The New Manufacturers'/Producers Deduction

The New Manufacturers’/Producers’ Deduction: New Consulting-Service Opportunities Abound

By Jack Surgent, CPA

The change made by the American Jobs Creation Act of 2004 that will have the broadest impact on the accounting profession is Code §199, the so-called manufacturers’/producers’ tax deduction.  

When fully phased in, the deduction is equal to nine percent of the lesser of the qualified production activities income (QPAI) of the taxpayer for the taxable year, or taxable income for the taxable year (adjusted gross income in the case of an individual). 

This new Code §199 deduction starts at three percent for taxable years beginning in 2005 and 2006 and six percent in the case of taxable years beginning in 2007, 2008, or 2009. However, the deduction cannot exceed 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. 

Consulting-service opportunities abound to help clients revise accounting systems to capture the information necessary to maximize the new tax deduction as well as choose the best entity and establish the optimum W-2 wage level.

Who Qualifies?

Many construction activities performed in the United States qualify for the deduction. This includes not only the prime construction contractor of residential or commercial buildings, but also all of the ancillary activities associated with the erection or substantial renovation of real property. 

All of the contractors and subcontractors on a job could qualify for the deduction. Electrical contractors, for example, may qualify the gross receipts from some of its jobs while other jobs will not. Improving land (i.e., grading and landscaping) and painting are activities that are considered “construction” in certain circumstances. Accountants must develop systems for such clients that will segregate the jobs that qualify from those that do not. 

Farming activities performed in the United States may also qualify for this new deduction if a production process (i.e., packaging) or storage activity occurs at the farm location. Traditionally, many small farm operations have elected out of the uniform capitalization rules in the past and will need professional assistance to establish a cost-allocation system to maximize the new manufacturers’/producers’ deduction and maintain the records to substantiate it.

Qualified production activity is somewhat of a misnomer as it sometimes encompasses services. Engineering and architectural services qualify as domestic production activities. However, taxpayers will have to draw the distinction between manufacture, production, growth, or extraction on the one hand and services or “embedded services” within a production process and separately account for them because of the different tax consequences. 

Embedded services can be disregarded in certain circumstances if the taxpayer, with your professional advice, can develop valuation methods that can determine the relative value of such services to the manufacture or production process. 

Because the deduction only applies to activities in whole or in significant part within the United States, many integrated business operations must determine which receipts are “domestic” and which are not. Hence, additional consulting-service opportunities exist if you understand the rules for related-party transactions under new Code §199.

Allocation Issues

Allocation issues abound in the new law. Cost allocation is required for the cost of goods sold. Taxpayers who are currently using uniform capitalization with respect to inventory will find this area generally familiar, but with modifications. However, the inventory generating QPAI must be segregated from those generating non-QPAI. 

The second cost allocation is for deductions, expenses, and losses directly allocable to domestic-production gross receipts. The third category is the ratable portion of deductions not directly allocable to those receipts or another class of income. Accountants will be called on to determine which items are directly allocable and which are not, and, in the latter case, to apportion such items between domestic-production gross receipts and other receipts. 

The apportionment is complex and has its own set of special rules. Fortunately, smaller taxpayers (measured by level of gross receipts) may use some simplified procedures for cost allocation.

Special Rules

Special rules apply with respect to pass-through entities and their owners. The deduction for qualified production activities is determined at the partner/member, shareholder, or similar level by taking into account the distributive or proportionate share of all items allocated or attributable to the pass-through entity's qualified production activities to the extent those items are not otherwise disallowed. 

The owner will aggregate its items of income or expense (including W-2 wages) allocated to the qualified production activities of the pass-through entity, regardless of whether the pass-through entity otherwise has taxable income. Accordingly, the limitation on the deduction in the case of an individual is based on the individual partner’s/member’s or shareholder’s adjusted gross income, which takes into account income from all sources. 

The determination of the W-2 wages also has a wrinkle in the pass-through context. The law limits the partner’s or shareholder’s share of W-2 wages to two times the “deduction rate” times the QPAI of the pass-through entity, taking into account only those items allocated to the partner or shareholder. Payment of W-2 wages after some point does not increase the deduction. Payment of wages by the right entity may be a new planning area for tax advisors.

Accountants are facing a daunting, but important, task in providing advice to clients across the board for this deduction. 

Jack Surgent is a renowned instructor and enlightening speaker for CPAs across the country. He is the highly rated speaker at MSCPA’s annual Surgent’s Tax Camp every year.