Starting with tax year 2005, certain companies can take a 3% deduction for US-based business activities.
"Every small business is the manufacturing industry should be looking at this as a tax deduction. While Section 199 comes with a very complex set of rules, chances are small businesses will qualify for the deduction much easier than the rules depict," according to Paul Schlather, a senior tax partner with PricewaterhouseCoopers' Private Company Services practice.
Here's the basics:Businesses with "qualified production activities" can take a tax deduction of 3% from net income. This is a tax break pure and simple. The more complicated the business, the more complicated the math for calculating the Domestic Production Activities Deduction. In a nutshell, businesses engaged in manufacturing and other qualified production activities will need to implement cost accounting mechanisms to make sure their tax deduction is accurately calculated.
Domestic Production Activities DeductionA business engaged in a qualfying production activity is eligible to take a tax deduction of 3% in tax years 2005 and 2006. The deduction increases to 6% in year 2007, and 9% in year 2010.
Qualified Production ActivitiesA business engaged in the following lines of business may qualify for the Domestic Production Activities Deduction. These are the "qualified production activities" eligible for claiming the deduction under Internal Revenue Code Section 199:
- Manufacturing based in the United States,
- Selling, leasing, or licensing items that have been manufactured in the United States,
- Selling, leasing, or licensing motion pictures that have been produced in the United States,
- Construction services in the United States, including building and renovation of residential and commercial properties,
- Engineering and architectural services relating to a US-based construction project,
- Software development in the United States, including the development of video games.
General Rule and Safe HarborThe Domestic Production Activities Deduction is limited to income arising from qualified production activies in whole or significant part based in the United States. Under a "safe harbor" rule (IRS Proposed Regulations 1.199.3.f.3), businesses can take the deduction if at least 20 percent of the total costs are the result of direct labor and overhead costs from US-based operations.
If any part of manufacturing or production activities is outside the United States, then businesses must use either the safe harbor rule (at least 20% of total costs are from US-based production activities) or allocate costs using the facts and circumstances of their business.
Not Qualified Production ActivitiesThe following lines of business are specifically excluded from claiming the Domestic Production Activities Deduction:
- Construction services that are cosmetic in nature, such as painting.
- Leasing or licensing items to a related party.
- Selling food or beverages prepared at a retail establishment.
Figuring the Tax DeductionCalculating the Domestic Production Activities Deduction can be either ridiculously simple or enormously complex, depending on the nature of the business. The key to figuring the Domestic Production Activities Deduction is to examine "qualified production activities income" (QPAI) and the limitations. I'm going to throw out several technical terms, and then explain how to figure the deduction step-by-step.
Domestic Production Activities Deduction Calculation
Qualified production activities income (QPAI)
minus Qualified production activities expenses
equals Qualified production activities net income
times The QPA deduction amount of 3%
equals The Tentative QPA Deduction
Qualified Production Activity Income (QPAI)
Qualified production activity income (QPAI) is all income arising from qualified production activities. For a business with only one line of business, this will be the same as gross income. For businesses with multiple lines of business, income will need to be allocated.
Qualified Production Activity Expenses
Qualified production activity expenses are all expenses directly related to the qualified production activities. For a business with only one line of business, this will be the same as total expenses. For businesses with multiple lines of business, income will need to be allocated.
More information: Domestic Production Activities Deduction - Limitations, Simplified Method, and Resources