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Section 199: how will recent amendments and new guidance affect your deduction?

Background

Enacted as part of the American Jobs Creation Act of 2004, (1) section 199 of the Internal Revenue Code provides a new permanent deduction for qualifying activities, including domestic production, construction, and engineering or architectural services. (2)

On January 19, 2005, the Department of Treasury and the Internal Revenue Service issued Notice 2005-14 which provided interim guidance in applying section 199. Until recently, Notice 2005-14 was the most significant guidance available to taxpayers regarding the application of section 199. On November 4, 2005, Treasury and the IRS issued proposed regulations under section 199. (3) These regulations clarify a number of issues raised in the January notice and provide detailed guidance on the section 199 deduction, including more examples to illustrate the application of certain rules.

According to the proposed regulations, the final regulations will apply to taxable years beginning after December 31, 2004. (4) Until final regulations are published in the Federal Register, however, taxpayers may rely on the interim guidance in both Notice 2005-14 and the proposed regulations. For this purpose, if the proposed regulations and Notice 2005-14 include different rules for the same particular issue, then the taxpayer may rely on either rule with one exception: If the proposed regulations include a rule that was not included in Notice 2005-14, taxpayers are not permitted to rely on the absence of a rule to apply a rule contrary to the proposed regulations.

The preamble to the proposed regulations notes that certain rules reflect the intent expressed in a July 21,2005, letter to Treasury from the Chairman and Ranking Member of the Senate Finance Committee and the Chairman of the House Ways and Means Committee regarding the proposed Tax Technical Corrections Act of 2005. On December 21, 2005, the Tax Technical Corrections Act of 2005 was signed into law as part of the Gulf Opportunity Zone Act of 2005. (5) The Technical Corrections Act amended portions of section 199, and these amendments are effective for taxable years beginning after December 31, 2004. Because of this retroactive effective date, taxpayers do not have the option of applying rules in Notice 2005-14 that are contrary to the changes made by the Technical Corrections Act.

Understanding the significant differences between the rules in Notice 2005-14, the amendments made by the Technical Corrections Act, and the new guidance in proposed regulations is critical to properly calculating the deduction under section 199. This article discusses these important differences. (6)

The Basics

Section 199 provides that for taxable years beginning in 2005 a taxpayer may deduct a statutory percentage (3 percent in 2005) of the lesser of: (1) the taxpayer's Qualified Production Activities Income (QPAI) for the taxable year, or (2) the taxpayer's taxable income for the year (or in the case of an individual, adjusted gross income). (7) The amount of the deduction cannot exceed 50 percent of W-2 wages of the taxpayer. (8)

QPAI for any taxable year is a net number equal to the taxpayer's Domestic Production Gross Receipts (DPGR) less the sum of:

(1) the cost of goods sold allocable to the receipts,

(2) expenses directly allocable to the receipts, and

(3) a ratable portion of other deductions not directly allocable to DPGR or to another class of income. (9)

DPGR means gross receipts from the following:

(1) any lease, rental, license, sale, exchange, or other disposition of:

(a) tangible personal property, computer software, and sound recordings (collectively referred to Qualified Production Property (QPP) as, that is Manufactured, Produced, Grown, or Extracted (MPGE) by the taxpayer in whole or in significant part within the United States;

(b) qualified film produced by the taxpayer; or

(c) electricity, natural gas, or potable water produced by the taxpayer in the United States;

(2) construction performed in the United States; and

(3) engineering or architectural services performed in the United States for construction projects in the United States. (10)

Net Operating Losses and Section 199

Taxable income for section 199 purposes has the same definition as taxable income under section 63 without regard to the section 199 deduction. (11) This means that taxable income is determined after the application of any net operating loss (NOL) carryover. Because of the taxable income limitation in section 199, a taxpayer that has an NOL or has its taxable income eliminated by an NOL carryover is not entitled to a deduction under section 199.

Before enactment of the Technical Corrections Act, it appeared that a section 199 deduction could create or increase an NOL carryback or carryover. That legislation, however, amended section 172 to eliminate this potential benefit. (12) As a result, except for a limited situation relating to the portion of a section 199 deduction allocated to a member of an Expanded Affiliated Group, (13) the section 199 deduction can neither create an NOL carryback or carryover nor increase the amount of an NOL carryback or carryover.

What Is An Item?

One of the most significant clarifications provided in the proposed regulations is the definition of the term "item" for purposes of' calculating QPAI. In order for the receipts from the lease, rental, license, sale, exchange, or other disposition of an item to be considered DPGR, the item itself must qualify as having been manufactured, produced, grown or extracted in whole or significant part by the taxpayer within the United States. Like Notice 2005-14, the proposed regulations provide that QPAI is determined on an item-by-item basis (and not, for example, on a division-by-division, product line-by-product line, or transaction-by-transaction basis/ and total QPAI is the sum of QPAI derived by the taxpayer from each item. (14) Whereas Notice 2005-14 is silent on what constitutes an item, the proposed regulations provide significant guidance in this area.

The proposed regulations define the term "item" as property offered for sale to customers where the receipts from the disposition of the property qualify, as DPGR under rules in Prop. Reg. [section] 1.199-3 and the general rules under Prop. Reg. [section] 1.199. (15) For example, if a finished product sold to a customer meets these requirements (that is, the activity performed by the taxpayer with respect to the product qualifies all the receipts from the sale of the finished product as DPGR), then the finished product is the item. If the finished product does not meet the definition of an item because it was not manufactured, produced, grown, or extracted in whole or significant part by the taxpayer in the United States, the proposed regulations provide an opportunity to qualify a portion of the receipts from its disposition through what has come to be known as the "shrinkback" rule.

