Articles
|
Publications
Update on Domestic Production Activities Deduction
By David M. Cohen and John R. Orrick, Jr.
Summary:
On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004, which added § 199 to the Internal Revenue Code, establishing a tax deduction for certain domestic production activities, including construction performed in the United States and engineering or architectural services performed in the United States for U.S. construction projects. The provision is effective for taxable years beginning after December 31, 2004. On January 19, 2005, the Treasury Department and IRS issued a Notice to assist taxpayers in calculating this newly enacted tax benefit and providing interim guidance in advance of regulations. This Alert will provide a brief summary of that guidance as it applies to domestic construction, engineering and architectural activities.
Discussion:
You should be aware of the following provisions in new IRC § 199, as interpreted by the recent Notice:
- Size of deduction: § 199(a)(1) allows a deduction equal to 9% (3% for taxable years beginning 2005 and 2006, and 6% for taxable years beginning 2007 through 2009) of the lesser of (a) income from “qualified production activities” or (b) taxable income (adjusted gross income, in the case of an individual) for the year. Qualified production activity includes (1) construction or substantial renovation of real property in the United States, including residential and commercial buildings and infrastructure such as roads, power lines, water systems and communications facilities; and (2) engineering and architectural services performed in the United States and relating to construction of real property.
- Wage-based limitation: The deduction for a taxable year may not exceed 50% of W-2 wages paid by taxpayer during the calendar year ending in such taxable year. An employer may take into account wages paid and reported by other entities (such as an agent of the employer) to the taxpayer’s employees, but it seems clear that fees paid to a contractor who provides his own employees will not constitute W-2 wages paid by the taxpayer for purposes of this limitation.
- Pass-through entities: For an employer which is pass-through entity (a partnership, LLC or S corporation), the deduction is applied at the shareholder or partner level, so it is necessary to calculate the income (and W-2 wages) allocable to that shareholder or partner.
- Qualifying construction activities: Qualifying activities include construction and substantial renovation of residential and commercial real property, as well as infrastructure. A taxpayer engaged in construction activities may qualify for the deduction even if the taxpayer does not own the property being improved, and more than one taxpayer may be regarded as constructing real property with respect to the same activity and the same construction project. For example, a general contractor and a subcontractor may both be engaged in construction activities with respect to the installation of a roof on a new building. Gross receipts derived from the rental of real property that the taxpayer constructs, however, are not considered derived from construction, but rather are income for the use or forbearance of the property. As a result, rental income for real property is not considered eligible for the qualified production activities deduction. Gain on the latter sale of the property, however, may qualify for the deduction if all other statutory requirements are satisfied, e.g., if the taxpayer engaged in construction on the property. According to the Notice, “construction” includes most activities typically performed in connection with the erection or substantial renovation of real property, but does not include tangential services, such as hauling trash and debris, and delivering materials, unless such services are provided by the taxpayer performing the construction. Improving land (for example, grading and landscaping) and painting are activities that are considered “construction”, but only if they are performed in connection with other construction-related activities, whether or not by the same taxpayer.
- Qualifying engineering and architectural services: To constitute qualified production activity, engineering or architectural services must relate to real property, must be performed in the United States, and the taxpayer providing those services must be able to substantiate that the services relate to the construction project within the United States. Such services constitute a qualified production activity even if the planned construction project is not undertaken or is not completed. Engineering services include any professional services requiring engineering education, training and experience, and the application of mathematical, physical or engineering sciences to those professional services, such as consultation, investigation, evaluation, planning, design or responsible supervision of construction for the purpose of assuring compliance with plans, specifications and design. Architectural services in connection with any construction project include the offering or furnishing of any professional services such as consultation, planning, aesthetic and structural design, drawings and specifications, or responsible supervision of construction (for the purpose of assuring compliance with plans, specifications and design) or erection, in connection with any construction project.
- Affiliated groups: In the case of an affiliated group of corporations (connected by 50% or greater voting control or stock value), all members of the affiliated group are treated as a single corporation for purposes of § 199 and the § 199 deduction is determined by aggregating the taxable income, loss, activity income and W-2 wages of all members of the group.
- Coordination with alternative minimum tax: Generally, the § 199 deduction is allowed for purposes of AMT, applicable against the lesser of the taxpayer’s qualified production activity income or AMT income for the taxable year.
We would be happy to discuss the application of the IRC § 199 qualified production activities deduction in further detail. Please contact us at your convenience.
© 2005
|
