Internal Revenue Bulletin 2006-25

Bulletin No. 2006-25

June 19, 2006







HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.





INCOME TAX Notice 2006–51, page 1144.

Renewable electricity production and refined coal pro-

duction; calendar year 2006 inflation adjustment factor

Rev. Rul. 2006–30, page 1134. and reference prices. This notice announces the calendar

Interest rates; underpayments and overpayments. The year 2006 inflation adjustment factor and reference prices for

rate of interest determined under section 6621 of the Code the renewable electricity production credit and refined coal pro-

for the calendar quarter beginning July 1, 2006, will be 8 per- duction credit under section 45 of the Code.

cent for overpayments (7 percent in the case of a corporation),

8 percent for underpayments, and 10 percent for large corpo- Rev. Proc. 2006–28, page 1147.

rate underpayments. The rate of interest paid on the portion of Guidance is provided to individuals who fail to meet the eligi-

a corporate overpayment exceeding $10,000 will be 5.5 per- bility requirements of section 911(d)(1) of the Code because

cent. adverse conditions in a foreign country preclude the individu-

als from meeting those requirements. A list of the country for

Rev. Rul. 2006–31, page 1133. tax year 2005 and the date that country is subject to the sec-

Regulated investment company (RIC). This ruling modifies tion 911(d)(4) waiver is provided.

Rev. Rul. 2006–1 to extend until September 30, 2006, the

transition period provided by that ruling, and clarifies that Rev.

Rul. 2006–1 was not intended to preclude a conclusion that

income from certain instruments (such as structured notes)

EMPLOYEE PLANS

that create a commodity exposure for the holder is qualifying

income under section 851(b)(2) of the Code. Rev. Rul. 2006–1 Notice 2006–55, page 1146.

modified and clarified. Weighted average interest rate update; 30-year Trea-

sury securities. The weighted average interest rate for June

T.D. 9263, page 1063. 2006 and the resulting permissible range of interest rates used

Final regulations under section 199 of the Code relate to the to calculate current liability and to determine the required con-

deduction for income attributable to domestic production activ- tribution are set forth.

ities. Section 199 was enacted as part of the American Jobs

Creation Act (AJCA) of 2004, and allows a deduction equal to 3

percent (for 2005 and 2006) of the lesser of the qualified pro- EXCISE TAX

duction activities income of the taxpayer for the taxable year, or

the taxable income of the taxpayer for the taxable year, subject

to certain limits. The applicable percentage rises to 6 percent Notice 2006–50, page 1141.

for 2007, 2008, and 2009, and 9 percent for 2010 and sub- This notice announces that the Service will follow the holding of

sequent years. Notice 2005–14 obsoleted for taxable years Am. Bankers Ins. Group v. United States, 408 F.3d 1328 (11th

beginning on or after June 1, 2006. Cir. 2005). The notice provides related guidance to taxpayers

and collectors. Notice 2005–79 revoked.









Finding Lists begin on page ii.

The IRS Mission

Provide America’s taxpayers top quality service by helping applying the tax law with integrity and fairness to all.

them understand and meet their tax responsibilities and by





Introduction

The Internal Revenue Bulletin is the authoritative instrument of court decisions, rulings, and procedures must be considered,

the Commissioner of Internal Revenue for announcing official and Service personnel and others concerned are cautioned

rulings and procedures of the Internal Revenue Service and for against reaching the same conclusions in other cases unless

publishing Treasury Decisions, Executive Orders, Tax Conven- the facts and circumstances are substantially the same.

tions, legislation, court decisions, and other items of general

interest. It is published weekly and may be obtained from the

The Bulletin is divided into four parts as follows:

Superintendent of Documents on a subscription basis. Bulletin

contents are compiled semiannually into Cumulative Bulletins,

which are sold on a single-copy basis. Part I.—1986 Code.

This part includes rulings and decisions based on provisions of

It is the policy of the Service to publish in the Bulletin all sub- the Internal Revenue Code of 1986.

stantive rulings necessary to promote a uniform application of

the tax laws, including all rulings that supersede, revoke, mod- Part II.—Treaties and Tax Legislation.

ify, or amend any of those previously published in the Bulletin. This part is divided into two subparts as follows: Subpart A,

All published rulings apply retroactively unless otherwise indi- Tax Conventions and Other Related Items, and Subpart B, Leg-

cated. Procedures relating solely to matters of internal man- islation and Related Committee Reports.

agement are not published; however, statements of internal

practices and procedures that affect the rights and duties of

taxpayers are published. Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to these

subjects are contained in the other Parts and Subparts. Also

Revenue rulings represent the conclusions of the Service on the included in this part are Bank Secrecy Act Administrative Rul-

application of the law to the pivotal facts stated in the revenue ings. Bank Secrecy Act Administrative Rulings are issued by

ruling. In those based on positions taken in rulings to taxpayers the Department of the Treasury’s Office of the Assistant Sec-

or technical advice to Service field offices, identifying details retary (Enforcement).

and information of a confidential nature are deleted to prevent

unwarranted invasions of privacy and to comply with statutory

requirements. Part IV.—Items of General Interest.

This part includes notices of proposed rulemakings, disbar-

ment and suspension lists, and announcements.

Rulings and procedures reported in the Bulletin do not have the

force and effect of Treasury Department Regulations, but they

may be used as precedents. Unpublished rulings will not be The last Bulletin for each month includes a cumulative index

relied on, used, or cited as precedents by Service personnel in for the matters published during the preceding months. These

the disposition of other cases. In applying published rulings and monthly indexes are cumulated on a semiannual basis, and are

procedures, the effect of subsequent legislation, regulations, published in the last Bulletin of each semiannual period.







The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.



For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.









June 19, 2006 2006–25 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code

of 1986

Section 199.—Income SUPPLEMENTARY INFORMATION: Act of 2004 (Public Law 108–357, 118

Attributable to Domestic Stat. 1418) (Act), and amended by section

Production Activities Paperwork Reduction Act 403(a) of the Gulf Opportunity Zone Act

of 2005 (Public Law 109–135, 119 Stat.

26 CFR 1.199–1: Income attributable to domestic The collection of information con-

production activities.

25) (GOZA) and section 514 of the Tax

tained in these final regulations has been Increase Prevention and Reconciliation

reviewed and approved by the Office Act of 2005 (Public Law 109–222, 120

T.D. 9263 of Management and Budget in accor- Stat. 345) (TIPRA). On January 19, 2005,

dance with the Paperwork Reduction Act the IRS and Treasury Department issued

DEPARTMENT OF

(44 U.S.C. 3507) under control number Notice 2005–14, 2005–1 C.B. 498, provid-

THE TREASURY 1545–1966. Responses to this collec- ing interim guidance on section 199. On

Internal Revenue Service tion of information are mandatory so that November 4, 2005, the IRS and Treasury

26 CFR Parts 1 and 602 patrons of agricultural and horticultural Department published in the Federal Reg-

cooperatives may claim the section 199 ister proposed regulations under section

Income Attributable to deduction. 199 (REG–105847–05, 2005–47 I.R.B.

Domestic Production Activities An agency may not conduct or sponsor, 987 [70 FR 67220]) (proposed regula-

and a person is not required to respond tions). On January 11, 2006, the IRS and

AGENCY: Internal Revenue Service to, a collection of information unless the Treasury Department held a public hearing

(IRS), Treasury. collection of information displays a valid on the proposed regulations. Written and

control number assigned by the Office of electronic comments responding to the

ACTION: Final regulations. Management and Budget. proposed regulations were received. This

The estimated annual burden per re- preamble describes the most significant

SUMMARY: This document contains fi-

spondent varies from 15 minutes to 10 comments received by the IRS and Trea-

nal regulations concerning the deduction

hours, depending on individual circum- sury Department. Because of the large

for income attributable to domestic pro-

stances, with an estimated average of 3 volume of comments received, however,

duction activities under section 199 of the

hours. the IRS and Treasury Department are not

Internal Revenue Code. Section 199 was

Comments concerning the accuracy able to address all of the comments in this

enacted as part of the American Jobs Cre-

of this burden estimate and sugges- preamble. After consideration of all of

ation Act of 2004 (Act). The regulations

tions for reducing this burden should the comments, the proposed regulations

will affect taxpayers engaged in certain do-

be sent to the Internal Revenue Service, are adopted as amended by this Trea-

mestic production activities.

