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Sec. 199: domestic production activities deduction.

Despite the economic slowdown, manufacturing continues to play an important role in the American economy. Congress, concerned that U.S. manufacturing was lagging behind foreign imports that in many cases benefited from foreign countries' subsidies and undercut U.S. producer prices, offered tax relief with the domestic production activities deduction. Since 2004, Sec. 199 has allowed as a deduction a percentage of qualifying production expenses, with "production" defined broadly and requiring only that it take place "in significant part" within the United States. (1)

[ILLUSTRATION OMITTED]

After starting at 3% of such costs, the deduction increased to 6% for tax years 2007-2009 and is 9% for 2010 and following years. It is designed to be the equivalent of a 3 percentage point reduction in the effective tax rate for U.S. manufacturers.(2) The amount of the deduction is limited to 50% of the taxpayer's W-2 wages attributable to domestic production gross receipts.

Because the domestic production activities deduction replaced the former foreign sales corporation and extraterritorial income provisions of the Code, U.S. manufacturers who did not benefit from those provisions' export tax benefits may overlook it. The domestic production activities deduction is available to a wide variety of U.S. taxpayers, not just those who export their products. This article describes eligibility for the deduction, its limitations, and how it is calculated.

Eligibility

To be eligible for the Sec. 199 deduction, taxpayers must have qualified production activities income (QPAI),(3) which is defined as domestic production gross receipts (DPGR) for a tax year minus cost of goods sold and other expenses, losses, or deductions allocable or properly attributable to those receipts.(4) DPGR comprises receipts obtained from the lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP), any qualified film, or electricity, natural gas, or potable water produced by the taxpayer in the United States. DPGR may also be derived from construction of real property or engineering/architectural services in the ordinary course of business in the United States by taxpayers that actively conduct a trade or business of construction or engineering/architectural services, respectively. (5)

QPP is property produced by manufacturing, producing, growing, or extracting (MPGE) activities performed in whole or in significant part within the United States. (6) QPP consists of:

* Tangible personal property;

* Any computer software; and

* Sound recordings. (7)

Under Regs. Sec. 1.199-3(e), MPGE activities include:

* Developing;

* Improving;

* Manufacturing from scrap, salvage, or junk material as well as from new or raw material;

* Processing, manipulating, or refining;

* Changing the form of the property;

* Combining or assembling;

* Cultivating soil;

* Raising livestock;

* Mining minerals;

* Fishing;

* Storage and handling activities connected with certain agricultural products; and

* Installing QPP, if the taxpayer also engages in other MPGE activity with respect to the QPP.

MPGE activities do not include:

* Transportation;

* Packaging;

* Labeling;

* Minor assembly; and

* Installation of QPP, if no other MPGE occurs with respect to the QPP.

Safe harbor: If the combination of direct labor and overhead used in MPGE activities totals 20% or more of the QPP's cost of goods sold (COGS) or, in a transaction without COGS (such as a lease, rental, or license), the direct labor and overhead total 20% or more of the unadjusted depreciable basis in the QPP, the taxpayer is deemed to have engaged in MPGE activities to produce QPP. (8)

Formula Components

Before computing the Sec. 199 deduction, the taxpayer should determine if the entity is a member of a new attribution entity created by Sec. 199: an expanded affiliated group (EAG). Having made this determination, the taxpayer can calculate the two components of the Sec. 1.99 formula:

* Taxable income, as modified by Sec. 199 criteria; and

* QPAI.

EAGs

EAGs generally follow the rules of Sec. 1504, governing affiliated groups, except that "50%" is substituted for "80%."(9) In effect, the EAG can encompass a larger group of entities than the normal rules of attribution. Exhibit 1 on p. 324 illustrates the EAG relationship compared with a Sec. 1504 affiliated group. Each EAG member must be engaged in the actual conduct of a trade or business. All EAG members must be considered in the Sec. 199 deduction. In effect, Sec. 199 becomes a consolidated deduction subject to allocation.

Modified Taxable Income

For corporations, taxable income for Sec. 199 purposes is determined without regard to the Sec. 199 deduction. In the case of corporate alternative minimum tax, alternative minimum taxable income will be used in place of taxable income. (10)

For individuals, adjusted gross income is substituted for taxable income in the Sec. 199 calculation. For this purpose, adjusted gross income is determined before applying Sec. 199 and after applying:

* Sec. 86: Social Security benefits;

* Sec. 135: Income from U.S. bonds used to pay higher education tuition and fees;

* Sec. 137: Adoption assistance programs;

* Sec. 219: Qualified retirement savings;

* Sec. 221: Interest on education loans;

* Sec. 222: Qualified tuition and related expenses; and

* Sec. 469: Passive activity losses and credits. (11)

QPAI

QPAI consists of DPGR for a tax year minus COGS and other expenses, losses, or deductions allocable or properly attributable to those receipts. (12) Taxable receipts and expenses are to be allocated in a "reasonable" manner to produce income attributable to QPAI.

