Treatment of prior-period expenses under Sec. 199.

• Author: Fairbanks, Greg A.

Taxpayers that are eligible for the domestic production activities deduction under Sec. 199 often face the difficult question of how to properly allocate prior-period expenses between activities that created domestic production gross receipts (DPGR) and activities that did not create DPGR (non-DPGR). Prior-period expenses are expenses for activities that occurred in prior years and could include things such as pension expenses relating to retired employees, environmental remediation expenses relating to contamination occurring in prior years, and workers' compensation claims relating to prior work-related accidents. The IRS recently released Chief Counsel Advice (CCA) 200946037, which addresses the proper treatment of prior-period costs that are recognized as part of cost of goods sold. An earlier legal advice memorandum (AM 2009-001) and directive (LMSB-04-0209-004) addressed the treatment of prior-period costs that were deductible as "other deductions" (i.e., not treated as part of cost of goods sold).

Even though prior-period expenses may result from activities that took place prior to the effective date of Sec. 199, such expenses might result in the creation of DPGR in future years. Where the costs incurred relate to years before Sec. 199 was enacted (Sec. 199 was enacted as part of the American Jobs Creation Act of 2004, P.L. 108-357, effective for tax years beginning on or after January 1, 2005), the question that taxpayers and advisers face is whether these prior-period costs are allocable to DPGR or non-DPGR.

Sec. 199 allows a deduction equal to 9% (for years beginning 2010 and after) of the taxpayer's qualified production activities income (QPAI). The deduction is limited based on a taxpayer's DPGR-related wages and taxable income. DPGR are gross receipts from qualifying activities such as the manufacture or construction of qualified production property in the United States. The regulations under Sec. 199 provide guidance on how to determine DPGR and allocable cost of goods sold (COGS) of qualifying activities in order to compute QPAI. A taxpayer would generally rather allocate fewer costs to DPGR because that would result in higher QPAI and a larger deduction. Regs. Sec. 1.199-4 (b) (2) (ii) states that if a taxpayer recognizes and reports gross receipts on a federal income tax return for a tax year and incurs COGS related to such gross receipts in a subsequent tax year, then regardless of whether the gross receipts ultimately...