Transcript DPGR – Construction Receipts

ABA Tax Section 2005 Fall Meeting
Committee on Sales, Exchanges, and Basis
New Proposed 199 Regulations:
How They Affect the Structure of
Real Estate Transactions
•George Manousos, Department of Treasury, Washington, DC
•(202) 622-1335
[email protected]
•Todd Reinstein, Pepper Hamilton LLP, Washington, DC
•(202) 230-5115
[email protected]
•Virginia Stevenson, Kennedy Covington Lobdell & Hickman, LLP, Charlotte, NC
•(704) 331-7512
[email protected]
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Code § 199 Background
-- Created in 2004 as part of the American Jobs Creation Act of 2004, P.L. 108-357
-- Drafted in response to repeal of export subsidy provisions
-- Unlike former export subsidy provisions, benefit of Code section 199 extends to
taxpayers engaging in solely domestic production
-- Preliminary guidance was contained in Notice 2005-14, 2005-7 I.R.B. 498, which
was issued on January 19, 2005
-- Proposed regulations are expected any minute, but were not available as of
September 14, 2005
-- Effective dates:
Statute is effective for TYs beginning after December 31, 2004.
Notice 2005-14 is also effective for TYs beginning after December 31,
2004.
The effective date of the regulations is unknown at this point, but may be
important for issues that the regulations treat differently than Notice 20052
14 did.
What Are The Transition Rules?
•
Reliance on Regs or Notice?
•
What if taxable year end is September 30, 2005?
•
What if taxable year end is June 30, 2005?
•
What if person is partner / S Corp shareholder in entity that has a FY
ending 9/30/2005. 199(b)(2) says that W-2 wages passed through are
those incurred during the CY that ends during the TY in issue. Are the
share of W-2 wages passed through for the FY starting 10/1/2005 to
include only those paid in October, November, and December or all
2005 W-2 wages?
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Code § 199 Basics: Definitions
Main Definitions:
QPAD = Qualified Production Activities Deduction (i.e., the 199 deduction) =
QPAI x applicable % (subject to caps and other limitations)
QPAI = Qualified Production Activities Income = DPGR minus various costs
DPGR = Domestic Production Gross Receipts (from domestic construction,
engineering and architectural services, and from the lease, rental, license, sale,
exchange or other disposition of domestically produced QPP)
QPP = Qualified Production Property (n.b., this is generally tangible personal
property or “TPP;” this is less relevant to our discussion, which focuses on income
from domestic construction services)
Also:
EAG = Expanded Affiliated Group (a concept for corporations that does not apply to
pass-through entities or their owners) 50% for attribution
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Code § 199 Basics: QPAI
Equation:
QPAI = DPGR – Costs(*)
(*) For 199, this is the sum of
(1) cost of construction / COGS allocable to DPGR,
(2) other deductions, losses, and expenses directly allocable to DPGR,
and
(3) a ratable share of other deductions, losses, and expenses
Most construction receipts are derived from:
-- construction activities
-- TPP components installed by the taxpayer or subcontractors
-- land (which may have appreciated since its purchase and which is also
excluded from DPGR)
QPAI is to be determined on an item-by-item basis, but we are looking to the
Proposed Regulations for a definition of item and how to apply it in the real estate /
construction / development context.
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Code § 199 Basics: QPAD
QPAD: 199 allows a deduction of the
lesser of
a fraction of QPAI for the tax year, or
taxpayer’s TI (or , if individual, AGI) or AMTI
Deduction fraction is
Note:
3% for TY beginning in 2005 and 2006
6% for TY beginning in 2007, 2008, and 2009
9% thereafter
CY taxpayers can take the deduction for all of 2005
FY taxpayers can take the deduction for the period of 2005 included in
their TY that ends in 2006
Deduction is further limited to a maximum of 50% of the W-2 wages paid by the
taxpayer during the taxable year. How does this affect individuals with very small
sole proprietorships
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Getting to QPAI: Cost Allocation Rules
To determine QPAI, taxpayers must reduce their qualifying gross income
(DPGR minus COGS) by allocable “below the line” period costs.
If gross receipts > $25 million, this is based on the allocation and
apportionment rules contained in Treas. Reg. for Code section 861.
These regulations allocate deductions between US-source and foreign
source income for purposes of sourcing items of income between
foreign and domestic sources. These allocations are based on factual
relationships that exist between the expense and categories of
income.
