THE NEW "PRODUCTION DEDUCTION"
With the passage of last year's "American Jobs Creation Act of 2004," Congress ushered in a brand new deduction to reward businesses for conducting certain activities within the United States. Among the businesses that may qualify are businesses involved in the following activities: manufacturing, construction, engineering and architectural services, energy production, mining, film production, software development, production of sound recordings, farming, and the processing or storing of food products. This new deduction is effective for tax years beginning after December 31, 2004, and is based on the following percentages of qualifying income: 2005-2006 (3%), 2007-2009 (6%), after 2009 (9%). However, the deduction cannot exceed 50% of the wages paid by the business. Furthermore, this deduction is generally allowed for "alternative minimum tax" purposes, and any type of business entity can qualify, including a regular C corporation, an S corporation, a partnership, an LLC, and a sole proprietor. We begin this segment of the letter with the mechanics for calculating the deduction, followed by a discussion of the types of business activities that qualify.
Overview of Rules for Computing the Deduction
For 2005 and 2006, if your business qualifies, your deduction will be 3% of the lesser of: 1) your qualified production activities income (QPAI), or 2) your taxable income. However, this result is limited to 50% of W-2 wages. IRS says that, generally, if you are engaged exclusively in the manufacture or construction of qualified property within the United States and you have no other sources of income, it is anticipated that your QPAI will equal your taxable income. If this is the case, the calculation is relatively simple. Your production deduction is equal to the lesser of: 1) 3% of your taxable income or 2) 50% of W-2 wages. In addition, IRS says you may treat all of your income as qualifying production income if your receipts, other than domestic production gross receipts, are less than 5% of total gross receipts.
Calculating Qualified Production Activities Income. If you have taxable income and if more than 5% of your total gross receipts are from sources other than qualified production activities (non-qualified income), you will need to compute your qualified production activities income (QPAI). QPAI is the excess of domestic production gross receipts over the sum of: 1) the cost of goods sold (CGS) allocable to such receipts; 2) other deductions, expenses, or losses directly allocable to such receipts; and 3) a ratable portion of deductions, expenses, and losses not directly allocable to such receipts or another class of income. The IRS has provided us with three alternative methods for allocating these costs, two of which offer short-cut methods. Planning Alert! These technical allocation rules are too complex to discuss in detail in this letter. However, if you believe that your business may qualify for this deduction, and if your business conducts both qualifying and non-qualifying activities, it is important that you determine, as soon as possible, if your accounting systems accumulate the information necessary to calculate the deduction. Please call our firm if you need assistance in evaluating how your business may take advantage of these cost allocation rules.
W-2 Wage Limitation. As previously mentioned, your production deduction cannot exceed 50% of the W-2 wages paid by your business, which can include wages paid to your employees who are providing services unconnected to your qualifying production or construction activities. Planning Alert! If you have a qualifying business that operates as a sole proprietorship or partnership with no common law employees (and, therefore, no W-2 wages), you should consider converting your business to an S corporation and pay yourself sufficient W-2 wages to qualify for the production deduction. Caution! There are many ramifications from converting a business to an S corporation. Please do not establish an S corporation without first discussing these ramifications with us.
Pass-Through Entities. If you operate your business as an S corporation, partnership, or other pass-through entity, your production deduction is generally allowed at the owner level. For calculating the production deduction, a shareholder, partner, beneficiary, etc. is allocated a proportionate part of the qualified production activity income (QPAI) from the pass-through entity. Subject to certain caps, the owners are also allocated a proportionate part of the W-2 wages from that entity.
Overview Of Selected Qualifying Activities
Summary. To qualify for the production deduction, your business must engage in a qualifying activity. Qualifying activities generally include:
1) The leasing, renting, licensing or selling of: a) tangible personal property, software, or a sound recording which was manufactured, produced, grown, or extracted in significant part by your business within the United States; b) qualified films produced by your business where at least 50 percent of the total compensation relating to the production of the film is for services performed in the U.S.; or c) electricity, natural gas, or potable water produced by your business in the U.S.;
2) Construction performed by your business in the United States, including the construction of residential and commercial buildings and infrastructure such as roads, power lines, etc.; and
3) Engineering and architectural services performed by your business in the U.S. relating to the qualified construction of real property in the U.S.
The Manufacture, Production, Growth or Extraction Of Production Property. Businesses that manufacture, grow, produce or extract qualifying production property may qualify for the production deduction. "Qualifying production property" generally includes tangible personal property, computer software, and sound recordings. The manufacture, growth, production or extraction also must occur "in significant part by the taxpayer within the U.S."