Attn: IRS Reports Clearance Officer, sury decision. Contemporaneous with

DATES: Effective Date: These regulations SE:W:CAR:MP:T:T:SP, Washington, DC the publication of these final regulations,

are effective June 1, 2006. 20224, and to the Office of Manage- temporary (T.D. 9262, 2006–24 I.R.B.

Date of Applicability: For date of appli- ment and Budget, Attn: Desk Officer for 1040) and proposed (REG–111578–06,

cability, see §§1.199–8(i) and 1.199–9(k). the Department of the Treasury, Office 2006–24 I.R.B. 1060) regulations have

of Information and Regulatory Affairs, been published involving the treatment

FOR FURTHER INFORMATION Washington, DC 20503. under section 199 of computer software

CONTACT: Concerning §§1.199–1, Books or records relating to this col- provided to customers over the Internet.

1.199–3, 1.199–6, and 1.199–8, lection of information must be retained as

Paul Handleman or Lauren Ross long as their contents may become mate- General Overview

Taylor, (202) 622–3040; concern- rial in the administration of any internal

ing §1.199–2, Alfred Kelley, (202) revenue law. Generally, tax returns and tax Section 199(a)(1) allows a deduction

622–6040; concerning §1.199–4(c) return information are confidential, as re- equal to 9 percent (3 percent in the case of

and (d), Richard Chewning, (202) quired by 26 U.S.C. 6103. taxable years beginning in 2005 or 2006,

622–3850; concerning all other pro- and 6 percent in the case of taxable years

visions of §1.199–4, Jeffery Mitchell, Background beginning in 2007, 2008, or 2009) of the

(202) 622–4970; concerning §1.199–7, lesser of (A) the qualified production ac-

Ken Cohen, (202) 622–7790; concern- This document amends 26 CFR part tivities income (QPAI) of the taxpayer for

ing §1.199–9, Martin Schaffer, (202) 1 to provide rules relating to the deduc- the taxable year, or (B) taxable income (de-

622–3080 (not toll-free numbers). tion for income attributable to domestic termined without regard to section 199) for

production activities under section 199 the taxable year (or, in the case of an indi-

of the Internal Revenue Code (Code). vidual, adjusted gross income (AGI)).

Section 199 was added to the Code by Section 199(b)(1) limits the deduction

section 102 of the American Jobs Creation for a taxable year to 50 percent of the W–2







2006–25 I.R.B. 1063 June 19, 2006

wages paid by the taxpayer during the cal- adjusted basis of leased or rented prop- Section 199(c)(4)(D) provides that for

endar year that ends in such taxable year. erty when the lease or rental gives rise to purposes of section 199(c)(4), if all of the

For this purpose, section 199(b)(2) defines DPGR. If the property has been exported interests in the capital and profits of a part-

the term W–2 wages to mean, with respect by the taxpayer for further manufacture, nership are owned by members of a sin-

to any person for any taxable year of such the increase in cost or adjusted basis gle expanded affiliated group (EAG) at all

person, the sum of the amounts described must not exceed the difference between times during the taxable year of such part-

in section 6051(a)(3) and (8) paid by such the value of the property when exported nership, the partnership and all members

person with respect to employment of em- and its value when brought back into the of such group shall be treated as a single

ployees by such person during the calen- United States after further manufacture. taxpayer during such period.

dar year ending during such taxable year. Section 199(c)(4)(A) defines DPGR to Section 199(c)(5) defines QPP to mean:

The term W–2 wages does not include any mean the taxpayer’s gross receipts that are (A) tangible personal property; (B) any

amount that is not properly included in a derived from: (i) any lease, rental, license, computer software; and (C) any property

return filed with the Social Security Ad- sale, exchange, or other disposition of described in section 168(f)(4) (certain

ministration on or before the 60th day after (I) qualifying production property (QPP) sound recordings).

the due date (including extensions) for the that was manufactured, produced, grown, Section 199(c)(6) defines a qualified

return. Section 199(b)(3) provides that the or extracted (MPGE) by the taxpayer in film to mean any property described in

Secretary shall prescribe rules for the ap- whole or in significant part within the section 168(f)(3) if not less than 50 per-

plication of section 199(b) in the case of an United States; (II) any qualified film pro- cent of the total compensation relating to

acquisition or disposition of a major por- duced by the taxpayer; or (III) electricity, production of the property is compensation

tion of either a trade or business or a sep- natural gas, or potable water (collectively, for services performed in the United States

arate unit of a trade or business during the utilities) produced by the taxpayer in the by actors, production personnel, directors,

taxable year. United States; (ii) in the case of a taxpayer and producers. The term does not include

Section 514(a) of TIPRA amended sec- engaged in the active conduct of a con- property with respect to which records

tion 199(b)(2) by excluding from the term struction trade or business, construction are required to be maintained under 18

W–2 wages any amount that is not prop- of real property performed in the United U.S.C. 2257 (generally, films, videotapes,

erly allocable to domestic production gross States by the taxpayer in the ordinary or other matter that depict actual sexually

receipts (DPGR) for purposes of section course of such trade or business; or (iii) in explicit conduct and are produced in whole

199(c)(1). The IRS and Treasury Depart- the case of a taxpayer engaged in the active or in part with materials that have been

ment plan on issuing regulations on the conduct of an engineering or architectural mailed or shipped in interstate or foreign

amendments made to section 199(b)(2) by services trade or business, engineering commerce, or are shipped or transported

section 514 of TIPRA. or architectural services performed in the or are intended for shipment or transporta-

United States by the taxpayer in the ordi- tion in interstate or foreign commerce).

Qualified Production Activities Income nary course of such trade or business with Section 199(c)(7) provides that DPGR

respect to the construction of real property does not include any gross receipts of the

Section 199(c)(1) defines QPAI for any

in the United States. taxpayer derived from property leased, li-

taxable year as an amount equal to the ex-

Section 199(c)(4)(B) excepts from censed, or rented by the taxpayer for use

cess (if any) of (A) the taxpayer’s DPGR

DPGR gross receipts of the taxpayer that by any related person. However, DPGR

for such taxable year, over (B) the sum of

are derived from: (i) the sale of food and may include such property if the property

(i) the cost of goods sold (CGS) that are al-

beverages prepared by the taxpayer at a is held for sublease, sublicense, or rent, or

locable to such receipts; and (ii) other ex-

retail establishment; (ii) the transmission is subleased, sublicensed, or rented, by the

penses, losses, or deductions (other than

or distribution of utilities; or (iii) the lease, related person to an unrelated person for

the deduction under section 199) that are

rental, license, sale, exchange, or other the ultimate use of the unrelated person.

properly allocable to such receipts.

disposition of land. See footnote 29 of H.R. Conf. Rep. No.

Section 199(c)(2) provides that the Sec-

Section 199(c)(4)(C) provides that 755, 108th Cong. 2d Sess. 260 (2004)

retary shall prescribe rules for the proper

gross receipts derived from the manufac- (Conference Report). A person is treated

allocation of items described in section

ture or production of any property de- as related to another person if both persons

199(c)(1) for purposes of determining

scribed in section 199(c)(4)(A)(i)(I) shall are treated as a single employer under ei-

QPAI. Such rules shall provide for the

be treated as meeting the requirements of ther section 52(a) or (b) (without regard to

proper allocation of items whether or not

section 199(c)(4)(A)(i) if (i) such prop- section 1563(b)), or section 414(m) or (o).

such items are directly allocable to DPGR.

erty is manufactured or produced by the

Section 199(c)(3) provides special rules Pass-thru Entities

taxpayer pursuant to a contract with the

for determining costs in computing QPAI.

Federal Government, and (ii) the Federal

Under these special rules, any item or Section 199(d)(1)(A) provides that, in

Acquisition Regulation requires that title

service brought into the United States is the case of a partnership or S corpora-

or risk of loss with respect to such property

treated as acquired by purchase, and its tion, (i) section 199 shall be applied at the

be transferred to the Federal Government

cost is treated as not less than its value im- partner or shareholder level, (ii) each part-

before the manufacture or production of

mediately after it enters the United States. ner or shareholder shall take into account

such property is complete.