[ILLUSTRATION OMITTED]

A reasonable method of allocation has the following characteristics:

* Whether the taxpayer uses the most accurate information available;

* The relationship between gross receipts and the method used;

* The accuracy of the method chosen as compared with other possible methods;

* Whether the taxpayer uses the method for internal management or other business purposes;

* Whether the method is used for other federal or state income tax purposes;

* The time, burden, and cost of using alternative methods; and

* Whether the taxpayer applies the method consistently from year to year.(13)

Exhibit 2 gives an example of the QPAI computation. The QPAIs in this example total $1,165 (QPAI 1 + QPAI 2).
Exhibit 2: QPAI Computation

Facts: Taxpayer is not a member of an EAG. All of taxpayer's MPGE
activities are in two distinct products.

Adjusted basis of assets attributable to:

 QPAI1 3,000

 QPAI2 4,000

 Non-QPAI 1,000 8,000
 activities

Square footage attributable to:

 QPAI1 2,500

 QPAI2 1,500

 Non-QPAI 1,000 5,000
 activities

Computations Taxable Allocation QPAM
 basis

Receipts Given
attributable
to:

 QPAI1 6,500 6,500

 QPAI 2 4,500

 Non-QPAI 4,000 15,000
 activities

COGS Given
attributable
to:

 QPAI1 (2,500) (2,500)

 QPAI 2 (1,0001

 Non-QPAI (2,5001 (6,000)
 activities

Non-COGS Given
expenses
attributable
to:

 QPAI1 (1,500) (1,500)

 QPAI 2 (1,000)

 Non-QPAI (500) (3,000)
 activities

Interest (1,000) (1,000) Adjusted (375) (500)
expense not basis of
included in assets
COGS*

Headquarters (1,200) (1,200) Square (600)
overhead footage
expense
[dagger]

Selling expenses related to all of taxpayer's gross income attributable
to:

 QPAI1 (1,200) (1,200)

 QPAI 2 (800) (2.000)

Net income 1,800 325

 1,165

* Allocation of
interest
expense

Adjusted % Interest Allocation
basis of expense
assets
attributable
to:

 QPAM 3,000 37.50% 1,000 375

 QPAI 2 4,000 50.00% 1,000 500

 Non-QPAI 1,000 12.50% 1,000 125
 activities

 8,000 100.00% 1,000

[dagger] Allocation of headquarters overhead expense

Square % Overhead Allocation
footage expense
attributable
to:

 QPAI1 2,500 50.00% 1,200 600

 QPAI 2 1,500 30.00% 1,200 360

 Non-QPAI 1,000 20.00% 1,200 240
 activities

 5,000 100.00% 1,200

Adjusted basis of assets attributable to:

 QPAI1

 QPAI2

 Non-QPAI
 activities

Square footage attributable to:

 QPAI1

 QPAI2

 Non-QPAI Non-QPAI
 activities

Computations QPAI 2 activities

Receipts attributable to:

 QPAI1

 QPAI 2 4,500

 Non-QPAI 4,000
 activities

COGS
attributable
to:

 QPAI1

 QPAI 2 (1,000)

 Non-QPAI (2,500)
 activities

Non-COGS expenses attributable to:

 QPAI1

 QPAI 2 (1,000)

 Non-QPAI (500)
 activities

Interest (125)
expense not
included in
COGS *

Headquarters (360) (240)
overhead
expense +

Selling expenses related to all of taxpayer's gross income attributable
to:

 QPAI1

 QPAI 2 (800)

Net income 840 635

* Allocation of interest expense

Adjusted basis of assets attributable to:

 QPAM

 QPAI 2

 Non-QPAI
 activities

[dagger] Allocation of headquarters overhead expense

Square footage attributable to:

 QPAI1

 QPAI 2

 Non-QPAI
 activities


Taxpayers with Oil-Related QPAI

Sec. 199 defines "oil-related qualified production activities income" as the QPAI attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product derived from these substances.(14) For tax years beginning after 2009, if a taxpayer has oil-related QPAI, the Sec. 199 deduction is reduced by 3% of the lesser of:

* The taxpayer's oil-related QPAI for the tax year;

* The taxpayer's QPAI for the tax year; or

* Taxable income (determined without regard to Sec. 199). (15)

In the Exhibit 2 calculation, if QPAI 1 were oil related, the Sec. 199 deduction would be reduced by $10 (rounded), which is 3% of the lower of QPAI 1 ($325), the total QPAI ($1,165), or total taxable income ($1,800).