According to the proposed regulations, 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. In addition, in the case of property customarily sold by weight or by volume, the item is determined using the custom of the industry, for example barrels of oil.

Shrinkback Rule

Under the shrinkback rule, if the property offered for sale does not meet the requirements of DPGR, the taxpayer must treat as the "item" any portion of the property offered for sale that meets the requirements. (16) The following example in the proposed regulations illustrates the application of the shrinkback rule:</p> <pre> X manufactures leather and rubber shoe soles in the United States. 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 this section and [section] 1.199-3, then under paragraph (c)(2)(i) of this section, X must treat the sole as the item if the sole meets the requirements under this section and [section] 1.199-3. (17) </pre> <p>The taxpayer in this example is required to shrinkback the shoe to the portion of property that qualifies as an item, which, in the example, is the sole of the shoe.

The shrinkback rule has its origins in the coffee example in a footnote in the legislative history to section 199, (18) which provides that a component may be treated as qualifying property in the case of food and beverages. According to the preamble to the proposed regulations, the footnote explains that, even though receipts from a cup of coffee prepared at a retail establishment do not qualify for the special deduction, receipts from a portion of the cup of coffee representing production activities conducted away from the retail facility (the coffee beans roasted at a facility separate from the retail establishment) do qualify. The preamble further cites language from the Joint Committee's "Blue Book" explanation of the 2004 tax law, (19) explaining that Congress intended that this issue not be limited to food and beverages, but be permitted with respect to section 199 in general.

The shrinkback rule offers additional opportunities for taxpayers to qualify more of their receipts as DPGR. There appears to be no restrictions on the extent to which the taxpayer may "shrinkback" in order to find an item that qualifies. Even if only a subcomponent of a subcomponent of a finished product constitutes an item, the shrinkback rule will allow a portion of the receipts from the sale of the finished product that includes the subcomponent to qualify as DPGR.

According to the proposed regulations, the shrinkback rule is mandatory. The proposed regulations also provide that in no case can the portion of the property offered for sale that is treated as the item exclude any other portion that meets the requirement. In the case of construction, or engineering and architectural services, the proposed regulations provide that a taxpayer may use any reasonable method, taking into account all of the facts and circumstances, to determine what activities and services constitute an item. (20)

Although the shrinkback rule should offer opportunities for taxpayers to qualify more receipts as DPGR, the rule may not be easy to apply. Taxpayers will need to determine which portion of the total gross receipts is allocable to an activity that is substantial in nature to a portion of a finished good. In Example 1 from the proposed regulations (discussed above), the gross receipts of the shoe would need to be apportioned between the sole and the rest of the shoe. Also, costs of goods sold for the sole would need to be determined as would any direct costs attributable to the production of the sole. The gross receipts must be allocated based on a reasonable method based on all the facts and circumstances. Taxpayers not keeping their books in a way to easily capture the information will face challenges in implementing this rule.

MPGE of QPP

The proposed regulations address a number of issues related to QPP (tangible personal property, computer software, and sound recordings) that is Manufactured, Produced, Grown, or Extracted (MPGE) by the taxpayer in whole or in significant part within the United States. The proposed regulations broadly define MPGE, consistent with Notice 2005-14, to include activities such as manufacturing, producing, growing, extracting, and developing. (21) MPGE does not include packaging, labeling, installing, or minor assembly if the taxpayer engages in no other activity with respect to the QPP. (22) The proposed regulations identify several issues that should be considered in determining whether a taxpayer meets the requirement to MPGE QPP in whole or in significant part in the United States.

In Whole or Significant Part in the United States

If the item of QPP is MPGE in whole by the taxpayer in the United States, the application of the rules is relatively easy and receipts from the lease, rental, license, sale, exchange, or other disposition of the QPP will generally be considered to be DPGR, though taxpayers will need to take into account other rules, such as those for embedded services. In contrast, where portions of the QPP are purchased or activities are performed on the QPP outside of the United States, the analysis is more complicated. In such a situation, a taxpayer must determine whether the activity it performs with respect to the QPP will meet the requirement of being MPGE in significant part within the United States. Like Notice 2005-14, the proposed regulations provide that this requirement will be met if the MPGE of the taxpayer within the United States is substantial in nature (23) A determination whether the activities of a taxpayer are substantial in nature must take into account all of the facts and circumstances, including the relative value added by, and relative cost of, the taxpayer's MPGE activity within the United States, the nature of the property, and the nature of the MPGE activity that the taxpayer performs within the United States. Research and experimental activities under section 174 and the creation of intangibles do not qualify as being substantial in nature for any QPP other than computer software and sound recordings. (24)

Consistent with Notice 2005-14, the proposed regulations provide a safe harbor under which a taxpayer will be treated as having MPGE QPP in significant part within the United States. Under this safe harbor, if, in connection with the QPP, conversion costs (direct labor and related factory burden) of the taxpayer account for 20 percent or more of the taxpayer's cost of goods sold of the property, then the requirement is satisfied. (25) The proposed regulations do not define the term "related factory burden," leaving some uncertainty about how this cost accounting concept is to be implemented in a tax setting. In determining whether the 20-percent test is met, research and experimental costs under section 174 and the costs of creating intangibles do not qualify as conversion costs for any QPP other than computer software and sound recordings. Research and experimental costs under section 174 and the costs of creating intangibles may be excluded from costs of goods sold in determining whether a taxpayer meets the safe harbor. (26)

The proposed regulations clarify the application of the above rules by providing seven examples. (27) In certain of the examples, taxpayers performing activities relating to refining oil, producing jewelry, and assembling automobiles were found to be conducting an MPGE activity that is substantial in nature. In other examples relating to duplicating film onto DVDs and the aging of cigars and pipe tobacco while being displayed and offered for sale, the taxpayers were not found to be conducting an MPGE activity that is substantial in nature. Two other examples illustrate that a taxpayer may be conducting an MPGE activity that is substantial in nature even if partially manufactured goods are imported into the United States or exported for further manufacturing.

