The IRS has issued temporary regulations dealing with allocation of W-2 wages for purposes of the domestic production activities deduction (DPAD) of IRC §199, along with proposed regulations dealing with that topic along with other issues related to DPAD. The temporary regulations are found in TD 9731 while the proposed regulations were released in REG-136459-09.
Generally IRC §199 provides a deduction from income for certain businesses engaged in qualifying activities. The following list quickly summarizes these rules:
- A deduction for qualifying taxpayers is allowed in the amount of 9% of the lesser of the
- The qualified production activities income (QPAI) of the taxpayer for the taxable year, or
- The taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income)
- The deduction may not exceed 50% of W-2 wages for the tax year of employees for employees performing services in the qualifying activity
- QPAI is defined as an amount equal to the excess (if any) of
- The taxpayer's domestic production gross receipts (DPGR, which are gross receipts from a qualifying activity) for such taxable year, over
- The sum of:
- The cost of goods sold (CGS) that are allocable to such receipts; and
- Other expenses, losses, or deductions (other than the deduction under section 199) that are properly allocable to such receipts.
The various topics discussed are detailed below.
The one area that has immediate impact will be the temporary regulations that deal with W-2 wages. The IRS found guidance was needed based on the following analysis of a specific situation:
In certain situations, a short taxable year may not include a calendar year ending within such short taxable year. Section 1.199-2(c) of the current regulations does not address these situations and does not reflect the amendment made by the Tax Increase Prevention Act of 2014. In order to provide guidance on the application of section 199(b)(3) to a short taxable year that does not include a calendar year ending within the short taxable year, the IRS and the Treasury Department are revising the regulations to address these situations. To provide immediate effect, the IRS and the Treasury Department are issuing these regulations as temporary regulations. These temporary regulations apply solely for purposes of section 199.
As the preamble describes the change:
The final regulations issued in connection with these temporary regulations remove the current language of §1.199-2(c) and replace it with a cross reference to these temporary regulations. In the place of the current language, these temporary regulations provide rules for calculating W-2 wages for purposes of the W-2 wage limitation in the case of an acquisition or disposition of a trade or business, the major portion of a trade or business, the major portion of a separate unit of a trade or business during the taxable year, or a short taxable year. Specifically, these temporary regulations provide a rule for acquisitions and dispositions if one or more taxpayers may be considered the employer of the employees of the acquired or disposed of trade or business during that calendar year. In that case, the temporary regulations provide that the W-2 wages paid during the calendar year to employees of the acquired or disposed of trade or business are allocated between each taxpayer based on the period during which the employees of the acquired or disposed of trade or business were employed by the taxpayer.
The temporary regulations provide that if there is a short tax year of a taxpayer for which there is no calendar year ending within that year, “[w] ages paid by a taxpayer during the short taxable year to employees for employment by such taxpayer are treated as W-2 wages for such short taxable year for purposes of” the DPAD W-2 wage limitation.
The temporary regulations are effective for tax years beginning on or after August 27, 2015 and expire on August 24, 2018. However, taxpayers may apply the rules contained in these regulations (Reg. §1.199-2T(c)) for any open tax year.
These temporary regulations are duplicated in the proposed regulations issued on the same day. However the proposed regulations contain provisions that will apply in other areas. The rest of this article discusses the proposed regulations which are not yet effective and will not be until they are published as final regulations by the IRS, at which point they would reflect any modifications the IRS might choose to make.
Oil Related Proposals
The IRS is proposing to make changes related to the interaction of the DPAD rules with oil and gas operations, specifically on the definition of QPAI.
The preamble notes:
…the proposed regulations define oil related QPAI as an amount equal to the excess (if any) of the taxpayer's DPGR from the production, refining, or processing of oil, gas, or any primary product thereof (oil related DPGR) over the sum of the CGS that is allocable to such receipts and other expenses, losses, or deductions that are properly allocable to such receipts. The proposed regulations specifically provide that oil related DPGR does not include gross receipts derived from the transportation or distribution of oil, gas, or any primary product thereof, except if the de minimis rule under §1.199-1(d)(3)(i) or an exception for embedded services applies under §1.199-3(i)(4)(i)(B). The proposed regulations further provide that, to the extent a taxpayer treats gross receipts derived from the transportation or distribution of oil, gas, or any primary product thereof as DPGR under §1.199-1(d)(3)(i) or §1.199-3(i)(4)(i)(B), the taxpayer must include those gross receipts in oil related DPGR.