DPGR

Understanding DPGR is critical for the W-2 wage limitation because the Sec. 199 deduction is limited to 50% of the taxpayer's W-2 wages attributable to DPGR activities.

Gross receipts are receipts for the tax year, as recognized by the taxpayer's normal method of accounting as used for income tax purposes. (16) They are determined on an item-by-item basis rather than by department, plant, or product line. (17) For this purpose, "items" are those goods offered for sale in the normal course of a taxpayer's trade or business. If property is sold by weight or volume, industry custom will determine the item. (18) For engineering, architectural, or construction activities, any reasonable method may be used to determine an item. (19)

For purposes of Sec. 199, gross receipts include:

* Income from services;

* Income from investments;

* Interest, dividends, and other such items, regardless of whether received in the taxpayer's ordinary course of business; or

* The amount of sales tax collected, if the tax is imposed on the seller and not the purchaser of the goods or services.

Gross receipts exclude:

* Principal received on payment of a liability;

* Proceeds from a nonrecognition transaction (e.g., Sec. 1031), except for the gain;

* Sales tax received from customers, if the tax is legally imposed on the purchaser and the seller is merely a collection agent; or

* The sale of food and beverages prepared by the taxpayer at a retail establishment.(20)

The taxpayer must allocate receipts between DPGR and non-DPGR using a reasonable method of allocation.(21) The term "reasonable" implies that the information is readily available and that the taxpayer can identify DPGR without "undue time and expense." This allocation is necessary because W-2 wages must be apportioned between activities relating to domestic and nondomestic production. The allocation affects the limitation by imposing a ceiling for the Sec. 199 deduction.

If the taxpayer's accounting method recognizes partial advance payments as income, use of historical data in subsequent years constitutes a reasonable method. However, if historical data are updated, those revisions must be reflected in the Sec. 199 calculation in the year of update and thereafter. (22)

A taxpayer using the percentage of completion method must be able to substantiate that the DPGR/non-DPGR allocation is reasonable. (23)

De minimis rules exist for determining DPGR. If less than 5% of gross receipts are non-DPGR, the taxpayer may generally treat all receipts as DPGR. If 5% or more of gross receipts are non-DPGR, the taxpayer must allocate receipts between DPGR and non-DPGR. (24)

The following rules are used to determine the entity level for gross receipts allocation:

* If the taxpayer is a member of an EAG but not a member of a consolidated group, determination is made at the corporate level.

* If the taxpayer is a member of a consolidated group, determination is made at the consolidated group level.

* If the taxpayer is an S corporation, partnership, trust, estate, or other passthrough entity, determination is made at the passthrough entity level.

* In the case of an owner of a passthrough entity, determination is made at the owner level, taking into account the gross receipts of all the owner's trades or businesses, including the passthrough entity.(25)

DPGR generally does not include any gross receipts of the taxpayer derived from property leased, licensed, or rented by the taxpayer for use by any related person. An exception occurs if QPP or qualified film is leased or rented to a related taxpayer and in turn is leased or rented for ultimate use by an unrelated party. In that case, the gross receipts will qualify as DPGR. The same exception would also apply to a qualified film that a taxpayer licenses or relicenses for ultimate use by an unrelated third party. (26)

Qualified Films

A qualified film is any motion picture film or videotape in which 50% or more of the total compensation relating to its production is for services performed in the United States by actors, production personnel, directors, and producers. The term includes copyrights, trademarks, or other intangibles of the film. The methods and means of distributing a qualified film do not hinder the Sec. 199 deduction. (27) Qualified films do not include films depicting actual sexually explicit conduct. (28)

W-2Wage Limitation

The wages comprising the 50% limitation must be attributable to DPGR and must have been correctly reported to the Social Security Administration within 60 days of the due date to qualify for Sec. 199. W-2 wages include wages actually paid, elective deferrals actually made,(29) deferred compensation actually deferred under Sec. 457, and designated contributions to a Roth IRA made after December 31, 2005.(30) "Correctly reported" includes being reported on Forms W-2, Wage and Tax Statement (or W-2c, Corrected Wage and Tax Statement), and W-3, Transmittal of Wage and Tax Statements (or W-3c, Transmittal of Corrected Wage and Tax Statements). (31)

If an original payroll tax return is filed within 60 days of the due date and a corrected return is timely filed, W-2 wages will consist of the amounts shown on the corrected return. If the original return is timely filed but the corrected return is filed later than within 60 days of the due date, any increases will not be considered for Sec. 199 purposes, but any decreases must be taken into account. If the original return is not timely filed within 60 days of the due date, the amounts on a corrected return are disregarded for Sec. 199 purposes. (32)

Originally, all W-2 wages were included in the 50% limitation. After May 17, 2006, wages included only the compensation allocable to DPGR. A taxpayer may use any allocation method as long as it is reasonable.(31) The effect of this change is to lower the ceiling of the deduction.

