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IRS Issues New Section 199 Guidance for a Short Tax Year

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Sep 10th 2015
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The “manufacturing deduction,” the name often used to describe the deduction for qualified domestic production activities under Section 199 of the tax code, can provide a big boost to traditional manufacturers, as well as other qualified business entities. But the deduction can't exceed certain annual limits. Now, the IRS has issued new regulations clarifying the rules in a short tax year.

Under Section 199, a business taxpayer can claim a deduction based on 9 percent of its qualified production activities income (QPAI). QPAI is equal to domestic production gross receipts minus the sum of:

  • The costs of goods sold that are allocable to the domestic production gross receipts.
  • Deductions, expenses, or losses that are directly allocable to the domestic production gross receipts.
  • Certain other deductions, expenses, and losses that are not directly allocable to domestic production gross receipts or another class of income.

Domestic production gross receipts include gross receipts derived from the sale, exchange, lease, rental, licensing, or other disposition of qualified production property manufactured, produced, grown, or extracted – in whole or in significant part – within the United States. However, the deduction can't exceed the company's taxable income for the year before the computation of QPAI. Furthermore, the annual deduction is limited to 50 percent of the W-2 wages paid by the company. This can be a significant restriction for some business entities.

According to Revenue Procedure 2006-47, the Section 199 computation of W-2 wages in a short tax year can only include wages reported on W-2s for the calendar year ending within the short tax year. Thus, if the short tax year doesn't include Dec. 31, the W-2 wage limit is zero.

The new guidance issued by the IRS, primarily in the form of temporary regulations, establishes rules for calculating W-2 wages in the event of an acquisition or disposition of a business, or a major part of it, in a short tax year. The temporary regs provide that the W-2 wages paid during the calendar year to employees of the business acquired or disposed of must be allocated between each taxpayer based on the period during which the employees were employed by the taxpayer.

The guidance also addresses the situation involving a short tax year in which there's no calendar year ending within the tax year. In this case, the wages paid by a taxpayer during the short tax year are treated as W-2 wages for the short tax year for Section 199 purposes.

Finally, the temporary regs describe the types of transactions that are considered either an acquisition or disposition under Section 199, including an incorporation, a formation, a liquidation, reorganization, or a purchase or sale of assets.

Although this new guidance on the manufacturing deduction is hardly groundbreaking, it does provide a blueprint for business taxpayers and practitioners with regards to the W-2 limit for Section 199 deductions in a short tax year.

The temporary regs are effective for tax years beginning on or after Aug. 27, 2015, and they expire on Aug. 24, 2018.

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