A similar rule applies in determining the such person’s allocable share of each item







June 19, 2006 1064 2006–25 I.R.B.

described in section 199(c)(1)(A) or (B) tion is equal to the applicable percent Section 199(d)(3)(F) provides that, for

(determined without regard to whether the of the lesser of the taxpayer’s (A) QPAI purposes of section 199(d)(3), the term

items described in section 199(c)(1)(A) for the taxable year, or (B) AGI for the specified agricultural or horticultural co-

exceed the items described in section taxable year determined after applying operative means an organization to which

199(c)(1)(B)), and (iii) each partner or sections 86, 135, 137, 219, 221, 222, and part I of subchapter T applies that is en-

shareholder shall be treated for purposes 469, and without regard to section 199. gaged (i) in the MPGE in whole or in sig-

of section 199(b) as having W–2 wages nificant part of any agricultural or horti-

for the taxable year in an amount equal Patrons of Certain Cooperatives cultural product, or (ii) in the marketing of

to the lesser of (I) such person’s allocable agricultural or horticultural products.

Section 199(d)(3)(A) provides that any

share of the W–2 wages of the partnership

person who receives a qualified payment Expanded Affiliated Group

or S corporation for the taxable year (as

from a specified agricultural or horticul-

determined under regulations prescribed

tural cooperative shall be allowed for the Section 199(d)(4)(A) provides that all

by the Secretary), or (II) 2 times 9 percent

taxable year in which such payment is re- members of an EAG are treated as a single

(3 percent in the case of taxable years

ceived a deduction under section 199(a) corporation for purposes of section 199.

beginning in 2005 or 2006, and 6 percent

equal to the portion of the deduction al- Section 199(d)(4)(B) provides that an

in the case of taxable years beginning in

lowed under section 199(a) to such coop- EAG is an affiliated group as defined in

2007, 2008, or 2009) of so much of such

erative which is (i) allowed with respect to section 1504(a), determined by substitut-

person’s QPAI as is attributable to items

the portion of the QPAI to which such pay- ing “more than 50 percent” for “at least 80

allocated under section 199(d)(1)(A)(ii)

ment is attributable, and (ii) identified by percent” each place it appears and without

for the taxable year.

such cooperative in a written notice mailed regard to section 1504(b)(2) and (4).

Section 514(b) of TIPRA amended

to such person during the payment period Section 199(d)(4)(C) provides that, ex-

section 199(d)(1)(A)(iii) to provide in-

described in section 1382(d). cept as provided in regulations, the sec-

stead that each partner or shareholder

Section 199(d)(3)(B) provides that the tion 199 deduction is allocated among the

shall be treated for purposes of section

taxable income of a specified agricultural members of the EAG in proportion to each

199(b) as having W–2 wages for the

or horticultural cooperative shall not be re- member’s respective amount (if any) of

taxable year equal to such person’s al-

duced under section 1382 by reason of that QPAI.

locable share of the W–2 wages of the

portion of any qualified payment as does

partnership or S corporation for the tax- Trade or Business Requirement

not exceed the deduction allowable under

able year (as determined under regulations

section 199(d)(3)(A) with respect to such

prescribed by the Secretary). The IRS Section 199(d)(5) provides that sec-

payment.

and Treasury Department plan on issuing tion 199 is applied by taking into account

Section 199(d)(3)(C) provides that, for

regulations on the amendments made to only items that are attributable to the ac-

purposes of section 199, the taxable in-

section 199(d)(1)(A)(iii) by section 514 of tual conduct of a trade or business.

come of a specified agricultural or hor-

TIPRA.

ticultural cooperative shall be computed Alternative Minimum Tax

Section 199(d)(1)(B) provides that, in

without regard to any deduction allowable

the case of a trust or estate, (i) the items

under section 1382(b) or (c) (relating to pa- Section 199(d)(6) provides that, for

referred to in section 199(d)(1)(A)(ii) (as

tronage dividends, per-unit retain alloca- purposes of determining the alternative

determined therein) and the W–2 wages

tions, and nonpatronage distributions). minimum taxable income under section

of the trust or estate for the taxable year,

Section 199(d)(3)(D) provides that, 55, (A) QPAI shall be determined without

shall be apportioned between the benefi-

for purposes of section 199, a specified regard to any adjustments under sections

ciaries and the fiduciary (and among the

agricultural or horticultural cooperative 56 through 59, and (B) in the case of a

beneficiaries) under regulations prescribed

described in section 199(d)(3)(F)(ii) shall corporation, section 199(a)(1)(B) shall

by the Secretary, and (ii) for purposes of

be treated as having MPGE in whole or be applied by substituting “alternative

section 199(d)(2), AGI of the trust or es-

in significant part any QPP marketed by minimum taxable income” for “taxable

tate shall be determined as provided in sec-

the organization that its patrons have so income.”

tion 67(e) with the adjustments described

MPGE.

in such paragraph. Unrelated Business Taxable Income

Section 199(d)(3)(E) provides that, for

Section 199(d)(1)(C) provides that the

purposes of section 199(d)(3), the term

Secretary may prescribe rules requiring Section 199(d)(7) provides that, for

qualified payment means, with respect

or restricting the allocation of items and purposes of determining the tax imposed

to any person, any amount that (i) is de-

wages under section 199(d)(1) and may by section 511, section 199(a)(1)(B) shall

scribed in section 1385(a)(1) or (3), (ii) is

prescribe such reporting requirements as be applied by substituting “unrelated

received by such person from a specified

the Secretary determines appropriate. business taxable income” for “taxable in-

agricultural or horticultural cooperative,

come.”

Individuals and (iii) is attributable to QPAI with re-

spect to which a deduction is allowed to

In the case of an individual, sec- such cooperative under section 199(a).

tion 199(d)(2) provides that the deduc-







2006–25 I.R.B. 1065 June 19, 2006

Authority to Prescribe Regulations such excluded amounts are taken into ac- reported on a Form W–2 to be included

count in determining QPAI. in the determination of W–2 wages of a

Section 199(d)(8) authorizes the Secre- taxpayer, the Form W–2 must be for em-

tary to prescribe such regulations as are Wage Limitation ployment by the taxpayer. Employees of

necessary to carry out the purposes of sec- the taxpayer are defined in §1.199–2(a)(1)

The final regulations give the Secretary

tion 199, including regulations that pre- of the final regulations as including only

authority to provide for methods of cal-

vent more than one taxpayer from being al- common law employees of the taxpayer

culating W–2 wages. Contemporaneous

lowed a deduction under section 199 with and officers of a corporate taxpayer. Thus,

with the publication of these final regu-

respect to any activity described in section the issue of whether the payments to the

lations, Rev. Proc. 2006–22, 2006–23

199(c)(4)(A)(i). employees are included in W–2 wages de-

I.R.B. 1033, has been published and pro-

pends on an application of the common

Effective Date vides for taxable years beginning on or be-

law rules in determining whether the PEO,

fore May 17, 2006, the enactment date of

the employee leasing firm, or the client

The effective date of section 199 in TIPRA, the same three methods of calcu-

is the employer of the worker. As noted

section 102(e) of the Act was amended lating W–2 wages as were contained in

in §1.199–2(a)(2) of the final regulations,

by section 403(a)(19) of the GOZA. Sec- Notice 2005–14 and the proposed regula-

taxpayers may take into account wages re-

tion 102(e)(1) of the Act provides that the tions. It is expected that any new revenue

ported on Forms W–2 issued by other par-

amendments made by section 102 of the procedure applicable for taxable years be-

ties provided that the wages reported on

Act shall apply to taxable years begin- ginning after May 17, 2006, will contain

the Forms W–2 were paid to employees of

ning after December 31, 2004. Section methods for calculating W–2 wages sim-

the taxpayer for employment by the tax-

102(e)(2) of the Act provides that, in de- ilar to the three methods in Rev. Proc.

payer. However, with respect to individu-

termining the deduction under section 199, 2006–22. The methods are included in

als who taxpayers assert are their common

items arising from a taxable year of a part- a revenue procedure rather than the final

law employees for purposes of section 199,

nership, S corporation, estate, or trust be- regulations so that if changes are made to

taxpayers are reminded of their duty to file

ginning before January 1, 2005, shall not Form W–2, “Wage and Tax Statement,” a

returns and apply the tax law on a consis-

be taken into account for purposes of sec- new revenue procedure can be issued re-

tent basis.

