Fall 2007 issue of Horizons

INDUSTRy u

Contractors

Tax Opportunities for Construction Contractors One of the hottest tax topics for construction contractors is the Production Activities Deduction (Section 199). This deduction became available for taxpayers for years beginning in 2005. The taxpayer is granted a deduction for tax years beginning in 2005 and 2006 equal to 3 percent of “qualified production activities income.” This percentage will increase incrementally to 9 percent in 2010. The deduction is limited to the lesser of taxable income computed before the deduction, or 50 percent of W-2 wages paid. The vast majority of taxpayers with long-term contract income eligible for the Section 199 deduction are taxpayers who contract to perform “construction of real property.” Construction includes: • The construction or erection of real property (i.e. residential and commercial buildings), including the structural components of such buildings • Inherently permanent structures other than tangible personal property such as machinery • Inherently permanent land improvements • Infrastructure The construction must be performed in the United States by a taxpayer engaged in a trade or business that is considered construction for purposes of the North American Industry Classification System on a regular and ongoing basis.

Now that many companies have filed their 2005 tax returns and calculated the Production Activities Deduction, numerous complexities and opportunities related to the deduction have come to light. In addition, legislative changes will affect the way the deduction is calculated in the future. Complexities • If the deduction is limited because either taxable income or 50 percent of wages is less than qualifying income, there is no provision for carryover. This qualification is especially significant for contractors, because they often experience wide swings in income. • Interest expense that has not been otherwise allocated should be allocated under the Section 861 Regulations. These regulations require that interest be allocated to production based on the book value of production assets and all other assets, or fair market values, at the option of the taxpayer. • The regulations require all expenses and losses be traced, allocated, or apportioned between qualifying income and all other activities. Taxpayers are usually able to specifically allocate contract costs without too much trouble. For other deductions that are not directly related to gross income, the regulations provide a general rule to apportion those costs based on qualifying gross income and non-qualifying gross income. • The contractor who purchases land and performs construction on the land under contract must carve out the land component of the contract price to arrive at the income base for the Section 199 deduction. There are, however, safe harbor methods to determine the land component of the contract price or the price of the property sold. Opportunities • For flow-through entities and contractors that utilize subcontractors, the W-2 wage limitation may be important. Guaranteed payments to partners are not W-2 wages, although they reduce production income. S corporation shareholders who receive their revenues in the form of distributions instead of salaries may be trading Section 199 deductions for lower Medicare

25 u winter 2007 issue