A new tax break known as the "Production Deduction" was signed into law by President Bush late last year and is effective for years beginning after Dec. 31, 2004. Construction contractors and engineers and architects involved in construction projects can benefit from this important new tax deduction.
Upon announcement, the legislation raised many issues, and the IRS recently issued guidance to clarify them.
For 2005 and 2006, the deduction is equal to the lesser of 3 percent of the taxpayer's qualified production-activities income or taxable income. The deduction increases to 6 percent for 2007 through 2009 and will rise to 9 percent for years 2010 and later.
The deduction is further limited to 50 percent of a taxpayer's W-2 wages.
The intent of the first limitation is to only provide a tax break to the taxpayers that are profitable.
Unlike the export exclusion that the production deduction replaced, it cannot increase a net operating loss. The intent of the second limitation is to provide a deduction only if the taxpayer has a payroll. Thus a taxpayer that can profitably manufacture and sell a widget with no payroll would not obtain a deduction.
In 2005, Acme Construction has $3 million of qualified production-activities income and $700,000 of taxable income. Under the new tax law, the company will get a $21,000 (3 percent of $700,000) deduction for domestic-production activities. Acme gets the full 3-percent deduction since the $21,000 does not exceed 50 percent of the wages Acme paid for the year.
Taxpayers that are considered commonly controlled or related entities must combine their activities to determine the deduction allocable to each entity in the group. Income from sales to related parties will not qualify. The income will qualify when the property is sold outside the group.
Since the production deduction is indirectly replacement legislation for the foreign sales corporation, the guidance incorporates by reference the rules related to foreign sales corporations for purpose of defining what is manufacturing and what is construction of real estate and related architectural and engineering services.
Taxpayers engaged in the construction of real estate qualify for the production deduction, as well as engineering and architectural services related to the construction.
Traditionally, real estate construction includes a residential or commercial building structure and structural components. 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 activities (whether or not by the same taxpayer) that constitute the erection or substantial renovation of real property. Otherwise, such activities alone will not qualify. The same property can yield a tax benefit for several taxpayers.
ABC Real Estate (who is not in the trade or business of construction and is the owner, under federal income tax principles, of a building within the United States) retains DEF Construction (a general contractor) to oversee a "substantial renovation" of the building.
DEF Construction retains GHI Electric (a subcontractor) to install a new electrical system in the building as part of that substantial renovation.
The amounts that DEF Construction receives from ABC Real Estate and amounts that GHI Electric receives from DEF Construction will qualify. The pro ceeds that ABC Real Estate receives from the subsequent sale of the building do not qualify because ABC Real Estate did not engage in any activity constituting construction.
Engineers and architects must perform their services in the United States for a construction project in the United States in order to qualify for the deduction. Fortunately for the architects and engineers, if the construction project is abandoned, the fees will still qualify.
There are unique situations that would require additional analysis, including taxpayers selling services embedded in the product cost, taxpayers engaged in more than one trade or business in the same entity, and taxpayers receiving income from intangibles in their product pricing.
It is recommended that companies consult with a financial consultant familiar with the industry to determine how the tax deduction applies to them.
Hedlund is a CPA and the principal in charge of the Construction and Design Group of Indianapolis-based Somerset CPAs PC. Views expressed are the writer's.