Articles

By Debbie R. Torrance, Partner, Smith & Howard, PC

What was introduced as a tax break for manufacturers, the Domestic Production Activities Deduction a.k.a. the “Production Deduction” could also be called the “Construction Deduction.” For qualifying construction activities, taxpayers may be able to reduce their effective tax rate by three percentage points when the new deduction is fully phased in. Like most tax laws, this tax incentive provided by Internal Revenue Code section 199 is complicated and subject to certain limitations. The production deduction may be taken on tax returns of eligible contractors for tax years beginning after December 31, 2004.

Who may take this deduction?

Anyone engaged in domestic production (including construction) activities may be eligible for the deduction. Among many other activities, eligible business activities include the design and construction of permanent real property. The deduction is there for contractors and subcontractors as well as developers, architects and engineers. It is likely that more than one company or person may take the deduction related to the same job where there are multiple contractors involved. For example, for a particular job the deduction could be taken by the general contractor and their subcontractors, the engineers and the architect who drew up plans.

Which construction activities qualify?

Many things related to the erection or substantial renovation of property will qualify. Construction may be commercial or residential, or even for infrastructure such as roads, bridges, power lines, sidewalks, etc. The sale of land is not a qualifying activity since land is not constructed. The key is that the deduction is available for those who are actually contributing to construction. A developer who buys property and hires a contractor and then sells the property would not get this deduction.

Some contractors are involved in other types of business besides just building, such as leasing equipment. Dividing up overall profit between all of a business’ activities could easily become complicated, but there is an exception for non-construction activities that comprise less than five percent of a contractor’s revenues. Contractors who have more than incidental non-qualifying activities will need to prepared detailed income statements for each separate activity indicating the revenues and expenses related to qualifying and non-qualifying activities. The determination of income related to qualifying versus non-qualifying activities will be extremely important to accurately compute the deduction.

How much is deductible?

The deduction for 2005 and 2006 is three percent of Qualified Production Activities Income (see below), which in a nutshell is the profit derived from qualifying production activities. This percentage goes up to six percent for 2007-2009 and finally tops out at nine percent in 2010 and subsequent years. So a corporation paying at the top corporate tax bracket of 35% would pay 32% as a result of the deduction (35% times 9%). The deduction is limited to taxable income; therefore an overall tax loss could not be created in any year by the deduction.

Finally, the amount of deduction in a year is limited to half of the amount of the company’s wages paid to employees. For the purpose of the last limitation, independent contractors do not qualify — only amounts reported on W-2s qualify as wages. Payments to owners of a partnership, although possibly subject to social security taxes, are also not considered “wages” for this purpose. This may present a problem for a small builder who is in a partnership and doesn’t have anyone on a payroll. However, if the same builder were an S Corporation, this builder/owner could pay him or herself a salary and thus have “wages.”

What is “Qualified Production Activities Income?”

This is essentially income from qualified activities, such as construction of real property. For example, a general contractor’s qualified income would be gross receipts, less the cost of goods and services related to the activity, less other expenses directly related to the revenues. This net amount is Qualified Production Activities Income. In no event is revenue related to the sale of land, or the renting of land or a building included in qualified income.

How is the deduction taken?

A C Corporation deducts the computed amount against its other income to arrive at taxable income. A pass-through entity such as an S Corporation, partnership, or LLC does not deduct the amount from their income, but rather the owners deduct it on their personal returns. The passthrough entity should provide the information needed by the owners to compute the deduction.

This new tax break presents a real opportunity for large tax savings for many businesses in the construction industry. For 2005, the three percent deduction may product tax savings for many contractors, but the real savings will be realized when the deduction is fully phased-in over the next four years. Like many areas of the tax law, the calculations involved can be quite complex, and the current guidance published by the IRS leaves many questions unanswered. Proper planning and accounting will ensure that contractors take full advantage of this new tax incentive.

For more information, contact Debbie Torrance at 404.874.6244.