Treatment of Prior-Period Expenses under Sec. 199

By Ellen Fitzpatrick, CPA, Washington, DC

Editor: Greg A. Fairbanks, J.D., LL.M.

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 priorperiod 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 DPGRrelated 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 qualify as DPGR, the taxpayer must allocate the COGS to:

  • DPGR if the taxpayer identified the related gross receipts as DPGR in the prior tax year; or
  • Non-DPGR if the taxpayer identified the related gross receipts as non-DPGR in the prior tax year or if the taxpayer recognized under its methods of accounting those gross receipts in a tax year to which Sec. 199 does not apply.
This provision would apply to income recognized from advance payments.

 

Regs. Sec. 1.199-4(c) states that other deductions (i.e., expense items that are not recognized as COGS) are properly allocated to DPGR using the rules of the Sec. 861 method but does not specifically mention prior-period costs. Under the Sec. 861 method, a deduction is first allocated to a class of gross income and then apportioned between the statutory and residual groupings of gross income within that class. The allocation is based on the factual relationship of a deduction to gross income whether the cost was incurred in the current period or in a prior period.

As noted above, the IRS has issued three items of guidance that discuss how a taxpayer should allocate prior-period costs when determining current-year QPAI. The IRS guidance items all relate to prior-period expenses; however, two relate to costs that were not part of COGS and one to costs that were part of COGS.

AM 2009-001

In AM 2009-001, the taxpayer incurred deferred-compensation costs that related to prior periods. The IRS National Office concluded that because the deferred-compensation costs were other deductions (not part of COGS) that related to two different products, the taxpayer should use the method prescribed in Sec. 861 to allocate and apportion those compensation deductions between the products.

The deferred compensation the taxpayer paid in 2005 related to one employee who worked on development, production, and sales of two products during 2004. In 2005, the sale of one product generated DPGR and the sale of the other product did not. Even though the expense was not part of COGS, the IRS memorandum states that the deferred compensation was a prior-period expense as described in Regs. Sec. 1.199-4(b)(4)(ii) (a section that relates to COGS). The advice concludes that because the prior-period expense at issue was not part of COGS, the taxpayer was required under Regs. Sec. 1.199-4(c) to use the method prescribed by Sec. 861 that allocates a deduction to a class of gross income.

Applying the rules of Sec. 861, the IRS reasoned that the taxpayer should not allocate costs entirely to non-DPGR just because the costs arose from services provided prior to the enactment of Sec. 199. Instead, the taxpayer must apportion the deduction based on whether those priorperiod services ultimately resulted in the production of items that generated DPGR. The facts in the memorandum state that the taxpayer knew the employee spent approximately 80% of his time working on the product that ultimately generated DPGR. Therefore, the IRS allocated 80% of the current-year deductions to DPGR.

The above advice, which the IRS published in January 2009, addresses only the allocation of deferred compensation where that compensation was not treated as part of COGS. The legal advice does not indicate whether the taxpayer was subject to Sec. 263A (UNICAP) or how these costs would have been treated if they were part of COGS. Arguably, these expenses would be subject to the UNICAP rules, and a portion of the deferred compensation paid in 2005 would be capitalizable to ending inventory.

LMSB 04-0209-004

In March 2009, the IRS released an Industry Director Directive (LMSB 04- 0209-004) in which the IRS Large and Mid-Size Business Division provided an acceptable method of allocating and apportioning prior-period compensation expenses (safe-harbor allocation method) that are not treated as part of COGS. In the directive, the IRS said it would not challenge taxpayers that apply that method. The safe-harbor method prescribed in the directive applies only to compensation expenses that:

  • Are currently deductible;
  • Relate to services provided to the taxpayer before the enactment of Sec. 199; and
  • Are not required to be included in the taxpayer’s COGS.
Taxpayers can avoid the burden of documenting the factual relationship as required under Sec. 861 by allocating 10% of the prior-period compensation costs to DPGR and the remaining 90% to non- DPGR. If this method is used, it must be followed consistently by the taxpayer.

