“Big Time Construction Corporation” made a significant profit this year resulting in higher taxable income than expected. Therefore, Big Time Construction Corporation is exploring opportunities to reduce their tax liability. As a construction contractor who builds or renovates real properties in the United States, the Company is eligible to take advantage of the IRC Section 199 deduction also known as The Domestic Production Activities Deduction (“DPAD”).
The DPAD encourages domestic production activities by allowing taxpayers a 9% deduction on the lesser of Qualified Production Activities Income (QPAI), or taxable income for corporations before the section 199 adjustment, or adjustable gross income for individual taxpayers. However, this deduction is limited to 50% of W-2 wages paid during the year for employees and officers.
Are you eligible to take the DPAD? Under the regulations, the following type of taxpayers qualify: C corporations, Shareholders, Beneficiaries of trusts or estates, and Individual taxpayers. Pass-through entities such as S corporations, LLCs, trusts, and estates, are only allowed the deduction on the shareholder or beneficiary level. These types of entities will provide a Schedule K-1 to its shareholders to provide the information needed to take the deduction.
What Activities Qualify as Domestic Production Activities?
In order for these activities to qualify for section 199 treatment, the gross receipts earned from these activities must meet two criteria. First, they must be earned thru the “ordinary course of trade or business” and earned from the “erection or substantial renovation of real property” in the United States.
So, what constitutes ordinary course of trade or business? For construction type activities, it can be the selling or exchanging of real property within 60 days of the property’s completion date to unrelated parties. For renovation type activities, it must result in permanent improvements or betterments of a property.
Real property is defined as an inherent permanent structure other than land, such as buildings, roofs, dams, etc. For example, Big Time Construction Corporation is contracted to build an elevator in a hotel and install portable washing machines. At the end of the contract, the Company sold leftover electrical wires. The only eligible gross receipt from these activities is the construction of the elevator, for which it is qualified as a permanent structure of the hotel. Portable machines and inventory on hand do not meet the definition of real property.
Under section 199, the determination of a substantial renovation is determined using the same criteria as new tangible property regulations when assessing betterments and adaptations. Therefore, substantial renovation is work performed meeting at least one of the following general criteria:
Big Time Construction Corporation has two contracts to provide plumbing services to hotels. The Company repaired and replaced old pipes, which resulted in an increase of ten years of useful life to the pipe system for their first contract. For the second contract, they fixed ten leaky toilets. Since the first contract meets the useful life criterion, the Company should include the gross receipts in the calculation for the deduction. However, the Company may not include the gross receipts from the second contract as the activity does not meet the criteria and would generally be considered repair and maintenance activity for the property.
Section 199 also provides additional considerations for services related to construction activities. However, these services alone would not be eligible. The services must be incidental, necessary, and in connection with the erection or substantial renovation of real property to be eligible as domestic production gross receipts (DPGR). Below are examples of such activities:
Gross receipts from tangential and administrative support services are only eligible for the general contractor. However, gross receipts from land preparation activities are eligible to both general contractors and subcontractors. For example, General Builder, LLC is the general contractor contracted to build a new hotel. Big Time Construction Corporation is subcontracted to clear the land. In the process, Big Time Construction Corporation hauls trash. Big Time Construction Corporation may only include the gross receipt from clearing the land but not from hauling trash.
Does the Domestic Production Activities Deduction Apply on the State Level? Once the QPAI is determined and the taxpayer calculates the amount of the 9% deduction, the taxpayer is also subjected to a final limitation as noted above. The taxpayer must apply the Section 199 deduction to no more than 50% of W-2 wages paid to employees and officers. These wages must be associated with the generation of DPGR. Consequently, if there are no W-2 wages paid, then construction contractors are not eligible for the Section 199 deduction.
Some states disallow the DPAD. Relevant to the mid-Atlantic region:
Construction contractors with substantial business income from the construction or renovation of real property in the United States should consider the Section 199 deduction to reduce taxes. A best practice for contractors eligible for the deduction would include maintaining accurate accounting records that separate income and expense statements related to domestic production from non-eligible amounts.
For more information on this topic or Aronson’s Construction and Real Estate Practice, please contact Brian Ballard at firstname.lastname@example.org or 240.364.2675.
