Significant new tax deductions for architects, contractors and engineers- a well-kept secret

By Kimberley K. Higgins, CPA, Partner, and
Stephanie Gaitten, CPA Senior Tax Manager

Architects, engineers and contractors who provide services related to real property may not know it yet, but they have just been given one of the largest tax breaks in recent memory. There has been relatively little ‘buzz’ about the new law, as few businesses and tax professionals have yet to realize the scope of the new deduction. This lack of awareness is possibly because the deduction, misleadingly known as the ‘manufacturing deduction,’ could give rise to confusion over which businesses actually benefit. Congress, with new interim guidance, has made their intent clear to make this new deduction available to as many U.S. businesses as possible.

The new deduction, which is available to taxpayers beginning in 2005, was added to the Tax Code by the American Jobs Creation Act of 2004 (2004 Jobs Act). When Congress was faced with replacing the old Foreign Sale Corporation/Extraterritorial Income regime, which the World Trade Organization declared an illegal trade subsidy since it primarily benefited large American exporters and mega manufacturers, they enacted a more extensive deduction, rather than create a new deduction just for exporters. Calling it a ‘manufacturing deduction’ or a tax break for production activities appears to leave out many businesses eligible for the deduction, since almost every industry that produces something is eligible for the tax break.

The deduction equals three percent of taxable income from production activities or taxable income, whichever is less. It rises to nine percent in 2010 when it is fully phased in. The deduction is then limited to 50% of W-2 wages paid by the taxpayer. Only ‘qualified production activities’ are eligible for the tax break. Congress has expanded the definition of "qualified production activities" beyond exporters or traditional manufacturers so that producers, growers and extractors of tangible personal property qualify. This has far-reaching implications for the whole economy in that software development, music recordings, electrical, natural gas and water systems production and construction also qualify. While the calculations can be quite complex, Congress has enacted safe harbors and de minimis rules that target smaller businesses, to ease the burden of these calculations.

The benefit was extended to many businesses not traditionally considered manufacturers who are not exporters or a multi-national company with overseas factories. In the case of architects and engineers, special interest groups added this benefit.

“Manufacturing” activities eligible for the deduction include Construction or substantial renovation of real property in the U.S. including residential and commercial buildings, roads, power lines, water systems, communications facilities and other infrastructure projects. Architectural and engineering services performed in the U.S. and related to construction of real property are also eligible. This would include mechanical and electrical engineering contractors as well as general contractors.

A construction company or an architectural firm reading about the deduction in the media might not think they qualify, since they don’t normally think of their activities as ‘manufacturing,’ yet construction is broadly categorized as including residential and commercial construction. Take the example of a contractor who owns a custom home building company and builds homes for the affluent in Metro Denver, does not own a factory, and has never done any business outside of Denver, let alone overseas. Yet the 2004 Jobs Act considers this company to be a ‘manufacturer,’ and the profits from its manufacturing are entitled to be sheltered by the manufacturing deduction, to the same extent as a giant automaker. The same would apply to an architectural firm that ‘manufactures’ plans for buildings.

Generally, only a taxpayer with the benefits and burdens of ownership of the tangible personal property during the manufacturing process will be treated as the manufacturer. However, construction is different and multiple taxpayers may benefit from the deduction. Qualifying production activities generally must be done in whole or in significant part in the U.S. What is significant is if the activity is substantial in nature. What is substantial depends on the facts and circumstances: the relative value added by the activity, the nature of the property and the nature of the activity performed by the taxpayer in the U.S.