Sec. 199 Deduction

The Service has released a new “Industry Director Directive” on the Sec. 199 domestic production activities deduction (DPAD). The directive, along with an associated document entitled “Minimum Checks for Section 199; Law and Explanation,” details the minimum audit checks IRS examiners are expected to complete when scrutinizing a corporation’s Sec. 199 DPAD. The directive is not an official legal pronouncement and cannot be used, cited or relied on as such; however, it provides corporations and their tax advisers with valuable insights on the aspects of Sec. 199 likeliest to be probed on audit.

Minimum checks: Under the directive, there are five minimum audit checks examiners should undertake to achieve a “comfort level with the taxpayer’s compliance level,” and give “the subsequent year examination teams a base for further review of the deduction.”

1. Does the taxpayer’s business make sense with the DPAD’s activity requirements? Examples: Most resellers (e.g., clothing stores and wholesalers) should not be claiming the deduction, nor should most professional service companies, as they are selling their services, even if in the process they provide a tangible item (such as a legal document). Auditors are instructed to review the corporation’s website and annual report, among other sources, to answer this question.
2. Compare the domestic production gross receipts (DPGR) reported on Form 8903, Domestic Production Activities Deduction, to the gross receipts or sales less returns and allowances on Form 1120, line 1(c). Gross receipts reported on line 1(c) should be greater than the DPGR reported on line 1 of Form 8903. If the gross receipts on Form 8903 match the gross receipts on line 1(c), the taxpayer may have not allocated to non-DPGR nonqualified income amounts such as gross receipts for services or for resale items, if applicable (this assumes the Regs. Sec. 1.199-1(d)(3)(i) de minimis rule does not apply). However, there may be situations in which DPGR is greater than total gross receipts, such as when partnership or S corporation flowthrough income is not reflected on Form 1120.
3. Is the taxpayer required to allocate gross receipts to remove nonqualified embedded service income, or determine the qualified income portion of a component of an item? If so, how did the taxpayer determine an allocation method? In some cases, the taxpayer must allocate gross receipts between qualifying and nonqualifying items. For example, if it produces/sells widgets and also buys/sells widgets, only the gross receipts from producing/selling widgets will qualify. In other cases, the taxpayer must allocate the gross receipts of an individual item between qualifying and nonqualifying portions. For example, if it produces/sells an item that includes nonqualifying services, it must make an allocation to determine the qualifying portion. However, no allocation is required when the service portion is one of the items specified in Regs. Sec. 1.199-3(i)(4), such as a qualified warranty, delivery, operating manual or installation not separately stated or separately offered by the taxpayer.
4. If the taxpayer is required to use the Sec. 861 method to allocate and apportion deductions, has it used it, and is it consistent with the application of Sec. 861 for foreign tax credit purposes, if applicable? The Sec. 861 method must be used to allocate and apportion deductions if the taxpayer’s average annual gross receipts exceed $100 million or total assets at the end of the tax year exceed $10 million. Within Sec. 861, there are various methods taxpayers can use to make allocations (e.g., gross receipts and asset methods), but they must be consistent with the chosen methods. (For a discussion of the methods, see Rollinson, et al., “Allocation and Apportionment of Expenses for Sec. 199 Purposes,” TTA, June 2006, p. 336.)