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Domestic Manufacturing Deduction _DMD_

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					                      Domestic Manufacturing Deduction (DMD)
                        (Sample Client Letter and Organizer)


This practice guide assists practitioners with the new Domestic Manufacturing Deduction
enacted by the American Jobs Creation Act. The first tax returns that are affected are
those reporting manufacturing activities for taxable years beginning after December 31,
2004. The following guide contains a sample letter for adaptation to your particular
needs that informs the client of the new deduction as well as the various complications
that may arise. Along with the letter is a flow chart and organizer that show the
calculation of the deduction and will assist in gathering pertinent information and
evaluating the DMD for each client.

Many situations will cause the practitioner to seek information and guidance beyond the
scope of this guide given the broad scope of the provision. For example, foreign sources
of income or expense, sub-assemblies that contain foreign materials & contract
manufacturing, are just a few. There are still many unanswered questions regarding the
applicability of the provision that will hopefully be cleared up by the issuance of final
regulations.

Please note that while the IRS has issued proposed regulations on this topic, final
regulations will not be complete until Spring, 2006 at best. This may affect how you
choose to cope with the DMD by filing or extension of the return depending on the
client's circumstances. For 2005 & 2006 returns the DMD rate is 3% of qualifying
income. For 2007 and later the rate gradually increases, raising the relative value of the
deduction. Naturally, you will need to evaluate these considerations when deciding the
proper course of action for each client's situation. Our website contains a page for
posting of items to help you deal with this issue as we produce them and they become
available. See http://tax.aicpa.org/Resources/Tax+Accounting, and click on Tools and
Aids.
Dear Client,


The Treasury Department and Internal Revenue Service have issued proposed regulations implementing
deductions under Section 199 for Domestic Production Activities. Section 199, commonly referred to as
the Domestic Manufacturers’ Deduction, is a dynamic new tax law. This deduction was the centerpiece of
the American Jobs Creation Act of 2004 and generally allows qualified businesses to deduct three percent
of Qualified Production Activities Income for 2005 and 2006, increasing to six percent for 2007, 2008, and
2009, and nine percent thereafter. Once the law is fully phased in, many businesses could potentially
reduce their effective tax rate up to three percentage points.

You may qualify for the Domestic Manufacturer’s Deduction if you:

        manufacture personal property; produce software, sound recordings or films; OR

        construct real property or; are an architectural or engineering firm.

The rules for calculating the Domestic Manufacturers’ Deduction can be complex. There can be many
computations, allocations and apportionments required to determine a taxpayer’s Qualified Production
Activity Income. The deduction is limited to 3% in 2005 and 2006 (6% for 2007, 2008, and 2009, and 9%
for all years thereafter) of the lesser of a taxpayer’s: (a) Qualified Production Activity Income (QPAI); or
(b) taxable income. Furthermore, the deduction cannot exceed 50% of the W-2 wages paid by a taxpayer
during the taxable year. Careful consideration must be made on weighing the benefits of claiming the
deduction with the opportunity cost incurred in calculating Qualified Production Activity Income.

We are here to assist in evaluating these Section 199 opportunities and risks. We have provided general
guidelines designed to assess whether your business may benefit from the Section 199 Deduction. The
guidelines provided are intended solely as a preliminary tool for your business and are not to replace
professional tax advice or planning. We are available to assist with calculating Qualified Production
Activity Income, claiming the deduction, and creating a business tax plan to optimize this new tax
legislation as it meets your business tax objectives.




Sincerely,
   UNDERSTANDING THE CALCULATION OF SECTION 199 DEDUCTION



As the flowchart below indicates, qualified production activities income (QPAI) equals
domestic production gross receipts or “DPGR”, less
       a. the cost of goods sold allocable to such receipts;
       b. other deductions, expenses, or losses directly allocable to such receipts; and
       c. a ratable portion of deductions, expenses, and losses not directly allocable to
           such receipts or another class of income.

QPAI is determined on an item-by item basis (and not, for example, on a division-by-
division, product line-by-product line, or transaction-by-transaction basis).