The regulations define oil as “including oil recovered from both conventional and non-conventional recovery methods, including crude oil, shale oil, and oil recovered from tar/oil sands.”
The IRS’s proposed regulations in the area of construction activities first deal with what the IRS saw as taxpayers overly broadly interpreting construction activities to include entities that only approved or authorized payments related to construction activities.
The preamble notes:
The Treasury Department and the IRS disagree that a taxpayer who only approves or authorizes payments is engaged in construction for purposes of §1.199- 3(m)(2)(i). Accordingly, §1.199-3(m)(2)(i) of the proposed regulations clarifies that a taxpayer must engage in construction activities that include more than the approval or authorization of payments or invoices for that taxpayer's activities to be considered as activities typically performed by a general contractor.
The original regulations defined construction activities, as opposed to what might be thought of as “repair” or “maintenance” activities (which are not DPGR) in a way that roughly corresponded to how those are treated by the customer in determining whether the costs must be capitalized or can be currently expensed.
However, last year final regulations under IRC §263(a) revised those rules considerably and the IRS now believes the DPAD regulations need to be revised to conform to the new tangible property rules to bring back the same relationship.
Thus, the preamble notes:
Section 1.199-3(m)(2)(i) provides that activities constituting construction are activities performed in connection with a project to erect or substantially renovate real property. Section 1.199-3(m)(5) currently defines substantial renovation to mean the renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use. This standard reflects regulations under §1.263(a)-3 related to amounts paid to improve tangible property that existed at the time of publication of the final §1.199-3(m)(5) regulations ([71 FR 31268] June 19, 2006) but which have since been revised. See ([78 FR 57686] September 19, 2013).
The proposed regulations under §1.199-3(m)(5) revise the definition of substantial renovation to conform to the final regulations under §1.263(a)-3, which provide rules requiring capitalization of amounts paid for improvements to a unit of property owned by a taxpayer. Improvements under §1.263(a)-3 are amounts paid for a betterment to a unit of property, amounts paid to restore a unit of property, and amounts paid to adapt a unit of property to a new or different use. See §1.263(a)-3(j), (k), and (l).
Under the proposed regulations, a substantial renovation of real property is a renovation the costs of which are required to be capitalized as an improvement under §1.263(a)-3, other than an amount described in §1.263(a)-3(k)(1)(i) through (iii) (relating to amounts for which a loss deduction or basis adjustment requires capitalization as an improvement). The improvement rules under §1.263(a)-3 provide specific rules of application for buildings (see §1.263(a)-3(j)(2)(ii), (k)(2), and (l)(2)), which apply for purposes of §1.199-3(m)(5).
The proposed regulations contain a clarification related to CGS for long-term contracts.
Section 1.199-4(b)(1) describes how a taxpayer determines its CGS allocable to DPGR. The Treasury Department and the IRS are aware that in the case of transactions accounted for under a long-term contract method of accounting (either the percentage-of-completion method (PCM) or the completed-contract method (CCM)), a taxpayer incurs allocable contract costs. The Treasury Department and the IRS recognize that allocable contract costs under PCM or CCM are analogous to CGS and should be treated in the same manner. Section 1.199-4(b)(1) of the proposed regulations provides that in the case of a long-term contract accounted for under PCM or CCM, CGS for purposes of §1.199-4(b)(1) includes allocable contract costs described in §1.460-5(b) or §1.460-5(d), as applicable.
The IRS also has a concern about an overly-expansive view of DPGR in construction projects where only a portion represents a substantial renovation. Thus the proposed regulations provide:
The Treasury Department and the IRS are aware that the item rule in §1.199- 3(d)(2)(iii) has been interpreted to mean that the gross receipts derived from the sale of a multiple-building project may be treated as DPGR when only one building in the project is substantially renovated. The Treasury Department and the IRS have concluded that treating gross receipts from the sale of a multiple-building project as DPGR, and the multiple-building project as one item, is not a reasonable method satisfactory to the Secretary for purposes of §1.199-3(d)(2)(iii) if a taxpayer did not substantially renovate each building in the multiple-building project. Section 1.199- 3(d)(4) of the proposed regulations includes an example (Example 14) illustrating the appropriate application of §1.199-3(d)(2)(iii) to a multiple building project.