In part one of our indirect costs series, we focused on what indirect costs are and why they are important to contractors. In this post, we will discuss cost pools and how to develop an appropriate indirect cost rate to allocate indirect costs to your construction projects.
As discussed previously, indirect costs are costs that directly arise from contracts but are not easily attributable to individual projects. Due to this, a rate must be determined to allocate these indirect costs to particular jobs. Before determining a rate you must determine how to accumulate indirect costs into cost pools.
Understanding Cost Pools
A cost pool accumulates similar indirect costs to be allocated to individual projects based on the indirect cost rates developed. Examples of cost pools include equipment, labor burden, vehicles, etc. In developing and tracking cost pools, a company must ensure that the money attributed to cost pools are truly indirect costs and not direct costs or general and administrative costs.
Indirect costs must then be allocated in a consistent way once an indirect cost rate has been established. Examples of rates include those based on direct labor costs, direct labor hours, or equipment usage hours. These cost drivers should be matched to cost pools that have a strong relationship with the incurrence of these costs. Take the following scenario (expanding on the example in Part One):
Alternatively, using the same data, Contractor XYZ could have allocated the indirect costs using an indirect cost rate based on the equipment hours incurred throughout the year, compared to waiting until year-end to allocate the costs. The following example demonstrates this scenario:
This scenario provides a total of $230,000, of indirect costs allocated to the job when a total of $250,000 of costs was incurred. The contractor could decide to reallocate the costs to the projects or if total costs incurred where not material, the contractor could attribute the difference as under-applied. A contractor’s specific circumstances will determine what treatment is best.
Additional examples of matching cost pools to cost drivers include:
Correct indirect cost allocation is vital for accurate financial reporting, both internal and external, and to portray an accurate picture of contract status. Stay tuned for part three of our five part indirect cost series, “Indirect Costs – Contract Estimation and Change Orders”. For questions relating to the development of cost pools and indirect rates, please contract Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.
This is part one of a five-part series on indirect costs.
When contractors are accounting for contracts, it’s easy to account for the typical project costs that come from an invoice for tangible materials delivered to a site. However, other costs, known as indirect costs, are often forgotten in the planning and budgeting process. In a five-part series, we will explore the reasons why indirect costs are just as important, not only for a job’s success, but also for your company’s overall success.
In this initial article, we will delve into the definition of indirect costs and how they contribute to your overall profitability.
Direct Costs and General/Administrative Expenses
To define indirect costs is to first understand which items aren’t indirect costs: direct costs and general and administrative expenses. Direct costs are costs that can easily be directly identifiable with or attributable to a particular job. Examples of these costs include direct materials, direct labor, and subcontractor costs. For instance, a direct subcontractor cost is easily traceable to a job because the subcontractor would submit invoices from the particular job that they are working on.
General and administrative expenses unrelated to contract activity, such as general legal and banking costs are neither direct nor indirect costs, and are typically incurred regardless of whether or not a company has active contracts. Both direct labor and general and administrative costs are easily identifiable, whereas indirect costs are more difficult to determine.
Indirect costs are expenses that are directly identifiable as costs of construction but are not easily attributable to specific contracts. Examples include labor not directly attributable to any one job (i.e., a project manager working on multiple jobs in the office), contract supervision, tools and equipment, supplies, quality control and inspection, insurance, repairs and maintenance, depreciation, and amortization.
When compared to general and administrative costs, indirect costs would not continue to be incurred if the company had no contracts. For example, if a company had no contracts, then the machinery and equipment used on jobs would not incur any additional wear and tear; hence, no additional repair and maintenance costs. Take the following scenario:
In the example above, depreciation and repairs and maintenance are indirect costs because the equipment is used on multiple contracts and the amount for each contract is not easily determinable. Note that the indirect costs would be distributed among Contractor XYZ’s contracts based on an allocation rate, which will be discussed in part two of our indirect cost series.
“Why should I care about indirect costs?”
Proper cost allocation is important for a multitude of reasons, including:
As you can see, it is crucial for your construction business to properly account for indirect costs in order to have a long, profitable existence. Look out for the next article in our five part series on indirect costs, which will focus on developing an indirect cost rate. For more information on indirect costs and why they are important, contact Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.
