Beginning in 2005, a new tax savings opportunity became available for qualifying manufacturers. The new income tax deduction was included in the American Jobs Creation Act of 2004.

New regulations regarding the application of the Domestic Production Activities Deduction under Section 199 of the Internal Revenue Code are now available. The following information will help you get acquainted with the deduction and how it applies to your company.

Do your production activities qualify?

The American Jobs Creation Act of 2004 created a new income tax deduction available to certain qualifying taxpayers. First available in tax years beginning on or after January 1, 2005, the deduction is calculated by multiplying net income from domestic production activities by a fixed percentage (3 percent in 2005, gradually increasing to 9 percent in 2010).

Net income used in the Domestic Production Activities Deduction calculation is derived from domestic production gross receipts that include:

• The manufacture, production, growth, or extraction of tangible personal property, computer software, or sound recordings in the United States.
• Qualified film production.
• Production of electricity, natural gas, or potable water in the United States.

The devil is in the details

As is the case with most tax deductions, there’s more to this deduction than meets the eye. While the above list may seem all-encompassing, each activity must be closely analyzed for items that can disqualify the activity or limit the amount of the deduction.

When determining the deduction, the following are just a few of the issues that must be addressed:

• Are your production activities “substantial?”
• Who bears the benefits and burdens of the production activity (a contract manufacturing issue)?
• Are services or warranties provided to your customers?
• Do embedded services (services for which a separate charge is not made) exist?
• Which of the allowed expense allocation methods will be the most beneficial yet administratively simple for your business?
• How does your company apply the taxpayer-favorable de minimis exception rules?
• Is your deduction affected by the taxable income and/or wage limitations? If so, would restructuring of your entities, compensation arrangements, or management fees provide a greater deduction?
• Are you part of an affiliated group of entities, or are you a flow-through entity?
• How does your company treat interest, dividends, and other receipts?

The following chart provides a high-level example of how the deduction calculation will work in the first year.

Do your data systems provide Section 199 information?

To obtain the maximum benefit, it is critical to prepare now. As outlined above, a number of questions will need to be answered and data gathered to properly claim the deduction.

You will need to provide many pieces of information to your tax advisor, and proper documentation will be essential for a successful claim. Planning now will help streamline the process at year-end. For more information, contact your nearest Wipfli office.