Maximizing the benefits of sec. 199 in an asset sale.

• Author: Reinstein, Todd

Over the past several years, there has been a great deal of discussion regarding the implementation of Sec. 199, which allows a deduction equal to a percentage o f a taxpayer's income attributable to domestic production activities. (1) Taxpayers often overlook the deduction, however, when they sell qualifying assets as part of the sale of an entire business in a transaction that is treated as an asset sale. This article addresses the opportunity to claim a Sec. 199 deduction when a business is sold in an asset sale or in a stock sale that is treated as an asset sale under a Sec. 338(h)(10) election. (2)

Sec. 199 Basics

For tax years beginning in 2010 and thereafter, the Sec. 199 deduction is equal to 9% of the lesser of a taxpayer's qualified production activities income (QPAI) or taxable income (modified adjusted gross income, in the case of individual taxpayers), determined without regard to the deduction itself. The deduction is phased in at 3% for tax years beginning in 2005 and 2006 and at 6% for tax years beginning in 2007 through 2009. (3) The QPAI for any tax year is equal to the taxpayer's domestic production gross receipts (DPGR) reduced by the sum of the cost of goods sold and below-the-line expenses allocable to DPGR. (4)

As relevant here, DPGR includes gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of tangible personal property, computer software, and certain sound recordings that were produced by the taxpayer in whole or in significant part within the United States. (5) For certain taxpayers regularly engaged in construction activities, DPGR also includes gross receipts derived from the construction of real property in the United States. (6) The allowance of the deduction for internally developed software and self-constructed real property is discussed in greater detail below, because such categories can present unique opportunities to claim a Sec. 199 deduction when a business is sold.

Purchase Price Allocations

Both parties to a sale of a group of assets that make up a trade or business must allocate the purchase price among the various assets sold in proportion to their fair market value (FMV), using the residual method. Under this method, assets are divided into seven classes, and priority is given to allocating purchase price, up to their FMV, to assets in classes that are easier to value, before any purchase price is allocated to more amorphous asset classes, such as goodwill and going concern value. (7) Furthermore, under Sec. 1060, the buyer and seller of the assets of a trade or business are bound by any written agreements allocating the purchase price, although the IRS may disregard allocations not in accordance with the residual method and FMV. In order for the IRS to determine whether the buyer and seller are reporting the transaction consistently, both parties are required to attach Form 8594, Asset Acquisition Statement Under Section 1060, to their income tax returns for the year of the sale, allocating the purchase price among the seven classes of assets specified under the residual method.

In order to avoid subsequent controversy, buyers and sellers in actual or deemed asset sales often agree on an allocation of the purchase price among the seven classes of transferred assets. This allocation typically...