If a taxpayer conducts an MPGE activity with regard to QPP that is significant in nature, then the total gross receipts from the lease, rental, license, sale, exchange, or other disposition of the QPP will be considered to be DPGR. A taxpayer that fails to satisfy the conversion costs safe harbor should consider whether the activity performed in the United States is substantial in nature taking into account all of the facts and circumstances. If the taxpayer's activity related to the QPP fails both the safe harbor and fact-and-circumstances test, then the taxpayer should apply the shrinkback rule to determine whether the MPGE activity performed in the United States is substantial for a portion of the QPP.

The proposed regulations define the United States in the same manner as Notice 2005-14. (28) The term does not include possessions or territories of the United States.

Embedded Services

Except for construction, architectural, and engineering services, gross receipts derived from the performance of services do not qualify as DPGR. (29) In the case of an embedded service--a service the price of which is not separately stated from the amount charged for the lease, rental, license, sale, exchange, or other disposition of the QPP, qualified films or utilities--DPGR does not include any receipts attributable to the embedded service. In addition, DPGR does not include gross receipts from the lease, rental, license, sale, exchange, or other disposition of non-qualifying property. For example, gross receipts from the lease, rental, license, sale, exchange, or other disposition of a replacement part that is not MPGE by the taxpayer in whole or in significant part in the United States do not qualify as DPGR. (30)

The proposed regulations increase the number of the exceptions to the general rule regarding embedded services from three to five. (31) Gross receipts related to embedded services or non-qualifying property that meet one of these five of the exceptions can qualify as DPGR. Four of these exceptions relate to specific services: (1) a qualified warranty; (2) a qualified delivery; (3) a qualified operating manual; and (4) a qualified installation. The fifth exception provides that a de minimis amount of gross receipts from embedded services or non-qualifying property may qualify as DPGR. In order for the service to be a qualified service under any of the five exceptions, it must meet the following two requirements: (1) in the normal course of the taxpayer's business the price of the service must not be separately stated; and, (2) the service must neither be separately offered by the taxpayer nor separately bargained for with the customer (i.e., a customer cannot purchase the property without the service). In addition, a qualified operating manual must not be provided in connection with a training course for the customer. A de minimis amount of gross receipts from embedded services and non-qualifying property is an amount that is less than 5 percent of the total gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of each item of QPP, qualified films or utilities. For purposes of the de minimis rule, gross receipts related to embedded services that meet one of the other four exceptions are treated as DPGR and do not have to be counted against the 5 percent of embedded services allowed as de minimis.

The proposed regulations contain four examples illustrating the embedded services rules. (32) In two of the examples, receipts allocable to separately stated training services and delivery services do not qualify as DPGR. The two other examples illustrate the application of the de minimis rule and the qualified delivery, warranty, and operating manual rules. Allocating receipts to non-qualifying embedded services may be a challenge to taxpayers depending on how they keep their books and records. The proposed regulations provide that the allocation of gross receipts attributable to embedded services or non-qualifying property will be deemed to be reasonable if the allocation reflects the fair market value of the embedded services or property. (33)

Expanded Affiliated Groups

The Technical Corrections Act amended the definition of an Expanded Affiliated Group (EAG) in section 199. (34) As enacted in 2004, section 199 defined an EAG as an affiliated group as defined in section 1504(a) determined by substituting "50 percent" for "at least 80 percent" for the voting and value test and includes insurance companies subject to section 801 and corporations that made an election under section 936 with respect to the possession tax credit. The 50-percent test allowed for a corporation to be part of two different EAGs with the potential for the corporation's DPGR to be utilized by both of the EAGs. The Technical Corrections Act eliminated this possibility by substituting "more than 50 percent" for "50 percent." The proposed regulations reflect this amended definition of an EAG. (35)

The EAG rules allow for the attribution of activities among members of the EAG. (36) For example, the gross receipts of a stand-alone corporation that distributes products that it did not MPGE in whole or significant part in the United States would generally not qualify for the section 199 deduction. In contrast, if the corporation is part of an EAG and it distributes products that were MPGE in whole or significant part in the United States by another member of the EAG, the receipts would qualify as DPGR. The proposed regulations clarify that attribution of activities among members of an EAG does not apply for purposes of the construction of real property or the performance of engineering and architectural services. (37)

EAG Partnership

Under Notice 2005-14, a partnership could not obtain the attribution benefits of being a member of an EAG. The Technical Corrections Act amended section 199 to provide for the concept of an EAG partnership. (38) An EAG partnership exists if all of the interests in the capital and profits of a partnership are owned by members of a single EAG at all times during the taxable year of the partnership. In such a situation, the EAG and all members of the EAG are treated as a single taxpayer for purposes of determining activities that qualify for the deduction. The proposed regulations reflect this change to section 199, and similar to the general rules for EAGs, the proposed regulations provide that attribution of activities does not apply for purposes of the construction of real property or the performance of engineering and architectural services. (39)

