On Jan. 19, 2005, the Internal Revenue Service released some initial guidance to taxpayers for claiming the new manufacturing deduction available for the first time in 2005 with respect to qualified domestic manufacturing, production, growing and extraction activities.
Brought about by the American Jobs Creation Act of 2004 and phasing in from 2005 to 2010, the deduction will eventually equal 9 percent of qualified production activities income, or an effective reduction in the tax rate on such income of three percentage points for most businesses. For 2005, the deduction is 3 percent.
The new guidance is extensive, yet only begins to touch on many of the issues arising out of this significant new provision of the tax law. Unlike the extra-territorial income provision that it replaced, this manufacturing deduction will apply to a very broad range of U.S. businesses that have almost any form of U.S. production activity.
Code Sec. 199
The calculation of qualified production activities income will require a determination of the gross receipts from the domestic production activities, and the direct and indirect costs, deductions, expenses and losses allocable to that income. In a potentially significant limit on the deduction, it cannot exceed 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in the tax year at issue.
Domestic production gross receipts is defined fairly broadly, and includes gross receipts derived from:
* Any lease, rental, license, sale, exchange or other disposition of (1) qualifying production property that was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the U.S., (2) any qualified film produced by the taxpayer, or (3) electricity, natural gas or potable water produced by the taxpayer in the U.S.;
* Construction performed in the U.S.; and,
* Engineering or architectural services performed in the U.S. for construction projects in the U.S.
Specifically excepted from the definition are:
* The sale of food and beverages prepared by the taxpayer at a retail establishment; and,
* The transmission or distribution of electricity, natural gas or potable water.
Qualified production property is also defined broadly to cover:
* Tangible personal property;
* Any computer software; and,
* Certain sound recordings as described in Code Sec. 168(f)(4).
The new guidance
The interim guidance clarifies some of the foregoing definitions and provides some de minimis rules and a safe harbor. There are also some computation alternatives available depending on business size.
The guidelines also discuss the impact of the new provision on pass-through entities. Where possible, the Treasury and the IRS tried to incorporate existing concepts in the hope of simplifying the guidance by staying with familiar territory.
Wage limitation. The new guidance discusses at some length the meaning of the W-2 wage limitation. Three alternatives are provided for calculating W-2 wages, one providing greater simplicity and the other two intended to provide greater accuracy.
QPAI. Qualified production activities income is to be determined on an item-by-item basis, rather than by division or product line. The guidance does state that, generally, if a taxpayer is engaged exclusively in the manufacture of qualifying production property within the U.S. and has no other sources of income, it is anticipated that QPAI will equal taxable income.
Generally, the IRS guidance states that only one taxpayer will have the benefits and burdens of ownership at any particular point in the process, and therefore only one taxpayer may claim the deduction with respect to the same function performed with respect to the same property.
In a contract manufacturing situation, this means that the deduction would belong to either the contractor or the customer, depending on which had the benefits and burdens of ownership. In contrast, with respect to construction activities, the guidance makes clear that more than one taxpayer may be regarded as deriving gross receipts from construction with respect to the same activity and the same construction project.
Qualifying domestic production. The guidance discusses at some length the various qualifying manufacturing, production, extraction and growing activities. In addition to tangible personal property, computer software and sound recordings are defined in more detail. Also discussed at length is the definition of "qualified film."
Electricity, natural gas and potable water are discussed with a de minimis provision provided for the distribution and transmission services of integrated producers. Bottled water is specifically excluded from the definition of potable water. Also, construction activities and engineering and architectural services are more extensively defined.
"Significant part." With respect to whether the domestic activity constitutes a "significant part" of the production process, the guidance requires that the activity in the U.S. be substantial in nature, depending on the facts and circumstances. Packaging, repackaging, labeling and minor assembly activities are not to be considered in determining whether the activity is substantial.
A safe harbor is provided under which a taxpayer will qualify if, in connection with the property, conversion costs (direct labor and related factory burden) to the property are incurred by the taxpayer within the U.S. and the costs account for 20 percent or more of the total cost of goods sold of the property.
"Within the U.S." Within the U.S. is defined under the guidance to include the 50 states and the District of Columbia, including territorial waters of the U.S., but does not include possessions and territories.
Services. In general, gross receipts derived from services will not qualify except for certain embedded services related to standard warranties or where there is a de minimis amount of gross receipts equal to less than 5 percent of total gross receipts of the property.
Costs and expenses. The IRS has also provided taxpayers with several methods of allocating costs and expenses, with one simplified method designed especially for small business.
Pass-through entities. Allocations to partners and S corporation shareholders are discussed, with the guidance focusing on making determinations at the partner or shareholder level. Although a partner may take into account his distributable share of W-2 wages, K-1 distributions to a partner would not count as W-2 wages.
Due to the manufacturing deduction's effective date for tax years beginning after Dec. 31, 2004, the IRS was under some pressure to get at least this interim guidance out to provide taxpayers with some direction as they start the year to arrange their processes to take advantage of the new deduction. The IRS has made it clear that they anticipate that there are still a large number of outstanding issues, and comments are invited to assist them in the promulgation of proposed regulations.
On the whole, tax practitioners seem pleased with the service's first steps, especially the speed with which the guidance was issued and the general flexibility that the guidance incorporates into the calculations. Only time will tell whether regulations promised later this year will confirm these initial expectations, or will pull back as details on contract manufacturing, the W-2 wage cap, the production process and other key elements of this deduction are filled in with a more comprehensive interpretation.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.
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