Sec. 199 deductions: Use statistical samplings

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Even expert tax practitioners can become confused by the complex tax rules pertaining to the Sec. 199 domestic "manufacturing" deduction. The IRS has already issued hundreds of pages of regulations on this issue.

Fortunately, it is also taking steps to cut down on some of the paperwork. Alert: The IRS continues to provide guidance for claiming the deduction. The latest missive explains how to use a statistical sampling for this purpose. (IRS Revenue Procedure 2007-35)

But the new IRS procedure only goes so far. It stops short of allowing blanket industrywide samplings without requiring taxpayers to apply their particular facts and circumstances.

First, here's some background information. The Sec. 199 deduction was authorized by the American Jobs Creation Act of 2004. The IRS originally set the deduction at 3 percent of the lesser of a company's qualified production activity income (QPAI), or its taxable income. The deduction percentage was hiked to 6 percenet for 2007 through 2009. It's scheduled to increase again to 9 percent for 2010 and beyond. QPAI is based on domestic production gross receipts (DPGR) from qualified manufacturing activities.

Furthermore, the IRS limits the annual deduction to 50% of W-2 wages. Production activities must be performed in whole or in significant part on U.S. soil.

Under the new IRS procedure, a statistical sampling may be used for the following purposes:

  1. The allocation of gross receipts between DPGR and non-DPGR.
  2. A determination whether gross receipts qualify as DPGR on an item-by-item basis.
  3. An allocation of the cost of goods sold between DPGR and non-DPGR.
  4. An allocation of deductions properly allocable to DPGR or gross income attributable to DPGR.

The guidelines on statistical sampling generally are effective for the tax years beginning after May 10, 2007. But a taxpayer can elect to apply the rules retroactively to the tax years beginning after 2004. In any event, once a client opens the door to statistical sampling, the IRS is free to challenge the methodology. The new procedure also outlines the technical requirements for statistical samplings. For instance, a sampling must be conducted in an "unbiased scientific manner" and judgment sampling can't be used. Some of the factors that may be used to determine if a statistical sample is appropriate are the time and cost of analyzing data and the availability of more accurate information.

Advisory: The new procedure provides the details of six samplings the IRS would approve. Find it at irb/2007-23_irb/ar10.html.

IRS OKs allocations for pass-through entities

In a companion ruling, the IRS now allows pass-through entities to calculate a partner's or S corporation shareholder's share of QPAI and W-2 wages at the entity level. (IRS Revenue Procedure 2007-34)The upshot: It will be easier to figure out Sec. 199 deductions for those individuals.

Generally, the Sec. 199 deduction is calculated at the partner or shareholder level of a pass-through entity. All items applicable to the deduction are passed through to the partner or shareholder. Previously, regulations authorized the IRS to permit an eligible entity to calculate a partner's or shareholder's share of QPAI and W-2 wages at the entity level.

New rules: The new IRS Revenue Procedure follows through on the authorization. It also establishes the methodology for allocating the appropriate share of QPAI and wages for the following entities:

  • Code Sec. 861 partnerships
  • Widely held pass-through entities
  • Small business pass-through entities

If an entity is eligible to calculate QPAI and W-2 wages at the entity level, it must use the appropriate cost-allocation method for that type of entity. Note: This new ruling is generally effective for the tax years beginning after May 10, 2007. However, taxpayers can elect to apply it to the tax years beginning after May 17, 2006. Advisory: Find Rev. Proc. 2007-34 at

Reprinted with permission from The Tax Strategist, August 2007. For continuing advice on this and numerous other tax strategies, go to Receive 2 FREE Bonus Reports and a 40% discount on The Tax Strategist when you use Promo Code WN0013.

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