U.S. Production Activities Deduction
(Section 199 Deduction)

by Jim Stephens, CPA Elliot & Warren, PLLC

The Internal Revenue Code Section 199 domestic production activities deduction was enacted to help reduce the tax burden on domestic manufacturers, make investments in domestic manufacturing facilities more attractive and offset the repeal of the extraterritorial income exclusion. The deduction is available to C corporations, S corporations, partnerships, sole proprietors, cooperatives, estates and trusts.

For tax years beginning after 2004, Internal Revenue Code Section 199 allows the taxpayers to claim a deduction equal to a specified percentage of the income earned from qualified production activities undertaken in the U.S. Production activities in the U.S. include manufacturing, food production, software development, film and music production, production of electricity, natural gas or water, construction and engineering/architectural services.

The deduction equals the lesser of A) the specified percentage of the smaller of 1) the "qualified production activities income" of the taxpayer for the year or 2) taxable income (modified adjusted gross income for individual taxpayers) without regard to the manufacturing deduction, and B) 50% of the W-2 wages of the employer for the year. These wages include wages that are subject to withholding that must be included on the employees Forms W-2. The deduction percentage is 3% for tax years beginning in 2005 and 2006, 6% for tax years beginning in 2007 - 2009, and 9% thereafter.

Qualified production activities income is equal to domestic production gross receipts over the sum of the cost of goods sold allocable to those receipts, other deductions or expenses directly allocable to those receipts (marketing & selling) and a ratable portion of other deductions and expenses not directly allocable to those receipts (general and administrative expenses allocable to selling and marketing. Qualified domestic gross receipts are: 1) The taxpayers gross receipts derived from any sale, exchange or other disposition, or any lease, rental or license, of qualifying production property that was manufactured, produced, grown or extracted by the taxpayer within the U.S. 2) Construction activities performed in the U.S. 3) Engineering or architectural services performed in the U.S. for construction projects located in the U.S. Qualified production activities income is determined on an item by item basis. For construction, architectural and engineering services, "item" is determined on a case by case basis, taking into account all the facts and circumstances.

To calculate the deduction the taxpayer must 1) determine its domestic production gross receipts, 2) determine its qualified production activities income by netting its costs of goods sold and deductions against domestic production gross receipts, 3) determine its taxable income without regards to the Section 199 deduction, 4) multiply the smaller of 2 or 3 by the applicable percent, and 5) apply the amount in 4 to the 50% of W-2's limitation. The result is the Section 199 deduction.

Activities available for the Section 199 Deduction:

• The manufacture or production of qualifying production property (tangible personal property, computer software, certain sound recordings) in whole or in significant part within the U.S.
• The performance of construction activities within the U.S by a taxpayer that is in a trade or business that is considered construction.
• The performance of engineering or architectural services in the U.S. in connection with construction projects in the U.S.
• The production of any qualified film.

The deduction is not available for services except for construction and engineering/architectural services, and is not available for purely sales activities.

Manufacturing and production activities include constructing, building, installing, manufacturing, developing, improving or creating. This includes materials analysis and selection, subcontractor inspections, testing of component parts, assisting customers in their review and approval of the property and productions inspections. This includes making qualified production property out of scrap, salvage or junk material as well as new or raw materials. The taxpayer is not required to manufacture or produce finished items, but may manufacture or produce component parts. Packaging, repackaging, labeling, performing minor assembly or installation, but not otherwise manufacturing or producing the property, does not entitle the taxpayer to the deduction.

The paragraphs above represent the general rules regarding the Section 199 deduction. Please contact Jim Stephens, CPA at (704) 333-8881 if you have any further questions.