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New IRS Regulations for the Manufacturing Deduction for Business


lThe IRS has released much-anticipated final regulations on the new, valuable "manufacturing deduction" for businesses. (NPRM REG-111578-06) They follow up proposed regulations issued  ast year and contain some "taxpayer friendly" provisions. But don’t count on simplicity: The new regs are more than 300 pages long and retain some of the complexities that have plagued taxpayers up until now.

Here are some of the key points covered in the new regulations:

  • The deduction is based on "domestic production gross receipts" (DPGR) from qualifying activities, minus the cost of goods sold and other allocable expenses. The result is your company's “qualified production activities income” (QPAI).

  • A business can deduct a percentage of its QPAI — three percent for 2005 to 2006, six percent for 2007 to 2009 and nine percent after 2009.

  • The proposed regulations treated sales and downloads of software as a qualifying sale of a product, but the use of online software as a nonqualifying service. The final regulations now allow favorable treatment for online software.

  • A taxpayer who wants to claim income from real property must have constructed the property. The final regs make it clear that a business may qualify if it performs management functions such as oversight, inspection and approval. The taxpayer doesn’t have to actually “hammer the nails in."

  • The new regs liberalize the rules determining expenses subtracted to arrive at QPAI. A simplified deduction method can now be used by taxpayers with revenue of up to $100 million as opposed to the previous limit of $25 million. This method allows companies to allocate expenses based on qualifying and nonqualifying receipts.
  • The proposed regs treated certain "embedded services" as gross receipts, including warranties, delivery, operating manuals and installation fees. A new exception is provided for embedded computer software maintenance contracts. None of these services qualify if they are separately stated or offered separately to customers.

    Many Types of Businesses Qualify

    Obviously, the deduction is available to traditional manufacturers of goods, food and clothing. However, the IRS has extended this tax break to production activities in the following areas:

    • Construction,
    • Music recordings and film production,
    • Electrical and natural gas,
    • Unbottled drinking water production,
    • Engineering and architecture services, and
    • Software development.

    IRS guidance also provides several "safe harbor rules" to ease administrative burdens for small businesses. For instance, production activities in the U.S. must be "substantial" in order to qualify for the deduction. (IRS Notice 2005-14) The IRS says this test will be met by qualified small businesses if their labor and overhead costs for the manufacture, production growth and extraction of property equals at least 20 percent of the total cost for the property.

    The manufacturing deduction can be claimed by any type of business entity, including C corporations, S corporations, limited liability companies (LLCs), partnerships and sole proprietors.

    Caveat: This is just a brief overview of the some of the provisions in the regulations. To determine the full impact for your business, call Ronald J. Cappuccio, J.D., LL.M. (Tax) at (856) 665-2121.

  • Ronald J. Cappuccio, J.D., LL.M.(Tax) 1800 Chapel Avenue West Suite 128 Cherry Hill, NJ 08002 Phone:(856) 665-2121      Fax: (856) 665-9005 Email:

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