Are You Maximizing the Section 199A (Pass-Through) Deduction?
As a construction business, your company may be eligible for the Section 199A deduction for “domestic production activities.” This tax break is known by several names, including the “domestic production activities deduction” and the “manufacturers’ deduction.”
In fact, many contractors overlook the Sec. 199 deduction because they believe it’s only for manufacturers. But it’s also available for “construction of real property performed in the United States” by a taxpayer “engaged in the active conduct of a construction trade or business.”
Claiming the Deduction
The Sec. 199 deduction is equal to 9% of the lesser of: 1) your qualified production activities income (QPAI) for the year, or 2) your taxable income (before taking the deduction). For individual taxpayers, adjusted gross income is used instead of taxable income. The deduction is capped at 50% of your company’s W-2 wages attributable to qualified production activities.
Determining your QPAI can be complicated but, generally, it’s your net income from constructing or substantially renovating buildings or other real property. It may also include net income from certain construction-related activities, such as management, land improvements, installing building components (such as HVAC systems or plumbing), delivering materials, hauling debris or providing administrative support.
QPAI doesn’t include income from construction activities outside the United States, sales of land or tangible personal property (other than certain construction materials and supplies), real property rentals, repairs or cosmetic work.
Note that, for pass-through entities such as S corporations and partnerships, the Sec. 199 deduction is determined at the shareholder or partner level.
Boosting your Benefit
Depending on the nature of your construction business, you may have opportunities to boost the benefit of the deduction. Here are some strategies to consider:
Evaluate your accounting system. It can be challenging to distinguish between qualifying and nonqualifying construction activities and then allocate revenues, expenses, deductions and losses between them. Ensure that your accounting system has the ability to track this information.
Increase W-2 wages. Because the Sec. 199 deduction is limited to 50% of W-2 wages, you can boost your deduction by increasing those wages. There are several ways to do this, including:
- Hiring more employees,
- Converting independent contractors into employees, or
- Paying bonuses to employees involved in qualified production activities.
If you’re a sole proprietor with no employees, consider incorporating your business and paying yourself a salary.
Use separate entities. If your business is involved in both qualified and nonqualified production activities, consider using a separate entity for qualified activities. This makes it easier to segregate the revenues, wages and other expenses attributable to qualified activities and can help increase your Sec. 199 deduction.
Restructure your compensation. Consider this example: George is the sole shareholder of a construction business organized as an S corporation. The company’s net income is $600,000, all of which is QPAI, and it has W-2 wages of $800,000, including George’s $300,000 salary. His taxable income before the deduction is $900,000 ($300,000 in wages plus $600,000 in pass-through income). Thus, the Sec. 199 deduction is $54,000 (9% of $600,000), reducing his taxable income to $846,000.
Now suppose George reduces his salary to $100,000 and receives a $200,000 distribution. This increases his company’s QPAI to $800,000. His taxable income before the deduction is still $900,000 ($100,000 in wages plus $800,000 in pass-through income). But the Sec. 199 deduction is increased to $72,000 (9% of $800,000), and George’s taxable income drops to $828,000.
Ensure that your accounting system has the ability to track all of the pertinent information.
In addition to increasing the value of the deduction, reducing George’s salary also lowers the company’s payroll taxes. (This assumes his new salary is considered reasonable. Work with your tax advisor to establish such an amount.)
Doing your Homework
As you can see, the Sec. 199 deduction’s benefits can be significant. So, as a contractor, it pays for you to do a little homework to determine whether you qualify and, if so, how you can get the most from it.