Some tax breaks are relatively easy to claim. The manufacturers’ deduction — also known as the “Section 199 deduction” or “the domestic production activities deduction” — isn’t always one of them. Like one of your construction projects, it calls for a solid foundation (of documentation) and an intricate infrastructure (of calculations). But the effort may be well worth it.
Putting in the work
Don’t let the name fool you: Although it does indeed apply to manufacturing businesses, among the primary qualifying activities of the so-called manufacturers’ deduction is “construction of real property performed in the United States” by a taxpayer “engaged in the active conduct of a construction trade or business.”
The deduction applies to domestic production gross receipts (DPGR) derived from constructing or erecting buildings or other real property, as well as from substantial renovations of real property. There are various examples of qualified production activities that may lead to DPGR.
For instance, activities “typically performed by a general contractor,” such as management and oversight, periodic inspections and required job modifications, are generally eligible. So is the construction or installation of building components (HVAC systems, elevators and plumbing) and infrastructure (roads, power lines, wiring, water systems and sewers).
Certain land improvements that aren’t capitalizable to the land (such as landscaping) may qualify. Other activities that physically transform the land (grading, demolition, clearing and excavating if performed in connection with building construction) may also fit the bill.
If your construction company provides tangential services (such as hauling debris or delivering materials), you may be able to claim them — but only if you perform the services while constructing or substantially renovating the property in question. Yet another example is administrative support services (billing or secretarial services) incidental and necessary to construction activities in which you’re engaged.
DPGR doesn’t include receipts from the sale of land or tangible personal property, though receipts attributable to materials and supplies consumed in the construction process are included.
Crunching the numbers
In practice, the manufacturers’ deduction calculation can be a bit complicated. So it’s best to have your tax advisor do the math.
He or she must first determine your construction company’s DPGR and then subtract expenses, losses and deductions (other than the manufacturers’ deduction itself) that are properly allocable to DPGR to arrive at your qualified production activities income (QPAI). From there, your advisor will compare your QPAI to your taxable income for the year and multiply the lower of QPAI or taxable income by 9%.
The result is your tentative manufacturers’ deduction. The deduction is limited to 50% of your QPAI-related W-2 wages for the year, so your tentative deduction will need to be reduced if it exceeds the wage threshold.
Construction businesses that rely heavily on independent contractors may be able to enhance their manufacturers’ deduction by converting some of these workers into W-2 employees. (Of course, there are many other factors to consider before doing this, such as the cost of employment taxes and employee benefits for these workers.)
As an added benefit of this process, the resulting deduction is allowable in determining taxable income for city income tax in most Ohio cities. Again, you should check with your CPA firm.
Refining the data
Allocating revenues, expenses and other items between construction activities and nonconstruction activities can be challenging. So, the regulations outline several allocation methods, including a simplified method for taxpayers with average annual gross receipts of $100 million or less or total assets of $10 million or less.
Under this method, you can allocate costs based on the percentage of your total receipts that qualify as DPGR. In addition, a “land safe harbor” allows you to use a formula to allocate gross receipts between land and real property other than land.
There’s also a de minimis exception: If less than 5% of your total gross receipts from a construction project (excluding receipts allocated to land sales) are derived from nonconstruction activities, you can treat all of your gross receipts as DPGR from construction.
Establishing a process
As you can see, the manufacturers’ deduction isn’t exactly simple. But establishing a process for claiming this break now could lower your tax bill not only this year, but for many years to come.
For more information contact Dan Lacey at [email protected]