Published May 2005

New tax deduction helps
broad range of businesses

By Mary Decker
Guest Columnist

There’s a brand new tax deduction in town. Understanding and planning for it could help you save taxes down the road. It’s the new “manufacturer’s deduction,” also known as the “domestic production activities” deduction.

This deduction was created as part of the American Jobs Creation Act of 2004, and is effective for tax years beginning after Dec. 31, 2004. It was designed to help offset the repeal of the “Extraterritorial Income Exclusion,” a tax benefit for exporters. However, the manufacturer’s deduction isn’t just for exporters. In fact, the new deduction isn’t just for manufacturers, either.

Who can take the deduction? It’s available to businesses that have all three of the following: Qualified Production Activities Income (QPAI), taxable income and wages paid. This includes sole proprietors, partnerships, “C” corporations and “S” corporations.

How much is it? The amount of the deduction is 9 percent of the lesser of QPAI or taxable income, and is limited to 50 percent of W-2 wages. For individuals, adjusted gross income is used instead of taxable income. It is being phased in, with the percentage set at 3 percent for 2005 and 2006, 6 percent for 2007 through 2009, and 9 percent thereafter.

What is QPAI? QPAI is net income from certain activities. Net income, in this case, means domestic production gross receipts (DPGR) minus cost of goods sold and other allocated costs for such activities.

DPGR includes several categories of income:

• Income from qualifying property that was manufactured, produced, grown or extracted by the taxpayer in whole or significant part within the United States.
• Income from production of qualified film, electricity, natural gas and potable water.
• Income from construction performed in the United States, plus engineering and architectural services performed in the United States for construction projects in the United States.

Qualifying property means tangible personal property, computer software and sound recordings. Generally, food production qualifies, but the sale of food and beverages prepared by the taxpayer at a retail establishment does not qualify for this deduction.

Construction means erection or substantial renovation of residential or commercial real property. Both general contractors and subcontractors may qualify. Rental income from self-constructed property does not qualify, but the sale of such property does. Engineering and architectural services must relate to real property construction, be performed in the United States and relate to a construction project in the United States.

How can you plan to maximize the deduction? Sole proprietors and partnerships may consider incorporating and taking salaries in order to create or increase W-2 wages. All businesses should make sure that their accounting systems are set up to distinguish between DPGR and non-DPGR and make the cost allocations allowed under the guidelines provided by the IRS. Engineers and architects should retain records documenting how their services qualify for the deduction.

If your business might benefit from this deduction, consult with your CPA regarding adjustments you could make now to make the most of the new “manufacturer’s” deduction.

Mary Decker, a shareholder with Hascal, Sjoholm & Co. PS in Everett, is a certified public accountant and a certified financial planner. She can be reached at 425-252-3173 or by e-mail to maryd@hascal.com.

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