These regulations are not typically used by domestic construction
firms!
Treasury received many comments from the construction industry calling for
relief from these rules since many are purely domestic businesses that do
not have any experience in dealing with these rules.
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DPGR: Which Construction Receipts Count?
Four requirements for gross receipts from construction to count as DPGR:
1. The taxpayer must be engaged in a construction trade or business
2. The taxpayer must engage in “construction activities”
3. The construction must be related to “real property”
4. The gross receipts must be derived from construction
Gross receipts do not include $ attributable to land!
Note: this is different than subtracting land cost from DPGR – receipts
attributable to intervening land appreciation are also excluded, even if
that is something that is usually never quantified in the taxpayer’s
ordinary course of business.
All other 23-NAICs code taxpayers get DPGR for receipts related to
their raw materials and inventory.
N.b. Capital gain treatment far preferable to individuals than QPAD, so
adding land component to DPGR not thought to be abusive. See E&Y,
PwC, KPMG Joint Comment Letter 7/14/2005; ABA Tax Section
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Comments (2005 TNT 136-51)
DPGR – Construction Receipts
Requirement 1: The taxpayer must be engaged in a construction trade or business
Per Notice 2005-14,
a taxpayer must be in a trade or business that is considered construction for
purposes of the NAICS.
•
n.b., this is not in the statute but confirmed in a pending technical
corrections bill (Tax Technical Corrections Act of 2005, S. 1447 and H.R.
3376)
•
http://www.census.gov/epcd/naics02/naicod02.htm
•
This is one of the most controversial aspects of 199.
•
It remains to be seen what the regulations will say with respect to this issue.
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DPGR – Construction Receipts
Requirement 1 – NAICS – Open issues:
Thus:
The expenses of self-construction by a non-23 NAICS code taxpayer not only
have no associated receipts (so no DPGR); but also fail the NAICs code hurdle
in any event (e.g., the sales proceeds from an apartment building that was built
with in-house labor upon its sale or condominium conversion)
Questions:
For some taxpayers, perhaps it is time to have a division that will qualify for a
23-NAICS code if that requirement survives in the regulations
On the other hand, if hiring out construction to a 23-NAICS code taxpayer
generates a QPAD, should that benefit be factored into the cost that customers
to pay (thus discouraging self-construction if the benefits of the QPAD are
passed along to the customer)? It remains to be seen how the benefits will be
shared between 23-NAICs code businesses and their customers.
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DPGR – Construction Receipts
Requirement 2: The taxpayer must engage in “construction activities”
Which construction activities count?
Per Notice 2005-14 Sec. 4.04(11)(a), the “erection or substantial renovation” of real
property (not tangible personal property), and inherently permanent land
improvements and infrastructure (e.g., roads, power lines, water systems,
sewers, sidewalks, cable, wiring, and communication facilities).
“Substantial renovation” = the renovation of a major component or substantial
structural part of the property that either materially increases the property’s
value, prolongs its useful life, or adapts the property to a new or different use.
Think in terms of Code § 263(a) and 263A: what has to be capitalized v. what may
be deducted:
structural improvements  “construction activity”
painting  not “construction activity” unless in conjunction with a larger
project that qualifies
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DPGR – Construction Receipts
Requirement 2 – Which construction activities count?
n.b., for expenses that wouldn’t otherwise qualify for 199, if they are performed
in connection with a larger project (i.e., the erection or substantial renovation of
real property) they will qualify for a QPAD even if different activities are
performed by different taxpayers; however, this never applies to tangential
services (e.g., trash hauling) unless done by taxpayer that also performs
construction activities
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DPGR – Construction Receipts
Requirement 3: The construction must be related to “real property”
Real property: residential and commercial buildings and structural components,
inherently permanent structures, inherently permanent land improvements,
infrastructure
State law is not determinative!
Not: machinery
De minimis safe harbor in Notice 2005-14: if > 95% of the total gross receipts from
the sale of a construction project are derived from real property (as defined in
1.263A-8(c)), then the total gross receipts are treated as all DPGR from
construction. The safe harbor should let taxpayers avoid having to allocate
between DPGR and non-DPGR on most construction projects (n.b., land still
never gets de minimis treatment).
