| Home Online Publications Online Issues TTA Home Table of Contents Clinic Index Gross Income | |
Treasury and IRS Guidance Sheds Light on Sec. 199 Deduction Acting on the belief that it is “important to provide tax cuts to U.S. domestic manufacturers,” and in its latest effort to make U.S companies competitive both domestically and abroad, Congress adopted a new deduction for domestic production activities via new Sec. 199. The statutory relief provided under Sec. 199 was enacted in response to a World Trade Organization (WTO) ruling that the extraterritorial income (ETI) exclusion was a forbidden export subsidy. Congress responded to the WTO by repealing the ETI exclusion and effectively replacing it with a new Sec. 199 deduction. Subject to certain limits, the deduction is based on a percentage of the lesser of:
QPAI is determined as the excess of: 1. The taxpayer’s domestic production gross receipts (DPGR) per Sec. 199 (c)(4), 2. Less the sum of: (a) Cost of goods sold (COGS) allocable to such receipts; (b) Other expenses and losses directly allocable to such receipts; and (c) A ratable portion of other deductions, expenses and losses not directly allocable to those receipts or to another residual class of income. The deduction is effective for tax years beginning in 2005, and will be phased in; see the exhibit.
Determining Costs On Oct. 20, 2005, the IRS released Prop. Regs. Secs. 1.199-1 to -8, which expand on the initial guidance offered in Notice 2005-14 by clarifying and providing additional instruction on a number of critical issues, including the rules for allocating and apportioning income and expenses in computing the base amount available for the Sec. 199 deduction. Under the proposed regulations, taxpayers must account for qualifying receipts and expenses recognized in different tax years (e.g., as in accounting for advanced payments) under their regular accounting method. Thus, when determining a Sec. 199 deduction, costs must be determined by the accounting method used for Federal income tax purposes.
Allocating COGS Taxpayers generally must specifically identify COGS directly allocable to DPGR and a ratable portion of other deductions not directly traceable to DPGR or another income class (Prop. Regs. Sec. 1.199-4(a)). In determining the directly allocable COGS, they must consider: (1) Sec. 263A (uniform capitalization rules), Sec. 471 (general inventory rules) and Sec. 472 (LIFO inventory rules) when determining ending inventory; (2) inventory valuation adjustments, such as lower-of-cost-or-market method writedowns; and (3) the adjusted basis of noninventory property, if the gross receipts from the sale are included in DPGR (Prop. Regs. Sec. 1.199-4(b)). Books and records may be insufficient to identify COGS allocable to DPGR. If this is the case, taxpayers must use a reasonable allocation method to determine COGS allocable to DPGR and those allocable to other gross receipts (Prop. Regs. Sec. 1.199-4 (b)(2)). Further, if they use a method to allocate gross receipts between domestic and nondomestic production gross receipts, they cannot use a different method for purposes of allocating COGS. Taxpayers that are unable to identify specifically COGS allocable to domestic production activities, and do not use a method to allocate gross receipts between domestic and nondomestic production gross receipts, can use any other reasonable allocation method based on the facts and circumstances. Such facts and circumstances include, but are not limited to:
Per Notice 2005-14, other reasonable ways to allocate COGS include methods based on gross receipts, number of units sold, number of units produced or total production costs. Small taxpayers (i.e., those with average annual gross receipts of $5 million or less) can use the small business simplified method to allocate not only COGS, but also all other expenses, deductions and losses in determining domestic production activities income (Prop. Regs. Sec. 1.199-4(c)). The determination of COGS and other expenses under this method is discussed below.
Allocating Deductions, Expenses and Losses Other than COGS Taxpayers must use the applicable method available to determine these additional deductions in arriving at domestic production activities income. The appropriate method can be selected from the following three alternative methods available (Prop. Regs. Sec. 1.199-4(c)(1)):
When allocating deductions to DPGR under any of these methods, the following additional rules must be considered (Prop. Regs. Sec. 1.199-4(c)(2)):
Sec. 861 method (Prop. Regs. Sec. 1.199-4(d)): Under this method, taxpayers apply the rules provided in the Sec. 861 regulations in allocating and apportioning deductions to DPGR. In general, when applying this method, they allocate deductions to the relevant gross income grouping and apportion these deductions among gross income attributable to DPGR and the residual grouping. According to IRS guidance, taxpayers that use a particular method to allocate and apportion deductions under Sec. 861 for purposes other than determining QPAI, must use that same method to allocate and apportion costs when determining QPAI. Simplified deduction method (Prop. Regs. Sec. 1.199-4(e)): The simplified deduction method, as mentioned above, is available to taxpayers with average annual gross receipts of $25 million or less. Average annual gross receipts are determined by analyzing gross receipts for the three tax years (or fewer, if the taxpayer was not in existence) preceding the current tax year. Under this method, deductions are allocated ratably based on the taxpayer’s qualified production activities’ gross receipts divided by the taxpayer’s gross receipts from all sources. If a taxpayer elects to allocate expenses under the simplified deduction method, it must use this method when allocating all deductions. Small business simplified overall method (Prop. Regs. Sec. 1.199-4(f)): Qualifying small taxpayers can use this method to allocate and apportion COGS and other deductions between DPGR and nondomestic production gross receipts. According to IRS Notice 2005-14, a qualifying small taxpayer is:
Further, according to Prop. Regs. Sec. 1.199-4(f)(2), a taxpayer, in addition to having average annual gross receipts of $5 million or less, must also have total costs for the current tax year of $5 million or less, to qualify as a small taxpayer. While the proposed regulations and Notice 2005-14 differ on the eligibility requirements for a qualifying small taxpayer, taxpayers have the liberty to rely on either rule until the proposed regulations become final. When implementing this method, taxpayers ratably apportion total COGS and other deductions between DPGR and other receipts based on relative gross receipts. As a result, the proportion of COGS and deductions apportioned to DPGR equals the proportion of DPGR to total gross receipts. While this method is certainly simpler than the Sec. 861 method, it may cause the taxpayer to imprecisely allocate more total deductions to DPGR, thus reducing the overall base income available to compute the Sec. 199 deduction.
Conclusion Notice 2004-15 and the proposed regulations help to give taxpayers an interim foundation from which to allocate qualifying income and deductions in determining the Sec. 199 deduction. However, the rules are complex and need to be tailored to each situation. Taxpayers transitioning from the ETI exclusion to the new Sec. 199 deduction should take a closer look at their internal methods of determining and allocating expenses attributable to domestic production activities, to reap the deduction’s full benefit. However, they should do so while understanding that the current methods of expense allocation are certainly subject to change. For taxpayers willing and able to gather this information cost effectively, the Sec. 199 deduction could prove to be a significant tax benefit in the coming years. From Kevin Rose, CPA, Frazier & Deeter, LLC, Atlanta, GA (Not Affiliated with BDO Seidman, LLP) |