An EAG partnership may not use the small business simplified overall method. (40) In addition, an EAG partnership is subject to the rules regarding the application of section 199 to pass-through entities, including the application of the rules that limit the amount of W-2 wages that may be allocated to a partner. Therefore, taxpayers could have their section deduction limited if the EAG partnership is the employer for a disproportionate number of employees of the EAG. (41)

Benefits-and-Burdens Rule

The Technical Corrections Act amended section 199(d) to provide Treasury and the IRS with the discretion to promulgate regulations that prevent more than one taxpayer from being allowed a deduction under section 199 with respect to a qualified activity. (42) Except as discussed below, the proposed regulations, similar to Notice 2005-14, provide that only one taxpayer may claim the section 199 deduction with respect to any qualifying activity performed in connection with the same QPP or the production of qualified films or utilities. (43) The proposed regulations, also similar to Notice 2005-14, provide that if one taxpayer performs a qualifying activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property under federal income tax principles during the period the qualifying activity occurs is treated as engaging in the qualified activity. (44) Such rules are now clearly authorized by the Technical Corrections Act.

The preamble to the proposed regulations notes that several commentators suggested alternative tests to provide more certainty to the benefits-and-burdens analysis in situations where property is produced under contract. None of these alternatives were adopted by the proposed regulations. Further, case law that has applied a benefits-and-burden analysis outside of situations where property is produced under a contract may not be dispositive pf the result under the proposed regulations. (45)

The proposed regulations provide two new examples to illustrate the benefits-and-burdens tests. (46)</p> <pre> Example (1). X designs machines that it uses in its trade or business. X contracts with Y, an unrelated taxpayer, for the manufacture of the machines. The

contract between X and Y is a fixed-price contract. The contract specifies that the machines will be manufactured in the United States using X's design. X owns the intellectual property attributable

to the design and provides it to Y with a restriction that Y may only use it during the manufacturing process and has no right to exploit the intellectual property. The contract specifies that Y controls the details of the manufacturing process while the machines

are being produced; Y bears the risk of loss or damage during manufacturing of the machines; and Y has the economic loss or gain upon the sale of the machines based on the difference between Y's

costs and the fixed price. Y has legal title during the manufacturing process and legal title to the machines is not transferred to X until final manufacturing of the machines has been completed. Based

on all of the facts and circumstances, pursuant to paragraph (e)(1) of this section, Y has the benefits and burdens of ownership of the machines under Federal income tax principles during the period the manufacturing occurs and, as a result, Y is treated as the manufacturer of the machines. Example (2). X designs and engineers machines that it sells to customers. X contracts with Y, an unrelated taxpayer, for the manufacture of the machines. The contract between X and Y is a cost-reimbursable type contract. X has the benefits

and burdens of ownership of the machines under Federal income tax principles during the period the manufacturing occurs except that legal title to the machines is not transferred to X until final manufacturing of the machines is completed. Based on all of the facts and circumstances, X is treated as the manufacturer of the machines under paragraph (e)(1) of this section. </pre> <p>Example 2 assumes that one of the taxpayers had all benefits and burdens of ownership of the machines under federal income tax principles during the period the manufacturing occurs except for legal title, but the example does not describe what those particular attributes of benefits and burdens are. Therefore, this example does not provide much guidance on what factors should be considered as part of the benefits-and-burdens analysis.

In Example 1, one taxpayer had the following benefits and burdens of ownership: (1) control of the details of the manufacturing process while the property is being produced; (2) risk of loss or damage of the property during the manufacturing process; (3) economic loss or gain upon the sale of the property based on the difference between the taxpayer's costs and the fixed price; (4) legal title during the manufacturing process; and (5) legal title is not transferred until final manufacturing of the product has been completed. In a situation where the facts are substantially similar to those in Example 1, a taxpayer may rely on the example in reaching a conclusion about the benefits and burdens of ownership. Where the facts are not substantially similar to those in Example 1, taxpayers will face the challenge of deciding which taxpayer has the benefits and burdens of ownership in a situation where property is produced under a contract.

Exceptions to the Benefits-and-Burdens Rule

The Technical Corrections Act amended section 199 to provide relief from the benefits-and-burdens rule for certain government contractors. (47) Under this new rule, QPP (or the production of films or utilities) will be treated as MPGE by the taxpayer if: (1) the QPP (or the production of films or utilities) are MPGE pursuant to a contract with the federal government; and (2) the Federal Acquisition Regulation requires that risk of loss with respect to the QPP (or the production of films or utilities) be transferred to the federal government before the MPGE is complete. This new rule is included in the proposed regulations. (48)

Additional exceptions to the general benefits-and-burdens rule are contained in the rules that apply to an EAG (49) and an EAG partnership. (50) Another exception is provided in the rules contained in the proposed regulations for oil and gas partnerships. (51)

Computer Software and Online Services

The proposed regulations continue to limit receipts related to online services. Gross receipts from the lease, rental, license, sale, exchange, or other disposition of computer software do not include gross receipts derived from Internet access services, online services, customer and technical support, telephone services, online electronic books and journals, games played through a website, provider-controlled software online access services, and other similar services that do not constitute the lease, rental, license, sale, exchange, or other disposition of computer software that was developed by the taxpayer. (52) The proposed regulations provide the following two examples to illustrate this rule:</p>

