Tax NewsFlash: Taxpayer’s Construction Activities Qualify for DPAD

Mar 3, 2011

In a recent tax ruling, the Tax Court found that an engineering and highway construction company’s project qualified for a deduction under Code Section 199, the Domestic Production Activities Deduction (DPAD).

In general, Code Sec. 199, DPAD, allows certain taxpayers to claim a deduction that is equal to a percentage of the income earned from production activities undertaken in the U.S. The deduction is subject to limitations, but in general the credit is: (1) a percentage, generally 9%, of the smaller of (a) the “qualified production activities income” of the taxpayer for the tax year or (b) taxable income for the tax year.

On its return for the tax year ending June 30, 2006, Gibson & Associates, Inc. (Gibson) claimed a deduction under DPAD, but the IRS challenged this deduction in Tax Court, holding that Gibson did not materially increase the value of real property.

In its decision, the tax court used principles to distinguish deductible repair expenses from capitalized renovation expenses. Under these principles, the taxpayer’s work constituted substantial renovation of property because it materially increased the value of the property, and substantially prolonged the useful life of the property. However, the IRS contended that the taxpayer’s work was routine maintenance, and simply brought the bridges back to operating condition. Additionally, the IRS asserted that the rehabilitation of one or more components of real property was just a repair, unless all the major components were replaced.

The tax court held that the IRS did not adequately understand the complexity of the taxpayer’s work, nor did the IRS take into account how the renovation of major components often extended the useful life of the structures as a whole on account of the intricate interaction of all the components. Furthermore, the tax court defined real property as each freestanding item of real property that operates and performs a discrete function in and of itself. As a result, Gibson was able to utilize DPAD for its repair on bridges and the distinct components of multiple bridges.