[Federal Register: November 4, 2005 (Volume 70, Number 213)]
[Proposed Rules]
[Page 67219-67276]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr04no05-17]
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Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Income Attributable to Domestic Production Activities; Proposed Rule
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-105847-05]
RIN 1545-BE33
Income Attributable to Domestic Production Activities
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations concerning the
deduction for income attributable to domestic production activities
under section 199. Section 199 was enacted as part of the American Jobs
Creation Act of 2004, (the Act). The regulations will affect taxpayers
engaged in certain domestic production activities. This document also
provides a notice of a public hearing on these proposed regulations.
DATES: Written or electronic comments must be received by January 3,
2006. Outlines of topics to be discussed at the public hearing
scheduled for Wednesday, January 11, 2006, must be received by December
21, 2005.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-105847-05), room
5203, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
105847-05), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC, or sent electronically, via the IRS
Internet site at http://www.irs.gov/regs or via the Federal eRulemaking Portal at http://www.regulations.gov (IRS-REG-105847-05). The public
hearing will be held in the IRS Auditorium, Internal Revenue Building,
1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec. 1.199-1, 1.199-
3, 1.199-6, and 1.199-8, Paul Handleman or Lauren Ross Taylor, (202)
622-3040; concerning Sec. 1.199-2, Alfred Kelley, (202) 622-6040;
concerning Sec. 1.199-4(c) and (d), Richard Chewning, (202) 622-3850;
concerning all other provisions of Sec. 1.199-4, Scott Rabinowitz,
(202) 622-4970; concerning Sec. 1.199-5, Martin Schaffer, (202) 622-
3080; concerning Sec. 1.199-7, Ken Cohen, (202) 622-7790; concerning
submission of comments, the hearing, and/or to be placed on the
building access list to attend the hearing, LaNita Van Dyke, (202) 622-
7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collections of information should be
sent to the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP,
Washington, DC 20224. Comments on the collection of information should
be received by January 3, 2006.
Comments are specifically requested concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether the
information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information;
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collections of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of service to provide information.
The collection of information in these proposed regulations is in
Sec. 1.199-6(b) involving patrons of agricultural and horticultural
cooperatives. This information is required so that patrons of
agricultural and horticultural cooperatives may claim the section 199
deduction. The collections of information is mandatory. The likely
respondents are business or other for-profit institutions.
Estimated total annual reporting burden: 9,000 hours.
Estimated average annual burden hours per respondent: 3 hours.
Estimated number of respondents: 3,000.
Estimated annual frequency of responses: annually.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
This document contains proposed regulations relating to the
deduction for income attributable to domestic production activities
under section 199 of the Internal Revenue Code (Code). Section 199 was
added to the Code by section 102 of the Act (Public Law 108-357, 118
Stat. 1418). On January 19, 2005, the IRS and Treasury Department
issued Notice 2005-14 (2005-7 I.R.B. 498) providing interim guidance on
section 199 and inviting comments on issues arising under section 199.
Written and electronic comments responding to Notice 2005-14 were
received. The IRS and Treasury Department have reviewed and considered
all the comments in the process of preparing these proposed
regulations. This preamble to the proposed regulations describes many
of the more significant comments received by the IRS and Treasury
Department. Because of the large volume of comments received, however,
the IRS and Treasury Department are not able to address all of the
comments in this preamble.
General Overview
Section 199(a)(1) allows a deduction equal to 9 percent (3 percent
in the case of taxable years beginning in 2005 or 2006, and 6 percent
in the case of taxable years beginning in 2007, 2008, or 2009) of the
lesser of: (a) The qualified production activities income (QPAI) of the
taxpayer for the taxable year; or (b) taxable income (determined
without regard to section 199) for the taxable year (or, in the case of
an individual, adjusted gross income (AGI)).
Section 199(b)(1) limits the deduction for a taxable year to 50
percent of the W-2 wages paid by the taxpayer during the calendar year
that ends in such taxable year. For this purpose, section 199(b)(2)
defines the term W-2 wages to mean the sum of the aggregate amounts the
taxpayer is required under section 6051(a)(3) and (8) to include on the
Forms W-2, ``Wage and Tax Statement,'' of the taxpayer's employees
during the calendar year ending during the
[[Page 67221]]
taxpayer's taxable year. Section 199(b)(3) provides that the Secretary
shall prescribe rules for the application of section 199(b) in the case
of an acquisition or disposition of a major portion of either a trade
or business or a separate unit of a trade or business during the
taxable year.
Qualified Production Activities Income
Under section 199(c)(1), QPAI is the excess of domestic production
gross receipts (DPGR) over the sum of: (a) The cost of goods sold (CGS)
allocable to such receipts; (b) other deductions, expenses, or losses
directly allocable to such receipts; and (c) a ratable portion of
deductions, expenses, and losses not directly allocable to such
receipts or another class of income.
Section 199(c)(2) provides that the Secretary shall prescribe rules
for the proper allocation of items of income, deduction, expense, and
loss for purposes of determining QPAI.
Section 199(c)(3) provides special rules for determining costs in
computing QPAI. Under these special rules, any item or service imported
into the United States without an arm's length transfer price shall be
treated as acquired by purchase, and its cost shall be treated as not
less than its value immediately after it enters the United States. A
similar rule applies in determining the adjusted basis of leased or
rented property when the lease or rental gives rise to DPGR. If the
property has been exported by the taxpayer for further manufacture, the
increase in cost or adjusted basis must not exceed the difference
between the value of the property when exported and its value when
imported back into the United States after further manufacture.
Section 199(c)(4)(A) defines DPGR to mean the taxpayer's gross
receipts that are derived from: (i) Any lease, rental, license, sale,
exchange, or other disposition of (I) qualifying production property
(QPP) that was manufactured, produced, grown, or extracted (MPGE) by
the taxpayer in whole or in significant part within the United States;
(II) any qualified film produced by the taxpayer; or (III) electricity,
natural gas, or potable water (collectively, utilities) produced by the
taxpayer in the United States; (ii) construction performed in the
United States; or (iii) engineering or architectural services performed
in the United States for construction projects in the United States.
Section 199(c)(4)(B) excepts from DPGR gross receipts of the
taxpayer that are derived from: (i) The sale of food and beverages
prepared by the taxpayer at a retail establishment; and (ii) the
transmission or distribution of electricity, natural gas, or potable
water.
Section 199(c)(5) defines QPP to mean: (A) Tangible personal
property; (B) any computer software; and (C) any property described in
section 168(f)(4) (certain sound recordings).
Section 199(c)(6) defines a qualified film to mean any property
described in section 168(f)(3) if not less than 50 percent of the total
compensation relating to production of the property is compensation for
services performed in the United States by actors, production
personnel, directors, and producers. The term does not include property
with respect to which records are required to be maintained under 18
U.S.C. 2257 (generally, films, videotapes, or other matter that depict
actual sexually explicit conduct and are produced in whole or in part
with materials that have been mailed or shipped in interstate or
foreign commerce, or are shipped or transported or are intended for
shipment or transportation in interstate or foreign commerce).
Section 199(c)(7) provides that DPGR does not include any gross
receipts of the taxpayer derived from property leased, licensed, or
rented by the taxpayer for use by any related person. A person is
treated as related to another person if both persons are treated as a
single employer under either section 52(a) or (b) (without regard to
section 1563(b)), or section 414(m) or (o).
Pass-Thru Entities
Section 199(d)(1) provides that, in the case of an S corporation,
partnership, estate or trust, or other pass-thru entity, section 199
generally is applied at the shareholder, partner, or similar level,
except as otherwise provided in rules applicable to patrons of
cooperatives. Section 199(d)(1) further provides that the Secretary
shall prescribe rules for the application of section 199, including
rules relating to: (a) Restrictions on the allocation of the deduction
to taxpayers at the partner or similar level; and (b) additional
reporting requirements.
The general rule is that section 199 is applied at the shareholder,
partner, or similar level. However, section 199(d)(1)(B) limits the
amount of W-2 wages from a pass-thru entity that may be used by each
shareholder, partner, or similar person to compute the section 199
deduction. Specifically, section 199(d)(1)(B) provides that such person
is treated as having been allocated W-2 wages from such entity in an
amount equal to the lesser of: (i) Such person's allocable share of
such wages (without regard to this rule) from such entity as determined
under regulations prescribed by the Secretary; or (ii) 2 times 9
percent (3 percent in the case of taxable years beginning in 2005 or
2006, and 6 percent in the case of taxable years beginning in 2007,
2008, or 2009) of the QPAI of that entity allocated to such person for
the taxable year.
Individuals
In the case of an individual, section 199(d)(2) provides that the
deduction is equal to the applicable percentage of the lesser of the
taxpayer's: (a) QPAI for the taxable year; or (b) AGI for the taxable
year determined after applying sections 86, 135, 137, 219, 221, 222,
and 469, and without regard to section 199.
Patrons of Certain Cooperatives
Section 199(d)(3) provides special rules under which a taxpayer
receiving certain patronage dividends or certain qualified per-unit
retain allocations from a cooperative (to which subchapter T applies)
engaged in the MPGE, in whole or in significant part, or in the
marketing of any agricultural or horticultural product is allowed a
section 199 deduction with respect to the amount of the patronage
dividends or qualified per-unit retain allocations that are: (a)
Allocable to the portion of the cooperative's QPAI that would be
deductible by the cooperative; and (b) designated as such by the
cooperative in a written notice mailed to its patrons during the
payment period described in section 1382. Such an amount, however, does
not reduce the taxable income of the cooperative under section 1382.
In determining the portion of the cooperative's QPAI that would be
deductible by the cooperative, the cooperative's taxable income is
computed without taking into account any deduction allowable under
section 1382(b) or (c) (relating to patronage dividends, per-unit
retain allocations, and nonpatronage distributions) and, in the case of
a cooperative engaged in marketing agricultural and horticultural
products, the cooperative is treated as having MPGE, in whole or in
significant part, any agricultural and horticultural products marketed
by the cooperative that its patrons have MPGE.
Expanded Affiliated Groups
Section 199(d)(4)(A) provides that all members of an expanded
affiliated group (EAG) are treated as a single corporation for purposes
of section 199. Taking into account the provisions of the Congressional
Letter, as described elsewhere, section 199(d)(4)(B) provides that an
EAG is an affiliated group as defined in section 1504(a), determined by
substituting ``more than 50 percent'' for ``at least 80 percent'' each
place it
[[Page 67222]]
appears and without regard to section 1504(b)(2) and (4).
Section 199(d)(4)(C) provides that, except as provided in
regulations, the section 199 deduction is allocated among the members
of the EAG in proportion to each member's respective amount (if any) of
QPAI.
Trade or Business Requirement
Section 199(d)(5) provides that section 199 is applied by taking
into account only items that are attributable to the actual conduct of
a trade or business.
Alternative Minimum Tax
Section 199(d)(6) provides rules to coordinate the deduction
allowed under section 199 with the alternative minimum tax (AMT)
imposed by section 55. Taking into account the provisions of the
Congressional Letter, as described elsewhere, section 199(d)(6)
provides that for purposes of determining alternative minimum taxable
income (AMTI) under section 55, the section 199 deduction shall be
determined without regard to any adjustments under sections 56 through
59, except that in the case of a corporation (including a corporation
subject to tax under section 511), the taxable income limitation is the
corporation's AMTI.
Authority To Prescribe Regulations
Section 199(d)(7) authorizes the Secretary to prescribe such
regulations as are necessary to carry out the purposes of section 199.
Congressional Letter
On July 21, 2005, the Chairman and Ranking Member of the Senate
Finance Committee and the Chairman of the House Ways and Means
Committee introduced the Tax Technical Corrections Act of 2005, H.R.
3376 and S. 1447, 109th Cong. (2005). In a letter on the same date to
the Treasury Department (the Congressional Letter), they provided
clarification for several issues so that appropriate regulatory
guidance may be issued reflecting their intention. These proposed
regulations reflect the intent expressed in the Congressional Letter
with respect to section 199.
