Gross Income

Highlights of the Sec. 199 Final Regs.

The following overview discusses how the final Sec. 199 regulations (TD 9263, issued 5/24/06), compare to the proposed regulations (REG-105847-05, issued 11/4/05), and to Notice 2005-14 (issued 1/1/9/05). The final regulations were effective June 1, 2006, but can be applied to earlier tax periods.

The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), enacted May 17, 2006, has also changed certain Sec. 199 provisions with respect to qualified wages. Although the IRS and Treasury should probably be commended for trying to simplify this very complex area of the law, many ambiguities still exist, which may lead to disagreements between taxpayers and the Service on how to apply the law.

Computing Taxable Income

Beginning with tax year 2005, a new deduction is available to companies that produce goods within the U.S. The deduction, created by the American Jobs Creation Act of 2004, was enacted in response to the phased-out repeal of the extraterritorial income (ETI) exclusion.

Under previous pronouncements, the Sec. 199 deduction could not be taken into account in computing a net operating loss (NOL) or an NOL carryback or carryover. However, final Regs. Sec. 1.199-1(b)(1) clarifies that in calculating taxable income in the year of the deduction, taxable income is computed without regard to the Sec. 199 deduction or the ETI exclusion.

Wage Limit

The final regulations give the Secretary the authority to authorize methods of calculating Form W-2 wages (i.e., within revenue procedures such as Rev. Proc. 2006-22); see Regs. Sec. 1.199-2(e)(3). The authority was granted so that changes could be made more quickly than by waiting to amend the final regulations for future changes to Form W-2.

The final regulations also responded to many small taxpayers’ concerns about the W-2 wage limit. Many of these taxpayers use professional employment organizations or employee leasing firms to give their employees the most beneficial and cost-effective benefits. Term employees (i.e., corporate officers and employees under common-law rules) are defined under Sec. 3121(d)(1) and (2), according to Regs. Sec. 1.199-2(a)(1). Regs. Sec. 1.199-2(a)(2) allows taxpayers to take into account amounts paid by and reported on Forms W-2 issued by other parties, provided the reported wages were paid to common-law employees. Thus, the issue of whether payments made to the “leased” employees are included in the W-2 wage limit depends on an application of the common-law rules under Sec. 3401 (d)(1).

Definition: Under Sec. 3401(d)(1), the term “employer” means the person for whom an individual performs, or has performed, any service, of whatever nature, as the employee of such person, except:

1. If the person for whom the individual performs or performed the services does not have control of the payment of the wages for such services, the term “employer” means the person having control of the payment of such wage; and

2. In the case of a person paying wages on behalf of a nonresident alien individual, foreign partnership, or foreign corporation, not engaged in trade or business within the U.S., the term “employer” means such person.

Based on the language in Regs. Sec. 1.199-2(a)(1), it appears that a corporate officer’s wages may be included in the W-2 wage limit whether or not the officer is considered a common-law employee under Sec. 3401(d)(1). Further, if other employees meet the common-law threshold, their wages may also be included. Regs. Sec. 1.199-2(e)(1) clarifies that W-2 wages include taxable wages (box 1 of Form W-2), the total amount of elective deferrals (under Sec. 402(g)(3)), compensation deferred under Sec. 457 and, for tax years after beginning 2005, the amount of designated Roth IRA contributions.

DPGR

The final regulations on the determination of domestic production gross receipts (DPGR) significantly modify the proposed regulations. First, under Regs. Sec. 1.199-3, a taxpayer with less than 5% of DPGR (reverse de minimis rule) can exclude (1) those receipts from Sec. 199 in their entirety or (2) total service income with de minimis DPGR, if it chooses. This means the taxpayer will not have to create an accounting method that otherwise would require the Service’s authority to change if the taxpayer wants to take the deduction in future years.

A second modification relates to the item-by-item standard required under the proposed regulations. While many taxpayers and their advocates had suggested statistical sampling as a means of reducing the burdens of calculating the domestic production activities deduction (DPAD), the final regulations are silent about this. According to the preamble to the final regulations, the IRS and Treasury are still considering the use of statistical sampling. Regs. Sec. 1.199-3(d)(1), however, clarifies the item-by-item standard, by providing that only DPGR must be determined on an item-by-item basis; the related expenses need not be.

In trying to address taxpayer concerns about the burden of identifying qualifying production activity income (QPAI) at the item level, the Service and Treasury have included in the final regulations both the “readily available” standard from Notice 2005-14 and the “undue burden and cost” standard from the proposed regulations, which allow taxpayers to choose whether to use specific identification standards for determining DPGR. Under Regs. Sec. 1.199-3(d)(1), taxpayers must determine, using any reasonable method that is satisfactory to the Secretary based on all the facts and circumstances, whether gross receipts qualify as DPGR on an item-by-item basis. They may find the specific identification standard is too costly for the benefits afforded by the deduction and may end up applying sampling techniques to minimize their current burden at the expense of future IRS audit scrutiny.

