Rethinking Sec. 199 based on new developments.

• Author: Arndt, Chris

The American Jobs Creation Act, enacted in October 2004, exchanged an export-tax-benefit regime in favor of a rate reduction for income attributable to qualified production activities. The new rules, codified as Sec. 199, provide tax benefits to companies primarily engaged in the manufacturing of personal property or construction of real property within the U.S.; these benefits became effective for tax years beginning after Oct. 22, 2004. The tax-rate benefit of this deduction could have been as much as 1% (3% of taxable income as a deduction) for calendar years 2005 and 2006; beginning in 2010, the maximum benefit may be 3% (9% of taxable income as a deduction).

Background

These new tax benefits have brought complexity with them. Questions quickly arose as to the definition of production income, who qualifies for the deduction and how to calculate it. Notice 2005-14 was issued in January 2005 to address some of these concerns; see Prop. Regs. Secs. 1.199-1 through 8; REG-105847-05 (10/20/05); and Rose, et al., Tax Clinic, "Treasury and IRS Guidance Sheds Light on Sec. 199 Deduction," TTA, May 2006, p. 274. A taxpayer could rely on either the notice or the proposed regulations to determine taxable income under Sec. 199, and to the extent they are inconsistent, pick and choose between the two.

Guidance: The notice and follow-up proposed regulations contain exhaustive definitions and rules as to qualification of income streams and application to different types of taxpayers.

* Manufacturing industry:

1. The deduction is based primarily on the calculation of domestic production gross receipts (DPGR), which for producers is income from the disposition of qualified production property (QPP). Expenses allocated or apportioned to DPGR result in qualified production activities income (QPAI). A deduction is allowed for 6% in 2007-2009 (9% thereafter) of the lesser of QPAI or taxable income. The resulting deduction is further limited to 50% of the entity's Form W-2 wages.

2. If less than 5% of gross receipts did not qualify as DPGR, all gross receipts could be considered DPGR under a de minimis rule. This treatment would minimize the complexity of an expense allocation calculation, because the taxpayer would be limited to taxable income in performing the calculation.

3. QPP is tangible personal property (including software) manufactured, produced, grown or extracted in the U.S. Dispositions of certain qualified films or electricity, natural gas or...