What is a Section 199 Deduction?

By Jim Jordan

With the enactment of the American Jobs Creation Act of 2004, Congress gave the construction industry a new tax deduction that began in 2005. It is called the domestic production activities deduction, and is included in Section 199.

Jim Jordan is director of construction services for Dallas/Fort Worth-based Weaver and Tidwell LLP.

The American Jobs Creation Act of 2004 was passed to keep U.S. manufacturers competitive with foreign companies and was designed to replace the Foreign Sales Corporation-Extraterritorial Income regime. The new deduction gives a benefit to companies that engage in production activities within the U. S. Fortunately for contractors, the act specifically included construction activities and engineering and architectural services in the definition of "production activities." Thus, contractors now have a new item they can deduct on their tax return.

While final regulations have not been issued, the Internal Revenue Service has issued interim regulations on how to apply Section 199. The deduction is being phased in over five years and is based on a percentage of Qualified Production Activities Income, or QPAI. The rate is:

• Three percent of QPAI for tax years 2005 and 2006.
• Six percent for tax years 2007 through 2009.
• Nine percent for tax years 2010 and thereafter.

The deduction is limited to the lesser of QPAI or taxable income, and cannot exceed 50 percent of the W-2 wages paid by the taxpayer during the year. It is allowable for purposes of calculating alternative minimum taxable income (including adjusted current earnings). Special rules apply to partnerships and S corporations.

The starting point is to determine what construction activities performed in the U.S. qualify as domestic production activities.

Section 199 defines construction activities as those directly related to the erection or substantial renovation of commercial and residential buildings and infrastructure. A renovation of a major component of real property that "materially increases the value of the property, significantly prolongs the useful life of the property or adapts the property to a new or different use," is considered a substantial renovation. The revenue from these activities is defined as domestic production gross receipts, or DPGR.

All of a contractor's gross receipts are treated as DPGR if less than 5 percent of total gross receipts are non-DPGR. If the amount of the gross receipts that do not qualify as DPGR equals or exceeds 5 percent of the total gross receipts, the taxpayer is required to allocate all gross receipts between DPGR and non-DPGR.

Determination of QPAI is key. Basically, QPAI equals domestic production gross receipts minus overhead and the cost of goods sold, which must be specifically identified with or directly traced to domestic production gross receipts. Overhead must be allocated to reduce gross receipts, and several allocation methods are included. While not all aspects of Section 199 have been set in stone, contractors should rely on the interim guidance and their tax experts.

It's important to note that a construction project in the U. S. doesn't have to be completed - or even initiated - for an architectural and engineering firm to qualify for the deduction.

Essentially, the tax reduction would work this way: Say a contractor at the end of the year had taxable income - and QPAI - of $1 million, and paid wages of $500,000. Under Section 199, the contractor's deduction in 2005 and again this year will be equal to 3 percent of QAPI, or $30,000. Assuming a 35-percent tax bracket, the reduction will lower federal taxes by about $10,500. In 2010 when the deduction jumps to 9 percent, the tax savings would be about $31,500, based on the same income and wages.

A key aspect of the law, as it pertains to construction, is that the general contractor and subcontractors may qualify for the deduction.

For partnerships, meeting eligibility requirements can be challenging. The IRS says that if an individual is a partner in a partnership, that individual cannot also be an employee, so that no amount paid to the individual by the partnership constitutes wages. For a partnership that otherwise would have a large amount of qualified production activities income, this can be significant. If the company operates as a limited liability company (taxed as a partnership), it could run into the wage limitation whereas it might not do so if it operated as a corporation.

Deciding whether to take advantage of the 2004 law requires numerous considerations that should be reviewed with a tax expert.

Because Section 199 offers significant tax savings, contractors should begin initiating a plan to maximize the benefit. Remember that this deduction will grow over the next few years, so make the most of it.