New deduction spells relief for contractors

By Jim Brandenburg

The American Jobs Creation Act, signed into law by President Bush in October, contains several provisions benefiting contractors. The legislation is expected to boost investment in the construction industry and stimulate job growth.

Within this legislation is a new deduction for contractors. Beginning in 2005, contractors may deduct up to 3 percent of their income related to construction activities.

The deduction, which will increase to 9 percent by 2010, is available to all contractors, regardless of company size or structure. Contractors do not need to expend any additional amounts in order to claim this deduction. It is a noncash deduction that offers a permanent tax savings.

This new deduction is based on "qualified production activities income," which is income from domestic manufacturing activities as well as income from film production, extraction, construction activities and engineering and architectural services.

You can calculate the qualified productions activities income by taking domestic gross receipts (such as construction contracts in the United States) and subtracting the cost of sales (such as direct job costs of materials and labor), the direct costs incurred in obtaining the contract and other indirect administrative overhead costs.

Construction activities covered under the new deduction include "activities that are directly related to the erection or substantial renovation of residential or commercial buildings and infrastructure." Substantial renovation includes structural improvements. Thus, not only is the definition of production construed very broadly for this new deduction to apply to construction activities, but the description of construction also would seem to cover most aspects and functions of both general and subcontractors. However, according to the legislative record, "mere cosmetic changes such as painting" do not qualify as substantial renovations and, therefore, do not qualify as construction activities for this deduction.

As with most new tax laws, there are several exceptions and limitations. First, the deduction is limited by the taxable income of the business for the year. Therefore, a contractor that incurs a taxable loss for the year would not be entitled to claim the deduction.

The deduction also may not exceed 50 percent of the wages paid by the business and reported on Internal Revenue Service Form W-2 by its employees for the year.

It also does not apply to income from the sale, lease, license or rental of property to a related party. It is quite common for contractors to use related parties for certain construction contracts and for the leasing of equipment or other assets. It is uncertain how this related-party limitation will apply or how it will be computed for the purposes of this new deduction. The IRS is expected to issue guidelines soon.

Although the American Jobs Creation Act provides an attractive tax benefit for contractors, it remains uncertain how Wisconsin will treat this new federal deduction.

Will the state permit this deduction, or will it disallow the tax benefit as it has done for several other recent federal tax business benefits? You can expect our state politicians to explore this item as they move into a new legislative calendar.

Jim Brandenburg is a tax shareholder with Kolb+Co., the largest locally owned accounting firm in Milwaukee. The group, which provides integrated services and coordinated solutions to closely held businesses and their owners, has five affiliated advisory firms.

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