tion 199(d)(1). Section 514(c) of TIPRA flecting those changes more promptly than

Commentators also raised the issue of

provides that the amendments made by an amendment to the final regulations.

whether an individual filing as part of a

section 514 apply to taxable years begin- Taxpayers have inquired whether remu-

joint return may include wages paid by his

ning after May 17, 2006, the enactment neration paid to employees for domestic

or her spouse to employees of his or her

date of TIPRA. services in a private home of the employer,

spouse in determining the amount of the

which remuneration may be reported on

individual’s W–2 wages for purposes of

Summary of Comments and Schedule H (Form 1040), “Household

the section 199 deduction. The example

Explanation of Provisions Employment Taxes,” or, under certain

given was an individual who had a trade

conditions, on Form 941, “Employer’s

or business reported on Schedule C (Form

Taxable Income QUARTERLY Federal Tax Return,” are in-

1040) with QPAI but no W–2 wages, and

cluded in W–2 wages. Such remuneration

the individual’s spouse had W–2 wages

The section 199 deduction is not taken is generally excepted from wages for in-

in a second trade or business reported on

into account in computing any net operat- come tax withholding purposes by section

Schedule C (Form 1040) but no QPAI.

ing loss (NOL) or the amount of any NOL 3401(a)(3) of the Code. Section 199(b)(5)

Section 1.199–2(a)(4) of the final regu-

carryback or carryover. Thus, except as provides that section 199 shall be applied

lations provides that married individuals

otherwise provided in §1.199–7(c)(2) of by only taking into account items that are

who file a joint return are treated as one

the final regulations (concerning the por- attributable to the actual conduct of a trade

taxpayer for purposes of determining W–2

tion of a section 199 deduction allocated or business. Payments to employees of a

wages. Therefore, an individual filing as

to a member of an EAG), the section 199 taxpayer for domestic services in a private

part of a joint return may take into ac-

deduction cannot create, or increase, the home of the taxpayer are not attributable

count wages paid to employees of his or

amount of an NOL deduction. to the actual conduct of a trade or business

her spouse in determining the amount of

For purposes of section 199(a)(1)(B), of the taxpayer. Accordingly, such pay-

W–2 wages provided the wages are paid

taxable income is determined without re- ments are not included in W–2 wages for

in a trade or business of the spouse and the

gard to section 199 and without regard purposes of section 199(b)(2).

other requirements of the final regulations

to any amount excluded from gross in- The IRS and Treasury Department have

are met. In contrast, if the taxpayer and the

come pursuant to section 114 of the Code also received numerous inquiries concern-

taxpayer’s spouse file separate returns, the

or pursuant to section 101(d) of the Act. ing whether amounts paid to workers who

taxpayer may not use the spouse’s wages

Thus, any extraterritorial income exclu- receive Forms W–2 from professional em-

in determining the taxpayer’s W–2 wages

sion or amount excluded from gross in- ployer organizations (PEOs), or employee

for purposes of the taxpayer’s section 199

come pursuant to section 101(d) of the Act leasing firms, may be included in the W–2

deduction because they are not considered

does not reduce taxable income for pur- wages of the clients of the PEOs or em-

one taxpayer.

poses of section 199(a)(1)(B), even though ployee leasing firms. In order for wages







June 19, 2006 1066 2006–25 I.R.B.

Domestic Production Gross Receipts the requirements of section 199. The pro- offered for lease, rental, license, sale, ex-

posed regulations also provide several ex- change or other disposition by the taxpayer

Commentators suggested that rules amples to illustrate this rule. Some com- does not meet the requirements of section

similar to the de minimis rules provided mentators observed that the examples in- 199, then each component that meets the

in §§1.199–1(d)(2) (gross receipts alloca- volving a manufacturer of toy cars that requirements of §1.199–3 must be treated

tion), 1.199–3(h)(4) (embedded services), sold the cars to toy stores appear to im- as a separate item and such component

1.199–3(l)(1)(ii) (construction services), ply that, in the case of property offered may not be combined with a component

and 1.199–3(m)(4) (engineering or archi- for lease, rental, license, sale, exchange that does not meet the requirements to be

tectural services) of the proposed regula- or other disposition by a wholesaler, the treated as an item. The final regulations

tions, under which taxpayers may treat de item is defined with reference to the prop- provide examples illustrating this rule. It

minimis amounts of non-DPGR as DPGR, erty offered for sale to retail consumers by follows that the de minimis rule for embed-

should be available in the opposite situ- the wholesaler’s customer. The rules for ded services and nonqualifying property,

ation. Thus, for example, if a taxpayer’s defining an item, and the related exam- as well as any other de minimis exception

gross receipts that are allocable to DPGR ples, have been clarified in the final reg- that is applied at the item level, must be ap-

are less than 5 percent of its overall gross ulations to provide that an item is defined plied separately to each component of the

receipts for the taxable year, the commen- with reference to the property offered by property that is treated as a separate item.

tators suggested that the final regulations the taxpayer for lease, rental, license, sale, The proposed regulations provide that

allow the taxpayer to treat those gross exchange or other disposition to the tax- gross receipts derived from a lease, rental,

receipts as non-DPGR. The IRS and Trea- payer’s customers in the normal course of license, sale, exchange or other dispo-

sury Department agree with this sugges- the taxpayer’s business, whether the tax- sition of qualifying property constitute

tion, and the final regulations provide such payer is a wholesaler or a retailer. DPGR even if the taxpayer has already

rules for the provisions discussed above The proposed regulations provide that, recognized gross receipts from a previous

as well as under §1.199–3(l)(4)(iv)(B) for if the property offered for lease, rental, lease, rental, license, sale, exchange or

utilities. license, sale, exchange or other disposi- other disposition of the property. The IRS

Several comments were received re- tion by the taxpayer does not meet the re- and Treasury Department recognize that

garding the burden imposed by the re- quirements of section 199, then the tax- in some cases, such as where the original

quirement in the proposed regulations that payer must treat as the item any portion item (for example, steel) that was MPGE

QPAI be computed on an item-by-item of that property that does meet those re- or produced by the taxpayer within the

basis (rather than on a division-by-di- quirements. In a case where two or more United States is disposed of by the tax-

vision, or product line-by-product line portions of the property meet the require- payer, and incorporated by another person

basis). Several commentators urged the ments of section 199, commentators in- into other property (for example, an au-

IRS and Treasury Department to limit quired whether the two or more portions tomobile) that is subsequently acquired

the item-by-item standard to the require- are properly treated as a single item or by the taxpayer, it would be extremely

ments of §1.199–3 in determining DPGR as two or more items. The final regu- difficult for the taxpayer to identify the

(that is, the lease, rental, license, sale, lations generally are consistent with the item the gross receipts of which constitute

exchange, or other disposition require- rules of the proposed regulations, and pro- DPGR upon lease, rental, license, sale, ex-

ment, the in-whole-or-in-significant-part vide that if the gross receipts derived from change or other disposition of the acquired

requirement, etc.). Specifically, the com- the lease, rental, license, sale, exchange or property. Therefore, the final regulations

mentators argued that the item-by-item other disposition of the property offered in provide that if a taxpayer cannot reason-

standard is inconsistent with the cost al- the normal course of a taxpayer’s business ably determine without undue burden and

location methods provided in §1.199–4. do not qualify as DPGR, then any com- expense whether the acquired property

The IRS and Treasury Department agree ponent of such property is treated as the contains any of the original qualifying

with this comment. Therefore, the final item, provided the gross receipts attribut- property, or the amount, grade, or kind

regulations clarify that the item-by-item able to the component qualify as DPGR. of the original qualifying property, that

standard applies solely for purposes of Allowing more than one component to be the taxpayer MPGE or produced within

the requirements of §1.199–3 noted above treated as a single item would effectively the United States, then the taxpayer is not

in determining whether the gross receipts permit taxpayers to define an item as any required to determine whether any portion

derived from an item are DPGR. The final combination of components that, in the ag- of the acquired property qualifies as an

regulations also provide that a taxpayer gregate, meets the requirements of section item. In such cases, the taxpayer may

must determine, using any reasonable 199, a result that the IRS and Treasury De- treat any gross receipts derived from the

method that is satisfactory to the Secretary partment believe could lead to significant disposition of the acquired property that

based on all of the facts and circumstances, distortions. Thus, the IRS and Treasury are attributable to the original qualifying

whether gross receipts qualify as DPGR Department believe that treating two or property as non-DPGR.