• Manufacture and Production. A business may be a manufacturer or producer qualifying for the production deduction if it manipulates, processes, changes, or refines an article’s form or assembles or combines two or more articles. Also, your business may qualify for the deduction if it installs tangible personal property. If you are a retailer or wholesaler that does not alter the form of an article or convert two or more articles into a different item, your business is not likely to qualify. However, if you are a retailer and you are also considered a "producer" under the "uniform capitalization" rules of IRC §263A, the income from those production activities should qualify. Caution! To qualify for the deduction, your manufacturing, production, processing, assembling, installation activities, etc. must be "substantial in nature." Planning Alert! Generally, revenues from providing services in connection with the leasing, licensing, or selling of qualified production property do not qualify for the deduction. However, income from certain warranties that cover the qualified property may qualify, as well as advertising revenue for publishers of newspapers and magazines.
• Farming and Mining. Revenue from cultivating soil, raising livestock, and mining minerals within the U.S. may qualify for the production deduction. Storing, handling, or processing (but not transporting) agricultural products within the U.S. qualify, if performed in connection with the sale or disposition of the product that is consumed or incorporated into a manufactured or processed product.
• Preparation of food and beverages sold at a retail establishment. Generally, income from the processing of meat, fish or other foodstuffs qualifies. However, income from the sale of food or beverages prepared by a business at a retail establishment will generally not qualify. Tax Tip. If your business processes food or beverages both for sale at retail and wholesale at the same facility, the IRS will permit you to allocate your income between the income derived from the retail sale of the food and beverages (which does not qualify for the deduction), and income derived from the wholesale sale (which does qualify).
• Contract manufacturing. The IRS has concluded that if an activity involves the manufacture, production, growth, or extraction of qualifying property, only one taxpayer may claim the deduction with respect to the same function performed with respect to the same property. For example, if A (a manufacturer) enters into an agreement with an unrelated taxpayer B to manufacture 100 widgets for B, the IRS says that only the taxpayer that has the "benefits and burdens" of ownership of the property under federal income tax principles during the period the qualifying manufacturing activity occurs qualifies for the deduction. Thus, under this rule, either A or B may qualify for the deduction, but both cannot obtain the benefit of the deduction for the same activity.
• Software Development. Your business will generally qualify for the production deduction if it develops in significant part computer software within the U.S., and generates revenue from leasing, licensing, renting, or selling it. Computer software includes video games and similar programs whether or not the program is designed to operate on a computer. For example, if you develop software in the United States and you sell it to customers who download it from the Internet, you will generally qualify for the deduction. Planning Alert! Generally, IRS says revenues generated from software that is merely offered for use to customers online for a fee does not qualify for the production deduction. Similarly, subject to limited exceptions, revenue from: 1) customer support in connection with the sale of computer software; 2) online services; 3) games played through a web site; 4) Internet access; or 5) telephone services over the Internet do not qualify.
• Qualifying Activities Must be Conducted "In Whole or in Significant Part" in the U.S. To qualify for the deduction, the manufacture, growth, processing, assembly, installation, etc., activities must be conducted "in whole or in significant part" by your business within the United States. Therefore, your qualifying activities must be conducted in significant part within the United States and your production activities must be significant (e.g., more than minor assembly, repackaging, or labeling) in order to qualify for the deduction. The IRS has provided certain safe harbor rules for determining whether you will meet these requirements. Please call our firm if you need more detailed information on how these rules might apply to your business.
Construction Activities. If you are in the business of constructing or substantially renovating commercial or residential buildings (including structural components), land improvements and infrastructure in the U.S., your business will probably qualify for the production deduction. The term "infrastructure" includes roads, power lines, water systems, railroad spurs, communications facilities, sewers, sidewalks, cable, wiring, and inherently permanent oil and gas platforms. Planning Alert! Although, the term "construction" generally includes most activities that are typically performed in connection with the erection or substantial renovation of real property, it generally does not include non-construction services such as hauling trash and debris, and delivering materials, even if these services are essential for construction. Tax Tip. If you are performing qualified construction and, in connection with that construction, you also deliver materials to the construction site and remove construction debris, the revenue derived from those non-construction services will qualify as revenue from construction activities.
• Land Improvements and Painting. If you improve land (for example, grading and landscaping) or if you are a painter, your activities are considered "construction," but only if they are performed in connection with other activities (whether by you or other taxpayers) that constitute the erection or substantial renovation of real property. For example, if you are a land developer who prepares land for new buildings, and you sell the developed lots to a builder, at least a portion of your profits should qualify for the deduction. Planning Alert! The IRS says that sales proceeds from the sale of land generally do not qualify as construction. Therefore, in the above example, you would presumably have to allocate the profit between the portion allocable to the land (which does not qualify) and the portion allocable to the land development activities (which does qualify).
