Using statistical sampling to support the Sec. 199 deduction.

• Author: Zaleski, Andy

Sec. 199 provides that for tax years beginning after December 31, 2004, manufacturers and other producers may be entitled to a tax deduction for income derived from certain qualified domestic production activities. In order to realize the full benefits of the domestic production activities deduction (DPAD or Sec. 199 deduction), taxpayers must follow intricate rules and perform several complex analyses and calculations. Further, the identification of the Sec. 199 deduction as a Tier 1 examination issue by the IRS has increased the need for proper documentation to support the deduction. To reduce the uncertainty related to the Sec. 199 computation, the Service issued Rev. Proc. 2007-35 on May 11, 2007, to provide guidance for determining when statistical sampling may be used for purposes of Sec. 199 and establish acceptable statistical sampling methodologies. This guidance addresses the difficulties taxpayers may encounter when computing, and accumulating documentation to support, the deduction.

Background

For tax years beginning in 2007, 2008, and 2009, Sec. 199(a)(1) allows a deduction equal to 6% of the lesser of (1) the qualified production activities income (QPAI) or (2) taxable income (determined without regard to Sec. 199) for the tax year. This percentage increases to 9% for tax years beginning in 2010 and later.

QPAI means an amount equal to the excess of:

* The taxpayer's domestic production gross receipts (DPGR) over

* The sum of (1) the cost of goods sold that are allocable to such receipts and (2) other expenses, losses, or deductions that are properly allocable to such receipts.

Sec. 199(c)(4)(A) defines DPGR as the taxpayer's gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, any qualified film produced by the taxpayer, or electricity, natural gas, or potable water produced by the taxpayer in the United States.

In the case of a taxpayer engaged in the active conduct of a construction trade or business, DPGR consists of gross receipts derived from construction of real property performed in the United States by the taxpayer in the ordinary course of such trade or business. In the case of a taxpayer engaged in the active conduct of an engineering or architectural services trade or business, DPGR consists of gross receipts...