Monday, December 25, 2006


Internal Revenue Code Section 199 provides a deduction to domestic manufacturers and producers. In 2006 this deduction is 3%, it increases to 6% for tax years beginning in 2007-2009, and will be 9% in later years, and is applied generally to net income from manufacturing and production (subject to a number of limitations, including that the deduction cannot exceed 50% of the taxpayer's W-2 wages for the taxable year). The IRS has issued a new Industry Director Directive, which, along with an associated document titled “Minimum Checks for Section 199; Law and Explanation,” details the minimum audit checks IRS examiners are expected to complete when reviewing a corporation's deduction.

While compliance with these guidelines will not ensure complete compliance with the requirements for the deduction, they are useful for taxpayers to make sure they are meeting the basic requirements and that they will clear the major audit hurdles. The following summarizes the guidelines and issues that the IRS will review on audit:

1. Does the taxpayer's business make sense with the activity requirements of the domestic production deduction? For example, most resellers (such as clothing stores and wholesalers) should not be claiming the deduction, nor should most professional service companies since they are selling their services even if in this process they provide a tangible item such as a legal document. Auditors are advised to review the corporation's web site and annual report, among other sources, in answering this question.

2. Compare the deduction to the gross receipts or sales less returns and allowances on line 1(c) of the Form 1120 (U.S. Corporation Income Tax Return). Gross receipts reported on line 1(c) of the 1120 should be greater then the deduction. If the gross receipts on the Form 8903 match the gross receipts on line 1(c) of the Form 1120, the taxpayer may have not allocated to non-DPGR nonqualified income amounts such as gross receipts for services or for resale items
3. Is the taxpayer required to allocate gross receipts to remove nonqualified embedded service income, or determine the qualified income portion of a component of an item? If so, how did the taxpayer determine an allocation method?
4. If the taxpayer is required to use the Code Sec. 861 method to allocate and apportion deductions has the taxpayer used it and is it consistent with the application of Code Sec. 861 for foreign tax credit purposes, if applicable? The Code Sec. 861 method must be used to allocate and apportion deductions if the taxpayer's average annual gross receipts exceed $100,000,000 or total assets at the end of the tax year exceed $10,000,000.
5. Has the taxpayer applied the wage and taxable income limitations? For example, under Code Sec. 199(b)(2)(B) , for tax years beginning after May 17, 2006, W-2 wages for Code Sec. 199 purposes only include amounts that are properly allocable to domestic production gross receipts.
While these issues apply only to the small subset of taxpayers who take the deduction, it is worth the effort of those that do to review these guidelines and assure compliance with them.