Section 199: Domestic Production Activities Deduction, What Counts?

“Big Time Construction Corporation” made a significant profit this year resulting in higher taxable income than expected. Therefore, Big Time Construction Corporation is exploring opportunities to reduce their tax liability. As a construction contractor who builds or renovates real properties in the United States, the Company is eligible to take advantage of the IRC Section 199 deduction also known as The Domestic Production Activities Deduction (“DPAD”).

The DPAD encourages domestic production activities by allowing taxpayers a 9% deduction on the lesser of Qualified Production Activities Income (QPAI), or taxable income for corporations before the section 199 adjustment, or adjustable gross income for individual taxpayers. However, this deduction is limited to 50% of W-2 wages paid during the year for employees and officers.

Are you eligible to take the DPAD? Under the regulations, the following type of taxpayers qualify: C corporations, Shareholders, Beneficiaries of trusts or estates, and Individual taxpayers. Pass-through entities such as S corporations, LLCs, trusts, and estates, are only allowed the deduction on the shareholder or beneficiary level. These types of entities will provide a Schedule K-1 to its shareholders to provide the information needed to take the deduction.

What Activities Qualify as Domestic Production Activities?

• Residential and commercial construction
• Infrastructure improvements
• Land preparation activities

In order for these activities to qualify for section 199 treatment, the gross receipts earned from these activities must meet two criteria. First, they must be earned thru the “ordinary course of trade or business” and earned from the “erection or substantial renovation of real property” in the United States.

So, what constitutes ordinary course of trade or business? For construction type activities, it can be the selling or exchanging of real property within 60 days of the property’s completion date to unrelated parties. For renovation type activities, it must result in permanent improvements or betterments of a property.

Real property is defined as an inherent permanent structure other than land, such as buildings, roofs, dams, etc. For example, Big Time Construction Corporation is contracted to build an elevator in a hotel and install portable washing machines. At the end of the contract, the Company sold leftover electrical wires. The only eligible gross receipt from these activities is the construction of the elevator, for which it is qualified as a permanent structure of the hotel. Portable machines and inventory on hand do not meet the definition of real property.

Under section 199, the determination of a substantial renovation is determined using the same criteria as new tangible property regulations when assessing betterments and adaptations. Therefore, substantial renovation is work performed meeting at least one of the following general criteria:

• Materially increase the value of the property
• Substantially increase the useful life of the property
• Changed the property to a new or different use

Big Time Construction Corporation has two contracts to provide plumbing services to hotels. The Company repaired and replaced old pipes, which resulted in an increase of ten years of useful life to the pipe system for their first contract. For the second contract, they fixed ten leaky toilets. Since the first contract meets the useful life criterion, the Company should include the gross receipts in the calculation for the deduction. However, the Company may not include the gross receipts from the second contract as the activity does not meet the criteria and would generally be considered repair and maintenance activity for the property.

Section 199 also provides additional considerations for services related to construction activities. However, these services alone would not be eligible. The services must be incidental, necessary, and in connection with the erection or substantial renovation of real property to be eligible as domestic production gross receipts (DPGR). Below are examples of such activities:

• Tangential services (e.g. hauling trash and delivering material)
• Other construction activities – gross receipts earned from any activities that physically change the land, such as landscaping, painting, grading, demolition, clearing, and excavating.
• Administrative support services (e.g. billing and secretarial services)
• De minimis exception: construction contracts may use the total DPGR if less than 5% of total gross receipts do not meet the requirements. For example, if a contractor has $100 of gross receipts, of which $95 is eligible DPGR and $5 is ineligible, then the contractor may use $100 as DPGR.

Gross receipts from tangential and administrative support services are only eligible for the general contractor. However, gross receipts from land preparation activities are eligible to both general contractors and subcontractors. For example, General Builder, LLC is the general contractor contracted to build a new hotel. Big Time Construction Corporation is subcontracted to clear the land. In the process, Big Time Construction Corporation hauls trash. Big Time Construction Corporation may only include the gross receipt from clearing the land but not from hauling trash.

Does the Domestic Production Activities Deduction Apply on the State Level? Once the QPAI is determined and the taxpayer calculates the amount of the 9% deduction, the taxpayer is also subjected to a final limitation as noted above. The taxpayer must apply the Section 199 deduction to no more than 50% of W-2 wages paid to employees and officers. These wages must be associated with the generation of DPGR. Consequently, if there are no W-2 wages paid, then construction contractors are not eligible for the Section 199 deduction.

Some states disallow the DPAD. Relevant to the mid-Atlantic region:

• States Allowed: DE, PA, VA
• States Disallowed: DC, MD, WV

Construction contractors with substantial business income from the construction or renovation of real property in the United States should consider the Section 199 deduction to reduce taxes. A best practice for contractors eligible for the deduction would include maintaining accurate accounting records that separate income and expense statements related to domestic production from non-eligible amounts.

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