The production activities deduction introduced in the American Jobs Creation Act of 2004 is a direct response to both the need to create new U.S. jobs and international concerns over favorable U.S. income taxation of extraterritorial income (ETI) represented in the Internal Revenue Code, first in 1971 with domestic international sales corporations and, then in 1984 with foreign sales corporations. In 2002, the World Trade Organization concluded the ETI regime constituted an impermissible export subsidy by the United States. Retaliatory tariffs were imposed by the European Union in January of 2004 due to the failure by Congress to repeal the extraterritorial income regime. The ETI regime was repealed by the American Jobs Creation Act and replaced by the production activities deduction (PAD). After January 1, 2005, U.S. business taxpayers now have two types of income for federal income tax purposes: qualified production activities income and all other income.

The PAD equals a percentage of the business entity’s qualified production activities income (QPAI). Qualified production activities income equals the entity’s net income from U.S. manufacturing, production, growth or extraction activities; U.S. film production; U.S. construction activities and U.S. engineering and architectural services.  Production includes the production of electricity, natural gas and potable water and growth includes food production, food storage and food processing. The deduction phases in over a period of five years, being computed at 3 percent of the entity’s QPAI for 2005 and 2006, 6 percent in 2007 through 2009, and 9 percent for 2010 and thereafter. A taxable corporation whose taxable income is composed entirely of QPAI will experience a drop in its top tax rate from 35 percent to 31.85 percent by 2010. For S corporations, partnerships (and LLCs) and sole proprietorships, the deduction will apply at the owner’s level of computing taxable income. However, as noted below, the deduction may be lost on these business entities to the extent they have no W-2 wages.

One purpose of the deduction is to encourage domestic production activities. The availability of the deduction to a business entity is therefore based on the lesser of the amount of the entity’s taxable income or 50 percent of W-2 wages for the year. Adding W-2 wages as a measure of the allowable deduction should increase wages paid to U.S. workers.

The domestic production activities income deduction incorporates a number of income tax components, which Congress left to the Treasury Department to define and interpret.  The IRS is currently developing Treasury regulations under the Internal Revenue Code Section providing for the deduction (Section 199), and in the interim, is issuing notices (notices 2005-7 and 2005-14) in an attempt to provide guidance in computing the deduction. For example, what activities are included in the definition of to manufacture, produce or extract. What are W-2 wages for purposes of computing the wage limitation?  Finally, since the deduction is computed as a percentage of taxable income derived from qualified production activity, how does the taxpayer allocate costs of goods sold and other deductions to determine the taxable income arising from qualified production activities when the business entity is also engaged in nonqualified production activities?  

Qualified production activity

Qualified production activity equals the gross receipts derived from the sale, lease, license or other disposition of tangible personal property manufactured, produced, grown or extracted in whole or in significant part within the United States less the costs of manufacturing, producing or extracting the property and other available deductions.  Since the entity may also be engaged in nonqualified production activities, determining which costs are allocable to qualified production activities and which are allocable to nonqualified production activities will become important. To the extent costs may be allocable to qualified or nonqualified production activities, it would be advantageous to allocate costs to nonqualified production activities to result in a larger QPAI figure and hence a greater PAD.  For property to be considered as being manufactured in significant part in the United States, at least 20 percent of the total manufacturing cost must be incurred in the United States.

In the field of construction, qualified production activity will include the construction and substantial renovation of real property including residential and commercial buildings and infrastructure such as roads, power lines, water systems and communication facilities.  However, rental income, from such facilities will not qualify as qualified production activity. An entity engaging in the growth or preparation of food and beverage items in the U.S. which are sold at wholesale will be considered as engaged in a qualified production activity, while an entity engaging in retail sales of these items will not be considered as engaged in a qualified production activity.  Since many entities engage in both wholesale and retail activities of this sort, allocation of costs between wholesale and retail activities will become an important issue for these business entities in determining the PAD.

Ancillary activities

When two business entities are involved in the production of an item of tangible personal property, how is the PAD calculated or allocated? The entity with the benefits and burdens of ownership of the tangible personal property during the manufacturing process will be treated as the manufacturer for purposes of computing the PAD.  The Treasury Department has announced that it will provide rules for determining which taxpayer has QPAI from qualifying production activities in situations involving multiple business entities.

In the construction industry, both the general contractor and subcontractor are engaged in construction activities for a project. Here, even though a construction business taxpayer may not have the benefits or burdens of ownership, it may still qualify for being engaged in qualified production activities. Each taxpayer’s qualified production activity will be determined by a percentage of its profit on the total contract.

Wage limitation

The PAD is limited to the lesser of the entity’s taxable income or 50 percent of W-2 wages. W-2 wages are generally those reported in box 1 or box 5 of Form W-2 issued by the business entity. The Treasury Department has determined that W-2 wages are those wages of common law employees of the taxpayer. This may give some relief for taxpayers who engage in employee leasing.

Costs of goods sold

The easiest way to allocate costs of goods sold for a qualified production activity in determining QPAI is specific identification. Taxpayers engaging in qualified and nonqualified production activities must use the same method used in the determination of gross profit in determining an allocation of costs of goods sold between qualified and nonqualified production activities. Allocation of other deductions is more complicated.  Taxpayers with gross receipts of $25 million or less, however, may allocate deductions based on the ratio of receipts from qualified production activities to receipts from all activities. Taxpayers with gross receipts of $5 million or less and cash method accounting taxpayers may allocate both costs of goods sold and other deductions based on the percentage of the qualified production activities to total activities. Look for the Treasury Department to develop a number of accounting safe harbors in dealing with the PAD.  It is senseless to provide taxpayers a deduction that costs more to compute than the tax dollars saved.

Congress gave the Treasury Department a humongous job of interpreting its intent in defining and applying the PAD under Section 199.  It will behoove business entities with qualified activities falling within the definitions noted above to take time now to learn about the new PAD and the extent the entity may qualify for it. The entity may not need to incur additional costs or do anything differently other than to keep appropriate records and use some creativity to justify its qualification for the deduction.

Until the Treasury Department has spoken (and there is much yet to learn about the new PAD), accounting imagination (and additional work) will be at a premium. Now you know another reason for that smile on your tax adviser’s face.

		Robert L. Hood is a shareholder with the law firm of Willingham & Cote, P.C. specializing in business and tax law matters.