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DPGR – Construction Receipts
Requirement 4: The gross receipts must be derived from construction
1. Compensation received for performing construction services
and
2. Proceeds from the sale, exchange, or other disposition of real property
constructed by the taxpayer (regardless of when this occurs in relation to the
construction date)
Observations:
Income from property leasing does not count. Nevertheless, gain on the later sale
of the property may qualify if all the requirements are met per the Notice. Can
selling or turning an apartment building or hotel into a condo conversion get
around this? What about the SIC code issue?
Improving the land (e.g., landscaping, painting and grading) is considered to be a
construction activity if it is performed in connection with other activities (whether
or not by the same taxpayer) that constitute the erection or substantial
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renovation of real property.
EAG Allocation
EAG = Expanded Affiliated Group; all corporations are members of an EAG if you
use 1504(a) and can substitute 50% for 80% (n.b. pending technical corrections
bill changes “50%” to “more than 50%”)
1. Each member of an EAG computes its separate QPAI, taxable income, and W-2
wages
2. QPAI, taxable income, and W-2 wages are aggregated at the EAG level.
3. The EAG multiplies the applicable percentage (3% for taxable years beginning
after 2005, etc.) by the lesser of the EAG’s aggregate QPAI or aggregate taxable
income to get the total QPAD.
4. The EAG’s QPAD is the allocated among its members in proportion to each
member’s relative amount of contributed QPAI.
Thus, an EAG member with a loss that contributes QPAI to the group could
theoretically receive a portion of the deduction and thus increase its loss for that
year.
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Open EAG Allocation Issues
What happens if an EAG has some members that have 23-NAICS codes and some
that do not?
Note that a member with negative QPAI will reduce the QPAD available to other
members of the EAG – is this the right result if the business generating the
negative QPAI would be barred from taking a QPAD because of its NAICS code?
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Pass-Throughs
The QPAD attributable to activities of a partnership or S corporation is determined
at the partner or S corporation shareholder level, not at the entity level.
Each partner/S Corp shareholder is allocated its share of items (including items of
income, gain, loss or deduction) allocable or attributable to qualifying production
activities of the pass thru entity.
Allocation of W-2 wages: a partner / S Corp shareholder is treated as having been
allocated wages from the entity in an amount equal to the lesser of (1) the
person’s allocable share of wages (per regulations yet to be issued) or (2) twice
the appropriate deductible percentage (i.e., 3%, 6%, 9%) of QPAI that is
allocated to such person for the TY. We aren’t yet sure how Schedule Ks are
going to handle this.
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Pass-Throughs
Each partner/S Corp shareholder must then aggregate its share of these items from
this qualifying activity and items from any other qualifying activities in arriving at
its QPAD.
Special allocations of 199 items.
It appears that there can be special allocations of 199 items, subject to the usual
rules for substantial economic effect.
Use of 199 items may be further limited by passive activity rules and at-risk rules
that limit a partner / S Corp shareholder’s ability to use QPADs, especially if the
taxpayer belongs to several partnerships or S Corps.
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General Contractor/Sub-Contractor DPGR Issues
Notice 2005-14 states that qualifying gross receipts from construction activities
need not be derived from a lease, rental, license, sale or exchange, or other
disposition of property; they can also be from performing services.
Unlike other manufacturing activities, taxpayers engaged in construction may claim
the deduction without having the benefits and burdens of ownership of the
property being constructed. Thus, more than one taxpayer may be regarded
as constructing real property with respect to the same project.
Situations where a general contractor hires a sub-contractor to perform the work will
qualify for a QPAD for each. See example in Sec. 3.04(11)(e)(1) of the Notice.
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Deposits
Deposits received by developers:
-- Per Notice 2005-14, developer must use a “reasonable method” for
determining whether deposits constitute DPGR
-- Many residential developers have pre-construction sales as a means of
securing financing for a project.
-- What if the deposit is received in 2005 for a townhouse to be delivered in
2006? If it is included in 2005 DPGR, there are not necessarily any offsetting
costs in 2005 – does this distort income? Will the regulations address this?
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Homeowner Warranties
For tangible personal property (TPP), embedded services are generally excluded
from DPGR. One exception to this is for services related to warranties that are
provided in connection with the sale of TPP as long as the warranty was sold in
the normal course of business and was not separately offered or bargained for.
Thus, the expenses associated with the warranty on a waffle iron is disregarded
in the waffle iron maker’s DPGR.
What about the homeowner’s warranty that is required by law on new construction?
Stay tuned! This issue was discussed on comments submitted and may be
addressed in the regulations.
