Production Deduction: The 6% Solution For Businesses
By Michael D. Koppel, CPA/PFS
Gray, Gray & Gray, LLP
What would you give for a magic wand that would reduce your company’s taxable income by 6% without effecting the income you report on your financial statement? For many businesses the opportunity to reduce their taxable income already exists in the form of a “Production Deduction” (Internal Revenue Code §199).
The Production Deduction was created as part of the American Jobs Creation Act of 2004. It allows for a deduction equal to the lesser of taxable income or the following percentage of Qualified Production Activity Income (QPAI).
YEARS |
PERCENT DEDUCTION |
2005 -2006 |
3% |
2007-2009 |
6% |
thereafter |
9% |
“Qualified Production Activity Income” is defined as Domestic Production Gross Receipts (DPGR), less the cost of goods sold (CGS), plus selling, general and administrative expenses (SG&A) directly associated with the DPGR, less the DPGR’s allocable share of SG&A which cannot be allocated to any sales. The deduction is limited to 50% of the W-2 wages directly associated with DPGR. Here is a simple example:
A federal income tax savings of over $15,000 is significant for most business. Remember the business does not have spend anything for the tax savings.
Notice that the deduction is for production, not just manufacturing. Activities that qualify for DPGR are very broadly defined. The following activities will generally qualify for production deduction treatment:
- Tangible personal property, sound recordings, or computer software that are manufactured, produced, grown or extracted wholly or in a significant part in the United States
- A qualified film
- Electricity, natural gas or potable water produced in the United States
- Construction in the United States
- Engineering and architectural services performed for construction in the United States
A taxpayer can meet the “significant part” safe harbor test by having at least 20% of the cost of goods sold of a product from direct labor and overhead directly related to the product performed in the United States.
It is not necessary for a taxpayer to produce a finished product in order to qualify for the production deduction. As shown in the following example each business along the production chain can qualify for the production deduction.
A, B, and C are unrelated taxpayers and are not cooperatives. A owns grain storage bins in the United States. A purchases B's agricultural products (e.g., corn) that were grown in the United States and stores them in the bins. A then sells the products to C. C processes A's agricultural products into refined agricultural products (e.g., corn syrups) in the United States. The gross receipts from A's, B's, and C's activities are DPGR.
It is important to notice that each business in the example is unrelated. The rules for the production deduction provide significant restrictions on related party transactions.
It is important that to remember that the Production Deduction is not just for large businesses. Businesses of all sizes can qualify. Pass-through entities such as partnerships and S corporations can also qualify, although the calculations for their stakeholders is a little complex.
This article present the basics of the Production Deduction. There are complexities and restrictions at each stage that are beyond the scope of this brief article. If you have further questions regarding the Production Deduction please contact our office.
Reprinted with permission from CPAmerica.