Summary of Comments
Qualified Production Activities Income
One commentator requested that the proposed regulations clarify the
treatment of advance payments, and the costs related to those payments,
for purposes of computing QPAI. Section 4.03(3) of Notice 2005-14
provides that, in the case of advance payments (for goods, services,
and use of property) that are recognized under the taxpayer's method of
accounting in a taxable year earlier than that in which the property or
services are delivered, performed, and provided, the taxpayer must
accurately identify, based on a reasonable method, whether the receipts
(and the corresponding expenses) qualify as DPGR. If a taxpayer
recognizes an advance payment in Year 1, and the CGS in Year 2, the
commentator asks whether CGS must be applied to reduce DPGR in Year 2,
even though the DPGR and CGS are recognized in different taxable years.
The proposed regulations clarify that, in the example the
commentator cites involving advance payments, as well as other
circumstances (such as taxpayers that use the cash receipts and
disbursements method) where gross receipts and corresponding expenses
are recognized in different taxable years, taxpayers must take the
receipts and expenses into account for purposes of section 199 in the
taxable year such items are recognized under their methods of
accounting for Federal income tax purposes. The IRS and Treasury
Department believe it would be unduly burdensome and complicated to
create a separate set of timing rules for purposes of section 199.
Thus, gross receipts and costs are taken into account for purposes of
computing QPAI in the taxable year they are recognized for Federal
income tax purposes under the taxpayer's methods of accounting, even if
the related gross receipts or costs, as applicable, are taken into
account in different taxable years. If the gross receipts are
recognized in an intercompany transaction within the meaning of Sec.
1.1502-13, see also Sec. 1.199-7(d).
A commentator requested clarification of how the advance payment
rules would apply in the following scenario. In Year 1, a taxpayer
sells for $100 a one-year software maintenance agreement that provides
for software updates (that the taxpayer would MPGE in whole or in
significant part within the United States) and customer support
services. At the end of Year 1, the taxpayer uses a reasonable method
to allocate 60 percent of the gross receipts ($60) to the software
updates and 40 percent ($40) to the customer support services. The
taxpayer treats the $60 as DPGR in Year 1. In Year 2, no software
updates are provided. The commentator asks whether the taxpayer in this
scenario would be required to amend its Year 1 return and reduce its
DPGR by $60, reduce DPGR by $60 in Year 2, or make no adjustment for
Year 1 or Year 2.
Consistent with the application of the rules relating to advance
payments, which require that the taxpayer follow its methods of
accounting for Federal income tax purposes, the taxpayer should make no
adjustment in Year 1 (by amended return) or in Year 2 for the $60 that
was appropriately treated as DPGR in Year 1, even though no software
updates were provided in Year 2.
A commentator suggested that the proposed regulations clarify how a
taxpayer that uses a long-term contract method determines the portion
of the percentage of completion revenue reported for each contract for
the taxable year that is allocated to DPGR. The proposed regulations
provide that taxpayers using a long-term contract method (for example,
under section 460) may use any reasonable method of allocating gross
receipts under such a contract between DPGR and non-DPGR.
A number of comments were received regarding the rule in section
4.03(1) of Notice 2005-14 that requires that section 199 be applied on
an item-by-item basis. Some commentators stated that applying section
199 on an item-by-item basis is unduly burdensome, and that the
proposed regulations should permit taxpayers to determine QPAI on a
division or product-line basis instead. The IRS and Treasury
Department, however, continue to believe that applying section 199 on a
basis other than item-by-item would allow taxpayers to receive the
benefits of section 199 with respect to gross receipts that should not
qualify as DPGR. Accordingly, the proposed regulations retain the
requirement that section 199 be applied on an item-by-item basis.
Many commentators requested clarification of what constitutes an
item. Commentators asked whether an item is a final product or whether
one or more component parts of the final product may qualify as an
item. For example, if a final product does not meet the in whole or in
significant part requirement (so that gross receipts from the sale of
the final product are non-DPGR), commentators inquired whether they
could allocate gross receipts to a component of the product that did
meet all of the requirements of section 199(c), and thereby treat that
portion of the gross receipts as DPGR.
H.R. Conf. Rep. No. 755, 108th Cong., 2d Sess. 272 n. 27 (2004)
(the Conference Report) indicates that a component may be treated as
qualifying property in the case of food and beverages. Footnote 27 of
the Conference Report explains that, in the context of food and
beverages prepared
[[Page 67223]]
at a retail establishment, although a cup of coffee prepared at a
retail establishment does not qualify under section 199(c), a portion
of the cup of coffee, that is, the coffee beans (roasted at a facility
separate from the retail establishment) that meet the requirements
under section 199(c), does qualify under section 199. The Joint
Committee on Taxation Staff, General Explanation of Tax Legislation
Enacted in the 108th Congress, 109th Cong., 1st Sess. 172 (2005) (the
Blue Book), indicates Congressional intent that this treatment is not
limited to food and beverages, but rather, is permitted with respect to
section 199 in general. Accordingly, in the case of QPP, qualified
films, and utilities, the proposed regulations define an item as the
property offered for sale to customers that meets all of the
requirements under section 199(c). If the property offered for sale
does not meet all of the requirements under section 199(c), a taxpayer
must treat as the item any portion of the property offered for sale
that meets all of these requirements. However, in no case shall the
portion of the property offered for sale that is treated as the item
exclude any other portion that meets all of the requirements under
section 199(c). For example, assume that the taxpayer MPGE software
entirely within the United States, attaches the software to a router
that it MPGE entirely outside the United States, and then sells the
combined property. Assume further that if the combined property is
treated as the item, the gross receipts from the sale will not qualify
as DPGR because the combined property does not satisfy the in whole or
in significant part requirement. The proposed regulations require the
taxpayer to treat the software as an item; separate from the router,
because the software meets all of the requirements of section 199(c)
(that is, it is computer software that is MPGE by the taxpayer in whole
or in significant part within the United States). This is the case even
if the software is not offered for sale to customers separately from
the router. Accordingly, the gross receipts from the software qualify
as DPGR, but the gross receipts from the router do not qualify as DPGR.
Alternatively, assume that the taxpayer MPGE only software but that
some of the content is MPGE within the United States and some content
is MPGE outside the United States. Assuming that the software does not
meet the requirements of section 199(c), that portion of the software
that is MPGE within the United States must be treated as the item.
Accordingly, gross receipts from the sale of the software must be
allocated (using any reasonable method) between that portion that is
MPGE within the United States (which is DPGR if all other requirements
of section 199(c) are met) and that portion that is MPGE outside the
United States (which is non-DPGR).
In the case of construction and architectural and engineering
services, commentators asked that the proposed regulations clarify
whether the item is the construction project itself, or whether the
item can constitute a task or sub-task that is performed as part of the
construction project. The IRS and Treasury Department believe that the
determination of what constitutes the item for purposes of construction
and architectural or engineering services should be made on a case-by-
case basis taking into account all of the facts and circumstances.
Taxpayers may use any reasonable method of determining the item for
this purpose.
A commentator requested that the proposed regulations clarify how
the rules for determining DPGR apply in the case of a taxpayer that
repairs or rebuilds property for a customer. The commentator suggested
the IRS and Treasury Department distinguish between ``repair''
activities and ``rebuild'' activities. In the case of a repair contract
where the customer retains the benefits and burdens of the property
while it is being repaired, the commentator suggests that the
contractor should be permitted to treat as DPGR the gross receipts
attributable to parts that the contractor MPGE in whole or in
significant part within the United States, as well as the gross
receipts attributable to the installation of those parts. Gross
receipts attributable to the parts MPGE by the taxpayer in whole or in
significant part within the United States are DPGR (assuming all the
other requirements of section 199(c) are met). Consistent with the
general rule for installation (discussed below), the installation
activity will be considered an MPGE activity only if the contractor
retains the benefits and burdens of ownership with respect to the parts
while the parts are being installed. In addition, the gross receipts
attributable to the installation of parts that the contractor MPGE may
qualify as DPGR if the exception for embedded installation described in
Sec. 1.199-3(h)(4)(ii)(D) of the proposed regulations applies. The
contractor is not permitted to treat as DPGR gross receipts
attributable to purchased parts, or the installation of purchased
parts.
The commentator suggested that the proposed regulations provide a
special rule for ``rebuild'' contracts, which the commentator suggested
be defined as any contract where the value of the rebuild work
performed exceeds 25 percent of the value of the preexisting property
immediately before the rebuild. The commentator further suggested that
if more than 50 percent of the contractor's costs of performing the
rebuild is attributable to the cost of parts that the contractor MPGE,
the contractor should not be required to allocate its gross receipts
between parts that it MPGE and any parts that it purchased. The
commentator's suggested rule would effectively create for rebuild
contracts a separate de minimis exception to the general allocation
requirement. The IRS and Treasury Department believe that the de
minimis exceptions provided in the proposed regulations (for example,
the 5 percent de minimis exception discussed later generally applicable
to embedded services and embedded nonqualifying property) are
appropriate. Accordingly, the proposed regulations do not adopt this
suggestion.
Section 4.03(2) of Notice 2005-14 provides that, if the amount of
the taxpayer's gross receipts that do not qualify as DPGR equals or
exceeds 5 percent of the total gross receipts, the taxpayer is required
to allocate all gross receipts between DPGR and non-DPGR. For purposes
of this 5 percent de minimis rule, the proposed regulations in Sec.
1.199-1(d)(2) provide that, in the case of an S corporation,
partnership, estate, trust, or other pass-thru entity, the
determination of whether less than 5 percent of the pass-thru entity's
total gross receipts are non-DPGR is made at the pass-thru entity
level. In the case of an owner of a pass-thru entity, the determination
of whether less than 5 percent of the owner's total gross receipts are
non-DPGR is made at the owner level, taking into account the owner's
share of any of the pass-thru entity's gross receipts as well as all
other gross receipts of the owner. In addition, the 5 percent de
minimis exception in Sec. 1.199-3(h)(4)(ii)(E) applies at the entity
level to each item that qualifies.
Commentators also observed that, in determining whether the
taxpayer's method of allocating gross receipts and CGS between DPGR and
non-DPGR is reasonable, the list of factors cited in section 4.03(2) of
Notice 2005-14 with respect to gross receipts is inconsistent with the
list of factors cited in section 4.05(2)(b) of the notice with respect
to CGS. The list of factors was intended to be as consistent as
possible for both gross receipts and CGS, and appropriate changes to
the lists have been
[[Page 67224]]
incorporated into the proposed regulations as necessary.
Taxable Income
In the Congressional Letter, the Treasury Department was advised
that unrelated business taxable income, rather than taxable income,
applies for purposes of section 199(a)(1) in computing the unrelated
business income tax under section 511. Accordingly, the proposed
regulations in Sec. 1.199-1(b) provide that, for purposes of
determining the tax imposed by section 511, section 199(a)(1)(B) is
applied using unrelated business taxable income.
The Congressional Letter also indicates that the section 199
deduction is not taken into account for purposes of computing taxable
income under the rules relating to the carryover of a net operating
loss (NOL). Accordingly, the proposed regulations provide that for
purposes of computing the section 199 deduction, the definition of
taxable income under section 63 applies, but without regard to section
199. The proposed regulations also provide that the section 199
deduction is not taken into account in computing taxable income when
determining the amount of the NOL carryback and carryover under section
172(b)(2). Thus, except as otherwise provided in Sec. 1.199-7(c)(2) of
the proposed regulations (concerning the portion of a section 199
deduction allocated to a member of an EAG), the section 199 deduction
can neither create an NOL carryback or carryover nor increase the
amount of an NOL carryback or carryover.
Wage Limitation
A commentator requested that the IRS and Treasury Department
clarify whether self-employment income of self-employed individuals as
reported on the individuals' Schedule SE, ``Self-Employment Income,''
of Form 1040 and/or payments for nonemployee compensation reported by
the taxpayer on Form 1099-MISC, ``Miscellaneous Income,'' are included
in determining the amount of the W-2 wages of the taxpayer. A
commentator also requested that the IRS clarify whether guaranteed
payments to partners are included in W-2 wages for purposes of section
199.
The statutory language in section 199(b) refers to the amounts a
taxpayer is required to report as wages on Form W-2 pursuant to section
6051 with respect to the employment of employees of the taxpayer.
Neither self-employment income nor guaranteed payments to partners are
required to be reported under section 6051. In addition, section
4.02(1)(a) of Notice 2005-14 and Sec. 1.199-2(a)(1) of the proposed
regulations define employees as including only common law employees of
the taxpayer and officers of a corporate taxpayer. Consistent with the
statutory intent, this definition does not include independent
contractors or partners. Thus, payments to independent contractors and
self-employment income, including guaranteed payments made to partners,
are not included in determining W-2 wages.
