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Section 199 production activities deduction: What does it mean for your organization?

By Debbie Schleicher, CPA

Many taxpayers are now aware that the American Jobs Creation Act of 2004 includes a wide reaching benefit that impacts many domestic taxpayers, including certain organizations that have not traditionally been considered "manufacturers."

The new Internal Revenue Code Section 199 generally provides a phased-in deduction for a percentage of net income attributable to certain U.S. manufacturing, production and other activities for tax years beginning after 2004 ("qualified production activities income"). ₁

On Jan. 19, the Treasury Department released extensive interim guidance with a set of rules and definitions that will be the framework for future proposed regulations. ₂ This guidance provides many nuances and complex rules which can impact taxpayers in different industries in distinct ways. Only certain provisions of the notice and IRC Section 199 are highlighted in this article.

This new law compels taxpayers to promptly analyze their domestic production activities and understand the available tax reduction opportunity provided. However, these provisions can impact more than just a taxpayer's tax liability.

For example, organizations also must assess the processes and systems needed to identify qualified production activities income and the related allocated costs. Business changes affecting supply chain matters should be coordinated with this new tax saving opportunity. Tax accounting methods affecting inventory and cost of goods sold also should be reviewed due to this new deduction.

Another timely consideration is the impact of this provision on 2005 financial reporting processes, internal control activities and cash flow projections. Calendar year-end companies with quarterly reporting requirements will need to factor in their estimates of the impact of IRC Section 199 on related tax liabilities and financial reporting accounts and disclosures in each affected quarterly report.

Taxpayers should also look ahead to understand the analysis and data which will be needed to compute the deduction. What may seem to be a simple formula, can in reality, require a complex underlying analysis. In general, for 2005, taxpayers claiming an IRC Section 199 deduction must determine and appropriately document the items in the following computation:

3 percent multiplied by the lesser of (1) qualified production activities income, or (2) taxable income (limited to 50 percent of W-2 wages).

For example, if in 2005 Taxpayer A is a domestic manufacturer with:

• gross sales receipts of $50 million;
• cost of goods sold and other allocable deductions totaling $45 million;
• taxable income of $8 million; and
• applicable W-2 wages of $2 million;

then in 2005, Taxpayer A will be entitled to a deduction of $150,000 ($5 million multiplied by 3 percent). This deduction will double, assuming facts stay the same, in 2006 and increase again (for the same fact pattern) in 2010.

Qualified production activities income is the net of "domestic production gross receipts" and certain deductions that are allocable to those receipts. Domestic production gross receipts include receipts from any lease, rental, license, sale, exchange or other disposition of qualifying production property that was manufactured, produced, grown or extracted by the taxpayer within the United States (subject to certain exclusions). Qualifying production property includes tangible personal property, software development and music recordings. Farmers, oil producers and miners also fall within this provision.

Domestic production gross receipts include the following:

• Receipts from the lease, rental, license, sale, exchange or other disposition of qualifying production property that was manufactured, produced, grown or extracted by the taxpayer within the United States (subject to certain exclusions).
• Receipts from the production of electricity, natural gas or potable water in the United States.
• Qualifying production property such as tangible personal property, software development and music recordings.
• U.S. real property construction, engineering and architectural services performed in the United States for real property construction located within the United States.
• The sale or license of films produced in the United States. ₃
• Farmers, oil producers and miners.

However, receipts from food and beverages prepared by the taxpayer at a retail establishment are excluded, as is the transmission or distribution of electricity, natural gas or potable water.

Although the computation itself is straightforward, there are new definitions and tax concepts as well as a complex web of rules to consider. The notice requires a taxpayer to identify qualifying gross receipts.

In addition, ordinary business income will be divided into new categories that will receive different types of tax treatment. This may impact not only data gathering, financial reporting and record keeping requirements, but a taxpayer's contracting processes with customers as well.

For example, in a transaction in which a service is provided in conjunction with a qualifying gross receipt, only receipts attributable to the qualifying property transaction will be eligible for the tax deduction. This may result in new needs to value the components of transactions with customers; to frame the manner in which the services and property are sold; and in changes to related systems, documentation and recordkeeping requirements.

The allocation of expenses to offset domestic production gross receipts also requires analysis. Three possible methods are provided. Taxpayers with average annual gross receipts over the prior three-year period of $25 million or less can afford themselves of one of two simplified methods. Alternatively, taxpayers not meeting this gross receipts criterion will be required to perform a more complex expense allocation exercise.

Another item in the notice which can impact a business is the provision regarding contract manufacturing. It states that only the taxpayer with the benefits and burdens of ownership of the manufactured property during the manufacturing process will be treated as the manufacturer for purposes of determining qualified production activities income. Accordingly, companies may find it prudent to integrate decisions regarding their contractual relationships and the terms of third-party contracts with the related tax implications.

An added consideration is how to determine the amount of W-2 wages used in applying the deduction limitation under IRC Section 199. This amount may not be readily available through historic payroll or other tax records without some additional analysis. The notice provides three alternative methods to perform this calculation. Taxpayers will need to review the cost / benefit of each of the methods since the simplest method provided will often result in a lower deduction limitation.

It is important for taxpayers to understand the mechanical and technical requirements of this new law to identify which activities qualify for the deduction and how the relevant allocations will be made. In addition, taxpayers must focus their attention on how they will gather the necessary information and on the systems, processes and internal controls needed to support ongoing compliance and documentation needs.

Debbie Schleicher, CPA, is a partner in the attest, tax and business advisory practice at Stout, Causey & Horning, P.A.

Notes

1. The percentages are 3 percent in 2005 and 2006, 6 percent for 2007 through 2009, and 9 percent thereafter. This applicable percentage is applied against the lesser of qualified production activities income or regular taxable income. This deduction is then limited to 50 percent of the employer's domestic wages. Special limitations also apply for receipts from a related person.

2. See Notice 2005-14 (the "notice"). This notice provides interim guidance which may be relied upon until the related final regulations are issued.

3. Provided that at least 50 percent of the total compensation relating to the film production is for specified production services performed within the United States.