on an item-by-item basis. more components of the property offered The proposed regulations provide that,

The proposed regulations provide that for lease, rental, license, sale, exchange or for purposes of the requirement to allo-

an item is defined as the property offered other disposition by the taxpayer as sepa- cate gross receipts between DPGR and

for lease, rental, license, sale, exchange or rate items is the appropriate result. The fi- non-DPGR, if a taxpayer can, without un-

other disposition to customers that meets nal regulations clarify that, if the property due burden or expense, specifically iden-





2006–25 I.R.B. 1067 June 19, 2006

tify where an item was manufactured, or if a subsequent taxable year. The final reg- commentator requested that the final reg-

the taxpayer uses a specific identification ulations retain this rule in §1.199–4(b)(2). ulations permit unrelated parties to a con-

method for other purposes, then the tax- One commentator questioned whether this tract manufacturing arrangement to desig-

payer must use that specific identification rule applies to CGS incurred in a taxable nate, through a written and signed agree-

method to determine DPGR. One com- year to which section 199 applies, if the ment between the parties, which of them

mentator observed that Notice 2005–14 gross receipts were recognized in a taxable shall be treated for purposes of section 199

applies a readily available rather than an year prior to the effective date of section as engaging in MPGE activities conducted

undue burden or expense standard for this 199 but would have qualified as DPGR in pursuant to the arrangement. The final reg-

purpose, and questioned whether the pro- that taxable year if section 199 had been in ulations do not adopt the commentator’s

posed regulations were intended to impose effect. The IRS and Treasury Department suggestion. The IRS and Treasury Depart-

a substantively different standard. The believe that all gross receipts and costs ment continue to believe that the benefits

standard was changed in the proposed reg- must be allocated between DPGR and non- and burdens of ownership must be deter-

ulations in response to comments received DPGR on a year-by-year basis, and the fi- mined based on all of the facts and circum-

on Notice 2005–14. The commentators nal regulations provide that for taxpayers stances and a designation of benefits and

were concerned that taxpayers would be using the section 861 method or the simpli- burdens would not be appropriate.

required under Notice 2005–14 to use fied deduction method, CGS that relates to

specific identification to allocate gross gross receipts recognized in a taxable year Government Contracts

receipts under section 199 if their infor- prior to the effective date of section 199

Section 403(a)(7) of the GOZA added

mation systems contained the information must be allocated to non-DPGR.

new section 199(c)(4)(C), which contains

necessary to use specific identification, For items that are disposed of under

a special rule for certain government con-

even if capturing such information would contracts that span two or more taxable

tracts. The final regulations clarify that

require costly system reconfigurations. years, the final regulations permit the use

the special rule for government contracts

The undue burden and expense standard, of historical data to allocate gross receipts

also applies to gross receipts derived from

however, was not intended to expand the between DPGR and non-DPGR. If a tax-

certain subcontracts to manufacture or

scope of the requirement to use specific payer makes allocations using historical

produce property for the Federal gov-

identification to include taxpayers for data, and subsequently updates the data,

ernment. See The Joint Committee on

whom the information necessary to use then the taxpayer must use the more recent

Taxation Staff, Technical Explanation of

that method is not readily available in or updated data, starting in the taxable year

the Revenue Provisions of H.R. 4440, The

their existing systems. Accordingly, the in which the update is made.

Gulf Opportunity Zone Act of 2005, 109th

final regulations utilize both terms. Two commentators suggested that the

Cong., 1st Sess. 77 (2005).

Commentators were concerned that the final regulations permit taxpayers to clas-

disposition of qualifying property would sify multi-year contracts for purposes of In Whole or in Significant Part

not give rise to DPGR if provided as part section 199 with reference to their clas-

of a service related contract. However, sification under section 460. For exam- The proposed regulations, like Notice

the proposed regulations in Example 4 in ple, if a contract is classified as a con- 2005–14, provide generally that QPP is

§1.199–3(d)(5) already address this issue struction contract under section 460, the MPGE in whole or in significant part by

by illustrating a qualifying disposition re- commentators suggested that the contract the taxpayer within the United States only

sulting in DPGR as part of a service re- also be classified as a construction con- if the taxpayer’s MPGE activity in the

lated contract. In that example, Y is hired tract under section 199. The IRS and Trea- United States is substantial in nature. Al-

to reconstruct and refurbish unrelated cus- sury Department have determined, how- though some language in the section 199

tomers’ tangible personal property. Y in- ever, that the statutory requirements un- substantial-in-nature requirement bears

stalls the replacement parts (QPP) that Y der sections 199 and 460, and the regula- similarities to language in the definition

MPGE within the United States. The ex- tions thereunder, are sufficiently different of manufacture in §1.954–3(a)(4), the two

ample concludes that Y’s gross receipts that it would not be appropriate for the fi- standards are different both in purpose

from the MPGE of the replacement parts nal regulations to permit the classification and in substance. Whether operations

are DPGR. The final regulations retain this of multi-year contracts under section 460 are substantial in nature is relevant un-

example and include other examples of to determine whether the requirements of der section 954 in determining whether

service related contracts that also involve section 199 are met with respect to that manufacturing has occurred. By contrast,

the disposition of qualifying property giv- contract. Accordingly, the final regula- the substantial-in-nature requirement un-

ing rise to DPGR if all of the other section tions do not adopt this suggestion. der section 199 is relevant in determin-

199 requirements are met. ing whether the MPGE activity, already

The proposed regulations provide that, By the Taxpayer determined to have occurred under the

if a taxpayer recognizes and reports on a requirement provided in §1.199–3(d) of

Federal income tax return for a taxable One commentator suggested a simplify- the proposed regulations (§1.199–3(e) of

year gross receipts that the taxpayer identi- ing convention to determine which party the final regulations), was performed in

fies as DPGR, then the taxpayer must treat to a contract manufacturing arrangement whole or in significant part by the taxpayer

the CGS related to such receipts as relat- has the benefits and burdens of ownership within the United States. Accordingly, as

ing to DPGR, even if they are incurred in under Federal income tax principles. The stated in the preamble to Notice 2005–14,





June 19, 2006 1068 2006–25 I.R.B.

case law and other precedent under sec- personal property ever treated as direct account all MPGE or production activities

tion 954 are not relevant for purposes of labor and overhead, and taxpayers should of the other EAG members rather than just

the substantial-in-nature requirement un- exclude such costs from their CGS or un- the previous MPGE or production activi-

der section 199. Nor are they relevant adjusted depreciable basis, as applicable. ties of the members. The final regulations

for purposes of determining whether an However, the final regulations also clar- do not adopt this suggestion because the

activity is an MPGE activity under section ify that, in the case of computer software IRS and Treasury Department believe that

199. Similarly, the regulations under sec- and sound recordings, research and exper- the EAG member must determine whether

tion 199 are not relevant for purposes of imental expenditures under section 174 re- its MPGE or production activities meet the

section 954. lating to the computer software or sound substantial-in-nature requirement at or be-

Because the substantial-in-nature re- recordings, the cost of creating intangi- fore the time EAG member disposes of the

quirement is generally applied by taking ble assets for computer software or sound property. Similar rules apply for purposes

into account all of the facts and circum- recordings, and (in the case of computer of the safe harbor under §1.199–3(g)(3)(i).

