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As a construction business, your company may be eligible for the Section 199 (Sec. 199) deduction for “domestic production activities.” This tax break is known by several names, including the “domestic production activities deduction” and the “manufacturers’ deduction.”
In fact, many contractors overlook the Sec. 199 deduction because they believe it’s only for manufacturers. But it’s also available for “construction of real property performed in the United States” by a taxpayer “engaged in the active conduct of a construction trade or business.”
The Internal Revenue Service (IRS) uses a two-pronged definition of inherently permanent structures to determine if a taxpayer’s units can be considered real property.
To qualify as real property a structure must:
If your project contains property meeting the above requirements, these construction activities would be used in determining your Domestic Production Activity Deduction (DPAD).
The Sec. 199 deduction is equal to 9 percent of the lesser of: 1) your Qualified Production Activities Income (QPAI) for the year, or 2) your taxable income (before taking the deduction). For individual taxpayers, adjusted gross income is used instead of taxable income. The deduction is capped at 50 percent of your company’s W-2 wages attributable to qualified production activities.
Determining your QPAI can be complicated and may require the help of a construction CPA. You must first determine your Domestic Production Gross Receipts (DPGR). For taxpayers engaged in the active conduct of a construction trade or business, the gross receipts derived from the construction of real property performed in the United States in the ordinary course of business is considered DPGR.
Generally speaking your QPAI is your net income from constructing or substantially renovating buildings or other real property. It may also include net income from certain construction-related activities, such as management, land improvements, installing building components (such as HVAC systems or plumbing), delivering materials, hauling debris or providing administrative support.
QPAI doesn’t include income from construction activities outside the United States, sales of land or tangible personal property (other than certain construction materials and supplies), real property rentals, repairs or cosmetic work.
Note that, for pass-through entities such as S corporations and partnerships, the Sect. 199 deduction is determined at the shareholder or partner level.
Depending on the nature of your construction business, you may have opportunities to boost the benefit of the deduction. Here are some strategies to consider:
Evaluate your accounting system. It can be challenging to distinguish between qualifying and nonqualifying construction activities and then allocate revenues, expenses, deductions and losses between them. Ensure your accounting system has the ability to track this information.
Increase W-2 wages. Because the Sec. 199 deduction is limited to 50 percent of W-2 wages, you can boost your deduction by increasing those wages.
There are several ways to do this, including:
If you’re a sole proprietor with no employees, consider incorporating your business and paying yourself a salary.
Use separate entities. If your business is involved in both qualified and nonqualified production activities, consider using a separate entity for qualified activities. This makes it easier to segregate the revenues, wages and other expenses attributable to qualified activities and can help increase your Sec. 199 deduction.
Restructure your compensation. Consider this example: George is the sole shareholder of a construction business organized as an S corporation. The company’s net income is $600,000, all of which is QPAI, and it has W-2 wages of $800,000, including George’s $300,000 salary. His taxable income before the deduction is $900,000 ($300,000 in wages plus $600,000 in pass-through income). Thus, the Sec. 199 deduction is $54,000 (9 percent of $600,000), reducing his taxable income to $846,000.
Now suppose George reduces his salary to $100,000 and receives a $200,000 distribution. This increases his company’s QPAI to $800,000. His taxable income before the deduction is still $900,000 ($100,000 in wages plus $800,000 in pass-through income). But the Sec. 199 deduction is increased to $72,000 (9 percent of $800,000), and George’s taxable income drops to $828,000.
In addition to increasing the value of the deduction, reducing George’s salary also lowers the company’s payroll taxes. This assumes his new salary is considered reasonable. Work with your construction CPA to establish such an amount.
To date, many construction companies may have been missing out on the deduction because they thought their activities didn’t qualify due to the fact that the structural components of the project were considered to be in the nature of machinery. However, last September the IRS released a technical advice memorandum (TAM) that analyzed the DPAD qualification of gross receipts related to a U.S. taxpayer’s activities.
A U.S. construction contractor conducting business on a regular and ongoing basis involving various activities in construction phases claimed that the substantial renovation, construction or erection of the property contributed to the construction of real property under Sec. 199. The taxpayer’s gross receipts related to projects involving major renovations and construction in completing the installation or replacement of components of units at the project sites.
When the Large Business and International examination team disagreed they requested technical advice from the Chief Counsel’s Office.
After analysis the Chief Counsel sided with the taxpayer stating the inherently permanent structure met the two basic requirements of being affixed to real property and remaining affixed for an indefinite period.
The TAM addressed two types of projects the taxpayer engages in, one involving singularly installed units affixed to real property, the other involving tandem pairs of units affixed to real property at higher elevations. Both sets of projects involve units weighing hundreds or thousands of tons and, as such, are required to be attached to concrete foundations. The units have a useful life of several decades, as long as the required maintenance is performed. Generally, the units remain affixed to the real property for the duration of their useful lives until abandoned in place.
As you can see, the Sec. 199 deduction’s benefits can be significant. So, as a contractor, it pays for you to do a little homework to determine whether you qualify. Work with the construction CPAs at Doeren Mayhew to maximize your deduction. Contact them today!
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