Sec. 199: domestic production activities deduction.

• Author: Schurrer, Phillip J.

Despite the economic slowdown, manufacturing continues to play an important role in the American economy. Congress, concerned that U.S. manufacturing was lagging behind foreign imports that in many cases benefited from foreign countries' subsidies and undercut U.S. producer prices, offered tax relief with the domestic production activities deduction. Since 2004, Sec. 199 has allowed as a deduction a percentage of qualifying production expenses, with "production" defined broadly and requiring only that it take place "in significant part" within the United States. (1)

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After starting at 3% of such costs, the deduction increased to 6% for tax years 2007-2009 and is 9% for 2010 and following years. It is designed to be the equivalent of a 3 percentage point reduction in the effective tax rate for U.S. manufacturers.(2) The amount of the deduction is limited to 50% of the taxpayer's W-2 wages attributable to domestic production gross receipts.

Because the domestic production activities deduction replaced the former foreign sales corporation and extraterritorial income provisions of the Code, U.S. manufacturers who did not benefit from those provisions' export tax benefits may overlook it. The domestic production activities deduction is available to a wide variety of U.S. taxpayers, not just those who export their products. This article describes eligibility for the deduction, its limitations, and how it is calculated.

Eligibility

To be eligible for the Sec. 199 deduction, taxpayers must have qualified production activities income (QPAI),(3) which is defined as domestic production gross receipts (DPGR) for a tax year minus cost of goods sold and other expenses, losses, or deductions allocable or properly attributable to those receipts.(4) DPGR comprises receipts obtained from the lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP), any qualified film, or electricity, natural gas, or potable water produced by the taxpayer in the United States. DPGR may also be derived from construction of real property or engineering/architectural services in the ordinary course of business in the United States by taxpayers that actively conduct a trade or business of construction or engineering/architectural services, respectively. (5)

QPP is property produced by manufacturing, producing, growing, or extracting (MPGE) activities performed in whole or in significant part within the United States. (6) QPP consists of:

* Tangible personal property;

* Any computer software; and

* Sound recordings. (7)

Under Regs. Sec. 1.199-3(e), MPGE activities include:

* Developing;

* Improving;

* Manufacturing from scrap, salvage, or junk material as well as from new or raw material;

* Processing, manipulating, or refining;

* Changing the form of the property;

* Combining or assembling;

* Cultivating soil;

* Raising livestock;

* Mining minerals;

* Fishing;

* Storage and handling activities connected with certain agricultural products; and

* Installing QPP, if the taxpayer also engages in other MPGE activity with respect to the QPP.

MPGE activities do not include:

* Transportation;

* Packaging;

* Labeling;

* Minor assembly; and

* Installation of QPP, if no other MPGE occurs with respect to the QPP.

Safe harbor: If the combination of direct labor and overhead used in MPGE activities totals 20% or more of the QPP's cost of goods sold (COGS) or, in a transaction without COGS (such as a lease, rental, or license), the direct labor and overhead total 20% or more of the unadjusted depreciable basis in the QPP, the taxpayer is deemed to have engaged in MPGE activities to produce QPP. (8)

Formula Components

Before computing the Sec. 199 deduction, the taxpayer should determine if the entity is a member of a new attribution entity created by Sec. 199: an expanded affiliated group (EAG). Having made this determination, the taxpayer can calculate the two components of the Sec. 1.99 formula:

* Taxable income, as modified by Sec. 199 criteria; and

* QPAI.

EAGs

EAGs generally follow the rules of Sec. 1504, governing affiliated groups, except that "50%" is substituted for "80%."(9) In effect, the EAG can encompass a larger group of entities than the normal rules of attribution. Exhibit 1 on p. 324 illustrates the EAG relationship compared with a Sec. 1504 affiliated group. Each EAG member must be engaged in the actual conduct of a trade or business. All EAG members must be considered in the Sec. 199 deduction. In effect, Sec. 199 becomes a consolidated deduction subject to allocation.

Modified Taxable Income

For corporations, taxable income for Sec. 199 purposes is determined without regard to the Sec. 199 deduction. In the case of corporate alternative minimum tax, alternative minimum taxable income will be used in place of taxable income. (10)

For individuals, adjusted gross income is substituted for taxable income in the Sec. 199 calculation. For this purpose, adjusted gross income is determined before applying Sec. 199 and after applying:

* Sec. 86: Social Security benefits;

* Sec. 135: Income from U.S. bonds used to pay higher education tuition and fees;

* Sec. 137: Adoption assistance programs;

* Sec. 219...