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The Basics

The American Jobs Creation Act of 2004 created a deduction for domestic production activities, generally referred to as the "Section 199 deduction," after the Internal Revenue Code section describing the deduction. The deduction is effective for tax years beginning after December 31, 2004. Eligible taxpayers are entitled to a deduction equal to the lesser of:

  • A percentage of qualified production activities income (QPAI) or taxable income, whichever is less, or
  • 50 percent of W-2 wages for the applicable year that are properly allocable to QPAI

Tip: In the case of an individual, or an estate or trust, the deduction is equal to the lesser of (1) a percentage of qualified production activities income (QPAI) or adjusted gross income (rather than taxable income as stated above), or (2) 50 percent of W-2 wages for the applicable year that are properly allocable to QPAI.

The deduction percentage is as follows:

  • 3 percent for tax years beginning in 2005 and 2006
  • 6 percent for tax years beginning in 2007, 2008, and 2009
  • 9 percent for tax years beginning in 2010 and thereafter

The deduction is available to:

  • C corporations
  • S corporations
  • Partnerships
  • Sole proprietors
  • Cooperatives
  • Trusts
  • Estates

Caution: The Emergency Economic Stabilization Act of 2008 capped the deduction at 6 percent for oil and gas production.

Caution: Special rules apply to pass-through entities, affiliated groups, and agricultural/horticulture cooperatives.

The deduction is primarily intended to help domestic manufacturers, but it also applies to construction companies, filmmakers, farmers, architects, and engineers.

Tip: The deduction is available against the regular income tax and the alternative minimum tax (AMT).

What Is Qualified Production Activities Income (QPAI)?

QPAI is the taxpayer's domestic production gross receipts (DPGR) less (1) the cost of goods sold (COGS) that are allocable to such receipts, (2) other deductions, expenses, or losses that are directly allocable to such receipts, and (3) a pro-rata share of other deductions, expenses, and losses that are not directly allocable to either such receipts or another class of income.

Tip: See IRS Notice 2005-14 and Rev. Proc. 2006-22 for guidance regarding what constitutes QPAI. Taxpayers taking the deduction should carefully create and maintain supporting documentation detailing activities inside and outside of the United States.

Caution: QPAI must be determined on an item-by-item basis. As a result, the QPAI for each item may be either positive or negative. The taxpayer's total QPAI is the sum of the QPAI derived for each item. This is a complex calculation. Consult a tax professional for assistance.

What Are Domestic Production Gross Receipts (DPGR)?

Domestic production gross receipts (DPGR) are derived from:

  1. Any lease, rental, license, sale, exchange, or other disposition of qualified production property (QPP) that is manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States,
  2. Any lease, rental, license, sale, exchange, or other disposition of any qualified film produced by the taxpayer,
  3. Any lease, rental, license, sale, exchange, or other disposition of electricity, natural gas, or potable water produced by the taxpayer in the United States,
  4. Construction performed in the United States, or
  5. Engineering or architectural services performed in the United States for construction projects in the United States.

However, DPGR are not derived from (1) the sale of food or beverages prepared at a retail establishment, (2) the transmission or distribution of electricity, natural gas, or potable water, or (3) the performance of services (except with respect to construction, engineering, or architectural services). In addition, DPGR are not derived from property that is leased, licensed or rented by the taxpayer for use by any related person.

The taxpayer must distinguish DPGR from gross receipts that are not DPGR. No single allocation method for doing so is mandated, but the method should be a reasonable one that accurately identifies gross receipts based on all the information available to the taxpayer to substantiate the allocation. Factors that will be considered in determining if the method is reasonable include:

  • Whether the taxpayer is using the most accurate information available
  • The accuracy of the method chosen compared to other methods
  • Whether the method is used for internal management or other business purposes
  • Whether the method is used for other income tax purposes

Tip: A taxpayer with less than 5 percent of its total gross receipts from items other than DPGR may treat all its receipts as DPGR.

What Is Qualified Production Property (QPP)?

In General

DPGR is limited to any lease, rental, license, sale, exchange, or other disposition of qualified production property (QPP) that is manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States. QPP includes:

  • Tangible personal property (not land or buildings)
  • Computer software, and
  • Property described in Internal Revenue Code Section 168(f)(4) (certain sound recordings)

QPP will be considered MPGE by the taxpayer "in whole or significant part" within the United States if the taxpayer's MPGE activity within the United States is "substantial in nature" as determined by all the facts and circumstances. The United States is considered to include the 50 states and the District of Columbia, but not its possessions, territories, or airspace.

Computer Software, Sound Recordings, and Qualified Film

Computer software is any program designed to cause a computer to perform a function or a designed set of functions, as well as the machine-readable coding for video games and similar programs. Sound recordings are works that result from the fixation of a series of musical, spoken, or other sounds. A qualified film is any motion picture, video tape, or television programming (live or delayed) where not less than 50 percent of the total compensation related to producing the film is compensation for services performed in the United States by actors, production personnel, directors, and producers.

