Do you know where your employees' wages are? New section 199 W-2 wage limitation guidance.

• Author: Auclair, David

Background

Section 199 was added to the Internal Revenue Code (1) by section 102 of the American Jobs Creation Act of 2004 (2) and was amended by section 403(a) of the Gulf Opportunity Zone Act of 2005 (3) and, on May 17, 2006, by section 514 of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). (4) Section 199 provides a permanent deduction associated with qualifying activities such as domestic production of certain property, and construction and related engineering or architectural services performed in the United States. (5)

A taxpayer's section 199 deduction is limited to 50 percent of the W-2 wages of the taxpayer for the calendar year ending during the taxable year. (6) Prior to the 2006 amendment of section 199 by TIPRA, a taxpayer was generally able to include all W-2 wages for the purpose of determining this limitation. The W-2 wages of a pass-through entity that could be taken into account, however, were limited by the amount of qualifying activity performed by the pass-through entity. The TIPRA amendments to section 199 narrowed the term "W-2 wages" to include only those amounts properly allocable to domestic production gross receipts (DPGR), (7) placing an additional burden of determining the portion of W-2 wages that are properly allocable to DPGR on taxpayers. The TIPRA amendments did, however, remove the limitation on the amount of W-2 wages of a pass-through entity that may be considered, as long as the wages are properly allocable to DPGR. The TIPRA amendments are effective for taxable years beginning after May 17, 2006.

In October 2006, the IRS and Treasury Department published proposed and temporary regulations under section 199 to provide guidance relating to the TIPRA amendments (Temporary Regulations). (8) In addition, the IRS published Rev. Proc. 2006-47 (9) which provides methods to compute total W-2 wages.

This article discusses the highlights of the new IRS guidance, as well as the effect of the TIPRA amendments relating to W-2 wages on taxpayers in general and on certain taxpayers in particular.

Additional Burden Created by the TIPRA Amendments

For purposes of section 199, W-2 wages are defined as "the sum of the amounts described in paragraphs (3) and (8) of section 6051(a) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year." (10) Under the new rules in the TIPRA amendments, amounts described in paragraphs (3) and (8) of section 6051(a) that are paid with respect to employment of employees need to be determined and any portion of that amount that is not allocated or apportioned to DPGR to determine Qualified Production Activities Income (QPAI) (11) is excluded. Fifty percent of the remaining amount becomes a limitation on the amount of the section 199 deduction for the taxable year.

All taxpayers who calculate a section 199 deduction will face the additional burden of having to determine the amount of W2 wages allocable to DPGR. For calendar year taxpayers who do not capitalize or absorb wages into assets or inventory, this extra burden may not be as great as for others. Fiscal year taxpayers, as well as any taxpayer that capitalizes or absorbs wages into assets or inventory, will face a greater burden because the wages that are being taken into account in calculating QPAI for the taxable year are not necessarily the same wages that are paid in the calendar year ending during such taxable year.

The Temporary Regulations attempt to address the additional burden created by the TIPRA amendments. In general, the Temporary Regulations allow taxpayers to use any reasonable method to determine the portion of W-2 wages allocable to DPGR. The Temporary Regulations also provide a safe harbor that applies the percentage of wages included in a particular class of expenses to the amount of wages paid in the appropriate calendar year. Unfortunately, the safe harbor does not provide extensive guidance on how taxpayers are to determine what percentage of wages is included in a particular class of expense, leaving this potentially difficult question to be resolved on a case-by-case basis.

A Two-Step Process

Rev. Proc. 2006-47 clarifies that under the new TIPRA rules, the calculation of the W-2 wage limitation involves a two-step process under which a taxpayer must (1) determine its W-2 wages as defined in section 199(b)(2)(A) and Treas. Reg. [section] 1.199-2(e)(1); (12) and then (2) determine the portion of the above amount that is properly allocable to DPGR using Temp. Reg. [section] 1.199-2T(e)(2).

Rev. Proc. 2006-47 provides guidance relating only to the first step. (13) The revenue procedure provides the same general three methods for calculating W-2 wages that were contained in previously issued guidance: (1) Unmodified box method; (2) Modified Box 1 method; and (3) Tracking wages method. The revenue procedure instructs taxpayers that, after W-2 wages are determined under one of the prescribed methods, those amounts must then be subject to the further limitations imposed by TIPRA amendments.

Allocating W-2 Wages to DPGR

The Temporary Regulations provide the general rule that a taxpayer may determine the amount of W-2 wages "properly allocable" to DPGR by using any "reasonable method that is satisfactory to the Secretary based on all the facts and circumstances." (14) In apparent recognition that such language offers taxpayers a great deal of flexibility, but not much certainty, the...