What's all the buzz about the new manufacturing deduction?

Most companies that I have spoken to after the beginning of 2005 have asked me what is this manufacturing credit that we have heard about and does my company qualify for taking the deduction. The new manufacturing deduction applies to most manufacturing companies and some non-manufacturing companies. The new manufacturing deduction was enacted as part of the American Jobs Creation Act of 2004 to help United States manufacturers remain competitive with similar foreign companies after several export tax benefits were repealed. The deduction applies to companies, as well as, individuals who are self-employed. The deduction could be a substantial tax savings to those who qualify. The objective of the new deduction is to allow taxpayers, for tax years beginning after 2004, a deduction equal to a statutory percentage multiplied by the lesser of a taxpayers qualified production activities income for a tax year or a taxpayer's taxable income for that year. The deduction is allowed for both regular and alternative minimum tax purposes. The applicable deduction percentage for 2005 and 2006 is three percent. That percentage will increase to six percent for tax years beginning in 2007, 2008 or 2009 and will eventually increase to nine percent for tax years beginning after 2009. However, the amount of the deduction is limited to fifty percent of the wages paid by the taxpayer to the taxpayer's employees during the year.

You may ask what is qualified production activities income? It is the excess of domestic production gross receipts over the sum of the costs of goods son allocable to such receipts, other deductions, expenses, and losses directly allocable to sum receipts and a ratable portion of not directly allocable items to such income.

In the near future, recordkeeping of these direct and indirect expenses will need to be maintained in order to calculate the appropriate allocable expenses. Domestic production gross receipts are defined as the taxpayer's gross receipts that are derived from any lease, rental, license, sale, exchange, or other disposition of qualifying property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States. Qualifying property is any tangible personal property or any computer software. Some of the less obvious domestic production that qualify could be, but is not limited to, any qualified film produced, electricity, natural gas or potable water produced, construction performed, and engineering or architectural services performed. However, the sale of food and beverages at a retail establishment and the transmission or distribution of electricity, natural gas, or potable water is excluded from domestic production income. There are many other forms that qualify as domestic production that have not been listed.

Since we are in Los Angeles and it is home to the entertainment industry, I want to give you more background on what is considered a qualified film. The rules define a qualified film to mean any property if more than fifty percent of the total compensation relating to production of the property is compensation for services performed in the United States by actors, production personnel, directors, and producers. The term does not include property, which generally consist of films, videotapes or other matter that depict sexually explicit conduct and are produced in whole or in part with materials that have been mailed or shipped in interstate or foreign commerce.

If you are a pass-through entity such as a partnership, S corporation, estate or trust, generally the manufacturers deduction is passed through to the partner, shareholder or beneficiary and taken as a deduction on their tax return. However, the wage limitation on the deduction has specific guidelines as to how much of the wages are to be allocated to each individual, so be aware of these guidelines when making the calculation on your tax return.

In the case of an individual who is self-employed, the rules provide that the deduction is equal to the applicable percent of the lesser of the taxpayer's qualified production activities income for the tax year or the individual's adjusted gross income for the tax year.

The new manufacturing deduction can save a company or an individual substantial tax dollars. Understand the discussion above was just a basic overview of the manufacturing deduction. Make sure you understand the requirements to qualify for taking the deduction before you deduct it on your tax return. Consult with your tax advisor about accurately calculating this complex deduction according to the guidelines.

Michael Kaplan, CPA, is a partner at Miller, Kaplan, Arase & Co., LLP and can be reached at [phone] or by e-mail at [e-mail].