March 24, 2005
Tax breaks coming for contractors, design firms
By TIM SEARING
In the American Jobs Creation Act of 2004, Congress broadly defined manufacturing to include not only production, but also construction, engineering and architectural services performed in the United States. Furthermore, it provided for "deductions relating to U.S. production activities income."
This tax deduction provides both cash flow and financial statement benefits. Businesses that fit into these categories gain a phased-in tax break that starts at 3 percent this year and culminates in a 9 percent deduction in 2010.
The deduction is allowed for activities directly related to the erection or substantial renovation of residential or commercial buildings and infrastructure. Structural improvements qualify, but painting or other cosmetic changes do not.
For example, if your effective tax rate is 35 percent now, it could be reduced to 32 percent. For a company with $100,000 of qualifying income in 2005, the deduction would return to your company a savings of $3,000.
The actual calculation is based on construction activity. If you have only one construction activity, the calculation is simple it is generally based on your net income. However, if you have multiple activities within the same company or as a part of an affiliated group of companies doing business with each other you have just muddied the waters. In this situation, the various activities have to be analyzed so that certain overhead, administrative and other expenses can be allocated between the qualifying and non-qualifying activities.
An example: ABC Company constructs a building under a contract that qualifies for the deduction. ABC also builds, holds and leases buildings to the public. The construction under the contract activity qualifies for the deduction, but the retained buildings that are leased to the public do not. ABC needs to allocate expenses between the two activities in order to calculate the deduction.
Obviously, ABC would like to allocate more of its expenses to the non-qualifying activity and away from the qualifying activity to increase income in the qualifying activity, thereby increasing the deduction. However, the new rules require a "reasonable allocation method" be used. Look for further guidance from the IRS.
There are other more complicated and technical issues as well, but the previous example should give you a feel for the possible complexity of such an allocation.
The message here is that you must begin now to set up your accounting procedures to accommodate calculating qualifying activities and the amount of that income.
In addition, there are a couple of limitations on the amount that may be deducted after you have identified a qualified activity and its income. Further, the deduction cannot exceed 50 percent of W-2 wages or taxable income from all activities of the company.
This rule begs the question: If you are a single member LLC that qualifies for the deduction but subs out all your work so you have no W-2 wages, will you get any benefit from this new law? The answer is no.
Based on this ruling, many may wonder if they should incorporate and take wages that will be reported on a W-2. The answer is "possibly," but there is a need to weigh all the pros and cons of such a move.
As with all new laws with new or amended provisions, there are initially more questions than answers. To ensure that your business can take advantage of this new deduction, consult with your tax and business advisors.
Tim Searing is a managing director with RSM McGladrey's tax practice. He has more than 30 years of experience and specializes in real estate and construction.
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