The new Section 199 deduction, a boon to taxpayers who qualify, is anything but to the filers who are struggling with the new concepts, rules, exceptions and safe harbors of the legislation.The domestic production activities deduction, enacted as part of the American Jobs Creation Act of 2004,went into effect for tax years beginning after 2004 and permits taxpayers to claim a deduction from taxable income attributable to domestic production activities.
This is the first tax season that practitioners have had to deal with it, either at the corporate or the individual level.
"Section 199 is the No. 1 challenge that practitioners are facing," said Ann Petrie, senior tax manager at the Milwaukee office of Grant Thornton. "With the Treasury guidance coming out so late, practitioners are still trying to understand it, and there are still uncertainties in the area. It's a problem just to explain to our clients how the calculation is computed."
The Internal Revenue Services defines qualified production activities as including "manufacturing, producing, growing and extracting tangible personal property, computer software and sound recordings, and the construction and substantial renovation of real property including infrastructure. The production of certain films is also a qualifying activity, as are certain engineering or architectural services."
The deduction, intended to help offset the repeal of the extraterritorial income exclusion, is a percentage of the lesser of the taxpayer's qualified production activities income or taxable income for the taxable year. The specified percent increases from 3 percent for tax years beginning in 2005 and 2006, to 6 percent in tax years beginning in 2007 to 2009, and tops out at 9 percent for years after 2009.
"Congress could no longer provide export tax incentives, and they concluded that most exporters were manufacturers," said Dorothy Coleman, National Association of Manufacturers vice president for tax and domestic economic policy.
"Since they could not have an export-specific tax incentive, they created a deduction from income from domestic manufacturing activity," she said.
"The rules can get extremely complex. For example, for companies with international operations that manufacture in the U.S. and overseas," said Holly O'Connor, CPA, executive managing director and chief financial officer of Chicago-based True Partners, a tax and business advisory firm.
"There are plenty of gray areas," agreed New York-based CPA Alan Strauss, vice chairman of the New York State Society of CPAs' IRS Relations Committee. "The really difficult areas are where a taxpayer is engaged in a bunch of activities, or someone who manufactures and also has a company store. If you manufacture and sell at retail, you've got issues."
The fact that the deduction is calculated at the partnership or shareholder level for pass-through entities complicates matters, according to Petrie.
"It can become a real nightmare," she said. "The pass-through entity has to report on the K-1 the pieces of information, then the partner or shareholder has to calculate the deduction, taking into account all of his or her activities for which the deduction relates. If you have an interest in five S corporations, you'll get a K-1 from all five - then you have to combine five different activities to calculate the individual Section 199 deduction."
"We're seeing people struggling to get their arms around Section 199," said Mel Schwarz, a partner in Grant Thornton's national tax office. "The partnership figures out your share of the net profits, puts it on a K-1 and sends it to you - you put it on your Form 1040 and you're through. But with the production deduction, they send you the elements the partner will need, and let the partner calculate them himself."
Tom Limroth, a partner at Seminole, Fla., firm Donovan & Limroth CPAs PA, agreed. "That is what's slowing the most returns in our office right now," he explained. "We've got the calculations pretty much down, but we're working on determining which industries qualify for it. There are a lot of easy ones, but once you get beyond them, there's a fair amount of confusion."
"The complexities are unreal," agreed Atlanta-based attorney and CPA Patti Richards. "I don't think Congress had any idea how complex this would be or how complicated the interpretations would get."
For example, she noted, "If a taxpayer isn't eligible to use the simplified method for allocating deductions to domestic production gross receipts, they're asked to use the Section 861 method," she said. "For taxpayers who have never used that section, it's a nightmare."
In addition to the Committee Report accompanying the legislation, the IRS has issued two official interpretations of the rules. Notice 2005-14, issued a year ago, contains 30 pages of guidance, while the proposed regs, issued last fall, contain over 85 pages in the preamble alone, together with another 135 pages of regulations.
Where the notice and the regs are different, the taxpayer may rely on either one until the IRS comes out with final regs, advised Beth Mary Benko, a senior manager with the Washington office of Ernst & Young. "However, a taxpayer cannot use the notice's silence on an issue to justify not doing something required by the proposed regs," she said.
"There was some question as to exactly what is covered where production activity is in whole or in part in the United States," said CCH principal analyst Mark Luscombe. "The proposed regs go into extensive discussion. They conclude that the deduction will be applied on an item-by-item basis. For example, a shoe made overseas may have domestically manufactured shoe laces. The regs say you can segregate out the shoelace as a qualifying item and get the deduction."
"Businesses have to allocate between qualifying receipts and non-qualifying receipts, and that can be an accounting nightmare," added Fred Stein, senior tax analyst at RIA. "Notice 2005-14 provided the first major guidance on this, but it left a lot of questions unanswered. A lot of those were filled in by the proposed regs, but they haven't covered every single base yet."
"Some companies think it's just not worth the accounting cost, at least for the current couple of years," said Richards.
In fact, because computing the deduction is proving to be burdensome for some taxpayers, especially small taxpayers, the question has arisen as to whether it is a "required deduction," according to Benko, who authored BNA's portfolio on the deduction.
The Treasury says that the language that the deduction "shall be allowed" makes it mandatory, she indicated.
"However, what Treasury is concerned about is a taxpayer that may be experiencing losses on the sale of particular products," she said. "The taxpayer can't just choose to apply the deduction to revenue-producing products."
Limroth agreed that, given the cost of accounting, some are having second thoughts about the deduction. "For clients that do qualify, it may not be that significant this year, but we're stressing how significant it will become," he said. "It's important to get accounting systems in place now, especially for those who partially qualify, so we can better track their income."
"We have a couple of clients where the deduction will amount to a couple of hundred dollars, but we like to think our clients are growing, and the deduction is going to grow as well," he added. "Once the accounting system is in place to track it, there won't be that much of a headache."
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