Sec. 199 defined: what you need to know for the 2005 tax season.

IRC Sec. 199, enacted to replace the phase out of the extraterritorial income regime (ETI), and the centerpiece of the American Jobs Creation Act of 2004, permits taxpayers to claim a domestic manufacturing deduction (DMD) from taxable income attributable to certain domestic production activities.

Compared to the ETI, the DMD provides benefits to a much broader range of taxpayers. Guidance has been limited to the statute, Notice 2005-14 and the proposed regulations issued Oct. 20, 2005.

Domestic Production Activities

Sec. 199 defines domestic production gross receipts.

First, to claim the DMD, the taxpayer must establish that the qualifying property was manufactured, produced, grown or extracted "by the taxpayer in whole or in significant part within the United States." Stated differently, the taxpayer must separate qualifying activities from non-qualifying activities.

If one taxpayer performs manufacturing activities for another taxpayer, only the taxpayer with the benefits and burdens of qualifying property ownership during the manufacturing process will be treated as the manufacturer.

The proposed regulations help determine what an item is. The law has a mandatory shrink-back provision to help the manufacturer determine what part of the product is eligible and to prevent abuse.

For example, in the case of a company that manufactures shoes in a foreign country, but manufactures the shoelaces in the United States, the taxpayer would shrink back their analysis to the shoelace manufacturing and that would be available for the DMD.

Second, after subdividing gross receipts between qualifying and non-qualifying sources, each member must assign its Cost of Goods Sold to such revenue sources. COGS must be allocated to qualifying property using one of these methods:

* Sec. 861 Method;

* Simplified Deduction Method; or

* Small Business Simplified Overall Method.

Taxpayers are limited as to which of these methods can be used. The new regulations provide some helpful relief from the accounting nightmare of segregating these costs.

An IRS study found that 99.1 percent of all S and C corps have gross receipts less than $25 million, so it carved out simplified procedures for these businesses. The Small Business Simplified Overall Method is for businesses with annual gross receipts of less than $5 million and allows the allocation of COGS and overhead based on gross receipts.

The Simplified Deduction Method for businesses between $5 million and $25 million in gross receipts, or $10 million in assets, must allocate COGS as above using Sec. 263A, but can allocate overhead based on gross receipts.

The Sec. 861 Method, the most onerous and complicated, is for businesses with income of more than $25 million and comes out of the old ETI rules.

Significant Provisions

In general, qualified production activities' income for any taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. Notice 2005-14 looks to common law to determine which payee wages the taxpayer can include for purposes of the W-2 limitation. Compensation paid to independent contractors is excluded for these purposes.

It is important to note that, on the surface, the wage limitation would not have much effect since labor is always needed to manufacture. However, this provision will limit small Schedule C businesses, partnerships and LLCs that pay little or no salary. Owners' draw, subcontracting and independent contractor costs will not qualify. No payroll, no deduction.

Planning point: Should proprietors, partners and LLCs consider S corp elections to pay payroll to themselves to get the credit? This year the deduction is only 3 percent of determined net income, but it will go to 9 percent in the future.

In addition, all members of an expanded affiliate group, in general, are treated as a single corporation for purposes of the DMD, determined by a "50 percent" ownership test by application of Sec. 1504(a). This provision may allow wages in other affiliated entities to be used to calculate the overall wage limitation for the group.

With respect to pass-through entities, such as partnerships, S corps and estates, the DMD is determined at the partner, shareholder or owner-level by taking into account its distributive or proportionate share of income, loss, gain, deduction and COGS. This requirement will make the K-1 reporting more complex because adequate information must be passed down to partners and shareholders to determine their proper deduction.

Real estate development is considered manufacturing, so a developer who builds and sells a building gets the deduction for the construction costs, but not the land. This is true whether the developer sells it when completed, or holds it for 20 years.

Planning point: Property held for 5 years or less assumes a 5-percent land value appreciation; less than 10 years, a 10-percent value appreciation; under 15 years, a 15-percent appreciation; and more than 15 years, an appraisal would be necessary. Depending on the real estate market this deduction could be valuable.

Potential trap: If you performed a cost segregation study and allocated a large portion of the building cost to personal property, it appears not to qualify for the manufacturing deduction.

By George Paulsen, CPA and John Williams, CPA

George Paulsen, CPA is a partner at San Francisco-based Hood & Strong LLP and a member of CalCPA's Committee on Taxation. You can reach him at [e-mail]. John Williams, CPA, JD, LLM is a senior tax manager at Hood & Strong. He can be reached at [e-mail].