Internal Revenue Bulletin: 2008-14 |
April 7, 2008 |
Table of Contents
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
This document contains final regulations concerning the amendments made by the Tax Increase Prevention and Reconciliation Act of 2005 to section 199 of the Internal Revenue Code. The final regulations also contain a rule concerning the use of losses incurred by members of an expanded affiliated group. Section 199 provides a deduction for income attributable to domestic production activities. The final regulations affect taxpayers engaged in certain domestic production activities.
Effective Date: These regulations are effective on February 15, 2008.
Applicability Date: For dates of applicability, see §1.199-8(i)(5) and (6).
Concerning §§1.199-2(e)(2) and 1.199-8(i)(5), Paul Handleman or David McDonnell, (202) 622-3040; concerning §§1.199-3(i)(7) and (8), and 1.199-5, William Kostak, (202) 622-3060; and concerning §§1.199-7(b)(4) and 1.199-8(i)(6), Ken Cohen, (202) 622-7790 (not toll-free numbers).
This document provides rules relating to the deduction for income attributable to domestic production activities under section 199 of the Internal Revenue Code (Code). Section 199 was added to the Code by section 102 of the American Jobs Creation Act of 2004 (Public Law 108-357, 118 Stat. 1418), and amended by section 403(a) of the Gulf Opportunity Zone Act of 2005 (Public Law 109-135, 119 Stat. 25), section 514 of the Tax Increase Prevention and Reconciliation Act of 2005 (Public Law 109-222, 120 Stat. 345) (TIPRA), and section 401 of the Tax Relief and Health Care Act of 2006 (Public Law 109-432, 120 Stat. 2922). On June 1, 2006, the IRS and Treasury Department published final regulations under section 199 (T.D. 9263, 2006-1 C.B. 1063 [71 FR 31268]). On October 19, 2006, the IRS and Treasury Department published final and temporary regulations on the TIPRA amendments to section 199 (T.D. 9293, 2006-2 C.B. 957 [71 FR 61662]) and cross-referencing proposed regulations (REG-127819-06, 2006-2 C.B. 1013 [71 FR 61692]). No public hearing was requested or held on the proposed regulations. One comment responding to the proposed regulations was received. After consideration of the comment, the proposed regulations are adopted as amended by this Treasury decision and the corresponding temporary regulations are removed.
Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income (AGI)).
Section 199(b)(1) limits the deduction for a taxable year to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. For this purpose, section 199(b)(2)(A) defines the term W-2 wages to mean, with respect to any person for any taxable year of such person, the sum of the amounts described in section 6051(a)(3) and (8) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. Section 514(a) of TIPRA added new section 199(b)(2)(B), which provides that the term W-2 wages does not include any amount which is not properly allocable to domestic production gross receipts (DPGR) for purposes of section 199(c)(1). Section 199(b)(2)(C) provides that the term W-2 wages does not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for the return.
Section 199(d)(1)(A) provides that, in the case of a partnership or S corporation, (i) section 199 shall be applied at the partner or shareholder level, (ii) each partner or shareholder shall take into account such person’s allocable share of each item described in section 199(c)(1)(A) or (B) (determined without regard to whether the items described in section 199(c)(1)(A) exceed the items described in section 199(c)(1)(B)), and (iii) each partner or shareholder shall be treated for purposes of section 199(b) as having W-2 wages for the taxable year in an amount equal to such person’s allocable share of the W-2 wages of the partnership or S corporation for the taxable year (as determined under regulations prescribed by the Secretary).
Section 199(d)(1)(B) provides that, in the case of a trust or estate, (i) the items referred to in section 199(d)(1)(A)(ii) (as determined therein) and the W-2 wages of the trust or estate for the taxable year shall be apportioned between the beneficiaries and the fiduciary (and among the beneficiaries) under regulations prescribed by the Secretary, and (ii) for purposes of section 199(d)(2), AGI of the trust or estate shall be determined as provided in section 67(e) with the adjustments described in such section.
Section 199(d)(1)(C) provides that the Secretary may prescribe rules requiring or restricting the allocation of items and wages under section 199(d)(1) and may prescribe such reporting requirements as the Secretary determines appropriate.
Section 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation for purposes of section 199. Section 199(d)(4)(B) provides that an EAG is an affiliated group as defined in section 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” each place it appears and without regard to section 1504(b)(2) and (4).
Section 199(d)(9) authorizes the Secretary to prescribe such regulations as are necessary to carry out the purposes of section 199, including regulations that prevent more than one taxpayer from being allowed a deduction under section 199 with respect to any activity described in section 199(c)(4)(A)(i).
For taxable years beginning after May 17, 2006, §1.199-2T(e)(2)(i) provides that the term W-2 wages includes only amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages) that are properly allocable to DPGR (as defined in §1.199-3) for purposes of section 199(c)(1). A taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances.
