November 22, 2006
Introduction
The amount of a taxpayer’s Section 199 deduction is limited to 50 percent of a taxpayer’s W-2 wages for the taxable year. As originally enacted, Section 199 provided that all W-2 wages could be used for purposes of determining the limitation. Section 199 also provided, however, that the amount of W-2 wages of a pass-through entity that could be considered was limited by the amount of qualifying activity performed by the entity.
On May 17, 2006, Section 199 was amended by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Under TIPRA, “W-2 wages” include only those amounts properly allocable to domestic production gross receipts (DPGR). TIPRA did, however, remove the limitation on the amount W-2 wages of a pass-through entity that may be considered, provided the wages are properly allocable to DPGR. These changes are effective for taxable years beginning after May 17, 2006.
In mid-October 2006, the IRS and Treasury published Rev. Proc. 2006-47, which provides methods to compute W-2 wages (as defined in Section 1.199-2(e)(1) — hereinafter “(e)(1) wages”) and published temporary regulations which provide methods for determining the amount of (e)(1) wages (calculated under Rev. Proc. 2006-47) that are properly allocable to DPGR.
The amount of a taxpayer’s Section 199 deduction is limited to 50 percent of a taxpayer’s W-2 wages for the taxable year. As originally enacted, Section 199 provided that all W-2 wages could be used for purposes of determining the limitation. Section 199 also provided, however, that the amount of W-2 wages of a pass-through entity that could be considered was limited by the amount of qualifying activity performed by the entity.
On May 17, 2006, Section 199 was amended by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Under TIPRA, “W-2 wages” include only those amounts properly allocable to domestic production gross receipts (DPGR). TIPRA did, however, remove the limitation on the amount W-2 wages of a pass-through entity that may be considered, provided the wages are properly allocable to DPGR. These changes are effective for taxable years beginning after May 17, 2006.
In mid-October 2006, the IRS and Treasury published Rev. Proc. 2006-47, which provides methods to compute W-2 wages (as defined in Section 1.199-2(e)(1) — hereinafter “(e)(1) wages”) and published temporary regulations which provide methods for determining the amount of (e)(1) wages (calculated under Rev. Proc. 2006-47) that are properly allocable to DPGR.
The temporary regulations provide, generally, that a taxpayer may determine the amount of (e)(1) wages “properly allocable” to DPGR using any “reasonable method that is satisfactory to the IRS based on all the facts and circumstances.” The regulations offer safe harbor methods for computing wages properly allocable to DPGR. The safe-harbor method a taxpayer uses depends on whether the taxpayer uses either the Section 861 or the simplified deduction method to allocate costs or whether the taxpayer uses the small business simplified overall method.
Wage expense safe harbor
Taxpayers using either the Section 861 method or the simplified deduction method to allocate costs may use the “Wage Expense Safe Harbor” to determine the amount of wages properly allocable to DPGR. Under the Wage Expense Safe Harbor, the amount of wages properly allocable to DPGR is determined by multiplying the amount of (e)(1) wages by a ratio. The ratio is the “taxpayer’s wage expense included in calculating qualified production activities income over the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income for the taxable year.” A taxpayer using either the Section 861 method or the simplified deduction method for cost allocation must use the same expense allocation and apportion methods that it uses to determine qualified production activities income to allocate and apportion wage expense for purpose of this safe harbor.
Small business simplified overall method safe harbor
Taxpayers using the small business simplified overall method may simply determine their W-2 wages allocable to DPGR by using the same ratio (DPGR/Total Gross receipts) and multiplying the ratio by the taxpayer’s (e)(1) wages.
Effect of TIPRA on expanded affiliated groups
Prior to the amendment to Section 199, it was irrelevant which member of an Expanded Affiliated Group (“EAG”) had the W-2 wage expense and whether those wages were allocable to DPGR, because W-2 wages of all the members of an EAG were aggregated. However, because the definition of W-2 wages changed under TIPRA, the temporary regulations take the position that the Section 199 deduction for members of an EAG may be reduced if: (1) the members do not join in the filing of a consolidated federal income tax return, and (2) one member of the EAG uses employees of another member of the EAG to perform qualifying activities and does not have (e)(1) wages attributable to qualifying activities.
W-2 effect of TIPRA on pass-through entities
Prior to TIPRA, a partner’s share of W-2 wages was the lesser of the partner’s allocable share of such wages, or two times three percent of the QPAI (Qualified Production Activities Income) computed by taking into account only the items of the partnership allocated to the partner for that taxable year. TIPRA removed the limitation based on QPAI. The temporary regulations provide guidance regarding the partner’s share of W-2 wages after the effective date of TIPRA. The temporary regulations clarify that a partnership allocates its W-2 ((e)(1) wages) wages among its partners in the same manner as wage expenses. After adding its share of (e)(1) wages from all sources, a partner then determines its “W-2 wages properly allocable” to DPGR. The regulations provide a special transitional rule for situations in which a partner and partnership have different taxable years, only one of which predates the effective date of TIPRA. Under the rule, the taxable year of the partnership governs.
Other provisions
The temporary regulations also address other issues not related to TIPRA. For example, the regulations provide relief in situations where, under existing rules, the same net operating loss could be used twice to limit the amount of a Section 199 deduction.
Effective dates
In general, the temporary regulations apply to taxable years beginning on or after Oct. 19, 2006, but may be applied for taxable years beginning after May 17, 2006. Certain provisions can be applied to any taxable year after Dec. 31, 2004.
Who to contact
For questions related to the new guidance, please contact:
David Auclair
National Tax Office
T 202.521.1515
E [email protected]
Mel Schwarz
National Tax Office
T 202.521.1564
E [email protected]
Richard Shevak
National Tax Office
T 202.521.1569
E [email protected]
Jim Wittmer
Strategic Federal Tax Services
T 215.656.3065
E [email protected]
The information contained herein is general in nature and is based on authorities that are subject to change. It is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the specific circumstances or needs, and may require consideration of non-tax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
© 2006 Grant Thornton LLP. All rights reserved. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying, or using any information storage and retrieval system, without written permission from Grant Thornton LLP.
For questions related to the new guidance, please contact:
David Auclair
National Tax Office
T 202.521.1515
E [email protected]
Mel Schwarz
National Tax Office
T 202.521.1564
E [email protected]
Richard Shevak
National Tax Office
T 202.521.1569
E [email protected]
Jim Wittmer
Strategic Federal Tax Services
T 215.656.3065
E [email protected]
The information contained herein is general in nature and is based on authorities that are subject to change. It is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the specific circumstances or needs, and may require consideration of non-tax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
© 2006 Grant Thornton LLP. All rights reserved. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying, or using any information storage and retrieval system, without written permission from Grant Thornton LLP.
This document supports Grant Thornton LLP’s marketing of professional services, and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document we encourage you to contact us or an independent tax advisor to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.