If the employer listed on the W-2 form does not have control of the payment of wages, or if the taxpayer is paying wages as an agent of another taxpayer, those wages will not be counted as W-2 wages for purposes of Sec. 199. (34)

In a short tax year, only the wages actually paid, elective deferrals actually made,(35) and deferred compensation actually deferred under Sec. 457 during the short year may be counted for Sec. 199 purposes.(36)

In the event of an acquisition or disposition of a business or major portion of a business, wages will be allocated between the predecessor and successor businesses.(37) Duplication of wages between tax years or different taxpayers is not permitted.(38)

For taxpayers having a noncalendar-year end, the term "W-2 wages" means wages paid during the calendar year ending during the taxpayer's tax year, as stated in Regs. Sec. 1.199-2(e)( 1). A taxpayer may determine the amount of W-2 wages that is properly allocable to DPGR for a tax year by multiplying the amount of W-2 wages for the tax year by the ratio of the taxpayer's wage expense included in calculating QPAI (as defined in Regs. Sec. 1.199-1(c)) for the tax year to the taxpayer's total wage expense used in calculating the taxpayer's taxable income (or adjusted gross income, if applicable) for the tax year (Regs. Sec. 1.199-2(e)(2)(ii)).

Computation of the Deduction

To compute the Sec. 199 deduction, the taxpayer determines the lesser of QPAI or taxable income, as modified. The smaller number is then multiplied by the appropriate percentage:

* 3% for tax years beginning in 2005 or 2006;

* 6% for tax years beginning in 2007, 2008, or 2009; or

* 9% for tax years beginning in 2010 and thereafter.

This result is then limited by 50% of W-2 wages attributable to DPGR.
 Example: In 2010, A Corp. has taxable income of $210,000, QPAI of
 $145,000, and DPGR wages of $26,000. The Sec. 199 deduction would be
 $13,000 ($145,000 x 9% = $13,050, limited by $26,000x50% = $13,000).


Had the year been 2007, the applicable percentage would have been 6%, and the Sec. 199 deduction would have been $8,700 ($145,000 x 6% = $8,700). The wage limitation of $13,000 would have been irrelevant. Exhibit 3 shows a Sec. 199 computation.
Exhibit 3: Sec. 199 computation

Facts: Corporation has year end of 4/30/11

Not a member of an EAG

Engages in activities that generate both DPGR and non-DPGR W-2
wages in 2010

2010 3,000
calendar-year
W-2 wages

Total wages 1,800
for year
ending
4/30/11

 Wages

 Total

Receipts income QPAI Total QPAI

DPGR 3,000 3,000

Non-DPGR 3,000 6,000

COGS

DPGR Wages (200) 200 200

 Nonwages (400) (600) (600)

Non-DPGR Wages (600) (1,800) 600
 Nonwages (1,200)

Other
deductions*

 Wages (1,000) (500) 1,000 500

 Nonwages (1,220) (2,220) (610)

 Total 1,380 1,290 1,800 700

* Allocation to QPAI based on ratio of DPGR receipts to total receipts

QPAI wage
computation

700 [division 3,000 = 1,167
sign]1,800 x

Sec. 199
computation

Taxable income 1,380
(Tl)

QPAI 1,290

Lesser of(Tl) or QPAI 1,290
 x9% 116

Wages
limitation

 1,167x50% 584
 =

Sec. 199 116
deduction


Allocation of the Deduction

Pending the issuance of regulations, the allocation of the Sec. 199 deduction is based on each EAG member's portion of QPAI.(39) See Exhibit 4, adapted from the regulations.
Exhibit 4: Allocation of Sec. 199 deduction

Corporations A and B are members of an EAG. Assume these facts
for 2010:

 A B

Taxable 1,380 1,710
income

QPAI 1,455 905

Wages 1,042 400
attributable
to DPGP.

