Sec. 199 Exam Status and Update

By Kurt Hanway, CPA, Washington, DC, Trevor Ackerman, J.D., CPA, Philadelphia, PA, and Scott Vance, J.D., LL.M., Washington, DC

Sec. 199 provides a deduction based on a percentage of income attributable to certain domestic production activities. 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. In brief, QPAI equals eligible receipts, or domestic production gross receipts (DPGR), less allocable cost of goods sold and other deductions. The resulting amount is further limited to 50% of W-2 wages for the tax year.

The Sec. 199 deduction has garnered increased attention in IRS exams over the past two years. Furthermore, with the increase in the rate of the Sec. 199 deduction from 6% to 9% for tax years beginning in 2010, taxpayers should expect and prepare for even more scrutiny by IRS exam teams. Due to the complexity of qualifying for and computing the Sec. 199 deduction, an IRS exam team may propose adjustments.

The Large and Mid-Size Business (LMSB) Division of the IRS has issued three industry director directives (IDDs) discussing Sec. 199 deduction exams. These IDDs can serve as important references in both planning for and calculating the amount of the Sec. 199 deduction and in defending the Sec. 199 deduction on exam. The LMSB issued its first Sec. 199 directive (IDD No. 1) on December 6, 2006, Industry Director Directive on Domestic Production Deduction (LMSB-04-1206-018), which identified the Sec. 199 deduction as a Tier I issue. Tier I issues represent areas of high strategic importance to the LMSB that have a significant impact on one or more industries and typically involve a large number of taxpayers, significant dollar risk, and substantial compliance risk.

The second LMSB directive (IDD No. 2), issued on August 24, 2007, serves as a follow-up and is closely related to IDD No. 1 in that it expands the scope of the Sec. 199 deduction exams (LMSB-04-0707-049). IDD No. 2 refers to IDD No. 1 as setting forth five minimum checks required on every exam and further explains that not all exams lead to a mandatory audit of the Sec. 199 issue. In IDD No. 2, the LMSB industry director explains that cases meeting certain established criteria (including the size of the deduction) will be subject to mandatory exams. In addition to established criteria, IDD No. 2 also establishes additional exam team procedures and expanded internal IRS coordination on the issues involved.

In the third LMSB directive (IDD No. 3), issued on March 4, 2009, Industry Director Directive on Domestic Production Deduction No. 3 (LMSB-04-0209-004), the industry director took up the issue of how prior-period expenses might result in the creation of DPGR in future years, even though the expenses may have resulted from activities that took place prior to the effective date of Sec. 199. IDD No. 3 also addressed how prior-period expenses should be allocated against DPGR and non-DPGR. It explains that although taxpayers must establish that the entire prior-period compensation is factually related to non–Sec. 199 income to exclude it from QPAI, taxpayers may allocate 10% to Sec. 199 income and 90% to non–Sec. 199 income as a safe harbor. This safe harbor presents an alternative to the factually intensive approach taken in Attorney Memorandum 2009-001. (See Fitzpatrick, “Treatment of Prior-Period Expenses Under Sec. 199,” 41 The Tax Adviser 87 (February 2010).)

In the authors’ experience, Sec. 199 exams are most often conducted by a domestic revenue agent or case coordinator responsible for the taxpayer’s exam, or they may be performed by an engineer whose experience may be rooted in valuation or cost segregation/depreciation-type issues. In approaching the exam, the responsible IRS agent typically submits a standard information document request (IDR) designed to gather specific quantitative information with respect to the Sec. 199 deduction. This information allows the agent to perform certain audit procedures to verify the mathematical accuracy of the deduction, including tying amounts to the trial balance and ensuring that the proper limitations (QPAI, taxable income, W-2 wages) were applied. In addition, the initial IDR or subsequent IDRs may focus on specific qualitative issues, such as whether the qualified production property (QPP) was manufactured, produced, grown, or extracted (MPGE) by the taxpayer, treatment of prior-period compensation, contract manufacturing arrangements, propriety of Sec. 861 allocations, etc. If examined, a taxpayer can reasonably expect to expend some effort to adequately respond to the issues raised on exam.

Substantial in Nature Requirement

To qualify for the Sec. 199 deduction, the taxpayer’s production activities must be “substantial in nature.” The regulations provide a safe harbor when a taxpayer incurs direct labor and overhead that accounts for at least 20% of the cost of goods sold of the property. In the authors’ experience, taxpayers claiming that their activities are substantial in nature and not claiming the 20% safe harbor may face significant hurdles in sustaining a deduction that is consistent with the taxpayer’s activities.

For example, if a U.S. manufacturing company manufactures a key raw material abroad or purchases the raw material from a third party and then combines or compounds the raw material with other ingredients before processing, testing, packaging, and labeling, among other steps, the IRS may contend that the company’s MPGE activities are not substantial in nature under the test in Regs. Sec. 1.199-3(g). Even when the company does not claim the 20% safe harbor under Regs. Sec. 1.199-3(g)(3), the IRS in some cases has requested that the company compute the 20% safe harbor as an indicator of whether the taxpayer’s activities may in fact be substantial in nature. If the taxpayer contends that the production activities are substantial in nature based upon the relevant facts and circumstances and does not rely on the safe-harbor test, it would seem that direct labor and overhead costs as a percentage of cost of goods sold, while not irrelevant, may not be as critical as suggested in some cases.

In at least two cases that the authors are aware of, taxpayers have been asked to provide schedules of costs at each step of the manufacturing process for representative products, not just aggregate costing data. In support of such requests, the field agents in those two cases explained that this information may be required under the regulations relating to relative cost and relative value. The field agents also explained that the taxpayers may need to shrink back from the end product to some other stage/step in the manufacturing process, thereby suggesting that they will allow only the individual process steps that meet the safe-harbor test. Barring use of the “shrinkback” rule, there does not appear to be an explicit requirement under the regulations to make this determination at less than the item level.

The terms “relative cost” and “relative value” are contained in the regulations defining “in whole or in significant part. Under Regs. Sec. 1.199-3(g)(2), QPP will be treated as MPGE in significant part by the taxpayer within the United States if it is substantial in nature, taking into account all the facts and circumstances, including:

  • The relative value (viewed quantitatively and qualitatively) added by the taxpayer’s MPGE activity that the taxpayer performs within the United States;
  • The relative cost of the taxpayer’s MPGE activity that the taxpayer performs within the United States;
  • The nature of the QPP; and
  • The nature of the MPGE activity that the taxpayer performs in the United States.

Taxpayers who cannot meet the safe harbor or who do not have the data in support of the safe harbor can try to analogize their situation to the examples at Regs. Sec. 1.199-3(g)(5), but ultimately their situations may be rather different. Taxpayers will continue to need to document the relative value added by, and relative cost of, the taxpayer’s MPGE activity within the United States, the nature of the property, and the nature of the MPGE activity that the taxpayer engages in.

Benefits and Burdens of Ownership/Contract Manufacturing

Benefits and burdens of ownership in the context of MPGE by the taxpayer have also been an area of focus for the IRS. For example, a manufacturing company may have the issue of which party has the benefits and burdens of ownership through its contract manufacturing arrangements. Regs. Sec. 1.199-3(f)(1) allows only one taxpayer to claim the Sec. 199 deduction for any qualifying activity. If one taxpayer performs a qualifying MPGE activity under a contract with another party, only the taxpayer that has the benefits and burdens of ownership of the QPP under federal income tax principles during the period in which the qualifying activity occurs is treated as engaged in the qualifying activity.

Based upon an analysis of the terms of the contract between the taxpayer and the contract manufacturer and application of relevant federal case law interpreting “benefits and burdens of ownership,” the taxpayer may appear to retain a majority of the benefits and burdens of ownership through the manufacturing process. For example, the taxpayer may control part of the (or the entire) manufacturing process, including having technical and quality control personnel at the counterparty’s site, retaining economic risk of inventory obsolescence, and owning the intellectual property and some equipment used in production. However, the taxpayer may not retain legal title to the raw materials or have risk of loss with respect to casualty or workmanship. In some cases, there may be price flexibility through the adjustment of various elements of cost. The authors are aware of at least one IRS exam team that is considering whether these facts preclude a taxpayer from having the benefits and burdens of ownership of the QPP during the production process as required by Regs. Sec. 1.199-3(e) and accordingly whether the taxpayer should treat the gross receipts derived from it as non-DPGR.

As a further example, a taxpayer may maintain legal title to the active ingredient throughout the manufacturing process, have the right of possession, receive all profits from the sale of the product, treat it as its property for state apportionment factors, control the entire process, and pay the contractor a fixed fee for quantity manufactured, while the contract manufacturer, rather than the taxpayer, retains the risk of loss. Since no one factor is dispositive, it is uncertain how the IRS would resolve such an issue in the exam context.


Despite the relatively short history of Sec. 199, there is quite a bit of administrative guidance. Even so, there are many technical issues and principles within the Sec. 199 statutory and regulatory framework that remain difficult to administer on exam. As the exam approach to the Sec. 199 deduction rapidly develops, it seems that some inquiries are not rooted in this statutory or regulatory framework but instead in (presumably) forthcoming administrative guidance or unwritten interpretations of existing guidance. It is therefore important for taxpayers with Sec. 199 deductions to stay abreast of current developments and IRS exam trends to help mitigate exposure in relation to their deduction. By keeping current, taxpayers can continue to develop appropriate practices. Companies may want to maintain more detailed information for representative products, perhaps leveraging on batch records.

Taxpayers claiming the deduction for contract manufacturing, whether as contractor or contractee, should be especially cautious to ensure that they retain the benefits and burdens of ownership with respect to the QPP being MPGE in the United States. One approach may be to include in the documentation files a matrix or memo discussing each of the factors determining which party has the benefits and burdens of ownership under the terms of the contract. Taxpayers must look to federal income tax case law, such as Grodt & McKay Realty, Inc., 77 T.C. 1221 (1981), to help make such determinations. Although case law holds that no single factor determines which party has the benefits and burdens of ownership, presently the IRS appears to be placing a higher level of emphasis on which party has the risk of loss. If a taxpayer does not have the risk of loss under the contract, the taxpayer can reasonably expect the IRS to press this issue under exam.

Editor: Mary Van Leuven, J.D., LL.M.


Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.

For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or

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

This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

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