Winner of the Well Workplace Small Business Award

 

October 30, 2005 -- I own a small manufacturing company and have heard something about a new tax change called the "Production Deduction"; can you explain how this might affect me?

For tax years beginning after 2004, business taxpayers can claim a deduction to offset income from domestic manufacturing and other production activities.

For 2005, the deduction is equal to 3% of the lesser of (1) the business’s total taxable income (adjusted gross income in the case of a sole proprietor) or (2) the business’s “qualified production activities income” for the year. In addition, the amount of the deduction for any tax year may not exceed 50% of the employer's W-2 wages for that tax year. The deductible percentage will remain at 3% for 2006, after which it will gradually increase to 9% for tax years beginning after 2009.

Qualified production activities eligible for the deduction include:

• Manufacture, production, growth or extraction of qualifying production property (i.e., tangible personal property such as clothing, goods, or food as well as computer software or music recordings) by a taxpayer either in whole or in significant part within the United States.
• Film production (other than production of certain sexually explicit films) if at least 50% of the total compensation relating to the production is for services performed in the United States by actors, production personnel, directors, and producers.
• Production of electricity, natural gas, or water in the United States.
• Construction or substantial renovation of real property in the United States, including residential and commercial buildings and infrastructure such as roads, power lines, water systems, and communications facilities.
• Engineering and architectural services performed in the United States and relating to the construction of real property.

As mentioned, the deduction is limited to 50% of the W-2 wages paid by the business during the calendar year that ends in the tax year. Special computations may be necessary. For purposes of the deduction, W-2 wages include wages, tips and other compensation as well as elective deferrals to 401(k) and certain other plans. As a result, there is no single box on the Form W-2 that shows the exact amount of W-2 wages for computing the deduction cap. It is important for businesses to calculate the tentative production deduction and the W-2 deduction cap before year-end. If the deduction cap will limit the otherwise available deduction-for example, in the case of a closely held business whose owners do not draw substantial salaries-the business may want to bonus out additional compensation to maximize their deduction.

For pass-thru entities (such as S corporations, partnerships, estates and trusts), the deduction generally is determined at the shareholder or partner level by taking into account at that level the proportional share of the qualified production activities income of the entity.

Return to Tax Talk.