The so-called “manufacturing deduction” isn’t limited to companies that manufacture products only in the traditional sense. It’s available to a wider range of business operations.

Strategy: See whether your company can squeeze through one of the loopholes. If you qualify, you are eligible to deduct up to 6% of your qualified production activity income (QPAI) for the year.

Even better, the maximum deduction increases to 9% of QPAI in 2010. If your company is in the 35% tax bracket, this amounts to a 3.15% tax rate cut!

Here’s the whole story: Under Sec. 199 of the tax code, a qualified domestic producer can currently deduct 6% of the lesser of its QPAI or its taxable income. The maximum deduction was initially doubled from 3% after 2006.

QPAI is equal to domestic production gross receipts (DPGR) from qualified activities (see box) minus expenses. Expenses include the cost of goods sold allocable to the receipts, allocable direct and indirect costs and a ratable portion of other costs.

Production activities must be performed in whole, or in significant part, on U.S. soil. The annual deduction is limited to 50% of the company’s W-2 wages.

Note: The Sec. 199 deduction can be claimed by just about any business entity, such as S corporations, partnerships and sole proprietors—even estates and trusts are eligible. This tax break isn’t restricted to C corps.

Obviously, the deduction is fair game for traditional manufacturers of goods, but it also applies to farmers, fishermen, miners and various businesses in the construction field. Construction activities receive special treatment. For instance, a qualified company doesn’t actually have to construct buildings. The deduction may be extended to certain taxpayers in the painting, drywall and landscaping businesses. 

Similarly, the deduction is available to engineers and architects. As long as the services are related to construction, the costs qualify for the deduction, even if no actual construction takes place. The deduction may also be claimed by businesses conducting feasibility and environmental impact studies. 

Key point: The regulations clarify that you don’t have to actually “hammer in the nails” if you supervise a construction project. 

Under a special safe-harbor rule, a business can take the deduction if at least 20% of the total costs are the result of direct labor and overhead costs from U.S.-based operations. If any part of the production activities comes from outside the United States, the business must use either the safe-harbor rule (at least 20% of total costs are from U.S-based production activities) or allocate costs using the particular facts and circumstances. 

What about your business? Don’t make a snap judgment that you aren’t eligible if your operation falls outside a traditional manufacturing activity.

Tip: It might be advantageous to adjust operations to qualify for the 9% deduction that kicks in next year. 

Breaking up costs is hard to do   

For 2009, your company may deduct 6% of its taxable income from QPAI. Generally, you determine QPAI separately for each item.

Strategy: Break down your production costs. Under IRS regulations, you might deduct expenses based on product components.

Specifically, the regs give you an option. If an item as a whole doesn’t qualify for the deduction, you can elect to treat the part that does qualify as a separate item for these purposes. Check with your tax pro about segmenting costs.

Tip: Claim the Section 199 deduction on Form 8903, Domestic Production Activities Deduction.  It can be found at www.irs.gov/pub/irs-pdf/f8903.pdf.