Sec. 199 defined: what you need to know for the 2005 tax season.

• Author: Paulsen, George
• Position: Corporate tax

IRC Sec. 199, enacted to replace the phase out of the extraterritorial income regime (ETI), and the centerpiece of the American Jobs Creation Act of 2004, permits taxpayers to claim a domestic manufacturing deduction (DMD) from taxable income attributable to certain domestic production activities.

Compared to the ETI, the DMD provides benefits to a much broader range of taxpayers. Guidance has been limited to the statute, Notice 2005-14 and the proposed regulations issued Oct. 20, 2005.

Domestic Production Activities

Sec. 199 defines domestic production gross receipts.

First, to claim the DMD, the taxpayer must establish that the qualifying property was manufactured, produced, grown or extracted "by the taxpayer in whole or in significant part within the United States." Stated differently, the taxpayer must separate qualifying activities from non-qualifying activities.

If one taxpayer performs manufacturing activities for another taxpayer, only the taxpayer with the benefits and burdens of qualifying property ownership during the manufacturing process will be treated as the manufacturer.

The proposed regulations help determine what an item is. The law has a mandatory shrink-back provision to help the manufacturer determine what part of the product is eligible and to prevent abuse.

For example, in the case of a company that manufactures shoes in a foreign country, but manufactures the shoelaces in the United States, the taxpayer would shrink back their analysis to the shoelace manufacturing and that would be available for the DMD.

Second, after subdividing gross receipts between qualifying and non-qualifying sources, each member must assign its Cost of Goods Sold to such revenue sources. COGS must be allocated to qualifying property using one of these methods:

* Sec. 861 Method;

* Simplified Deduction Method; or

* Small Business Simplified Overall Method.

Taxpayers are limited as to which of these methods can be used. The new regulations provide some helpful relief from the accounting nightmare of segregating these costs.

An IRS study found that 99.1 percent of all S and C corps have gross receipts less than $25 million, so it carved out simplified procedures for these businesses. The Small Business Simplified Overall Method is for businesses with annual gross receipts of less than $5 million and allows the allocation of COGS and overhead based on gross receipts.

The Simplified Deduction Method for businesses between $5 million and $25...