Construction firms gain from new tax rules
Passed last October, the American Jobs Creation Act of 2004 contains many new tax rules that have an impact on nearly all taxpayers in one form or another, but one of its most significant provisions is a new business deduction for “qualified domestic production activities.”
The aim of the provision is to phase out and replace the extraterritorial income, or ETI, deduction — a previous benefit applicable only to manufacturers that had export sales. The new deduction will apply to a much broader group of businesses – including construction and engineering firms — and should be carefully reviewed by both large and small businesses to determine its applicability.
For purposes of this new deduction, “qualified domestic production activities” include the following activities, provided that they are undertaken in the United States:
• Manufacture of tangible personal property
• Software production
• Construction activities (both buildings and infrastructure)
• Engineering or architectural services
• Production of film and sound recordings
• Production of electricity, natural gas or potable water
• Food processing.
Unlike the ETI deduction, there is no requirement that any of the above activities produce sales of products outside of the United States.
Qualifying taxpayers can start taking advantage of the deduction beginning in 2005. Once the new deduction rules are completely phased in, both corporate and individual taxpayers paying at the 35 percent tax rate could see a reduction in their top marginal rate by up to three percentage points.
For 2005 and 2006, the deduction is equal to 3 percent of qualified production activities income, which is calculated by determining gross receipts from the qualifying activities, less allocable cost of sales, direct and indirect expenses. For 2007, 2008 and 2009, the deduction percentage increases to 6 percent and in 2010 it becomes fully phased in at 9 percent.
A couple of noteworthy rules may reduce the final deduction amount, however.
First, qualifying production activities income cannot exceed the overall taxable income of the taxpayer (determined without regard to the deduction). Second, the amount of the deduction cannot exceed 50 percent of the taxpayer’s W-2 wage expense.
Many organizations will find that while some of their business activities qualify for this deduction, other business activities may not.
For example, a company that produces revenue from the sale of its manufactured product also may generate separate service revenue from the installation or repair of its product. The service activity will not qualify as a domestic production activity. In order for this business to properly calculate and maximize its deduction, it must be able to account for the separate types of qualifying and non-qualifying revenues and their related costs of sales and direct expenses.
It would be wise for businesses with multiple activities to consult with their accounting and tax advisers as soon as possible in order to ensure that they are equipped to capture the appropriate revenue and expense data that will allow them to calculate the correct deduction amount.
Special rules for construction
There are a number of special rules in this area that may add a layer of complexity to the process of determining the appropriate deduction.
For example, while the deduction applies to pass-through entities, such as S corporations, partnerships and LLCs, the partners/shareholders of these entities must calculate their benefit by aggregating the qualifying income and deductions that are passed through from all of their separate activities.
Another area in which special rules and definitions apply is in the area of construction activities. Qualifying activities include construction and substantial renovation of real property. Such real property may be commercial or residential buildings or infrastructure, such as roads, power lines, water systems and communications facilities.
In this category, it is conceivable that more than one taxpayer will qualify for the deduction with respect to the same property. For example, both a subcontractor and a general contractor may qualify for the deduction on the income that they generate from the installation of a new roof.
Other special rules apply to contract manufacturers and situations in which portions of the production are done both in the United States and offshore. There also are specific rules that apply to the proper method for allocating indirect expenses.
There also are certain de minimus rules and safe harbors that may apply to limit the complexities and burdens of properly identifying and allocating qualifying revenues and expenses.
All told, the new deduction for qualified domestic production activities could provide a significant tax benefit to a broad array of businesses, both large and small. The challenges that businesses will encounter in securing this deduction include identifying the separate activities of their business that qualify, and accounting for the income and deductions attributable to those activities.
Depending on each taxpayer’s profile and situation, navigating some of the special rules also will add to the complexity. Up-front planning and a discussion with your accounting and tax advisers will go a long way toward ensuring that you are prepared to take full advantage of this tax-savings opportunity.
Karl A. Heafield, senior manager at the accounting firm of Baker Newman Noyes in Manchester, advises clients on tax-planning and compliance matters related to ongoing business operations and transactions.