By Brian Hoffman, CPA,CFE
The domestic manufacturing tax deduction, a highlight of the American Jobs Creation Act of 2004, initially became available to taxpayers during 2005. Tax professionals grappled with the Act’s complex provisions as part of the tax planning process, and in preparing tax returns during 2006. To date, additional regulations and guidance concerning the deduction continue to be issued by the Treasury Department and the IRS. What is clear, however, is that significant tax savings are available to domestic manufacturers, and that these tax savings are set to increase significantly through 2010.Who qualifies?
Eligibility for the deduction is broader than one might initially believe. Traditional manufacturers of tangible personal property are eligible, but so are engineers, architects, film producers, developers of software, and firms involved in real property construction and renovation, among others. Of course, only production activity within the United States qualifies for the tax break, as implied by the deduction’s name.
What is the Deduction Worth?
Manufacturers need to compute net income from domestic manufacturing activities. Once computed, this figure (called “qualified production activities income” by accountants) becomes the basis for the calculation of the new tax deduction. In 2005, the manufacturing deduction amounted to 3 percent of a company’s qualified production activities income. Importantly, the 3 percent deduction rate is set to rise to 6 percent in 2007, and to 9 percent in 2010. The value of the manufacturing deduction is therefore quite significant.
Consider a manufacturer reflecting $500,000 of qualified production activities income. In 2007, a $30,000 deduction (6 percent) would potentially be available. The value of this manufacturing deduction could be in excess of $10,000, assuming a 35 perecnt tax bracket for the company.
Companies reflecting net losses, and companies with low payroll expenses, are subject to certain limitations on the manufacturing deduction.
Complexities
Alas, what at first seems a relatively straightforward tax deduction is, in fact, laden with complexities. The calculation of qualified production activities income can be daunting, and the law continues to be interpreted by the taxing authorities. Each company is obviously unique. Questions that arise include:
• Determining what constitutes domestic production when a company maintains an international production presence;
• Allocating cost of goods sold to the revenues from qualified production when some production activities are eligible while other activities are not;
• Selecting an approved methodology for allocating other costs to revenues derived from qualified production activities;
• Determining whether subcontracting activities are eligible for the deduction;
• Selecting among three approved approaches for calculating the wage limitation on the deduction; and
• Calculating the deduction in pass-through entities such as “S” corporations and limited liability companies, since the deduction is available at the owners’ level rather than at the corporate level.
Summary
Given the significance of the tax deductions available to manufacturers under the Act, executives should be working closely with their advisors and accountants so as to maximize tax benefits. The Act’s provisions are complicated, yet provide great incentives to domestic manufacturers, especially in the coming years. Though interpretation of the Act is continuing, and guidance from the taxing authorities is forthcoming, clearly the opportunities for dramatic tax savings are present for manufacturers. Detailed, proactive tax planning is essential in maximizing available benefits.
Brian J. Hoffman, CPA CFE, is a shareholder at the Philadelphia-based accounting firm, Shechtman, Marks, Devor, P.C.