stances, both the proposed regulations software) costs of developing the com- Section 3.04(5)(d) of Notice 2005–14

and Notice 2005–14 provide a safe harbor puter software that are described in Rev. generally provides that design and devel-

under which the in-whole-or-in-signifi- Proc. 2000–50, 2000–2 C.B. 601 (soft- opment activities must be disregarded in

cant-part requirement is satisfied if the ware development costs), are included in applying the general substantial-in-nature

taxpayer’s conversion costs (that is, direct both direct labor and overhead and CGS or requirement and the safe harbor for tangi-

labor and related factory burden) are 20 unadjusted depreciable basis for purposes ble personal property. The proposed reg-

percent or more of the taxpayer’s CGS of the safe harbor, even if the costs are ulations clarify that research and exper-

with respect to the property. Commenta- incurred in a prior taxable year. In addi- imental activities under section 174 and

tors expressed confusion concerning the tion, the final regulations also clarify that the creation of intangibles do not qual-

related factory burden component of this this is the case whether the computer soft- ify as substantial in nature. A commen-

safe harbor, and suggested that overhead ware or sound recording is itself the item tator questioned whether, with respect to

be substituted for related factory burden in for purposes of section 199, or is affixed tangible personal property, activities that

the final regulations. Commentators fur- or added to tangible personal property and constitute both an MPGE activity as well

ther noted that not all transactions yielding the taxpayer treats the combined property as a section 174 activity must nonethe-

DPGR under section 199 involve CGS as computer software or a sound record- less be excluded from the determination of

(for example, a lease, rental, or license ing under the rules of §1.199–3(i)(5)). In whether the taxpayer’s MPGE of the QPP

of QPP). In response to these comments, the case where the taxpayer produces com- is substantial in nature because all section

the IRS and Treasury Department have puter software and manufactures part of 174 activities are disregarded in making

changed the safe harbor in the final reg- the tangible personal property to which the such a determination. The IRS and Trea-

ulations. The final regulations provide computer software is affixed, the taxpayer sury Department continue to believe that,

that the in-whole-or-in-significant-part may combine the direct labor and overhead with the exception of computer software

requirement is satisfied if the taxpayer’s for the computer software and tangible per- and sound recordings, it is not appropri-

direct labor and overhead to MPGE the sonal property produced or manufactured ate to include any section 174 activities in

QPP within the United States account for by the taxpayer in determining whether it the determination of whether the MPGE

20 percent or more of the taxpayer’s CGS, meets the safe harbor. of QPP is substantial in nature. However,

or in a transaction without CGS (for exam- The final regulations provide that, in the IRS and Treasury Department recog-

ple, a lease, rental, or license) account for applying the safe harbor to an item for the nize that, although section 174 costs are

20 percent or more of the taxpayer’s un- taxable year, all computer software devel- not required to be capitalized under sec-

adjusted depreciable basis of the QPP. No opment costs, any cost of creating intangi- tion 263A to the produced property, a tax-

inference is intended regarding any similar ble assets for computer software or sound payer may capitalize such costs to the QPP

safe harbor under the Code, including the recordings, and section 174 costs (for com- under section 263A. Accordingly, the fi-

safe harbor in §1.954–3(a)(4)(iii). For tax- puter software or sound recordings), in- nal regulations permit, as a matter of ad-

payers subject to section 263A, overhead cluding those paid or incurred in a prior ministrative convenience, a taxpayer to in-

is all costs required to be capitalized under taxable year, must be allocated over the clude such costs as CGS or unadjusted de-

section 263A except direct materials and estimated number of units of the item of preciable basis for purposes of the 20 per-

direct labor. For taxpayers not subject to which the taxpayer expects to dispose. An cent safe harbor.

section 263A, overhead may be computed example of this rule is provided in the final A commentator asked that the final reg-

using any reasonable method that is satis- regulations. ulations clarify that gross receipts relating

factory to the Secretary based on all of the The proposed regulations provide that to computer software updates that are pro-

facts and circumstances, but may not in- an EAG member must take into account all vided as part of a computer software main-

clude any cost, or amount of any cost, that of the previous MPGE or production activ- tenance contract qualify as DPGR if all of

would not be required to be capitalized ities of the other members of the EAG in the requirements of section 199(c)(4) are

under section 263A if the taxpayer were determining whether its MPGE or produc- met. The final regulations include an ex-

subject to section 263A. In no event are tion activities are substantial in nature. It ample demonstrating that gross receipts re-

section 174 costs, and the cost of creating has been suggested that this rule be modi- lating to computer software updates may

intangible assets, attributable to tangible fied to allow the EAG member to take into qualify as DPGR even if the computer





2006–25 I.R.B. 1069 June 19, 2006

software updates are provided pursuant to In Example 4 in §1.199–3(f)(4) of of the machines. Rather, the machines are

a computer software maintenance agree- the proposed regulations, X licenses a used to provide a service and, thus, the

ment. qualified film to Y for duplication of the gross receipts are non-DPGR. While the

The preamble to the proposed regula- film onto DVDs. Y purchases the DVDs general rule stated in §1.199–3(h)(1) of

tions states that the creation and licens- from an unrelated person. The exam- the proposed regulations is retained in the

ing of copyrighted business information ple concludes that unless Y satisfies the final regulations under §1.199–(3)(I)(1),

reports do not constitute the MPGE of QPP safe harbor under §1.199–3(f)(3) of the the preamble example is not included in

because the database is not QPP. However, proposed regulations, Y’s income for du- the final regulations because the determi-

it has come to the attention of the IRS and plicating X’s qualified film onto DVDs nation of whether a transaction is a service

Treasury Department that some business is non-DPGR because the duplication is or a rental is based upon all the facts

information reports published by the tax- not substantial in nature relative to the and circumstances. No inference should

payer may qualify as QPP, for example, DVD with the film. One commentator be drawn as to whether the transaction

business information reports published by disagreed with the conclusion in this ex- constitutes a service or rental (or some

the taxpayer in books that qualify as QPP. ample because duplicating a DVD may combination thereof) by the removal of

Therefore, no inference should be drawn involve considerable activities. This ex- the example.

from the preamble to the proposed regu- ample and other examples illustrating the Section 1.199–3(h)(1) of the proposed

lations as to whether business information substantial-in-nature requirement have regulations provides that the value of prop-

reports qualify for the section 199 deduc- been removed from the final regulations erty received by a taxpayer in a taxable

tion. because the determination of what is sub- exchange of QPP MPGE in whole or in

The proposed regulations provide in stantial in nature is determined based on significant part within the United States,

§1.199–3(f)(2) that QPP will be treated as all the facts and circumstances. No in- a qualified film produced by the taxpayer,

MPGE in significant part by the taxpayer ference should be drawn as to whether an or utilities produced by the taxpayer in the

within the United States if the MPGE of activity is, or is not, substantial in nature United States, for an unrelated person’s

the QPP by the taxpayer within the United by the removal of any example. property is DPGR for the taxpayer. How-

States is substantial in nature taking into ever, unless the taxpayer meets all of the

account all of the facts and circumstances, Derived From a Lease, Rental, License, requirements under section 199 with re-

including the relative value added by, and Sale, Exchange, or Other Disposition spect to any further MPGE by the taxpayer

relative cost of, the taxpayer’s MPGE of the QPP or any further production by

activity within the United States, the na- Section 1.199–3(h)(1) of the pro- the taxpayer of the film or utilities received

ture of the property, and the nature of the posed regulations provides that applicable in the taxable exchange, any gross receipts

MPGE activity that the taxpayer performs Federal income tax principles apply to derived from the sale by the taxpayer of the

within the United States. determine whether a transaction is, in property received in the taxable exchange

One commentator suggested that, if a substance, a lease, rental, license, sale, are non-DPGR, because the taxpayer did

taxpayer manufactures a key component of exchange, or other disposition of QPP, not MPGE or produce such property, even

QPP and purchases the rest of the compo- whether it is a service, or whether it is if the property was QPP, a qualified film,

nents, the fact that the taxpayer manufac- some combination thereof. In the pream- or utilities in the hands of the other party

tured the key component should satisfy the ble to the proposed regulations, the IRS to the transaction.

substantial-in-nature requirement with re- and Treasury Department acknowledge A commentator requested that, with

spect to the QPP that incorporates the key that the short-term nature of a transaction regard to certain taxable exchanges, the

component. For example, X manufactures does not, by itself, render the transaction final regulations provide a safe harbor

computer chips within the United States. a service for purposes of section 199 and that would accommodate long-standing

X installs the computer chips that it man- that many transactions include both ser- industry accounting practices for these ex-

ufactures in computers that X purchases vice and property rental elements. The changes. The final regulations provide a

from unrelated persons and sells the fin- preamble further states that not every safe harbor whereby the gross receipts de-

ished computers individually to customers. transaction in which property is used in rived by the taxpayer from the sale of eligi-

