Determining Qualifying Construction-Related Gross Receipts under Sec. 199

Enacted as part of the American Jobs Creation Act of 2004, Sec. 199 establishes a deduction for income from certain production activities, including construction activities, performed in the U.S.

The IRS provided interim guidance on implementing the new legislation in January 2005, in Notice 2005-14. However, considerable controversy still exists, particularly on issues posed by the construction industry, such as the exclusion for the sale of land. Treasury and the Service are currently developing proposed regulations to provide additional guidance, with final regulations to be issued in 2006.

This item outlines an approach for determining qualifying construction-related gross receipts, based on the guidance currently available. The taxpayer begins by determining its qualifying construction activities, then calculating qualifying gross receipts from these activities, allocating revenue as necessary. Finally, the taxpayer applies any applicable de minimis rules.

Sec. 199 Overview

In general, under Sec. 199(a)(1), the domestic production activities deduction equals a percentage of the lesser of qualified production activities income (QPAI), or taxable income (adjusted gross income, for individuals). It is further limited by Sec. 199(b)(1) to 50% of Form W-2 wages. The applicable percentage for 20052006 under Sec. 199(a)(2) is 3%, increasing to 6% for 20072009, and to 9% for 2010 and after.

According to Sec. 199(c)(1), QPAI equals domestic production gross receipts (DPGR), reduced by the sum of the directly allocable cost of goods sold, deductions, expenses and losses, as well as a ratable portion of other deductions, expenses and losses.

Under Sec. 199(c)(4)(A), DPGR are gross receipts derived from, among other things:

• Any lease, rental, license, sale, exchange or other disposition of certain specified property manufactured, produced, grown or extracted in the U.S.;

• Construction performed in the U.S.; or

• Engineering or architectural services performed in the U.S. for construction projects in the U.S.

The exhibit is a diagram of Sec. 199 QPAI. (For more details on Sec. 199, see Karlinsky and Orbach, The AJCAs Domestic Business Provisions, TTA, March 2005, and Gibbs and Rathnau, Tax Clinic, Notice 2005-14 Offers Sec. 199 Guidance, TTA, June 2005.)

Determining Qualifying Construction Activities

A taxpayer must be engaged in construction activity in the U.S. with regard to real property, for the revenue to qualify as DPGR. The taxpayer is not required to be the tax owner; thus, more than one taxpayer may be regarded as constructing real property with respect to the same activity and the same construction project. For example, a general contractor and a subcontractor may both be engaged in construction activities with respect to installing a roof on a new building. Each taxpayers DPGR will include the gross receipts received from that installation.

Under Notice 2005-14, Section 4.04(11), construction means the construction or erection of real property (including substantial renovation) by a taxpayer in a trade or business that is considered construction, generally determined by reference to the North American Industry Classification System. This definition encompasses both residential and commercial buildings and their structural components, permanent structures (other than tangible personal property in the nature of machinery) and permanent land improvements and infrastructure.

A substantial renovation, defined consistently with Sec. 263(a) (capital improvements), means the renovation of a major component or substantial structural part of real property that materially increases its value, substantially prolongs its useful life or adapts it to a new or different use; see Notice 2005-14, Section 4.04(11)(d). Infrastructure includes roads, power lines, water systems, communication facilities, sewers, sidewalks, cable and wiring; see Section 4.04(11)(c).

Improving land and painting real estate improvements are construction activities, but only if performed in connection with other activities deemed construction activities, whether or not performed by the same taxpayer.

Determining DPGR from Qualifying Construction Activities

DPGR derived from construction include proceeds from the sale, exchange or other disposition of real property constructed by the taxpayer in the U.S., whether or not the property is sold immediately after construction is completed. They also include compensation for construction services performed by the taxpayer in the U.S; see Section 4.04(11)(e).

Notably, construction revenue, for the purpose of calculating qualifying DPGR, excludes the following under Section 4.04(11):

• Proceeds from sale of land, even if the land is sold as an integral part of the sale of property constructed by the taxpayer.

• Proceeds from sale of tangible personal property (e.g., appliances or furniture and fixtures sold as part of a construction project).

• Revenue for engineering and architectural services, which are addressed separately in Sec. 199.

• Revenue for tangential services (including hauling trash and debris, and delivering material), even if such services are essential for construction. An exception applies if the taxpayer performs tangential services in connection with its own construction project (such as delivering materials to its construction site and removing construction debris).

• Revenue from the rental of real property, even if the taxpayer constructed the property. This revenue is deemed income from the use of the property and, as such, is not eligible.

Allocating Gross Receipts

If a taxpayer has gross receipts from both construction-related activities that qualify as DPGR and other activities that do not (e.g., revenue from the sale of constructed property that includes land, a building and tangible personal property), the taxpayer must be able to separately identify or otherwise allocate them. If not, the taxpayer cannot include any of the revenue in DPGR.

Safe-Harbor/De Minimis Rules

Treasury has provided de minimis rules for taxpayers that would otherwise be required to allocate gross receipts for purposes of calculating DPGR. These rules are determined on two levels and are calculated independently.

The first-level rule, specific to construction projects, states that if more than 95% of the total gross receipts from a taxpayers construction project are attributable to real property (i.e., less than 5% of the taxpayers gross receipts from a construction project derive from tangible personal property), then all of the receipts are considered attributable to real property qualifying as DPGR; see Section 4.04(11)(a). If, for example, a taxpayer derives 4% of its total gross receipts from the sale of a propertys furniture and appliances, no allocation is necessary. The taxpayers total gross receipts are deemed DPGR from construction.

The second-level rule applies after all other de minimis rules have been applied. It treats all gross receipts as DPGR if less than 5% of the taxpayers total gross receipts are non-DPGR; see Section 4.03(2).

Thus, the bi-level calculation makes it possible for a taxpayer to treat all gross receipts as DPGR, even though nearly 10% of its total gross receipts are non-DPGR.

Example: Taxpayer T builds a building on land subject to a ground lease, and sells it for $1 million. The sales price includes $40,000 for tangible personal property and $960,000 for real property. In addition, the taxpayer has $45,000 interest income.

First de minimis rule. In the example, only 4% of Ts gross receipts from the sale of the building are non-DPGR ($40,000/$1,000,000). Thus, all of Ts receipts from the sale of the building are attributable to real property and qualify as DPGR.

Second de minimis rule. After applying the above rule, T applies the overall de minimis rule. Once again, less than 5% of Ts total gross receiptsincluding the interest incomeare non-DPGR (($45,000/$1,045,000), or 4.3%). Thus, all of Ts gross receipts are DPGR.

As a result of applying the two de minimis rules, slightly over 8% of Ts total receipts were reclassified from non-DPGR to DPGR ($85,000/ $1,045,000).

If, in the above example, T had actually owned the land and sold it along with the building, T would have been required to allocate the sales price between the land and building, as a sale of land does not generate DPGR. This restriction is the subject of intense discussion; Treasury is being pressured into considering the sale of land that is part of a construction project as DPGR. It is being asked, at a minimum, to allow for the inclusion of land sales as DPGR if certain thresholds are met (e.g., if construction costs exceed 10% or more of the propertys total sales price) or to establish a flat reduction, such as 5%, to be applied to the taxpayers total QPAI.

Conclusion

Hopefully, the proposed regulations will provide taxpayers with relief and eliminate the need to perform complicated DPGR/non-DPGR calculations for land/building sales.

From Rodney K. Fujita, CPA, Shareholder, Bader Martin Ross & Smith PS, Seattle, WA