New Section 199 Domestic Production
Deduction and How It Applies to the
Construction and Real Estate Industry
By Pat Derdenger
www.steptoe.com
May 3, 2007
History and Background
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Passed as part of the American Jobs Creation Act of 2004 and
codified at 26 U.S.C. § 199.
Replaced the old Foreign Sales Corporation/Extraterritorial
Income Regime.

Broader application.

Focuses on domestic manufacturing and production rather
than exports.
Department of Treasury proposed regulations in November
2005.
With some changes, final regulations adopted in May 2006.

Became effective on June 1, 2006.

To be codified at 26 C.F.R. §§ 1.199-1 through 1.199-9.
2
Overview
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Effective tax years beginning after December 31, 2004.
Deduction calculated as a percentage of the lesser of:

Total taxable income OR

Net income derived from qualifying activities.
Full deduction phased in between 2005 & 2010.

3% for 2005-2006.

6% for 2007-2009.

9% beginning in 2010.
LIMITATION: deduction may not exceed 50% of the taxpayer’s
W-2 wages paid during the applicable tax year.
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Terminology
Qualified Production Activities Income
QPAI
 Net income from qualifying activities is called

Qualified Production Activities Income OR
QPAI.
QPAI is statutorily defined as: domestic
production gross receipts minus the
sum of costs of goods sold allocable to
those receipts plus other expenses,
losses and deductions allocable to those
receipts.
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Terminology
Domestic Production Gross Receipts
DPGR

Domestic Production Gross Receipts as defined by
statute determine eligibility for the deduction.

Receipts from three broad categories of activities
qualify as DPGR:
1. manufacture, production, cultivation or extraction by
the taxpayer in the U.S.
2. architectural and engineering services provided in
conjunction domestic real property construction.
3. the construction of real property in the U.S.
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Applicability
Most residential and commercial contractors
and subcontractors will qualify for the Domestic
Production Deduction because they will have
income that meets the statutory and regulatory
definitions of DPGR.
 General contractors and subcontractors may take the
deduction on the same project because the
subcontractor’s gross receipts match the general
contractor’s costs.
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Determining DPGR for the
Construction Industry
 Taxpayers must determine whether receipts

qualify as DPGR on an item-by-item basis.
For the construction industry, what
constitutes an item will be determined on a
reasonable, case-by-case basis considering all
the facts and circumstances.
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Determining DPGR for the Construction
Industry
(continued)
In order for a contractor to allocate receipts to
DPGR, the following requirements must be met:
Taxpayer’s activity must be “construction.”
Construction must be of “real property.”
At the time of construction, taxpayer must be actively
engaged in a construction trade or business on a
regular and ongoing basis.
Taxpayer must actually perform the work and work
must be done in the U.S.
Taxpayer’s gross receipts must derive from the
construction.
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Requirement One
Activity Must Be ‘Construction.’
Final regulations define ‘construction’ as the
“erection of real property in the U.S.”
9
Requirement One
Activity Must be ‘Construction.’
(continued)
Construction includes:
Actual building.
Substantial renovation.
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Renovation to major components or structural parts
of real property that material increases property
value, prolongs use or converts the property to a
different use.
painting and redecorating are not substantial
renovation.
 Managerial functions normally conducted by general
contractors.
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Requirement One
Activity Must be ‘Construction.’
(continued)
Construction does not include:
Tangential services, such as hauling debris or
delivering material, unless performed by the taxpayer
in conjunction with its role as builder.
Administrative (billing & secretarial) services unless
undertaken by the builder on the project.
Improvements, such as grading, demolition,
excavation, landscaping and painting, unless they are
performed in conjunction with a building or
renovation project (whether or not by the same
taxpayer).
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Requirement Two
Construction Must Be of ‘Real Property.’
Real Property includes:
Residential and commercial buildings and their
structural components.
Inherently permanent structures that affix to property
over time.
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Swimming pools, fences, parking lots.
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Roads, sidewalks, power lines, water & sewer and
communications systems.
 Inherently permanent land improvements.
 Oil & gas wells.
 Infrastructure
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Requirement Two
Construction Must Be of ‘Real Property.’
(continued)
Real Property Does not Include:
Tangible personal property sold as part of
completed construction projects.


Appliances, furniture and fixtures.
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Requirement Three
Must Engage in Construction Trade or
Business
At the time of construction taxpayer must:

Be engaged in a construction trade as
defined by the North American Industry
Classification System.

The classified trade need not be taxpayer’s
primary or only trade.
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Requirement Three
Must Engage in that Trade on a Regular
and Ongoing Basis
 A taxpayer is deemed to have met this requirement if
it sells constructed real property to an unrelated
purchaser within five years of project completion.

