Sec. 199 Prop. Regs.: what is an item?

Enacted by American Jobs Creation Act of 2004 Section 102(a), Sec. 199 provides a new, permanent deduction for qualifying activities, including domestic production, construction and engineering or architectural services. Under Sec. 199(a), the deduction is a percentage (3% for tax years beginning in 2005 and 2006, 6% for tax years 2007-2009 and 9% thereafter) of the lesser of taxable income or qualified production activities income (QPM), and is limited by Sec. 199(b) to 50% of a taxpayer's Form W-2 wages. QPAI is calculated by determining gross receipts from qualifying activities and reducing that amount by cost of goods sold, direct expenses and an allocable portion of indirect expenses; see Sec. 199(c).

Notice 2005-14

In January 2005, Notice 2005-14 was issued to provide guidance in applying Sec. 199; for details, see Gibbs and Rathnau, Tax Chnic, "Notice 2005-14 Offers Sec. 199 Guidance," TTA, June 2005, p. 339. Section 3.03 of the notice states that QPAI is determined on an item-by-item basis (and not, for example, on a division-by-division, product-line-by-product-fine or transaction-by-transaction basis) and is the sum of QPAI derived by the taxpayer from each item. For this purpose, QPAI from each item could be positive or negative. The notice failed, however, to define the term "item."

Prop. Regs.

In November 2005, Sec. 199 proposed regulations were issued (REG-105847-05, 11/4/05).These rules provide more detail, including the definition of an item in determining QPAI.

Defining "item": Prop. Regs. Sec. 1.199-1(c)(2)(i) defines "item" as property offered for sale to customers that meets the requirements of Prop. Regs. Sec. 1.199-1(c) and -3. For example, if a finished product is sold to a customer and the taxpayer performed a qualifying activity with respect to it, then the finished product is the item.

If the property offered for sale does not meet these requirements, the taxpayer must treat as the item any portion of the property offered for sale that meets the requirements (the "shrinkback" rule). Prop. Regs. Sec. 1.199-1(c)(2)(ii), Example 1, illustrates this rule substantially as follows.

Example 1: X manufactures leather and rubber shoe soles in the U.S. X imports shoe uppers, which are the parts of the shoe above the sole. X manufactures shoes for sale by sewing or otherwise attaching the soles to the imported uppers. If the shoes do not meet the requirements under Prop. Regs. Sec. 1.199-1(c) and -3, then, under Prop. Regs. Sec. 1.199-1(c)(2)(i), X must treat the sole as the item if the sole meets those requirements.

In the above example, X is required to "shrinkback" the shoe to the portion of property that qualifies as an item (the sole). Such treatment is mandatory.

Prop. Regs. Sec. 1.199-1(c)(2)(i) also provides that in no case may the portion of the property offered for sale that is treated as the item exclude any other portion that meets the requirements. Further, in no event may an item consist of two or more properties offered for sale that are not packaged and sold together as one item. Prop. Regs. Sec. 1.199-1(c)(2)(ii), Examples 3 and 4, illustrate these concepts substantially as follows.

Example 3: Y manufactures toy cars in the U.S. Y also purchases cars that were manufactured by unrelated parties. In addition to packaging some cars individually, Y also packages some cars in sets of three. Some of the cars in the sets may have been manufactured by Y and some may have been purchased. The three-car packages are sold by toy stores at retail. Y must treat each three car package as the item. However, if the three-car package does not meet the requirements under Prop. Regs. Sec. 1.1991(c) and -3, Y must treat a toy car in the three-car package as the item, provided the toy car meets the requirements.

Example 4: The facts are the same as in Example 3 above, except that the toy store follows Y's recommended pricing arrangement for the individual toy cars for sale to customers at three for $10. Frequently, this results in retail customers purchasing three individual cars in one transaction. Y must treat each toy car as an item and cannot treat three individual toy cars as one item, because the individual toy cars are not packaged together for retail sale.

In addition, Prop. Regs. Sec. 1.1991(c)(2)(i) provides that in the case of property customarily sold by weight or volume, the item is determined using the custom of the industry (e.g., barrels of oil). In the case of construction or engineering and architectural services, a taxpayer may use any reasonable method, taking into account all of the facts and circumstances, to determine which construction activities or engineering or architectural services constitute an item.

Summary

Although the proposed regulations provide additional guidance as to what constitutes an item for Sec. 199 purposes, many taxpayers may find the application of the definition challenging, especially the shrinkback rule.

FROM DAVID AUCLAIR, ESQ., WASHINGTON, DC

Editor: Stefan Gottschalk, J.D., LL.M., CPA Senior Manager Grant Thornton LLP Washington, DC