Sections Supplements

The ‘Domestic Production Deduction’

A New Tax Consideration for ‘Producers’
Does your business ‘produce’ anything? Beginning in 2005, any business that is considered to be a ‘producer’ by the Internal Revenue Service is entitled to a new deduction called the “Domestic Production Deduction.” The dollar amount of the deduction will equal 3% of your income in 2005, and this percentage will steadily increase in future years to a maximum of 9% by the year 2010. But more on that later.

First things first. In order to qualify for the deduction, you must determine if your business is a ‘producer.’ As with any tax law provision passed by Congress, there is a long-winded definition that goes like this: A producer is a taxpayer who derives revenues from the “lease, exchange, rental, license, sale or other disposition of tangible property that was manufactured, produced, grown, or extracted (‘MPGE’) in whole or significant part within the United States.”

‘MPGE’ is further defined to mean “activities relating to manufacturing, producing, growing, extracting, installing, developing, improving, creating, processing, manipulating, refining, and combining.”

There you have it. If you can make a reasonable argument that your business activity falls within the above definition, you should qualify for the deduction. In many cases, the determination will be obvious, but in some cases not so obvious.

For example, most manufacturing and agricultural activities clearly qualify (note that the activity has to be in the U.S.). Most service businesses will not qualify. But there are myriad business activities that may be questionable. For example, what about a dentist filling cavities? There will be many situations where tax accountants and their clients will have some interesting discussions, to say the least.

In addition to the above general definition, the tax law also carves out certain business activities that will specifically qualify, as follows:

  • Real estate construction
  • Architectural and engineering services for real estate construction
  • Film production
  • Production of natural gas, electricity, or potable water
  • Production of computer software (but not software accessed via the Internet)

Calculating the Deduction

Once you determine that you qualify for the producer deduction, the next step is to figure the amount of the deduction. For 2005 and 2006, the deduction will equal 3% of your income from the production activity (or your taxable income if less). From 2007 to 2009 the percentage will be 6% of income, and in 2010 it will top out at 9%.

For example, in 2005 for every $10,000 of income, you’ll get a deduction of $300. This will in turn create a tax savings based on your marginal tax rate (e.g. marginal tax rate of 33% would yield a tax savings of $100 for every $10,000 of income).

If all of your business activities qualify for the production deduction, the above computation is relatively quick and painless for your accountant. He or she will simply multiply your taxable income by the percentage, and that’s the deduction. There is also a relatively simple one page tax form (Form 8903) that the Internal Revenue Service has provided for claiming the deduction.

On the other hand, there might be significant complications if you are a partial qualifier, that is, some of your business activities qualify and some do not. In those situations, your total business income will have to be broken out between the qualifying production activities and the non-qualifying non-production activities. That will require revenue and cost allocations that might be extremely complicated, depending on the particular situation. It could be an accounting nightmare that is more costly than the deduction is worth.

Here are some other points to consider:

  • The producer deduction applies to tax years beginning on or after Jan. 1, 2005. In general, this means it will first apply to taxpayers with calendar years ending on Dec. 31, 2005.
  • Any type of taxpayer can qualify, including sole proprietors, partnerships, limited liability companies, corporations and trusts.
  • The deduction cannot exceed 50% of W-2 wages paid by the business, which means that if the owner runs the business alone with no employees, there would be no producer deduction.
  • The producer deduction will not be allowed on Massachusetts tax returns.

Conclusion

The new Domestic Production Deduction represents tax savings for certain businesses, therefore this is a tax provision that you and your accountant should know about.

Rodney McCorkill, CPA Director of Tax Services for Springfield-based Moriarty & Primack, P.C; (413) 739-1800.

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