- New Law Provides Tax Breaks for Domestic Production Activities
- December 7, 2004 | Author: Joan M. Roll
- Law Firm: Pepper Hamilton LLP - Philadelphia Office
The American Jobs Creation Act of 2004 creates a new tax deduction for businesses engaged in domestic production activities. The new deduction replaces the extraterritorial income (ETI) exclusion for U.S. exports. Unlike the ETI exclusion, the new deduction is not limited to exports and is not limited to traditional manufacturing. The new deduction is effective for tax years beginning after December 31, 2004 and will be phased in over the next six years. When fully phased in, the deduction will translate to an effective 3 percent reduction in tax rates for income from domestic production activities. The deduction applies to corporations, partnerships, LLCs and sole proprietorships.
What are "Domestic Production Activities" Eligible for the Deduction?
Domestic production activities are significantly broader than traditional manufacturing activities, and include manufacturing, production, growth or extraction (but not the distribution) of:
- tangible personal property
- computer software
- certain sound recordings
- certain films
- electricity, natural gas or potable water.
Application to U.S. Construction Industry
The deduction also applies to U.S. construction, and engineering or architectural services performed in the U.S. for U.S. construction projects. Eligible construction includes erection or substantial renovation of residential and commercial buildings. However, cosmetic changes, such as painting, are not eligible.
Calculating the Deduction
In general, the amount of the deduction is equal to a percentage (see table below) of "qualified production activities income."
Tax Year Applicable Percentage 2005, 2006 3 percent 2007, 2008, 2009 6 percent 2010 9 percent
W-2 Wage Limit
The amount of the deduction may not exceed 50 percent of the taxpayer's W-2 wages for the taxable year. Businesses with relatively few employees, or that rely significantly on contractors, may not be able to fully benefit from the new deduction. Affiliated groups will benefit from a rule that treats all corporations in the group as a single taxpayer. For this purposes, the definition of affiliated group is expanded to include 50-percent-owned corporations (but excludes foreign corporations).
Planning Around the W-2 Limitation
The limitation of the deduction to 50 percent of W-2 wages may affect a taxpayer's choice of entity and how it compensates its employees. For example, a sole proprietorship may benefit by incorporating as an S corporation so that the sole proprietor can be paid W-2 wages. LLCs and partnerships that pay salaries to members/partners are in a similar situation, because those salaries are considered guaranteed payments and not W-2 wages. Converting to a corporation may result in a larger domestic production activities deduction. However, this benefit needs to be weighed against the disadvantages (including double taxation) of the corporate form.
Distinguishing Production Activities From Sales and Services
The deduction will not be available for purely sales activities or for purely service activities.
The line between what constitutes "domestic production activities" versus "sales" or "services" may not always be obvious. For example, a taxpayer who buys coffee beans and roasts those beans at its facility for sale through unrelated parties is eligible for the deduction, but if the taxpayer also brews coffee at its facility for sale to customers, the brewing activity would not be eligible. A panoply of other activities exist where the distinction between "domestic production activities" and "sales" or "services" will be unclear -- the taxpayer will have to carefully analyze whether its activity is eligible for the deduction.
Allocation of Expenses to Production Income
Qualified production activities income is defined as domestic production gross receipts less allocable cost of goods sold, directly allocable deductions and expenses, and a ratable portion of other deductions and expenses that are not directly allocable. Taxpayers planning to maximize their deduction for qualified production activities income will need to carefully consider the allocation of expenses, especially indirect expenses such as overhead. For activities that combine qualified production activities with non-qualified activities such as services or sales, the taxpayer will have to allocate income and expenses between the two sources. Until regulations are issued, taxpayers may look for guidance to existing rules for determining the costs of goods sold and those that apply for determining source of income and expenses (i.e., U.S. or foreign). Additionally, many more taxpayers will be subject to rules similar to the transfer pricing rules of Section 482 to address allocation of income and expenses.
The new deduction creates incentives for businesses to engage in production activities that employ workers in the U.S. Corporations that operate both in the U.S. and abroad will need to consider the new tax break when planning for the location of new production activities. Existing intercompany agreements and transfer pricing policies may also need to be reevaluted in light of the new tax break.