As part of the American Jobs Creation Act of 2004, a deduction for a portion of the income attributable to certain production activities in the United States has been created. A business may be allowed to reduce a portion of its taxable income by 3 percent, for federal tax purposes, beginning in 2005, increasing to 9 percent by 2010.
The American Jobs Creation Act of 2004 was signed into law on Oct. 22, 2004, and on Jan. 19, 2005, the Internal Revenue Service (IRS) issued additional guidance establishing the foundation for this tax relief.
Without question, this recent guidance truly provides an opportunity for a diverse group of businesses to take advantage of an additional deduction without having to purchase anything. Under this law, any business that has activities in the following areas, in the United States, may qualify for this deduction:
• A business that makes a finished product by processing, manipulating, refining or changing the form of a product, or by combining or assembling two or more products.
• A business that makes food and/or beverages for sale to wholesalers.
• A business that participates as part of new construction or substantial renovation of commercial or residential real property, including framing, electrical, grading, landscaping and painting just to list a few examples.
• A business that receives income for engineering and architectural services related to the new construction or substantial renovation of real property.
• A business that receives income from the sale of software developed by the company.
• A business that produces films primarily in the United States.
• A business that produces electricity, natural gas or water in the United States.
This deduction was designed to encourage manufacturing activities in the United States. With the broad definition of manufacturing, this is an opportunity that all businesses should be aware of and utilize.
To the extent that businesses have qualifying activities and generate taxable income, they are allowed to take this additional deduction. The deduction for 2005 equals 3 percent of the lesser of taxable income derived from those qualified manufacturing activities or taxable income of the entire business.
For example, if a business has multiple activities (i.e. seller of products manufactured by the business and seller of products manufactured by another company) and qualifying manufacturing activities generate net taxable income of $100,000, while taxable income for the entire business is $500,000, the business would receive an additional deduction of $3,000 (3 percent of $100,000).
However, it is important to note that the law limits the deduction to 50 percent of W-2 wages paid during the calendar year by the business. To further illustrate, in order to receive the $3,000 deduction, a business would need to have paid wages of at least $6,000.
The key to optimizing this deduction is for a business to make sure that the taxable income of the qualifying activity is maximized. To use the example above, if the business were to evaluate how it determined the income from qualifying activities and they discover that the true income for the qualifying activities was $200,000, they will have doubled their deduction by making this evaluation.
With that said, determining taxable income for qualifying activities is not an arbitrary process. The IRS expects all businesses to follow the established rules for determining taxable income. In an effort to assist small businesses (entities with less than $25 million in total gross receipts), the IRS will allow for the use of simplified formulas to make the calculation of taxable income from a qualifying activity less of a burden on businesses.
Keep in mind that simplified rules may not produce the maximum deduction, but may be a cost effective option.
In summary, this deduction should be taken by any business that has the following: (1) taxable income from qualifying production activities; (2) taxable income for the year; and (3) W-2 wages. To the extent that a business has qualifying activities, I encourage that business to track those activities separately and evaluate how the qualifying income is determined early in the process.
If you desire more information on this topic, you can refer to the IRS Notice 2005-14.
Daniel Glomski is the tax manager
of the Milwaukee office of Komisar Brady & Co., LLP.
March 18, 2005, Small Business Times, Milwaukee, WI
