Friday, November 10, 2006

Domestic Production Activities Deduction analyzed

For those that produce goods, develop software or construct property in the U.S., regardless of whether they are exported, Congress has provided you the means to significantly reduce your tax bill.
How does the Section 199 deduction work?
The deduction is permanent in nature and is equal to a percentage of the lesser of your taxable income or net income earned from qualified production activities. It is available for tax years beginning after Dec. 31, 2004. The deduction will be 3% for tax years 2005 and 2006; 6% for tax years 2007, 2008 and 2009; and 9% for tax years 2010 or later.

What activities qualify for the Section 199 deduction?
Qualified domestic production activities include:
Manufacture, production, growth or extraction of tangible personal property, computer software or sound recordings or qualified films
Production of electricity, natural gas or potable water in the U.S.
Construction services including related engineering and architectural services performed in the U.S.

How is Qualified Production Activities Income calculated?
Domestic Production Gross Receipts minus expenses equal Qualified Production Activities Income (QPAI). Expenses include the cost of goods sold allocable to the receipts, allocable direct and indirect costs, and a ratable portion of other costs.

What's so complex about Section 199?
There are a number of interlinking issues that come into play when calculating the most advantageous Section 199 deduction. Ask yourself the following questions:

How did you define your revenue streams?
Do you have a full understanding of the relevant Section 861 regulations; and can you demonstrate how you maximized them?
Which of the three W-2 limitations is most beneficial?
What impact does the expanded affiliated group definition have on your calculation?
What state planning activities need to be re-evaluated after completing your Section 199 computation?

Figuring the Tax Deduction -
Calculating the Domestic Production Activities Deduction (DPAD) can be either simple or complex, depending on the nature of the business. The key to figuring the Domestic Production Activities Deduction (DPAD) is to examine "qualified production activities income" (QPAI) and the limitations (QPAE).

The formula
DPAD=QPAI-QPA=QPANI*3%=Tentative QPA Deduction [3% for 2005&6, higher later]
Domestic Production Activities Deduction (DPAD) Calculation Qualified production activities income (QPAI) minus Qualified production activities expenses (QPAE) equals Qualified production activities net income (QPANI) times The QPA deduction amount of 3% equals The Tentative QPA Deduction

1-Qualified Production Activity Income (QPAI)
Qualified production activity income (QPAI) is all income arising from qualified production activities in the US. For a business with only one line of business, this will be the same as gross income. For businesses with multiple lines of business, income will need to be allocated.
2-Qualified Production Activity Expenses (QPAE)
Qualified production activity expenses are all expenses directly related to the qualified production activities. For a business with only one line of business, this will be the same as total expenses. For businesses with multiple lines of business, income will need to be allocated.

Limits on the Deduction
W-2 Wages can limit the amount of the DPAD!!

General Overview
Although Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income (AGI)).
Section 199(b)(1) limits the deduction for a taxable year to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year.