Sec. 199
calculation

 A S Total

Taxable 1,380 1,710 3,090
income (Tl)

QPAI 1,455 905 2,360

 Lesser of TI % 2,360 212
 or QPAI

 x9

Wage x 50% 1,042 400 1,442 721
limitation

Wage
limitation
not relevant

Allocation of
Sec. 199
deduction

QPAI 1,455 905 2,360

 62% 38% 100%

Total Sec. 212 212 212
199
deduction

Sec. 199 131 81 212
deduction
allocation


Conclusion

This article presents an overview of the domestic production activities deduction. In addition to the statute, nine regulations spell out in detail topics such as expanded affiliated groups, domestic production gross receipts, qualified production activities income, special rules for agricultural and horticultural cooperatives and passthrough entities, and the W-2 limitation (both before and after May 17, 2006).

Practitioners should be aware of the Sec. 199 deduction and be comfortable with its calculations so clients can take full advantage of its provisions. In some cases, refinements will have to be made to the taxpayer's accounting system in order to capture the required data--e.g., DPGR versus non-DPGR and the related wages.

RELATED ARTICLE: EXECUTIVE SUMMARY

* The domestic production activities deduction is generally calculated as a percentage of a taxpayer's qualified production activities income (QPAI). QPAI is defined as domestic production gross receipts (DPGR) for a tax year less cost of goods sold and other expenses, losses, or deductions allocable or properly attributable to those receipts.

* DPGR are receipts from the lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) and certain other property. QPP is property produced by manufacturing, producing, growing, or extracting activities performed in whole or in significant part within the United States, including tangible personal property, any computer software, and sound recordings.

* The amount of the deduction is limited to 50% of the taxpayer's W-2 wages attributable to DPGR.

(1) Sec. 199 was enacted by the American Jobs Creation Act of 2004, P.L. 108-357, and modified by the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222.

(2) Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress (JCS-5-05) (May 2005).

(3) Sec. 199(a).

(4) Sec. 199(c)(1).

(5) Sec. 199(c)(4)(A).

(6) Sec. 199(c)(4)(A)(i)(I).

(7) Sec, 199(c)(5).

(8) Regs. Sec. 1.199-3(g)(3)(i).

(9) Sec. 199(d)(4)(B).

(10) Sec. 199(d)(6)(B).

(11) Sec. 199(d)(2).

(12) Sec. 199(c)(1).

(13) Regs. Sec. 1.199-4(b)(2)(i).

(14) Sec. 199(d)(9)(B).

(15) Sec. 199(d)(9)(A).

(16) Regs. Sec. 1.199-3(c).

(17) Regs. Sec. 1.199-3(d)(1).

(18) Regs. Sec. 1.199-3(d)(2)(ii).

(19) Regs. Sec. 1.199-3(d)(2)(iii).

(20) Regs. Sec. 1.199-3(c).

(21) Regs. Sec. 1.1 99-3(d)(1).

(22) Regs. Sec. 1.199-(e)(1).

(23) Regs. Sec. U199-1(e)(2).

(24) Regs. Sec. 1.199-1 (d)(3).

(25) Regs. Sec. 1.199-1(d)(3)(i).

(26) Regs. Sees. 1.1993(b)(1) and (2).

(27) Sec. 199(c)(6).

(28) Sec. I99(c)(6) excludes property subject to the record-retention requirement of 18 U.S.C. $2257, which applies to various products that contain "visual depictions ... of actual sexually explicit conduct."

(29) Sec Sec. 402(g)(3).

(30) Regs. Sec. 1.199-2(e)(1).

(31) Regs. Sec. 1.199-2(a)(3)(i).

(32) Regs. Sees. 1.1 99-2(a)(3)(ii) and (iii).

(33) Regs. Sec. 1.199-2(e)(2).

(34) Regs. Sec. 1.199-2(a)(2).

(35) See Sec. 402(g)(3).

(36) Regs. Sec. 1.199-2(b).

(37) Regs. Sec. 1.199-2(c).

(38) Regs. Sec. 1.199-2(d).

(39) Sec. 199(d)(4)(C).

Sec. 199 acronyms

DPGR--domestic production gross receipts

EAG--expanded affiliated group

MPGE--manufacturing, producing, growing, or extracting

QPAI--qualified production activities income

QPP--qualifying production property

EditorNotes

Phillip Schurrer is an instructor in accounting and: taxation at Bowling Green State University in Bowling Green, OH. for more information about this article, contact Mr. Schurrer at pschurr@bgsu.ecju.

By: Phillip J. Schurrer, CPA, MBA
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Publication:The Tax Adviser
Date:May 1, 2010
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