The rules on government contracts were also modified in the Gulf Opportunity Zone Act of 2005. Contractors and others providing qualified production property (QPP) to the Federal government can now claim the deduction. The final regulations clarify the application of these rules to subcontractors as well; see Regs. Sec. 1.199-3(f)(2) and (3).

“In-Whole-or-in-Significant-Part” Requirement

The Service and Treasury re-ceived many comments on determining which items qualify as QPP manufactured, produced, grown or extracted in the U.S. One commentator requested guidance for taxpayers that do not maintain expenses through cost of goods sold (COGS) and asked how to apply the safe-harbor rules in those cases. According to Regs. Sec. 1.199-3(g)(3), the in-whole-or-in-significant-part requirement is met if the taxpayer’s direct labor and overhead related to a QPP item accounts for 20% or more of its COGS or, in a transaction without COGS (e.g., a lease, rental or license), direct labor and overhead account for 20% or more of the QPP’s unadjusted basis. Further, for taxpayers subject to Sec. 263A, overhead includes all costs requiring capitalization under Sec. 263A (except direct labor and materials). For taxpayers not subject to Sec. 263A (i.e., percentage-of-completion contractors), the 20% test is based on those items that would have been subject to Sec. 263A had the taxpayer been required to calculate its expenses consistent with that provision.

For most taxpayers, Sec. 174 costs are not included in determining the in-whole-or-in-significant-part test. However, computer software and sound-recording taxpayers may include Sec. 174 costs; see Regs. Sec. 1.199-3(g)(3)(iii). Also under the final regulations, Sec. 174 costs incurred by these taxpayers in prior tax years may be included in determining whether an item meets the in-whole-or-in-significant-part requirement. However, the total costs must be allocated on a per-unit basis over the estimated number of units the taxpayer anticipates selling to determine DPGR; see Regs. Sec. 1.199-3(g)(3)(iii).

Taxpayers and the Service may have difficulties agreeing on the number of units a taxpayer will be selling over its life and may have to make a “look-back” adjustment to future regulations to minimize this issue.

A rule similar to that for print media advertising as QPAI was added for qualified filmmakers (and TV productions); see Regs. Sec. 1.199-3(a)(1)(ii) and (l). Treasury and the Service recognize that filmmakers’ advertising revenue is similar to print media; this revenue can be added to QPAI.

Definitions of Tangible Personal Property and Real Property

Regs. Sec. 1.199-3(j)(2)(i) defines tangible personal property as any tangible property other than land, real property (as described in Regs. Sec. 1.199-3(m)(1), computer software, sound recordings, qualified films and utilities. Additionally, it includes gas (other than described in Regs. Sec. 1.199-3(l)(2)), chemicals and similar property (steam, oxygen, etc.). Real property is defined by Regs. Sec. 1.199-3(m)(3) to include buildings, inherently permanent structures (other than machinery), inherently permanent land improvements, oil and gas wells, and other infrastructure.

Activities Constituting Construction and Engineering

Construction activities have been expanded to include demolition and land grading; see Regs. Sec. 1.199-3(m)(2)(iii). The final regulations provide a safe harbor for special-purpose entities for single projects, and permit these entities to meet the “active conduct of a construction trade or business” requirement. Before this modification, commentators were concerned whether entities used for the construction of a single project would meet the active business requirement, thus allowing the income from these entities to qualify as DPGR; see Regs. Sec. 1.199-3(m)(1)(ii).

Treasury received many comments on the proposed regulations requesting the removal of the gross receipts associated with the sale of land from the gross receipts subject to the de minimis exception. It has allowed this exclusion under the final regulations, as long as the taxpayer meets the land safe-harbor rules; see Regs. Sec. 1.199-3(m) (1)(iii).

Allocation of COGS and Other Deductions

Several taxpayers and their advocates requested either increasing or removing the average annual gross-receipts threshold for the simplified method. In response, for taxpayers that want to use the simplified method of Regs. Sec. 1.199-4(e), Treasury has increased the threshold for annual gross receipts to $100 million, or total assets at the end of the tax year of $10 million or less. Under the simplified method, a taxpayer’s expenses, losses or deductions are apportioned between DPGR and non-DPGR based on their relative percentage to total gross receipts.

Expanded Affiliated Groups

The final regulations provide that the de minimis rule applies at the consolidated-group level, not at the single-member level. This will reduce the effect of intercompany tax allocations between members of the same group.

Passthrough Entities

According to the preamble to the final regulations, Treasury is still considering modifications to the pass-through rules and intends to modify the final regulations on shareholders and partners of passthrough entities. However, it provided some clarifications in the final regulations. Regs. Sec. 1.199-9 provides that the DPAD does not reduce an S corporation shareholder’s or partner’s basis. It also clarifies that if an entity calculates QPAI at the entity level, the partner or shareholder must follow the cost-allocation rules determined at that level.

From Timothy J. Giacoletti, CPA, MST, The Rehmann Group, Troy, MI