Accounting and Taxes | Archive

Editor’s note: This column begins a bimonthly, online commentary on accounting and tax issues by members of the Virginia staff of the accounting firm Cherry, Bekaert & Holland. The next column will appear in March.

IRS provides guidance on tax deductions for keeping jobs in U.S.

by R. David Field II
for Virginia Business
January 2006

The Treasury Department and the Internal Revenue Service (IRS) recently issued proposed regulations addressing requirements for the new domestic production activities tax deduction, which was enacted as part of the American Jobs Creation Act of 2004.

The domestic production deduction applies to tax years beginning after Dec. 31, 2004. The deduction is equal to 3 percent of a taxpayer’s qualifying income for 2005, and increases to 6 percent in 2006, then 9 percent for 2007-2009. The deduction is limited to the lesser of: 1) a taxpayer’s “qualified production activities income” or 2) his or her taxable income for the tax year. The deduction is further limited to 50 percent of W-2 wages paid during the relevant tax year and also can be used for purposes of the alternative minimum tax (AMT).

In order to determine the deduction, business owners must first calculate their qualified production activities income, which is equal to their “domestic production gross receipts,” reduced by the sum of:
-- allocable costs of goods sold;
-- other deductions directly allocable to such receipts; and
-- a proper share of other expenses indirectly related to such receipts.

Qualifying receipts
What types of transactions generate domestic production gross receipts? Taxpayers should review their gross receipts to determine if they derive income from:
-- sale of tangible property or tangible personal property (including computer software or sound recordings) manufactured, produced, grown or extracted in whole or in significant part within the U.S.;
-- sale of certain films produced by the taxpayer;
-- sale of electricity, natural gas or potable water produced by the taxpayer;
-- construction activities performed in the U.S.; or
-- engineering or architectural services performed for construction projects in the U.S.

Gross receipts derived from the performance of services are not qualifying receipts. However, gross receipts from certain embedded services (e.g., a qualified warranty, delivery and installation relating to the sale of qualifying property) may be included.

A safe harbor is provided for taxpayers whose gross receipts are predominantly domestic production gross receipts. If less than 5 percent of a taxpayer’s gross receipts are nonqualifying, then they are not required to allocate gross receipts.

The deduction is determined at the partner/shareholder level in the case of a partnership or S-corporation. Items attributable to qualifying production activities may pass through to the partner or shareholder only if the allocation has a substantial economic effect. It is up to each partner or shareholder to aggregate items allocable to the pass-through entity’s qualified activities, expenses directly incurred by the individual allocable to such activities, and items allocable to the individual's other qualified activities.

Start tax planning now
But even if a business generates income from domestic production activities, it may not qualify for the deduction. For example, if a business simply purchases and resells a product, that sale may not qualify. Also, if a taxpayer provides manufacturing services to another taxpayer (i.e. contract or toll manufacturing), then only the taxpayer who has the “benefits and burdens of ownership” of the property during the manufacturing process qualifies for the deduction.

The IRS regulations provide many examples to help taxpayers comply with these very complex rules. Developing an accounting system and tax strategy for implementing these rules will require a great deal of work for many business owners. However, the rewards of compliance with the new regulations may provide substantial tax savings.

With the start of a new tax year, taxpayers should work with their accountant to develop a plan for determining their eligibility for this new deduction. Without proper planning, business owners may miss a great opportunity to reduce their tax bill for the 2005 tax year and the years ahead.