Manufacturing deduction

guest commentary by David Potts

The American Jobs Creation Act of 2004 created a new deduction to provide incentives for manufacturing companies to manufacture their products in the United States. This deduction is sometimes referred to as “the manufacturing deduction,” the “domestic production deduction” or the “section 199 deduction.”

The amount of the deduction was phased in, beginning in 2005, equaling  3% of net income from eligible activities undertaken in the United States, to 9% of that net income in 2010 and years thereafter. For 2010 and years thereafter, this deduction effectively cuts the business’ income tax rate on this income two to three percent, depending on the taxpayer’s effective tax rate bracket.

The deduction is calculated by multiplying the lessor of “qualified production activities income” or its taxable income by 9%. The deduction is limited to 50% of the business’ W2 wages attributed to its domestic production activities. But rather than engage in an exercise in calculating the amount of this deduction, let’s investigate the possibility that you qualify for this deduction and might not know it. You should let your income tax preparer calculate the amount of the deduction, but make sure he understands how you make your money. Without a full understanding of how your business makes its money, your tax return preparer may be inadvertently understating the amount of your section 199 deduction or even failing to take the deduction at all.

Qualified production activities are activities performed in the United States by manufacturing, producing, growing, or extracting. The definition of qualified production activities income is so broad that if your business has gross receipts from the lease, rental, license, sale, exchange, or other disposition of tangible personal property, computer software, electricity, natural gas, or potable water your business produced in the United States, or gross receipts from the construction of real property including engineering and architectural services, your business should qualify for the section 199 deduction.

Tax regulations describe qualifying activities as developing; improving; manufacturing from scrap, salvage, or junk material as well as from new or raw material; processing, manipulating, or refining; changing the form of the property; combining or assembling; cultivating soil; raising livestock; mining materials; fishing; storage and handling activities connected with certain agricultural products. Qualifying activities do not include transportation, packaging, labeling, or minor assembly. Preparing and selling food in a restaurant are specifically excluded as a qualified activity.

The point I want to make is that correctly calculating your section 199 deduction is complicated and if you want the full benefit of the deduction in 2010, you should sit down with your income tax preparer to discuss in detail how your business operates and make sure he understands enough about your business to properly calculate your section 199 deduction. There are tax planning opportunities available to save you money, but the best results will be achieved through a team effort with you and your income tax preparer.

Keep in mind that you’re working with the Internal Revenue Code and the Internal Revenue Service. What the Lord giveth, the Lord taketh away. The IRS has designated the section 199 deduction and its calculation as a top audit issue. When calculating section 199 deduction make sure your calculation is well documented.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

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