The proposed regulations provide for the same three methods of
calculating W-2 wages as contained in Notice 2005-14. It is anticipated
that when final regulations are issued, these three methods will be
published in a notice rather than as part of the final regulations. It
is anticipated that this notice will be published at the same time as
the final regulations. The methods will be included in a notice rather
than the final regulations so that if changes are made to the box
numbers on Form W-2, ``Wage and Tax Statement,'' a new notice can be
issued reflecting those changes more promptly than an amendment to
final regulations.
The non-duplication rule in Sec. 1.199-2(e) continues to provide
that amounts that are treated as W-2 wages for any taxable year under
any method may not be treated as W-2 wages for any other taxable year.
Additional language has been added to the non-duplication rule to
clarify that the same W-2 wages cannot be claimed by more than one
taxpayer for purposes of section 199.
Domestic Production Gross Receipts
DPGR includes the gross receipts of the taxpayer that are derived
from any lease, rental, license, sale, exchange, or other disposition
of property described in section 199(c)(4)(A)(i). Commentators
specifically asked whether fees such as cotton or real estate broker's
fees are DPGR. These fees are non-DPGR because they are not derived
from any lease, rental, license, sale, exchange, or other disposition
of property under section 199(c)(4)(A)(i).
Commentators asked for clarification of whether DPGR includes gross
receipts derived by a taxpayer from the subsequent sale or lease of QPP
MPGE within the United States by the taxpayer, sold, and then
reacquired by the taxpayer. The proposed regulations in Sec. 1.199-
3(h)(2) provide an example to illustrate the rule that gross receipts
from the subsequent sale or lease of QPP are DPGR to the taxpayer that
originally MPGE the QPP within the United States. Any interest
component of the lease payment also qualifies as DPGR because section
199(c)(4)(A)(i) provides that DPGR means gross receipts derived by the
taxpayer from any lease.
Commentators pointed out that the rule for allocating gross
receipts for purposes of identifying DPGR under section 3.04(1) of
Notice 2005-14 appears to adopt a specific identification standard,
whereas section 4.03(2) appears to provide a reasonable basis standard.
The proposed regulations provide in Sec. 1.199-1(d)(1) that the
taxpayer must allocate its gross receipts from all transactions based
on a reasonable method that is satisfactory to the Secretary based on
all of the facts and circumstances and that accurately identifies the
gross receipts that constitute DPGR. If a taxpayer can, without undue
burden or expense, specifically identify where an item was
manufactured, or if the taxpayer uses a specific identification method
for other purposes, then the taxpayer must use that specific
identification method to determine DPGR. If a taxpayer does not use a
specific identification method for other purposes and cannot, without
undue burden or expense, use a specific identification method, the
taxpayer is not required to use a specific identification method to
determine DPGR.
Related Persons
Section 199(c)(7) provides that DPGR does not include any gross
receipts of the taxpayer derived from property leased, licensed, or
rented by the taxpayer for use by any related person. A person is
treated as related to another person if both persons are treated as a
single employer under either section 52(a) or (b) (without regard to
section 1563(b)), or section 414(m) or (o). However, footnote 29 in the
Conference Report indicates that this provision is not intended to
apply to property leased by the taxpayer to a related person if the
property is held for sublease or is subleased to an unrelated person
for the ultimate use of such unrelated person, or to a license to a
related person for reproduction and sale, exchange, lease, rental or
sublicense to an unrelated person for the ultimate use of such
unrelated person. Accordingly, the proposed regulations include these
exceptions from the general rule of exclusion under section 199(c)(7).
One commentator stated that if a television network licenses
programming to an affiliate station, applying section 199(c)(7) to
treat the royalty payment received from the affiliate as non-DPGR
places these vertically integrated companies at a competitive
disadvantage. The commentator therefore suggested that the proposed
regulations provide an
[[Page 67225]]
exception for networks and affiliate stations. The proposed regulations
do not adopt this suggestion, which is not consistent with section
199(c)(7).
Derived From a Lease, Rental, License, Sale, Exchange, or Other
Disposition
Commentators asked whether gains and losses associated with hedging
transactions are included in DPGR. For example, utilities may hedge to
manage the risk of changes in prices of ordinary inputs into the
production process. For purposes of section 199 only, the proposed
regulations include a rule in Sec. 1.199-3(h)(3) concerning hedges
(within the meaning of section 1221(b)(2) and Sec. 1.1221-2(b)) of
inventory that is QPP and supplies consumed in activities giving rise
to DPGR. The proposed regulations require gain or loss on the hedging
transaction to be taken into account in determining DPGR. The proposed
rule applies to hedges that manage the risk of currency fluctuations
but only to the extent that the hedges are not integrated with an
underlying transaction under Sec. 1.988-5(b).
Commentators suggested that the proposed regulations treat gross
receipts attributable to the distribution or delivery of QPP as derived
from the lease, rental, license, sale, exchange, or other disposition
of that property. The commentators stated that section
199(c)(4)(B)(ii), which specifically provides that DPGR does not
include gross receipts derived from the transmission and distribution
of utilities, indicates (by negative implication) that gross receipts
attributable to the distribution or delivery of QPP is intended to be
considered DPGR. Moreover, some commentators interpreted language in
section 3.04(10)(c) of Notice 2005-14, stating that bottled water is
treated as QPP and that DPGR may include gross receipts attributable to
distribution of bottled water, as suggesting that gross receipts
attributable to distribution and delivery of QPP are considered DPGR.
In general, the IRS and Treasury Department believe that gross
receipts attributable to distribution and delivery of QPP are not DPGR
because distribution and delivery are properly regarded as services,
regardless of whether the taxpayer retains the benefits and burdens of
ownership of the property at the time it is delivered. No inference to
the contrary in Notice 2005-14 was intended. Thus, the proposed
regulations clarify that taxpayers generally must allocate gross
receipts between the lease, rental, license, sale, exchange, or other
disposition of the property itself and the delivery component. The IRS
and Treasury Department, however, believe that, because distribution
and delivery are service components common to QPP, it is appropriate,
as a matter of administrative convenience, to treat embedded
distribution and delivery services similar to the qualified warranty
exception in section 4.04(7)(b) of Notice 2005-14. Thus, the taxpayer
must include in DPGR gross receipts attributable to the distribution
and delivery of QPP if (1) in the normal course of business, the charge
for the delivery or distribution service is included in the price
charged for the sale of the QPP, and (2) the charge for the delivery or
distribution service is neither separately offered nor separately
bargained for with the customer.
For similar reasons, the proposed regulations also treat embedded
qualified operating manuals provided in connection with the sale or
disposition of QPP, qualified films, and utilities similar to embedded
qualified warranties.
The proposed regulations also provide special rules for
installation activities. The IRS and Treasury Department believe that,
in some circumstances, installation is appropriately viewed as an MPGE
activity, and in others it is appropriately viewed as a service. For
example, installation is properly viewed as an MPGE activity if the
taxpayer MPGE QPP within the United States and installs the QPP while
the taxpayer retains the benefits and burdens of ownership of the QPP.
In that case, gross receipts attributable to the installation, whether
or not embedded, are derived from the lease, rental, license, sale,
exchange, or other disposition of the QPP. If, however, the benefits
and burdens of ownership pass to the customer prior to the installation
of the QPP, the taxpayer is performing a service by installing the
customer's property. In that case, gross receipts attributable to
installation are not derived from the lease, rental, license, sale,
exchange, or other disposition of the property, and the taxpayer
generally is required under the proposed regulations to allocate gross
receipts between the proceeds of sale or disposition of the property
(DPGR) and the installation service (non-DPGR). However, the IRS and
Treasury Department believe that, because installation is a service
component common to sales or dispositions of QPP, if the benefits and
burdens of ownership pass to the customer prior to the installation, it
is appropriate to treat embedded installation similar to an embedded
qualified warranty, qualified delivery, and a qualified operating
manual.
A number of commentators suggested that the IRS and Treasury
Department expand the exception to the allocation requirement for a
qualified warranty to include all services (including training,
technical and customer support, and regular maintenance of the
property), as well as all nonqualifying property (including purchased
spare parts), the charge for which is embedded in the contract price of
the lease, rental, license, sale, exchange, or other disposition of
QPP, qualified films, and utilities. Other commentators stated that the
proposed regulations should adopt principles similar to Sec. 1.482-
2(b), so that services that are ancillary and incidental to the sale of
QPP, qualified films, and utilities would not be treated as embedded
services and no allocation of gross receipts to those services would be
required. These commentators believe that footnote 27 in the Conference
Report supports such a position in stating that the conferees intend
that the Secretary provide guidance regarding the allocation of gross
receipts that draws on the principles of section 482. Other
commentators stated that, elsewhere in the Code and regulations,
transactions are given a single characterization based on their
predominant nature and that section 199 should be applied in the same
manner. For example, if the predominant nature of a transaction is the
sale of property, all gross receipts from the transaction should be
treated as proceeds from the sale. Finally, some commentators stated
that a taxpayer's treatment of a transaction for financial reporting
purposes should govern its characterization for section 199 purposes.
The IRS and Treasury Department infer that the commentators are
referring to Sec. 1.482-2(b)(8), which provides that, in general, no
separate allocation will be made in connection with ancillary and
subsidiary services provided with a transfer of property. Services
ancillary and subsidiary to another transaction may be referred to,
outside the section 199 context, as embedded services. The IRS and
Treasury Department do not intend that services defined as embedded
services under section 199 will be treated in the same manner provided
in Sec. 1.482-2(b)(8) because such treatment would be generally
inconsistent with the intent and purpose of section 199.
The IRS and Treasury Department further believe that the reference
to section 482 principles in footnote 27 of the Conference Report
reflects an intent to apply section 482 principles
[[Page 67226]]
consistently with the general intent and purpose of section 199. The
IRS and Treasury Department continue to believe that the statutory
language and legislative history require that transactions be
bifurcated into qualifying and nonqualifying elements and that gross
receipts be allocated accordingly for purposes of section 199. The IRS
and Treasury Department further believe that the exceptions to this
general rule should be limited. Expanding the special exceptions to
include all, or ancillary or incidental, embedded services and embedded
nonqualifying property would result in the inclusion in DPGR of gross
receipts that the IRS and Treasury Department do not believe were
intended to be within the scope of section 199. The legislative history
also does not support adopting principles applicable to other Code
sections under which a single predominant nature character is assigned
to a transaction, or characterizing transactions for purposes of
section 199 according to their treatment for financial reporting
purposes. Accordingly, the proposed regulations do not adopt these
suggestions.
One commentator requested that the proposed regulations clarify
whether the embedded services rule is intended to require taxpayers to
treat certain service-type activities that take place as part of the
MPGE process as embedded services. The proposed regulations clarify
that embedded services do not include service-type activities that take
place as part of the MPGE process (that is, while the taxpayer is
engaged in an MPGE activity with respect to the property and retains
the benefits and burdens of ownership of the property). For example,
with respect to QPP, activities such as non-construction engineering,
materials analysis and selection, subcontractor inspections and
approval, routine production inspections, product testing and
documentation, and assistance with certain regulatory approvals, if
undertaken in connection with a qualifying MPGE activity, are
considered part of the MPGE of the QPP and are not considered embedded
services. No separate allocation of gross receipts to such activities
is required.
Services and nonqualifying property are not considered embedded if
they are either separately offered or separately bargained for, or a
charge for the service or nonqualifying property is separately stated.
Thus, for example, if a charge for freight or delivery is separately
stated on an invoice for the sale of an item of QPP, the delivery
service is not embedded and gross receipts attributable to that service
are non-DPGR, even if the purchaser does not have the option of
refusing the service. Further, separately stated or bargained for
amounts will not be respected unless they reflect the fair market value
of the service or nonqualifying property. For example, if a taxpayer
offers contracts to customers that include a cellular phone priced on
the invoice at $595 and three years of cellular telephone service
priced on the invoice at $5, the $5 stated amount for the service will
only be respected if it represents an allocation of gross receipts
consistent with the principles of section 482.
