IRS Issues Second IDD on Domestic Production Deduction

The IRS has issued a follow-up directive to the industry director directive (IDD) issued on December 6, 2006 (LMSB-04-1206-018), on the Sec. 199 domestic production deduction (DPD) (LMSB-04-0707-049). The DPD is a designated Tier I issue and as such must be identified, developed, and resolved in a consistent manner across all IRS Large and Mid-Size Business cases involving similarly situated taxpayers. The IRS believes that the DPD collectively represents significant tax dollars, and early indications suggest that taxpayers have inconsistently applied the rules promulgated under Sec. 199. The intent of the follow-up IDD is to describe controls being placed on the review of larger deduction amounts.

The previous IDD set forth five minimum checks required in every case, which can help an IRS exam team determine whether to include the issue in the audit plan. Not all cases will lead to mandatory audit of the DPD. In the IDD, the Service states that cases meeting certain established criteria will be subject to mandatory audit. Those criteria, however, have been redacted from the document.

When the DPD is audited, the IRS continues to concentrate on determining the most effective way to audit and the specific areas on which the audit team should focus. To aid in the development and resolution of DPD cases, the following requirements will be put in place for returns with the DPD:

1. The team manager assigned to the case will contact the DPD technical advisers to share and discuss the audit plan.

2. Contact will be maintained with the DPD technical advisers throughout the audit process to discuss issues and involve them as needed.

3. Form 5701, Notice of Proposed Adjustment, Form 886A, Explanation of Items, and/or Form 906, Closing Agreement, will be provided to the DPD technical advisers for review and concurrence. The technical adviser team has indicated that it will put in place a 10-workday turnaround on the review of these forms.

4. For fast track, pre-appeals conferences, and pre-filing agreement cases, the team manager will contact the DPD technical advisers to involve them in the process, including conference attendance and concurrence with any agreement.

The Service recognizes that the law related to the DPD is complex, with many nuances, and DPD technical advisers are ready to assist audit teams by both examining the DPD and providing answers to specific questions that might arise.

Implications

The IDD emphasizes the internal IRS coordination that is now required around the DPD as a result of its designation as a Tier I issue. However, the IDD is unique in that it is the first directive on a Tier I or Tier II issue that contains redactions. For example, the criteria for subjecting a taxpayer’s DPD to mandatory audit are specifically removed from the IDD. The reason for such redactions remains unclear.

Editor Notes:

David J. Kautter, CPA Ernst & Young LLP Washington, DC

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

If you would like additional information about these items, contact Mr. Kautter at (202) 327-8878 or david.kautter@ey.com.