Notice 2005-14 offers Sec. 199 guidance.
Notice 2005-14 provides interim guidance on which taxpayers may rely until regulations are issued. It indicates that Treasury and the IRS expect the regulations to incorporate the rules set forth in the notice, which is effective for tax years beginning after 2004. The 43-page notice resolves several issues, but also raises some questions.
The following discussion summarizes some of Sec. 199's and Notice 2005-14's major provisions, as well as a few of the significant issues.
In general, Sec. 199(a)(1) allows a deduction equal to 9% of the lesser of a taxpayer's (1) qualified production activities income (QPAI) for the tax year or (2) taxable income (determined without regard to Sec. 199) for the tax year (or, in the case of an individual, adjusted gross income (AGI), under Sec. 199(d)(2)). The deduction is 3% for tax years beginning in 2005 and 2006, and 6% for tax years beginning in 2007-2009. It is limited to 50% of the W-2 wages the taxpayer pays during the calendar year that ends in such tax year, under Sec. 199(b)(1) and (2).
Sec. 199 applies to passthrough entities (e.g., S corporations, partnerships, estates or trusts) at the shareholder, partner or similar level, except as otherwise provided in rules applicable to individuals and patrons of cooperatives; see Sec. 199(d). Similarly, it provides additional rules for expanded affiliated groups (discussed in greater detail below).
Under Sec. 199(c)(1), QPAI is the excess of domestic production gross receipts (DPGR) over the sum of:
1. The cost of goods sold allocable to such receipts;
2. Other deductions, expenses or losses directly allocable to such receipts; and
3. A ratable portion of deductions, expenses and losses not directly allocable to such receipts or another income class.
For alternative minimum tax purposes, the Sec. 199 deduction equals the applicable percent of the lesser of a taxpayer's:
1. QPAI, determined without regard to subchapter A, Part IV, of the Code; or
2. Alternative minimum taxable income (AMTI) for the tax year (determined without regard to Sec. 199). For individuals, AGI (determined without regard to Sec. 199) is used instead of AMTI; see Notice 2005-14, Section 2.08.
The calculation of DPGR may depend first on identifying qualifying production property (QPP), which includes tangible personal property, computer software and sound recordings, according to Sec. 199(c)(5). Under Notice 2005-14, Section 4.04 (8)(b), tangible personal property is any tangible property other than land, buildings (including structural components) and any property described in Sec. 199(c)(4)(A)(i)(II) and (III), or 199(c)(5)(B) and (C).
While under Notice 2005-14, Section 4.04(8)(b), the tangible medium on which the property is fixed (e.g., a videocassette, a computer diskette or other similar tangible item) is tangible personal property, it is hoped that the IlLS will provide a de minimis rule, so taxpayers will not have to bifurcate qualifying and nonqualifying gross receipts from a qualified film or computer software.
The creation of copyrighted material in a form other than a tangible medium (e.g., a manuscript) is not QPP.
"Manufactured, Produced, Grown or Extracted"
As is discussed below, the calculation of DPGR may next depend on whether QPP was manufactured, produced, grown or extracted (MPGE) in the U.S. MPGE, under Sec. 199(c)(4)(A)(i)(I) and Notice 2005-14, Section 4.04(3) (a), includes activities relating to:
1. Manufacturing, producing, growing, extracting, installing, developing, improving and creating QPP;
2. Making QPP out of scrap, salvage or junk material, as well as from new or raw material by processing, manipulating, refining or changing the form of an article, or by combining or assembling two or more articles; and
3. Cultivating soil, raising livestock, fishing and mining minerals.
More expansive rules for certain activities related to the sale, exchange or other disposition of agricultural products are provided in Notice 2005-14, Section 4.04(3)(a).
Sec. 199(c)(4)(A) defines DPGR as gross receipts derived from:
1. Any lease, rental, license, sale, exchange or other disposition of (i) QPP that was MPGE by the taxpayer in whole or in significant part within the U.S., (ii) any qualified film produced by the taxpayer or (iii) electricity, natural gas or potable water produced by the taxpayer in the U.S.;
2. Construction performed in the U.S. (excluding gross receipts from the lease or rental of real property constructed by the taxpayer or attributed to the sale or other disposition of land, under Notice 2005-14, Section 4.04(11)(e)); or
3. Engineering or architectural services performed in the U.S. for U.S. construction projects.
Under Sec. 199(c)(7)(A), DPGR do not include receipts from property leased, licensed or rented by the taxpayer for use by a related person.
