Section 199: how will recent amendments and new guidance affect your deduction?

• Author: Auclair, David

Background

Enacted as part of the American Jobs Creation Act of 2004, (1) section 199 of the Internal Revenue Code provides a new permanent deduction for qualifying activities, including domestic production, construction, and engineering or architectural services. (2)

On January 19, 2005, the Department of Treasury and the Internal Revenue Service issued Notice 2005-14 which provided interim guidance in applying section 199. Until recently, Notice 2005-14 was the most significant guidance available to taxpayers regarding the application of section 199. On November 4, 2005, Treasury and the IRS issued proposed regulations under section 199. (3) These regulations clarify a number of issues raised in the January notice and provide detailed guidance on the section 199 deduction, including more examples to illustrate the application of certain rules.

According to the proposed regulations, the final regulations will apply to taxable years beginning after December 31, 2004. (4) Until final regulations are published in the Federal Register, however, taxpayers may rely on the interim guidance in both Notice 2005-14 and the proposed regulations. For this purpose, if the proposed regulations and Notice 2005-14 include different rules for the same particular issue, then the taxpayer may rely on either rule with one exception: If the proposed regulations include a rule that was not included in Notice 2005-14, taxpayers are not permitted to rely on the absence of a rule to apply a rule contrary to the proposed regulations.

The preamble to the proposed regulations notes that certain rules reflect the intent expressed in a July 21,2005, letter to Treasury from the Chairman and Ranking Member of the Senate Finance Committee and the Chairman of the House Ways and Means Committee regarding the proposed Tax Technical Corrections Act of 2005. On December 21, 2005, the Tax Technical Corrections Act of 2005 was signed into law as part of the Gulf Opportunity Zone Act of 2005. (5) The Technical Corrections Act amended portions of section 199, and these amendments are effective for taxable years beginning after December 31, 2004. Because of this retroactive effective date, taxpayers do not have the option of applying rules in Notice 2005-14 that are contrary to the changes made by the Technical Corrections Act.

Understanding the significant differences between the rules in Notice 2005-14, the amendments made by the Technical Corrections Act, and the new guidance in proposed regulations is critical to properly calculating the deduction under section 199. This article discusses these important differences. (6)

The Basics

Section 199 provides that for taxable years beginning in 2005 a taxpayer may deduct a statutory percentage (3 percent in 2005) of the lesser of: (1) the taxpayer's Qualified Production Activities Income (QPAI) for the taxable year, or (2) the taxpayer's taxable income for the year (or in the case of an individual, adjusted gross income). (7) The amount of the deduction cannot exceed 50 percent of W-2 wages of the taxpayer. (8)

QPAI for any taxable year is a net number equal to the taxpayer's Domestic Production Gross Receipts (DPGR) less the sum of:

(1) the cost of goods sold allocable to the receipts,

(2) expenses directly allocable to the receipts, and

(3) a ratable portion of other deductions not directly allocable to DPGR or to another class of income. (9)

DPGR means gross receipts from the following:

(1) any lease, rental, license, sale, exchange, or other disposition of:

(a) tangible personal property, computer software, and sound recordings (collectively referred to Qualified Production Property (QPP) as, that is Manufactured, Produced, Grown, or Extracted (MPGE) by the taxpayer in whole or in significant part within the United States;

(b) qualified film produced by the taxpayer; or

(c) electricity, natural gas, or potable water produced by the taxpayer in the United States;

(2) construction performed in the United States; and

(3) engineering or architectural services performed in the United States for construction projects in the United States. (10)

Net Operating Losses and Section 199

Taxable income for section 199 purposes has the same definition as taxable income under section 63 without regard to the section 199 deduction. (11) This means that taxable income is determined after the application of any net operating loss (NOL) carryover. Because of the taxable income limitation in section 199, a taxpayer that has an NOL or has its taxable income eliminated by an NOL carryover is not entitled to a deduction under section 199.