Gross receipts attributable to embedded services, embedded
nonqualifying property, or any other embedded element (other than a
qualified warranty, qualified delivery, qualified installation, and a
qualified operating manual) may be considered DPGR under the 5 percent
de minimis exception. The proposed regulations clarify that, with
respect to the de minimis exception, taxpayers should apply the 5
percent against the total amount of the gross receipts derived from the
lease, rental, license, sale, exchange, or other disposition of the
item of QPP, qualified films, or utilities. The total amount of DPGR
includes gross receipts attributable to a qualified warranty, qualified
delivery, qualified installation, and/or a qualified operating manual
that are treated as DPGR with respect to that item. In the case of a
lease or an installment sale, the de minimis exception is applied by
taking into account the total amount of gross receipts under the lease
or installment sale that are attributable to the item of QPP, qualified
films, or utilities.
Under the proposed regulations, as under Notice 2005-14, applicable
Federal income tax principles apply in determining whether a
transaction (or any part of a transaction) is, in substance, a lease,
rental, license, sale, exchange, or other disposition, or whether it is
a service. For this purpose, section 3.04(7)(a) of Notice 2005-14 cites
Rev. Rul. 88-65 (1988-2 C.B. 32), and describes that revenue ruling as
treating a short-term rental as a service. Many commentators asked that
the proposed regulations clarify that not all short-term rentals will
be regarded as services for purposes of section 199. They observed that
Rev. Rul. 88-65 involves the lease of automobiles and trucks on a daily
basis (normally for not more than one week), and that the taxpayer
performs significant services in connection with the vehicle, including
maintenance and repairs, and pays all taxes and insurance on the
vehicle. The IRS and Treasury Department acknowledge that the short-
term nature of a transaction does not, by itself, render the
transaction a service for purposes of section 199 and that many
transactions include both service and property rental elements.
Therefore, the proposed regulations clarify that, in such cases,
taxpayers must allocate gross receipts between the qualifying rental of
QPP or qualified films (DPGR) and the non-qualifying services (non-
DPGR). The allocation must be based on the facts and circumstances of
each transaction. Generally, in the case of short-term transactions,
such as those described in Rev. Rul. 88-65, in which significant
services are provided in connection with the property, the transaction
will consist mostly of services.
Not every transaction in which property is used in connection with
providing a service to customers, however, constitutes a mixture of
services and rental for which allocation of gross receipts is
appropriate. For example, assume that a taxpayer operates a video game
arcade that features video game machines that the taxpayer MPGE. The
machines remain in the taxpayer's possession during the customers' use.
Gross receipts derived from customers' use of the machines at the
taxpayer's arcade are not derived from the lease, rental, license,
sale, exchange, or other disposition of the machines. Rather, the
machines are used to provide a service and, thus, the gross receipts
are non-DPGR.
A number of commentators objected to the position taken in section
4.04(7)(d) of Notice 2005-14 that gross receipts from Internet access
services, online services, customer support, telephone services, games
played through a website, provider-controlled software online access
services, and other services are not derived from a lease, rental,
license, sale, exchange, or other disposition of the software.
Consistent with the notice, the proposed regulations reflect the
position that the use of online computer software does not rise to the
level of a lease, rental, license, sale, exchange, or other disposition
as required under section 199 but is instead a service. This is the
case even if the customer must agree to terms and conditions (which may
be termed a license by the software provider) before using the software
online, or receive enabling software to facilitate the customer's use
of the primary software on the customer's hardware.
If gross receipts attributable to the use of online software were
permitted to qualify as DPGR because the same or similar software also
is available to
[[Page 67227]]
customers on disk or by download, different items of software available
online would be subject to disparate treatment under section 199. In
addition, if online software were permitted to qualify as DPGR, it
would be difficult to distinguish this online software from software
that is used to facilitate a service. The IRS and Treasury Department
are requesting comments in the Request for Comments section on this
issue.
One commentator suggested that the term lease, rental, license,
sale, exchange, or other disposition, especially the term other
disposition, was intended to be interpreted broadly to include gross
receipts from any means of commercialization of property, whether or
not an actual transfer of the property occurs. Another commentator
noted that section 3.04(7)(d) of Notice 2005-14 states that gross
receipts derived by a taxpayer from software that is merely offered for
use to customers online for a fee are non-DPGR, and suggested that if
the software is also offered to customers on disk or by download, then
gross receipts for online use of otherwise qualifying software would be
DPGR. The commentator also noted that the same section provides that a
``service provided using computer software that does not involve a
transfer of the computer software does not result in [DPGR],'' and
suggested that this language implies that if the software is not used
in providing a service, no transfer is required for purposes of section
199. The IRS and Treasury Department did not intend the results
suggested by the commentators and the proposed regulations have been
clarified as necessary.
A number of commentators requested clarification and expansion of
the rule in Notice 2005-14 that treats advertising receipts
attributable to the sale or other disposition of newspapers and
magazines as DPGR. Notice 2005-14 explains that advertising receipts in
this context are inextricably linked to the gross receipts derived from
the lease, rental, license, sale, exchange, or other disposition of the
newspapers and magazines. In response to comments, the proposed
regulations clarify that this rule also applies, under the same
rationale, to advertising receipts relating to telephone directories
and periodicals, whereby a taxpayer's gross receipts derived from the
lease, rental, license, sale, exchange, or other disposition of the
telephone directories or periodicals that are MPGE in whole or in
significant part within the United States includes advertising income
from advertisements placed in those media, but only to the extent the
gross receipts, if any, derived from the lease, rental, license, sale,
exchange, or other disposition of the telephone directories or
periodicals are DPGR. The proposed regulations clarify that advertising
revenue for advertising in online newspapers and periodicals is non-
DPGR, because any underlying receipts from the property itself are non-
DPGR, as there is no lease, rental, license, sale, exchange, or other
disposition of such property. The proposed regulations provide similar
treatment for gross receipts attributable to product placements in a
qualified film. The gross receipts attributable to product placements
will be treated as DPGR, but (as with newspapers) only if the gross
receipts derived from the lease, rental, license, sale, exchange, or
other disposition of the qualified film are DPGR. Thus, for product
placement revenue to be derived from a qualified film, there must be a
lease, rental, license, sale, exchange, or other disposition of the
qualified film.
Section 3.04(9)(a) of Notice 2005-14 provides that revenue from the
licensing of film characters is not derived from the lease, rental,
license, sale, exchange, or other disposition of a qualified film. One
commentator stated that this treatment is inconsistent with the income
forecast method, and that revenue from licensing of film-related
intangibles is inextricably linked to (and therefore should be treated
as derived from) the qualified film. The proposed regulations do not
adopt this comment. Section 199(c)(4)(A)(i)(II) clearly requires that
receipts must be derived from a lease, rental, license, sale, exchange,
or other disposition of a qualified film to be DPGR. Receipts derived
from the licensing of related intangibles, including film characters,
trademarks, and trade names, do not meet this requirement. Further, the
IRS and Treasury Department do not agree that receipts derived from
licensing of film-related intangibles are inextricably linked to the
gross receipts derived from a qualified film.
Some commentators objected to the rule in section 4.04(7)(a) of
Notice 2005-14 that provides that if a taxpayer exchanges QPP MPGE by
the taxpayer in whole or in significant part within the United States
for other property in a taxable exchange, the value of the property
received by the taxpayer is DPGR; whereas any gross receipts derived
from a subsequent sale by the taxpayer of the acquired property are
non-DPGR because the taxpayer did not MPGE the acquired property. The
commentators noted that in their industry, fungible commodities held
for sale to customers are exchanged routinely between producers as a
practical means of avoiding logistical problems in meeting customers'
needs and reducing transportation and storage costs. The commentators
noted that these exchanges typically are not treated as taxable
exchanges on the parties' financial records. The commentators requested
that the proposed regulations instead provide that if the property
relinquished in the exchange is QPP, qualified films, or utilities,
then the property received in the exchange should be treated as QPP,
qualified films, or utilities and gross receipts derived from the
subsequent sale of that property should be treated as DPGR. Another
commentator suggested that this treatment be applied only to nontaxable
exchanges.
The proposed regulations do not adopt these suggestions. The IRS
and Treasury Department believe that the character of property as
having been MPGE in whole or in significant part by the taxpayer within
the United States is not an attribute of the property, like basis and
holding periods, that may be substituted with the transfer of the
property. The IRS and Department Treasury believe that the
commentators' interpretations are inconsistent with section
199(c)(4)(A)(i)(I).
Commentators requested that the IRS and Treasury Department clarify
whether gross receipts from mineral royalties and net profits interests
are properly treated as DPGR. Mineral royalties, including net profits
interests, are returns on passive interests in mineral properties, the
owner of which makes no expenditure for operation or development. The
courts and the IRS have long considered these types of income to be in
the nature of rent (see, for example, Kirby Petroleum Co. v. Comm'r,
326 U.S. 599 (1946)). Accordingly, the proposed regulations in Sec.
1.199-3(h)(9) provide that gross receipts from mineral interests and
net profits interests other than operating or working interests are not
treated as DPGR.
Definition of Manufactured, Produced, Grown, or Extracted
Section 4.04(3)(b) of Notice 2005-14 provides that a taxpayer that
MPGE QPP for the taxable year should treat itself as a producer under
section 263A with respect to the QPP for the taxable year unless the
taxpayer is not subject to section 263A. In response, commentators
questioned whether all taxpayers that are subject to section 263A are
considered to have MPGE QPP for purposes of section 199. Taxpayers who
do not MPGE QPP may nevertheless be subject to section 263A. For
example, a taxpayer that has
[[Page 67228]]
property produced for it under a contract is considered a producer of
property under section 263A, but may not be considered as having MPGE
property for purposes of section 199 if it does not have the benefits
and burdens of ownership of the property while it is being produced.
Additionally, in some circumstances a taxpayer that manufactures
property for a customer pursuant to a contract may be considered the
producer of the property for purposes of section 263A and not to have
MPGE the property for purposes of section 199. Accordingly, not all
taxpayers that are subject to section 263A are considered to have MPGE
QPP for purposes of section 199.
Commentators also have questioned whether a taxpayer that engages
in certain production activities that are exempt from section 263A (for
example, developing computer software under Rev. Proc. 2000-50 (2000-1
C.B. 601), producing property pursuant to a long-term contract under
section 460, or farming exempt under section 263A(d)) must treat itself
as a producer under section 263A if the taxpayer wants to be treated as
MPGE QPP for purposes of section 199. The proposed regulations in Sec.
1.199-3(d)(4) provide that a taxpayer that has MPGE QPP for the taxable
year should treat itself as a producer under section 263A with respect
to the QPP for the taxable year unless the taxpayer is not subject to
section 263A. A taxpayer whose MPGE activity is exempt from section
263A is not required to change its method of accounting under section
263A to treat itself as engaged in the MPGE of QPP for purposes of
section 199.
Commentators requested clarification as to whether a reseller that
engages in de minimis production activities or that has property
produced for it under contract, which constitutes the MPGE of QPP under
section 199, is precluded from using the simplified resale method
provided by Sec. 1.263A-3(d). Section 1.263A-3(a)(4)(ii) provides that
a reseller with de minimis production activities is permitted to use
the simplified resale method. Likewise, Sec. 1.263A-3(a)(4)(iii)
provides that a reseller otherwise permitted to use the simplified
resale method is permitted to use the method if it has personal
property produced for it under a contract if the contract is entered
into incident to its resale activities and the property is sold to its
customers. The section 263A consistency rule provided in Sec. 1.199-
3(d)(4) of the proposed regulations does not affect the rules provided
in Sec. 1.263A-3. Accordingly, a reseller with de minimis production
or that has property produced for it under a contract that is
considered the MPGE of QPP for purposes of section 199 is not precluded
from using the simplified resale method if the taxpayer meets the
requirements of Sec. 1.263A-3(a)(4)(ii) or (iii).
Definition of By the Taxpayer
Section 1.199-3(e)(1) of the proposed regulations provides that,
with the exception of rules that are applicable to an EAG, certain oil
and gas partnerships described in Sec. 1.199-3(h)(7), EAG partnerships
described in Sec. 1.199-3(h)(8), and certain government contracts
described in Sec. 1.199-3(e)(2), only one taxpayer may claim the
section 199 deduction with respect to the MPGE of QPP. If one taxpayer
MPGE QPP pursuant to a contract with another person, then only the
taxpayer that has the benefits and burdens of ownership of the property
under Federal income tax principles during the time the property is
MPGE will be considered to have MPGE the QPP. In contrast, Sec.
