The code section 199 production activities deduction.

The recently enacted American Jobs Creation Act of 2004 put into effect, for tax years beginning after 2004, a new deduction for "domestic production activities." The deduction is equal to a percentage of the net income from those activities--3 percent in 2005-2006, 6 percent for 2007-2009, 9 percent after 2009. When fully phased in, the deduction is designed to be economically equivalent to a 3 percentage point reduction in the tax rate on domestic production activities. However, the amount of the deduction for any tax year may not exceed the taxpayer's taxable income or, in the case of individuals, the taxpayer's adjusted gross income. In addition, the amount of the deduction may not exceed 50 percent of the W-2 wages that the taxpayer pays as an employer for the tax year. (If the taxpayer doesn't pay any W-2 wages as an employer for the tax year, the taxpayer isn't entitled to the deduction.)

The deduction is allowed--for both regular tax and alternative minimum tax (AMT) purposes--to individuals and corporations with net income from qualified activities, and to the members of pass-thru entities (S corporations, partnerships, estates and trusts) with net income from qualified activities. Patrons of agricultural and horticultural cooperatives may also qualify for the deduction, under slightly different rules.

The qualified activities that entitle a taxpayer to the deduction are defined very broadly. They include:

* the manufacture, production, growth or extraction of "qualifying production property"--i.e., tangible personal property, any computer software, and certain sound recordings--if the activity is conducted by the taxpayer in whole or in significant part within the U.S.;

* the production by the taxpayer of any qualified film--any motion picture film or videotape (except for certain sexually explicit films), if not less than 50 percent of the total compensation relating to the film's production is for services performed in the U.S. by actors, production personnel, directors, and producers;

* the production (but not the transmission or distribution) of electricity, natural gas, or potable water by the taxpayer in the U.S.;

* construction performed in the U.S.;

* engineering and architectural services performed in the U.S. for construction projects in the U.S.

In the case of the manufacture, production, growth or extraction of qualifying production property, the production of qualified films, and the production of electricity, natural gas or potable water, the deduction is allowed with respect to gross receipts from the lease, rental, license, sale, exchange or other disposition of the underlying property. IRS has interpreted this to mean that, in these cases, the deduction is allowed only to the owner of that property, and not to persons who work under contract for the owner. However, according to IRS, this restriction doesn't apply to construction activities, or to engineering and architectural services. Therefore, taxpayers engaged in construction, engineering or architectural work with respect to other persons' property are still entitled to the deduction.

The deduction isn't available for purely sales activities, nor is it available for purely service activities, except for the engineering and architectural activities described above. In addition, the deduction isn't available with respect to the preparation of food and beverages for sale at retail, although it is available with respect to the growth, storage, and handling of food products, and the processing and preparation of food products for sale at wholesale.

Frederick M. Stein is a senior tax analyst at RIA, a Thomson business providing tax information and software to tax professionals.