Section 1.199-2T(e)(2)(ii) and (iii) provide safe harbors for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under the wage expense safe harbor in §1.199-2T(e)(2)(ii)(A) for taxpayers using either the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e), a taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR by multiplying the amount of paragraph (e)(1) wages by the ratio of the taxpayer’s wage expense included in calculating QPAI for the taxable year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or AGI, if applicable) for the taxable year. For purposes of determining the amount of wage expense included in cost of goods sold (CGS) for this safe harbor, §1.199-2T(e)(2)(ii)(B) provides that a taxpayer may determine its wage expense included in CGS using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances.
Under the wage expense safe harbor in §1.199-2T(e)(2)(ii)(A), a taxpayer uses its wage expense, not W-2 wages, to determine the amount of W-2 wages that are properly allocable to DPGR. Section 1.199-2T(e)(2)(ii)(A) defines the term wage expense as wages (that is, compensation paid by the employer in the active conduct of a trade or business to its employees) that are properly taken into account under the taxpayer’s method of accounting.
The commentator suggested that, in certain circumstances, it should not be necessary for W-2 wages to be paid by a taxpayer in order for those wages to be properly allocable to DPGR. Specifically, the commentator suggested that W-2 wages should be treated as properly allocable to DPGR if the wages are paid to employees that are performing services in connection with an activity attributable to DPGR. Thus, in the case of partnership-shared services, if the employees of one partnership perform services that give rise to DPGR for another partnership and both partnerships have common ownership, then some or all of the W-2 wages should be treated as properly allocable to DPGR. The commentator further suggested that W-2 wages should be properly allocable to DPGR as long as the owner of the pass-thru entity includes in its taxable income DPGR (as a distributive share of another pass-thru entity’s DPGR) and deducts from its taxable income wages paid to employees (those employed by the pass-thru entity) whose services created that DPGR.
As an alternative, the commentator suggested that owners of certain pass-thru entities be permitted to treat non-DPGR as DPGR for purposes of determining whether W-2 wages are properly allocable to DPGR. The commentator suggested that the activity attribution rules for qualifying in-kind partnerships in §1.199-3T(i)(7)(i), EAG partnerships in §1.199-3T(i)(8)(ii), and EAGs in §1.199-7(a)(3) be extended to pass-thru entities with respect to gross receipts attributable to services performed by employees of a pass-thru entity if such gross receipts are taken into account as an item of income on a tax return in which the DPGR attributable to those services also is reported. The commentator believes the result of such a rule would be to recharacterize non-DPGR as DPGR if the activities giving rise to the employee wages contribute to generating DPGR that is reported on the same tax return as the wage deduction. Therefore, the pass-thru entity with the employees would be treated as engaged in a qualifying production activity to the extent of the W-2 wages and the W-2 wages would be treated as properly allocable to DPGR.
The interplay between the TIPRA amendment to section 199(b)(2) and the rules for qualifying in-kind partnerships under §1.199-3T(i)(7), EAG partnerships under §1.199-3T(i)(8), and EAGs under §1.199-7 may reduce or eliminate the section 199 deduction for EAGs and partners in qualifying in-kind partnerships if one entity uses employees of another entity to perform activities giving rise to DPGR. In addition, even though §1.199-3(f) provides rules for contract manufacturing and certain government contracts, the TIPRA amendment to section 199(b)(2) may reduce or eliminate the section 199 deduction for taxpayers entering into such contracts because the contract manufacturer’s W-2 wages are not attributed to the taxpayer.
The commentator’s suggestions would treat pass-thru entities more favorably than non-consolidated EAGs. In general, §1.199-7(a) and (b) provides that each member of an EAG calculates its own taxable income or loss, QPAI, and W-2 wages, which are then aggregated in determining the EAG’s section 199 deduction. After the TIPRA amendment to section 199(b)(2), to qualify as W-2 wages within the meaning of §1.199-2T(e)(2), paragraph (e)(1) wages must be properly allocable to DPGR. Because each member of an EAG separately calculates its own items before they are aggregated by the EAG, the member having the paragraph (e)(1) wages must itself have DPGR to which the wages are properly allocable in order to qualify those wages as W-2 wages. Paragraph (e)(1) wages that are not properly allocable to DPGR of the member having the paragraph (e)(1) wages do not qualify as W-2 wages, even if the paragraph (e)(1) wages were paid in connection with another member’s DPGR activities. Example 5 in §1.199-2T(e)(2)(iv) illustrates this point.
Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) regarding a partner’s or shareholder’s share of W-2 wages from a partnership or S corporation for taxable years beginning after May 17, 2006. After TIPRA, the section 199(d)(1)(A)(iii) rule for determining a partner’s or shareholder’s share of W-2 wages from a pass-thru entity no longer includes the second prong of the former two-prong standard, by which a partner’s or shareholder’s share of W-2 wages from the partnership or S corporation was limited to the lesser of that person’s allocable share of W-2 wages from the entity or a specified percentage of the person’s QPAI, computed by taking into account only the items of the entity allocated to that person for the taxable year of the entity. Before TIPRA, if the employees of a partnership performed services that gave rise to DPGR for another entity, but the partnership had no DPGR, then under the section 199(d)(1)(A)(iii) wage limitation, a partner could not take into account any W-2 wages from the partnership. After TIPRA, if the partner uses the section 861 method of cost allocation under §1.199-4(d), the partner cannot take into account any W-2 wages from the partnership because the W-2 wages do not generate DPGR in the partnership. Thus, in the case of partnership-shared services where the partner uses the section 861 method, the TIPRA amendment to section 199(b)(2) retains the result that the partner cannot take into account any W-2 wages from the partnership in applying the wage limitation under section 199(b)(1).
Moreover, the TIPRA amendment modified the W-2 wage limitation to narrow the availability of the section 199 deduction. The commentator’s suggestions would allow more taxpayers to claim the section 199 deduction and increase the amount of the deduction for some taxpayers, which conflicts with the changes made by TIPRA. Accordingly, the final regulations do not adopt the commentator’s suggestions.
In finalizing §1.199-5, certain clarifying changes have been made and conforming clarifications have been made to §1.199-9.
As described in the preamble to the final and temporary regulations on the TIPRA amendments to section 199, published on October 19, 2006 (T.D. 9293, 71 FR 61662), the combination of the aggregation rules for determining the taxable income of an EAG in §1.199-7(b)(1) of the June 1, 2006 final regulations (T.D. 9263, 71 FR 31268) and the rules of section 172 for net operating loss deductions could cause the unintended result of the same loss being used twice in determining the taxable income limitation under section 199(a)(1)(B). To eliminate this unintended result, §1.199-7T(b)(4) was promulgated to prevent a loss that was used in the year it was sustained in determining any EAG’s taxable income for purposes of the taxable income limitation under section 199(a)(1)(B) from being used again as either a carryover or carryback to any taxable year in determining the taxable income limitation under section 199(a)(1)(B). No comments were received on the provisions of §1.199-7T(b)(4) and those provisions are finalized without change.
Section 199 applies to taxable years beginning after December 31, 2004. Sections 1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 are applicable for taxable years beginning on or after October 19, 2006 (the effective date of the temporary regulations). A taxpayer may apply §§1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 to taxable years beginning after May 17, 2006, and before October 19, 2006, regardless of whether the taxpayer otherwise relied upon Notice 2005-14, 2005-1 C.B. 498 (see §601.601(d)(2)(ii)(b)), the provisions of REG-105847-05, 2005-2 C.B. 987, or §§1.199-1 through 1.199-8. Section 1.199-7(b)(4) is applicable for taxable years beginning on or after February 15, 2008.
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation, and because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.
Accordingly, 26 CFR part 1 is amended as follows:
Paragraph 1. The authority citation for part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.199-0 is amended by adding new entries for §§1.199-2(e)(2), 1.199-3(i)(7), 1.199-3(i)(8), 1.199-5, and 1.199-7(b)(4) to read as follows:
* * * * *
(e) * * *
(2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.
(i) In general.
(ii) Wage expense safe harbor.
(A) In general.
(B) Wage expense included in cost of goods sold.
(iii) Small business simplified overall method safe harbor.
(iv) Examples.
* * * * *
* * * * *
(i) * * *
(7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.
(i) In general.
(ii) Definition of qualifying in-kind partnership.
(iii) Other rules.
(iv) Example.
(8) Partnerships owned by members of a single expanded affiliated group for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.
(i) In general.
(ii) Attribution of activities.
(A) In general.
(B) Attribution between EAG partnerships.
(C) Exceptions to attribution.
(iii) Other rules.
(iv) Examples.
* * * * *
(a) In general.
(b) Partnerships.
(1) In general.
(i) Determination at partner level.
(ii) Determination at entity level.
(2) Disallowed losses or deductions.
(3) Partner’s share of paragraph (e)(1) wages.
(4) Transition rule for definition of W-2 wages and for W-2 wage limitation.
(5) Partnerships electing out of subchapter K.
(6) Examples.
(c) S corporations.
(1) In general.
(i) Determination at shareholder level.
(ii) Determination at entity level.
(2) Disallowed losses and deductions.
(3) Shareholder’s share of paragraph (e)(1) wages.
(4) Transition rule for definition of W-2 wages and for W-2 wage limitation.
(d) Grantor trusts.