• Leasing Constructed Realty Does Not Qualify. Unlike the leasing or renting of qualified "personal property," the leasing or rental of otherwise qualified constructed real property does not qualify for the production deduction. You must sell the constructed property to qualify.
• Contractors and Subcontractors May Both Qualify. Unlike the manufacture, production, etc. of personal property, it is possible that more than one taxpayer may generate qualifying income from real estate construction that involves the same activity and the same construction project. Example. Assume Owner (who is not in the trade or business of construction) owns a building within the United States and retains General Contractor to oversee a substantial renovation of Owner’s building. General Contractor, in turn, retains Subcontractor to install a new electrical system in the building as part of that substantial renovation. The amounts that General Contractor receives from Owner, and the amounts that Subcontractor receives from General Contractor, will qualify as construction revenue. Tax Tip. The "benefits and burdens" of ownership requirement imposed on contract manufacturers of personal property (discussed previously) does not apply to general contractors and subcontractors involved in the qualified construction of real property.
Engineering or Architectural Services. Income from engineering or architectural services performed with respect to a qualified construction project qualifies for the production deduction. Tax Tip. Gross receipts from qualifying engineering or architectural services will still qualify even if an otherwise qualifying construction project is not ultimately undertaken or completed.
ENERGY TAX INCENTIVES ACT OF 2005
On August 8, 2005, President Bush signed the Energy Tax Incentives Act of 2005 (the "Energy Act"), which creates a long list of tax breaks for consumers who install qualified energy-efficient devices in their homes or buy qualified energy-efficient vehicles. The Energy Act also provides the business community with several new targeted tax deductions and credits in addition to the credits for energy-efficient vehicles. Businesses that will most likely benefit are: businesses installing qualified energy-efficient equipment in a commercial building, contractors constructing qualified energy-efficient homes, manufacturers of certain energy-efficient appliances, and energy companies that incur qualified expenditures to improve the infrastructure for supplying energy to consumers or that increase their energy production capabilities. The purpose of this segment is to provide you with a brief overview of selected tax credits and deductions that may be available to you or your business. Planning Alert! These tax breaks are generally not available unless the qualified energy-efficient property is "placed-in-service" after December 31, 2005. "Placed-in-service" generally means that the property is on hand and it is ready and available for use. If you are planning to purchase property qualifying for any of these new benefits, you should consider postponing the final completion of qualifying installations, or the purchase of a qualifying energy-efficient vehicle, until after December 31, 2005.
Caution! The credits for non-business vehicles do not reduce your alternative minimum tax (AMT). In addition, the energy credits allowed to your business for vehicles or other qualifying energy expenditures do not reduce AMT. Thus, if you anticipate being hit by the AMT in 2006, your potential tax benefit of these new tax breaks could be diminished, or eliminated completely.
New Credits for Energy-Efficient Vehicles
New Alternative Motor Vehicle Credits (Effective for vehicles placed-in-service after 2005 and generally before 2010). For qualifying vehicles placed-in-service after December 31, 2005, the Energy Act creates the following four new separate tax credits: 1) the hybrid motor vehicle credit, 2) the advanced lean burn technology motor vehicle credit, 3) the fuel cell motor vehicle credit, and 4) the alternative fuel motor vehicle credit. These credits expire at various dates ranging from January 1, 2010 to January 1, 2015.
Hybrid Motor Vehicle Credit. Since hybrid vehicles are the predominant "green" vehicles currently being mass produced, this should be the most often utilized motor vehicle credit for the next few years. If you purchase a new qualifying hybrid passenger vehicle or light truck weighing no more than 8,500 lbs., your credit could be as high as $3,400, depending on the efficiency of the vehicle. Manufacturers should be announcing the official credit amounts for each model of qualifying hybrid. If the qualified hybrid vehicle weighs more than 8,500 pounds, the credit is equal to a percentage (based on a sliding scale) of the incremental cost of the qualified vehicle (capped at various amounts depending upon the weight of the vehicle). Planning Alert! Starting in 2006, once a specific auto maker’s sales of hybrid (and lean burn) vehicles reach 60,000, the energy credits for purchases on and after that date begin phasing out. Tax Tip. Next year when this credit becomes available, before buying a hybrid or lean-burn vehicle, be sure to check with the manufacturer to determine 1) the amount of the credit, and 2) whether the credit is still available for that manufacturer’s hybrids. If you need more information on the new alternative motor vehicle credits, please call our firm.
