Manufacturers’ deduction offers contractors valuable tax savings

Unfortunately, many contractors overlook the manufacturers’ deduction because it sounds like it applies only to manufacturing companies. Not so — many construction businesses, as well as architectural and engineering firms, can avail themselves of the deduction’s valuable tax savings.

Also known as the “Section 199 deduction” or “the domestic production activities deduction,” this tax break reached its top level in 2010. This means you can now take a deduction amounting to as much as 9% of your company’s income from “qualified production activities.”

Which activities qualify?

One of the activities the manufacturers’ deduction is available for 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. (See the sidebar “Renovation or maintenance?”)

Some examples of qualified production activities that may lead to DPGR include:

• Activities “typically performed by a general contractor,” such as management and oversight, periodic inspections and required job modifications,
• Certain land improvements that are not capitalizable to the land (such as landscaping) and other activities that physically transform the land (grading, demolition, clearing and excavating if performed in connection with building construction — even if by different taxpayers),
• Construction or installation of building components (HVAC systems, elevators and plumbing) and infrastructure (roads, power lines, wiring, water systems and sewers),
• Tangential services (hauling debris or delivering materials — but only if performed by the same taxpayer that constructs or substantially renovates the property), and
• Administrative support services (billing or secretarial services) performed by a taxpayer engaged in construction activities and that are incidental and necessary to the construction project.

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.

How is the deduction calculated?

Conceptually, the Sec. 199 deduction calculation is simple. But in practice, the calculation can be a bit complicated. So it’s best to have your CPA do the math, which requires him or her to:

1. Determine your company’s DPGR, 
2. Subtract expenses, losses and deductions (other than the manufacturers’ deduction) that are properly allocable to DPGR to arrive at your qualified production activities income (QPAI), 
3. Compare your QPAI to your taxable income for the year, and
4. 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 may 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.)

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 also is 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.

Boosting your cash flow

Calculating the manufacturers’ deduction calls for a considerable amount of administrative work. But, for many contractors, the eventual tax benefits justify the time and energy invested. If your construction company qualifies, you can boost your cash flow by claiming the deduction for work you’re already doing.

Renovation or maintenance?

For purposes of claiming the manufacturers’ deduction (see main article), the distinction between substantial renovation and maintenance is critical. The former constitutes “construction of real property” that qualifies for the deduction, while the latter doesn’t.

Tax regulations define “substantial renovation” as “the renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use.”

Recently, the U.S. Tax Court decided its first case interpreting the manufacturers’ deduction, Gibson & Associates, Inc. v. Commissioner. The case involved an engineering and heavy construction company that erects or rehabilitates streets, bridges and airport runways. The court ruled that Gibson’s work rehabilitating bridges and other real property that had suffered significant casualty damages or become dilapidated qualified for the manufacturers’ deduction.

This conclusion was based on expert testimony that rehabilitation work increased the value of the property and substantially prolonged its useful life. The Tax Court rejected the IRS expert’s opinion that “the useful life of a structure as a whole does not change if work is performed on only part of the structure.”