March 1, 2006
By Scott Lloyd Anderson
Section 199 of the Internal Revenue Code offers anyone engaged in an eligible manufacturing or production activity a deduction for those activities. When fully phased in, the deduction could reduce the effective tax rate by up to three percent. Simply put, if you make something, you are more than likely eligible for the deduction.
Contractors, subcontractors, suppliers, architects, engineers, and a slew of others involved in the construction industry are eligible to benefit from Section 199. It should be noted that Section 199 does not follow all of the existing tax laws like the uniform capitalization rules (Section 263A). As such, before a company can fully utilize the Section 199 deduction, they might have to change their bookkeeping and administrative policies. Therefore, a company thinking about utilizing the Section 199 deduction should consult with a tax attorney or CPA to maximize the benefits available under the new tax law.
Enacted in 2004, the Section 199 deduction is an entirely new concept and represents a very significant change in the taxation of American businesses. The Section 199 deduction is allowed to all taxpayers: individuals, C corporations, owners of S corporations and partnerships, farming cooperatives, estates and trusts. Both large and small businesses are eligible.
One limitation is that a taxpayer must have employees in order to be eligible for the deduction. The amount of the deduction cannot exceed 50% of W-2 wages that a taxpayer pays to its employees for the year. In calculating this limit, the taxpayer includes wages paid to all employees during the tax year, not just the wages of workers that are engaged in qualified production activities. Payments to independent contractors and self employment income, including guaranteed payments made to partners, are not included as W-2 wages for the purposes of calculating the limitation.
Under Section 199, the Qualified Production Activities Deduction (“QPAD”) is equal to a percentage of the lesser of (a) income derived from qualified production activities for the taxable year (“QPAI”) or (b) taxable income. The deduction starts at 3% in 2005 and 2006, increases to 6% in 2007 through 2009, and finally ends up at 9% in 2010 and thereafter.
QPAI is calculated by subtracting from domestic production gross receipts (“DPGR”), for the taxable year (a) cost of goods sold that are allocable to such receipts, (b) other deductions directly allocable to such receipts, and (c) a ratable portion of other deductions.
DPGR generally includes the gross receipts of the taxpayer that are derived from:
· Any lease, rental, license, sale, exchange, or other disposition of (1) qualifying production property (“QPP”) which was manufactured, produced, grown, or extracted in whole or significant part by the taxpayer within the United States, (2) any qualified film produced by the taxpayer, or (3) electricity, natural gas, or potable water production by the taxpayer in the United States.
· Construction performed in the United States .
· Engineering or architectural services performed in the United States for construction projects in the United States .
To calculate DPGR, a taxpayer generally must allocate gross receipts among qualifying activities and items and non-qualifying activities and items. There are exceptions to this rule for certain warranties, distribution services, delivery services, operating manuals or installation activities where the item or service is neither separately negotiated nor a price separately stated for such item or service.
One industry that can take advantage of the Section 199 deduction is the construction industry. According to the proposed regulations, construction means the construction or erection of real property, inherently permanent land improvements and infrastructure in the United States by a taxpayer engaged in the trade or business that is considered construction for the purposes of the North American Industry Classification System (“NAICS”) on a regular and ongoing basis.
Examples of business with eligible construction activities are residential remodelers, commercial and institutional building contractors, foundation, structure, and building exterior contractors, structural steel and precast concrete contractors, electrical, plumbing, heating and air-conditioning contractors. Construction also means “substantial renovation”, so construction activities include extreme home/office makeovers, but not include decorating or redecorating. However, for the purposes of Section 199, “construction” does not include tangential services such as hauling trash and debris and delivery of materials, even if these services are essential for construction.
It should be noted that a contractor is treated differently from a producer of personal property. That is, the contractor’s gross receipts from construction services are qualifying income, regardless of who bears the benefits and burdens of ownership during construction. Moreover, subcontractors as well as the general contractor can earn a Section 199 deduction. Thus, the excavator’s site preparation for the owner or general contractor is construction and the income from the contract is qualified production income for the excavator and general contractor even though the excavator and general contractor do not add any materials nor have an ownership interest in the property. This does not create a double deduction since the subcontractor’s price (including the subcontractor’s profits) is the general contractor’s cost, deducted in arriving at the general contractor’s qualified income.
