Applying the U.S. Production Activities Deduction to Construction Companies

By Brad Gross

The American Jobs Creation Act of 2004 affords taxpayers engaged in U.S. production activities a new deduction called the U.S. Production Activities Deduction. Construction is included in the definition of production activities, providing a free deduction-and tax savings.

The production activities deduction is calculated as a percentage of the net income from U.S. construction activity. For 2005 and 2006 tax years the deduction is 3 percent. It will change to 6 percent for 2007, 2008 and 2009, and 9 percent in 2010 and succeeding years. Using the top corporate tax rate of 34 percent, the deduction will save construction companies a maximum of 1.02 percent in taxes in 2005 and 2006, 2.04 percent in 2007, 2008, and 2009, and 3.06 percent in 2010 and beyond. The deduction is available to all construction companies, not just corporations, so that partnerships and sole proprietorships may also receive the deduction.

The PAD is formally called the U.S. Production Activities Deduction because it is calculated as a percentage of the net income of the taxpayer from U.S. qualifying activities. If the taxpayer has foreign production activities, these would not qualify for the deduction. Companies with international projects need to segregate those projects from U.S. projects to calculate the PAD. Also, companies with both qualifying construction activity and non-qualifying activities such as maintenance, repair and cosmetic remodeling services, will be required to calculate the net income from the qualifying services separately to calculate the PAD.

Limits on the Deduction In keeping with the title of the American Jobs Creation Act of 2004, the PAD is limited to 50 percent of the W-2 wages paid. Therefore, sole proprietorships or partnerships with all the work done by the owners would have no W-2 wages and would not qualify for the PAD. Consider the following example. A small construction company has a net income of $300,000 in 2005. As a partnership, all of the construction work is being done by two owners. They also have a receptionist on the payroll earning $20,000 annually. So, a PAD of $9,000 is allowed. Since the $9,000 PAD is less than 50 percent of the $20,000 W-2 wages, or $10,000, the PAD is allowed in full.

A second limitation applies primarily to sole proprietorships, partnerships and S corporations but could also apply to companies with qualifying and non-qualifying activities. This is known as the taxable income (modified adjusted gross income for individuals) limitation. A C corporation with a loss for the year, and which has only qualifying construction activity, will, by definition, have no net income on which to calculate the PAD. A C corporation with qualifying activity net income, but with losses from non-qualifying activities, will have its PAD limited to the taxable income of the company.

Pass-through entities such as S corporations and partnerships calculate the PAD and the "W-2 wages paid" limitation at the entity level, and report the allocated share to each owner. The individual owners must then calculate the modified adjusted gross income limitation to determine if they may take the PAD. Just like C corporations with qualifying and non-qualifying activities, individuals with losses from other ventures could find their PAD limited. The PAD is an "above the line" deduction attributed to the trade or business of the taxpayer, not an itemized deduction. However, it is not allowed for self-employment tax purposes.

Alternative Minimum Tax The PAD is allowed for AMT purposes, but the taxable income limitation for C corporations is revised for AMT purposes to be alternative minimum taxable income determined without regard to the PAD.

Affiliated Groups Affiliated groups are treated as a single corporation for purposes of the PAD. The definition of an affiliated group is determined by the definition in Internal Revenue Code Section 1504(a), expanded by substituting 50 percent for 80 percent each place it appears in the definition. The calculation of the PAD is made by determining the qualified production activities income for the group, allocating it to the members in proportion to the amount each contributed to the group total. In the case with two group members with profits, and one with losses, the profits would be added together with the losses, the PAD calculated, and allocated only to the two profitable members. One benefit of this rule is that the "W-2 wages paid" limitation is calculated at the group level, including the W-2 wages of members with no qualified production activity.