This provision is intended to provide a safe harbor to
business entities created to build specific projects.
 Newly-Formed Organizations (less than one year-old)
are deemed to have met this requirement if they
expect to engage in a construction trade on a regular
basis.
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Requirement Four
Taxpayer Must Actually Perform the
Domestic Construction Activity
 Project must be in the U.S.
 Taxpayer must actually perform the construction

activity from which it derives gross receipts.
Example

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NAICS contractor buys a building, hires a general
contractor to oversee a renovation, then sells the
building.
NAICS contractor’s receipts from sale are not DPGR.
General contractor’s receipts are DPGR.
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Requirement Five
Gross Receipts Must Derive from
Construction
Income derived from construction:
Gross proceeds from the sale of real property
constructed by the taxpayer.
Gross proceeds from contract services.
Contractor’s mark-up on materials consumed
in the project or that become a permanent
part of the project.
Non-negotiated, non-separately stated
construction warranties.
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Requirement Five
Gross Receipts Must Derive from
Construction (continued)
Income NOT derived from construction:
Gross proceeds from sale of reacquired real
property that the taxpayer originally
constructed – no “double dipping.”
Lease or rental income on property
constructed by the taxpayer.
The value of the underlying land including
soft costs capitalized to the land.
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De minimis Rule and Land Safe
Harbor
Section 199 potentially increases taxpayer
administrative burdens and record-keeping
requirements because it forces allocation
between DPGR and non-DPGR.
The final regulations contain two safe harbors
to reduce these burdens under certain
circumstances.
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De minimis Rule
De minimis rule:
If less than 5% of a taxpayer’s gross receipts
on a construction project are not allocable to
DPGR, all the gross receipts will qualify as
DPGR.
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Land Safe Harbor
The Land Safe Harbor:
 Applicable where a portion the taxpayer’s

gross receipts from a construction project
derive from the sale of the underlying land
and entitlements.
Formulary approach.
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Land Safe Harbor
(Continued)

Taxpayer subtracts the original costs of the land, entitlements
and other common improvements from the costs of goods sold
allocable to DPGR.

Taxpayer subtracts those same costs plus a fixed percentage of
those costs based on years of ownership from DPGR.

1-5 years – 5%

5-10 years – 10%

10-15 years – 15%

Land held more than 15 years does not qualify for the safe
harbor.
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Land Safe Harbor
Example
 Developer buys land in 2005 for $2 million to
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build a small, but upscale apartment complex.
It costs $50,000 to re-zone the property.
Construction costs for the completed complex
are $6,500,000.
Total Costs = $8,550,000.
Developer sells complex to California-based
investor for $10 million.
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Land Safe Harbor
Example
(continued)
 Sale occurs in 2009:
 Costs of goods sold allocable to DPGR =
$6,500,000.

Developer subtracts $2,050,000 (land plus
entitlement costs) from $8,550,000 (total
costs).
 DPGR = $7,847,500

Developer subtracts $2,152,500 (cost of land
and entitlements plus 5%) from $10 million
sale.
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Land Safe Harbor
Example
(continued)
 Sale occurs in 2012:
 Costs of goods sold allocable to DPGR is the

same at $6,500,000.
But DPGR = $7,745,000.

Developer subtracts $2,255,000 (cost of land
and entitlements plus 10%) from $10 million
sale price.
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Affiliated and Consolidated Groups &
Arizona’s Marketing-Arm/ContractingArm Structure
 Section 199 has special rules for affiliated
entities and contains two distinct affiliated
entity concepts.
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The Expanded Affiliated Group (“EAG”).
The Consolidated Group.
 Section 199 defines both groups with
reference to Section 1504(a)’s requirements
for consolidated reporting, but uses different
stock ownership thresholds.
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Affiliated and Consolidated Groups &
Arizona’s Marketing-Arm/ContractingArm Structure (continued)
 An EAG is an affiliated group as defined in

Section 1504(a) (for consolidated return
purposes) but with a lower stock ownership
threshold of greater than 50% (as opposed to
greater than or equal to 80%).
Section 199 treats EAGs as single
corporations.
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Affiliated and Consolidated Groups &
Arizona’s Marketing-Arm/ContractingArm Structure (continued)

Section 199 Deduction for EAGs.


Each EAG member separately computes its
own taxable income & loss, QPAI and W2
wages.
These amounts are then aggregated.
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Affiliated and Consolidated Groups &
Arizona’s Marketing-Arm/ContractingArm Structure (continued)
 EAGs may be comprised of either partially
consolidated or wholly consolidated members.
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A partially consolidated EAG has both
consolidated and non-consolidated members.
The deduction for partially consolidated EAGs
follows the above-referenced methodology,
but the consolidated group is treated as a
single member.
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Affiliated and Consolidated Groups &
Arizona’s Marketing-Arm/ContractingArm Structure (continued)
 In a wholly consolidated EAG, the EAG
consists of only consolidated entities.

The Section 199 deduction is determined
using the group’s consolidated taxable
income & loss, QPAI, and W2 wages.
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Attribution Rules and the MarketingArm/Contracting-Arm Structure
 At the EAG level, a builder’s qualifying
construction activities (contracting-arm)
are not attributed to a related entity
(marketing-arm) that purchases and resells
the improved property.
 QPAI is the limited difference between the
sales price to the related entity less
construction costs.
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Attribution Rules and the MarketingArm/Contracting-Arm Structure
 But in a consolidated group, the builder’s
construction activities (contracting-arm)
are attributed to the related entity
(marketing-arm) that purchases and resells
the improved property.
 QPAI is the larger difference between the

final sales price and the construction costs.
Thus, the Section 199 deduction is
maximized in a consolidated group setting; it
is based on the marketing arm’s sales price.
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Attribution Rules and the MarketingArm/Contracting-Arm Structure
Contracting
Arm
$65K
Marketing
Arm
Homebuyer
$100K
• At 50% common ownership (EAG), DPGR is $65,000
less costs.
•At 80% common ownership (consolidated group),
DPGR is $100,000 less costs.
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THANK YOU
Patrick Derdenger
Partner, Steptoe & Johnson LLP
201 E. Washington Street, 16th Floor
Phoenix, Arizona
(602) 257-5209
www.steptoe.com
May 3, 2007