1.263A-2(a)(1)(ii)(B) provides that property produced for the taxpayer
under a contract is considered as produced by the taxpayer to the
extent the taxpayer makes payments or otherwise incurs costs with
respect to the property, even if the taxpayer is not the owner of the
property while the property is being produced. Commentators questioned
why a similar rule does not apply in the context of section 199. The
rule provided by Sec. 1.263A-2(a)(1)(ii)(B) is derived from section
263A(g)(2). That section specifically provides that a taxpayer is
treated as producing property produced for it under a contract to the
extent that it has made payments or incurred costs with respect to the
contract. In contrast, section 199(c)(4)(A)(i) provides that DPGR only
includes gross receipts of the taxpayer that are derived from any
lease, rental, license, sale, exchange, or other disposition of QPP
MPGE by the taxpayer in whole in significant part within the United
States. Accordingly, the proposed regulations do not contain a
provision that is analogous to Sec. 1.263A-2(a)(1)(ii)(B).
While sections 199, 263A, and 936 all have benefits and burdens
standards, the standard under section 199 is not the same as those
under sections 263A and 936. Commentators suggested that the proposed
regulations adopt the broader standard under Sec. 1.263A-
2(a)(1)(ii)(A) that provides that a taxpayer is not considered to be
producing property unless the taxpayer is considered the owner of the
property produced under Federal income tax principles. The
determination of whether a taxpayer is considered an owner is based on
all of the facts and circumstances, including the various benefits and
burdens of ownership vested with the taxpayer. Because the standard
under the section 263A regulations is broad, it has been interpreted to
allow two taxpayers to be considered the producer of the same property.
Compare, for example, Suzy's Zoo v. Comm'r, 114 T.C. 1 (2000), aff'd
273 F.3d 875 (9th Cir. 2001) and Golden Gate Litho v. Comm'r, T.C. Memo
(1998-184).
The IRS and Treasury Department continue to believe that the
requirement of section 199(c)(4)(A)(i) that property be MPGE by the
taxpayer means that only one taxpayer may claim the section 199
deduction with respect to the same function performed with respect to
the same property. Therefore, it would be inappropriate to adopt the
standard under the section 263A regulations. In addition, this
interpretation is supported by the Congressional Letter that states the
Treasury Department has the authority to prescribe rules to prevent the
section 199 deduction from being claimed by more than one taxpayer with
respect to the same economic activity described in section
199(c)(4)(A)(i). Thus, consistent with Notice 2005-14, the proposed
regulations in Sec. 1.199-3(e)(1) provide that only one taxpayer may
claim the section 199 deduction with respect to any MPGE activity.
Commentators also proposed other alternatives to the benefits and
burdens standard, such as looking to the person that has the economic
risks and benefits, adopting the qualified research rules under Sec.
1.41-2(e)(2), providing safe harbors based on contract terms, treating
the person that arranges for the acquisition of the property as the
owner, and looking to the person that controls the process by which the
property is MPGE. The proposed regulations do not adopt any of these
suggestions because the IRS and Treasury Department believe that there
is considerable variation in the types of contract manufacturing
situations. Therefore, the proposed regulations contain the same
benefits and burdens standard used in Notice 2005-14 because it is a
standard that the IRS and Treasury Department believe covers all of the
varied factual situations.
Commentators requested that the proposed regulations provide
examples of how to apply the benefits and burdens standard. The
proposed regulations contain examples illustrating contract
manufacturing situations in which the taxpayer with the benefits and
burdens of ownership
[[Page 67229]]
under Federal income tax principles is treated as manufacturing the
QPP.
In the Congressional Letter, the Treasury Department was advised
that gross receipts derived from certain contracts to manufacture or
produce property for the Federal government are derived from the sale
of such property and, therefore, are DPGR. The proposed regulations in
Sec. 1.199-3(e)(2) provide that a taxpayer will be treated as meeting
the by the taxpayer requirement if the QPP, qualified films, or
utilities are MPGE or otherwise produced in the United States by the
taxpayer pursuant to a contract with the Federal government and the
Federal Acquisition Regulation requires that title or risk of loss with
respect to the QPP, qualified films, or utilities be transferred to the
Federal government before the MPGE or production of the QPP, qualified
films, or utilities is complete.
In Whole or In Significant Part
Under section 199(c)(4)(A)(i)(I), QPP must be MPGE in whole or in
significant part by the taxpayer within the United States. The proposed
regulations in Sec. 1.199-3(f)(1) clarify that the in whole or in
significant part requirement applies to both the by the taxpayer
requirement and the within the United States requirement.
Section 4.04(5)(b) of Notice 2005-14 provides that QPP will be
treated as having been MPGE in significant part by the taxpayer within
the United States if the MPGE of the QPP performed within the United
States is substantial in nature. Design and development costs do not
qualify as substantial in nature for any QPP other than computer
software and sound recordings. The proposed regulations in Sec. 1.199-
3(f)(2) substitute research and experimental expenditures under section
174 for design and development costs. ?>
Section 4.04(5)(c) of Notice 2005-14 provides that a taxpayer will
be treated as having MPGE property in whole or in significant part
within the United States if, in connection with the property,
conversion costs (direct labor and related factory burden) to MPGE the
property are incurred by the taxpayer within the United States and the
costs account for 20 percent or more of the total CGS of the property.
The proposed regulations in Sec. 1.199-3(f)(3) provide that, in the
case of tangible personal property, research and experimental
expenditures under section 174 and any other costs of creating
intangibles may be excluded from total CGS for purposes of the safe
harbor.
A commentator suggested that a taxpayer's activity within the
United States that is critical to the functionality or nature of
property should be considered to meet the in significant part
requirement under section 199(c)(4)(A)(i)(I) even if the activity is
not substantial in nature. The proposed regulations do not adopt this
suggestion because the IRS and Treasury Department do not believe that
this is an accurate measurement of the degree of activity required to
satisfy the in whole or in significant part requirement.
Qualifying Production Property
Commentators requested that the IRS and Treasury Department
reconsider the rule under section 4.04(8)(c) and (d) of Notice 2005-14
which provides that, if the medium in which computer software or sound
recordings are contained is tangible, then such medium is considered
tangible personal property for purposes of section 199. This rule has
been removed and the proposed regulations in Sec. 1.199-3(i)(5)
provide that if a taxpayer MPGE computer software or sound recordings
that the taxpayer fixed on, or added to, tangible personal property
(for example, a computer diskette or an appliance), then the tangible
medium with the computer software or sound recordings may be treated by
the taxpayer as computer software or sound recordings, as applicable.
However, the proposed regulations provide that, if a taxpayer treats
the tangible medium as computer software or sound recordings, any costs
under section 174 attributable to the tangible medium are not
considered in determining whether the taxpayer's activity is
substantial in nature under Sec. 1.199-3(f)(2) or conversion costs
under Sec. 1.199-3(f)(3). In addition, because a taxpayer may MPGE
tangible personal property, but not computer software or sound
recordings that the taxpayers fixes on, or adds to, the tangible
personal property MPGE by the taxpayer, the proposed regulations
provide that the computer software or sound recordings may be treated
by the taxpayer as tangible personal property.
Commentators requested that the proposed regulations clarify
whether the exceptions from computer software under section
168(i)(2)(B)(iv) apply to computer software under section 199. In
response to this comment, the proposed regulations provide in Sec.
1.199-3(i)(3)(i) that these exceptions do not apply for purposes of
section 199 and computer software also includes the machine-readable
code for video games and similar programs, for equipment that is an
integral part of other property, and for typewriters, calculators,
adding and accounting machines, copiers, duplicating equipment, and
similar equipment, regardless of whether the code is designed to
operate on a computer (as defined in section 168(i)(2)(B)). Computer
programs of all classes, for example, operating systems, executive
systems, monitors, compilers and translators, assembly routines, and
utility programs as well as application programs, are included.
A commentator requested that the proposed regulations provide that
the creation and licensing of copyrighted business information reports
constitutes the MPGE of QPP. Formerly distributed in hard copy, this
information is now generally distributed electronically. Customers are
required to use the information only for their own use, and no
copyright is transferred to them. The commentator contends that, while
the activity of creating the business information reports provided to
customers is not a production activity in the traditional sense, the
definition of MPGE is broad enough to encompass this activity. The IRS
and Treasury Department do not agree with this comment because creating
a database of business information is not MPGE, the database is not
QPP, and the business information reports are not QPP MPGE by the
taxpayer.
Qualified Films
Similar to the rules for computer software, section 4.04(9)(a) of
Notice 2005-14 provides that if a medium on which a qualified film is
fixed is tangible (such as a DVD), the property consists of both a
qualified film and tangible personal property. The notice contains
examples in which taxpayers that either produce a qualified film and
purchase the tangible medium, or MPGE the tangible medium and license
the qualified film, must allocate gross receipts between the tangible
medium and the qualified film. For the reasons stated under the
discussion of computer software, the proposed regulations allow certain
taxpayers to treat such combined property as either tangible personal
property or a qualified film, as applicable.
One commentator requested that the proposed regulations clarify the
requirement that 50 percent of the total compensation relating to the
production of the film be compensation for services performed in the
United States by actors, production personnel, directors, and
producers. Specifically, the commentator requested that the phrase
``total compensation relating to the production of the film'' be
interpreted to mean compensation for services performed only by actors,
production personnel, directors, and producers. The commentator further
requested that the term ``compensation'' be interpreted to
[[Page 67230]]
include all compensation (not just W-2 wages) that is paid to these
individuals and that is required to be capitalized by film producers
under section 263A and Sec. 1.263A-1(e)(2) and (3). These suggestions
have been adopted in the proposed regulations.
Definition of Construction Performed in the United States
Section 4.04(11)(a) of Notice 2005-14 defines the term
``construction'' to mean the construction or erection of real property
by a taxpayer that is in a trade or business that is considered
construction for purposes of the North American Industry Classification
System (NAICS). Commentators asked how a taxpayer in multiple trades or
businesses determines if it is in a construction NAICS code. The
proposed regulations clarify that in order for a taxpayer to be
considered in a construction NAICS code, it must be engaged in a
construction trade or business (but not necessarily its primary trade
or business) on a regular and ongoing basis. The determination of
whether an entity is in a NAICS code is generally tested on an entity-
by-entity basis. Under this rule, a member of an EAG must perform the
construction activity in order for its gross receipts to qualify as
DPGR from construction. See Sec. 1.199-7(a)(3). In addition, the
taxpayer must actually perform the construction activity. For example,
if a taxpayer in a construction NAICS code hired an unrelated general
contractor to construct a building, the gross receipts derived by the
taxpayer from the sale of the building would not be DPGR because the
taxpayer did not construct the building. The proposed regulations
provide an example to illustrate this rule.
Commentators also asked that the proposed regulations clarify
whether eligible construction activities are limited to a specific
NAICS code. Section 1.199-3(l)(1)(i) provides that a trade or business
that is considered construction for purposes of the NAICS codes means a
construction activity under the two-digit NAICS code of 23 and any
other construction activity in any other NAICS code relating to the
construction of real property. For example, a construction activity
relating to the construction of real property that is not under the
two-digit NAICS code of 23 but which qualifies as an eligible
construction activity would include the construction of oil and gas
wells for NAICS code 213111 (drilling oil and gas wells) and 213112
(support activities for oil and gas operations). Commentators also
asked that the proposed regulations include a listing of construction
activities relating to oil and gas wells. In response to this request,
the proposed regulations provide, as a matter of administrative grace,
that qualifying construction activities also include activities
relating to drilling an oil well and mining, and include any activities
treated by the taxpayer as intangible drilling and development costs
under section 263(c) and Sec. 1.612-4 and development expenditures for
a mine or natural deposit under section 616.
Commentators contend that gross receipts attributable to the
leasing or rental of constructed real property qualify as DPGR because
the right to use constructed property represents one right in the
bundle of rights derived from the construction of real property. The
proposed regulations do not adopt this interpretation because gross
receipts derived from the rental of real property that a taxpayer
constructs are not derived from construction, but are instead
compensation for the use or forbearance of the property. Similarly,
gross receipts derived from renting or leasing equipment such as
bulldozers and generators to contractors for use in the construction of
real property are non-DPGR (assuming the rental companies do not
manufacture the equipment).
