New Section 199 Domestic Production Deduction and How It Applies to the Construction and Real Estate Industry By Pat Derdenger
History and Background • Passed as part of the American Jobs Creation Act of 2004 and codified at 26 U.S.C. § 199. • Replaced the old Foreign Sales Corporation/Extraterritorial Income Regime. • Broader application. • Focuses on domestic manufacturing and production rather than exports. • Department of Treasury proposed regulations in November 2005. • With some changes, final regulations adopted in May 2006. • Became effective on June 1, 2006. • To be codified at 26 C.F.R. §§ 1.199-1 through 1.199-9.
Overview • Effective tax years beginning after December 31, 2004. • Deduction calculated as a percentage of the lesser of: • Total taxable income OR • Net income derived from qualifying activities. • Full deduction phased in between 2005 & 2010. • 3% for 2005-2006. • 6% for 2007-2009. • 9% beginning in 2010. • LIMITATION: deduction may not exceed 50% of the taxpayer’s W-2 wages paid during the applicable tax year.
TerminologyQualified Production Activities IncomeQPAI • Net income from qualifying activities is called Qualified Production Activities Income OR QPAI. • QPAI is statutorily defined as: domestic production gross receipts minus the sum of costs of goods sold allocable to those receipts plus other expenses, losses and deductions allocable to those receipts.
Terminology Domestic Production Gross ReceiptsDPGR • Domestic Production Gross Receipts as defined by statute determine eligibility for the deduction. • Receipts from three broad categories of activities qualify as DPGR: • manufacture, production, cultivation or extraction by the taxpayer in the U.S. • architectural and engineering services provided in conjunction domestic real property construction. • the construction of real property in the U.S.
Applicability Most residential and commercial contractors and subcontractors will qualify for the Domestic Production Deduction because they will have income that meets the statutory and regulatory definitions of DPGR. • General contractors and subcontractors may take the deduction on the same project because the subcontractor’s gross receipts match the general contractor’s costs.
Determining DPGR for the Construction Industry • Taxpayers must determine whether receipts qualify as DPGR on an item-by-item basis. • For the construction industry, what constitutes an item will be determined on a reasonable, case-by-case basis considering all the facts and circumstances.
Determining DPGR for the Construction Industry(continued) In order for a contractor to allocate receipts to DPGR, the following requirements must be met: • Taxpayer’s activity must be “construction.” • Construction must be of “real property.” • At the time of construction, taxpayer must be actively engaged in a construction trade or business on a regular and ongoing basis. • Taxpayer must actually perform the work and work must be done in the U.S. • Taxpayer’s gross receipts must derive from the construction.
Requirement OneActivity Must Be ‘Construction.’ Final regulations define ‘construction’ as the “erection of real property in the U.S.”
Requirement OneActivity Must be ‘Construction.’(continued) Construction includes: • Actual building. • Substantial renovation. • Renovation to major components or structural parts of real property that material increases property value, prolongs use or converts the property to a different use. • painting and redecorating are not substantial renovation. • Managerial functions normally conducted by general contractors.
Requirement OneActivity Must be ‘Construction.’(continued) Construction does not include: • Tangential services, such as hauling debris or delivering material, unless performed by the taxpayer in conjunction with its role as builder. • Administrative (billing & secretarial) services unless undertaken by the builder on the project. • Improvements, such as grading, demolition, excavation, landscaping and painting, unless they are performed in conjunction with a building or renovation project (whether or not by the same taxpayer).
Requirement TwoConstruction Must Be of ‘Real Property.’ Real Property includes: • Residential and commercial buildings and their structural components. • Inherently permanent structures that affix to property over time. • Swimming pools, fences, parking lots. • Inherently permanent land improvements. • Oil & gas wells. • Infrastructure • Roads, sidewalks, power lines, water & sewer and communications systems.
Requirement TwoConstruction Must Be of ‘Real Property.’(continued) Real Property Does not Include: • Tangible personal property sold as part of completed construction projects. • Appliances, furniture and fixtures.
Requirement ThreeMust Engage in Construction Trade or Business At the time of construction taxpayer must: • Be engaged in a construction trade as defined by the North American Industry Classification System. • The classified trade need not be taxpayer’s primary or only trade.
Requirement ThreeMust Engage in that Trade on a Regular and Ongoing Basis • A taxpayer is deemed to have met this requirement if it sells constructed real property to an unrelated purchaser within five years of project completion. • This provision is intended to provide a safe harbor to business entities created to build specific projects. • Newly-Formed Organizations (less than one year-old) are deemed to have met this requirement if they expect to engage in a construction trade on a regular basis.
Requirement FourTaxpayer Must Actually Perform the Domestic Construction Activity • Project must be in the U.S. • Taxpayer must actually perform the construction activity from which it derives gross receipts. • Example • NAICS contractor buys a building, hires a general contractor to oversee a renovation, then sells the building. • NAICS contractor’s receipts from sale are not DPGR. • General contractor’s receipts are DPGR.
Requirement FiveGross Receipts Must Derive from Construction Income derived from construction: • Gross proceeds from the sale of real property constructed by the taxpayer. • Gross proceeds from contract services. • Contractor’s mark-up on materials consumed in the project or that become a permanent part of the project. • Non-negotiated, non-separately stated construction warranties.
