Revisiting the fully phased in Section 199 deduction

Year-end is quickly approaching, and the fall offers an opportunity to revisit available tax opportunities, one of which is the section 199 deduction.

The section 199 deduction, also known as the Domestic Production Activities Deduction, was introduced into US tax law as part of the American Jobs Creation Act of 2004. Beginning in tax years after 2009, the deduction is fully phased in at 9%, up from 6% for years 2007 – 2009 and from 3% for years 2005 - 2006. The deduction is currently permanent in nature, which is another reason revisiting the deduction is worthwhile.

There are technical complexities to address when calculating the section 199 deduction and the deduction has been designated as a Tier 1 issue by the IRS. However, the deduction can provide a valuable benefit for qualifying taxpayers. Eligible taxpayers should revisit their calculations annually to ensure they are complying with the applicable rules and applying the correct percentage in determining their potential deduction.

Eligible taxpayers

Taxpayers who may qualify for the Section 199 deduction include contractors, subcontractors, engineers, architects, manufacturers, qualified film producers, and software developers whose activities are primarily performed in the United States.

Types of taxpayers that qualify for the deduction include C-Corporations, individual owners of partnerships and S-Corporations, estates, trusts and their beneficiaries, and farming cooperatives.

Section 199 calculation basics

To figure out the deduction, an eligible taxpayer first must calculate its Domestic Productions Gross Receipts (DPGR). Next, the taxpayer must deduct the sum of allocable cost of goods sold and other expenses, losses and deductions which are properly allocable to DPGR to determine its Qualified Production Activity Income (QPAI). The required methods for allocating costs between DPGR and non-DPGR vary depending on the size of the taxpayer. For years after 2009, the deduction is equal to the lesser of the following:

  • 9% of QPAI for the taxable year
  • 9% of taxable income for the taxable year
  • 50% of eligible form W-2 wages

This deduction can then be used to offset taxable income for both regular tax and alternative minimum tax purposes.

Domestic Production Gross Receipts

A taxpayer must determine the portion of its gross receipts that are considered DPGR and gross receipts that are considered non-DPGR. Under the de minimis rules, all of the taxpayer’s gross receipts may be treated as DPGR if less than 5 percent of the taxpayer’s total gross receipts are non-DPGR.

Domestic Production Gross Receipts include gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of the following:

  • Qualifying production property which was manufactured, produced, grown, or extracted in whole or in significant part within the United States
  • Any qualified film produced in the United States
  • Electricity, natural gas, or potable water produced in the United States

Other types of DPGR include the following:

  • Construction of real property performed in the United States, including building and renovation of residential and commercial properties
  • Engineering or architectural services performed in the U.S. that relate to the construction of real property in the United States
  • The following types of gross receipts are not considered DPGR:
  • The sale of food and beverages prepared at a retail establishment, such as a restaurant
  • The transmission or distribution of electricity, natural gas, or potable water
  • The lease, rental, license, sale, exchange, or other disposition of land

Other recent section 199 developments

In the first tax court case with an opinion on the section 199 deduction, the tax court sided with Gibson and Associates, Inc., petitioner, regarding receipts that qualify as DPGR . Gibson & Associates, Inc. v. Commissioner, 136 T.C. No. 10 (February 24, 2011).

Gibson and Associates, Inc. is an engineering and heavy construction company that primarily erects and rehabilitates streets, bridges, airport runways and other related real property. The company also repairs and maintains real property. The court held that the petitioner’s receipts are DPGR to the extent the petitioner erected or substantially renovated real property. Substantial renovation includes materially increasing the value of real property, substantially prolonging the useful life of real property, and/or adapting the real property to a different or new use. Activities were not considered DPGR to the extent the activities included repairing or otherwise maintaining real property.

Conclusion

The fully phased in 9% section 199 deduction can provide a valuable benefit to eligible taxpayers. Eligible taxpayers should revisit their calculations annually to ensure they are properly identifying DPGR and non-DPGR, allocating costs under the appropriate method and applying the correct percentage for determining the potential deduction. Additionally, taxpayers should ensure they maintain proper documentation for their section 199 deduction to comply with IRS guidelines. Section 199 includes many additional provisions beyond the scope of this article, and eligible taxpayers should consult with their tax advisors regarding their business and particular situation when calculating the deduction.