The IRS has issued final (REG-136459-09) and temporary (T.D. 9731) regulations allowing taxpayers to consider W-2 wages paid during a short taxable year in calculating their Section 199 domestic production activities deduction (DPAD), regardless of whether the short taxable year includes Dec. 31. Taxpayers may apply the regulations to any open year. Importantly, the proposed regulations address several controversial issues in the determination of DPAD.
The proposed regulations affect the treatment of contract manufacturing, films and oil, and reject the reasoning in United States v. Dean, 945 F.Supp.2d 1110 (C.D. Cal. 2013), which held that the assembly of gift baskets was a manufacturing activity and not solely packaging or repackaging for purposes of section 199.
Only one taxpayer may claim DPAD regarding a qualifying activity. Currently, the taxpayer with the benefits and burdens of ownership during the period in which the qualifying activity is performed is entitled to the deduction. The proposed regulations would eliminate this rule and assign the deduction to the party that performs the activity. In most contract manufacturing cases, this would assign the deduction to the contract manufacturer, whether or not its customer had the benefits and burdens of ownership during production.
Oil-related qualified production activities income is limited to a 6% DPAD, rather than the 9% allowed for other qualified activities income. The proposed regulations would clarify that the transportation or distribution of oil, gas or any primary product thereof is not oil-related income and therefore is eligible for the normal 9% DPAD.
The proposed regulations would also treat testing as a nonqualified activity, require each building in a multi-building project to be substantially renovated in order to qualify the entire project, clarify that a taxpayer who only approves or authorizes payments is not engaged in construction for DPAD purposes, incorporate previous legislative changes into the treatment of films, and require item testing to be performed after the elimination of embedded service income, as well as make other changes.
The proposed regulations are proposed to be effective after their publication as final regulations. However, several of the proposed changes reflect current IRS thinking, and taxpayers may encounter these positions in examination of returns for taxable years before the regulations are final.
Temporary regulations will require taxpayers to consider W-2 wages paid during a short taxable year, regardless of whether the short year includes Dec. 31. DPAD is normally limited to 50% of the amount of W-2 wages that can be attributed to domestic production and that are paid by the taxpayer during the calendar year ending during the taxable year. This would prevent a taxpayer from claiming a Section 199 deduction for any taxable year that was not considered to include Dec. 31. Authority to address this issue through regulations was extended to all short taxable years in the Tax Increase Prevention Act of 2014.
The regulations also clarify that when a trade or business (or a major portion thereof) is disposed of during a calendar year, the W-2 wages paid to employees of that trade or business (or major portion thereof) are to be allocated, and may be considered for the limitation on the Section 199 deduction, between the taxpayer reporting the trade or business for the period before the disposition of the trade or business and the taxpayer reporting the trade or business for the portion of the year after the acquisition. The allocation is based on the period during which the employees of the trade or business were employed by the respective taxpayers.
The regulations will be effective once they're published in the Federal Register. However, any taxpayer can apply the regulations to any year for which the limitations for assessment haven't expired. Taxpayers who limited their Section 199 deduction as a result of short years that didn't include Dec. 31 should consider filing amended returns in order to claim a larger Section 199 deduction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