Although the computer chips are key com- connection with providing a service to ble property (as defined later) received in

ponents of the computers and the com- customers, however, constitutes a mixture a taxable exchange, net of any adjustments

puters will not operate without them, the of services and rental for which alloca- between the parties involved in the taxable

manufacture of the key components does tion of gross receipts is appropriate and exchange to account for differences in the

not, by itself, satisfy the substantial-in-na- provides an example of a video arcade eligible property exchanged (for example,

ture requirement with respect to the fin- that features video game machines that the location differentials and product differ-

ished computers and the taxpayer’s activi- taxpayer MPGE. The machines remain in entials), may be treated as the value of the

ties with respect to the finished computers the taxpayer’s possession during the cus- eligible property received by the taxpayer

must meet either the substantial-in-nature tomers’ use. The example concludes that in the taxable exchange. In addition, if the

requirement under §1.199–3(g)(2) or the gross receipts derived from customers’ use taxpayer engages in any further MPGE

safe harbor under §1.199–3(g)(3) of the fi- of the machines at the taxpayer’s arcade or production activity with respect to the

nal regulations. The final regulations con- are not derived from the lease, rental, li- eligible property received in the taxable

tain an example to illustrate this rule. cense, sale, exchange, or other disposition exchange, then, unless the taxpayer meets





June 19, 2006 1070 2006–25 I.R.B.

the in-whole-or-in significant-part require- One commentator asked for clarifica- film does not limit the amount of gross re-

ment under §1.199–3(g)(1) with respect to tion concerning the meaning of the term ceipts attributable to the advertising that

the property sold, the taxpayer must also normal course of a taxpayer’s trade or may be treated as DPGR under the rule. In

value the property sold without taking into business and when something would be addition, the final regulations clarify that

account the gross receipts attributable to considered to be separately stated or sepa- there need be no gross receipts attributable

the further MPGE or production activity. rately offered to a customer. The purpose to the disposition of the printed materials

The final regulations define eligible prop- of the exceptions is to reduce the bur- or qualified film for the gross receipts from

erty as oil, natural gas, and petrochemicals, den on a taxpayer of having to allocate the advertising to qualify as DPGR.

or products derived from oil, natural gas, a portion of its gross receipts to these One commentator requested that the

petrochemicals, or any other property or commonly occurring types of services final regulations recognize that gross re-

product designated by publication in the and property if the taxpayer does not nor- ceipts derived from the sale of advertising

Internal Revenue Bulletin. Under the safe mally price or offer such items separately. slots in live or delayed television broad-

harbor, the taxable exchange is deemed to Whether a taxpayer separately offers or casts (that are produced by the taxpayer

occur on the date of the sale of the eligible states the price for such an item in the and that otherwise meet the requirements

property received in the exchange to the normal course of its trade or business de- for a qualified film) are DPGR. While

extent that the sale occurs no later than the pends on the facts and circumstances. If, live and delayed television programming

last day of the month following the month for example, a taxpayer separately states may otherwise meet the requirements to

in which the exchanged eligible property the price for installation for a few of its be treated as a qualified film, in order for

is received by the taxpayer. customers on a case by case basis, then the the gross receipts derived from advertis-

The proposed regulations provide that, taxpayer may be considered to have not ing slots to be DPGR, there must also be

in the case of gross receipts derived from separately stated the price of installation in a qualifying disposition of the qualified

a lease of QPP or a qualified film, the en- the normal course of its trade or business. film. The IRS and Treasury Department

tire amount of the lease income, including The requirements have been changed in continue to believe that a live or delayed

any interest that is not separately stated, the final regulations to clarify that the television broadcast of a qualified film is

is considered derived from the lease of normal-course-of-trade-or-business re- not a lease, rental, license, sale, exchange

the QPP or qualified film. Commentators quirement applies to both the separately or other disposition of the qualified film.

noted that many leases of personal prop- stated price prong and the separately of- Commentators noted, however, that if the

erty separately state a finance or interest fered prong of the embedded services and live or delayed television programming is

component. The IRS and Treasury De- nonqualifying property rules. licensed to an unrelated cable company,

partment believe that Congress intended Several comments were received con- then the license of the programming is

for all financing or interest components cerning the rule in the proposed regula- a qualifying disposition that gives rise

of a lease of qualifying property to be tions under which gross receipts attribut- to DPGR and if the rule for advertising

considered DPGR (assuming all the other able to advertising in newspapers, maga- were extended to qualified films, then the

requirements of section 199 are met). Ac- zines, telephone directories, or periodicals portion of the advertising receipts relating

cordingly, the final regulations provide may qualify as DPGR to the extent that the to the license of the qualified film would

that all financing and interest components gross receipts, if any, derived from the dis- also be DPGR. The IRS and Treasury De-

of a lease of qualifying property are con- position of those printed materials quali- partment agree with these comments, and

sidered to be derived from the lease of fies as DPGR. The final regulations clar- the final regulations provide examples to

such qualifying property. ify that this list is not limited to these four clarify these points.

Section 1.199–3(h)(4) of the proposed types of printed materials, and that the rule

regulations provides exceptions to the gen- applies to other similar printed materials. Qualifying Production Property

eral rule that DPGR does not include gross Section 3 of Notice 2005–14 explains

receipts derived from services or nonqual- that the basis for the rule relating to adver- Under §1.199–3(i)(5)(i) of the pro-

ifying property. The exceptions are for tising income is that such income is inex- posed regulations, if a taxpayer MPGE

embedded qualified warranties, delivery, tricably linked to the gross receipts (if any) computer software or sound recordings

operating manuals, and installation. The derived from the disposition of the printed that is affixed or added to tangible per-

final regulations retain these exceptions materials listed in the proposed regula- sonal property by the taxpayer (for exam-

and provide a new exception for embed- tions. After considering the comments re- ple, a computer diskette or an appliance),

ded computer software maintenance con- ceived, the IRS and Treasury Department then the taxpayer may treat the tangible

tracts. None of these exceptions, which al- believe that the same reasoning applies in personal property as computer software

low gross receipts attributable to such em- the case of a qualified film (for example, or sound recordings, as applicable. A

bedded services and nonqualifying prop- a television program). Accordingly, the commentator questioned whether this rule

erty to be treated as DPGR, is available if, rule for advertising has been extended in should apply if, for example, a taxpayer

in the normal course of the taxpayer’s trade the final regulations to apply to qualified hires an unrelated person to affix computer

or business, the price for the service or films. The wording of the advertising rule software or sound recordings produced by

nonqualifying property is separately stated has been changed to clarify that the amount the taxpayer to a compact disc. In response

or is separately offered to the customer. of gross receipts attributable to the dispo- to this comment, the final regulations have

sition of the printed materials or qualified dropped the by-the-taxpayer requirement





2006–25 I.R.B. 1071 June 19, 2006

in this context. A similar rule has been formed. The final regulations provide an gineering and architectural services for a

provided for qualified films. example of this calculation. construction project include W–2 wages

earned as an employee. At the time the

Qualified Films Tangible Personal Property and Real taxpayer performs construction activities,

Property or engineering or architectural services,

Section §1.199–3(j)(1) of the proposed the taxpayer must be engaged in a trade

Commentators requested that the fi-

regulations provides that, a qualified film or business that is considered construc-

nal regulations define tangible personal

means any motion picture film or video tion, engineering or architectural services

property and real property for purposes

tape under section 168(f)(3), or live or de- for purposes of the North American In-

of section 199. The final regulations de-

layed television programming, if not less dustry Classification System (NAICS).

fine tangible personal property as any

than 50 percent of the total compensation W–2 wages earned by an employee are

tangible property other than land, real

paid to all actors, production personnel, not earned in connection with a trade or

property described in the construction

directors, and producers relating to the business that is considered construction,

rules in §1.199–3(m)(1), computer soft-

production of the motion picture film, or engineering or architectural services,

ware described in §1.199–3(j)(3), sound

video tape, or television programming for purposes of the NAICS. Consequently,

recordings described in §1.199–3(j)(4), a

is compensation for services performed this recommendation has not been adopted

qualified film described in §1.199–3(k)(1),

in the United States by those individu- in the final regulations.

