February 20, 2012
Section 199 Domestic Production Deduction
The Domestic Production Activities Deduction, Section 199 of the Internal Revenue Code, was introduced into law as part of the American Jobs Creation Act of 2004. Starting with tax year 2005, certain companies with “qualified production activities” can take a 3% to 9% deduction from net income for US-based business activities.
Many businesses engaged in the following lines of business may qualify for the Domestic Production Activities Deduction (DPAD). These are the "qualified production activities" eligible for claiming the deduction under Internal Revenue Code Section 199:
- Manufacturing based in the United States,
- Selling, leasing, or licensing items that have been manufactured in the United States,
- Selling, leasing, or licensing motion pictures that have been produced in the United States,
- Construction services in the United States, including building and renovation of residential and commercial properties,
- Engineering and architectural services relating to a US-based construction project,
- Software development in the United States, including the development of video games.
This law provides very generous deductions to qualifying businesses. The rules are also very complex and may require the implementation of a separate cost accounting system. Since the law is fairly new, not many cases have been reviewed by the IRS or been presented at Tax Court. Gibson & Associates, Inc. v. Commissioner is the first Tax Court case opinion on Section 199 deduction activities. The result of the case sided in favor of the taxpayer.
The taxpayer was a family-owned corporation from Texas that filed a June 30, fiscal yearend tax return. The taxpayer was an engineering and heavy construction company that carried out three types of construction projects in its course of business. These projects included casualty projects, rehabilitation projects, and new construction projects. The taxpayer's activities specifically involved erecting or rehabilitating streets, bridges, airport runways, and other related real properties.
On the federal income tax return, Gibson reported that its receipts from business were domestic production gross receipts (DPGR) and therefore eligible for a deduction under section 199. The IRS concluded that the taxpayer's activities were amounted to repair and maintenance projects and did not rise to the level of substantial renovation, and as a result, would not qualify as DPGR deductible under section 199.
The Tax Court established a two part test with respect to construction projects in order to determine if the receipts would qualify as DPGR. This test involved determining whether the renovations significantly increased the worth of the real property, considerably prolonged the useful life of the real property, and/or adapted the real property to a dissimilar or new use.
The taxpayer took that position that it erected or substantially renovated real property and the disputed amount of receipts would qualify as DPGR. The IRS argued that such work would not qualify as DPGR.
The Tax Court sided with the taxpayer based on expert testimony on issues including bridge rehabilitation. The taxpayer’s specialist concluded that the taxpayer’s major rehabilitation work on a bridge increased each bridge’s value by the cost of the rehabilitation work and also extended the bridge’s useful life. Therefore, the revenue generated from this activity was domestic production gross receipts for purposes of the section 199 domestic production deduction.
The case determined that certain gross receipts of an engineering and heavy construction company qualify as domestic production gross receipts, therefore, qualifying to be included in the domestic production activities deduction calculation. When a taxpayer's trade or business may include both qualifying and non-qualifying activities it is imperative that contemporaneous records be maintained to allow for identification of the non-qualifying activities. The decision of this case provides important guidance in the areas of what represents an item or a unit of real property for the purpose of applying Section 199 and what constitutes substantial renovation of real property.