Section 4.04(11)(a) of Notice 2005-14 contains a safe harbor rule
for determining when tangible personal property that is sold as part of
a construction project may be considered real property. If more than 95
percent of the total gross receipts derived by a taxpayer from a
construction project are derived from real property (as defined in
Sec. 1.263A-8(c)), then the total gross receipts derived by the
taxpayer from the project are DPGR from construction. Commentators
stated that it was unclear what items of tangible personal property are
included in this rule (for example, small or major appliances, home
theaters, and fixtures installed by a builder) and whether it was
intended that land be included for purposes of this safe harbor.
Consequently, this rule has been replaced in the proposed regulations
with a de minimis exception in Sec. 1.199-3(l)(1)(ii). Accordingly, if
less than 5 percent of the total gross receipts derived by a taxpayer
from a construction project are derived from activities other than the
construction of real property in the United States (for example, from
non-construction activities, the sale of tangible personal property, or
land) then the total gross receipts derived by the taxpayer from the
project are DPGR from construction.
Many commentators suggested that the proposed regulations treat
gross receipts attributable to the sale or other disposition of land as
DPGR derived from construction of real property. Commentators also
suggested that construction begins as soon as production activities
begin, that is, when land is acquired and the entitlement process, such
as obtaining proper zoning and permits, commences in connection with
construction of real property. The proposed regulations do not adopt
these suggestions. The IRS and Treasury Department continue to believe
that Congress intended the benefit under section 199 only for
construction services performed in the United States. Taxpayers do not
construct land and thus any gain attributable to the disposition of
land (including zoning, planning, entitlement costs and other costs
capitalized to the land such as the demolition of structures under
section 280B) is not eligible for the section 199 deduction.
Commentators also argue that the land exclusion creates an
administrative and financial burden because a valuation will be
necessary for any sale of real property that includes land. To address
the administrative burden in identifying and valuing the gross receipts
attributable to land in connection with qualifying construction
activities, the proposed regulations provide a safe harbor in Sec.
1.199-3(l)(5)(ii). Under this safe harbor, a taxpayer may allocate
gross receipts between the proceeds from the sale, exchange, or other
disposition of real property constructed by the taxpayer and the gross
receipts attributable to the sale, exchange, or other disposition of
land by reducing its costs related to DPGR in Sec. 1.199-4 by costs of
the land and any other costs capitalized to the land (collectively,
land costs) (including land costs in any common improvements as defined
in section 2.01 of Rev. Proc. 92-29 (1992-1 C.B. 748)), and by reducing
its DPGR from qualifying construction activities by those land costs
plus a specified percentage. The percentage is based on the number of
years that elapse between the date the taxpayer acquires the land,
including the date the taxpayer enters into the first option to acquire
all or a portion of the land, and ends on the date the taxpayer sells
each item of real property on the land. The percentage is 5 percent for
years zero through 5; 10 percent for years 6 through 10; and 15 percent
for years 11 through 15. Land held by a taxpayer for 16 or more years
is not eligible for the safe harbor and the taxpayer must allocate
gross receipts between the land and the qualifying real property. For
example, if a taxpayer acquires land in 2001 and constructs houses that
it sells in 2005, 2008, and
[[Page 67231]]
2012, the houses sold in 2005 are subject to the 5 percent reduction;
the houses sold in 2008 are subject to the 10 percent reduction; and
the houses sold in 2012 are subject to the 15 percent reduction.
Commentators suggested that developers of raw land should be
entitled to a section 199 deduction for improvements to land such as
building roads, sidewalks, and installing utilities. In addition, they
suggested that entitlements such as zoning, permits, and surveys that
add value to the land should be included in DPGR similar to the
treatment of design and development costs for software and sound
recordings. The proposed regulations provide that a taxpayer in a
construction NAICS code that sells developed land will have DPGR to the
extent the receipts are attributable to real property such as
infrastructure but not to the land and any entitlements attributable to
the land. The proposed regulations provide examples in Sec. 1.199-
3(l)(5)(iii) to illustrate this rule.
Commentators suggested that the proposed regulations extend the
embedded services exception for qualified warranties in connection with
the sale of property to construction warranties. The IRS and Treasury
Department agree with this suggestion. Accordingly, Sec. 1.199-
3(l)(5)(i) provides DPGR derived from the construction of real property
includes gross receipts from any warranty that is provided in
connection with the construction of the real property if, in the normal
course of the taxpayer's business, the charge for the construction
warranty is included in the price for the construction project and the
construction warranty is neither separately offered by the taxpayer nor
separately bargained for with the customer (that is, the customer
cannot purchase the constructed real property without the construction
warranty).
Engineering and Architectural Services
Section 4.04(12)(a) of Notice 2005-14 provides that DPGR includes
gross receipts derived from engineering or architectural services
performed in the United States for real property construction projects
in the United States. Commentators stated that the definition of
engineering and architectural services should not be limited to real
property because this limitation is inconsistent with the rules for
engineering and architectural services under the domestic international
sales corporation, foreign sales corporation, and extraterritorial
income exclusion provisions. The IRS and Treasury Department continue
to believe that the statutory language in section 199(c)(4)(A)(iii)
requires that only engineering and architectural services relating to
real property qualify for the section 199 deduction and that the same
rules relating to construction of real property apply for engineering
or architectural services. In addition, the Blue Book at page 172 n.
292, states that DPGR includes gross receipts derived from the
engineering or architectural services performed with respect to real
property only. Thus, DPGR only includes gross receipts derived from
engineering or architectural services performed in the United States
for the construction of real property in the United States. In
addition, the IRS and Treasury Department believe that, consistent with
the rules for construction activities, a taxpayer performing
engineering and architectural services must be in a trade or business
described in an engineering or architectural NAICS code. Accordingly,
the proposed regulations require that, at the time the taxpayer
performs the engineering or architectural services, the taxpayer must
be in a trade or business on a regular and ongoing basis (but not
necessarily its primary trade or business) that is considered
engineering or architectural services for purposes of the NAICS codes,
for example NAICS codes 541330 (engineering services) or 541310
(architectural services).
A commentator also requested clarification of whether a structure
enclosing an electric generation station as described in Rev. Rul. 69-
412 (1969-2 C.B. 2) would be considered real property for purposes of
section 199(c)(4)(A)(iii). In that revenue ruling, the structure
qualified as section 38 property for investment credit purposes. The
revenue ruling does not determine whether the property was real or
personal property. Under section 4.04(11)(a) of Notice 2005-14, real
property includes residential and commercial buildings including items
that are structural components of such buildings and inherently
permanent structures other than tangible personal property in the
nature of machinery. The proposed regulations in Sec. 1.199-3(l)(1)(i)
retain this language. Thus, a structure enclosing an electric
generation station as described in Rev. Rul. 69-412 is treated as real
property for purposes of section 199(c)(4)(A)(iii).
In addition, similar to the rules for construction, the
determination of whether an entity is in an engineering or
architectural NAICS code is made on an entity-by-entity basis. Under
this rule, a member of an EAG must perform the engineering or
architectural services in order for its gross receipts to qualify as
DPGR from engineering or architectural services. See Sec. 1.199-
7(a)(3). In addition, the taxpayer must actually perform the
engineering or architectural services.
One commentator pointed out that the requirement in section
4.04(12)(a) of Notice 2005-14 that a taxpayer must substantiate that
the engineering or architectural services relate to a construction
project in the United States is unnecessary because taxpayers are
already required to identify and allocate gross receipts attributable
to DPGR based upon a reasonable method satisfactory to the Secretary
for purposes of determining QPAI. Because there was no intention on the
part of the IRS and Treasury Department to create an additional
substantiation requirement for engineering and architectural services,
this additional substantiation requirement is not required under the
proposed regulations.
Commentators requested clarification of whether gross receipts
attributable to feasibility studies, for example, planning possible
road or building configurations for a potential real property
development project, is a qualifying activity. The commentators state
that engineering and architectural firms are often hired for these
studies to determine a project's practicability. Accordingly, the
proposed regulations provide in Sec. 1.199-3(m)(1) that DPGR includes
gross receipts derived from engineering or architectural services,
including feasibility studies for a construction project in the United
States, even if the planned construction project is not undertaken or
is not completed.
Food and Beverages
Section 199(c)(4)(B)(i) provides that DPGR does not include gross
receipts of the taxpayer that are derived from the sale of food and
beverages prepared by the taxpayer at a retail establishment. Section
4.04(13) of Notice 2005-14 defines a ``retail establishment'' as real
property leased, occupied, or otherwise used by the taxpayer in its
trade or business of selling food or beverages to the public at which
retail sales are made. One commentator stated that food carts and
portable food stands should not be considered retail establishments
because they do not constitute real property. The IRS and Treasury
Department believe that the term ``retail establishment'' is intended
to be interpreted broadly to include any facility at which the taxpayer
prepares food or beverages and makes retail sales of the food or
beverages to the public. See Conference Report at page 272 (footnote
27) (retail establishment not
[[Page 67232]]
limited to establishments at which customers dine on premises or to
those engaged primarily in the dining trade). Accordingly, the proposed
regulations do not adopt this suggestion, and the term ``retail
establishment'' is clarified to include both real and personal
property. In addition, a facility at which food and beverages are
prepared solely for take out service or delivery is a retail
establishment (for example, a caterer).
Consistent with Notice 2005-14, the proposed regulations provide
that if a taxpayer's facility is a retail establishment, then, as a
matter of administrative grace, a taxpayer is permitted to allocate its
gross receipts between gross receipts derived from the wholesale sale
of the food and beverages prepared at the retail establishment (which
are DPGR, assuming all the other requirements of section 199(c) are
met) and the gross receipts derived from the retail sale of the food
and beverages prepared and sold at the retail establishment (which are
non-DPGR). For this purpose, wholesale sales are defined as sales of
food and beverages to be resold by the purchaser.
One commentator requested clarification how the retail
establishment exception applies in the case of wineries. While
producers of distilled spirits, wines, and beer may conduct retail
sales of their products on their premises, such sales do not transform
the entire premises of the distilled spirits plant, bonded wine cellar
(or bonded winery), or brewery into a retail establishment. Chapter 51
of Title 26 of the United States Code, and the implementing regulations
found in 27 CFR parts 19, 24, and 25, create clear distinctions between
that portion of a distilled spirits plant, winery, or brewery devoted
to production activities and the portion devoted to other activities,
such as retail sales. Consistent with the treatment of such facilities
for purposes of Chapter 51 of Title 26 of the United States Code and
the regulations thereunder, the proposed regulations provide that the
portion of a distilled spirits plant, bonded winery, or brewery that is
restricted to production activities, including the processing and
blending of distilled spirits, wine, and beer products, will not be
treated as a retail establishment for purposes of section
199(c)(4)(B)(i). Thus, for example, for purposes of section 199,
taxpaid wine sold from the taxpaid premises of a bonded winery is not
considered to have been produced at a retail establishment because it
is considered to have been produced on the bonded premises of the
winery. Accordingly, the sales of such wine will be treated as DPGR for
purposes of section 199 (assuming all the other requirements of section
199(c) are met). A similar result applies to the sale of taxpaid
distilled spirits from the general (taxpaid) premises of a distilled
spirits plant, and to the sale of taxpaid beer from the tavern portion
of a brewery.
A commentator suggested that the proposed regulations interpret the
term food and beverages to mean only items prepared by the taxpayer in
a single serving size for immediate consumption by the purchaser. The
commentator believes that the Conference Report in footnote 27 supports
this interpretation because these characteristics are common to the
examples that the footnote provides (that is, brewed coffee and venison
sausage prepared at a restaurant). The commentator further contends
that this interpretation eliminates the distinction between food and
beverages prepared off-site (gross receipts from the retail sale of
which may be DPGR) and those prepared on-site (gross receipts from the
retail sale of which are non-DPGR), a distinction that the commentator
believes Congress did not intend.
The IRS and Treasury Department do not believe that the statute or
Conference Report supports the commentator's interpretation. If the
commentator's interpretation was correct, then gross receipts from the
retail sale of the roasted coffee beans in footnote 27 would have
qualified as DPGR even if the taxpayer had roasted the beans at its
retail establishment because the beans are not sold in single servings
for immediate consumption. However, footnote 27 makes clear that the
gross receipts attributable to the beans only qualify because the beans
were roasted at a facility separate from the retail establishment.
Thus, the statute and legislative history clearly provide different
treatment for gross receipts attributable to the retail sale of food
and beverages prepared at a retail establishment and food and beverages
prepared elsewhere.