New Tax Benefits for Consumers
New $500 Lifetime Energy-Savings Home Improvement Tax Credit (Effective for qualifying property placed-in-service after 2005 and before 2008). Beginning in 2006, if you place qualified energy-savings property in service with respect to your "principal residence" you may qualify for a credit of up to $500. The $500 is a lifetime limitation, not an annual limitation. Tax Tip. Presumably, you and your spouse would each get a lifetime credit of $500, even if you file a joint return. Furthermore, your principal residence can include a manufactured home that conforms to certain Federal construction and safety standards. Vacation homes, second homes, rental property, and foreign homes do not qualify. Additional Dollar Caps. In addition to the overall $500 lifetime limitation, there is a $200 lifetime limit for energy-saving windows; a $50 lifetime limit for advanced main air circulating fans; a $150 lifetime limit for any qualified natural gas, propane, or oil furnace or hot water boiler; and a $300 lifetime limit for any item of "energy efficient building property" (e.g., electric heat pumps, water heaters, central air conditioners, etc.). Planning Alert! These properties generally must satisfy IRS-approved energy-efficiency standards and some qualify for a 100% credit, while others qualify for only a 10% credit. If you are interested, please call our firm and we will be glad to provide you more details.
Residential Alternative Energy-Generating Equipment Credit (Effective for property placed-in-service after 2005 and before 2008). If you place "qualified alternative energy-generating equipment" in service with respect to your U.S. residence, after December 31, 2005, you may qualify for a new 30% tax credit. Planning Alert! Expenditures related to swimming pools or hot tubs (e.g., solar equipment to heat water or run electrical pumps) do not qualify. The two most common classifications of "alternative energy-generating equipment" that will qualify are: 1) a solar water heater used in your principal or secondary residence that meets certain certification requirements (this credit may not exceed $2,000 for a taxable year), and 2) modular solar panels, commonly known as photovoltaics, PV panels, or PVs, that provide either a supplemental or exclusive source of electricity to your principal or secondary residence (this credit is also limited to $2,000 for a taxable year).
New Tax Benefits For Businesses
Home Contractor’s Credit for Building Energy-Efficient Residences (Effective for homes substantially completed after 8/08/05 and sold after 2005 and before 2008). Contractors who construct or reconstruct qualified energy-efficient homes in the U.S. may be eligible for a new tax credit of $2,000 for each home. To qualify for this credit, the new or reconstructed home must be certified to have met specific IRS approved energy-efficient criteria (generally, the homes must satisfy a 50% reduction in energy consumption standard). Manufacturers of qualifying energy-efficient manufactured homes certified under IRS procedures will also qualify for the $2,000 credit. Certain manufactured homes that meet a lesser energy-efficient standard may qualify for a $1,000 credit instead of the $2,000 credit. In addition, the credit is available for existing homes that are substantially reconstructed or rehabilitated to satisfy the IRS-approved energy-efficient standards.
Up-Front Deduction For Energy-Efficient Buildings (Effective for property placed-in-service after 2005 and before 2008). If you build or renovate a commercial building in compliance with specified energy-efficient standards, and you place that building in service in 2006 or 2007, you may be able to take an up-front deduction of the lesser of 1) the cost of qualifying "energy efficient commercial building property" or 2) $1.80 per square foot of the building (in certain situations you may be entitled to only a partial deduction of $0.60 per square foot). Energy efficient commercial building property is generally property: 1) installed in a building located in the U.S. as part of: the interior lighting systems; heating, cooling, ventilation, and hot water systems; or the "building envelope" (e.g., windows, walls, foundation, basement slab, ceiling, roof system, and insulation); and 2) which is certified under procedures developed by the IRS to reduce the "total" annual energy and power costs of the building by at least 50%, as compared to a comparable building meeting other specified minimum requirements. To qualify for this deduction, the energy-efficient systems must be inspected and tested by individuals who have been recognized by an IRS-approved organization as having the qualifications to certify. The Energy Act also requires that the cost savings calculation be prepared by computer software which the designers certify meet the IRS requirements. Tax Tip. If you are primarily responsible for designing the qualified energy-efficient plan for a public building (e.g., government buildings, public schools, etc.), you may be entitled to the deduction that would have otherwise been available to the building’s owner, had the owner been a private party. It is anticipated that the IRS will issue guidance on these provisions in the near future. We will monitor this closely.
Final Comments
We have not attempted to address all of the provisions of the Production Deduction or the Energy Act. If you have heard or read about a provision that is not discussed in this letter, please call our office. We will help you research the matter to determine whether it will have a tax impact on you or your business. This letter also contains several planning ideas. We suggest that you call our firm before implementing any tax planning technique discussed in this letter, or if you need more information.
Note: The information contained in this material represents a general overview of tax developments and should not be relied upon without an independent, professional analysis of how any of these provisions may apply to a specific situation.
IRS Circular 230 Disclaimer: Any tax advice contained in the body of this material was not intended or written to be used, and cannot be used, by the recipient for the purpose of i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
