"Manufacturing deduction" increases for contractors in 2007

Real Estate Weekly,  May 9, 2007  by Marc Newman

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Increased deductions allowable under the American Jobs Creation Act (AJCA) of 2004 can make 2007 a more profitable one for the architectural, engineering and construction (A/E/C) industries.

Categorized under the very broad definition of "manufacturers," companies that provide domestic design, construction or substantial renovation services will be able to deduct up to 6 percent in 2007 of their "Qualified Production Activity Income" (QPAI) as stated in Section 199 of the Internal Revenue Code. This allowance doubles the 3 percent that architectural, engineering and construction companies were allowed to deduct from their income during the first two years of the tax law (2005 and 2006) and should go a long way to improving the after-tax profitability of these firms.

It may be difficult for a firm to determine whether certain gross receipts qualify under the Act, without professional guidance. In some situations, the regulations may permit a company with small amounts of other non-qualifying activity to still treat 100% of their taxable income as QPAI. Therefore, we advise any firm wishing to take advantage of this deduction to consult an accounting professional.

As an example, the sole shareholder of a Subchapter "S" Corporation with $10 million of QPAI for tax year 2007 may be able to deduct $600,000 from his taxable income. For a NYC resident in the top tax bracket that would result in an estimated tax savings of $256,000. The deduction would also be included as a full $600,000 deduction for purposes of calculating the much publicized Ahemative Minimum Tax (AMT). Moreover, the phased-in deduction will increase to 9 percent in 2010. Companies that did not file for the deduction in 2005, the first year it was allowed, may file an amended return.

It is interesting that the A/E/C industries were included in what has been dubbed as "the manufacturing deduction," particularly since the law was a response to the repeal of subsidies from the Foreign Sales Corporation and Extraterritorial Income Acts and sanctions issued by the European Union on United States exports. In addition to the A/E/C industry, energy production, computer software, film industry and agricultural processing companies are defined as manufacturers under the AJCA. The wide scope of the Act can be attributed to heavy lobbying efforts in Washington.

"Construction," according to the new IRS guidelines, includes construction or substantial renovation of real property by a taxpayer that is in a trade or business that is considered construction for purposes of the North American Industry Classification System (NAICS) codes. Be sure to include your proper NAICS code on your federal tax return.

Real property includes residential and commercial buildings, including their structural components, permanent structures (other than personal property in the nature of machinery), permanent land improvements and certain infrastructure. Real property does not include appliances, furniture, fixtures and other personal property.

Engineering, architectural, and construction services qualify for the deduction if they're performed in the U.S. for a U.S. construction project, and meet certain other requirements.

The law also makes provisions for services which would not qualify independently for the "manufacturing deduction" but do qualify when used in conjunction with construction or renovation services, such as rubbish carting, and the delivery of building materials. Receipts from improving land (grading and landscaping, for example) and from painting could be qualified if the services are performed in connection with a construction or substantial renovation project. Such receipts could qualify whether or not they are carried out by the firm performing the actual construction or substantial renovation project.

The deduction is limited by the company's taxable income. In other words, the deduction cannot be used to generate a loss. The deduction also cannot exceed 50 percent of the company's W-2 wages, which is a key factor for companies that "sub out" the vast majority of their work. Additionally, the law requires companies to identify and track qualifying and non-qualifying activities and allocate costs, deductions and losses accordingly.

The manufacturing deduction could be a very effective tool to reduce taxable income but it requires a good deal of preparation and tax planning. You'll need to track receipts from qualifying and nonqualifying activities and allocate costs, deductions and losses among those activities according to IRS guidelines.

As always, tax law is complicated. Consult with your accountant to determine if and how you can best take advantage of the "manufacturing deduction."

BY MARC NEWMAN, CPA ANCHIN, BLOCK & ANCHIN LLP

COPYRIGHT 2007 Hagedorn Publication
COPYRIGHT 2008 Gale, Cengage Learning