In the first two articles in Aronson’s Tax Compliance Series for Construction Contractors, we explored the various methods of accounting available, as well as the lookback provision. This article will focus on the Long-Term Contract Adjustment (LTCA).
LTCA comes into play with our dear old friend, the Alternative Minimum Tax (AMT). The LTCA is an adjustment that must be computed on contracts that do not use the percentage of completion method of accounting. You must compute the gross profit earned on these contracts as if you were using the percentage of completion method and then compare it to your normal method. The difference between the two gross profits is the LTCA (positive or negative) used to determine your AMT.
There are two exceptions that exempt a contractor from computing this adjustment:
Compliance in this area is often overlooked or, due to their complexities, computations are performed incorrectly. You should determine if you are subject to the LTCA provisions each year considering your method of accounting and revenue threshold.
For more information on these common tax reporting issues, or to discuss how they may impact your construction business, please reach out to Chavon Wilcox, CPA, CCIFP, partner in Aronson LLC’s Construction and Real Estate Group at 301.231.6288.
Q. How do you file for a refund in Maryland for sales tax paid on purchases for exempt jobs in the District of Columbia?
A. Maryland requires contractors to pay sales tax on all purchases of materials that will be incorporated into real property as part of a construction contract. However, Maryland allows contractors to apply for a refund if the materials will be used for a contract in another jurisdiction where the same purchase would not have been subject to tax (e.g., a contract with a government agency in the District of Columbia). Virginia has a similar rule; however, the contractor can prequalify for an exemption from tax, rather than having to pay the tax upfront and apply for a refund after the fact.
Maryland has a standard refund application that is required when claiming a refund of sales and/or use tax; claimants are required to describe the reason for the claimed refund, including exemptions. Claimants must provide substantiation for the requested refund by attaching the receipts/invoices reflecting the tax paid, the contract to perform the work in the exempt area, and support for the exemption (e.g., sales tax exemption certificate of the customer).
Q. Where can I download the Maryland application for refund?
A. Maryland’s sales and use tax refund application (Form ST205) can be found on the Comptroller’s website.
Q. What are the time limitations on claiming a refund?
A. Every state has rules that limit the time for the filing of a refund claim. Typically, states allow refund claims to be filed for taxes paid within a three to four year period, depending on the state. Maryland, Virginia, and the District of Columbia all have three year limitation periods for the filing of a claim for refund. It’s important to keep in mind that if you have not paid use tax in a state and have never filed a use tax return that it is likely that there will be limitations on the years for which they can issue an assessment. The period of limitation for assessment purposes is only triggered once a return is filed.
Q. Does sales tax apply to repair services in Virginia and Maryland?
A. Most states only impose sales tax on services that are specifically listed as a service subject to tax. Neither Virginia nor Maryland imposes sales tax on repair services performed on real property. For repairs to tangible personal property, Maryland does not impose a tax on the labor. However, if separate charges are made for the materials incorporated in the property being repaired, Maryland requires that sales tax be collected on the charges for the materials. Under these circumstances, purchases of materials transferred to customers in connection with the repair work can be purchased tax-free by presenting the supplier a resale certificate.
Similarly, Virginia does not tax repair services. However, sales tax must be collected for materials and parts used to perform the repair. In order for the labor charges to remain exempt from tax, the contractor needs to separately itemize such charges on the customer’s invoice. If the contractor does not separately state the labor, then Virginia requires sales tax to be collected on the entire charge.
Q. Does sales tax apply to freight/shipping charges?
A. The taxability of freight varies from state to state. A number of states base the taxability of an item on the tax rules of its final destination. In these states, the shipping charge is considered part of the price of the taxable item. Further, many states do not tax shipping charges when the service is provided by a third party (i.e., not the seller of the items being shipping). Contractors are typically considered the consumer of goods purchased for incorporation in their construction projects.
Aronson recently held a webinar on sales and use tax for construction companies, highlighting the above topics and more. To view a recording of the webinar and ask more questions, please click here and fill out the brief registration form for instant access. For a review and analysis of your specific situation, contact your Aronson tax advisor or Michael L. Colavito, Jr. at 301.231.6200 or email@example.com.