share of expenses and losses that is not directly allocable to such receipts.
Domestic production gross receipts are derived from the following:
• A sale, exchange, lease, rental or license of qualifying production property that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part in the United States. Qualifying production property includes tangible personal property, computer software, or any sound recordings
• A sale, exchange, lease, rental, or license of qualified film produced by the taxpayer
• A sale or exchange (but not the transmission or distribution) of electricity, natural gas, or potable water produced by the taxpayer in the U.S.
• Construction activities performed in the U.S.
• Engineering or architectural services performed in the U.S. for construction projects in the U.S.
Domestic production gross receipts do not include the sale or food or beverages prepared by the taxpayer at the retail establishment, or property that is leased, licensed, or rented to a related party. Several limitations apply to the deduction: the deduction can’t exceed 50 percent of W-2 wages or the specified percentage of QPAI (or taxable income of lower). There are possible Alternative Minimum Tax limitations as well.
How much can the manufacturers’ tax deduction lower business taxes? Every business will be different and it will depend on the amount of goods produced in the U.S.
Evaluating accounting firm options
How does a company make sense of all of the regulations under the manufacturers’ tax deduction? The best approach to making sense of all the regulations under the manufacturers’ tax deduction is to work with a CPA firm that understands its intricacies. A qualified tax professional will be able decipher what can and cannot be deducted and recommend the proper systems for tracking existing and future production costs that fall under the new deduction.
As complexities in tax laws increase, it’s important for companies to find qualified accountants with a deep understanding of their industry.
A regional-based firm with the right industry expertise would be a wise investment to take advantage of tax savings such as the manufacturers’ tax deduction. Understanding it can be made easy with the right assistance. A CPA firm with the right expertise can easily help a business to effectively implement, monitor, and maximize the manufacturers’ tax deduction.
Allen Falke is a CPA with Carlin, Charron &Rosen LLP, 1400 Computer Drive, Westboro. He can be reached at afalke@ccrgroup.com or by phone at 508-926-2237.
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