March 2012

What Work Qualifies for the Domestic Production Activities Deduction?

One attractive tax break available to many construction companies is the domestic production activities deduction (DPAD), which is basically a tax deduction for a percentage of a company’s “qualified production activities income” (or taxable income, if less). The applicable deduction percentage is currently 9%.

A recent Tax Court decision* in favor of a construction firm clarifies some of the issues surrounding the DPAD and provides important guidance in several areas.

Case Background

The firm involved in the case is engaged in engineering and heavy construction activities, including erecting or rehabilitating bridges, streets, airport runways and other related real property. For the 2006 tax year, the firm reported $25.9 million in domestic production gross receipts (DPGR) for work it did on improving a series of old bridges and repairing other inoperable bridges. The work entailed adding lanes, ramps, driveways, traffic rails, bridge decks and retaining walls to existing roads.

The firm claimed its receipts from the bridge projects were eligible for the DPAD since the work consisted of erecting or substantially renovating real property. The IRS disallowed the deduction, claiming the firm had no DPGR for the year in question. The IRS said the firm’s work was routine maintenance that simply restored the bridges’ operating condition. The IRS also claimed the company was engaged in repair work since not all of the bridges’ components were replaced.

Repair or Substantial Renovation?

The distinction between “repair” and “substantial renovation” is important because activities performed in connection with a project to substantially renovate real property can qualify for the deduction. The DPAD regulations define substantial renovation as renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs its useful life or adapts the property to a new or different use.

Taxpayer Victory

The court ruled in favor of the construction firm and allowed the tax deduction. It noted that the receipts in question qualified as DPGR because the firm’s work:

• Materially increased the value of the bridges
• Significantly prolonged the bridges’ useful lives
• Helped adapt the bridges for new and different uses

*Gibson & Associates, Inc. 136 TC No.10

Can Your Company Qualify for a DPAD?

To claim the DPAD for construction work, a contractor must:

• Be engaged in the active conduct of a trade or business treated as a construction activity
• Carry out construction activities involving real property in the U.S.
• Derive DPGR from the construction activity

Real property includes buildings and inherently permanent structures (other than machinery) and their structural components, inherently permanent land improvements, oil and gas wells, and infrastructure. Structural components include walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators and escalators, and other similar property. Infrastructure includes roads, power lines, water systems, railroad spurs, communications facilities, sewers, sidewalks, cable, wiring and inherently permanent oil and gas platforms.

For More Guidance

The DPAD issue is quite complex. If you need clarification on this or any other tax-related issue, This e-mail address is being protected from spambots. You need JavaScript enabled to view it. .