<pre> Example 1. X produces and prints a newspaper in the United States which it sells to customers. X also has an online version of the newspaper which is available only to subscribers. The gross receipts derived from the sale of the newspaper X produces and prints qualify as DPGR. However, because X's gross receipts from the online newspaper subscription are not derived from the lease, rental, license, sale, exchange, or disposition of computer software

under paragraph (h)(6)(i) of this section, the gross receipts attributable to the online newspaper subscription fees are non-DPGR under paragraph (h)(6)(i) of this section. (53) Example (2). The facts are the same as in Example 1 except that X's gross receipts attributable to the online version of its newspaper are derived

from fees from customers to view the newspaper online and payments from advertisers to display advertising online. X's gross receipts derived from allowing customers online access to X's newspaper

are non-DPGR because, pursuant to paragraph (h)(6)(i) of this section, the gross receipts relating to online newspapers are not derived from the lease, rental, license, sale, exchange, or other

disposition of QPP, but rather is the provision of an online access service. As a result, because X's gross receipts from the online access services are non-DPGR, the related online advertising receipts are similarly non-DPGR under paragraph (h)(5)(i) of this section. (54) </pre> <p>The rule regarding online services remains controversial. In the preamble to the proposed regulations the IRS and Treasury have requested comments concerning whether the provision of certain types of online software should qualify under section 199.

Construction

Construction is another area affected by the Technical Corrections Act. In order to qualify for the section 199 deduction, a taxpayer now must be engaged in the active conduct of a construction trade or business and receipts must be received in the ordinary course of such trade or business. (55) The Technical Corrections Act also places similar requirements on taxpayers providing engineering or architectural services. (56)

The proposed regulations continue to distinguish between certain activities that do and do not qualify as construction. Construction is defined as the construction or erection of real property, including structural components of buildings, inherently permanent structures other than tangible personal property, inherently permanent land improvements, oil and gas wells, and infrastructure. (57) The rules relating to construction clarify that at the time the taxpayer constructs real property the taxpayer must be engaged in a trade or business (but not necessarily its primary, or only, trade or business) that is considered construction for the purposes of the North American Industry Classification System (NAICS) (58) on a regular and ongoing basis. (59)

Consistent with Notice 2005-14, tangential services such as hauling trash and debris are DPGR only if the taxpayer provides these services in connection with performing construction. Improvements to land that are not capitalizable to the land, such as landscaping, and painting are considered construction only if performed in connection with other activities (whether or not by the same taxpayer) that constitute the erection or substantial renovation of real property. Tangible personal property sold as part of a construction project is not considered real property. (60)

Also consistent with Notice 2005-14, the proposed regulations provide a de minimis rule that, if less than 5 percent of the total gross receipts derived by a taxpayer on a construction project are from activities other than construction of real property in the United States, the total gross receipts derived by the taxpayer from the project are DPGR from construction. (61) The proposed regulations add a new rule whereby gross receipts from a qualified construction warranty are DPGR. (62)

Proceeds from the sale, exchange, or other disposition of real property constructed by a taxpayer in the United States, whether or not the property is sold immediately after construction is completed and whether or not the construction project is complete, qualify as DPGR. (63) DPGR also includes compensation for the performance of construction services by the taxpayer in the United States. Gross receipts from the lease or rental or real property, however, are not DPGR.

The Technical Corrections Act also settled any doubt about gross receipts attributable to the sale or other disposition of land qualifying as DPGR by amending section 199 to specifically exclude such receipts. (64) The proposed regulations reflect this exclusion (65) and, in an effort to address the complexity of determining the appreciation in value of land sold as part of a construction project, the proposed regulations introduce a land safe harbor whereby DPGR is reduced by land costs (including costs capitalizable to the land) plus a certain percentage. The percentage is based on the number of years that elapse between the date the taxpayer acquires the land, including the date the taxpayer enters into the first option to acquire all or a portion of the land, and ends on the date the taxpayer sells each item of real property on the land. The percentage is 5 percent for years zero through 5; 10 percent for years 6 through 10; and 15 percent for years 11 through 15. Land held by a taxpayer for 16 or more years is not eligible for the safe harbor. (66) The proposed regulations provide two examples illustrating the application of this safe harbor. (67)

The proposed regulations also contain an unusual example regarding gross receipts allocable to materials used during the construction process. In the example, an electrical contractor purchases the wires, conduits, and other electrical materials that it installs in construction projects in the United States. In a particular construction project, all of the wires, conduits, and other electrical materials installed by the taxpayer for the operation of the building are considered structural components of the building. The example concludes that the gross receipts derived from installing the property qualify as DPGR, but gross receipts derived from purchased materials do not qualify. (68) This result appears to be inconsistent with the language of section 199 that all receipts from construction qualify as DPGR. This inconsistent result has been brought to the attention of Treasury and the IRS. It will be interesting to see whether the conclusion in the example will be retained in the final regulations.

