Federal Tax: The New Domestic Production Activities Deduction
By Mel Schwarz
For many taxpayers, the centerpiece of last year’s tax legislation is the new domestic production activities deduction. Estimated to reduce taxes by more than $76 billion over the next 10 years, this provision primarily benefits those who produce products or build things in the United States .
The new domestic production activities deduction is equal to a percentage (3 percent in 2005, phasing up to 9 percent by 2010) of the lesser of net income from qualified domestic production activities or taxable income. Income from qualified domestic production activities includes any amounts received on the sale, lease, rental, license, exchange or other disposition of tangible personal property that is substantially produced in the United States , as well as income derived from construction, engineering and architectural services performed in connection with U.S. construction projects. The amount of the domestic production activities deduction cannot exceed 50 percent of the W-2 wages the taxpayer pays as an employer.
The deduction is available to partnerships, sole proprietorships, S corporations, LLCs, cooperatives, estates and trusts, as well as C corporations. In the case of an S corporation, partnership, estate or trust, or other pass-through entity, the shareholder, partner or other owner determines the deduction by taking into account its allocable share of the entity’s qualified production activities income and wages.
The domestic production activities deduction is allowed in computing alternative minimum taxable income and adjusted current earnings, as well as regular taxable income.
The Internal Revenue Service (IRS) has indicated that it believes Congress intended for the domestic production activities deduction to be available to taxpayers for a wide variety of production activities. Production itself if a very broad concept and includes more than just manufacturing. Production occurs whenever the taxpayer converts physical things into something else. The assembly of component parts into an item of personal property may qualify, as may the transformation of property into a different type of property. Existing IRS guidance focuses on how different the end product is, and how much expense and effort is devoted to the conversion. The assembly of component parts will generally qualify as production if labor and other direct costs of assembly represent at least 20 percent of the total cost of the finished item.
While there are specific limitations on what kinds of activities will qualify for the domestic production activities deduction, it is worth talking to your tax advisor about your company’s situation. Don’t miss out on your share of the $76 billion in tax reductions!
The information contained herein is general in nature and is based on authorities that are subject to change. It is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the specific circumstances or needs, and may require consideration of non-tax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
Mel Schwarz is Legislative Affairs Director in Grant Thornton’s National Tax Office in Washington, D.C. Grant Thornton LLP is the U.S. member firm of Grant Thornton International, one of the six global accounting, tax and business advisory organizations.
Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 4520, the “American Jobs Creation Act of 2004” (JCX-69-04), Oct. 7, 2004.
IRS Notice 2005-14.
Treas. Regs. Sec. 1.954-3(a)(4)(iii), referenced in sec. 3.04(3) of N. 2005-14.
Treas. Regs. Sec. 1.954-3(a)(4)(ii), referenced in sec. 3.04(3) of N. 2005-14.