However, the contractor’s work must be a capital expenditure by the customer. Thus, a painting contractor’s work must be done in connection with the construction or rehabilitation of a building. The maintenance of an existing building provided that land improvements made subsequent to the erection or renovation of a building, are not qualified production.
In addition, gross receipts derived from construction do not include the markup on materials purchased and installed in the building or structure. For example, an electrical contractor that installs lighting that becomes part of the structure on a construction project would have qualifying revenue on the installation charges but not on any markup on the materials.
The proposed regulations provide a de minimus rule for non-DPGR generated from construction activities. If less than 5% of the total gross receipts from a construction project is derived from activities other than the construction of real property in the United States , then all gross receipts derived by the taxpayer from the project are considered to be from construction. But the de minimus rule applies only if all gross receipts associated with nonqualifying items, including land, tangible personal property, and the markup on materials that become real property components, in the aggregate, are less than 5% of the total project revenue.
In the case where a contractor purchases land and performs construction on the land under contract, the contractor must carve out of the contract price the land component in arriving at the income base for the Section 199 deduction. Unlike other areas in the proposed regulations, the developer/contractor is given precise methods of removing the non-qualified land transaction. The contractor is permitted to use a safe harbor proxy for the land component of the contract price or the price of the property sold. The safe harbor amount is:
105% of the cost of the land, if the land is held for five years or less.
110% if the land is held at least six years, but not less than 11 years.
115% if the land is held at least 11 years, but not less then 16 years.
If the land is held more than 16 years, it is not eligible for the safe harbor treatment. The contractor must exclude the capitalized cost of the land in arriving at the costs related to qualifying gross receipts. Apparently, if the safe harbor is not used, the contractor must obtain separate appraisals of the land without the construction to arrive at the nonqualifying income from the land sale.
The Section 199 definition of DPGR distinguishes “construction” from “engineering and architectural services.” Eligible engineering services include consultation, investigation, evaluation, planning, design, and supervision of construction. Eligible architectural services include consultation, planning, aesthetic and structural design, and supervision of construction. The construction contractor may actually provide engineering, architectural, as well as construction services. It would seem that the design-build contractor should aggregate all of the revenues and costs for a contract.
It should not matter whether the services were engineering, architectural, or construction, because Section 199 rates apply to the aggregate qualifying income. The one situation where aggregation could affect the results is where the architectural and engineering activities relate to the personal property component of a project. Nevertheless, the proposed regulations require that the contractor must treat these as two separate activities: construction and architectural/engineering.
Currently more than half of the states conform to the Code with respect to Section 199. These states are just beginning to grapple with the application of the provision under their laws. It is unclear if separate company reporting states will apply the expanded affiliated group concept. It is also unclear how the rules will apply to unitary states, where the definition of an expanded affiliated group for federal purposes may be more inclusive than the unitary/combined group. Some states permit the use of allocated QPAI in accordance with the proposed regulations, whereas other may require a separate calculation at the entity level. A number of issues may surface under state audits, including whether the states will require the calculation of federal QPAI to be modified to reflect special state income tax rules pertaining to depreciation, nondeductibility of some items, and other addbacks. Finally, some states may require that the manufacturing or production activity must be performed in their state in order to claim the Section 199 deduction.
Currently taxpayers will have to unbundle certain revenue streams to separately test items that may be non-DPGR. At times it may also be difficult to determine the benefits and burdens requirement and what to include when determining the 5% safe harbor. But for all these issues, taxpayers cannot overlook a 3% drop in their effective tax rates. Careful consideration should be given to implementing the administrative procedures that would allow a company to benefit from Section 199.
Please feel free to contact us, your CPA or other tax professional if you need assistance in evaluating the application of Section 199 to your business.
Not For Penalty Protection: Nothing contained in this briefing paper was intended or written to be used, can be used, nor may be relied upon or used, by any taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer under the Internal Revenue Code of 1986, as amended; and any written statement contained in this briefing paper relating to any Federal tax transaction or matter may not be used by any person to support the promotion or marketing of, or to recommend any Federal tax transaction(s) or matter(s) addressed in, this briefing paper.
This discussion is generalized in nature and should not be considered a substitute for professional advice. © FWH&T