The same commentator requested clarification of how the food and
beverages exception applies to in-store bakeries. Footnote 27 of the
Conference Report provides an example of a taxpayer that operates a
supermarket that includes an in-store bakery, and provides that the
taxpayer may allocate its gross receipts between DPGR and non-DPGR. The
commentator believes that the example could be interpreted to mean that
all gross receipts allocable to sales (both retail and wholesale) of
items prepared in the bakery are non-DPGR. Section 4.04(13) of Notice
2005-14 however, as a matter of administrative grace, permits gross
receipts from wholesale sales of food and beverages produced at a
retail establishment to qualify as DPGR (if all other requirements of
section 199(c) are met), and the proposed regulations retain this rule.
Thus, gross receipts from wholesale sales of items produced at the in-
store bakery (for example, items sold to restaurants) may qualify as
DPGR (if all other requirements of section 199(c) are met). The
commentator further stated, consistent with the first comment, that
gross receipts from retail sales of bakery products that require
further processing by the consumer to be suitable for individual
consumption (such as unsliced cakes and unsliced loaves of bread)
should not be excluded from DPGR under section 199(c)(4)(B)(i). For the
reasons stated above, the IRS and Treasury Department believe that
retail sales of these items are subject to that exclusion. Receipts
allocable to wholesale sales of these items, however, may qualify as
DPGR under the administrative exception, assuming all the other
requirements of section 199(c) are met.
Determining Costs
To determine its QPAI for the taxable year, a taxpayer must
subtract from its DPGR the amount of CGS allocable to DPGR, the other
deductions, expenses, and losses (deductions) directly allocable to
DPGR, and a ratable portion of other deductions that are not directly
allocable to DPGR or another class of income. A taxpayer's costs must
be determined using the taxpayer's methods of accounting for Federal
income tax purposes.
Allocation of Cost of Goods Sold
Notice 2005-14 provides that if a taxpayer can identify from its
books and records CGS allocable to DPGR, CGS allocable to DPGR is that
amount. The Notice also provides that if a taxpayer's books and records
do not allow it to identify CGS allocable to DPGR, the taxpayer may use
a reasonable allocation method to allocate CGS between DPGR and non-
DPGR. The Notice further provides that, if a taxpayer uses a method to
allocate gross receipts between DPGR and non-DPGR, then the taxpayer
may not use a different method for purposes of allocating CGS.
Commentators suggested that a taxpayer should be permitted to
allocate CGS using a reasonable method separate from the method used to
allocate gross receipts because using the same allocation method for
gross receipts and CGS may not be possible or may distort income. For
example, a taxpayer that
[[Page 67233]]
can identify from its books and records gross receipts allocable to
DPGR may not be able to specifically identify CGS allocable to DPGR.
Commentators also questioned whether a taxpayer that can identify from
its books and records CGS allocable to DPGR must allocate CGS on such
basis when it allocates gross receipts using a different method. The
proposed regulations clarify that if a taxpayer does, or can without
undue burden or expense, specifically identify from its books and
records CGS allocable to DPGR, CGS allocable to DPGR is that amount
irrespective of whether the taxpayer uses another allocation method to
allocate gross receipts between DPGR and other gross receipts. The
proposed regulations also clarify that if a taxpayer cannot, without
undue burden or expense, use a specific identification method to
determine CGS allocable to DPGR, the taxpayer is not required to use a
specific identification method to determine CGS allocable to DPGR, but
may use some other reasonable method. A taxpayer's use of a method for
purposes of allocating CGS between DPGR and non-DPGR that is different
from its method for allocating gross receipts between DPGR and non-DPGR
will ordinarily not be considered reasonable unless the method for
allocating CGS is demonstrably more accurate than the method used to
allocate gross receipts.
Commentators also suggested that CGS allocable to DPGR may not be
readily ascertainable when a taxpayer uses the last-in, first-out
(LIFO) method to account for its inventory. Therefore, commentators
requested that a simplified method be provided to allocate CGS between
DPGR and non-DPGR when a taxpayer uses the LIFO method to account for
its inventory. The proposed regulations provide that a taxpayer that
uses the LIFO method to account for its inventory may use any
reasonable method to allocate CGS between DPGR and non-DPGR. In
addition, the regulations provide simplified methods that a taxpayer
may use to allocate CGS when a taxpayer uses the LIFO method to account
for its inventories.
The IRS and Treasury Department also received comments requesting
clarification of the types of costs that are required to be allocated
as CGS allocable to DPGR. In particular, commentators stated that
section 263A only requires taxpayers to capitalize costs with respect
to inventory on hand at the end of the taxable year and that as a
result taxpayers generally do not include indirect costs in CGS, but
instead deduct the amount not allocated to ending inventory. Section
263A requires a taxpayer that produces inventory to include in
inventory costs the direct costs of producing the property and the
property's properly allocable share of indirect costs for purposes of
determining both ending inventory and CGS. Consistent with Notice 2005-
14, the proposed regulations provide that, for purposes of determining
CGS allocable to DPGR, CGS includes the costs that would have been
included in ending inventory under the principles of sections 263A,
471, and 472 if the goods sold during the taxable year were on hand at
the end of the taxable year. However, a taxpayer is permitted to use
any reasonable method to allocate indirect costs properly included in
CGS between DPGR and non-DPGR if the taxpayer's books and records do
not, or cannot without undue burden or expense, specifically identify
CGS allocable to DPGR.
Comments also were received concerning whether a taxpayer is
permitted to use a reasonable allocation method to allocate CGS if it
uses the simplified production method or simplified resale method for
additional section 263A costs. The proposed regulations clarify that a
taxpayer that uses either the simplified production method or the
simplified resale method for additional section 263A costs may use a
reasonable allocation method to allocate both section 471 costs and
additional section 263A costs included in CGS. The proposed regulations
further provide that if a taxpayer uses the simplified production
method or the simplified resale method to allocate additional section
263A costs to ending inventory, additional section 263A costs
ordinarily should be allocated in the same proportion as section 471
costs are allocated.
Allocation and Apportionment of Deductions
Consistent with Notice 2005-14, the proposed regulations provide
three methods for allocating and apportioning deductions. However, as
described below, modifications have been made in these proposed
regulations to the qualification requirements of the simplified
deduction method and the small business simplified overall method.
The first method, the ``section 861 method,'' is required to be
used by a taxpayer, unless the taxpayer is eligible and chooses to use
either the simplified deduction method or the small business simplified
overall method. Under the section 861 method, section 199 is treated as
an operative section described in Sec. 1.861-8(f). Accordingly, a
taxpayer determines the deductions allocated and apportioned to DPGR by
applying the allocation and apportionment rules provided by Sec. Sec.
1.861-8 through 1.861-17 and Sec. Sec. 1.861-8T through 1.861-14T (the
section 861 regulations), subject to certain special rules. The IRS and
Treasury Department recognize that the allocation and apportionment
rules of the section 861 method may be burdensome to certain taxpayers,
particularly smaller taxpayers, that otherwise would not be required to
use these rules. Accordingly, the proposed regulations provide two
alternative methods, the simplified deduction method and the small
business simplified overall method, with a goal of minimizing the need
for smaller taxpayers to devote additional resources to compliance.
Under the ``simplified deduction method,'' a taxpayer's deductions
are apportioned between DPGR and other receipts based on relative gross
receipts. The simplified deduction method does not apply to the
allocation of CGS. Notice 2005-14 permits only taxpayers with average
annual gross receipts of $25,000,000 or less to use the simplified
deduction method. Several commentators requested that the simplified
deduction method also be made available to taxpayers with gross
receipts in excess of $25,000,000. Many of these comments were from
taxpayers that have not in the past been required to allocate and
apportion deductions under the section 861 regulations. Some
commentators suggested that the simplified deduction method be used for
all costs, except for limited identified costs such as interest, for
which the section 861 method would continue to apply. Still other
commentators suggested that taxpayers be allowed to use other existing
cost allocation methods, such as those under section 263A or under
other government regulatory procedures.
In response to these comments, the IRS and Treasury Department have
modified the eligibility requirements for the simplified deduction
method. Under the proposed regulations, a taxpayer may use the
simplified deduction method if it has average annual gross receipts of
$25,000,000 or less, or total assets at the end of the taxable year of
$10,000,000 or less. However, the IRS and Treasury Department still
believe that for taxpayers above this threshold the section 861 method
is the appropriate method of allocating and apportioning deductions for
purposes of determining QPAI. Furthermore, the alternative allocation
methods suggested by commentators would each require additional rules
and guidance to address
[[Page 67234]]
the interaction of the suggested methods with other Federal income tax
rules and would result in administrative complexity and inefficiency.
The IRS and Treasury Department believe that use of the section 861
method will result in an appropriate cost allocation and apportionment
for purposes of section 199 and will be easier administratively for
both taxpayers and the IRS than any new, equally comprehensive cost
allocation and apportionment rules that might be created.
Section 1.199-4(f) of the proposed regulations provides that a
qualifying small taxpayer may use the ``small business simplified
overall method'' to apportion CGS and deductions to DPGR. Under Notice
2005-14, a qualifying small taxpayer is a taxpayer that has average
annual gross receipts of $5,000,000 or less or a taxpayer that is
eligible to use the cash method as provided in Rev. Proc. 2002-28
(2002-1 C.B. 815). The IRS and Treasury Department are concerned that
the $5,000,000 average annual gross receipts threshold without further
modification could be used by large taxpayers to circumvent the
requirements to allocate and apportion deductions using the section 861
method. As a result, a deduction limitation has been added to this
method. In addition, commentators requested that the definition of
qualifying small taxpayer for purposes of the small business simplified
overall method be expanded to include farmers that are not required to
use the accrual method under section 447. The proposed regulations
incorporate this suggestion. Accordingly, the proposed regulations
provide that a qualifying small taxpayer is a taxpayer that; (1) has
both average annual gross receipts of $5,000,000 or less, and CGS and
deductions (excluding NOL deductions and deductions not attributable to
the conduct of a trade or business) for the current taxable year of
$5,000,000 or less; (2) is engaged in the trade or business of farming
that is not required to use the accrual method under section 447; or
(3) is eligible to use the cash method as provided in Rev. Proc. 2002-
28.
Notice 2005-14 specifically requested comments on whether taxpayers
should be able to change between the three cost allocation methods of
section 199 on amended returns and whether there should be restrictions
on a taxpayer's ability to change from one method to another. Several
commentators suggested that a taxpayer should be allowed to change its
cost allocation method on an amended return and that a taxpayer should
be able to annually choose to use any of the three methods. The IRS and
Treasury Department agree that a taxpayer that qualifies to use a
particular allocation and apportionment method should be able to change
to that method at any time. Accordingly, the proposed regulations
generally provide that a taxpayer eligible to use the simplified
deduction method may choose at any time to use the simplified deduction
method or the section 861 method for a taxable year. A taxpayer
eligible to use the small business simplified overall method may choose
at any time to use the small business simplified overall method, the
simplified deduction method, or the section 861 method for a taxable
year. This rule does not affect, however, any restrictions or
limitations that apply within the section 861 method.
Pass-Thru Entities
Section 199 applies at the owner level in a manner consistent with
the economic arrangement of the owners of the pass-thru entity. Under
the proposed regulations, each owner computes its section 199 deduction
by taking into account its distributive or proportionate share of the
pass-thru entity's items (including items of income and gain, as well
as items of loss and deduction not otherwise disallowed by the Code),
CGS allocated to such items of income, and gross receipts included in
such items of income. In response to a commentator's inquiry, the
proposed regulations make it clear that the owner of a pass-thru entity
need not be engaged directly in the entity's trade or business in order
to claim a section 199 deduction on the basis of that owner's share of
the pass-thru entity's items.
Some commentators recommended that section 199 be applied to
partnerships by using an aggregate approach in situations where the
qualified production activities are conducted by the partnership, which
distributes or sells the QPP, qualified films, or utilities to a
partner who then leases, rents, licenses, sells, exchanges, or
otherwise disposes of the property, or where the qualified production
activities are conducted by a partner which contributes or sells the
QPP, qualified films, or utilities to the partnership, which then
leases, rents, licenses, sells, exchanges, or otherwise disposes of the
property. The commentators maintained that the income derived by the
partners and the partnerships from the lease, rental, license, sale,
exchange, or other disposition of the property in these situations
should be treated as QPAI and qualify for the section 199 deduction.