Before enactment of the Technical Corrections Act, it appeared that a section 199 deduction could create or increase an NOL carryback or carryover. That legislation, however, amended section 172 to eliminate this potential benefit. (12) As a result, except for a limited situation relating to the portion of a section 199 deduction allocated to a member of an Expanded Affiliated Group, (13) the section 199 deduction can neither create an NOL carryback or carryover nor increase the amount of an NOL carryback or carryover.

What Is An Item?

One of the most significant clarifications provided in the proposed regulations is the definition of the term "item" for purposes of' calculating QPAI. In order for the receipts from the lease, rental, license, sale, exchange, or other disposition of an item to be considered DPGR, the item itself must qualify as having been manufactured, produced, grown or extracted in whole or significant part by the taxpayer within the United States. Like Notice 2005-14, the proposed regulations provide that QPAI is determined on an item-by-item basis (and not, for example, on a division-by-division, product line-by-product line, or transaction-by-transaction basis/ and total QPAI is the sum of QPAI derived by the taxpayer from each item. (14) Whereas Notice 2005-14 is silent on what constitutes an item, the proposed regulations provide significant guidance in this area.

The proposed regulations define the term "item" as property offered for sale to customers where the receipts from the disposition of the property qualify, as DPGR under rules in Prop. Reg. [section] 1.199-3 and the general rules under Prop. Reg. [section] 1.199. (15) For example, if a finished product sold to a customer meets these requirements (that is, the activity performed by the taxpayer with respect to the product qualifies all the receipts from the sale of the finished product as DPGR), then the finished product is the item. If the finished product does not meet the definition of an item because it was not manufactured, produced, grown, or extracted in whole or significant part by the taxpayer in the United States, the proposed regulations provide an opportunity to qualify a portion of the receipts from its disposition through what has come to be known as the "shrinkback" rule.

According to the proposed regulations, in no event may an item consist of two or more properties offered for sale that are not packaged and sold together as one item. In addition, in the case of property customarily sold by weight or by volume, the item is determined using the custom of the industry, for example barrels of oil.

Shrinkback Rule

Under the shrinkback rule, if the property offered for sale does not meet the requirements of DPGR, the taxpayer must treat as the "item" any portion of the property offered for sale that meets the requirements. (16) The following example in the proposed regulations illustrates the application of the shrinkback rule:

 X manufactures leather and rubber shoe soles in the United States. 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 this section and [section] 1.199-3, then under paragraph (c)(2)(i) of this section, X must treat the sole as the item if the sole meets the requirements under this section and [section] 1.199-3. (17)

The taxpayer in this example is required to shrinkback the shoe to the portion of property that qualifies as an item, which, in the example, is the sole of the shoe.

The shrinkback rule has its origins in the coffee example in a footnote in the legislative history to section 199, (18) which provides that a component may be treated as qualifying property in the case of food and beverages. According to the preamble to the proposed regulations, the footnote explains that, even though receipts from a cup of coffee prepared at a retail establishment do not qualify for the special deduction, receipts from a portion of the cup of coffee representing production activities conducted away from the retail facility (the coffee beans roasted at a facility separate from the retail establishment) do qualify. The preamble further cites language from the Joint Committee's "Blue Book" explanation of the 2004 tax law, (19) explaining that Congress intended that this issue not be limited to food and beverages, but be permitted with respect to section 199 in general.

The shrinkback rule offers additional opportunities for taxpayers to qualify more of their receipts as DPGR. There appears to be no restrictions on the extent to which the taxpayer may "shrinkback" in order to find an item that qualifies. Even if only a subcomponent of a subcomponent of a finished product constitutes an item, the shrinkback rule will allow a portion of the receipts from the sale of the finished product that includes the subcomponent to qualify as DPGR.

According to the proposed regulations, the shrinkback rule is mandatory. The proposed regulations also provide that in no case can the portion of the property offered for sale that is treated as the item exclude any other portion that meets the requirement. In the case of construction, or engineering and architectural services, the proposed regulations provide that a taxpayer...