Domestic Production Activities Deduction

Potentially, a lot.  If a taxpayer is taxed at the top 35 percent rate, the deduction will approximately translate into a 2% cut in tax rate starting next year, and a 3.15% tax cut rate in 2010.  (Assuming no limitations on deduction such as insufficient W-2 wages). 

For 2006, Internal Revenue Code Section 199 provides a deduction in amount equal to 3% of a company’s “Qualified Production Activities Income” (QPAI).  The deduction percentage is scheduled to increase to 6% in 2007 and 9% in 2010.  The QPAI is based on domestic production gross receipts from qualified production activities.

The annual deduction is limited to 50% of W-2 wages paid by the manufacturer.  In addition, production activities must be performed in whole or in significant part within the United States . 

"Qualified Production Activities”

As noted above, the Section 199 deduction equals a percentage of net income from eligible activities.  Among the more common eligible activities are:

Construction activities are eligible for the Section 199 deduction but only for construction of real property performed in the U.S.   The real property may consist of residential or commercial buildings, permanent structures (like docks and wharves), permanent land improvements (like swimming pools and parking lots), oil and gas wells, platforms, and pipelines, and infrastructure (like roads, sewers, sidewalks, and power lines).  Examples of businesses conducting eligible construction activities are residential remodelers, commercial and institutional building construction contractors, foundation structure, and building exterior contractors, structural steel and precast concrete contractors, electrical, plumbing, heating, and air-conditioning contractors.

Often times it may be difficult to determine whether the contractor’s work is “substantial renovation” or non-qualifying maintenance.  For example, an electrical subcontractor is hired to modestly increase the electrical service supplied to an industrial facility.  This relatively minor work is needed for the facility to provide power for a small, underutilized portion of the facility.

The electrical contractor may be unaware of planned leasehold improvements to the facility, and may simply consider the services a repair or possibly maintenance; even though these same services are integral to subsequent capital improvements performed at the site and are possible eligible for the Domestic Production Activities Deduction.

Engineering and Architectural clients

The Section 199 definition of Domestic Production Gross Receipts (DPGR) distinguishes “construction” from “engineering and architectural services.”  Eligible engineering services include consultation, investigation, evaluation, planning, design, and supervision of construction.  Eligible architectural services include consultation, planning, aesthetic and structural design, and supervision of construction.  The construction contractor may actually provide engineering, architectural, as well as construction services.  It would seem that the design-build contractor should aggregate all of the revenues and costs for a contract. 

Calculating the deduction often becomes quite complex

            Domestic Production Gross Receipts (DPGR) (defined above)

-         allocable cost of goods sold;

-         directly allocable deductions expenses, or losses;

-         indirectly allocable deductions, expenses, and losses;

= Qualified Production Activities Income (QPAI) *(unless total taxable income is less.  In such an event, the lower total taxable income number equals is the number to use for the potential deduction)

          QPAI  x  6% (applicable rate for 2007 – 2009) and limited to 50% of W-2 wages paid

= Section 199 Deduction

However, there are a number of interlinking issues that come into play when calculating the most advantageous Section 199 deduction. For example, the following questions often arise:

• How did you define your revenue streams?
• If your company must use the Section 861 method to allocated domestic production gross receipts and non-domestic production do you have a full understanding of the relevant Section 861 regulations; and can you demonstrate how you maximized them?
• What impact does the expanded affiliated group definition have on your calculation?

There is lot more to the Section 199 deduction.  The rules are complicated.  If you would like to discuss whether the Section 199 deduction would benefit you, and how to take advantage of it, please do not hesitate to contact us.