That example in the proposed regulation reads as follows:
Example 14. Z is engaged in the trade or business of construction under NAICS code 23 on a regular and ongoing basis. Z purchases a piece of property that has two buildings located on it. Z performs construction activities in connection with a project to substantially renovate building 1. Building 2 is not substantially renovated and together building 1 and building 2 are not substantially renovated, as defined under paragraph (m)(5) of this section. Z later sells building 1 and building 2 together in the normal course of Z's business. Z can use any reasonable method to determine what construction activities constitute an item under paragraph (d)(2)(iii) of this section. Z's method is not reasonable if Z treats the gross receipts derived from the sale of building 1 and building 2 as DPGR. This is because Z's construction activities would not have substantially renovated buildings 1 and 2 if they were considered together as one item.
Z's method is reasonable if it treats the construction activities with respect to building 1 as the item under paragraph (d)(2)(iii) of this section because the proceeds from the sale of building 1 constitute DPGR.
Manufactured, Produced, Grown or Extracted (MPGE)
The IRS includes a provision in the area of the definition of MPGE that is meant to overturn the result in the case of United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) which found that a taxpayer who prepared gift baskets was not simply repackaging but rather was involved in manufacturing.
The preamble notes:
Section 1.199-3(e)(2) provides that if a taxpayer packages, repackages, labels, or performs minor assembly of QPP and the taxpayer engages in no other MPGE activities with respect to that QPP, the taxpayer's packaging, repackaging, labeling, or minor assembly does not qualify as MPGE with respect to that QPP. This rule has been the subject of recent litigation. See United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013 (concluding that the taxpayer's activity of preparing gift baskets was a manufacturing activity and not solely packaging or repackaging for purposes of section 199). The Treasury Department and the IRS disagree with the interpretation of §1.199- 3(e)(2) adopted by the court in United States v. Dean, and the proposed regulations add an example (Example 9) that illustrates the appropriate application of this rule in a situation in which the taxpayer is engaged in no other MPGE activities with respect to the QPP other than those described in §1.199-3(e)(2).
The IRS proposes changing the test for who gets the DPAD in a contract manufacturing situation, getting rid of the “benefits and burdens” test. The preamble notes:
Taxpayers and the IRS have had difficulty determining which party to a contract manufacturing arrangement has the benefits and burdens of ownership of the property while the qualifying activity occurs. Cases analyzing the benefits and burdens of ownership have considered the following factors relevant: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest was acquired; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser and which party has control of the property or process; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; (8) which party receives the profits from the operation and sale of the property; and (9) whether a taxpayer actively and extensively participated in the management and operations of the activity. See ADVO, Inc. & Subsidiaries v. Commissioner, 141 T.C. 298, 324-25 (2013)141 T.C. 298, 324-25 (2013); see also Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)77 T.C. 1221 (1981). The ADVO court noted that the factors it used in its analysis are not exclusive or controlling, but that they were in the particular case sufficient to determine which party had the benefits and burdens of ownership. ADVO, Inc., 141 T.C. at 325141 T.C. at 325 n. 21. Determining which party has the benefits and burdens of ownership under Federal income tax principles for purposes of section 199 requires an analysis and weighing of many factors, which in some contexts could result in more than one taxpayer claiming the benefits of section 199 with respect to a particular activity. Resolving the benefits and burdens of ownership issue often requires significant IRS and taxpayer resources.
The IRS proposes to remove the above test and rather substitute the following new provision:
To provide administrable rules that are consistent with section 199, reduce the burden on taxpayers and the IRS in evaluating factors related to the benefits and burdens of ownership, and prevent more than one taxpayer from being allowed a deduction under section 199 with respect to any qualifying activity, the proposed regulations remove the rule in §1.199-3(f)(1) that treats a taxpayer in a contract manufacturing arrangement as engaging in the qualifying activity only if the taxpayer has the benefits and burdens of ownership during the period in which the qualifying activity occurs. In place of the benefits and burdens of ownership rule, these proposed regulations provide that if a qualifying activity is performed under a contract, then the party that performs the activity is the taxpayer for purposes of section 199(c)(4)(A)(i). This rule, which applies solely for purposes of section 199, reflects the conclusion that the party actually producing the property should be treated as engaging in the qualifying activity for purposes of section 199, and is therefore consistent with the statute's goal of incentivizing domestic manufacturers and producers. The proposed rule would also provide a readily administrable approach that would prevent more than one taxpayer from being allowed a deduction under section 199 with respect to any qualifying activity.
The proposed regulations contain guidance in other specific areas that advisers dealing with clients with activities in those areas should review. These include:
- Qualified film production
- Hedging transactions
- Agricultural and horticultural cooperatives