Sec. 199 provides that for tax years beginning after December 31, 2004, manufacturers and other producers may be entitled to a tax deduction for income derived from certain qualified domestic production activities. In order to realize the full benefits of the domestic production activities deduction (DPAD or Sec. 199 deduction), taxpayers must follow intricate rules and perform several complex analyses and calculations. Further, the identification of the Sec. 199 deduction as a Tier 1 examination issue by the IRS has increased the need for proper documentation to support the deduction. To reduce the uncertainty related to the Sec. 199 computation, the Service issued Rev. Proc. 2007-35 on May 11, 2007, to provide guidance for determining when statistical sampling may be used for purposes of Sec. 199 and establish acceptable statistical sampling methodologies. This guidance addresses the difficulties taxpayers may encounter when computing, and accumulating documentation to support, the deduction.
For tax years beginning in 2007, 2008, and 2009, Sec. 199(a)(1) allows a deduction equal to 6% of the lesser of (1) the qualified production activities income (QPAI) or (2) taxable income (determined without regard to Sec. 199) for the tax year. This percentage increases to 9% for tax years beginning in 2010 and later.
QPAI means an amount equal to the excess of:
- The taxpayer’s domestic production gross receipts (DPGR) over
- The sum of (1) the cost of goods sold that are allocable to such receipts and (2) other expenses, losses, or deductions that are properly allocable to such receipts.
Sec. 199(c)(4)(A) defines DPGR as the taxpayer’s gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, any qualified film produced by the taxpayer, or electricity, natural gas, or potable water produced by the taxpayer in the United States.
In the case of a taxpayer engaged in the active conduct of a construction trade or business, DPGR consists of gross receipts derived from construction of real property performed in the United States by the taxpayer in the ordinary course of such trade or business. In the case of a taxpayer engaged in the active conduct of an engineering or architectural services trade or business, DPGR consists of gross receipts derived from engineering or architectural services performed in the United States by the taxpayer in the ordinary course of such trade or business with respect to the construction of real property in the United States.
Allocation of DPGR and Non-DPGR
Regs. Sec. 1.199-1(d) provides that a taxpayer must determine the portion of its gross receipts for the tax year that is DPGR and the portion that is non-DPGR. In determining whether the taxpayer’s method of allocating gross receipts between DPGR and non-DPGR is reasonable, the IRS will take into consideration factors such as whether the taxpayer uses the most accurate information available; the relationship between the gross receipts and the method used; the accuracy of the method chosen as compared with other possible methods; the time, burden, and cost of using alternative methods; and whether the taxpayer applies the method consistently from year to year. Therefore, a taxpayer must use specific identification to determine DPGR if it has the information readily available and can, without undue burden or expense, specifically identify whether the gross receipts derived from an item are DPGR (Regs. Sec. 1.199- 1(d)(2)). The regulations do not specify how a taxpayer must address this allocation when the information is not available without undue burden and expense.
To add further complexity, Regs. Sec. 1.199-3(d)(1) provides that a taxpayer must determine DPGR on an item-by-item basis. The determination is made using any reasonable method that is satisfactory to the IRS, based on all the facts and circumstances. The term “item” means the property offered by the taxpayer in the normal course of the taxpayer’s business if the gross receipts from the disposition of such property qualify as DPGR. Alternatively, if property offered for sale by the taxpayer consists of components that qualify as DPGR and other components that do not qualify as DPGR, the components must be treated as separate items and cannot be combined.
Difficulties may arise in determining DPGR for taxpayers in certain industries that produce products that include components of DPGR and non-DPGR for various reasons:
- Certain components of their product may be purchased from related parties but manufactured outside the United States;
- Certain components are purchased, not produced, by the taxpayer from nonrelated entities;
- A portion of the disposition of their otherwise qualifying product involves a services component; or
- For construction activities, certain components of a construction project may include tangible personal property.
Furthermore, problems may arise for taxpayers that lack information systems capable of tracking the data necessary to support the Sec. 199 deduction. These complexities can make it difficult for taxpayers to allocate DPGR and non-DPGR with reasonable accuracy.
Statistical Sampling Revenue Procedure
Statistical sampling is a method of sampling a portion of a body or population of data and extrapolating the results of the sample to the entire data population. Rev. Proc. 2007-35 provides guidance for determining when statistical sampling may be used for purposes of the Sec. 199 deduction only.
Section 4.01 of Rev. Proc. 2007-35 provides that the use of statistical sampling will be considered a reasonable method satisfactory to the Service to the extent the sampling methodology meets the requirements of §4.02 and follows the detailed sampling procedures provided in the revenue procedure’s appendix. For example, under this revenue procedure, statistical sampling may be used to:
- Allocate gross receipts between DPGR and non-DPGR under Regs. Sec. 1.199-1(d)(1);
- Determine whether gross receipts qualify as DPGR on an item-by-item basis under Regs. Sec. 1.199-3(d)(1);
- Allocate cost of goods sold between DPGR and non-DPGR under Regs. Sec. 1.199-4(b)(2)(i); and
- Allocate deductions that are properly allocable to DPGR or gross income attributable to DPGR under Regs. Sec. 1.199-4(c)(1).
Although not specified in the revenue procedure, other areas in which statistical sampling might be applied include determining:
- Whether a taxpayer meets the de minimis rules in the regulations;
- Whether a taxpayer meets the “in whole or in significant part” requirement or the 20% safe-harbor test in the regulations;
- Whether a taxpayer has the benefits and burdens for its various contracts with external vendors; or
- The real and personal property components of a construction, architectural, or engineering project.
Section 4.02 of the revenue procedure further provides that the appropriateness of using a statistical sample for purposes of Sec. 199 is a facts-and-circumstances determination. Factors used in determining whether a statistical sample is appropriate include, but are not limited to, the time required to analyze large volumes of data, the cost of analyzing data, the existence of verifiable information relevant to the Sec. 199 calculation, and the availability of more accurate information. For purposes of Sec. 199, statistical sampling will generally be considered appropriate if the taxpayer can demonstrate a compelling reason for its use.
Section 4.03 of the revenue procedure provides several examples of situations in which statistical sampling would be appropriate. One of the examples describes a taxpayer (X) that sells over 5,000 different products. X manufactures the products in the United States and Mexico. In addition, some of these products are purchased from nonrelated entities. Each product may constitute an item within the meaning of Regs. Sec. 1.199-3(d)(1).
Although X maintains a separate stock-keeping unit (SKU) for each product, its computer system does not distinguish whether the product sold is manufactured in the United States or Mexico or is purchased from nonrelated entities. X can, however, determine the gross receipts derived from the sale of each product. X estimates it would take one staff day to make a determination of the DPGR derived from each SKU. Therefore, X would have to spend over 5,000 staff days to make a determination of DPGR. In this case, the revenue procedure states that it would be appropriate for X to use statistical sampling to determine DPGR derived from the sale of each product.
Rev. Proc. 2007-35 is effective for tax years beginning on or after May 11, 2007, but may be applied to tax years beginning after December 31, 2004, and before May 11, 2007.
As the Sec. 199 deduction percentages are phased in to the full 9% for tax years beginning in 2010, taxpayers will be faced with greater opportunities to maximize their Sec. 199 deductions and increase compliance risk. Where appropriate, taxpayers can use statistical sampling under Rev. Proc. 2007-35 to substantially reduce the time and cost of complying with the complex Sec. 199 rules and regulations and to provide some certainty for their allocation methodologies.
Lorin Luchs is a partner in National Tax Services of BDO Seidman, LLP in Bethesda, MD.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.
For additional information about these items, contact Mr. Luchs at (301) 634-0250 or firstname.lastname@example.org.