United States: Domestic Production Activities Deduction Presents new Planning Opportunities

The newly-created Section 199 provides a deduction for domestic manufacturers and others that work to effectively lower their income tax rates on qualified activities. The deduction applies to tax years beginning on or after January 1, 2005. Advance planning may maximize your deduction, not only for 2005, but perhaps more importantly, for future periods. The release of interim guidance in Notice 2005-14 makes initial advanced planning possible.

Eligible taxpayers are permitted to claim a deduction of 3% of qualified production activities income in 2005, which increases to 6% in 2007 and 9% in 2010. Activities that qualify for the deduction include more than traditional manufacturing. The lease, rental, sale, license, exchange, or disposition of qualifying production property is eligible if the taxpayer conducts all or a significant portion of the manufacturing, production, growth, or extraction in the United States. Qualified production property includes tangible personal property, computer software and sound recordings. Engineering and architectural services and the production of electricity, natural gas, and potable water may also qualify.

The amount of the deduction is equal to the gross receipts related to the production activity, less the cost of goods sold, less an allocable portion of direct and indirect costs for the production activity. Taxpayers need to adopt a methodology for determining each of these items. The interim IRS guidance generally gives taxpayers flexibility in choosing methods for calculating each of these items.

Gross receipts are allocated using any reasonable method. Reasonableness will depend upon, among other things, (1) whether the taxpayer uses the most accurate information, (2) whether the taxpayer uses the same information for internal management or other business purposes, (3) the time, burden, and cost of the various methods, and (4) whether the taxpayer applies the method consistently from year to year. The consistent use of a method means that the selection of the method in the first year may have lasting impact. For example, ABC Manufacturing produces its product partially overseas and partially in the United States. An allocation method is needed to divide its gross receipts between foreign activities and the domestic activities. Only the U.S. portion qualifies for the deduction, so ABC chooses to maximize the allocation to the domestic activity. In determining which method to use, ABC should consider not only how the methodology will impact 2005, but also the projected impact on 2006 and subsequent years.

The interim guidance requires the use of specific identification of cost of goods in accordance with the taxpayer's books and records. If the books and records do not permit specific identification, then any reasonable method may be used.

The interim guidance provides three methods for allocating direct and indirect costs. All taxpayers may allocate expenses by applying the rules provided for under Section 861, the foreign source income rules. Smaller taxpayers may avail themselves of one of two simplified methods. A taxpayer with average annual gross receipts of $25 million or less may use the simplified deduction method. Under the simplified deduction method, the taxpayer ratably allocates deductions based on relative gross receipts. Taxpayers with average annual gross receipts of $5 million or less, or who use the cash method, may use the small business simplified overall method. This method allows for ratable allocation based on the cost of goods sold.

All United States taxpayers are eligible for the deduction. Corporations and individuals claim the deduction on their tax returns for pass-through entities, such as S corporations and partnerships. The qualified production activities income is allocated to their owners, who claim the deduction on their returns.

• Taxpayers should assume they will need to defend on audit whether their activity constitutes qualified production activity. Taxpayers who split operations between the U.S. and other countries should consider creating or preserving documentation detailing the activities that occur in and outside of the United States.

• The interim guidance states that only one taxpayer may qualify for the deduction for any single activity. Only the party who is considered the owner under general tax principles may claim the deduction. Thus, contract manufacturers who do not own the property for federal income tax purposes are providing non-deductible services. Taxpayers using contract manufacturers, or who are contract manufacturers, may consider adding provisions to their OEM agreements that specify which party owns the qualified production property and thus may claim the deduction.

• Before adopting any method of allocation, a taxpayer should consider the impact the methodology may have on subsequent periods. The Internal Revenue Service may claim these methods constitute accounting methods that require its consent to change once adopted. Even if such an allocation method does not require consent to change, use of a method factors into the determinatess.

• The determination of the deduction occurs after all other portions of the Internal Revenue Code are applied, including the carryforward or carryback of net operating losses ("NOLs"). The deduction may not be carried forward or backward. To the extent a taxpayer has NOLs, a taxpayer may desire to delay, to the extent possible, the recognition of domestic production gross receipts to future periods when the taxpayer will not have NOLs.

• The computation of the qualified production activities income takes into account all of the activities of an expanded affiliated group ("EAG"). The test for an EAG generally borrows from the consolidated group rules in Section 1504(a), but substitutes "50%" for "80%." Affiliated entities may desire to change their relative ownership percentages to allow or prevent an entity from being included as part of an EAG. For example, combining a brother-sister entity may be advisable if one entity domestically produces a product that is sold or marketed (at a profit) by a related entity. If combined as an EAG, all of the combined income from that product may now be eligible for the deduction (as opposed to just the entity with domestic production).

• The deduction is also limited to 50% of the activities' employees' W-2 wages. The interim guidance provides for the flow-through of both the qualified production activities income and W-2 wages to their owners. Both the income and wages are aggregated at the ultimate taxpayer level. Taxpayers expecting qualified production activities income from entities that have no, or very low, W-2 wages, may consider investing in another entity that will provide for the flow-through of W-2 wages. For example, a taxpayer owns an interest in a wind farm that generates electricity. The wind farm has no employees, and therefore no W-2 wages. This taxpayer may gain the benefit of the deduction if the taxpayer also owns an interest in an entity with W-2 wages from domestic production activities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.