Use Safe Harbors to Navigate Manufacturing Deductions
At this point in the year, you’ve probably figured out which business clients qualify for the Section 199 “manufacturing deduction.” But a tax law enacted last year changed the way the annual limit is imposed on business entities.
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Now, the IRS has issued new temporary and proposed regulations explaining how to apply the limits. (NPRM REG-127819-06)
Here’s the story: For 2006 tax returns, an employer is able to deduct 3 percent of the lesser of its qualified production activity income (QPAI) or its taxable income. The deduction percentage increases to 6 percent for the 2007 tax year and is scheduled to jump again to 9 percent in 2010.
QPAI is based on domestic-production gross receipts (DPGR) from qualified activities, i.e., those performed in whole or in significant part in the United States.
Key point: The annual Sec. 199 deduction is limited to 50 percent of the employer’s W-2 wages. But the Tax Increase Prevention and Reconciliation Act (TIPRA) modified the
methodology for establishing the limit. Instead of restricting the Sec. 199 deduction to 50 percent of all W-2 wages the employer has paid, TIPRA imposes the 50 percent limit only on W-2 wages actually incurred in connection with the qualified domesticproduction activity.
In other words, an employer’s allowable deduction may drop due to the revised calculation for 2007 just when the amount will double from 3 percent of QPAI to 6 percent.
Safe-harbor methods: Fortunately, the new regulations provide two safe harbors for determining the amount of W-2 wages allocable to DPGR. These methods have been called the “wage expense method” and the “small business simplified overall method.”
Here are two new safe harbors:
1. Under the wage-expense method, the employer multiplies W-2 wages by the ratio of its wage expense used to calculate QPAI over the total wage expense used to calculate taxable income for the year.
2. With the small-business simplified overall method, the amount of W-2 wages charged against DPGR is based on the ratio of W-2 wages that DPGR bears to total gross receipts.
Refer to the regulations for in-depth examples of both of these safe-harbor methods.
The new rules also address several other technical issues relating to the Sec. 199 deduction. The regs generally apply to tax years beginning after Oct. 19, 2006, but employers can elect to apply them to tax years beginning after May 17, 2006.
Other transitional rules apply to deductions for pass-through entities such as S corporations with tax years beginning after May 17, 2006.
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