Made in America

U.S. taxpayers can immediately take a 3% tax deduction for U.S.-based business activities.

by Rizvana Zameeruddin

EXECUTIVE SUMMARY

IRC section 199 provides a permanent and recurring deduction equal to 3% to 9% of the lesser of qualified production activities or taxable income, which cannot exceed 50% of W-2 wages paid. The deduction applies to activities related to installing, developing, improving or creating goods that are “manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the United States.” The deduction is being phased in between tax years 2005 and 2010. IRS notice 2005-14 provides guidance on the deduction and temporary regulations; taxpayers may rely on either of these sources until final regulations are issued. The deduction is available to individuals, trusts and estates, partnerships and other pass-through entities such as S corporations and limited liability companies who provide certain services, or legally manufacture or retail products in the United States. For purposes of the qualified production activities (QPA) deduction, all members of an expanded affiliated group (EAG) are treated as a single corporation. In allocating and apportioning expenses, CPAs must specifically identify the costs attributable to domestic receipts. If that’s not possible, they can use any reasonable method for allocation. Most taxpayers that have qualifying domestically produced gross receipts (DPGR) can apply the QPA deduction for the purposes of both regular and alternative minimum tax. Rizvana Zameeruddin, CPA, JD, LLM, is an assistant professor of accountancy at the University of Wisconsin-Parkside in Kenosha. Her e-mail address is zameerud@uwp.edu.

espite its complexity, IRC section 199 provides significant and immediate tax relief to many U.S. taxpayers. Section 199 is a tax deduction equal to 3% of net income. Due to a broad interpretation of what constitutes “manufacturing,” if your clients are in the manufacturing, retail or certain service industries, they may be entitled to take advantage of the qualified production activities (QPA) tax deduction.

American Jobs Creation Act of 2004 to help grow U.S. manufacturing jobs. The IRC section 199 qualified production activities deduction replaces IRC section 114, extraterritorial income (ETI) exclusion. This article gives CPAs guidance on how to calculate the QPA deduction and outlines areas that may be relevant or troublesome for their clients. Until final regulations have been issued, CPAs may rely on either IRS notice 2004–15, or the temporary regulations for further guidance.

OVERVIEW OF THE DEDUCTION
The qualified production activities (QPA) deduction is available to individuals, trusts and estates, partnerships and other pass-through entities such as S corporations and limited liability companies who provide certain services, or legally manufacture or retail products in the United States. For pass-through entities, the QPA deduction’s rules are applied at the shareholder or partner level, and for affiliated groups, the test is determined at the corporate-entity level. The deduction is claimed on IRS form 8903; CPAs should review form 8903, consolidated roll-ups and schedule K-1 before preparing the client’s tax return.

Unlike the extraterritorial income (ETI) deduction, the qualified production activities (QPA) deduction does not mandate that taxpayers export their product to qualify. Many products and services produced and performed in the United States qualify for the QPA deduction, including film, sound recordings, construction, engineering services, architectural services and computer software.

In order to obtain the qualified production activities (QPA) deduction benefit, taxpayers must satisfy the threshold definition of qualified production activities income (QPAI). If a taxpayer has a current-year net operating loss (NOL) determined after NOL carryovers, the deduction is not allowed, and an ordering rule prevents the QPA deduction from creating or increasing an NOL.

CALCULATING THE DEDUCTION
Depending on the nature of your client’s business, computing the deduction can be either very straightforward or extremely involved. To accurately calculate the deduction, CPAs must look closely at the qualified production activities income (QPAI) and the limitations. The deduction percentage is 3% for tax years 2005 to 2006. The deduction increases to 6% for tax years 2007 to 2009, and maximizes at 9% for tax year 2010 and after.

The deduction is calculated by taking the lesser of the taxpayer’s QPAI or taxable income, multiplying it by the phased-in deduction percentage, which ranges from 3% to 9%, and then applying the W-2 wage cap, which is 50% of wages paid. QPAI is determined by reducing the domestically produced gross receipts (DPGR) by the cost of goods sold allocable to DPGR, other deductions and expenses directly allocable to DPGR, and a ratable portion of other expenses indirectly allocable to DPGR. For purposes of applying the W-2 wage limitation, an owner’s share of allocated QPAI also is treated as the owner’s share of W-2 wages from the pass-through entity. The following chart provides the maximum qualified production activities (QPA) deduction percentage permitted between tax years 2005 and 2010.

