Sec. 199 Prop. Regs.: what is an item?

• Author: Auclair, David

Enacted by American Jobs Creation Act of 2004 Section 102(a), Sec. 199 provides a new, permanent deduction for qualifying activities, including domestic production, construction and engineering or architectural services. Under Sec. 199(a), the deduction is a percentage (3% for tax years beginning in 2005 and 2006, 6% for tax years 2007-2009 and 9% thereafter) of the lesser of taxable income or qualified production activities income (QPM), and is limited by Sec. 199(b) to 50% of a taxpayer's Form W-2 wages. QPAI is calculated by determining gross receipts from qualifying activities and reducing that amount by cost of goods sold, direct expenses and an allocable portion of indirect expenses; see Sec. 199(c).

Notice 2005-14

In January 2005, Notice 2005-14 was issued to provide guidance in applying Sec. 199; for details, see Gibbs and Rathnau, Tax Chnic, "Notice 2005-14 Offers Sec. 199 Guidance," TTA, June 2005, p. 339. Section 3.03 of the notice states that QPAI is determined on an item-by-item basis (and not, for example, on a division-by-division, product-line-by-product-fine or transaction-by-transaction basis) and is the sum of QPAI derived by the taxpayer from each item. For this purpose, QPAI from each item could be positive or negative. The notice failed, however, to define the term "item."

Prop. Regs.

In November 2005, Sec. 199 proposed regulations were issued (REG-105847-05, 11/4/05).These rules provide more detail, including the definition of an item in determining QPAI.

Defining "item": Prop. Regs. Sec. 1.199-1(c)(2)(i) defines "item" as property offered for sale to customers that meets the requirements of Prop. Regs. Sec. 1.199-1(c) and -3. For example, if a finished product is sold to a customer and the taxpayer performed a qualifying activity with respect to it, then the finished product is the item.

If the property offered for sale does not meet these requirements, the taxpayer must treat as the item any portion of the property offered for sale that meets the requirements (the "shrinkback" rule). Prop. Regs. Sec. 1.199-1(c)(2)(ii), Example 1, illustrates this rule substantially as follows.

Example 1: X manufactures leather and rubber shoe soles in the U.S. X imports shoe uppers, which are the parts of the shoe above the sole. X manufactures shoes for sale by sewing or otherwise attaching the soles to the imported uppers. If the shoes do not meet the requirements under Prop. Regs. Sec. 1.199-1(c) and -3, then, under Prop. Regs...