Lunch & Learn:

The Basic Understanding of the Section 199 Deduction

Presenter: Eric Olsen

Agenda

• Background• Formula for Calculating the DPAD• Domestic Production Gross Receipts

(DPGR)• Methods for Allocating Deductions to DPGR• Wages • NOL Deduction• UltraTax Example

Background

• Section 199 is the latest in a series of tax incentives designed to stimulate domestic US manufacturing and exports

• Much of the manufacturing formerly done in the US is now done in low wage countries such as China – this trend seems to be largely irreversible

• Focus is on what the taxpayer is doing in the US, not what the taxpayer exports or moves out of the US

Background

• Starting in 2010 and after the Section 199 Deduction, Domestic Production Activities Deduction (DPAD) is 9% of the lesser of Qualified Production Activities Income (QPAI) or if lesser, the taxpayer’s taxable income.

• This deduction originally started at 3% of QPAI allowed in 2005-2006 then moved to 6% allowed in 2007-2009.

• All taxpayers are entitled to take the DPAD (sole proprietorships, C corporations, pass-through entities & trusts)

Background

• It remains an open question whether the DPAD had preserved or created any manufacturing jobs in the US. Costs just remain too attractive in low wage countries and DPAD does not overcome this.

Formula for Calculating the DPAD

• +Domestic Production Gross Receipts (DPGR)• - Allocable cost of goods sold• - Directly allocable deductions• - Ratable amount of indirect expenses• = QPAI (not in excess of taxable income)• X 9% (2010 and after)• = DPAD (not greater than 50% of W-2 wages)

Example (Formula)

• GPP Inc., which manufactures shoes, has QPAI of $4 million in the current year and a taxable income of $1 million. What is GPP’s DPAD for the current year before considering the W-2 wage limit?– GPP’s DPAD for the current year is 9% x $1 million or

$90,000 (remember it is the lesser of 9% of $1 million or $4 million)

• The next step would be to insure that GPP meets the wage (W-2) limit, as DPAD cannot exceed 50% of GPP’s wages, what would the minimum W-2 wages be?– $180,000 ($180,000 x 50% = $90,000)

DPGR

• DPGR means the gross receipts of the taxpayer which are derived from:– Any lease, rental, license, sale, exchange, or

other disposition of:• Qualifying production property (QPP) manufactured,

produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the US

• Any qualified film produced by the taxpayer; or• Electricity, natural gas, or drinkable water produced

by the taxpayer in the US

DPGR

– The active construction of real property performed in the US by the taxpayer in the ordinary course of such trade or business; or

– Engineering or architectural services performed by the taxpayer in the US within respect to the construction of real property in the US

QPP

• Tangible personal property;• Any computer software; and• Sound recordings (such as discs, tape, or other

phonorecords, in which such sounds are embodied)

MPGE

• MPGE includes manufacturing, producing, growing, extracting, installing, developing, improving, and creating QPP.

• Making QPP out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles qualifies.

• Cultivating soil, raising livestock, fishing, and mining minerals qualifies.

MPGE

• MPGE also includes storage, handling, or other processing activities (other than transportation activities) within the US related to the sale, exchange, or other disposition of agricultural products, provided the products are consumed in connection with or incorporated into the MPGE of QPP, whether or not by the taxpayer.

• The taxpayer must have the benefits and burdens of ownership of the QPP under federal income-tax principles during the period the MPGE activity occurs in order for gross receipts derived from the MPGE of QPP to qualify as DPGR.

Example (DPGR)

• A, B, and C are unrelated persons. B grows agricultural products in the US and sells them to A, who owns agricultural storage bins in the US. A stores the agricultural products and has the benefits and burdens of ownership under federal income-tax principles of the agricultural products while they are being stored. A sells the agricultural products to C, who processes them into refined agricultural products in the US. Do A, B, and C activities qualify for DPGR?– Yes because the gross receipts from A’s, B’s, and C’s

activities are DPGR from the MPGE of QPP.

Example (DPGR)

• The facts are the same as in the prior example except that B grows the agricultural products outside the US and C processes them into refined agricultural products outside the US. Do A, B, and C activities qualify for DPGR?– The gross receipts derived by A from its sale of the

agricultural products to C are DPGR from the MPGE of QPP within the US

– B’s and C’s own MPGE activities occur outside the US; therefore, their own gross receipts are non-DPGR

DPGR do not include

• The sale of food and beverages prepared by the taxpayer at the retail establishment;

• The transmission of electricity, natural gas, or drinkable water; or

• The lease, rental, license, sale, exchange, or other disposition of land.

• Also, DPGR does not include the rental income from real estate, although DPGR does include proceeds on ultimate disposition but only if owner is engaged in related construction activities.

Determining DPGR

• A taxpayer determines DPGR using any reasonable method that is satisfactory to the IRS based on all of the facts and circumstances.

• In many cases, a product consists of the combination of several components, some of which may be qualified property (i.e.; manufactured in the US and some of which may not)

• Determine DPGR on item by item basis and NOT on a division by division, product line by product line or transaction by transaction basis

Determining DPGR

• Requires analyzing each component of the property and determining its origin even though doing so is burdensome and costly– This is the so called “shrinkback” rule – taxpayer must

shrink back the product to the largest component that does qualify as DPGR

• Purpose – to prevent taxpayers from receiving benefits for gross receipts that do not qualify for the DPAD.