(e) Non-grantor trusts and estates.
(1) Allocation of costs.
(2) Allocation among trust or estate and beneficiaries.
(i) In general.
(ii) Treatment of items from a trust or estate reporting qualified production activities income.
(3) Transition rule for definition of W-2 wages and for W-2 wage limitation.
(4) Example.
(f) Gain or loss from the disposition of an interest in a pass-thru entity.
(g) No attribution of qualified activities.
* * * * *
* * * * *
(b) * * *
(4) Losses used to reduce taxable income of expanded affiliated group.
(i) In general.
(ii) Examples.
* * * * *
Par. 3. Section 1.199-1 is amended by removing the language “§1.199-9(d)” in paragraphs (d)(3)(i) and (ii) and adding the language “§1.199-5(d) or §1.199-9(d)” in its place.
Par. 4. Section 1.199-2 is amended by revising paragraph (e)(2) to read as follows:
* * * * *
(e) * * *
(2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. The term W-2 wages includes only amounts described in paragraph (e)(1) of this section (paragraph (e)(1) wages) that are properly allocable to domestic production gross receipts (DPGR) (as defined in §1.199-3) for purposes of section 199(c)(1). A taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances.
(ii) Wage expense safe harbor—(A) In general. A taxpayer using either the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR for a taxable year by multiplying the amount of paragraph (e)(1) wages for the taxable year by the ratio of the taxpayer’s wage expense included in calculating qualified production activities income (QPAI) (as defined in §1.199-1(c)) for the taxable year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or adjusted gross income, if applicable) for the taxable year, without regard to any wage expense disallowed by section 465, 469, 704(d), or 1366(d). A taxpayer that uses the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) to determine QPAI must use the same expense allocation and apportionment methods that it uses to determine QPAI to allocate and apportion wage expense for purposes of this safe harbor. For purposes of this paragraph (e)(2)(ii), the term wage expense means wages (that is, compensation paid by the employer in the active conduct of a trade or business to its employees) that are properly taken into account under the taxpayer’s method of accounting.
(B) Wage expense included in cost of goods sold. For purposes of paragraph (e)(2)(ii)(A) of this section, a taxpayer may determine its wage expense included in cost of goods sold (CGS) using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, such as using the amount of direct labor included in CGS or using section 263A labor costs (as defined in §1.263A-1(h)(4)(ii)) included in CGS.
(iii) Small business simplified overall method safe harbor. A taxpayer that uses the small business simplified overall method under §1.199-4(f) may use the small business simplified overall method safe harbor for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under this safe harbor, the amount of paragraph (e)(1) wages that is properly allocable to DPGR is equal to the same proportion of paragraph (e)(1) wages that the amount of DPGR bears to the taxpayer’s total gross receipts.
(iv) Examples. The following examples illustrate the application of this paragraph (e)(2). See §1.199-5(e)(4) for an example of the application of paragraph (e)(2)(ii) of this section to a trust or estate. The examples read as follows:
Example 1. Section 861 method and no EAG. (i) Facts. X, a United States corporation that is not a member of an expanded affiliated group (EAG) (as defined in §1.199-7) or an affiliated group as defined in the regulations under section 861, engages in activities that generate both DPGR and non-DPGR. X’s taxable year ends on April 30, 2011. For X’s taxable year ending April 30, 2011, X has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. All of X’s production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of X’s production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). X is able to specifically identify CGS allocable to DPGR and to non-DPGR. X incurs $900 of research and experimentation expenses (R&E) that are deductible under section 174, $300 of which are performed with respect to SIC AAA and $600 of which are performed with respect to SIC BBB. None of the R&E is legally mandated R&E as described in §1.861-17(a)(4) and none of the R&E is included in CGS. X incurs section 162 selling expenses that are not includible in CGS and are definitely related to all of X’s gross income. For X’s taxable year ending April 30, 2011, the adjusted basis of X’s assets is $50,000, $40,000 of which generate gross income attributable to DPGR and $10,000 of which generate gross income attributable to non-DPGR. For X’s taxable year ending April 30, 2011, the total square footage of X’s headquarters is 8,000 square feet, of which 2,000 square feet is set aside for domestic production activities. For its taxable year ending April 30, 2011, X’s taxable income is $1,380 based on the following Federal income tax items:
| DPGR (all from sales of products within SIC AAA) | $3,000 |
| Non-DPGR (all from sales of products within SIC BBB) | 3,000 |
| CGS allocable to DPGR (includes $200 of wage expense) | (600) |
| CGS allocable to non-DPGR (includes $600 of wage expense) | (1,800) |
| Section 162 selling expenses (includes $600 of wage expense) | (840) |
| Section 174 R&E-SIC AAA (includes $100 of wage expense) | (300) |
| Section 174 R&E-SIC BBB (includes $200 of wage expense) | (600) |
| Interest expense (not included in CGS) | (300) |
| Headquarters overhead expense (includes $100 of wage expense) | (180) |
| X’s taxable income | 1,380 |
(ii) X’s QPAI. X allocates and apportions its deductions to gross income attributable to DPGR under the section 861 method in §1.199-4(d). In this case, the section 162 selling expenses and overhead expense are definitely related to all of X’s gross income. Based on the facts and circumstances of this specific case, apportionment of the section 162 selling expenses between DPGR and non-DPGR on the basis of X’s gross receipts is appropriate. In addition, based on the facts and circumstances of this specific case, apportionment of the headquarters overhead expense between DPGR and non-DPGR on the basis of the square footage of X’s headquarters is appropriate. For purposes of apportioning R&E, X elects to use the sales method as described in §1.861-17(c). X elects to apportion interest expense under the tax book value method of §1.861-9T(g). X has $2,400 of gross income attributable to DPGR (DPGR of $3,000 - CGS of $600 allocated based on X’s books and records). X’s QPAI for its taxable year ending April 30, 2011, is $1,395, as shown in the following table:
| DPGR (all from sales of products within SIC AAA) | $3,000 |
| CGS allocable to DPGR | (600) |
| Section 162 selling expenses ($840 x ($3,000 DPGR/$6,000 total gross receipts)) | (420) |
| Section 174 R&E-SIC AAA | (300) |
| Interest expense (not included in CGS) | |
| ($300 x ($40,000 (X’s DPGR assets)/$50,000 (X’s total assets))) | (240) |
| Headquarters overhead expense ($180 x (2,000 square feet attributable to | |
| DPGR activity/total 8,000 square feet)) | (45) |
| X’s QPAI | 1,395 |
(iii) W-2 wages. X chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:
(A) Step one. X determines that $625 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 1, as shown in the following table:
| CGS wage expense | $200 |
| Section 162 selling expenses wage expense ($600 x ($3,000 DPGR/$6,000 total gross receipts)) | 300 |
| Section 174 R&E-SIC AAA wage expense | 100 |
| Headquarters overhead wage expense ($100 x (2,000 square feet attributable to DPGR | |
| activity/8,000 total square feet)) | 25 |
| Total wage expense taken into account | 625 |
(B) Step two. X determines that $1,042 of the $3,000 in paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:
| Step one wage expense x X’s paragraph (e)(1) wages |
| X’s total wage expense for taxable year ending April 30, 2011 |
| $625 x $3,000 = $1,042 |
| $1,800 |
(iv) Section 199 deduction determination. X’s tentative deduction under §1.199-1(a) (section 199 deduction) is $124 (.09 x (lesser of QPAI of $1,395 or taxable income of $1,380)) subject to the wage limitation under section 199(b)(1) (W-2 wage limitation) of $521 (50% x $1,042). Accordingly, X’s section 199 deduction for its taxable year ending April 30, 2011, is $124.
Example 2. Section 861 method and EAG. (i) Facts. The facts are the same as in Example 1 except that X owns stock in Y, a United States corporation, equal to 75% of the total voting power of the stock of Y and 80% of the total value of the stock of Y. X and Y are not members of an affiliated group as defined in section 1504(a). Accordingly, the rules of §1.861-14T do not apply to X’s and Y’s selling expenses, R&E, and charitable contributions. X and Y are, however, members of an affiliated group for purposes of allocating and apportioning interest expense (see §1.861-11T(d)(6)) and are also members of an EAG. Y’s taxable year ends April 30, 2011. For Y’s taxable year ending April 30, 2011, Y has $2,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. For Y’s taxable year ending April 30, 2011, the adjusted basis of Y’s assets is $50,000, $20,000 of which generate gross income attributable to DPGR and $30,000 of which generate gross income attributable to non-DPGR. All of Y’s activities that generate DPGR are within SIC Industry Group AAA (SIC AAA). All of Y’s activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). None of X’s and Y’s sales are to each other. Y is not able to specifically identify CGS allocable to DPGR and non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of Y’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. For Y’s taxable year ending April 30, 2011, the total square footage of Y’s headquarters is 8,000 square feet, of which 2,000 square feet is set aside for domestic production activities. Y incurs section 162 selling expenses that are not includible in CGS and are definitely related to all of Y’s gross income. For Y’s taxable year ending April 30, 2011, Y’s taxable income is $1,710 based on the following Federal income tax items:
