The fact that the new regulations under Code Section 199, released on May 24, 2006, are the final regulations should not be interpreted as an indication that the Treasury and the Internal Revenue Service will not be looking at Code Sec. 199 for a while.For one thing, the final regulations were accompanied by temporary and proposed regulations covering specific issues, and a statement that none of the regulations, final or proposed, address the changes made to Code Sec. 199 by the newly-enacted Tax Increase Prevention and Reconciliation Act of 2005. As predicted by the Treasury in originally opposing the adoption of Code Sec. 199, this is becoming one of those all-too-common code sections where even lengthy guidance is never enough and the questions keep coming.
The good news for tax practitioners is that businesses and members, partners and shareholders of pass-through entities will need all the help that they can get to take maximum advantage of the new deduction without violating any of the myriad rules associated with its enactment and implementation.
And, as a group, tax advisors will likely get plenty of practice using them on behalf of the over 17 million taxpayers that the IRS estimated will be taking advantage of the deduction.
The final regulations
The final regulations take no dramatic departures from the proposed ones, but provide a number of helpful clarifications in response to submissions received regarding the proposed regulations. The regulations are effective June 1, 2006.
Among the clarifications included in the final regulations are the following:
* A Code Sec. 199 deduction cannot create or increase a net operating loss deduction.
* The 5 percent de minimis rule for allocating gross receipts to domestic production gross receipts is also allowed to treat de minimis DPGR gross receipts as non-DPGR.
* The "undue burden and expense" standard was meant to clarify the "readily available" standard, and does not expand the scope of the requirement to use specific identification.
* Cost of goods sold that relates to gross receipts recognized in a taxable year prior to the effective date of Sec. 199 must be allocated to non-DPGR.
* Special rules for government contracts can also apply to subcontractors.
* In determining whether the "in-whole-or-significant-part" test is met, taxpayers without cost of goods sold may look to the unadjusted depreciable basis of the qualifying production property to calculate the 20 percent test.
* The cost of creating intangible assets for computer software or sound recordings, and the costs of developing certain computer software, are included in both direct labor and overhead and cost of goods sold or unadjusted depreciable basis for purposes of the 20 percent safe harbor test, even if the costs are incurred in a prior tax year.
* Computer software updates may qualify as DPGR even if provided as part of a maintenance agreement.
* Despite the preamble to the original proposed regulations, it is possible that, under the right circumstances, business information reports may qualify for the Code Sec. 199 deduction.
* A safe harbor is provided for exchanges involving oil, natural gas and petrochemicals, or products derived therefrom.
* All financing and interest components of a lease of qualifying property are considered to be derived from the lease of such qualifying property.
* Several helpful clarifications are included with respect to the Code Sec. 199 treatment of qualified films.
* A definition is provided for tangible personal property that differentiates land, real property under the construction rules, certain computer software, certain sound recordings, qualified film, and certain utilities, and includes certain gases and chemicals. Real property for Code Section 199 purposes is also defined.
* The availability of the simplified deduction method is expanded.
* The final regulations also include several clarifications related to the treatment of the construction of real property, expanded affiliated groups and pass-through entities.
The final regulations make several clarifications to the calculation of W-2 wages in response to various inquiries:
* Payments to employees for domestic services in a private home of the taxpayer are not included in W-2 wages.
* Clients of professional employer organizations may only include W-2 wages paid by the PEO in their Code Sec. 199 calculation if the employee at issue is a common law employee of the client.
* Married individuals filing a joint return are treated as one taxpayer for the purposes of determining W-2 wages.
Several clarifications are also made to the application of the item-by-item standard introduced in the proposed regs:
* The item-by-item standard applies solely for determining whether the gross receipts derived from an item are DPGR.
* An item is defined with reference to the property offered by a taxpayer for lease, rental, license, sale, exchange or other disposition to the taxpayer's customers, whether the taxpayer is a wholesaler or a retailer.
* Each component of an item that meets the Code Sec. 199 requirements must be treated as a separate item.
* If the taxpayer cannot determine without undue burden whether acquired property contains any original qualifying property, or the amount, grade or kind of qualifying property, then the taxpayer is not required to determine whether any portion of the acquired property qualifies as an item.
The proposed regulations had taken the position that online software does not qualify under Code Sec. 199. A set of temporary and proposed regulations would relax this rule in a couple of significant areas.
First, if the online software is identical to software affixed to a tangible medium from which gross receipts are derived from its disposition, the online software may also qualify under Code Sec. 199. Even if the taxpayer itself does not affix the software to a tangible medium, the online software may still qualify if an unrelated party affixes substantially identical software to a tangible medium.
Second, a safe harbor is created by classifying all computer software games as substantially identical software. This would generally make all online games qualify under Code Sec. 199.
These rules are effective for tax years beginning on or after June 1, 2006, although a taxpayer may apply them to tax years beginning after Dec. 31, 2004, and before June 1, 2006.
Calculation of W-2 wages
The IRS had previously provided three methods for calculating W-2 wages for Code Sec. 199 purposes. TIPRA changed the method of calculating W-2 wages to include only those wages associated with DPGR, effective after May 17, 2006.
The IRS has not yet provided guidance as to how to comply with the new requirements of TIPRA. Revenue Procedure 2006-22 has been issued, however, addressing how to apply the W-2 calculation for those taxpayers who choose to apply the final regulations to tax years beginning before June 1, 2006, but only for tax years beginning on or after Jan. 1, 2005, and on or before May 17, 2006.
As tax practitioners struggle to help their clients fully understand how best to take advantage of Code Sec. 199, any amount of further guidance is a plus. These final regulations on the whole appear to try to respond favorably to practitioner concerns as to the application of Code Sec. 199 in circumstances unanticipated in the proposed regulations.
Many questions remain, and the recent TIPRA legislation restricting the use of W-2 wages was not helpful, but at least the additional clarity moves tax practitioners a few steps closer to helping their clients.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a WoltersKluwer company.
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