Activities such as packaging, repackaging, labeling and minor assembly operations do not qualify as domestically produced gross receipts (DPGR). A safe-harbor rule permits taxpayers to allocate all gross receipts as domestically produced if less than 5% of those receipts are non-domestically produced. In the ordinary course of a taxpayer’s business, embedded services generally qualify as DPGR, provided they are not bargained for or offered to the customer separately from the qualified production property (QPP). There are five exceptions to this rule identified in the temporary regulations: qualified warranties, qualified deliveries, qualified operating manuals (may not be provided in conjunction with a customer training course), qualified installations (including assembly) and de minimis amount of 5% received from embedded services. Since keeping track of DPGR and related expenses can be cumbersome, CPAs should help their clients by designing and implementing an accounting system that helps to make these tasks easier.

Example. Park Co. manufactures copy machines. It offers customers training but invoices them a single fee for the machines and training. Park Co. must allocate the receipts and costs between the equipment and the training services. If gross receipts from the training are less than 5% of the gross receipts for the equipment, the services qualify as domestically produced gross receipts (DPGR) under the de minimis rule.

Qualified production property (QPP) includes any tangible personal property, certain sound recordings and computer software, including software that is an integral part of other property, copiers, printers and accounting machines. Software does not include Internet access, online services or technical support.

Example. If a musician produces a sound recording on a purchased CD, which is tangible personal property, then the sound recording itself is treated as tangible personal property. If the musician then sells a duplicated CD, the gross receipts from the sale are domestically produced gross receipts (DPGR).

Under section 199, goods that are manufactured, produced, grown or extracted (MPGE) in the United States are included in the calculation for the QPA deduction. Section 199 broadly defines MPGE activities as those relating to installing, developing, improving and creating qualified production property. Making qualified production property (QPP) out of scrap material, changing the form of an article or combining or assembling two or more articles also constitutes “manufacturing.” If an activity is manufactured under section 199, it is a qualified production activity and can therefore be included in the calculation for the qualified production activity (QPA) deduction. Certain farming activities also may qualify as MPGE; however, resale and repair activities generally do not qualify.

Example. Madison Co. manufactures farm equipment, which is qualified production property in the United States, and sells it to Lane Co., an unrelated party. Lane leases the farm equipment for two years to Mayfair Co., an unrelated party to both Madison and Lane. Madison then repurchases the farm equipment from Lane, and Mayfair remains the tenant until the end of the lease. At lease end Mayfair purchases the farm equipment from Madison. Madison’s proceeds derived from the sale of the farm equipment to Lane, from the lease to Mayfair and the sale to Mayfair all qualify as DPGR.

To take the deduction, taxpayers should maintain the benefits and burdens of qualified production property ownership while the goods are manufactured, produced, grown or extracted. Section 199 specifically states that property manufactured for the federal government qualifies for the deduction while income generated from the disposition of land does not. Corporations claiming the deduction for income of a subsidiary must own more than 50% of the subsidiary. Only one taxpayer may claim the deduction for any one QPP. This rule is inconsistent with IRC section 263A rules, where more than one taxpayer may be considered a producer.

Example. Park Co. enters into a contract with Lane Co. to manufacture a printing press, which is qualified production property. Park maintains control over the manufacturing process, while Lane has the benefits and burdens of the printing press manufacturing process. Only Lane is considered a producer for IRC section 199 purposes, though both companies are considered producers under section 263A. As a producer for section 199 purposes, Lane may include the cost of the printing press in its calculation of its qualified production activities deduction.

Section 199 permits a deduction for items manufactured in whole or in significant part. In identifying whether to treat an item as manufactured in whole or in significant part, one of two tests must be met. The first is the “substantial in nature” test. To meet its requirements the taxpayer’s activity must add relative value to the product. The value added must be substantial in nature, based on the nature of the product and the taxpayer’s manufactured, produced, grown or extracted (MPGE) activity.

Example. Lexington Co. purchases fur to produce coats in the United States. Lexington measures, cuts, stitches and lines the fur and combines the finished materials. The raw material costs are greater than 80% of the finished product. The nature of the product and Lexington’s activities are substantial in nature.

The second test is a safe harbor “20% conversion costs” test. If the taxpayer’s conversion costs, which consist of direct labor and factory burden, are at least 20% of the total cost of the property, they are deemed to be substantial under this test.

Example. Broadway Co. manufactures radar detectors at a total cost of $200 per unit. Broadway purchases electronic component parts from a foreign supplier for $120 per unit. Raw materials cost $40 and conversion costs $40 (labor and factory burden). Broadway satisfies the 20% conversion cost test.

Example. Home Co. produces the chemical ingredient for cologne in the United States and sells it to Overseas Co., a foreign corporation. Overseas uses the ingredient to manufacture finished cologne and sells the finished product to Home. Home then sells the cologne to its customers. Home has domestically produced gross receipts (DPGR) for its initial sale of the chemical ingredient to Overseas. If its conversion costs are at least 20% or the value added is substantial in nature, Home also has DPGR for the finished cologne.