 

CCA 200946037

In a more recent legal memorandum (CCA 200946037), published in November 2009, the IRS National Office ruled that the Sec. 199 regulations do not require or permit corporations to allocate part of an inventory item’s COGS to non- DPGR when the gross receipts from the sale of that item are treated as DPGR.

In the CCA, the taxpayer manufactured product A from 1999 through 2004. In 2004 and going forward, it began producing product B, which was a new and improved version of A. The taxpayer used a standard cost method to determine its Sec. 471 costs and the simplified production method to determine the amount of UNICAP costs that are capitalizable to ending inventory. In 2008, the taxpayer incurred three types of prior-period expenses that related back to periods before to the enactment of Sec. 199. These expenses (2008 expenses) were medical costs for employees who had retired in 2000, worker’s compensation costs for an employee who was injured while manufacturing A in 2004, and environmental remediation costs that the taxpayer caused at its manufacturing facility from 2000 to 2004. The taxpayer’s position in the CCA was that under Regs. Sec. 1.199- 4(b)(2)(ii)(B), the portion of its COGS related to these prior-period costs should be allocated to non-DPGR because the costs were related to activities that generated gross receipts before the enactment of Sec. 199.

Regs. Sec. 1.199-4(b)(1) anticipates a situation in which gross receipts related to the manufacture of qualified production property might be included in the computation of DPGR in a year different from the COGS related to that property— such as in the case of income recognized for advance payments. In addition, Regs. Sec. 1.199-4(b)(1) provides that the taxpayer’s COGS is to be determined under the methods of accounting the taxpayer uses to compute taxable income under Secs. 263A, 471, and 472. All three of the costs in the CCA are costs that a taxpayer is required to capitalize as additional Sec. 263A costs. Regs. Sec. 1.263A-2(a)(3)(i) provides that producers must generally capitalize direct and indirect costs properly allocable to property produced under Sec. 263A without regard to whether those costs are incurred before, during, or after the production period.

The CCA states that generally the treatment of Sec. 199 expenses is required to follow the treatment of Sec. 263A costs. Because the taxpayer’s methods under Secs. 471 and 263A determine the inventory cost of each unit of property and consider the 2008 expenses as part of the cost of producing B, the prior-period expenses that were part of COGS were viewed as costs to produce B. Once a cost is recognized as part of COGS, the taxpayer is then allowed to use a reasonable method, as provided in Regs. Sec. 1.199- 4(b)(2), to allocate COGS between DPGR and non-DPGR. In the CCA, the taxpayer produced only one product (B). The CCA goes on to state that the most reasonable method for allocating COGS to items produced would be to use the specific identification method. Under that method, because all sales of B generated DPGR, the taxpayer should allocate all the COGS allocated to this product to DPGR.

Conclusion

Both the advice memorandum and the CCA indicate that just because an expense relates to services performed or other actions taken prior to the enactment of Sec. 199, such costs are nonetheless allocable— at least in part—to DPGR if the activity contributed to the production of a product that generated DPGR. While the CCA resulted in all the prior-period costs being allocated to DPGR where such costs are treated as COGS, the directive provides some flexibility to the taxpayer who has prior-period compensation expenses that are not part of COGS. As stated above, the IRS will not challenge a taxpayer’s use of the safe-harbor allocation method for prior-period deferred compensation expenses where those expenses are not treated as part of COGS.


EditorNotes

Greg Fairbanks is a tax manager with Grant Thornton LLP in Washington, DC.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@gt.com

Newsletter Articles

AWARD

James M. Greenwell Wins 2014 Best Article Award

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

 

FEATURE

How Legal Marijuana Businesses Are Treated Federally

This article examines the tax problems that these businesses face and warns that professionals may provide services to them at their peril.