Pass-Through Entities

The proposed regulations reflect changes made by the Technical Corrections Act relating to the application of section 199 to pass-through entities. (69) Pass-through entities do not calculate the section 199 deduction. Rather, the proposed regulations require partnerships and S corporations to provide information to partners and shareholders so that the section 199 deduction can be calculated at the partner or shareholder level. The type of information that must be provided depends on whether the partnership or S Corporation uses the small business simplified overall method described in Prop. Reg. [section] 1.199-4(f). (70)

In the case of a partnership or an S corporation that uses the small business simplified overall method, the pass-through entity calculates its QPAI and each partner or shareholder is allocated its share of QPAI and W-2 wages from the pass-through entity. The partner or shareholder combines these amounts with its QPAI and W-2 wages from other sources. In all other situations, each partner or shareholder is allocated its share of pass-through items (including items of income, gain, loss, and deduction), costs of goods sold (CGS) allocated to such items of income, and gross receipts that are included in such items of income even if the partner's or shareholder's share of CGS and other deduction and losses exceeds DPGR. To determine its section 199 deduction for the taxable year, a partner or shareholder aggregates its distributive share of such items with those items it incurs outside the pass-through entity for purposes of allocating and apportioning deductions to DPGR and computing its QPAI. The proposed regulations contain examples illustrating the application of these rules. (71)

The proposed regulations do not provide any exceptions to the partner's or shareholder's W-2 wage limitations as contained in section 199(d)(1). Under these rules, a partner's or shareholder's share of W-2 wages of a pass-through entity is the lesser of: (1) the partner's or owner's allocable share of the wages, or (2) 2 times 3 percent (72) of the QPAI taking into account only the items of the pass-through entity allocated to the partner or shareholder for the taxable year of the pass-through entity. (73) This has the effect of limiting the amount of W-2 wages from a pass-through entity to the amount necessary to support the section 199 deduction attributable to the activities of' the pass-through entity. Therefore, pass-through entities cannot be used to generate additional W-2 wages to support section 199 deductions that arise in other parts of the partner or S corporation shareholder's business. Businesses that are structured to have the majority of employees in pass-through entities could have their section 199 deduction limited by the application of the W-2 limitation rules. As previously noted, this is true even in the case of a partnership that qualifies as an EAG partnership.

The proposed regulations also reflect the changes to the rules for trusts and estates made by the Technical Corrections Act. (74) The proposed regulations contain an example to illustrate the application of these rules. (75)

De minimi Rules

The proposed regulations provide for a number of de minimis rules that need to be taken into consideration in calculating the section 199 deduction. One of the more significant of these rules provides that, if the amount of the taxpayer's gross receipts that do not qualify as DPGR is less than 5 percent of the taxpayer's total gross receipts, the taxpayer may treat all of its gross receipts as DPGR. (76) The proposed regulations clarify that if a corporation is a member of an EAG or a consolidated group, the determination of whether less than 5 percent of the taxpayer's total gross receipts are non-DPGR is made at the corporation level rather than at the EAG or consolidated group level, as applicable. Further, in the case of an S corporation, partnership, estate, or trust, or other pass-through entity, the determination whether less than 5 percent of the pass-through entity's total gross receipts are non-DPGR is made at the pass-through entity level. In the case of an owner of a pass-through entity, the determination of whether less than 5 percent of the owner's total gross receipts are non-DPGR is made at the owner level, taking into account all gross receipts earned by the owner from its activities as well as the owner's share of any pass-through entity's gross receipts.

Allocation of Costs

The proposed regulations clarify that CGS is determined under the methods of accounting that the taxpayer uses to compute taxable income and that additional section 263A costs must be included in determining CGS. (77) This means that taxpayers will be required to calculate tax CGS on sales of goods that occurred during the taxable year.

The proposed regulations provide additional guidance for the allocation of CGS for inventories accounted for using the specific goods LIFO method or the dollar-value LIFO method. As explained in the proposed regulations, whenever a specific goods grouping or a dollar-value pool contains PP, qualified films or utilities that produce DPGR and goods that do not, the taxpayer must allocate CGS between DPGR and non-DPGR using a reasonable method. (78)

The regulations provide two new safe harbor methods for LIFO taxpayers to allocate CGS: (1) the "LIFO/FIFO ratio method," which can be used by taxpayers using the specific goods LIFO method or the dollar-value LIFO method; and (2) the "change in relative base-year cost method," which can be used only by a taxpayer using the dollar-value LIFO method. (79) The proposed regulations contain detailed examples illustrating the application of each safe-harbor method. (80)

Simplified Allocation Methods

In addition to subtracting CGS from DPGR, in determining its QPAI, a taxpayer must also subtract deductions that are directly allocable to DPGR, and a ratable portion of deductions that are not directly allocable to DPGR or to another class of income. Consistent with Notice 2005-14, the proposed regulations provide three methods for making this allocation and apportionment; the regulations, however, made the changes discussed below.

A taxpayer generally must allocate and apportion these deductions using the section 861 method. (81) Under the section 861 method, a taxpayer must apply the rules provided in the section 861 regulations, subject to certain modifications, to allocate and apportion deductions (including its distributive share of deductions) to gross income attributable to DPGR. Generally, the taxpayer allocates deductions to the relevant class of gross income and apportions (if necessary) such deductions within the class of gross income between gross income attributable to domestic production gross receipts (the statutory grouping) and other income (the residual grouping) under section 861.

In the preamble to the proposed regulations, Treasury and the IRS acknowledge that the allocation and apportionment rules of the section 861 method may be burdensome to certain taxpayers, particularly smaller taxpayers, that otherwise would not be required to use these rules. In addition to this method, the proposed regulations provide two simplified methods that can be used by certain taxpayers.