Qualified production activities income is determined on an item-by-item basis only; allocation by product line or division is not permitted. A product offered for sale that meets all the requirements of section 199 is an item. If only a portion of the product meets the requirements, only that portion is considered an item. (This is known as the shrink-back rule.) If two or more pieces of property are offered for sale, they must be packaged and sold together to qualify as an item.

Example. Canvas Co. manufacturers and sells framed artwork. Canvas prints the artwork, imports the frames and assembles the product. If the total conversion costs in the United States are equal to or greater than 20%, then all of the receipts qualify as domestically produced gross receipts. If the conversion costs are less than 20%, the printed artwork is considered the item and only the gross receipts allocable to the artwork qualify as DPGR. See the case study on calculating the QPA deduction.

ADDITIONAL CONSIDERATION
In allocating and apportioning expenses, CPAs must specifically identify the costs attributable to domestic receipts. If that’s not possible, they can use any reasonable method for allocation that is satisfactory and accurately identifies the gross receipts that constitute domestic receipts. CPAs can help clients maximize the deduction by advising clients to use time-saving technologies such as tax allocation software. Interim guidance provides three methods of allocation and apportionment of deduction: the section 861 method, simplified deduction method or small business simplified method.

Practical Tips

In order to maximize the QPA deduction, advise clients to use time-saving technologies to keep track of DPGR and related expenses. Review form 8903, consolidated roll-ups and schedule K-1 before preparing the tax return. If the simplified method is not applicable, allocate expenses using IRC section 861.

SPECIAL INVENTORY RULES
If CPAs determine that their clients do not qualify for the two simplified methods, they must use the section 861 method. If they use Fifo for inventory valuation, they should allocate the proper share of valuation adjustments. If Lifo is used, a reasonable method to allocate between domestically produced gross receipts (DPGR) and non-DPGR should be used. For unified capitalization (UNICAP) rule purposes, the absorption ratio is applied to the section 471 cost of goods sold (COGS). The UNICAP rules provide that certain distribution costs incurred in distributing goods to nonrelated customers do not need to be capitalized.

Even if receipts and costs are in different accounting periods, CPAs can use their own method to account for gross receipts and costs. This may result in DPGR being recorded in a year earlier than the related costs.

Example. In 2006 Flower Co. enters into a contract with Tree Co. (an unrelated party) for the sale of landscaping plants, which are qualified production property (QPP), and Tree Co. pays Flower Co. In 2007 Flower Co. grows the landscaping plants and delivers them to Tree Co. Flower Co. includes Tree’s payment in its 2006 gross income figure, and the payment is DPGR in 2006. Flower’s cost of goods sold is included in determining its qualified production activities income in 2007.

EXPANDED AFFILIATED GROUPS
For purposes of the qualified production activities (QPA) deduction, all members of an expanded affiliated group (EAG) are treated as a single corporation. An EAG is a chain of includible corporations connected through at least 80% stock ownership with a common parent corporation. Each EAG can receive only one QPA deduction, which is allocated ratably in proportion to each group member’s qualified production activities income (QPAI). If transactions between EAG members are created purely to qualify for domestically produced gross receipts (DPGR), the entire benefit is eliminated. For members of a consolidated group, income and expenses may be re-determined under Treasury regulations section 1.1502-13. This produces the effect on income as if the members were a single corporation.

Example. ABC Co. and XYZ Co. are members of a consolidated group. ABC manufactures bindery equipment costing $10,000 and leases it to XYZ for $4,000. XYZ uses the machinery in its manufacturing business and deducts depreciation of $1,500. XYZ sells books (qualified production property) manufactured with the machinery for $12,000 and incurs $3,000 of COGS related to the sale. To determine the QPAI, it would first re-determine income under 1.1502-13, then eliminate lease income and expense: DPGR ($12,000) – COGS ($3,000) – depreciation ($1,500) = QPAI ($7,500).

FINAL THOUGHT
Although section 199’s allocation requirements seem cumbersome, the vast benefits of the deduction may be reaped immediately. The regulations provide much-needed clarification of the simplified methods and safe harbors under notice 2005-14. Although the administrative burden of allocating qualified production property gross receipts between domestically produced gross receipts (DPGR) and non-DPGR may seem vast for smaller taxpayers, the simplified allocation methods make the potential benefit worth the extra costs. Larger taxpayers, despite having to use the cumbersome section 861 regulations for allocation, also may see immediate benefits.

Taxpayers who manufacture qualified production property in the United States and assemble the finished product overseas may be especially surprised to find that the section 199 deduction is much greater than they originally had anticipated.