| DPGR (all from sales of products within SIC AAA) | $3,000 |
| Non-DPGR (all from sales of products within SIC BBB) | 3,000 |
| CGS allocated to DPGR (includes $300 of wage expense) | (1,200) |
| CGS allocated to non-DPGR (includes $300 of wage expense) | (1,200) |
| Section 162 selling expenses (includes $300 of wage expense) | (840) |
| Section 174 R&E-SIC AAA (includes $20 of wage expense) | (100) |
| Section 174 R&E-SIC BBB (includes $60 of wage expense) | (200) |
| Interest expense (not included in CGS and not subject to §1.861-10T) | (500) |
| Charitable contributions | (50) |
| Headquarters overhead expense (includes $40 of wage expense) | (200) |
| Y’s taxable income | 1,710 |
(ii) QPAI. (A) X’s QPAI. Determination of X’s QPAI is the same as in Example 1 except that interest is apportioned to gross income attributable to DPGR based on the combined adjusted bases of X’s and Y’s assets. See §1.861-11T(c). Accordingly, X’s QPAI for its taxable year ending April 30, 2011, is $1,455, as shown in the following table:
| DPGR (all from sales of products within SIC AAA) | $3,000 |
| CGS allocated to DPGR | (600) |
| Section 162 selling expenses ($840 x ($3,000 DPGR/$6,000 total gross receipts)) | (420) |
| Section 174 R&E-SIC AAA | (300) |
| Interest expense (not included in CGS and not subject to §1.861-10T) ($300 x ($60,000 (tax book | |
| value of X’s and Y’s DPGR assets)/$100,000 (tax book value of X’s and Y’s total assets))) | (180) |
| Headquarters overhead expense ($180 x (2,000 square feet attributable to DPGR activity/total | |
| 8,000 square feet)) | (45) |
| X’s QPAI | 1,455 |
(B) Y’s QPAI. Y makes the same elections under the section 861 method as does X. Y has $1,800 of gross income attributable to DPGR (DPGR of $3,000 - CGS of $1,200 allocated based on Y’s gross receipts). Y’s QPAI for its taxable year ending April 30, 2011, is $905, as shown in the following table:
| DPGR (all from sales of products within SIC AAA) | $3,000 |
| CGS allocated to DPGR | (1,200) |
| Section 162 selling expenses ($840 x ($3,000 DPGR/$6,000 total gross receipts)) | (420) |
| Section 174 R&E-SIC AAA | (100) |
| Interest expense (not included in CGS and not subject to §1.861-10T) ($500 x ($60,000 (tax book | |
| value of X’s and Y’s DPGR assets)/$100,000 (tax book value of X’s and Y’s total assets))) | (300) |
| Charitable contributions (not included in CGS) ($50 x ($1,800 gross income attributable to | |
| DPGR/$3,600 total gross income)) | (25) |
| Headquarters overhead expense ($200 x (2,000 square feet attributable to DPGR activity/total | |
| 8,000 square feet)) | (50) |
| Y’s QPAI | 905 |
(iii) W-2 wages. (A) X’s W-2 wages. X’s W-2 wages are $1,042, the same as in Example 1.
(B) Y’s W-2 wages. Y chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:
(1) Step one. Y determines that $480 of wage expense were taken into account in determining its QPAI in paragraph (ii)(B) of this Example 2, as shown in the following table:
| CGS wage expense | $300 |
| Section 162 selling expenses wage expense ($300 x ($3,000 DPGR/$6,000 total gross receipts)) | 150 |
| Section 174 R&E-SIC AAA wage expense | 20 |
| Headquarters overhead wage expense ($40 x (2,000 square feet attributable to DPGR activity/ | |
| 8,000 total square feet)) | 10 |
| Total wage expense taken into account | 480 |
(2) Step two. Y determines that $941 of the $2,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:
| Step one wage expense x Y’s paragraph (e)(1) wages |
| Y’s total wage expense for taxable year ending April 30, 2011 |
| $480 x $2,000 = $941 |
| $1,020 |
(iv) Section 199 deduction determination. The section 199 deduction of the X and Y EAG is determined by aggregating the separately determined taxable income, QPAI, and W-2 wages of X and Y. See §1.199-7(b). Accordingly, the X and Y EAG’s tentative section 199 deduction is $212 (.09 x (lesser of combined QPAI of X and Y of $2,360 (X’s QPAI of $1,455 plus Y’s QPAI of $905) or combined taxable incomes of X and Y of $3,090 (X’s taxable income of $1,380 plus Y’s taxable income of $1,710)) subject to the combined W-2 wage limitation of X and Y of $992 (50% x ($1,042 (X’s W-2 wages) + $941 (Y’s W-2 wages)))). Accordingly, the X and Y EAG’s section 199 deduction is $212. The $212 is allocated to X and Y in proportion to their QPAI. See §1.199-7(c).
