Joseph A. Bellinghieri, Esquire
and Eric Ten Broeck, CPA

Recent Internal Revenue Code addition encourages production of U.S. goods through a novel approach to tax policy

With the addition of Section 199 to the Internal Revenue Code, the American Jobs Creation Act of 2004 has provided for a new deduction for those firms involved in the production of certain domestically produced goods and services. What is intriguing about this newly created deduction is its truly novel approach toward U.S. tax policy. Instead of offering an incentive to spur capital spending, such as Section 179 expense, bonus depreciation and investment tax credits, this legislation is a supply-side approach to encourage the making of goods and services manufactured, produced, grown or extracted by the taxpayer in whole or significant part within the United States. The following will discuss the application of the deduction, its limitations, and what firms are eligible.

The Section 199 deduction is literally passed down the distribution chain until the qualified goods and services are completed. It has the opposite effect of a Value-Added Tax (so called VAT taxes), which adds tax onto manufactured goods each time they are sold or exchanged, thereby increasing the cost to the end consumer.

As the name implies, the American Jobs Creation Act of 2004 is legislation designed to create U.S. jobs. As discussed below, the deduction is tied in part to the W-2 wage base of the taxpayer. Firms with low wage bases may not be able to take full advantage of the newly created Section 199 tax deduction.

In general economic terms, firms that realize newfound savings have a choice of distributing the profits to the owners or redeploying them into the business in the form of lower prices and/or capital investment opportunities. Congress, therefore, has given management a choice between distributing Section 199 savings to the owners of the firm or reinvesting them in the business. Unlike other tax incentives, the firm does not have to expend capital to avail itself of this deduction.

What this deduction will mean for the U.S. economy or the creation of new U.S. jobs remains to be seen. However, producers producing qualified production receipts (QPR) will enjoy significant U.S. tax savings with the proper tax planning.

How the Section 199 Deduction Works
The Section 199 deduction is phased in over a period of years beginning in 2005 with the full deduction occurring for years beginning after 2009, as outlined in the following table:

Table No. 1: Phase-In of Deduction

Example: Scott Manufacturing Company has $100,000 in qualified production gross receipts (QPGR) , $60,000 in cost of goods sold (COS) directly allocable to domestic qualified production gross receipts (DPGR) and $5,000 in allocable expenses not directly allocable to DPGR. In addition, Scott Mfg. Co. has taxable income of $30,000 without respect to the Section 199 deduction. Table No. Two and Table No. Three, below, illustrate how Scott Mfg. Co. calculates the deduction.

Table No. Two - Calculation of Section 199 Deduction

Table No. Three - Deduction of Section 199 Deduction
Against Taxable Income

Deduction Limitations
In an effort to stimulate the creation of United States jobs, the Act limits the deduction to 50 (fifty) percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. In addition, the deduction is limited to the lesser of the qualified production activities income, or the taxable income determined without regard to the Section 199 deduction.

Qualified production activities income (QPAI) is the excess of domestic production gross receipts (DPGR) over the sum of cost of goods sold allocable to such receipts, other deductions, expenses, or losses directly allocable to such receipts and a ratable portion of deductions, expenses and losses not directly allocable to such receipts. The following table contains a detailed listing of activities giving rise to DPGR.

Qualified production property (QPP): In general this is property that is manufactured, produced, grown, or extracted (MPGE), and includes (1) tangible personal property, (2) computer software, and (3) sound recordings.

Qualified film: Qualified films include any motion picture film or videotape, as well as live or delayed television programming, if not less than 50 percent of the total compensation relating to the production of the property is compensation for services performed in the United States by actors, production personnel, directors, and producers.

Construction means the construction of real property; that is residential and commercial buildings (including items that are structural components of such buildings).

Activities constituting construction: The U.S. Treasury Department and the Internal Revenue Service (a division of the U.S. Treasury Department) believe the term "construction" includes most activities that are typically performed in connection with the erection or substantial renovation of real property, but does not include tangential services such as hauling trash and debris and delivering materials.

Substantial renovations are the taxpayer's activities that result in permanent improvements or betterments of property, such that the cost of the activities must be capitalized. In addition, Code Section §263(a) defines the term "substantial renovation" to mean the renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use.

Qualified Services Under Section 199
In addition to qualified production property, certain services, outlined below, also give rise to a Section 199 deduction.

Engineering services: The term engineering includes engineering services in connection with any construction project, and any professional services requiring engineering education, training, and experience which apply the special knowledge of the mathematical, physical, or engineering sciences in the form of consultations, investigations, evaluations, planning, design, or responsible supervision of construction.

Architectural services: The term architectural services includes architectural services in connection with any construction project, including the offering or furnishing of any professional services such as consultations, planning, aesthetic and structural design, drawings and specifications or responsible supervision of construction (for the purpose of assuring compliance with plans, specifications, and design).

Flow-Through Entities
S-Corporations and other flow-through entities: The Section 199 deduction is determined at the shareholder level. As a result, each shareholder must compute his deduction separately. The IRS is scheduled to issue additional regulations concerning the deduction for S-Corporations and other flow-though entities, and other material matters concerning the Section 199 deduction.

Conclusion
Firms producing qualified production receipts will enjoy significant U.S. tax savings with the proper tax planning. A knowledgeable legal team can help you understand the complexities of the Section 199 addition, and may help you take advantage of this novel new law. Contact the business department of MacElree Harvey for more information.

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