The proposed regulations do not follow the commentators' recommendation
because section 199(c)(4)(A) requires that the gross receipts must be
derived from the taxpayer's own qualified production activities to
qualify as DPGR. Accordingly, except for; (i) certain qualifying oil
and gas partnerships; and (ii) EAG partnerships, discussed below, the
proposed regulations provide that the owner of a pass-thru entity is
not treated as directly conducting the qualified production activities
of the pass-thru entity, and vice versa, with respect to the property
transferred between the pass-thru entity and the owner. This rule
applies to all partnerships, including partnerships that have elected
out of subchapter K under section 761(a). In addition, attribution of
activities does not apply for purposes of the construction of real
property and the performance of engineering and architectural services.
The proposed regulations, pursuant to the Congressional Letter,
provide a limited exception for certain partnerships in which all of
the capital and profits interests are owned by members of a single EAG
at all times during the taxable year of the partnership (EAG
partnership). For purposes of determining the DPGR of a partnership and
its partners, an EAG partnership and all members of the EAG in which
the partners of the EAG partnership are members are treated as a single
taxpayer during the taxable year for purposes of section 199(c)(4).
Thus, if an EAG partnership MPGE or produces property and distributes,
leases, rents, licenses, sells, exchanges, or otherwise disposes of
that property to a member of an EAG in which the partners of the EAG
partnership are members, then the MPGE or production activity conducted
by the EAG partnership will be treated as having been conducted by the
members of the EAG. Similarly, if one or more members of an EAG in
which the partners of an EAG partnership are members MPGE or produces
property, and contributes, leases, rents, licenses, sells, exchanges,
or otherwise disposes of that property to the EAG partnership, then the
MPGE or production activity conducted by the EAG member (or members)
will be treated as having been conducted by the EAG partnership.
Except as otherwise provided, an EAG partnership is generally
treated the same as other partnerships for purposes of section 199.
Accordingly, the proposed regulations provide that an EAG partnership
is subject to the rules of Sec. 1.199-5 regarding the application of
section 199 to pass-thru entities, and the application of the section
199(d)(1)(B)
[[Page 67235]]
wage limitation under Sec. 1.199-5(a)(3). Under the proposed
regulations, if an EAG partnership distributes property to a partner,
then, solely for purposes of section 199(d)(1)(B)(ii), the EAG
partnership is treated as having gross receipts in the taxable year of
the distribution equal to the fair market value of the property at the
time of distribution to the partner and the deemed gross receipts are
allocated to that partner, provided the partner derives gross receipts
from the distributed property during the taxable year of the partner
with or within which the partnership's taxable year (in which the
distribution occurs) ends. Costs included in the adjusted basis of the
distributed property and any other relevant deductions are taken into
account in computing the partner's QPAI. The proposed regulations
provide that the small business simplified overall method is not
available to EAG partnerships.
Another commentator asked whether the owner of a pass-thru entity
might have to perform multiple QPAI calculations, distinguishing
between pass-thru and non-pass-thru production activities. The proposed
regulations make it clear that, when determining its section 199
deduction, an owner of a pass-thru entity aggregates items of income
and expense from the entity (including W-2 wages) with its own items of
income and expense (including W-2 wages) for purposes of allocating and
apportioning deductions to DPGR. As noted above, the amount of W-2
wages of a pass-thru entity taken into account by an owner in applying
the wage limitation of section 199(b) is determined under section
199(d)(1)(B). The proposed regulations provide that in determining an
owner's allocable share of wages under section 199(d)(1)(B)(i), W-2
wages are deemed to be allocated in the same way as wage expense is
allocated. In the case of a non-grantor trust or estate, the W-2 wages
are deemed to be allocated among the trust or estate and the various
beneficiaries in the same manner as QPAI, as described below. Although
a pass-thru entity's QPAI is computed by deducting wages paid by the
entity during its entire taxable year, generally it is the pass-thru
entity's W-2 wages (as shown on the Forms W-2 for the calendar year
ending within that taxable year) that are used to compute the wage
limitation under section 199(b) and an owner's allocable share of wages
under section 199(d)(1)(B)(i). If QPAI, computed by taking into account
only the items of the pass-thru entity allocated to the owner, is not
greater than zero, the owner may not take into account the W-2 wages of
the entity in computing the section 199(b) wage limitation.
A commentator requested that the proposed regulations clarify and
illustrate by example how the section 199(d)(1)(B) wage limitation
applies in a tiered partnership structure. In particular, the
commentator suggested that the W-2 wages of a lower-tier partnership
with positive QPAI are properly allocable to the partner of the upper-
tier partnership even if the QPAI allocated to the partner from the
upper-tier partnership is less than zero. The proposed regulations do
not adopt this suggestion. The proposed regulations provide that the
section 199(d)(1)(B) wage limitation must be applied at each level in a
tiered structure. Thus, in a tiered structure, the owner of a pass-thru
entity (including an owner that itself is a pass-thru entity)
calculates the amounts described in section 199(d)(1)(B)(i) (allocable
share) and (d)(1)(B)(ii) (twice the applicable percentage of the QPAI
from the entity) separately with regard to its interest in that pass-
thru entity. The proposed regulations provide rules regarding the
treatment of W-2 wages when a pass-thru entity (upper-tier entity) owns
an interest in one or more other pass-thru entities (lower-tier
entities). An example in the proposed regulations illustrates the
application of these rules.
The proposed regulations contain special rules for trusts and
estates. To the extent that a grantor or another person is treated as
owning all or part of a trust under sections 671 through 679 (grantor
trust), the owner will compute its QPAI with respect to the owned
portion of the trust as if that QPAI had been generated by activities
performed directly by the owner. In the case of a non-grantor trust or
estate, the DPGR and expenses needed to compute the QPAI, as well as
the W-2 wages relevant to the computation of the wage limitation, must
be allocated among the trust or estate and its various beneficiaries.
Each beneficiary's share of the trust's or estate's QPAI (which will be
less than zero if the CGS and the deductions allocated and apportioned
to DPGR exceed the trust's or estate's DPGR) and W-2 wages will be
determined based on the proportion of the trust's or estate's
distributable net income (DNI), as defined by section 643(a), that is
deemed to be distributed to that beneficiary for that taxable year.
Similarly, the proportion of the entity's DNI that is not deemed
distributed by the trust or estate will determine the entity's share of
the QPAI and W-2 wages. In addition, if the trust or estate has no DNI
in a particular taxable year, any QPAI and W-2 wages are allocated to
the trust or estate, and not to any beneficiary.
Section 199(d)(1)(A)(i) provides that, in the case of an estate or
trust (or other pass-thru entity), section 199 shall apply at the
beneficiary (or similar) level. Pursuant to this provision, as
clarified by the Congressional Letter, the proposed regulations provide
that a trust or estate may claim the section 199 deduction to the
extent that QPAI is allocated to it.
Solely for purposes of determining the section 199 deduction for
the taxable year, the QPAI of a trust or estate must be computed by
allocating the expenses described in section 199(d)(5) under Sec.
1.652(b)-3 with respect to directly attributable expenses. With respect
to other expenses described in section 199(d)(5), a trust or estate
that qualifies for the simplified deduction method described in Sec.
1.199-4(e) must use that method, and any other trust or estate must use
the section 861 method described in Sec. 1.199-4(d). The small
business simplified overall method is not available to a trust or
estate.
Because the sale of an interest in a pass-thru entity does not
reflect the realization of DPGR by that entity, DPGR generally does not
include gain or loss recognized on the sale, exchange or other
disposition of an interest in the entity. However, consistent with
Notice 2005-14, if section 751(a) or (b) applies, then gain or loss
attributable to partnership assets giving rise to ordinary income under
section 751(a) or (b), the sale, exchange, or other disposition of
which would give rise to an item of DPGR, is taken into account in
computing the partner's section 199 deduction.
Section 199 applies to taxable years beginning after December 31,
2004. Accordingly, these proposed regulations apply to taxable years of
pass-thru entities that begin on or after January 1, 2005. The IRS and
Treasury Department recognize that a pass-thru entity will need to
provide certain information to its owners to allow those persons to
compute the section 199 deduction. No special provision with regard to
information reporting is made for electing large partnerships (ELPs) as
defined by section 775, which are subject to the same methods for
allocating and apportioning deductions as are other partnerships. Thus,
ELPs are required to provide the same information to their partners as
other partnerships for purposes of computing the section 199 deduction.
The IRS and the Treasury Department intend to provide information
reporting rules for
[[Page 67236]]
pass-thru entities in the relevant forms and instructions.
Agricultural and Horticultural Cooperatives
A commentator suggested that the proposed regulations provide that
patrons cannot include patronage dividends and per-unit retain
certificates in the computation of the QPAI from the patron's other
farming operations to the extent that those amounts were taken into
account by a cooperative in determining the cooperative's section 199
deduction. The commentator stated that in many cases, both the
cooperative and its patrons will be engaged in qualifying activities.
For example, gross receipts from crops raised by a farmer in the United
States may be eligible for the section 199 deduction as well as the
receipts the cooperative derives from the marketing of the crop. To
avoid duplication of section 199 benefits, the proposed regulations
clarify that under Sec. 1.199-6(h) patronage dividends and per-unit
allocations a patron receives from a cooperative that are taken into
account as part of the cooperative's computation of QPAI may not be
taken into account in computing the patron's QPAI from its own
qualifying activities. In addition, patronage dividends and per-unit
retain allocations include any advances on patronage or per-unit
retains paid in money made during the taxable year. Examples are
provided to illustrate this rule.
A commentator suggested that the proposed regulations clarify the
amount of the section 199 deduction a cooperative is required to pass
through to its patrons. Accordingly, the proposed regulations clarify
in Sec. 1.199-6(d) that the cooperative may, at its discretion, pass
through all, some, or none of the allowable section 199 deduction to
its patrons.
A commentator suggested that it would be useful if the proposed
regulations address whether a cooperative member of a federated
cooperative may pass through to its patrons the section 199 deduction
it receives as a patron cooperative. Accordingly, the proposed
regulations in Sec. 1.199-6(d) provide that a cooperative patron of a
federated cooperative may pass through the section 199 deduction it
receives to its member patrons.
A commentator requested that the proposed regulations address the
form, content, and timing of the patron notification requirements. The
commentator stated that the notice should not have to accompany the
patronage distribution. For instance, a cooperative should be permitted
to send out a notice passing through an estimated amount of the section
199 deduction at the time patronage dividends are paid and a second
notice (when the Federal income tax return is completed and the section
199 deduction is actually determined) covering anything that was not
passed through by the first notice, provided the notice is sent during
the payment period in section 1382(d). The proposed regulations provide
in Sec. 1.199-6(b) that, in order for a patron to qualify for the
section 199 deduction, the cooperative must designate the patron's
portion of the section 199 deduction in a written notice mailed by the
cooperative to its patrons no later than the 15th day of the ninth
month following the close of the cooperative's taxable year. The
cooperative may use the same written notice, if any, that it uses to
notify patrons of their respective allocations of patronage dividends,
or may use a separate timely written notice(s) to comply with this
section. The cooperative must report the amount of the patron's section
199 deduction on Form 1099-PATR, ``Taxable Distributions Received From
Cooperative,'' issued to the patron.
A commentator suggested that the proposed regulations clarify that
patrons (whether they use the cash or accrual method of accounting) are
entitled to claim the section 199 deduction passed through from the
cooperative on the return for the taxable year in which they receive
written notification from the cooperative. The proposed regulations
provide in Sec. 1.199-6(d) that patrons may claim the section 199
deduction for the taxable year they receive the written notice
informing them of the section 199 deduction amount.
A commentator suggested that the proposed regulations clarify that
the section 199 deduction of a cooperative is subject to the W-2 wage
limitation under section 199(b) at the cooperative level and that it is
not subject to a second W-2 wage limitation at the patron level to the
extent the section 199 deduction is passed through to its patrons. The
proposed regulations provide in Sec. 1.199-6(e) that the W-2 wage
limitation shall be applied only at the cooperative level whether or
not the cooperative chooses to pass through some or all of the section
199 deduction. In addition, the proposed regulations in Sec. 1.199-
6(d) provide that patrons may claim the section 199 deduction without
regard to the taxable income limitation.
A commentator suggested that the proposed regulations address what
happens when an audit determination results in a decrease in the amount
of a cooperative's section 199 deduction passed through to i