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Open Issues – Developers & Land Costs
People who are basic developers . . . Buy land, add utilities and roads, subdivide
and sell lots to individuals who may or may not build a house there  DPGR
here?
1.
2.
3.
4.
Is developer engaged in a construction trade or business
(NAICS)?
Was there “construction activities” – inherently permanent land
improvements?
Did the construction activity relate to “real property?”
Were the gross receipts derived from construction (and not from
land?)
Teardowns – buy real property, demolish existing structure. Does any basis from
the original purchase then get allocated to the land or to the new improvements?
How does this work w/ no DPGR for land?
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Open Issues – W-2 Wage Limitation
The statute limits the amount of the deduction to 50% of the taxpayer’s W-2 wages
paid during the calendar year that ends within the taxable year.
-- LLC with no employees that subs out everything
-- what about person who is in a pass-though that pays no wages (and person isn’t
otherwise in construction business)
-- think of FLP scenarios
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General Open Issues
What about a developer who gives land for a park and a school in exchange for
rezoning?
What about a contractor who builds on another’s land?
What about a developer who builds on land the developer already owns? What if it
is already the customer’s land?
A final note on TPP:
To the extent that there is TPP, subcontractors and others involved in construction
must also classify receipts between TPP and construction services activities
based on:
-- who had the benefits and burdens of TPP during its manufacture
-- who had the benefits and burdens of TPP when installed
-- portion of receipts from construction services activities
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Example 1
Farmer has land that is now valuable for residential development. Farmer has been
approached by Developer. What should Farmer do in light of 199?
-- Farmer is an individual who can benefit from the capital gains rates on the
sale of his land. If he sells his land in bulk to Developer, he can get capital gains
rates on the sale.
-- Farmer and Developer may form Joint Venture to develop the land. Joint
Venture had no employees but contracts with Developer’s firm and
subcontractors to grade the land, add utilities, and build houses (so Developer
and the subcontractors generate DPGR). As houses are sold, Joint Venture has
DPGR.
-- Developer takes his share of Joint Venture DPGR and W-2 wages (and may
have the same from other sources) . . .
-- Farmer takes his share of Joint Venture DPGR and W-2 wages in determining
his QPAD (subject to the limitations discussed on slide 6)
-- Query whether Farmer can argue that he is a developer in that he is a joint
venturer in a development business. What if some of Developer’s employees
and subcontractors are reclassified so that they get a W-2 from Joint Venture?
Could that increase Developer’s QPAD?
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Example 2
Which construction activities count?
Developer Co (SIC code 236117) sells house to Buyer
In the construction of the house:
buys land from Landowner
hires Grader Co (SIC code 23721) to grade and put in streets, sewer, cable and
electrical lines
does some construction work in-house
hires Tile Co (SIC code 23834) and other subcontractors
Which expenses are counted for 199 for Developer Co?
Which subs have DPGR that also counts towards QPAI?
Isn’t this double counting?
What if all work had been subcontracted out by Developer Co? Any change?
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Example 3 -- NAICS
NAICs code application issues:
Compare what happens to a construction business that is:
-- an individual taxpayer
-- an individual taxpayer who has several trades and businesses
-- an individual who is an active participant in a partnership that has a 23-NAICs
code
-- that individual’s children, who are limited partners in that partnership (and do not
participate in the business)
-- part of an EAG, most of the members of which are not in 23-NAICs code
businesses
-- just in the business of assembling pre-fab houses on lots owned by the
homeowner (does this depend on risk of loss?)
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Example 4
Consider the treatment of these taxpayers
A developer who buys land, rezones it, develops it, and sells lots.
A contractor who hires subcontractors and performs construction activities.
A developer who sells finished houses directly to individuals.
A contractor who meets the “substantial transformation” test for remodeling an
existing structure.
A landscaper (does the work make a difference: hardscaping v. planting trees (v.
planting trees in the context of a total neighborhood development from raw
land)?).
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Example 5 – Later-Arising DPGR
Plaza Hotel example:
-- A hotel is built as a hotel.
-- It closes for a substantial renovation, after which reconfigured units will be sold
pursuant to a condominium conversion.
-- The substantial renovation expenses, even if done in-house, should qualify the
owner for a 23-NAICs code and the receipts from the condominium sales should
generate DPGR for a QPAD.
-- Even if the substantial renovation occurred before the enactment of 199, the
condominium sales should still generate DPGR. It is the timing of DPGR in a
post 12/31/2004 TY that governs, not when the construction activities occurred.
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