Example (Determining DPGR)

• GPP manufactures leather and rubber shoe soles in the US and GPP imports shoe uppers, which are the parts of the shoe above the sole. GPP manufactures shoes for sale by sewing or otherwise attaching the soles to the imported uppers. GPP offers the shoes for sale to customers in the normal course of GPP’s business. Do the gross receipts from the sale of the shoes qualify as DPGR?– No; therefore, GPP must treat the sole as the item that the

gross receipts derived from which qualifies as DPGR. (“shrinkback” rule)

Allocation of DPGR

• Factors taken into consideration in determining whether taxpayer’s method of allocating gross receipts between DPGR and non-DPGR is reasonable include:– Whether the taxpayer uses the most accurate

information available;– Relationship between gross receipts and method used;– Accuracy of the method chosen as compared with other

possible methods;– Whether the method is used by the taxpayer for

internal management or other business purposes;

Allocation of DPGR

– Whether the method is used for other federal or state income-tax purposes;

– Time, burden, and cost of using alternative methods; and

– Whether the taxpayer applies the method consistently from year to year.

• Thus, if a taxpayer has the information readily available and can, without undue burden or expense, specifically identify whether the gross receipts derived from an item are DPGR, then the taxpayer must use that specific identification to determine DPGR.

Allocation Deductions to DPGR

• After determining DPGR then allocate expenses to arrive at QPAI

• For some taxpayers, taxable income and QPAI will be the same. (i.e., manufacturers)– Example: A business that manufacturers only electric

cars in the US taxable income and QPAI should be the same

• There are three methods taxpayers can us to allocate deductions:– The small business simplified overall method;– Simplified deduction method; and– Section 861 method

The Three Methods

• Small Business Simplified Overall Method– Taxpayers with gross receipts less than $5 million may

allocate all costs, including CGS, based on gross receipts– Taxpayers on the cash method of accounting with gross

receipts less than $10 million may use this method

• Simplified Deduction Method– Taxpayers with less than $25 million in gross receipts

may allocate non-CGS expenses based on gross receipts

The Three Methods

• Section 861– This method is mandatory for taxpayers with gross

receipts greater than $25 million; a voluntary method for all others

– It basically allocates deductions to the class of gross income (and apportions deductions within that class of gross income to the statutory grouping of gross income) that the deductions are definitely related to.

– Deductions that are either not definitely related to a class of gross income or to a statutory grouping within a class of gross income are generally, subject to special rules for interest expense, research and development expenses and certain other expenses, ratably apportioned to all classes of gross income.

Example (Section 861)

• GPP Corporation manufactures only one item of property that it sells to customers. GPP Corporation has total gross receipts of $30,000,000 that consist of $20,000,000 of DPGR and $10,000,000 of gross receipts that are not DPGR. Its CGS that is directly allocable to DPGR is $10,000,000 and other gross receipts is $5,000,000. GPP Corporation must use the Code Section 861 method for allocating its costs and deductions to DPGR and other gross receipts. Its costs that are definitely related to DPGR is $5,000,000 and other gross receipts is $3,000,000. Other deductions that are not definitely related to any class of gross income amount to $3,000,000. What would be the ratable portion of these costs to DPGR?– $2,000,000 (20,000,000 DPGR/30,000,000 Total GR x $3,000,000)

Example (Section 861)

• The next step would be to compute the QPAI.– DPGR = $20,000,000– Costs:

• $10,000,000 = CGS directly allocable• $ 5,000,000 = Other costs directly allocable to DPGR• $ 2,000,000 = Other costs ratably apportioned to DPGR• $17,000,000 = Total Costs

– QPAI = $3,000,000

W-2 Wages

• W-2 wages are defined as the sum of wages and elective deferrals (e.g., payments to a 401(k) plan)

• Sum of Box 1 From W-3– Fiscal Year-End

• Only the wages related to DPGR are considered in computing the wage limit.

• The amount of the DPAD cannot exceed 50% of the qualified W-2 wages of the employer for the tax year.

Non-Qualified Wages

• The W-2 requirement precludes many small businesses from eligibility for taking DPAD – K-1’s and 1099’s do not count as W-2’s.

• Wages do not include Schedule C earnings of sole proprietors or Schedule F earnings of farmers.

• Guaranteed Payments to partners do not count as wages for Section 199 purposes.

Example (Wages)

• Allan’s Manufacturing is a single member LLC. Allan himself performs all the work. Is Allan entitled to a DPAD?– No because he has no W-2s

• Allan incorporates his business and makes it an S corporation and he would pay himself through a W-2. Is Allan entitled to a DPAD?– Yes, presumably the business would be entitled to a

DPAD

NOL Deduction

• The DPAD does not produce or add to a NOL deduction

• Example 1:– GPP Corporation engages in production activities that

generate QPAI and taxable income of $1,000 in the current year without taking into account the Section 199 deduction and an NOL deduction. During the current year GPP incurs W-2 wages of $300 and GPP has an NOL carryover to the current year of $500. Compute the DPAD allowed in the current year.• GPP’s DPAD for the current year is $45 (.09 x lesser of QPAI of

$1,000 and taxable income of $500 ($1,000 taxable income - $500 NOL))

• Because the W-2 wage limitation is $150 (50% x $300) GPP’s DPAD is not limited by the 50% of W-2 limit.

NOL Deduction

• Example 2:– Same facts as example 1 except for QPAI and taxable

income is $500 in the current year.• GPP’s DPAD for the current year is $0 (.09 x (lesser of QPAI of $500

and taxable income of $0 ($500 taxable income - $500 NOL))

Questions?

Email or call:Eric Olsen, CPA

Goldin Peiser & Peiser, LLP

EOlsen@GPPcpa.com214.635.2538

www.GPPcpa.comhttp://Manufacturing.GPPcpa.com/