Sec. 199 deduction and government contractors.

• Author: Fairbanks, Greg A.

Although the domestic production activities deduction (DPAD) came into law in 2004, certain types of taxpayers eligible for the deduction often fail to claim it on their income tax returns. The types of taxpayers who do not take advantage of the deduction include contractors doing business with the federal government.

Sec. 199 generally provides a deduction for qualifying domestic production activities equal to 9% of the lesser of the taxpayer's qualified production activities income or taxable income determined without regard to Sec. 199. One of the qualifying domestic production activities includes any lease, rental, license, sale, exchange, or other disposition of qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States.

The term "qualifying production property" includes tangible personal property (other than land and real property) and computer software. Computer software for qualifying production property purposes is defined as any program or routine or any sequence of machine-readable code that is designed to cause a computer to perform a desired function and the documentation required to describe and maintain that program or routine.

Regs. Sec. 1.199-3(i)(4) specifies that gross receipts derived from the performance of services including embedded services do not qualify as domestic production gross receipts. An embedded service is one where the price of the service is not separately stated from the amount charged for the sale of qualified production property. However, there are six exceptions to the embedded service rule:

* A qualified warranty;

* A qualified delivery;

* A qualified operating manual;

* A qualified installation;

* A qualified computer software maintenance agreement; and

* A de minimis amount (5%) of gross receipts from embedded services and nonqualified property.

To qualify, all services specifically stated above must be provided in connection with qualified production property, the price for the service should not be separately stated from qualified production property, and the service should not be separately offered by the taxpayer or separately bargained for with customers.

Based on the brief overview of the Sec. 199 rules above, government contractors are faced with the following requirements in determining the applicability of DPAD to their operations.

Qualified Production Property

Typically, a government...