Example 3. Simplified deduction method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z is able to specifically identify CGS allocable to DPGR and to non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items:
| DPGR | $3,000 |
| Non-DPGR | 3,000 |
| CGS allocable to DPGR (includes $200 of wage expense) | (600) |
| CGS allocable to non-DPGR (includes $600 of wage expense) | (1,800) |
| Expenses, losses, or deductions (deductions) (includes $1,000 of wage expense) | (2,220) |
| Z’s taxable income | 1,380 |
(ii) Z’s QPAI. Z uses the simplified deduction method under §1.199-4(e) to apportion deductions between DPGR and non-DPGR. Z’s QPAI for its taxable year ending April 30, 2011, is $1,290, as shown in the following table:
| DPGR | $3,000 |
| CGS allocable to DPGR | (600) |
| Deductions apportioned to DPGR ($2,220 x ($3,000 DPGR/$6,000 total gross receipts)) | (1,110) |
| Z’s QPAI | 1,290 |
(iii) W-2 wages. Z chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:
(A) Step one. Z determines that $700 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 3, as shown in the following table:
| Wage expense included in CGS allocable to DPGR | $200 |
| Wage expense included in deductions ($1,000 in wage expense x ($3,000 DPGR/$6,000 total gross receipts)) | 500 |
| Wage expense allocable to DPGR | 700 |
(B) Step two. Z determines that $1,167 of the $3,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:
| Step one wage expense x Z’s paragraph (e)(1) wages |
| Z’s total wage expense for taxable year ending April 30, 2011 |
| $700 x $3,000 = $1,167 |
| $1,800 |
(iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $116 (.09 x (lesser of QPAI of $1,290 or taxable income of $1,380)) subject to the W-2 wage limitation of $584 (50% x $1,167). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $116.
Example 4. Small business simplified overall method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items:
| DPGR | $3,000 |
| Non-DPGR | 3,000 |
| CGS and deductions | (4,620) |
| Z’s taxable income | 1,380 |
(ii) Z’s QPAI. Z uses the small business simplified overall method under §1.199-4(f) to apportion CGS and deductions between DPGR and non-DPGR. Z’s QPAI for its taxable year ending April 30, 2011, is $690, as shown in the following table:
| DPGR | $3,000 |
| CGS and deductions apportioned to DPGR ($4,620 x ($3,000 DPGR/$6,000 total gross receipts)) | (2,310) |
| Z’s QPAI | 690 |
(iii) W-2 wages. Z’s W-2 wages under paragraph (e)(2)(iii) of this section are $1,500, as shown in the following calculation:
| $3,000 in paragraph (e)(1) wages x ($3,000 DPGR/$6,000 total gross receipts) | $1,500 |
(iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $62 (.09 x (lesser of QPAI of $690 or taxable income of $1,380)) subject to the W-2 wage limitation of $750 (50% x $1,500). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $62.
Example 5. Corporation uses employees of non-consolidated EAG member. (i) Facts. Corporations S and B are the only members of a single EAG but are not members of a consolidated group. S and B are both calendar year taxpayers. All the activities described in this Example 5 take place during the same taxable year and they are the only activities of S and B. S and B each use the section 861 method described in §1.199-4(d) for allocating and apportioning their deductions. B is a manufacturer but has only three employees of its own. S employs the remainder of the personnel who perform the manufacturing activities for B. S’s only receipts are from supplying employees to B. In 2010, B manufactures qualifying production property (QPP) (as defined in §1.199-3(j)(1)), using its three employees and S’s employees, and sells the QPP for $10,000,000. B’s total CGS and other deductions are $6,000,000, including $1,000,000 paid to S for the use of S’s employees and $100,000 paid to its own employees. B reports the $100,000 paid to its employees on the 2010 Forms W-2 issued to its employees. S pays its employees $800,000 that is reported on the 2010 Forms W-2 issued to the employees.
(ii) B’s W-2 wages. In determining its W-2 wages, B utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. The entire $100,000 paid by B to its employees is included in B’s wage expense included in calculating its QPAI and is the only wage expense used in calculating B’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, B’s W-2 wages are $100,000 ($100,000 (paragraph (e)(1) wages) x ($100,000 (wage expense used in calculating B’s QPAI)/$100,000 (wage expense used in calculating B’s taxable income))).
(iii) S’s W-2 wages. In determining its W-2 wages, S utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. Because S’s $1,000,000 in receipts from B do not qualify as DPGR and are S’s only gross receipts, none of the $800,000 paid by S to its employees is included in S’s wage expense included in calculating its QPAI. However, the entire $800,000 is included in calculating S’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii)(A) of this section, S’s W-2 wages are $0 ($800,000 (paragraph (e)(1) wages) x ($0 (wage expense used in calculating S’s QPAI)/$800,000 (wage expense used in calculating S’s taxable income))).
