Contractors Receive 3% Tax Credit on Profits

BY ROBERT P. MADER of CONTRACTORs staff WASHINGTON Contractors involved in construction or substantial renovations will be eligible for a 3% tax credit on their profits, beginning for work done this year. For every dollar in profit a contractor earns, he can deduct 3 cents and pay taxes on 97 cents. The catch is what exactly constitutes profits on construction or substantial renovation. As John McNerny,

BY ROBERT P. MADER of CONTRACTOR’s staff

WASHINGTON — Contractors involved in construction or substantial renovations will be eligible for a 3% tax credit on their profits, beginning for work done this year. For every dollar in profit a contractor earns, he can deduct 3 cents and pay taxes on 97 cents.

The catch is what exactly constitutes profits on construction or substantial renovation. As John McNerny, executive director/government and labor relations for the Mechanical Contractors Association of America, pointed out, people in Washington have been slicing this tax onion thinner and thinner for years. Here’s what is known for now:

The tax break is part of the American Jobs Creation Act of 2004, signed into law last fall by President Bush.

“When the legislation went through there was language in the conference report that said construction and structural renovations would be included,” said Lake Coulson, vice president/government relations for Plumbing-Heating-Cooling Contractors — National Association. “It’s really a bill for manufacturing — that’s the focus. They added construction into the bill, and we’re thrilled about that.”

The notice itself from the Internal Revenue Service is 150 pages, and the IRS issued a fact sheet highlighting significant features of the law. The fact sheet states the following about construction, under the headline, “What construction activities qualify for the deduction?”:

“Qualifying activities include construction and substantial renovation of real property, including residential and commercial buildings and infrastructure such as roads, power lines, water systems and communications facilities.

“The statute does not provide that qualifying gross receipts for construction activities must be derived from a lease, rental, license, sale, exchange or other disposition of the property. As a result, a taxpayer engaged in construction activities may qualify for the deduction even if the taxpayer does not have the benefits and burdens of ownership of the property being constructed. Therefore, more than one taxpayer may be regarded as constructing real property with respect to the same activity and the same construction project. For example, a general contractor and a subcontractor may both be engaged in construction activities with respect to the installation of a roof on a new building. Each taxpayer’s benefit will be a percentage of its profit on its work with respect to the installation of the roof.”

For 2005, the deduction equals 3% of the lesser of taxable income derived from the qualified production activity or taxable income for the year, MCAA reports on its Website. However, the deduction for a taxable year is limited to 50% of the W-2 wages paid that year. In 2010, when the deduction is fully phased-in, the 3% rate will have increased to 9%.

The broad law applies across a number of industries. The activities eligible for the deduction include not only the manufacture of personal property such as clothing, goods and food, but also software development; film and music production; production of electricity, natural gas or water; construction; and engineering and architectural services.

Coulson said he believes it covers much of what contractors do.

“It’s construction or substantial renovation that includes real property so long as it results in a permanent improvement or betterment such that it must be capitalized,” he said. “So that would be renovation of a major component or part. If a homeowner changes a bathroom, for example. But I don’t know where this ends. Say if somebody puts a hot tub in his backyard, that’s a permanent improvement, and I would argue it materially improves the value of the property. It seems to apply to a lot of the stuff our guys do.”

McNerny, noting how obtuse the IRS can get, said he isn’t exactly sure what will qualify. What about a design/builder? Would the tax break apply only to a portion? What about prefabrication, McNerny asked. What about profit on owner-purchased equipment?

“It would be nice to get the IRS to think out loud about this in its regulatory guidance,” McNerny said.

The IRS guidelines issued in January are actually part of a larger IRS rulemaking process, he noted. The final regulations may not be in place until the end of 2005.

“The Treasury Department and IRS request comments on the rules contained in the Notice and any additional guidance that should be provided in the regulations,” the agencies state in their fact sheet. “Written comments must be received on or before March 31, 2005.”

Industry associations indicated that they plan to submit comments.