Court Ruling Defines When “Substantial Renovations” Qualify as Construction Activity

By Louis Sandor, CCIFP
WithumSmith+Brown Construction Services Team

On February 24, 2011, the Tax Court decided Gibson & Associates, 136 T.C. 10, a case that may impact several construction companies.

The court upheld the claim of a construction company that its income from certain projects qualified as domestic production gross receipts (“DPGR”) for purposes of computing the deduction under IRC §199. More importantly, this case was the first to interpret what constituted “substantial renovation” for purposes of the §199 regulations.

Facts: The taxpayer was an engineering and construction company that primarily erected or rehabilitated streets, bridges, airport runways, and other real property. The taxpayer did not “construct” assets in the conventional sense, but rather specialized in renovating real estate. In computing its tax return, the corporation reported $25.9 million of receipts from various renovation projects as DPGR, resulting in a §199 deduction of $63,000.

Relevant Law: Section 199 allows a corporate taxpayer to deduct a percentage (3% in the case, 9% currently) of the lesser of 1) its qualified production income, or 2) its taxable income, with the result being limited to 50% of the taxpayer’s wages. Qualified production income is defined as DPGR less costs of goods sold and certain expenses.

Section 199(c)(4)(A)(ii) includes in DPGR “gross receipts from the construction of real property.”

Section 199 does not define “construction of real property,” but final regulations issued in 2006 do. According to the regulations, “Activities constituting construction are activities in connection with a project to erect or substantially renovate real property.” Substantial renovation, according to the regulations, means “the renovation of a major component or substantial structural part of real property that either:

1) Materially increases the value of the property,
2) Substantially prolongs the useful life of the property, or
3) Adapts the property to a new or better use.”

The IRS’s Position: The IRS maintained the taxpayer’s income did not qualify as DPGR, as the taxpayer’s activities did not constitute substantial renovations, but rather represented repairs or maintenance. In the eyes of the IRS, the key was that the taxpayer worked on only part of a structure, such as bridge joints, and the rehabilitation of only one component of real property would have to be a repair unless all of the property’s major components were replaced.

The Taxpayer’s Position: The taxpayer used the testimony of two experts to argue that each of their renovation projects either increased the value, prolonged the life, or altered the future use of the property. Even though the taxpayer was only working on a small part of a larger structure (the bridge joints), their work was critical and essential to the well-being and future operation of the structures underlying the project (the bridge).

The Court: The Tax Court agreed with the taxpayer, holding that each of the disputed projects qualified as “substantial renovation.”  In reaching their decision, the court determined that the taxpayer’s 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.

What We Can Learn: This is the first case to tackle the definition of “substantial renovation” for purposes of the §199 deduction. There are a few important things to take away from this decision:

  1. In ruling in favor of the taxpayer, the court relied heavily on the testimony of the taxpayer’s experts (one of which was the CEO), and discredited the IRS’s expert for not having any practical experience with construction.
  2. The court did not require the taxpayer to quantify how either 1) the value of the property increased after the renovations, or 2) the life of the property increased after the renovation. The court relied on the taxpayer’s testimony that many of the renovations extended the life of the underlying structures 3-5 years.
  3. The taxpayer kept meticulous records. For each disputed project, the taxpayer recorded the nature of the project, the revenue generated, the work performed, and whether the work increased the life, value, or changed the use of the structure. These records certainly helped the court make a decision in a previously undecided area of law.

Notes: This article will appear in the April issue of the Utility and Transportation Contractor magazine. There are many details included in this case not discussed here. Be sure to contact your tax advisor to learn more.