Don’t overlook the Section 199 deduction
It goes by many names. You might hear it called the “domestic production activities deduction” or the “manufacturer’s deduction” or, as we’ll call it, the “Section 199 deduction.” About 10 years ago, this provision of the Internal Revenue Code was adopted to encourage domestic job growth.
Like many contractors, you still may not fully realize that your company could qualify for the Sec. 199 deduction. And you should, because it could allow your construction business to deduct from its taxable income as much as 9% of taxable income derived from qualifying activities.
Although one of its names suggests the deduction applies only to manufacturing companies, it’s available to many types of businesses. Most apropos to our purposes, the Sec. 199 deduction can be claimed by businesses involved in the construction or renovation of residential, commercial and institutional buildings, as well as many infrastructure projects. It can also be used by companies that provide architectural and engineering services for construction work — including consultation, planning, design, evaluation and supervision.
In all of these cases, the deduction applies only to “real property” construction projects performed in the United States. Real property doesn’t include machinery unless it’s a structural component. For work on existing structures, the tax break’s rules distinguish between substantial renovation (which fits within the eligible category) and maintenance (which is ineligible). To qualify as substantial renovation, a project should materially increase the value of the property, substantially prolong its useful life, or adapt it to a new or different use.
Identifying your activities
Once you’ve determined that your construction business is eligible, you need to track the income that serves as the basis for the deduction. Sec. 199 refers to this figure as qualified production activities income (QPAI) and defines it as the taxpayer’s domestic production gross receipts (DPGR) less the sum of:
- The costs of goods sold that can be allocated to those receipts, and
- Other expenses, losses and deductions that can be allocated to those receipts.
Taxpayers have to determine whether receipts qualify on a reasonable item-by-item basis — not on another basis such as corporate division, product line or transaction. But de minimis rules allow you to treat total gross receipts as DPGR if less than 5% of your total gross receipts are non-DPGR.
Calculating the deduction
In concept, once you know your DPGR and QPAI, calculating the Section 199 deduction appears relatively simple. In practice, however, you’ll probably encounter some significant challenges in arriving at those numbers and then determining which limitations apply under the tax code. So it’s a good idea to work closely with your tax advisor when attempting to claim the deduction. Together, you’ll have to essentially follow four steps:
- Determine your construction company’s DPGR,
- Subtract expenses, losses and deductions (other than the Sec. 199 deduction) that can properly be allocated to DPGR to arrive at your QPAI,
- Compare your QPAI to your taxable income for the year, and
- Multiply the lower of QPAI or taxable income by 9%.
The result will be your tentative Sec. 199 deduction. The maximum deduction you can actually take is limited to 50% of your QPAI-related W-2 wages for the year, so you may need to reduce the amount of the deduction if it exceeds the wage threshold.
Some construction businesses are heavily involved in projects that qualify for the Sec. 199 deduction, but rely more on independent contractors rather than bona fide employees to perform the work. If you’re in this situation, converting some of these workers to employees could help you maximize the deduction. But you’ll need to very carefully weigh doing so against the additional costs of employment taxes and benefits.
Justifying the effort
The Sec. 199 deduction entails meticulous recordkeeping and, as mentioned, some fairly complicated calculations. But, potentially, the tax savings could justify the time and effort involved. If you’re unsure whether it’s for you, some recent IRS regulations may help put the tax break in somewhat clearer perspective. (See “IRS issues regulations to clarify Section 199 requirements.”)