Construction Accounting Article -
Final Regulations- IRS Code Section 199

Target Audience: Construction Industry Professionals, IRS Regulations Interest, Contractors, Construction Business Owners, Tax Payers, Nashua & Boston Construction Accounting Firm Interest, Accounting Regulations Interest

The Treasury and IRS recently issued final regulations concerning Internal Revenue Code section 199, the deduction related to domestic production activities. Section 199 was enacted into law as part of the American Jobs Creation Act of 2004. When fully phased in for taxable years beginning in and years subsequent to 2010, the deduction is equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008 or 2009) of the lesser of the taxpayer’s (A) qualified production activities income (“QPAI”) or (B) taxable income. The deduction is further limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in the taxpayer’s taxable year.

For example, a fiscal 9/30/06 taxpayer with QPAI of $1 million, taxable income (without regard to the deduction) of $600,000 and W-2 wages of $200,000 would be allowed a deduction totaling $18,000 (i.e., 3% X the lesser of $1 million or $600,000).

The final regulations provide much needed guidance (including numerous examples) and administrative relief. Although these regulations are not effective until tax years beginning on or after June 1, 2006, taxpayers may adopt these regulations earlier in place of existing proposed regulations and other guidance provided in Revenue Procedure 2005-14.

As the final regulations including the preamble are contained in close to 250 pages, this discussion will be limited to selected provisions that more closely apply to the construction industry.

As mentioned above, the deduction is limited, in part, to a percentage of qualified production activities income. The regulations defined QPAI as domestic production gross receipts (“DPGR”) over the sum of cost of goods sold and other expenses, losses or deductions that are allocable to such receipts. DPGR include gross receipts derived from, in the case of a taxpayer engaged in the active conduct of a construction trade or business, the construction of real property performed in the United States.

The proposed regulations excluded gross receipts attributable to the sale of land including certain costs capitalized into the land such as grading and demolition of structures. The final regulations provide that services such as grading, demolition, clearing, excavating, and any other activities that physically transform the land constitute construction as long as these services are performed in connection with other activities (whether or not by the same taxpayer) that constitute the erection or substantial renovation of real property.

The proposed regulations provided that receipts from services performed with respect to a construction project are gross receipts derived from construction. However, gross receipts attributable to purchased materials (e.g., wiring and other electrical materials) are not qualifying gross receipts. An example was given involving an electrical contractor that held that gross receipts attributable to wiring, conduit and other materials did not qualify as DPGR, essentially requiring the taxpayer to break out such receipts. Fortunately, the final regulations took into consideration the administrative burdens that this rule would impose and, instead, provides the DPGR includes gross receipts derived from material and supplies consumed in the construction project or that become part of the constructed real property. This clarification addresses concerns expressed by the construction and engineering and architectural services industries over the requirement in the proposed regulations that gross receipts be allocated between services provided and purchased materials.

QPAI is determined, in part, by allocating other expenses, losses and deductions between DPGR and non DPGR. Although the final regulations retain the three allocation methodologies in the proposed regulations, they do provide significant relief by allowing taxpayers with average annual gross receipts of $100 million or less (an increase from $25 million) or total assets at the end of the tax year of $10 million or less to use the simplified deduction method.

The above is a small snapshot of the many provisions that apply to the construction as well as other industries. In general, these regulations favorably address the many issues provided during the comment period to the proposed regulations and provide considerable administrative relief. Although there may well be reasons to not adopt these regulations early, this decision must be made after very careful analysis as to how they apply to a specific business.

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