Requirement FiveGross Receipts Must Derive from Construction (continued) Income NOT derived from construction: • Gross proceeds from sale of reacquired real property that the taxpayer originally constructed – no “double dipping.” • Lease or rental income on property constructed by the taxpayer. • The value of the underlying land including soft costs capitalized to the land.
De minimis Rule and Land Safe Harbor Section 199 potentially increases taxpayer administrative burdens and record-keeping requirements because it forces allocation between DPGR and non-DPGR. The final regulations contain two safe harbors to reduce these burdens under certain circumstances.
De minimis Rule De minimis rule: If less than 5% of a taxpayer’s gross receipts on a construction project are not allocable to DPGR, all the gross receipts will qualify as DPGR.
Land Safe Harbor The Land Safe Harbor: • Applicable where a portion the taxpayer’s gross receipts from a construction project derive from the sale of the underlying land and entitlements. • Formulary approach.
Land Safe Harbor(Continued) • Taxpayer subtracts the original costs of the land, entitlements and other common improvements from the costs of goods sold allocable to DPGR. • Taxpayer subtracts those same costs plus a fixed percentage of those costs based on years of ownership from DPGR. • 1-5 years – 5% • 5-10 years – 10% • 10-15 years – 15% • Land held more than 15 years does not qualify for the safe harbor.
Land Safe HarborExample • Developer buys land in 2005 for $2 million to build a small, but upscale apartment complex. • It costs $50,000 to re-zone the property. • Construction costs for the completed complex are $6,500,000. • Total Costs = $8,550,000. • Developer sells complex to California-based investor for $10 million.
Land Safe HarborExample(continued) • Sale occurs in 2009: • Costs of goods sold allocable to DPGR = $6,500,000. • Developer subtracts $2,050,000 (land plus entitlement costs) from $8,550,000 (total costs). • DPGR = $7,847,500 • Developer subtracts $2,152,500 (cost of land and entitlements plus 5%) from $10 million sale.
Land Safe HarborExample(continued) • Sale occurs in 2012: • Costs of goods sold allocable to DPGR is the same at $6,500,000. • But DPGR = $7,745,000. • Developer subtracts $2,255,000 (cost of land and entitlements plus 10%) from $10 million sale price.
Affiliated and Consolidated Groups & Arizona’s Marketing-Arm/Contracting-Arm Structure • Section 199 has special rules for affiliated entities and contains two distinct affiliated entity concepts. • The Expanded Affiliated Group (“EAG”). • The Consolidated Group. • Section 199 defines both groups with reference to Section 1504(a)’s requirements for consolidated reporting, but uses different stock ownership thresholds.
Affiliated and Consolidated Groups & Arizona’s Marketing-Arm/Contracting-Arm Structure (continued) • An EAG is an affiliated group as defined in Section 1504(a) (for consolidated return purposes) but with a lower stock ownership threshold of greater than 50% (as opposed to greater than or equal to 80%). • Section 199 treats EAGs as single corporations.
Affiliated and Consolidated Groups & Arizona’s Marketing-Arm/Contracting-Arm Structure (continued) • Section 199 Deduction for EAGs. • Each EAG member separately computes its own taxable income & loss, QPAI and W2 wages. • These amounts are then aggregated.
Affiliated and Consolidated Groups & Arizona’s Marketing-Arm/Contracting-Arm Structure (continued) • EAGs may be comprised of either partially consolidated or wholly consolidated members. • A partially consolidated EAG has both consolidated and non-consolidated members. • The deduction for partially consolidated EAGs follows the above-referenced methodology, but the consolidated group is treated as a single member.
Affiliated and Consolidated Groups & Arizona’s Marketing-Arm/Contracting-Arm Structure (continued) • In a wholly consolidated EAG, the EAG consists of only consolidated entities. • The Section 199 deduction is determined using the group’s consolidated taxable income & loss, QPAI, and W2 wages.
Attribution Rules and the Marketing-Arm/Contracting-Arm Structure • At the EAG level, a builder’s qualifying construction activities (contracting-arm) are not attributed to a related entity (marketing-arm) that purchases and resells the improved property. • QPAI is the limited difference between the sales price to the related entity less construction costs.
Attribution Rules and the Marketing-Arm/Contracting-Arm Structure • But in a consolidated group, the builder’s construction activities (contracting-arm) are attributed to the related entity (marketing-arm) that purchases and resells the improved property. • QPAI is the larger difference between the final sales price and the construction costs. • Thus, the Section 199 deduction is maximized in a consolidated group setting; it is based on the marketing arm’s sales price.
Attribution Rules and the Marketing-Arm/Contracting-Arm Structure Contracting Arm Marketing Arm Homebuyer $100K $65K • At 50% common ownership (EAG), DPGR is $65,000 less costs. • At 80% common ownership (consolidated group), DPGR is $100,000 less costs.
THANK YOU Patrick Derdenger Partner, Steptoe & Johnson LLP 201 E. Washington Street, 16th Floor Phoenix, Arizona (602) 257-5209