and utilities described in §1.199–3(l). In

als. One commentator was concerned that The proposed regulations include

response to commentators’ suggestions,

the list of production personnel described within the definition of construction ser-

the final regulations further define tan-

under §1.199–3(j)(1) of the proposed vices activities relating to drilling an oil

gible personal property as also including

regulations diminishes the general rule well and mining pursuant to which the tax-

any gas (other than natural gas described

under §1.199–3(j)(5) that compensation payer could deduct intangible drilling and

in §1.199–3(l)(2)), chemicals, and simi-

for services includes all direct and indi- development costs under section 263(c)

lar property, for example, steam, oxygen,

rect compensation costs required to be and §1.612–4, and development expendi-

hydrogen, and nitrogen.

capitalized under section 263A for film tures for a mine or natural deposit under

The final regulations define the term

producers under §1.263A–1(e)(2) and (3). section 616. The IRS and Treasury De-

real property to mean buildings (includ-

The commentator also stated that it may partment are aware that in many situations

ing items that are structural components

be difficult to determine which persons are taxpayers provide these services with re-

of such buildings), inherently permanent

production personnel. The final regula- spect to property owned by another party,

structures (as defined in §1.263A–8(c)(3))

tions under §1.199–3(k)(1) clarify that the and therefore such taxpayers are ineligible

other than machinery (as defined in

list of production personnel is not exclu- to claim the deductions for such costs un-

§1.263A–8(c)(4)) (including items that

sive, and that compensation for services der the provisions described above. The

are structural components of such inher-

includes all direct and indirect compensa- language of the final regulations has been

ently permanent structures), inherently

tion costs required to be capitalized under changed to clarify that taxpayers providing

permanent land improvements, oil and

§1.263A–1(e)(2) and (3). such services are engaging in construction

gas wells, and infrastructure (as defined

In response to questions received by services that may qualify under section

in §1.199–3(m)(4)). Property MPGE by

the IRS and Treasury Department, the 199.

a taxpayer that is not real property in the

final regulations clarify that actors may The preamble to the proposed regula-

hands of such taxpayer, but that may be

include players, newscasters, or any other tions states that commentators requested

incorporated into real property by another

persons performing in a qualified film. that qualifying construction activities in-

taxpayer, is not treated as real property

The final regulations also clarify that clude construction activities related to oil

by the producing taxpayer (for example,

the not-less-than–50-percent-of-the-to- and gas wells. The preamble further states

bricks, nails, paint, and windowpanes).

tal-compensation requirement is deter- that the proposed regulations provide as a

Structural components of buildings and

mined by reference to all compensation matter of administrative grace that quali-

inherently permanent structures include

paid in the production of the film and is fying construction activities include activ-

property such as walls, partitions, doors,

calculated using a fraction. The numer- ities relating to drilling an oil well. Simi-

wiring, plumbing, central air conditioning

ator of the fraction is the compensation larly, under §1.199–3(l)(2) of the proposed

and heating systems, pipes and ducts, el-

paid by the taxpayer to actors, production regulations, construction activities include

evators and escalators, and other similar

personnel, directors, and producers for activities relating to drilling an oil well. A

property. In addition, an entire utility plant

services relating to the production of the commentator noted the inadvertent omis-

including both the shell and the interior

film (production services) performed in sion of gas wells and the final regulations

will be treated as an inherently permanent

the United States, and the denominator is correct the omission.

structure.

the sum of the total compensation paid by The proposed regulations provide that

the taxpayer to all such individuals regard- Construction of Real Property DPGR does not include gross receipts at-

less of where the production services are tributable to the sale or other disposition

performed and the total compensation paid One commentator recommended that of land (including zoning, planning, enti-

by others to all such individuals regardless DPGR derived from the construction of tlement costs, and other costs capitalized

of where the production services are per- real property as well as DPGR from en- into the land such as grading and demo-





June 19, 2006 1072 2006–25 I.R.B.

lition of structures under section 280B). construction project or become part of the §1.199–3(l)(5)(ii) of the proposed reg-

Commentators contended that grading constructed real property. ulations. Under the land safe harbor, the

and demolition are construction-related Section 199(c)(4)(A), as amended by taxpayer is permitted to allocate gross

activities, and that gross receipts attribut- the GOZA, requires that a taxpayer be receipts between real property other than

able to these activities should qualify as engaged in the active conduct of a con- land, and land, according to a formula.

DPGR. After considering the comments, struction trade or business for the tax- The taxpayer must reduce gross receipts

the IRS and Treasury Department believe payer’s construction activity to qualify by the costs of the land and any other costs

it is appropriate to apply to grading and under section 199. The proposed regu- capitalized to the land, plus a percentage

demolition activities the same rule that the lations provide that a taxpayer may not of those costs, and costs related to DPGR

proposed regulations apply to other con- treat as DPGR gross receipts derived from must be reduced by the costs of the land

struction activities, such as landscaping construction unless the taxpayer is en- and any other costs capitalized to the land.

and painting. Accordingly, services such gaged in a construction trade or business The percentage ranges from 5 to 15 per-

as grading, demolition, clearing, excavat- on a regular and ongoing basis. Com- cent, depending upon the length of time

ing, and any other activities that physically mentators expressed concern that this the taxpayer held the land. The commen-

transform the land are activities constitut- requirement would preclude construction tator asked whether the holding period

ing construction only if these services are project-specific joint ventures or partner- of a previous owner of the land would

performed in connection with other activi- ships, a common business structure in the be attributed to the new owner, and what

ties (whether or not by the same taxpayer) construction industry, from qualifying un- rules apply for purposes of computing the

that constitute the erection or substantial der section 199. Typically, such entities new owner’s cost basis. Generally, if an

renovation of real property. The IRS and are formed for the purpose of a specific existing provision of the Code or regula-

Treasury Department continue to believe construction project, and are terminated or tions would apply to require attribution of

that gross receipts attributable to the sale dissolved when the project is completed. the holding period of a previous owner of

or other disposition of land (including The final regulations continue to require property to a new owner, the same rules

zoning, planning, and entitlement costs) that a taxpayer be engaged in a regular and will apply in the case of a previous owner’s

are properly considered gross receipts at- ongoing construction trade or business, holding period in land for purposes of the

tributable to the land, not to a qualifying but provide a safe harbor rule under which land safe harbor rule of section 199. For

construction activity, and, therefore, are entities formed specifically for purposes example, the holding period of the previ-

non-DPGR. of a particular construction project may ous owner (P) would carry over to the new

In response to a suggestion by a com- qualify. Under the safe harbor rule, if owner (N) under existing Federal income

mentator, the final regulations provide that a taxpayer is engaged in a construction tax principles if P were a partner in part-

a taxpayer engaged in a construction ac- trade or business, then the taxpayer will be nership N, and P contributed the land to N.

tivity must make a reasonable inquiry or a considered to be engaged in such trade or The same result would apply if, instead,

reasonable determination whether the ac- business on a regular and ongoing basis if the land was distributed by partnership P

tivity relates to the erection or substantial the taxpayer derives gross receipts from an to N, its partner. In the case of partnership

renovation of real property in the United unrelated person by selling or exchanging or other pass-thru entity, the land safe har-

States. the constructed real property within 60 bor is applied at the partnership or other

The proposed regulations contain an ex- months of the date on which construction pass-thru entity level and is not applied at

ample of an electrical contractor who pur- is complete. the partner or owner level.

chases wires, conduits, and other electrical Commentators also expressed concern With regard to the land safe harbor dis-

materials that the contractor installs in con- that taxpayers would not meet the require- cussed in the preceding paragraph, the pro-

struction projects in the United States and ment of being engaged in a construction posed regulations state that the length of

that are considered structural components. business on a regular and ongoing basis if time a taxpayer is deemed to hold the land

The example concludes that the gross re- the taxpayer is newly-formed or otherwise begins on the date the taxpayer acquires

ceipts that the contractor derives from in- is in the first taxable year of a new con- the land, including the date the taxpayer

stalling these materials are derived from struction trade or business. Although some enters into the first option to acquire all or

construction, but that the gross receipts at- taxpayers may meet the regular-and-on- a portion of the land, and ends on the date

tributable to the purchased materials are going-business requirement under the safe the taxpayer sells each item of real prop-

not. Commentators objected to this result, harbor rule discussed previously, the final erty on the land. