Domestic Production Activities Deduction – Section 199 March 26, 2007 Pamela C. Beckey.

Domestic Production Activities Deduction – Section 199

March 26, 2007

Pamela C. Beckey

Copyright © 2006 Deloitte Development LLP. All rights reserved. 2

Agenda

• Introduction -General Application• Key Impact of TIPRA Changes• Changing certain Section 861 elections

•Rev Proc 2006-42 • Exam Experience

– LMSB Examination Guidelines – Minimum Checks– IDR / Exam Experience


Introduction – General Application

• Deduction equal to a fixed percentage times the lesser of:– Qualified Production Activities Income (“QPAI”) or

Taxable Income• QPAI is Domestic Production Gross Receipts

(“DPGR”) less COGS and directly and indirectly allocable expenses

• Fixed percentage increases from 3% to 6% for FY beginning after 12/31/2006, then 9% after 12/31/2009

• Taxable income & wage limitations• Broad application to US activities manufacturing,

film, software, sound recording, construction, engineering & architectural, power generation, mining, agricultural


Introduction – General Application

• Requirements to identify DPGR and COGS at Item Level

• Definition of an “item” is critical– Shrink-back

• QPAI can be positive or negative– Loss transactions may not be excluded

• Safe Harbor vs. Substantial in Nature Documentation


TIPRA – Key § 199 changes

•TIPRA effective for taxable years beginning after May 17, 2006

•W-2 wages include only amounts described in 1.199-2(e)(1) that are properly allocable to DPGR

•Pass-thru entities report each owner’s share of wages instead of 2 x 3% x QPAI


Limitation on W-2 wages

• May use any reasonable method to determine amount of W-2 wages properly allocable to DPGR

– Method must be satisfactory to the Secretary based on all of the facts and circumstances

• Temporary regulations provide two safe harbors

– Wage expense safe harbor for taxpayers using the § 861 method or simplified deduction method

– Small business simplified overall method safe harbor for taxpayers using the small business simplified overall method


Limitation on W-2 wages (cont.)

•Wage expense safe harbor– W-2 wages properly allocable to DPGR are equal to

W-2 wages multiplied by ratio of wage expense included in computing QPAI to total wage expense used in computing taxable income

W-2 wages X QPAI wagesTotal wages

– Must use the same allocation and apportionment methods used to determine QPAI to allocate and apportion wage expense for safe harbor


Limitation on W-2 wages (cont.)

•Wage expense included in cost of goods sold (“COGS”) determined using any reasonable method, including– Direct labor in COGS or § 263A labor costs in

simplified service cost method included in COGS

•COGS often includes goods manufactured in prior years – COGS would therefore include W-2 wages from

prior years attributable to DPGR

– Creates difficulty in determining amount of W-2 wages in COGS


EAG caution

•TIPRA amendments may impact EAG members

– EAG member uses employees of another EAG member to perform activities attributable to DPGR and does not have W-2 wages

• Each EAG member computes its taxable income or loss, QPAI, and W-2 wages, which are aggregated to determine the EAG’s § 199 deduction

– With the TIPRA changes, an EAG member with W-2 wages must also have DPGR to which the wages are properly allocable to qualify those wages as W-2 wages

– What if EAG members file a consolidated return?


Pass-thru entities

•The Secretary is authorized to permit a pass-thru entity to calculate an owner’s share of QPAI at the entity level– By publication in the Internal Revenue Bulletin

– Determination currently made at owner level

•Under TIPRA, a pass-thru entity must allocate its W-2 wages among its owners in the same way wage expense is allocated– Includes W-2 wages from a lower-tier partnership

of which the pass-thru entity is a partner


Changing certain Section 861 Elections

•Rev Proc 2006-42 provides guidance for securing automatic approval to change certain pre-existing expense allocation elections under Section 861– Interest Expense– Research and Development Expenditures

•Must file appropriate statement on Form 1118 with either the 2005 or 2006 tax return filing


Exam Issues

• LMSB-Directive re: § 199 exam procedures -December 6, 2006

• Minimum audit checks to examine 199 and incorporated in a team's risk analysis

• Domestic Production Deduction (DPD) technical advisor, significant support identified from the Computer Audit Specialist (CAS), engineering, and international programs

• Each programs has designated personnel to assist in key aspects of § 199 relevant to their programs

• Designated 14 industry technical advisors

• The DPD is not an accounting method that would permit teams to challenge the computation at any time

• Directive to challenge in early years even when # is not material, significant issue seen with attempts to challenge later

• Identification of 199 as a Tier 1 coordinated issue


LMSB Examination Guidelines

• Minimum Audit Checks to be performed by examining agents: – Does the taxpayer's business make sense with the activity

requirements of the domestic production deduction? – Comparison of the domestic production gross receipts (DPGR)

reported on Form 8903 to the gross receipts or sales less returns and allowances on the taxpayer's tax return, line 1c of the Form 1120.

– 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?

– If the taxpayer is required to use the Section 861 method to allocate and apportion deductions has the taxpayer used it and is it consistent with the application of Section 861 for purposes of the foreign tax credit, if applicable?

– Has the taxpayer applied the wage and taxable income limitations?


IDR / Exam experience

Standard § 199 IDR

•Describe qualified activities and income

•Is DPGR => Line 1c?

– Did the taxpayer use the 95% rule?

– If yes, show support

•Provide item-level detail files showing 20% safe harbor testing

– Distinct preference for safe harbor approach


IDR / Exam experience (cont.)

Standard § 199 IDR (cont.)

•Benefits and Burdens

•Describe use of “Shrink Back” to remove embedded services

•Confirm consistency with § 861 method for FTC and ETI purposes

•Confirm application of taxable income and wage limitations and show supporting schedules


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Domestic Production Activities Deduction – Section 199 March 26, 2007 Pamela C. Beckey.

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