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Tax Tips

T he I.R.C. Section 199 Domestic Production Activities Deduction rewards companies for putting Americans to work and producing goods domestically. The deduction, first available in 2005, allows a reduction in taxable income from qualified activities by up to 3 percent. This amount will phase up over time, until it reaches 9 percent in 2010.

June 05, 2006

The I.R.C. Section 199 Domestic Production Activities Deduction rewards companies for putting Americans to work and producing goods domestically. The deduction, first available in 2005, allows a reduction in taxable income from qualified activities by up to 3 percent. This amount will phase up over time, until it reaches 9 percent in 2010.

Constructing buildings and infrastructure in the U.S. qualifies as domestic production. Contractors can benefit from this new rule without incurring new expenses.

Determine when you are engaged in construction, and when you are simply providing a nonqualifying service.

It's the net income from qualified activities that determines the deduction. If a contractor is involved in nonqualified as well as qualified activities, then those activities, their costs, and the revenue they produce must be separated so that the deduction can be calculated on the qualifying revenue.

The rules for the new deduction can be a little complicated. By the rule, some contractors may be considered engaged in construction, while others are providing tangential services or even reselling goods. Mel Schwarz, Grant Thornton LLP, suggests that contractors review their revenue to make sure it can be treated as qualified. "In the construction arena, there are certain activities that may not qualify. For instance, if I'm in waste management, and the only thing I do is drop off a dumpster, and then pick it up when it is full, I am only tangentially involved in the construction. That isn't considered a qualified activity."

Mark-up of construction materials is excluded from the deduction.

Reselling items that were produced by others is also not a qualified activity. For instance, an electrical subcontractor may charge separately for stringing wires, the cost of the wire, and then a mark-up on that wire. According to Schwarz, "the IRS has said that the income earned stringing the wire would qualify, while the income earned reselling the wire would not. So, you'd have to go through the process of figuring out how much money was made on the qualified portion of the activity to take the deduction." However, Schwarz notes that many taxpayers have complained that the markup on the wire is really a part of the contract, and the IRS could provide for a different result when the rules are finalized later this year.

Enough W-2 wages must be present to support the deduction.

The deduction for any year cannot be more than either net income or 50 percent of the overall W-2 wages paid in the same tax year. "This is a mechanism that makes sure the incentive not only reflects U.S. production, but also reflects an element of U.S. employment," says Schwarz.

Schwarz pointed out that, at least for 2005 and 2006, W-2 wages necessary to taking the deduction do not have to be for workers tied directly to the qualified activity. Salary and wages paid to front office and bookkeeping staff can also be counted to support the deduction. "For the time being, the wages don't have to relate to the specific project I'm claiming the deduction with respect to. There just have to be sufficient W-2 wages to support the deduction. However, Congress has changed this rule and will only count wages that are also treated as expenses of the qualified activity starting in 2007."

Using payroll services to file wages doesn't prevent a business from counting the W-2 wages either. "If the workers are common-law employees of a business, the wages can be counted, assuming the wages were reported on a W-2. This is the case whether I'm filing the W-2 or I've contracted someone else to file the W-2."

This limitation may cause problems for smaller contractors. Schwarz uses the electrical contractor as an example here also. "Let's say I'm running my business on a Schedule C as a sole proprietorship and using independent contractors. I may not have any W-2 wages, even though I have to pay self employment tax on the earnings. You have to pay employees W-2 wages in order to take advantage of this deduction."

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