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THE ETI REPEAL BILL GIVES LIFE TO MONSTER TAX BREAK

October 07, 2004

The ETI repeal bill is a big deal. It will provide an huge and complicated new tax break for "producers" -- manufacturers, farmers, construction, and some related businesses. It also provides some narrow tax breaks that will be huge to affected industries. This post concentrates on the new deduction for "producers."

Only a potential filibuster by Senator Kennedy now stands in the way of passage of H.R. 4520, the ETI repeal bill. As six Democratic senators - including Minority Leader Tom Daschle - approved the final version of the bill, it seems unlikely that a filibuster will attract the 40 votes it would need. The House and Senate conferees had filibuster in mind when they crafted the bill, and they presumably added enough pet provisions to attract the 61 votes they need. (UPDATE: The filibuster failed Sunday when the Senate voted to end debate, 66-14).

THE DEDUCTION FOR PRODUCERS

The new deduction for "Domestic Production Activities" will probably affect more taxpayers than any other provision in the bill. The bill creates a new deduction for a portion of "qualified production activities income," which we abbreviate as "QPI" so we can pronounce it "cupie."

The deduction will be a percentage of QPI, or if less, of taxable income. The deduction will be phased in:

   2005-2006: 3 percent of QPI
   2007-2009: 6 percent of QPI
   2010 and after: 9 percent of QPI 

WHAT INCOME IS QPI?

Five categories of income qualify as QPI:

   1. Income from "qualifying production 
   property" which was manufactured, 
   produced, grown, or extracted by the 
   taxpayer in whole or in significant 
   part within the United States.  
   Qualifying Production Property 
   includes tangible property, software,
   and film and sound recordings.

The "grown or extracted" language is critical - embracing, for example, farms, quarries and mines.

   2. Income from films produced primarily
   in the U.S.

   3. Income from "electricity, natural 
   gas, or potable water" produced in 
   the U.S.

   4. Construction performed in the U.S.

   5. "engineering or architectural 
   services performed in the United 
   States for construction projects in 
   the United States."

We could have taken engineering courses, but we didn't. We aren't optimistic that we will convince the IRS that tax consulting is really "engineering," or that we "manufacture" pretty bound copies of tax returns.

WHAT INCOME IS PRODUCTION INCOME?

The QPI deduction requires taxpayers to split their taxable income between "qualifying" and "non-qualifying" activities. For example, a taxpayer with both manufacturing and retail income will have to determine how much of their taxable income is attributable to manufacturing. The law computes QPI as gross receipts from production activities, reduced by cost of goods sold (inventory production costs) and a ratable portion of other costs. The law punts further definition of QPI to the Treasury.

Taxpayers will try to allocate their deductions to "non-qualifying" income. Presumably the Treasury will put out regulations to try to stop them.

OTHER QUIRKS

The QPI deduction has some quirks.

The deduction cannot exceed 50% of the employer's W-2 wages for the year. This would seem to be a great motivator for home businesses and farmers with few or no employees to incorporate and pay themselves a salary.

The deduction isn't available for the production and sale of food at retail.

There will be rules to keep people from selling to related parties to take advantage of the deduction.

Other analysis of the bill here and here.

For more coverage:

Tax Analysts: ETI Bill Headed to House, Senate Floors

New York Times: Negotiators Approve Big Tax Cuts for Business

Tax Update: CHAIRMAN THOMAS ISSUES 'CHAIRMAN'S MARK' OF ETI REPEAL BILL

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