Consistent with Notice 2005-14, the proposed regulations provide that the "simplified deduction method" may be used by a taxpayer with average annual gross receipts of $25 million or less. (82) The regulations, however, expand upon the group of taxpayers that can use the method by also making it available to taxpayers with total assets at the end of the taxable year (83) of $10 million or less. (84) Under the simplified deduction method, a taxpayer's deductions (except the net operating loss deduction and deductions not attributable to the actual conduct of a trade or business) are ratably apportioned between DPGR and non-DPGR based on relative gross receipts. The proposed regulations clarify that whether an owner of a pass-through entity may use the simplified deduction method is determined at the level of the owner of the pass-through entity. (85) Also, whether the members of an EAG may use the simplified deduction method is determined by reference to the average annual gross receipts and total assets of the EAG. If the average annual gross receipts of the EAG are less than or equal to $25 million or the total assets of the EAG at the end of its taxable year are less than or equal to $10 million, each member of the EAG may individually determine whether to use the simplified deduction method, regardless of the cost allocation method used by the other members; members of the same consolidated group, however, must use the same cost allocation method. (86)

The proposed regulations also provide that certain taxpayers may use the "small business simplified overall method." Under this method, a taxpayer's total costs for the current taxable year (87) are apportioned between DPGR and other receipts based on relative gross receipts. The following taxpayers are authorized to use this method: (1) a taxpayer that has both average annual gross receipts of $5 million or less and total costs for the current taxable year of $5 million or less; (2) a taxpayer that is engaged in the trade or business of farming that is not required to use the accrual method of accounting under section 447; or (3) a taxpayer that is eligible to use the cash method as provided in Rev. Proc. 2002-28 (in general, taxpayers that are service providers and have average annual gross receipts of $10 million or less and that are not prohibited from using the cash method under section 448). (88)

The proposed regulations differ from Notice 2005-14 by making the small business simplified overall method available to certain taxpayers engaging in farming, but the regulations also deny the method to taxpayers that may have qualified under the Notice 2005-14 rules by adding the $5 million or less total costs limitation. The rules for application for determining whether a pass-through entity or a member of EAG may use this method are similar to rules under the simplified deduction method. (89) The proposed regulations also deny the use of this method to EAG partnerships, qualifying oil and gas partnerships, and trusts and estates. (90)

Conclusion

The Technical Corrections Act and the proposed regulations have made significant changes to the rules under section 199. These new rules provide additional opportunities to qualify property and increase the amount of the section 199 deduction through important changes such as the shrinkback and EAG partnership rules. Other rules, such as the change in the treatment of net operating losses and exclusion of gain from the disposition of land, foreclose opportunities. The changes simplify compliance through safe harbors and de minimis rules, yet also introduce complicated new procedures that may not fit with existing accounting methodologies. Understanding and applying these new rules, and taking advantage of their opportunities while managing their challenges, will be critical to a proper determination of a taxpayer's section 199 deduction.

(1) Pub. L. No. 108-357 (October 22, 2004).

(2) Unless stated otherwise, all references to the "Code" or "section" refer to the Internal Revenue Code of 1986, as amended, and "regulation" or "reg." refers to applicable Treasury Regulations.

(3) REG-105847-05, 70 F.R. 67220 (Nov. 4, 2005).

(4) Prop. Reg. [section] 1.199-8(g).

(5) Title IV, Gulf Opportunity Zone Act of 2005, H.R. 4440. Section 403 contains the amendments related to the American Jobs Creation Act, including section 199.

(6) Notice 2005-14 is discussed at length in James L. Atkinson, Some Assembly Required: Treasury Provides First Round of Guidance on the Domestic Manufacturers' Deduction, 57 Tax Executive 138 (March-April 2005).

(7) I.R.C. [section] 199(a). The statutory percentage remains the same for taxable years beginning in 2006 and then increases to 6 percent for taxable years beginning in 2007, 2008, and 2009, and further increases to 9 percent for taxable years beginning thereafter.

(8) I.R.C. [section] 199(b).

(9) I.R.C. [section] 199(c)(1).

(10) I.R.C. [section] 199(c)(4).

(11) Prop. Reg. [section] 1.199-1(b).

(12) [section] 403(a)(17) of the Gulf Opportunity Zone Act of 2005.

(13) Prop. Reg. [section] 1.199-7(c)(2).

(14) Prop. Reg. [section] 1.199-1(c)(1).

(15) Prop. Reg. [section] 1.199-1(c)(2).

(16) Id.

(17) Prop. Reg. [section] 1.199-1(c)(2), Example 1.

(18) H.R. Rep. No. 755, 108th Cong., 2d Sess. 272 n.27 (2004) (Conference Report).

(19) Joint Committee on Taxation Staff, General Explanation of Tax Legislation Enacted in the 108th Congress, 109th Cong., 1st Sess. 172 (2005).

(20) Prop. Reg. [section] 1.199-1(c)(2).

(21) Prop. Reg. [section] 1.199-3(d).

(22) Id.

(23) Prop. Reg. [section] 1.199-3(f)(2).

(24) Id.

(25) Prop. Reg. [section] 1.199-3(f)(3).

(26) Id.

(27) Prop. Reg. [section] 1.199-3(f)(4).

(28) Prop. Reg. [section] 1.199-3(g)

(29) Prop. Reg. [section] 1.199-3(h)(4/(i).

(30.) Id.

(31) Prop. Reg. [section] 1.199-(h)(4)(ii).

(32) Prop. Reg. [section] 1.199-3(h)(4)(iii).

(33) Prop. Reg. [section] 1.199-3(hi(4)(ii).

(34) [section] 403(a)(10), Gulf Opportunity Zone Act of 2005.

