Visualize a tax deduction that keeps on giving from the federal government, a deduction that starts this year and doubles for 2007 and increase again in 2010.
Certain businesses will benefit from the new tax deduction including real estate developers, general and subcontractors, farmers,manufacturers, and software developers.
The tax deduction is the lesser of taxable income or qualified production activities.
The qualified production activities are equal to domestic production gross receipts, and those receipts are related to rental, license, and sale of property which was manufactured, produced, grown, or extracted in whole or, for the most part, in the United States.
Qualified production also includes engineering, or architectural services in the United States for construction projects.
The deduction is equal to 3 percent of taxable income until 2007, 6 percent for 2007 to 2009, and 9 percent afterwards.
The deduction is known as the Deduction for Domestic Production Activities (DDPA).
The deduction benefits taxpayers who have substantial income and who will have consistent or growing income for the future.
An example is a contractor with taxable income of $200,000 for 2005.
The taxpayer's tax reduction is $2,100 (presuming a tax rate of 35 percent).
For tax years 2007 to 2009 the tax reduction on $200,000 taxable income is $4,200.
For tax year 2010, the tax reduction is $6,300.
Please note: the deduction has a limitation on wages paid to employees.
Partners and S Corporation shareholders have limitations based on qualified income.
Receipts that do not qualify for the deduction are receipts qualified as production activities related to retail, transmission or distribution of electricity, natural gas, or potable water.
Wholesalers and retailers do not qualify for this deduction.
Also, the deduction is limited to 50 percent of wages paid by the employer for the year.
A planning note: Contractors who subcontract a large amount of production activities might consider paying under employment contracts when appropriate so that the contractor qualifies for the deduction.
The DDPA deduction is allowed for S corporations, partnerships, estates, and trusts.
It is applied at the shareholder, partner, or beneficiary level.
Each shareholder or partner must evaluate whether they qualify for the deduction individually.
Partners and S corporation shareholders are limited by the lesser of allocated shareholder wages or two times qualified production activity income (two times 3 percent in 2005).
The tax deduction is computed on the IRS form 8903, Domestic Production Activities Deduction.
Consider a planning note: Taxpayers,who do qualify for the deduction, will need to maintain proper accounting records to support their computation of the deduction.
Changes to financial recordkeeping might need to be made as the year begins to make future DDPA deductions easy to track.
Scott T.Wait is a CPA and a business management consultant practicing in Reno.
Contact him at scott@rswait.com.
