Sec. 199 provides a deduction based on a percentage of income attributable to certain domestic production activities. This item discusses how recent final regulations interpret statutory changes to Sec. 199 and how the regulations eliminate a potential issue in calculating taxable income for purposes of the Sec. 199 deduction.
Sec. 199 Overview
For tax years beginning after December 31, 2004, Sec. 199 allows a deduction equal to a specified percentage (3% for years beginning in 2005 and 2006; 6% for years beginning in 2007, 2008, and 2009; and 9% in subsequent years) of the lesser of qualifying production activity income (QPAI) or taxable income. The resulting amount is further limited to 50% of W-2 wages for the tax year. In brief, QPAI equals eligible receipts, or domestic production gross receipts (DPGR), less allocable cost of goods sold and other deductions.
For corporations, the Sec. 199 deduction is computed at the expanded affiliated group (EAG) level. In general, an EAG is an affiliated group as defined in Sec. 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” and disregarding Secs. 1504(b)(2) and (4). To compute the EAG’s Sec. 199 deduction, each member’s taxable income or loss, QPAI, and W-2 wages are aggregated. For partnerships and S corporations, the Sec. 199 deduction is generally computed by the partners or shareholders, to whom the entity allocates the items necessary for the computation.
The Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222 (TIPRA), enacted on May 17, 2006, amended Sec. 199; the amendments relate primarily to the determination of W-2 wages for purposes of the W-2 wage limitation. Before the enactment of TIPRA, the Sec. 199 deduction amount was limited to 50% of all W-2 wages paid by the taxpayer during the tax year regardless of whether the wages were attributable to production activities. This limitation was modified by TIPRA so that a taxpayer is now permitted to include only wages that are properly allocable to qualifying domestic production activities.
For a partnership or S corporation (under the pre-TIPRA law), the W-2 wages allocable to a partner or owner were limited to the lesser of the partner/owner’s allocable share of wages or two times the applicable Sec. 199 percentage of the QPAI computed by taking into account the partner/owner’s allocable share of items. Under TIPRA, this rule was amended so that a passthrough entity’s partner/owner’s share of W-2 wages is no longer limited to twice the applicable percentage of allocated QPAI for the year.
In October 2006, the IRS and Treasury released temporary regulations concerning the amendments made by TIPRA. During February 2008, the IRS and Treasury issued TD 9381, containing final regulations. This item next discusses the final regulations’ interpretation of TIPRA amendments to the W-2 wage limitation.
Final Regulations
W-2 wages in general: Under Regs. Sec. 1.199-2(e)(2), reflecting the TIPRA changes, the term “W-2 wages” for purposes of determining the Sec. 199 wage limitation amount includes only amounts that are properly allocable to DPGR. To determine this allocable amount, taxpayers may use any reasonable method determined to be satisfactory based on all facts and circumstances. The regulations do not provide any specific factors that would lead a taxpayer to determine that an allocation method is reasonable. However, the regulations do provide taxpayers with wage expense safe-harbor methods depending on the Sec. 199 cost allocation methods used.
Aside from establishing the safe harbors, the final regulations modify the provisions dealing with passthrough entities to reflect TIPRA’s removal of the aforementioned cap on W-2 wages that may be reported to partners/owners. Note that the final regulations do not appear to permit attribution of activities for purposes of determining the allocable portion of W-2 wages outside the consolidated return context.
Safe-harbor methods: One safe-harbor method is available for taxpayers using either the Sec. 861 method of cost allocation (Regs. Sec. 1.199-4(d)) or the simplified deduction method (Regs. Sec. 1.199-4(e)). These taxpayers may determine the allocable wage amount by multiplying total Regs. Sec. 1.199-2(e)(1) wages for the tax year by the ratio of wage expense included in QPAI to the total wage expense used in computing taxable income. For purposes of this computation, the term “wage expense” is defined as compensation paid by the employer in the conduct of an active trade or business to its employees that is properly taken into account under its method of accounting. Taxpayers may determine wage expense in cost of goods sold (COGS) using any reasonable method under the facts and circumstances, including, for example, the use of direct labor included in COGS or the use of Sec. 263A labor costs included in COGS.
Taxpayers that use the small business simplified overall method under Regs. Sec. 1.199-4(f) are also provided a safe-harbor method. Under this safe harbor, the amount of Regs. Sec. 1.199-2(e)(1) wages that are properly allocable to DPGR is determined on the basis of the proportion of DPGR to total gross receipts. This is the same ratio used to allocate the taxpayer’s total costs under the small business simplified overall method.
Losses incurred by members of an EAG: The final regulations also eliminate an unintended result that would allow a net operating loss (NOL) to be used in more than one tax year to reduce EAG taxable income for purposes of the Sec. 199 taxable income limitation.
The potential use of an NOL in more than one tax year’s taxable income limitation was the result of the operation of the Sec. 199 EAG rules, which aggregate the members’ taxable income or loss for purposes of an EAG’s taxable income limitation. For example, two members of an EAG (that do not file a consolidated federal tax return) could have positive QPAI, with one member having taxable income and the other an NOL that offsets the first member’s taxable income. However, the NOL member’s loss could be carried forward or back to another tax year and could then reduce the EAG member’s QPAI in the following year, thus reducing the EAG’s taxable income a second time. To prevent this result, Regs. Sec. 1.199-7(b)(4) provides that to the extent an NOL is used in the year it is sustained to determine an EAG’s taxable income limitation, the NOL cannot be carried forward or back to any other tax year for purposes of the taxable income limitation.
Effective dates: The provisions in the final regulations concerning the TIPRA amendments to the W-2 wage limitation rules apply to tax years beginning on or after October 19, 2006, but may be applied to tax years beginning after May 17, 2006, and before October 19, 2006. The provisions concerning losses incurred by EAG members apply to tax years beginning on or after February 15, 2008, while the prior temporary regulations are applicable to tax years beginning on or after October 19, 2006, and before February 15, 2008.
EditorNotes
Mary Van Leuven ia a Senior Manager at Washington National Tax KPMG LLP in Washington, DC
The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.
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If you would like additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.