(35) Prop. Reg. [section] 1.199-7(a)(1).

(36) Prop. Reg. [section] 1.199-7(a)(31.

(37) Id.

(38) [section] 403(a)(7), Gulf Opportunity Zone Act of 2005.

(39) Prop. Reg. [section] 1.199-3(h)(8).

(40) Prop. Reg. [section] 1.199-4(f)(4).

(41) Prop. Reg. [section] 1.199-3(h)(8).

(42) [section] 403(a)(13), Gulf Opportunity Zone Act of 2005.

(43) Prop. Reg. [section] 1.199-3(e).

(44) id.

(45) See e.g., Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981); Torres v. Commissioner, 88 T.C. 702 (1987).

(46) Prop. Reg. [section] 1.199-3(e)(3), Example 1 & Example 2.

(47) [section] 403(a)(7), Gulf Opportunity Zone Act of 2005.

(48) Prop. Reg. [section] 1.199-3(e)(2).

(49) Prop. Reg. [section] 1.199-7(a)(3).

(50) Prop. Reg. [section] 1.199-3(h)(8).

(51) Prop. Reg. [section] 1.199-3(h)(7).

(52) Prop. Reg. [section] 1.199-3(h)(6).

(53) Prop. Reg. [section] 1.199-3(h)(6)(ii), Example 1.

(54) Prop. Reg. [section] 1.199-3(h)(61(ii), Example 2.

(55) [section] 403(a1(5), Gulf Opportunity Zone Act of 2005.

(56) Id.

(57) Prop. Reg. [section] 1.199-3(1}(1)(i).

(58) A trade or business that is considered construction under the NAICS means a construction activity under the two-digit NAICS code of 23 and any other construction activity in any other NAICS code provided the construction activity relates to the construction of real property such as NAICS code 213111 (drilling oil and gas wells! and 213112 (support activities for oil and gas operations).

(59) Prop. Reg. [section] 1.199-3(1)(1)(i).

(60) Prop. Reg. [section] 1.199-3(1)(2).

(61) Prop. Reg. [section] 1.199-3(1)(1)(ii).

(62) A warranty is a qualified construction warranty if (1) in the normal course of the taxpayer's business, the price for the construction warranty is not separately stated from the amount charged for the constructed real property; and (2) the construction warranty is neither separately offered by the taxpayer nor separately bargained for with the customer (that is, the customer cannot purchase the constructed real property without the construction warranty). Prop. Reg. [section] 1.199-3(1)(5)(i).

(63) Prop. Reg. [section] 1.199-3(1)(5)(i).

(64) [section] 403(a)(61\), Gulf Opportunity Zone Act of 2005.

(65) Prop. Reg. [section] 1.199-3(1)(5)(i).

(66) Prop. Reg. [section] 1.199-3(1)(5)(ii).

(67) Prop. Reg. [section] 1.199-3(1t(5)(iii), Example 5 & Example 6.

(68) Prop. Reg. [section] 1.199-3(1)(5)(iii), Example 2.

(69) [section] 403(a)(8), Gulf Opportunity Zone Act of 2005.

(70) Prop. Reg. [sub section] 1.199-5(a) and (b).

(71) Prop. Reg. [section] 1.199-5(a)(4).

(72) The percentage remains 3 percent for taxable years beginning in 2006 and then increases to 6 percent for taxable years beginning in 2007, 2008, or 2009, and further increases to 9 percent for all later taxable years.

(73) Prop. Reg. [sub section] 1.199-5(a)(3) and -5(b)(3).

(74) [section] 403(a)(8), Gulf Opportunity Zone Act of 2005; Prop. Reg. [sub section] 1.199-5(c) and (d).

(75) Prop. Reg. [section] 1.199-5(d)(2).

(76) Prop. Reg. [section] 1.199-1(d)(2).

(77) Prop. Reg. [section] 1.199-4(b)(1).

(78) Prop. Reg. [section] 1.199-4(b)(5)(i).

(79) Prop. Reg. [section] 1.199-4(b)(5)(ii).

(80) Prop. Reg. [section] 1.199-4(b)(7).

(81) Prop. Reg. [section] 1.199-4(d).

(82) See Prop. Reg. [section] 1.199-4(g).

(83) See Prop. Reg. [section] 1.199-4(h).

(84) Prop. Reg. [section] 1.199-4(e)(1).

(85) Id.

(86) Prop. Reg. [section] 1.199-4(e)(2).

(87) See Prop. Reg. [section] 1.199-4(i).

(88) Prop. Reg. [section] 1.199-4(f)(2).

(89) Prop. Reg. [section] 1.199-4(f)(3).

(90) Prop. Reg. [section] 1.199-4(f)(4).

DAVID AUCLAIR is a Principal in Grant Thornton LLP's National Tax Office in Washington, D.C. Previously a senior reviewer at the IRS National Office, Mr. Auclair leads Grant Thornton's Methods and Periods Practice and specializes in tax accounting issues. He also specializes in issues involving tax controversies and IRS practice and procedure. MEL SCHWARZ is Partner for Tax Legislative Affairs in Grant Thornton LLP's National Tax Office where he is responsible for monitoring tax legislative activity. Additionally, his duties include individual and Subchapter S tax issues, depreciation, and the individual and corporate alternative minimum tax. Mr. Schwarz has more than 20 years of federal income tax experience, including six years on the staff of the Joint Committee on Taxation. Copyright 2006 by Tax Executives Institute and the authors.
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