(iv) Determination of EAG’s section 199 deduction. The section 199 deduction of the S and B EAG is determined by aggregating the separately determined taxable income or loss, QPAI, and W-2 wages of S and B. See §1.199-7(b). B’s taxable income and QPAI are each $4,000,000 ($10,000,000 DPGR - $6,000,000 CGS and other deductions). S’s taxable income is $200,000 ($1,000,000 gross receipts - $800,000 total deductions). S’s QPAI is $0 ($0 DPGR - $0 CGS and other deductions). B’s W-2 wages (as calculated in paragraph (ii) of this Example 5) are $100,000 and S’s W-2 wages (as calculated in paragraph (iii) of this Example 5) are $0. The EAG’s tentative section 199 deduction is $360,000 (.09 x (lesser of combined QPAI of $4,000,000 (B’s QPAI of $4,000,000 + S’s QPAI of $0) or combined taxable income of $4,200,000 (B’s taxable income of $4,000,000 + S’s taxable income of $200,000))) subject to the W-2 wage limitation of $50,000 (50% x ($100,000 (B’s W-2 wages) + $0 (S’s W-2 wages))). Accordingly, the S and B EAG’s section 199 deduction for 2010 is $50,000. The $50,000 is allocated to S and B in proportion to their QPAI. See §1.199-7(c). Because S has no QPAI, the entire $50,000 is allocated to B.
Example 6. Corporation using employees of consolidated EAG member. The facts are the same as in Example 5 except that B and S are members of the same consolidated group. Ordinarily, as demonstrated in Example 5, S’s $1,000,000 of receipts would not be DPGR and its $800,000 paid to its employees would not be W-2 wages (because the $800,000 would not be properly allocable to DPGR). However, because S and B are members of the same consolidated group, §1.1502-13(c)(1)(i) provides that the separate entity attributes of S’s intercompany items or B’s corresponding items, or both, may be redetermined in order to produce the same effect as if S and B were divisions of a single corporation. If S and B were divisions of a single corporation, S and B would have QPAI and taxable income of $4,200,000 ($10,000,000 DPGR received from the sale of the QPP - $5,800,000 CGS and other deductions) and, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, would have $900,000 of W-2 wages ($900,000 (combined paragraph (e)(1) wages of S and B) x ($900,000 (wage expense used in calculating QPAI)/$900,000 (wage expense used in calculating taxable income))). The single corporation would have a tentative section 199 deduction equal to 9% of $4,200,000, or $378,000, subject to the W-2 wage limitation of 50% of $900,000, or $450,000. Thus, the single corporation would have a section 199 deduction of $378,000. To obtain this same result for the consolidated group, S’s $1,000,000 of receipts from the intercompany transaction are redetermined as DPGR. Thus, S’s $800,000 paid to its employees are costs properly allocable to DPGR and S’s W-2 wages are $800,000. Accordingly, the consolidated group has QPAI and taxable income of $4,200,000 ($11,000,000 DPGR (from the sale of the QPP and the redetermined intercompany transaction) - $6,800,000 CGS and other deductions) and W-2 wages of $900,000. The consolidated group’s section 199 deduction is $378,000, the same as the single corporation. However, for purposes of allocating the section 199 deduction between S and B, the redetermination of S’s income as DPGR under §1.1502-13(c)(1)(i) is not taken into account. See §1.199-7(d)(5). Accordingly, the consolidated group’s entire section 199 deduction of $378,000 is allocated to B.
* * * * *
Par. 5. Section 1.199-2T is removed.
Par. 6. Section 1.199-3 is amended by:
1. Revising the first sentence of paragraph (f)(1).
2. Adding the language “paragraph (i)(8) of this section and” before the language “§1.199-9(j)” in paragraph (g)(4)(ii)(B).
3. Adding the language “paragraph (i)(7) of this section and” before the language “§1.199-9(i)” in paragraph (g)(4)(ii)(D).
4. Revising paragraphs (i)(7) and (8).
5. Removing the language “§1.199-9(e)” in the last sentence of paragraph (m)(6)(iv)(B) and adding the language “§§1.199-5(e) and 1.199-9(e)” in its place.
6. Revising the second and third sentences in paragraph (p).
The revisions read as follows:
* * * * *
(f) * * * (1) In general. With the exception of the rules applicable to an expanded affiliated group (EAG) under §1.199-7, qualifying in-kind partnerships under paragraph (i)(7) of this section and §1.199-9(i), EAG partnerships under paragraph (i)(8) of this section and §1.199-9(j), and government contracts under paragraph (f)(2) of this section, only one taxpayer may claim the deduction under §1.199-1(a) with respect to any qualifying activity under paragraphs (e)(1), (k)(1), and (l)(1) of this section performed in connection with the same QPP, or the production of a qualified film or utilities. * * *
* * * * *
(i) * * *
(7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005