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TREASURY ISSUES 'PRODUCTION DEDUCTION' PROPOSED REGULATIONS

October 21, 2005

The long-awaited Section 199 "domestic production activities deduction" regulations were finally issued yesterday. At 224 pages, they will make for scintillating weekend reading (No link yet, apparently; when they are posted on the IRS site, I think they will be here). UPDATE: here they are (thanks, reader BPC!).

WHAT SECTION 199 DOES

The Section 199 deduction allows taxpayers to take 3% off the top of their taxable income from "domestic production activities" starting in 2005. The deduction is scheduled to eventually increase to 9%. Because Section 199 treats "production activity" income different from other income, taxpayers will have to figure out what their "production activities" are and then allocate their taxable income between "production" and "other stuff." (OK, "other stuff" is my term.)

In general, "qualified production income" comes from manufacturing, construction, farming or resource extraction. It includes software manufacture - but maybe not internet-based software. It also includes architect and engineer services on domestic construction and "qualified" film production (if you don't have to carry it out of the video store in a brown bag, it's probably qualified). The "production activity" has to take place "in whole or significant part" in the U.S.

WHY IT IS A BAD IDEA

The regulation writers were given an impossible task: writing simple regulations for a law that requires arbitrary and complex allocation of income. Consider a simple example: if you import a t-shirt and print a design on it, is that "qualifying" activity? If so, how do you allocate the income between importing the shirt and printing the design? And what if you buy some of your shirts already printed - how do you allocate your overhead between purchased and produced items?

TAKE ADVANTAGE OF THEIR MISTAKE

Section 199 is a poorly-conceived tax provision. The attempt to favor some sectors of the economy over others is economic illiteracy become law. Yet while enacting Section 199 was a bad idea, not taking the deduction is a worse one. Taxpayers and practitioners now must figure out how to gather the information they'll need to harvest this deduction without blowing it all on tax consulting fees.

Links:

Professor Maule's May 2005 discussion of Section 199.

My Powerpoint presentation on Section 199 for the Iowa Bar Association Spring Tax Institute. (Firefox-readable version here)

Tax Analysts free coverage of the new regs.

Notice 2005-14, the IRS initial Section 199 guidance.

Prior Tax Update coverage.

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