The Manufacturers’ Deduction Benefit
By John B. McNamara, CPA, MST, Director, McGladrey & Pullen, LLP
The domestic manufacturing deduction (DMD) is a tremendous incentive for US manufacturers. In January, the IRS and the US Department of Treasury provided more than 100 pages of technical guidance to help manufacturers begin to understand the complexities of the DMD. Now businesses can analyze the rules and plan to realize the full benefit of the incentive.
The American Jobs Creation Act of 2004 represents the most significant tax reform for manufacturers in recent history. Among several opportunities within this legislation — and one of the most important for manufacturers — is the repeal of the Extraterritorial Income Exclusion (ETI) and the creation of the DMD. While called a replacement for the ETI, the DMD goes well beyond that for most mid-sized manufacturers. Large numbers of taxpayers who didn’t qualify for the ETI benefit will qualify for the DMD.
Also, all companies manufacturing within the United States should qualify for the DMD benefit – which isn’t based on exports, but on US manufacturing. In addition, the act broadly defines “manufacturing” and incorporates areas not traditionally referred to as manufacturing, including the sale, lease, or license of:
• Property manufactured, produced, or grown by the taxpayer (within the United States)
• Construction, engineering, or architectural services
• Electricity, natural gas, or potable water produced by the taxpayer
• Qualified film produced by the taxpayer
This deduction provides cash flow and financial statement benefits. Once fully phased in, the effective tax rate could be three percentage points lower (e.g. from 35 percent to 32 percent). The deduction will be effective for tax years beginning after Dec. 31, 2004 and will be phased in to nine percent over a five-year period.
In addition, businesses operating as S corporations, LLCs, partnerships, estates, and trusts will pass through this benefit to the owners. Remember, during the ETI phase out, companies qualifying for the ETI and DMD will benefit from both items.
Calculating the deduction may be generally straightforward for manufacturers that generate income solely through production activities that take place within the United States. For others, the guidance provides a complex set of requirements and safe harbors, including the following:
- Proceeds from business interruption insurance and certain payments not to produce qualify
- Publishers’ income for newspaper advertising qualifies
- Computer software, including machine-readable code for video games and other similar programs, qualifies
- A portion of non-qualifying receipts must be allocated to the service element when a transaction has a qualifying and a service element
- A safe harbor will qualify property produced in the United States if at least 20 percent of the costs to produce the property are conversion costs incurred in this country
- Design, development, packaging, and minor assembly activities and costs are specifically mentioned in the guidance as non-qualifying
- Consistency with other tax rules (e.g. uniform capitalization of inventory rules) is required
- A retail establishment will not qualify if less than 5 percent of the sales are retail sales (food and beverages prepared at a retail establishment do not qualify).
- Deduction amounts cannot exceed 50 percent of W-2 wages (Interestingly, the current W-2 form doesn’t contain a box with the specific amount used for the limit.
- Rather, the guidance provides three alternative methods from which you can choose to compute the limit).
Obviously, the benefits of the DMD are significant. The application of these rules to specific facts and circumstances are critical to realizing the full benefit of this incentive.
If you have any questions regarding research and development tax incentives, please contact either Jim Byman at (781) 685-3510, James.Byman@RSMI.com, or John McNamara at (781) 685-3560, John.McNamara@RSMI.com.
McGladrey & Pullen and RSM McGladrey have over 100 US Offices, and member firms of RSM International have over 600 offices in 75 countries with more than 20,000 people worldwide. Locally, the New England area is served through our Burlington MA office, which specializes in the areas of Manufacturing and Distribution, Construction, and Not-for-Profit accounting.
Reprinted with permission from Perspective -- an RSM McGladrey publication.