The costs to the taxpayer of designing and developing computer software and sound recordings may be considered countable expenses for purposes of determining if the computer software or sound recordings were MPGE by the taxpayer wholly or in significant part in the United States. The medium on which computer software is embedded (e.g., a diskette), a sound recording is embodied (e.g., a CD), or a qualified film is fixed (e.g., a DVD) is considered tangible personal property, whereas the software, sound recording, or master copy of a qualified film is not. As a result, a taxpayer must split the gross receipts and related expenses associated with these items. Revenue from ticket sales to view qualified films does not constitute DPGR.

Construction

A qualified Section 199 deduction for construction performed in the United States must be related to DPGR derived from activities performed by a taxpayer engaged in a trade or business that is considered construction for purposes of the North American Industry Classification System, and that involves the construction, erection, or substantial renovation of real property. Real property includes residential and commercial buildings, inherently permanent structures other than tangible property in the nature of machinery, inherently permanent land improvements, and infrastructure (e.g., roads, power lines, water systems, or sewers). Substantial renovation of real property means the renovation of a major component or substantial structural part of the property that materially increases its value, substantially prolongs its useful life, or adapts it to a new or different use.

Tangible personal property (e.g., appliances, furniture, or fixtures) sold as part of a construction project is not considered real property. However, if more than 95 percent of the total gross receipts derived by a taxpayer from a construction project are derived from real property, then the total gross receipts may be considered DPGR.

Tangential services to construction (such as delivering materials or hauling away debris) do not generate DPGR unless the taxpayer performing the construction provides them. Activities such as landscaping and painting are considered construction activities only if they are performed (whether or not by the same taxpayer) in connection with other activities that are considered construction, erection, or substantial renovation of real property.

DPGR derived from qualified construction activity includes the proceeds from the sale, exchange, or other disposition (but not the lease or rental) of the real property, whether the property is sold immediately or after construction. It also includes compensation for the performance of construction services by the taxpayer in the United States. It does not include gross receipts attributable to the sale or other disposition of land.

In certain situations, it is appropriate for more than one taxpayer (e.g., a general contractor and a subcontractor) to be regarded as deriving DPGR with respect to the same activity and the same construction project.

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Engineering and Architectural Services

To generate qualified DPGR, engineering and architectural services must be performed in the United States for a planned construction project of real property in the United States. Gross receipts from these services that would qualify as DPGR will not fail to qualify if the planned construction project ultimately is not undertaken or completed.

Engineering or architectural services in connection with a construction project in the United States that are (1) performed outside the United States, or (2) related to property other than real property may be treated as DPGR derived from that construction project if they are less than 5 percent of the total gross receipts derived by the taxpayer from that project.

Allocating Costs Related to DPGR

To determine QPAI, the taxpayer's DPGR must be reduced by (1) the cost of goods sold (COGS) that are allocable to such receipts; (2) other deductions, expenses, or losses directly allocable to such receipts; and (3) a proper share of other deductions, expenses, and losses that are not directly allocable to either such receipts or another class of income.

Cost of Goods Sold (COGS)

If a taxpayer can identify from its books and records COGS allocable to DPGR, then that is the amount that may be used. However, if a taxpayer's books and records do not allow the taxpayer to identify COGS allocable to DPGR, the taxpayer must use a reasonable method to allocate COGS between DPGR and other gross receipts. If a taxpayer uses a method to allocate gross receipts between DPGR and non-DPGR, the taxpayer must use the same method for allocating COGS.

Directly and Indirectly Allocable Deductions

Generally, a taxpayer must allocate and apportion direct and indirect deductions related to DPGR using the rules provided in IRC Section 861, and a taxpayer with average annual gross receipts greater than $25 million must do so. A taxpayer with average annual gross receipts of $25 million or less may use the simplified deduction method. Under this method, the taxpayer's deductions are ratably apportioned between DPGR and non-DPGR based on relative gross receipts.

Accordingly, the ratio of deductions apportioned to DPGR is the same as the ratio that DPGR bears to total gross receipts. A taxpayer with average annual gross receipts of $5 million or less may use the small business simplified overall method to allocate and apportion both COGS and deductions between DPGR and non-DPGR. Under this method, a taxpayer's total COGS and deductions are ratably apportioned between DPGR and non-DPGR based on relative gross receipts. Accordingly, the ratio of COGS and deductions apportioned to DPGR is the same as the ratio that DPGR bears to total gross receipts.

Caution: The small business simplified overall method accounts for the apportionment of both COGS and the other deductions, whereas the IRC Section 861 and simplified deduction methods account only for the apportionment of the deductions (and not COGS).

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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