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How you can benefit from the new domestic production deduction

On Oct. 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004, which has more than 600 provisions. One of the biggest provisions is the domestic production deduction. In January 2005, the Treasury Department issued its "first thoughts" regarding the new deduction. The entire notice can be retrieved from the IRS Web site; see IRS Notice 2005-14.

The domestic production deduction allows taxpayers to deduct from their net income a percentage of their "qualified production activity income" or QPAI. That percentage is:

• 3% in 2005-2006
• 6% in 2007-2009
• 9% after 2009

How much could the domestic production deduction lower your taxes?

Let's look at a simplified example to summarize the potential tax savings. Company WillHire has taxable income of $1 million. Assume that 100% of the taxable income of WillHire is QPAI, and that the taxable income is subject to a flat 35% federal tax rate (ignoring state tax complications). Without the new domestic production deduction, WillHire would owe $350,000 in federal income tax. The table below shows the tax savings possible with the new deduction:

Years	Potential Deduction	Taxable Income after Deduction	Income Tax	Savings
2005 and 2006	$30,000 (3% of $1,000,000)	$970,000	$339,500	$10,500
2007 through 2009	$60,000 (6% of $1,000000)	$940,000	$329,000	$21,000
2010 and after	$90,000 (9% of $1,000000)	$910,000	$318,500	$31,500

A few fortunate taxpayers will discover that a simple calculation may determine their domestic production deduction benefit. Most will find that their calculation will require much greater effort than shown in the above example.

As its name indicates, the domestic production deduction is a deduction, not a rate cut or a credit. To the extent your actual tax rate is less than 35%, your benefit will be less. However, since many states simply take federal taxable income as their taxable income, there could be a state benefit as well. A word of caution: As with bonus depreciation, many states may opt to adjust federal taxable income to disallow this new deduction.

Who qualifies for the domestic production deduction?

Taxpayers that “manufacture, produce, grow or extract” (MPGE) goods in the United States and have income from those activities will generally qualify for the domestic production deduction. This includes C corporations, S corporations, partnerships (including LLCs), individuals, estates and trusts. The deduction is also allowed for alternative minimum tax, or AMT, purposes. Consequently, taxpayers can benefit even if they incur the AMT.

Some qualifiers include:

• Manufacturers (broadly defined to include a wide variety of production activities);
• Farmers and handlers of agricultural products;
• Software companies;
• Film and music production companies;
• Electric, gas and water companies—production, but not transmission;
• Construction and renovation companies—commercial and residential, infrastructure construction and improvements (roads, power lines, water plant, sewage plant, etc.);
• Engineering and architectural firms—activities related to construction of real property as noted above; and
• Oil and gas companies

Who does not qualify?

The domestic production deduction does not apply to pure sales organizations or pure service companies. Rental of real property and non-flow-through security investments and security partnerships also do not qualify.

What constitutes domestic production gross receipts (DPGR)?

DPGR includes gross receipts derived from any lease, rental, license, sale, exchange or other disposition of:

• Qualifying production property manufactured, produced, grown or extracted (MPGE) by the taxpayer in whole or “in significant part” in the U.S.;
• Any qualified film produced by the taxpayer;
• Electricity, natural gas or potable water produced by the taxpayer in the U.S.;
• Gross receipts from the sale, exchange or other disposition of real estate constructed in the U.S. or from compensation received for construction services; and
• Engineering or architectural services performed in the U.S. for construction of U.S. real estate.

The deduction is based on U.S. activities. A safe-harbor rule is used to determine whether a product is MPGE “in significant part”—this rule indicates that the U.S. costs must be at least 20% of the total costs of the product in order for any allocation of gross receipts to DPGR (not including packaging and design costs).

Only one taxpayer may claim to “manufacture, produce, grow or extract” (MPGE) tangible personal property. Therefore, in contract manufacturing, only the taxpayer with the benefits and burdens of product ownership may count the receipts as DPGR. An exception is made for construction contractors; more than one contractor may claim to produce the same real estate asset (i.e., the general contractor and subcontractor on a construction project).

Many companies may find that only a portion of their activities qualify for the domestic production deduction. When a taxpayer has less than 95% of its gross receipts qualifying as DPGR, it must allocate its cost of goods sold and other expenses according to detail rules provided in IRS Notice 2005-14.

In some cases, it may be difficult to determine the domestic production deduction, such as real estate projects where land cost is part of the sale. (According to the notice, proceeds allocated to land do not count as DPGR). The method of transmission can also affect eligibility. For example, downloaded software does not qualify for the deduction, but software on CDs does.

What does not qualify as DPGR?

Embedded services do not qualify for the deduction unless they are less than 5% of total gross receipts, or they consist of “qualified warranties.” (A warranty that is not sold separately from the product is a qualified warranty.)
The sale of food and beverages prepared by the taxpayer at a retail establishment does not qualify. However, there is an exception carved out for food and beverages sold directly for wholesale use.
Transmission or distribution of electricity, natural gas or potable water does not qualify.

How can you calculate the domestic production deduction?

Find your domestic production gross receipts and subtract:

1. Allocable cost of goods sold;
2. Allocable direct expenses; and
3. Allocable portion of indirect expenses.

These steps will determine your qualified production activity income, or QPAI, which is then subject to the limitations noted below.

What are the limits of the domestic production deduction?

The deduction is limited to:

• The lesser of taxable income from qualified production activities, or taxable income for the year without regard to the domestic production deduction (or modified adjusted gross income in the case of an individual); and
• Fifty percent of domestic wages paid.

For pass-through entities such as S corporations and partnerships, the components of the deduction are calculated at the entity level and flow through to the shareholder/partner. The shareholder/partner must then combine all qualified activities to determine the deduction allowed on his or her return. The maximum amount of the wage component allowed to pass through to the shareholder/partner is double the calculated QPAI of the flow-through entity.

How are wages defined?

The notice lists three methods of computing W-2 wages for use in the wage limitation. The first method allows a taxpayer to use the lesser of the W-2 wages reported in Box 1 or Box 5 of Forms W-2. The other two methods provide a more precise determination of W-2 wages, but are more complex. W-2 wages are the wages of the taxpayer's common-law employees.

IRS notice gives rise to many questions

Taxpayer comments regarding the IRS notice have included questions such as:

• Do costs of leased employees qualify as W-2 wages?
• What about self-employed individuals who have no wages?
• Does hedging of inventory items qualify as DPGR?
• What does the IRS mean by the "benefits and burdens" of ownership in contract manufacturing situations and why the difference between manufacturers and contractors?

Need advice on which numbers you need to begin tracking to determine what the
domestic production deduction can offer you? Contact Mike Calahan at 312-980-2996. Our thanks to Leslie Dunlop for her assistance in writing this article.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.