Do You Qualify for the New Domestic Production Deduction?

By Michael Shelby

May 2006



New Internal Revenue Code Section 199, which was enacted as part of the American Jobs Creation Act of 2004 (AJCA), provides a tax deduction related to qualified production activities income (QPAI).

What makes this new provision especially significant is that the deduction is not derived from the taxpayer's own cash expenditures. It is simply a deduction based on a computation (subject to certain limitations), similar to the personal exemptions allowed on Form 1040, which are based on the number of qualifying taxpayers and dependents.

While this "paper deduction" concept is not new to individual taxpayers, it represents a new frontier in the federal business income tax regimen, which has traditionally used tax credits and rapid expensing elections to encourage targeted economic activity.

Moreover, this deduction has broad reach as to the types of businesses that may qualify for it, which range from small startups to multinational corporations.

Locally, Maryland has decoupled from this provision. Therefore, any Section 199 deduction taken on a federal return must be added back on the applicable Maryland tax return. In contrast, the District of Columbia, Pennsylvania, Delaware and Virginia will allow this deduction on their respective state/district returns.



How Much?

In general, for taxable years beginning in 2005 and 2006, the deduction is equal to 3% of the lesser of:

1. The QPAI of the taxpayer for the taxable year, or

2. Taxable income for the taxable year, as determined without regard to the deduction. This amount is further limited to 50% of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year.

For taxable years beginning in 2007, 2008 or 2009, the applicable percentage is 6% and, for tax years beginning in 2010 and after, the applicable percentage will be 9%. Currently, there is no automatic expiration date built into the statute. Therefore, this deduction will apply to all tax years after 2004, subject to the phase-in, unless it is later modified or repealed.



Tax Savings

The value of this deduction will mean more to taxpayers subject to higher income tax rates. For example, assume a business taxpayer has $100,000 in taxable income for which the 3% deduction can be based without any further limitation. The resulting deduction of $3,000 would represent a tax savings of $1,050 to a 35% taxpayer, versus $450 to a 15% taxpayer.

Obviously, the value at the 9% deduction level on the same $100,000 will be three times greater for both taxpayers ($3,150 and $1,350, respectively) in tax years beginning in 2010 and after.



What Qualifies?

In general, income derived from qualifying production property (QPP) that is manufactured, produced, grown or extracted by the taxpayer, in whole or in significant part within the United States, will qualify for the deduction. QPP is defined as tangible personal property, any computer software and certain sound recordings.

Tangible personal property is generally anything that is not real property, i.e., land and buildings, with a few exceptions. Generally, only the taxpayer with the benefits and burdens of ownership during the production process is entitled to the deduction.

For example, if Company A contracts Company B to manufacture widgets, and title of the property remains with B during the manufacturing process, B is entitled to the deduction, not A. An exception to this rule allows federal government contractors to claim the deduction where title passes to the federal government prior to the commencement of the production activity and such transfer is required by the Federal Acquisition Regulations.

Unfortunately for the restaurant industry, the sale of food or beverages prepared at a retail establishment is specifically excluded by the statute and, therefore, does not qualify for the deduction. Another notable restriction involves the sale of computer software.

While the lease, rental, license, sale, exchange or other disposition of computer software generally qualifies, a transfer of the software to the customer is required. The transfer can be made via tangible media, such as compact disc, or downloaded through the Internet. However, software that is merely used over the Internet, for free or for a charge, will generally not qualify, since it is deemed to be the sale of a service and not tangible property.

These rules seem straightforward. However, there are a growing number of software companies that provide web-based software applications in which a transfer of some software to the customer occurs, but interaction with the provider's web site is required for the software to function.

Unfortunately, for now, citing its concern over the complexity of determining whether such transactions are primarily the transfer of software or a service, the IRS is taking a restrictive view and does not allow such provider-controlled software to qualify. Still, given the rising trend in web-based software and the IRS's willingness to study this issue further, a compromise could be reached at a later date.



If You Build It

Construction services performed in the United States related to the construction or substantial renovation of real property (commercial or residential) qualify for the deduction, but only for those taxpayers who perform these services as part of their trade or business.

Generally, this will include home builders, general contractors and subcontractors such as carpenters, electricians, plumbers, roofers, installers, landscapers and painters. More than one taxpayer is allowed the deduction with respect to the same construction project.

For example, the general contractor and all subcontractors hired to build a house will generally qualify. However, only the construction related services will qualify. Any income derived from the resale of construction materials, e.g., lumber, electrical wiring and other building components, will not qualify unless it is less than 5% of the otherwise qualifying construction receipts.

Engineering and architectural services qualify with respect to the construction or substantial improvement of real property in the United States, including feasibility studies, even if the project is eventually not undertaken or completed.



Final Word

Business owners should discuss this new deduction with their tax adviser to determine whether any of their business activities may qualify. For some businesses, new internal accounting systems may have to be adopted to provide the information needed to support and compute the deduction where some, but not all, of their activities are qualified.

For this reason, you should also consider the potential costs of compliance and internal readjustments needed to secure the deduction. Obviously, it wouldn't be worth spending $100 to save $50. On the other hand, some investment today may pay large dividends into the future in the form of sizeable tax savings.



Michael Shelby, CPA, MST, is director of tax planning and compliance with Cardoni Waddell in Columbia. He can be reached at 410-290-0770 and mks@cardoniwaddell.com.