After the application of other de minimis safe harbors provided in Notice 2005-14, all of a taxpayer's gross receipts are treated as DPGR if less than 5% of the taxpayer's total gross receipts are non-DPGR; see Notice 2005-14, Section 4.03(2). In addition, under Sec. 199(c)(4) (B), gross receipts derived from the (1) sale of food and beverages prepared by the taxpayer at a retail establishment and (2) transmission or distribution of electricity, natural gas or potable water, are excepted from DPGR.
While DPGR generally do not include gross receipts derived from services (except for certain construction, engineering and architectural services), the gross receipts of certain services may be included in DPGR under Notice 2005-14, Section 4.04(7) (b), if they are:
1. From a warranty provided in connection with the sale of QPP in which (i) during the normal course of business, the warranty charge is included in the price charged for the lease, rental, license, sale, exchange or other disposition of the QPP; and (ii) the warranty is neither separately offered by the taxpayer nor separately bargained for with the customer (i.e., a "qualified warranty"); or
2. Less than 5% of the gross receipts are derived from the lease, rental, license, sale, exchange or other disposition of the property (exclusive of gross receipts from qualified warranties).
Under Notice 2005-14, Section 3.04(7) (c), advertising income attributable to the sale or other disposition of newspapers and magazines is "derived from" these activities, because the advertising income is "inextricably linked" to the gross receipts derived from their lease, rental, sale, exchange or other disposition. Hopefully, future guidance will expand and clarify this rule and explain whether it applies to broadcast advertising revenue or other analogous activities.
Revenue and Cost-Allocation Issues
Notice 2005-14, Section 3.05(1), discusses the determination and allocation of costs of computing QPAI. In general, DPGR must be reduced by (1) cost of goods sold directly allocable to DPGR; (2) deductions, expenses and losses directly allocable to DPGR; and (3) a ratable portion of other deductions not directly allocable to DPGR or another income class.
Any reasonable method may be used to allocate costs of goods sold between DPGR and non-DPGR sales. Three methods of allocating and apportioning deductions are provided in Notice 2005-14, Section 4.05(3) and (4):
1. The Sec. 861 method;
2. A simplified deduction method for taxpayers with average annual gross receipts of $25 million or less;
3. A small business simplified overall method for taxpayers with average annual gross receipts of $5 million or less or that are eligible to use the cash method as provided in Rev. Proc. 2002-28.
Sec. 199(d)(4)(A) and Notice 2005-14, Section 4.09, treat all members of an expanded affiliated group (EAG) as a single corporation for Sec. 199 purposes. A corporation must determine whether it is an EAG member on a daily basis. Under Sec. 199(d)(4)(B), an EAG is an affiliated group as defined in Sec. 1504(a) (without regard to Sec. 1504(b)(2) and (4); however, for the vote and value test, 50% is substituted for 80%).
If enacted, the Tax Technical Corrections Act of 2004 (S 3019 and HR 5395) would change "50%" to "more than 50%." Under Notice 2005-14, Section 4.09(2), each EAG member's taxable income or loss, QPAI and W-2 wages are aggregated to determine the EAG's Sec. 199 deduction. Significantly, too, under Notice 2005-14, Section 4.09(2)(b), each EAG member's activities are attributed to each other EAG member, so the revenue generated by sales subsidiaries from the sale of QPP produced by separate production subsidiaries qualifies as DPGR. For example, if one member of an EAG were to manufacturer QPP and a second member of the EAG earns revenue selling such QPP, both EAG members' gross receipts from the sale of the QPP would be DPGR.
An EAG is also required to make adjustments under Notice 2005-14, Section 4.09(2)(c)'s anti-avoidance rule, which requires it to eliminate a transaction's effect on the computation of the Sec. 199 deduction, if EAG members engage in or structure a transaction between them with a principal purpose of qualifying for, or modifying the amount of, the deduction for one or more EAG members.
Notice 2005-14 represents "round one" of the Sec. 199 guidance. Treasury and the IRS have indicated that they plan to publish proposed regulations by September 2005. The notice raises revenue and cost-allocation issues that present complex cost accounting questions for which such guidance will be critical. In the meantime, tax advisers and their clients should consider which property qualifies as QPP and which activities generate DPGR, and examine their allocable expenses to maximize the benefit from this new deduction.
FROM PAUL K. GIBBS, CPA, AND REGINA L. RATHNAU, J.D., CPA, WASHINGTON, DC