The Section 199 deduction for producing domestic products is often associated with the manufacturing industry. In fact, it is sometimes called the “manufacturer’s deduction.”
But it doesn’t belong exclusively to manufacturers. Other industries, including construction, may take advantage of it. To drive home this point, the IRS recently issued a Technical Advice Memorandum (TAM 201638022) approving the tax break for a company primarily engaged in renovation and construction.
The Section 199 deduction has been around for more than a decade. When it first took effect in 2005, it was equal to 3 percent of income from qualified production activities income (QPAI). It was doubled to 6 percent for 2007 through 2009, and raised to its current 9 percent level in 2010. For a business in the 35 percent tax bracket in 2017, that deduction effectively will amount to a tax cut of more than 3 percent.
The rules for computing QPAI are complex but, generally, it equals domestic production gross receipts (DPGR) minus the sum of:
- The costs of goods sold that are allocable to domestic production gross receipts,
- Deductions, expenses or losses that are directly allocable to those gross receipts, and
- Certain other deductions, expenses and losses that aren’t directly allocable to those receipts or another class of income.
For this purpose, DPGR includes money derived from the sale, exchange, lease, rental, licensing, or other disposition of certain qualifying property that must be manufactured, produced, grown or extracted (MPGE) in whole or in significant part within the United States. (See “Rules of the Road” below.)
Be aware that other significant limits may come into play. For instance, if a company’s taxable income is lower than its QPAI before the deduction is calculated, the break is claimed as a percentage of taxable income. Furthermore, the annual deduction is limited to 50 percent of W-2 wages the business pays. This can be a significant limitation for employers trying to keep a lid on salaries.
On the plus side, the Section 199 deduction isn’t limited to C corporations. It may also be claimed by other types of business entities, including S corporations, limited liability companies (LLCs), partnerships and sole proprietors. Thus, the tax break is available to a wide variety of taxpayers ranging from small businesses to corporate giants.
Inside the Technical Advice
Getting back to the IRS TAM, the company involved is considered to be a construction business under the North American Industry Classification System. Generally, it engages in all phases of field construction, including, but not limited to:
- Direct hire of most labor crafts,
- Construction and rigging engineering,
- Estimating, and
- Preparation for foundation and ground work.
The projects at issue involved the renovation, construction or erection of structures not specified in the TAM. The renovations either materially increased the property’s value, substantially prolonged its useful life, or both. Although specifics in the memorandum are largely redacted, the materials indicate that the projects were significant in terms of scale, crew and time commitment.
The firm also builds and uses in its construction activities large structures that weigh hundreds or even thousands of tons.
Under a little-publicized part of Section 199, gross receipts are treated as DPGR if they’re derived from the construction of “real property” within the United States while the taxpayer is actively engaged in construction activities.
The IRS has issued copious regulations on this issue. Notably, the regs include a special rule stating that, to determine what activities and services constitute an “item” of real property, a taxpayer in construction may use any reasonable method, based on all of the facts and circumstances.
Critical Tax Analysis
The company addressed in the TAM claimed that its activities were performed on real property under Section 199, with gross receipts from each project constituting DPGR. It said that it’s reasonable to consider each project as an “item” for this purpose. Note that the definition of “real property” in the regulations includes “inherently permanent structures” other than machinery, and structural components of inherently permanent structures.
However, the Large Business and International division of the IRS argued that treating each project as an “item” wasn’t reasonable. It contended that the company’s activities on these projects didn’t qualify as the construction of real property under Section 199 because the jobs were related to tangible personal property.
In analyzing the issue, the IRS Chief Counsel’s Office (which writes the TAMs) looked to the two basic requirements, under tax regulations, for an inherently permanent structure:
- It must be affixed to real property, and
- It must ordinarily remain affixed for an indefinite period of time.
The Chief Counsel’s Office first determined that the units were real property because they satisfy both requirements as inherently permanent structures. It also determined that the conclusion that the units qualified wasn’t affected by the exception for machinery mentioned earlier.
Rules of the Road
Under Section 199, domestic production gross receipts (DPGR) may be derived from the following activities:
- Manufacture, production, growth or extraction by the taxpayer of tangible personal property — including all tangible personal property (except land and building), computer software and sound recordings,
- Production of qualified film,
- Production of electricity, natural gas or water,
- Constructing real property, and
- Providing services of architecture/engineering.
DPGR resulting from the property produced must be owned by the taxpayer claiming the deduction.
Keep in mind that TAMs represent a final determination of an IRS position, but only regarding the specific issue in the case at hand.
Contractors can, however, take away this pearl: Any company may be eligible for the Section 199 deduction if it meets the requirements. If you think you may qualify, consult with us. This is a technical area of tax law best left to the experts.