                                       Section 199 Deduction

                                          The Lesser Of:


                              50% of                        3% (for 2005 &
                               W-2                             2006) of
                              Wages                          The Lesser of:




         Net Qualified Production Activities                              Taxable
                 Income (QPAI) =                                         Income or
   Domestic Production Gross Receipts (DPGR) –                        AGI for Individuals
   allocable Cost of Goods Sold – other allocable                      (Calculated
                                                                      without section
                        costs
                                                                           199)
    IDENTIFYING COMPONENTS OF DOMESTIC PRODUCTION GROSS
                      RECEIPTS(DPGR)

       1.   Derived from any lease, rental, license, sale, exchange or other dispositions
       2.   Qualifying Production Property
       3.   Manufactured, produced, grown, or extracted
       4.   By the Taxpayer
       5.   In whole or Significant Part
       6.   In the United States

“Derived” From Requirement – A taxpayer must determine the portion of its gross
receipts that are directly derived from Domestic Production Gross Receipts and the
portion of its gross receipts that are non-Domestic Production Gross Receipts. Domestic
Production Gross Receipts generally do not include gross receipts derived from the
performance of services. If less than 5% of total gross receipts do not constitute Domestic
Production Gross Receipts then all gross receipts can be treated as Domestic Production
Gross Receipts under the de minimis rule.

“Qualifying Production Property”(QPP) – is defined as tangible personal property,
computer software and sound recordings. The term “tangible personal property” for this
purpose is any tangible property other than land, buildings, and structural components of
buildings. Examples of tangible property include:

Clothing            Magazines                 Grocery Counters       Production machinery

Goods              Newspapers               Testing Equipment Display racks and
shelves
Office Equipment Refrigerators              Neon and other signs Hydraulic car lifts
Books              Printing Presses         Gasoline pumps          Automatic vending
machines
Transportation Equipment
Foods (excluding prepared by the taxpayer at a retail establishment and sold at retail)

**** A four part test must be met for tangible personal property to qualify. Please see
our supplemental handout to determine if your product qualifies.




 “Manufactured, Produced, Grown or Extracted”(MPGE) - Code Section 199 is
intended to apply to a wide variety of production activities. The term “produced”
includes: construct, build, manufacture, develop, improve, create, raise or grow. The
terms “manufacture,”        “production” and “extraction”: include the construction,
reconstruction or making of property out of scrap, salvage or junk as well as from new
material by processing, manipulating, refining or changing the form of an article. These
activities also include changing the form of an article by combining or assembling two or
more articles. In order to be a manufacturer, producer, grower or extractor, there must be
some substantial alteration in the form of the property.

“By the Taxpayer” –Generally, “by the taxpayer” indicates that only one taxpayer may
claim the deduction. The taxpayer that bears the benefits and burdens of the qualifying
property during the period in which manufacturing or production activities occur is
entitled to claim the section 199 deduction.

“In Significant Part” – Domestic Production Gross Receipts include all gross receipts
from qualifying production property that is manufactured “in whole or in significant part”
in the United States. The Manufactured, Produced, Grown or Extracted activity must be
substantial in nature to satisfy this requirement. A facts and circumstances test is used to
determine if the taxpayer’s manufacturing activities are “substantial in nature”. Factors
to consider are: value added by the activity, the relative cost of the Manufactured,
Produced, Grown, or Extracted activity, the nature of the activity, and the nature of the
property itself. A safe harbor exists when at least 20% of the conversion costs are
performed in the United States. Merely labeling or repackaging the product will
generally not be sufficient enough activity to constitute manufacturing, producing,
growing or extracting.


“In the United States”- This includes the 50 states and the District of Columbia,
territorial waters and the seabed and subsoil adjacent to those waters. Possessions and
territories are not included in this definition, as well as the airspace over the United
States.



 DETERMINING YOUR QUALIFIED PRODUCTION ACTIVITIES INCOME,
      COST OF GOODS SOLD AND ALLOCABLE DEDUCTIONS

                QUALIFIED PRODUCTION ACTIVITIES INCOME

To determine Qualified Production Activities Income (QPAI), a taxpayer must subtract
from Domestic Production Gross Receipts (DPGR): (a) the cost of goods sold allocable
to such receipts; (b) the amount of expenses or losses directly allocable to such receipts;
and (c) a ratable portion of costs that are not directly allocable to such receipts.

