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Manufacturing Deduction

For tax years beginning after 2004, business taxpayers can claim a deduction under the new Code Section 199 to offset income from qualified domestic production activities. The deduction has been commonly referred to as the Manufacturing Deduction which is actually a misnomer in that the deduction benefits many taxpayers engaged in qualified production activities, not just manufacturing firms. The deduction is properly known as the Section 199 Production Deduction.

The deduction is 3% for tax years beginning in 2005 and 2006, 6% for tax years beginning in 2007, 2008 and 2009, and is 9% for tax years beginning in 2010 and thereafter.

The deduction is limited to 50% of W-2 wages paid for a calendar year ending during the business' taxable year. The more you pay in wages, the greater the amount of Section 199 Production Deduction you may be entitled.

Qualified production activities eligible for the deduction are not limited to traditional manufacturing activities. Eligible activities include:

  • Manufacture, production, growth or extraction of qualifying production property (i.e., tangible personal property such as goods, food and clothing, computer software and sound recordings).
  • Certain qualified film production if at least 50% of the compensation relating to the production is for services performed in the U.S.
  • Production of electricity, natural gas or water in the U.S.
  • Construction or substantial renovation of real property and certain infrastructure in the U.S.
  • Engineering and architectural services performed in the U.S. and relating to the construction of real property.

This new law may affect tax planning for international operations where, as a result of the production deduction, the effective tax rates for countries in which a business' operations are located have flipped as compared to the business' U.S. effective tax rate.

Under these circumstances, it may be time to consider restructuring the business' operations so as to take advantage of the flip in rates by shifting a greater amount of the total profit into the U.S. Our economists can help you calculate the deduction and assist you or your tax advisor in reviewing your current structure to determine if you have completely minimized taxes across your worldwide operations.

Since Code Section 199 is new, there is little in the way of guidance from the IRS as how to precisely allocate certain items of income and deductions for purposes of determining the production deduction.

Most tax experts have commented that businesses engaged in activities eligible and not eligible for the deduction will need to establish methodologies used in transfer pricing studies to justify the allocation of overhead expenses and certain items of income and expense as required by Code Section 199. Taxpayers will need to be prepared to demonstrate such methodologies were properly followed to sustain the deduction if the issue is raised in a tax audit.

Our professionals regularly deal with transfer pricing issues and use the same methodologies and techniques that are needed to determine your production deduction. Our vast experience in addressing these issues and providing innovative solutions will result in you receiving the greatest possible benefit from this new deduction.