New Domestic Production Activities Deduction

November 3, 2005

The American Jobs Creation Act of 2004 added the domestic production activities deduction, a tax benefit for certain domestic production activities. This deduction provides a tax savings against income attributable to domestic production activities.  The Act created new Internal Revenue Code section 199 and is available to corporations, individuals, and pass-thru entities such as S Corporations, partnerships, estates and trusts.  For the pass-thru entities, the deduction is applied at the individual partner, shareholder, or similar level. This deduction is available for tax years beginning after December 31, 2004.

For 2005 and 2006, the deduction equals 3% of the lesser of: (a) qualified production activities income; or (b) taxable income for the taxable year.  However, the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year.  The deduction is phased-in; for 2007 through 2009 the percentage increases to 6% and for 2010 and after the percentage will be 9%.

Qualified production activities include manufacturing, producing, growing, and extracting tangible personal property, computer software, and sound recordings, and the construction and substantial renovation of real property including infrastructure.  The production of certain films is also a qualifying activity as are certain engineering or architectural services.

For gross receipts to be considered domestic production gross receipts that are used in calculating qualified production activities income, the gross receipts must be the result of a lease, rental, sale, license, exchange or other disposition of the property and the qualified production activity that created these receipts must have occurred in whole or in significant part within the United States.  There is a safe harbor to determine if the property is produced in whole or in significant part within the United States.  To qualify for the safe harbor, direct labor and related factory burden incurred by the taxpayer in the United States for the manufacture, production, growth or extraction of the property, must be at least 20% of the total cost of goods sold of the property.  There are special rules for the production of films, computer software, sound recordings, utilities, and food and beverages.  There are also special rules for construction and engineering or architectural services.

A taxpayer is required to determine the portion of its gross receipts that are domestic production gross receipts and the portion that are not domestic production gross receipts.  The taxpayer must use a reasonable allocation method to make this determination.  All of a taxpayer’s gross receipts will be treated as domestic production gross receipts if less than 5% of the total gross receipts are not domestic production gross receipts.

Once domestic production gross receipts are determined, the taxpayer has to compute qualified production activities income.  This is done by reducing domestic production gross receipts by the cost of goods sold that are allocable to such receipts, other deductions that are directly allocable and a ratable amount of indirect expenses.  A simplified method for allocating costs (other than cost of goods sold) is available for businesses that have average annual gross receipts of $25 million or less.  Another simplified cost allocation method, the small business simplified overall method, is available to a qualifying small taxpayer.  Under this method all costs, including costs of goods sold, are apportioned based on gross receipts.  Generally, a small taxpayer is one that has average annual gross receipts of $5,000,000 or less.

The 50 percent of W-2 wages limitation is based only on the wages of the taxpayer’s common law employees.  There are three methods provided to compute the W-2 wages.  The simplest method computes wages using the total entries in Box 1 or Box 5 of the Form W-2.

Additional guidance is available in Treasury News Release JS-2201, Treasury and IRS Issue Guidance on Manufacturing Deduction.  Regulations are forthcoming and will provide more information when released.