New Tax Break for "US Production Activities"
Applies to Many Businesses

On Oct. 22, 2004, the President signed into law the American Jobs Creation Act of 2004. As part of the broad-based tax relief for domestic manufacturing, the Act creates a new tax deduction for domestic production activities. Interestingly, this new deduction applies to many companies with activities beyond the traditional definition of “manufacturing,” including construction, engineering, energy production, architectural services and agricultural production.

Why do we have this new deduction? The Act attempts to level the playing field for US-based exporters who are taxed on worldwide income in contrast to exporters headquartered in other countries who are taxed only on income earned in the country imposing the tax. Past attempts to solve this dilemma violated World Trade Organization agreements resulting in the imposition of severe trade sanctions on US export goods. This deduction is the fix: it is designed to provide a tax benefit that is economically equivalent to the former extra-territorial income exclusion. Good news: a much broader group of activities qualify for the deduction. Bad news: non-manufacturing exporters, such as distributors and export agents, do not qualify. Silver lining: all US manufacturing, whether sold in the US or abroad, qualifies under the new rules. It’s not just for exporters anymore.

How much is the deduction? In 2005, the deduction will effectively reduce the income tax rate for a domestic manufacturer in the 35% bracket to 34%. In 2010, when fully phased in, the deduction will effectively reduce that rate from 35% to 32%. If you have $10,000,000 in net income from domestic “manufacturing,” that’s a $300,000 savings.

Who gets to take the deduction? The important thing to know is that, in general, income from the following activities qualifies:

• Any lease, rental, license, sale, exchange or other disposition of tangible personal property, computer software and sound recordings that were manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the Unites States.
• Construction and substantial renovation performed in the United States.
• Engineering or architectural services performed in the United States for construction in the United States.
• Any lease, rental, license, sale, exchange or other disposition of any qualified film produced by the taxpayer.
• Any lease, rental, license, sale, exchange or other disposition of electricity, natural gas or potable water produced by the taxpayer within the United States.
• The sale, exchange or other disposition of agricultural products if (a) the taxpayer performs storage, handling or other processing activities (other than transportation activities) and (b) the products are consumed or integrated into other qualifying products.

Income that does not qualify includes income from the sale of food and beverages prepared at a retail establishment, such as a restaurant; income from the transmission or distribution of electricity, natural gas or potable water; and income property leased, licensed or rented by the taxpayer for use by a related person.

Planning tip: Review your income producing activities. If you have any of the above types of income, the deduction needs to be part of your tax planning and it is time to begin understanding the intricacies of the calculation.

Are there any catches? Other key factors to keep in mind are:

• Pass-through entities, including S Corporations, partnerships, estates and trusts, qualify. The deduction generally applies at the shareholder, partner or similar level with component allocations, such as costs and wage limits, passing through to the shareholder, partner or similar person to determine the amount of the deduction.
• To make sure that the monies support US-based workers, the deduction is limited to 50% of the W-2 wages paid to employees during the year. The wage limit rewards companies who hire employees instead of outsourcing work to other companies, independent contractors or other temporary workers.
• The wage limitation does not appear to be restricted to wages paid to employees involved with production, and it may be perfectly acceptable to aggregate wages paid by affiliates operating service businesses with those of manufacturing affiliates to boost the 50% limitation.

Planning tip: Consider reviewing your current staffing strategy to determine whether using in-house employees instead of outsourcing would benefit your company.

What else do I need to know? The new law creates significant potential planning opportunities related to qualifying activities, the allocation of costs to determine income for qualifying activities and computing the wage limitations. Questions remain as to what constitutes manufacturing: Does it include the mere assembly or repackaging of a product? How much value must be added to an item before it is considered “manufactured?”

Planning considerations can also take on a multi-year dimension. For example, taxpayers who have claimed bonus depreciation on manufacturing equipment deployed in domestic production activities will receive an indirect added benefit for the next several years because lower future depreciation expenses mean higher taxable income from these activities in the future. Since the deduction is 3% - 9% (depending on the year) of this income, higher income will increase the deduction. Likewise, when considering future capital additions, a less aggressive depreciation method may be warranted in some situations.

While the Jobs Act of 2004 provides a great boost for manufacturers, many questions about the enacted law remain. Congress has given the Treasury the task of providing further guidance. Berntson Porter and Company, PLLC will continue to monitor this new tax act and keep you informed as these and other questions are answered.

Dave Berthon, CPA, MAcc (Tax)
Tax Manager

Rhonda Neben, JD, CPA, LLM (Tax)
Director of Business Development