New Deduction for Domestic Production Activities

The American Jobs Creation Act of 2004 includes a deduction that will effectively reduce the tax rate of domestic manufacturing corporations by three percentage points for income attributable to domestic production activities.

The Deduction

The deduction, beginning in 2005, is a specified percentage of the lesser of the taxpayer's qualified production activities income (QPAI) or taxable income for the tax year. QPAI is equal to gross receipts from manufacturing, production, growth, and extraction activities net of expenses attributable to the actual conduct of the trade or business. Domestic production gross receipts may be derived from lease, rental, license, sale, exchange or other disposition. For tax years beginning after 2004 and before 2010, the percentage deduction is phased-in according to the following chart:

When fully phased-in, the deduction is designed to be economically equivalent to a 3% tax rate reduction on domestic production activities.

The deduction is also limited to wages paid and shall not exceed 50% of the W-2 wages of the employer for the taxable year. The deduction is allowable in computing alternative minimum taxable (AMT) income. It is not allowable for purposes of computing net earnings from self-employment.

Domestic Production Activities

According to Section 199 of the Internal Revenue Code, domestic production activities include manufacturing, food production, software development, film and music production, production of electricity, natural gas or water, and construction, engineering, and architectural services. The sale of food and beverages prepared by the taxpayer at retail establishments as well as the distribution of electricity, natural gas, or potable water do not qualify as domestic production activities. The activities related to qualifying production property (tangible personal property, computer software) must be performed "in significant part" within the United States . To qualify under a safe harbor, the conversion costs to manufacture, produce, grow or extract the property in the U.S. must account for 20% or more of the total cost of goods sold of the property.

Application to Pass-Thru Entities, Individuals, and Expanded Affiliated Groups

S-Corporations, partnerships, estates, trusts, and other pass-thru entities are entitled to a deduction which shall be applied at the shareholder, partner, or similar level. Individuals should base their deduction on the lesser of QPAI or adjusted gross income rather than taxable income. Expanded affiliated groups are treated as one corporation for the section 199 deduction which is then allocated among members based on their proportionate share of QPAI.

Effect on Extraterritorial Income Exclusion

The Act repeals the extraterritorial income (ETI) exclusion, with certain transition rules in effect.

Filing Requirements

All taxpayers claiming the Domestic Production Activities Deduction must use Form 8903, a one-page form that details qualified production activities income, applies the limitations, and yields the allowable deduction.

Source - Thomson /RIA (http://ria.thomson.com)