The manufacturers’ deduction, also commonly referred to as the domestic production activities deduction or Section 199 deduction, has been around for several years, yet many businesses that are eligible have not taken advantage of it. Although the tax break was intended by Congress to benefit primarily U.S. manufacturers, it also applies to other types of businesses. This includes construction companies that provide architectural, engineering or actual construction services for projects within the United States.
Calculating the deduction
Essentially, the deduction allows you to deduct 9% of qualified production activities income (QPAI) for amounts earned in 2010 and thereafter.
To calculate QPAI, you need to first determine your construction company’s domestic production gross receipts (DPGR), which include income from construction, engineering or architectural services performed in the United States. You must then reduce this amount by the sum of the following:
- Cost of goods sold that are allocable to these receipts,
- Other deductions, expenses or losses directly related to these receipts, and
- A portion of other deductions, expenses and losses not directly allocable to these receipts.
There are, however, two important limitations. First, the deduction cannot reduce your taxable income below zero. Second, it’s limited to 50% of the W-2 wages you pay during the tax year that are attributable to qualified domestic production activities.
Determining qualified activities
The manufacturers’ deduction limits qualifying activities for contractors to the construction of real property, permanent structures, permanent land improvements, substantial renovations and certain infrastructure.
You cannot include personal property sold in connection with construction, engineering and architectural services in your DPGR calculation. You may, however, add in engineering and architectural services even if you don’t undertake the corresponding project.
Re-evaluating your operations
One way the deduction may affect your operations is to inspire a reassessment of your use of independent contractors. Naturally, engaging these workers will lower the amount of W-2 wages you pay and, consequently, your QPAI. Thus, by hiring employees instead, you can increase your allowable deduction.
Another item worth considering is how your company compensates partners (if it’s a partnership) or you (if it’s a sole proprietorship). Any income distributed to owners in these types of entities, be it through guaranteed payments or earnings allocations, isn’t includable in your W-2 wage base.
Therefore, operating as a partnership could severely limit your eligibility for the manufacturers’ deduction, depending on the number of partners in your organization and how much compensation they receive. Alternatively, if you incorporated your business, you could compensate those same individuals via W-2 wages and make better use of the deduction.
Entity choice may be especially important for sole proprietors. A construction company with no employees earning W-2 wages would not qualify for the deduction. But if that company converted to an S corporation, any wages its single shareholder received would potentially qualify.
These benefits notwithstanding, approach an entity change cautiously. There are many other factors — financial, legal and operational — to consider before making this decision.
Addressing accounting woes
The manufacturers’ deduction may also bring on some accounting woes — particularly if your construction business has both qualifying and nonqualifying gross income. To track eligible and ineligible projects, and their associated direct and indirect costs, you’ll need to ultimately extract this information from your accounting system.
Depending on the sophistication of that system, doing so could prove difficult and expensive. In addition to determining the cost of goods sold and direct costs, you must establish a method of allocating indirect costs to qualifying and nonqualifying projects. IRS guidance provides some options for properly allocating these costs, but getting the job done may call for an upgrade to your accounting system, a revision of your accounting methods — or both.
Keeping up with the changes
The manufacturers’ deduction is one of the more complex tax breaks a construction company can claim. Thus, it’s important to obtain professional tax advice when undertaking any effort to take advantage of it.