Is your company affected by the new IRC Section 199 regulations? Once you’ve answered that question, ask yourself whether you’re sure.

The IRS issued proposed regulations under IRC Section 199 (added by the American Jobs Creation Act of 2004) to clarify the new domestic manufacturing deduction that lets business taxpayers deduct from gross receipts up to 3% of qualifying income from certain activities—causing an effective decrease in their income tax rates. The deduction is scheduled to increase to 6% for tax years 2007 through 2009 and to 9% thereafter.

Who can benefit
Who benefits from the new deduction? The deduction can be taken by C corporations and by pass-through entities such as S corporations, partnerships, and limited liability companies. It can also be taken by sole proprietorships. The deduction must be claimed at the partner, shareholder, or beneficiary level.

Definition of qualified production activities
The deduction applies to businesses that sell, lease, or license property that is manufactured (regardless of whether entirely or partially) in the United States. Manufacturing is broadly defined, and includes manufacturing activities of tangible personal property; production activities (including computer software production); domestic construction; civil engineering; architecture for U.S-performed projects; film and video tape licensing and production; food processing (but not retail); farming and growing agricultural products for food; engineering; the production of utilities (electricity, gas, and potable water); and other activities that extract or grow a product.
One notable exception: The deduction does not apply to businesses that supply services.

What you can deduct
For tax year 2006, you can deduct the lesser amount of 3% of the smaller of (1) the qualified production activities income for the year, or (2) modified adjusted gross income (AGI) for that tax I year or one-half of the employer’s Form W-2 wages for that year.

The percentage is based on your company’s net income derived from qualified production activities. Call our office to determine whether the deduction affects your business and to discuss which receipts you should retain throughout the year to support the deduction. A caveat to look out for—among several more complicated points—is that the deduction must not be greater than 50% of the wages paid to your employees.