IRS Issues Proposed Regulations on the Domestic Production Activities Deduction

By Cheryl Cornwell

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Overview of the Domestic Production Activities Deduction

The IRC section 199 deduction is equal to 3% of qualified production activities income of the taxpayer in tax years 2005 and 2006, 6% in 2007 through 2009, and 9% in 2010 and thereafter; if taxable income is less than this amount, then the deduction is equal to taxable income. Additionally, the deduction is limited to 50% of the W-2 wages paid by the taxpayer for that taxable year.

The activities eligible for the deduction include not only the manufacture of personal property but also software development; film and music production; the production of water, natural gas, and electricity; and construction, engineering, and architectural activities and services.

Clarifications from the Proposed Regulations

Application on an item-by-item basis. The proposed regulations confirmed the guidance in Notice 2005-14, which states that IRC section 199 must be applied on an item-by-item basis, even though doing so is unduly burdensome. The IRS believes that taxpayers might otherwise receive benefits for gross receipts that do not qualify. The proposed regulations in certain cases allow portions of an item (e.g., the portion of software produced in the United States) to qualify.

Treatment of advance payments. The proposed regulations clarify that when gross receipts and corresponding expenses are recognized in different taxable years, taxpayers must take the receipts and expenses into account, for the purposes of IRC section 199, in the taxable year in which the items are recognized under the methods of accounting for federal income tax purposes. The IRS believes that it would be unduly burdensome and complicated to create a separate set of timing rules for section 199.

Net operating losses. The proposed regulations further clarify that the IRC section 199 deduction is not taken into account in computing taxable income when determining the amount of a net operating loss carryback or carryforward under IRC section 172(b)(2). With limited exceptions, the section 199 deduction can neither create nor increase the amount of an NOL carryback or carryforward.

Wages. The proposed regulations clarify that neither self-employment income nor guaranteed payments to partners qualify as W-2 income for purposes of determining the IRC section 199 deduction.

The nonduplication rule continues to provide that amounts that are treated as W-2 wages in one year cannot be treated as W-2 wages in another taxable year. In addition, the same W-2 wages cannot be claimed by more than one taxpayer for the purposes of section 199.

Related parties. IRC section 199(c)(7) states that domestic production gross receipts do not include any gross receipts of the taxpayer derived from property leased, licensed, or rented by the taxpayer for use by any related person. The proposed regulations continue to include the exception from this general rule; that is, the provision is not intended to apply to a related party if the property held by that related party is held for sublease to, or is subleased to, an unrelated party for the ultimate use of an unrelated party.

IRC section 263A treatment. The proposed regulations provide that a taxpayer that has manufactured, produced, grown, or extracted qualifying production property for the taxable year should treat itself as a producer under IRC section 263A with respect to the qualifying property, unless the taxpayer is not subject to the section 263A capitalization rules. A taxpayer whose manufactured, produced, grown, or extracted activity is exempt from section 263A is not required to change its method of accounting under section 263A for the purposes of section 199.

Construction activities. The proposed regulations define the term “construction” to mean the construction or erection of real property by a taxpayer that is in a trade or business that is considered construction for the purposes of the North American Industry Classification System (NAICS). The proposed regulations clarify that in order for a taxpayer to be considered in an NAICS construction code, it must be engaged in a construction trade or business (but which is not necessarily its primary trade or business) on a regular and ongoing basis.

A taxpayer must actually perform construction activities in order to qualify for the IRC section 199 deduction. If all the work is contracted out, the gross receipts will not qualify as domestic production gross receipts even though the taxpayer is in the construction business.

Gross receipts attributable to land sales generally cannot be treated as domestic production gross receipts from real property construction. However, the proposed regulations provide a safe harbor method under which the gross receipts attributable to land are calculated by adding a markup percentage to land costs. This percentage is based on the number of years the land is held (5% for up to 5 years, 10% for years 6 through 10, and 15% for years 11 through 15). The safe harbor is not allowed for land held for 16 or more years.

Other Provisions

Allocation of costs of goods sold. The proposed regulations clarify that if a taxpayer does, or can, without undue burden or expense, specifically identify from its books and records the costs of goods sold allocable to domestic production gross receipts (DPGR), the cost of goods sold allocable to DPGR is that amount, irrespective of whether the taxpayer uses another allocation method to allocate gross receipts between DPGR and other gross receipts.

Allocation and apportionment of deductions. The proposed regulations are consistent with Notice 2005-14, in that they continue to provide three methods for allocating and apportioning deductions. The first method, the IRC section 861 method, must be used by a taxpayer, unless the taxpayer is eligible and chooses to use either the simplified deduction method or the small business simplified overall method. The rules of section 861 have significance when determining which income or deductions are considered from within the United States and which are from outside the U.S.

Second, a business taxpayer may use the simplified deduction method if it has average annual gross receipts of $25 million or less, or total assets at the end of the taxable year of $10 million or less.

Finally, a qualifying small business taxpayer may use the small business simplified overall method to apportion cost of goods sold and deductions to domestic production gross receipts. The proposed regulations provide that a qualifying small business taxpayer is a taxpayer that meets one of the following conditions:

• It has both average annual gross receipts of $5 million or less, and cost of goods sold and deductions (excluding NOL deductions and deductions not attributable to the conduct of a trade or business) for the current taxable year of $5 million or less;
• It is engaged in a trade or business of farming that is not required to use the accrual method under IRC section 447; or
• It is eligible to use the cash method as provided in Revenue Procedure 2002-28.

The apportionment under the last two methods is generally based on relative gross receipts.

Pass-through entities. The proposed regulations make it clear that an owner of a pass-through entity does not need to be engaged directly in the entity’s trade or business in order to claim an IRC section 199 deduction on the basis of that owner’s share of the entity’s pass-through items.

The proposed regulations also make it clear that when determining its section 199 deduction, an owner of a pass-through entity aggregates items of income and expense from the entity (including W-2 wages) with its own items of income and expense (including W-2 wages) for purposes of allocating and apportioning deductions to DPGR.

An owner’s share of W-2 wages for purposes of determining the owner’s 50% W-2 wage limit is the lesser of its allocable share of the wages or of double the applicable percentage (3% in 2005 and 2006, 6% for 2007 through 2009, 9% thereafter) of allocated qualified production activities income.

Alternative minimum tax. In accordance with IRC section 199(d)(6), the proposed regulations provide that, for purposes of determining alternative taxable income under IRC section 55, a taxpayer that is not a corporation may deduct an amount equal to the applicable percentage (3% in 2005 and 2006, 6% for 2007 through 2009, 9% thereafter) of the lesser of the taxpayer’s qualified production activities income for the taxable year or the taxpayer’s taxable income for the taxable year determined without regard to the section 199 deduction. In the case of an individual, adjusted gross income is used for the limitation on taxable income. A corporation, however, is limited to the applicable percentage of qualified production activities income or the alternative minimum taxable income determined without regard to the section 199 deduction. For purposes of computing the alternative minimum taxable income, the qualified production activities income is computed without any adjustments under IRC sections 56 through 59. The amount of the section 199 deduction for any taxable year is still limited to 50% of the W-2 wages of the employer for the taxable year.