Sec. 199 exam status and update.

• Author: Hanway, Kurt

Sec. 199 provides a deduction based on a percentage of income attributable to certain domestic production activities. For tax years beginning after December 31, 2004, Sec. 199 allows a deduction equal to a specified percentage (3% for years beginning in 2005 and 2006, 6% for years beginning in 2007, 2008, and 2009, and 9% in subsequent years) of the lesser of qualifying production activity income (QPAI) or taxable income. In brief, QPAI equals eligible receipts, or domestic production gross receipts (DPGR), less allocable cost of goods sold and other deductions. The resulting amount is further limited to 50% of W-2 wages for the tax year.

The Sec. 199 deduction has garnered increased attention in IRS exams over the past two years. Furthermore, with the increase in the rate of the Sec. 199 deduction from 6% to 9% for tax years beginning in 2010, taxpayers should expect and prepare for even more scrutiny by IRS exam teams. Due to the complexity of qualifying for and computing the Sec. 199 deduction, an IRS exam team may propose adjustments.

The Large and Mid-Size Business (LMSB) Division of the IRS has issued three industry director directives (IDDs) discussing Sec. 199 deduction exams. These IDDs can serve as important references in both planning for and calculating the amount of the Sec. 199 deduction and in defending the Sec. 199 deduction on exam. The LMSB issued its first Sec. 199 directive (IDD No. 1) on December 6, 2006, Industry Director Directive on Domestic Production Deduction (LMSB-04-1206-018), which identified the Sec. 199 deduction as a Tier I issue. Tier I issues represent areas of high strategic importance to the LMSB that have a significant impact on one or more industries and typically involve a large number of taxpayers, significant dollar risk, and substantial compliance risk.

The second LMSB directive (IDD No. 2), issued on August 24, 2007, serves as a follow-up and is closely related to IDD No. 1 in that it expands the scope of the Sec. 199 deduction exams (LMSB-04-0707-049). IDD No. 2 refers to IDD No. 1 as setting forth five minimum checks required on every exam and further explains that not all exams lead to a mandatory audit of the Sec. 199 issue. In IDD No. 2, the LMSB industry director explains that cases meeting certain established criteria (including the size of the deduction) will be subject to mandatory exams. In addition to established criteria, IDD No. 2 also establishes additional exam team procedures and expanded internal IRS coordination on the issues involved.

In the third LMSB directive (IDD No. 3), issued on March 4, 2009, Industry Director Directive on Domestic Production Deduction No. 3...