                   ALLOCATING THE COST OF GOODS SOLD

Generally, a taxpayer must use a reasonable method to allocate cost of goods sold to its
Domestic Production Gross Receipts. In the case of inventory, cost of goods sold is
determined under the method of accounting the taxpayer uses to compute its taxable
income. If a taxpayer is unable to specifically identify the cost of goods sold that is
attributable to Domestic Production Gross Receipts without undue burden or expense,
cost of goods sold for the purposes of the deduction should be determined using a
reasonable allocation method.




                   ALLOCATING THE OTHER DEDUCTIONS

All other deductions must be allocated and apportioned between Domestic Production
Gross Receipts and non-Domestic Production Gross Receipts. Three methods are
available, based on certain average annual gross receipt limitations.

                                     SUMMARY

This guide will allow you to make an initial determination regarding whether your
business will benefit from the Section 199 deduction. This guide does not address all the
rules potentially applicable to your business and business stakeholders given the length
and complexity of the Proposed Regulations. We expect more guidance to be issued in
late spring/early summer. Please contact or send the attached questionnaire to us for
additional tax planning considerations.

As required by IRS Circular 230, any advice expressed in this writing as to tax
matters was neither written nor intended by the sender to be used and cannot be
used by any taxpayer for the purpose of avoiding tax penalties that may be imposed
on the taxpayer. If any such tax advice is made to any person or party other than to
our client to whom the advice is directed and intended, then the advice expressed is
being delivered to support the promotion or marketing (by a person other than
___________________________) of the transaction or matter discussed or
referenced. Each taxpayer should seek advice based on the taxpayer’s particular
circumstances from an independent tax advisor.
                              MANUFACTURING
 CLIENT NAME: _____________________            TYPE OF ENTITY:
____________________

     DETERMINING IF YOUR PRODUCT IS QUALIFIED PROPERTY

  1. Do you have W-2 wage expense? _______ (If not, Section 199 does not apply)

  2. Do you have Taxable Income? ________ (If not, Section 199 does not apply)

  2. Is the product manufactured, produced, grown, or extracted?

         a. ___ Do you manufacture, produce, grow, extract, develop, improve, or
            create your product?
         b. ___ Is the product tangible personal property, computer software, sound
            recordings, films, or the production of electricity, natural gas or unbottled
            drinking water?
         c. ___ Do you install and/or assemble the property?
         d. Please list your products on an “item by item” basis and discuss how each
            is
            manufactured:________________________________________________
            ____________________________________________________________
            ____________________________________________________________
            ____________________________________________________________
            ____________________________________________________________
            ____________________________________________________________
            ____________________________________________________________
            _____________________________

  3. Is the product manufactured or produced by you? ______
      Factors to consider when answering that question
            Is title passed to another taxpayer?
            Do you bear the economic risk of loss?
            Do you have control over manufacturing process?
            Do you have the right to accept or reject goods?
            Do you have the right to market or sell the property?
            Do you have the right to alter the property?
            Do you have the rights to the intellectual property?
         Do you have the responsibility to insure the property?
         Do you have the responsibility to pay tax on the property?
       e. Please identify and discuss any exceptions to the
          above:______________________________________________________
          ____________________________________________________________
          ____________________________________________________________
          ____________________________________________________________
          ____________________________________________________________
          ____________________________________________________________
          ____________________________________________________________
          _____________________________



4. In whole or significant part?
       a. ___ Are your added costs of the product at least 20% of the total direct
          costs(cost of the goods and direct labor & overhead) disregarding research
          and development costs
       b. Please explain the nature of your
       product:________________________________________________________
       _______________________________________________________________
       _______________________________________________________________
       _______________________________________________________________
       _______________________________________________________________
       _______

5. In the United States
       a. ___ Does activity occur within the 50 states and District of Columbia?
       b. ___ Does activity occur within a US Possession or Territory?
       c. ___ Does activity occur in territorial waters?
       d. Please identify and discuss any
           exceptions:__________________________________________________
           ____________________________________________________________
           ____________________________________________________________
           ____________________________________________________________
           ____________________________________________________________
           _____________________

6. Are your Gross Receipts
      a. ___ Less than $5,000,000
      b. ___ Greater than $5,000,000 but less than $25,000,000
      c. ___ Greater than $ 25,000,000

7. Do you own more than 50% of a related entity that you sell product to? _____

				
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