First, who is eligible for tax deductions under Section 199? Any corporation, partnership, individual or other business entity may claim this deduction provided it is for a qualified production activity. Section 199 does not apply to sole proprietors but the tax benefit can be passed through to individuals by Subchapter S corporations, partnerships and limited liability companies not taxed as corporations. For pass-through entities, the deduction applies at the partner or shareholder level. Each partner or shareholder computes its share of qualified production activities according to its distributive or proportionate share of pass-through entity items.
In 2005, the available deduction was three percent (3%) of the lesser of: (a) taxable income from the “qualified production activity”; or (b) taxable income for the taxable year. From 2007 through 2009, the deduction increased to six percent (6%) of taxable income. In 2010, the deduction has increased to nine percent (9%).
In order to receive the deduction, the activity must come from “qualified domestic production activities”. What are “qualified domestic production activities”? Examples could include:
- Manufacturing activities based in the U.S. that are:
- Selling, leasing or licensing items that have been manufactured, produced, grown or extracted in the U.S.
- Selling, leasing or licensing motion pictures, television shows, music and photography that have been produced in the U.S.
- Construction of real property in the U.S. including building and renovation of residential and commercial properties
- Engineering and architectural services performed in the U.S. that relate to the construction of real property in the U.S.
- Software development in the U.S., including the development of video games.
Applicability to Software Industry
Because the purpose of the Act is to create jobs in the U.S., all, or a significant part, of the product production must take place in the U.S. Applying the Act to the software industry, the focus is to encourage software development in the U.S. rather than offshore. In 2004, when the Act was passed, there was considerable debate regarding development of on-line software. Income received from software provided on a disc automatically qualifies under Section 199. However, for on-line software that is not provided on a tangible medium, the debate continued into 2007. A barrage of comments from the software industry asked that the distinction for on-line software be removed. However, the Treasury Department issued final regulations that did not adopt that suggestion.
Taxpayers that create computer software and offer access to it for a consumer’s direct use while connected to the Internet are the ones most affected by the regulations presented by the Treasury Department. New temporary and proposed regulations provide that receipts from providing software for customers’ direct use online will qualify if (a) the software provider also sells a substantially identical product on disk or by download or (b) an unrelated party sells a substantially identical product on disk or by download. For this purpose, all computer games are considered substantially identical. The final regulations add a new exception for embedded computer software maintenance agreements that entitle software users to receive future updates, cyclical releases, rewrites of the underlying software or customer support services.
The commentary from the IRS and Treasury Department recognized that the trend is to provide software on-line but they distinguished between software provided on-line and software downloaded or on a tangible medium. However, by associating eligibility under Section 199 with the distribution method for the software, the government does not recognize that trend in the regulations. Software must be provided on a tangible medium, such as a disc, or it must be downloadable to qualify under Section 199.
Applicability to Real Estate Industry
When issuing the final regulations regarding Section 199, the Treasury Department provided clarification on the scope of the deductions available under Section 199 for construction and real estate development. For example, they expanded on the definition of real property to include buildings, inherently permanent structures, land improvements and infrastructure, including structural components and inherently permanent structures (including walls, wiring, central air conditioning and heating systems, pipes and ducts and comparable property). However, items such as bricks, nails and paint are not eligible as they are not considered to be real property.
Construction activities do include services incidental to performing construction activities. Incidental administrative support services (for example, billing and secretarial services) are now considered construction services performed by the taxpayer. A similar extension of qualified activities applies to engineering and architectural service firms. Originally, Section 199 provided that, for example, if an electrical contractor installed wiring in a building, the contractor would have been required to segregate installation from materials. Under the final regulations, both the materials and installation charges will be considered construction qualifying activities under Section 199.
The final regulations apply the same rule to grading land and demolishing structures that applies to landscaping and painting. Any activities that transform land and are performed in connection with erecting or substantially renovating real property are deemed to be construction activities for purposes of Section 199.
In summary, for construction and real estate development, there are three revenue generating activities that qualify for the Section 199 deduction:
- The taxpayer must currently conduct construction activities on a regular, on-going basis;
- Such activities must involve real property located in the U.S. Infrastructure improvements also qualify which could include sewers, sidewalks or roads.
- Revenues must have been generated from performing construction services on real property (so the sale of the land itself does not generally qualify). Landscaping, painting, demolition, project management or other similar services may qualify if they are part of a larger project.
Anyone who is considering taking advantage of the Section 199 deduction should evaluate their business and check with their tax advisors as to what extent, if any, their business activity qualifies. If some, but not all, of your business activities qualify, you must be able to identify the qualifying income and separate it from the non-qualifying revenue. Because of the breadth of the Act, you may qualify, under Section 199 for deductions.