Section 199 Update
Roth & Company, P.C.
December 5, 2005
Course Objective: To review the the new deduction for qualified production activities income in light of IRS guidance issued in 2005.
What is the benefit of Section 199?
Section 199 is a “gimme” deduction of three percent of the lesser of:
· “Qualified Production Activities Income,” (QPI) or
· Taxable income.
The deduction becomes 6% in 2007 and 9% in 2010. (Section 199(a))
The deduction requires no special expenditures; once QPI is determined, the three percent comes off the top.
For individuals, substitute “adjusted gross income” for taxable income (Sec. 199(d)).
What other limits apply?
The deduction is limited to 50% of taxpayer W-2 wages. SE Income and Guaranteed payments don’t count. Sec. 199(b).
When is it effective?
Taxable years beginning after 2004. That means our 9/30 and 10/31 fiscal year filers will not be eligible this filing cycle.
What IRS guidance has been issued on Section 199?
Notice 2005-14; proposed regulations 1.199-1 through 1.199-8. If they conflict, you can rely on either one until final regulations are issued.
What businesses qualify for it?
And it doesn’t apply (Sec. 199(c)(4)) to:
“Qualifying Production Property” includes (Sec. 199(c)(5)):
· Sound recordings.
Domestic Production requirements
An item will qualify if it is manufactured “in whole or substantial part” in the U.S.
There is a 20% U.S. Conversion cost “safe harbor” in determining “substantial part.” So if 20% of your COGS for an item are U.S. costs (screen printing a t-shirt, for example), 100% of your sales price for the item is domestic production gross receipts.
The 20% is a safe harbor, not a minimum.
“Shoelace Rule.” The domestic production requirement applies to each “item.” If an “item” as a whole doesn’t qualify, you can “shrinkback” the item to its largest qualifying component. For example, if you import a shoe and add a U.S. shoelace, the sales price attributable to the shoelace qualifies. This has to be determined by some rational allocation (e.g., relative costs).
Considering our client list, what clients have such income?
How is qualifying income determined – Gross receipts and net income?
There are three basic methods of allocating deductions among types of gross income. First, the taxpayer may be required to show some direct relationship between the deduction and the income. Second, the taxpayer may be required to apply a formula to divide the deduction between types of income. Third, the Code may require that an arbitrary percentage apply.
Definitely Related deductions. Sec. 1.861-8 provides that expenses are allocated to income where it is “definitely related” to the income. The regulations say a deduction is “definitely related”:
if it is incurred as a result of, or incident to, an activity or in connection with property from which such class of gross income is derived. (Regs. 1.861-8(b)(2)).
Other deductions are apportioned between QPI and non-QPI in proportion to production and other gross income.
Specific rules apply to certain types of deductions:
Interest expense: Interest expense is allocated to both QPI and non-QPI in accordance with the value of the assets used in generating each class of income. This can be done using either book value or fair-market value, but once you elect one, you can’t switch without permission. (1.861-9T). BUT:
Non-recourse debt is allocable to one class of property if it is used to purchase or improve property and is fully secured by such property. (1.861-10T(b)).
Research and experimental expense is allocated between QPI and Non-QPI by product categories. For example, if you import one product category and manufacture another in the U.S., you must match your R&E to categories, to the extent you can’t allocate it to specific categories, it’s allocated in proportion to gross income from the categories (1.861-17(a)).
Loss on non-inventory personal property is allocated the same way income would be allocated were the property sold at a gain. Unless the property is qualified production property (e.g., construction), such losses will be non-QPI expenses.
Charitable contributions: “Deductions for charitable contributions …must be ratably apportioned between gross income attributable to DPGR and other gross income based on the relative amounts of gross income. For individuals, this provision applies solely to deductions for charitable contributions that are attributable to the actual conduct of a trade or business.” (1.199-4(d)(2)).
Simplified deduction method (1.199-4(e)): Allows qualifying taxpayers to allocate non-COGS deductions between domestic production gross receipts and non-DPGR based in the ratio of gross receipts.
Qualifying taxpayers are those with
· average annual gross receipts (3-year rolling average) of $25 million or less, OR
· Assets at year end of $10 million or less.
Members of “expanded affiliated groups (consolidated return tests using 50% threshold) are combined for this.
Small business simplified overall method (1.199-4(f)): Allows qualifying taxpayers to allocate all deductions, including costs of sales, based on gross receipts.
Qualfiying taxpayers are those with:
· Average annual gross receipts (3-year rolling average) of $5 million or less, OR
· A farmer not required by Section 447 to use accrual accounting, OR
· A taxpayer who would qualify for an automatic change to cash method under Rev. Proc. 2002-28 (average gross receipts <=$10 million and not subject to 448, “including partnerships, S corporations, C corporations or individuals.”
But Section 448 rules out C corporations that flunk the $5 million gross receipts test, as well as “ tax shelters.”
What Construction Qualifies?
Regs. 1.199-3(l) covers qualifying domestic construction income. “Activities constituting construction include activities performed in connection with a project to erect or substantially renovate real property…” (1.199-3(l)(2). Specific items:
“The Service and Treasury Department believe that the standard to be applied in determining whether there has been a substantial renovation of real property is the standard applied under § 263(a) to determine whether a taxpayer's activities result in permanent improvements or betterments of property, such that the cost of the activities must be capitalized.
De Minimis rules for allocation
Pass-through and Section 199
Partners (1.199-5(a)) and S corporation shareholders (1.199-5(b)) compute their Section 199 deduction on their own 1040. The pass-throughs need to report on the K-1 each partner or shareholders share of
In computing a partner or shareholder’s QPI, deductions disallowed (eg, by passive loss rules or basis limits) aren’t counted until they are used.
W-2 limits: Unless the partnership uses the Simplified Overall Method of allocating deductions, the partner has to compute its tentative Section 199 deduction from the partnership and multiply it by two; the lesser of that product or the actual share of W-2 income from the partnership is the amount of the W-2 income from the partnership that the partner can use in computing his deduction. If the SOM is used, then each partner is allocated a net QPAI and a net W-2 number not exceeding the equivalent of twice the deduction.
Example (example 1, 1.199-5(a)(4).
Since the deduction is a personal deduction, not a corporate deduction, it doesn’t affect AAA or basis.
Gross Income v. Gross Receipts: Gross receipts includes tax exempt income, but only gain from sale of long-term assets. Gross receipts includes gross sales (net of returns), but gross income is sales reduced by cost of goods sold.
All content © Roth & Company, P.C.Back to the Roth & Company Tax Update Blog