Small Business Advisor

American Jobs Creation Act
New Deduction for Manufacturers

by Richard Jungck & Mark Wilkerson

Richard Junck and Mark Wilkerson

The recently enacted American Jobs Creation Act contains a significant new deduction for manufacturers, including an expanded definition of manufacturing. This article explains who would qualify for this deduction and strategies a taxpayer may need to adopt to enhance benefits from this new act.

Background

There have been various programs to aid businesses that exported products manufactured in the United States, ranging from the domestic international sales corporation to the foreign sales corporation and most recently the extraterritorial income exclusion. America���s trading partners objected because they felt these incentives were inconsistent with existing trade agreements. The new provision provides a deduction to companies that produce goods in the U.S. but does not require the goods be exported. You can qualify for the new deduction if you engage in any of the following activities:

Construction companies can qualify for the deduction if they engage in activities directly related to erection or substantial renovation of residential and commercial buildings and infrastructure. Activities merely cosmetic in nature, such as painting, would not qualify for the deduction. Any engineering or architectural services related to the qualifying construction activities would however, qualify for the deduction. Other activities specifically excluded from the new rule include:

The Jobs Act will phase out the foreign sales corporation and extraterritorial income exclusion that existed under the prior law. For example, if you qualified under prior rules you still receive 100% of your benefit in 2004 but only 80% of the benefits in 2005 and 60% in 2006. At that point the benefits for exporters are eliminated except for certain contracts. The new deduction will be effective for taxpayers whose tax year begins in 2005.

To determine the amount of the deduction, compute your domestic production gross receipts which would be the gross income from the qualifying activities identified earlier. From this gross income you deduct the direct cost of producing the item and any other expenses directly allocable to the production activity plus a proportionate share of indirect expenses. You may need to modify your accounting systems to capture this information.

Most businesses will likely have manufacturing activities qualifying for the deduction and other activities that do not qualify. For example, a manufacturer might provide other services to its customers, such as warranty work, and there would need to be an allocation between the income and expenses of the manufacturing activity and the non manufacturing activities. Once the qualified production activity income has been determined, you are entitled to a deduction that is a percentage of this net income. For 2005 and 2006, the deduction is 3% of the qualified income. In the tax years beginning in 2007 through 2009, the deduction is 6% and 9% after 2009. Thus, if after deducting allocable expenses from your qualified production income you have income of $500,000, the deduction for 2005 is 3% or $15,000, and once the deduction is fully implemented in 2009, the deduction increases to $45,000 for that year.

Example:

If a taxpayer is in the top income tax bracket, the effect of this law when it is fully implemented would reduce your top income tax rate by approximately 3%. If you are in a lower effective tax bracket then the benefit of this deduction will be less.

This deduction also reduces a taxpayer���s alternative minimum tax so that it does not have the flaw that some tax incentives have, in that it reduces your regular income tax but do not reduce your alternative minimum tax.

There are two limitations that could reduce your benefit from this new deduction. One is that your qualified production income cannot be higher than the entity���s taxable income if you are a C-corporation or your adjusted gross income if you are a sole proprietor or a pass-through owner such as a partner, S corporation shareholder or an LLC member.

The other potential limitation on the deduction for production activities is that the deduction cannot be more than 50% of your W-2 wages of the taxpayer. At this time, our understanding is that all W-2 wages can be included and that you are not limited to W-2 wages of production employees.

If you are a member of a pass-through entity, you would be allocated your share of the entity���s qualified production activity income and the lesser of your share of the entity���s W-2 wages or 18% of the qualified production activity income. An individual would then compute their allowable deduction applying the 50% of W-2 wages and adjusted gross income limitations. The qualified production activity deduction will not reduce self-employment income for purposes of computing self-employment tax.

One question unanswered is how do you determine whether an item is produced in the United States? The act itself does not define this term. Accordingly, taxpayers that import some of the components that go into the products they manufacture in the US may need to wait until regulations are issued to determine exactly how this calculation is going to be made. The Senate Bill did imply that at least 50% of the development and production costs must be incurred in the United States in order to qualify for this deduction.

As regulations are issued, it should become clearer as to which activities will qualify for the deduction as well as determining how to allocate expenses between qualifying and non qualifying activities.

Conclusion

Now is the time for you to review your activities to determine whether they qualify for this new deduction. Second, in the case of many taxpayers, you will have qualifying and non qualifying activities to allocate to compute the deduction. By using planning and foresight, you can enhance the amount of the deduction you could realize and thereby reduce your overall tax liability.

 

Richard Jungck is a partner and Mark Wilkerson, is a manager with BKD, LLP. They may be reached at 816.221.6300 or by email at djungck@bkd.com and mwilkerson@bkd.com.