Regulations: Section 199 guidance, W-2 wage limitation

Section 199 guidance, W-2 wage limitation

The Treasury Department and IRS today released for publication in the Federal Register temporary regulations (T.D. 9731), and by cross-reference, proposed regulations (REG-136459-09) under section 199, and specifically concerning the qualified production activities income—QPAI.

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Background

Under section 199, a deduction is allowed at 9% for the lesser of: (1) the QPAI of the taxpayer for the tax year; or (2) taxable income determined without regard to section 199 for the tax year.  The rate of the deduction was 3% for tax years beginning in 2005 or 2006, and 6% for tax years beginning in 2007, 2008 or 2009.

The amount of the section 199 deduction for any tax year cannot exceed 50% of the W-2 wages for the tax year.  

Temporary, proposed regulations

The regulations incorporate a significant number of changes encompassing a variety of section 199 issues. Most notably, the temporary regulations [PDF 213 KB] address the determination of the W-2 wage limitation for taxpayers with a short tax year.  Prior to the issuance of the temporary regulations, taxpayers with short years that did not contain a calendar year-end (for example, a tax year from 1/1/20XX to 6/30/20XX) were seemingly unable to claim the section 199 deduction for the short tax year because a literal reading of the section 199 regulations suggested that the W-2 wage limitation for years without a calendar year end was “zero” (0).  The temporary regulations now clarify that in such instances, wages paid by the taxpayer during the short tax year may be included in the determination of the W-2 wage limitation, even if the short tax year does not contain a calendar year-end. 

Additionally, the proposed regulations [PDF 262 KB] provide guidance concerning, among other items, contract manufacturing; clarification of activities that qualify as manufacturing, producing, growing or extracting (MPGE); and the allocation of cost of goods sold.  

Many of the provisions included in the proposed regulations may significantly limit the scope of section 199 for certain taxpayers with specific fact patterns, some of which are summarized below:

  • The proposed regulations eliminate the “benefits and burdens of ownership” rule that allow taxpayers in certain contract manufacturing arrangements to claim the section 199 deduction.  The proposed regulations provide that only the party actually producing the property is to be treated as engaging in the qualifying activity for section 199.  
  • The proposed regulations include an example of a taxpayer that packages gift baskets via an assembly line, consistent with the facts provided in United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).  The example in the proposed regulations considers the taxpayer’s activity to be packaging, repacking, labeling or minor assembly that, if performed on a standalone basis, do not qualify as MPGE. Thus, the taxpayer in the example is not considered to have engaged in MPGE for purposes of section 199.    
  • With respect to the allocation of cost of goods sold, the proposed regulations clarify that a taxpayer may not segregate cost of goods sold into component costs and allocate those component costs between qualifying gross receipts and non-qualifying gross receipts—even if certain costs included in cost of goods sold can be associated with activities undertaken in a pre-section 199 year (e.g., retiree medical costs). 

A public hearing on the proposed regulations is scheduled for December 16, 2015, and comments concerning the proposed regulations and/or outlines of topics to be discussed at the hearing are due by a date that is 90 days after August 27, 2015 (the date when these regulations will be published in the Federal Register).

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