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Domestic Production Activities
Deduction – Section 199
March 26, 2007
Pamela C. Beckey
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
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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
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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
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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
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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
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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 wages
Total wages
– Must use the same allocation and apportionment
methods used to determine QPAI to allocate and
apportion wage expense for safe harbor
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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
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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 W2 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?
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Pass-thru entities
• The Secretary is authorized to permit a passthru 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
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Changing certain Section 861 Elections
• Rev Proc 2006-42 provides guidance for securing
automatic approval to change certain preexisting 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
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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
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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?
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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
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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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