Originally enacted to help offset the repeal of a tax break for U.S. exporters, this provision of the tax code provides a deduction for many U.S. businesses that’s allowed for both regular tax and alternative minimum tax (AMT) purposes. And, despite the deduction’s history, it’s fully available to taxpayers who don’t export.
For 2010 and later years, the deduction equals 9% of the net income from eligible activities but cannot exceed 50% of the wages paid to employees whose work relates to the production of the income eligible for the deduction. This means that businesses operated as sole proprietorships or partnerships with no employees aren’t eligible for the deduction. To take advantage of the deduction, such businesses can incorporate and pay W-2 wages to their principals. (However, the decision to incorporate should not be based solely on claiming this credit¾many other factors need to be considered.)
The following is an example of how this deduction works. Suppose your business manufactures a product which you wholesale to retailers. Your net income from sales of that product for the year is $550,000, and the wages you paid to your employees to manufacture that product totaled $100,000. Your deduction would be the lesser of 9% of the $550,000 in revenue or 50% of the $100,000 wages. Thus, your business’ domestic production activities deduction would be $49,500 (.09 x $550,000).
The domestic production activities deduction is allowed with respect to the following activities:
(1) The manufacture, production, growth, or extraction of qualifying production property (tangible personal property, computer software, and certain sound recordings) by the taxpayer in whole or in significant part within the United States;
(2) The production of any qualified film by the taxpayer if at least 50% of the total compensation relating to its production is compensation for services performed in the United States by actors, production personnel, directors, and producers;
(3) The production of electricity, natural gas, or potable water by the taxpayer in the United States;
(4) Real property construction in the United States; and
(5) The performance of engineering or architectural services in connection with U.S. real property construction projects.
The deduction is allowed to all taxpayers, including individuals, C corporations, farming cooperatives, estates, trusts, and their beneficiaries. The deduction is allowed to partners and the owners of S corporations and may be passed through by farming cooperatives to their patrons.
A broad range of activities qualify as eligible manufacturing or production activities. The taxpayer’s raw materials and finished products may be brand new, or they may be made out of scrap, salvage, or junk material. Manufacturing or producing components used by another party in later manufacturing or production activities is an eligible activity, as is manufacturing or producing finished items from components manufactured or produced by others.
The processing and preparation of food products for sale at wholesale are eligible “production” activities, but the preparation of food and beverages for sale at retail is not.
Construction activities are eligible for the deduction, but only if the construction is of real property and it is performed in the United States. The real property may consist of residential or commercial buildings and permanent structures. Eligible construction activities don’t include tangential services such as hauling trash and debris or delivering materials, even if the tangential services are essential for construction.
Engineering and architectural services are eligible for the deduction, but only if they’re performed in the United States for real property construction projects in the United States.
The foregoing is only an overview of this deduction; careful analysis of its application to each type of manufacturing activity must be done. The deduction applies to both large and small businesses, so don’t assume that just because your business is small, you won’t benefit from the deduction. If you have questions related to how the domestic production deduction might apply to your specific circumstances, please give this office a call.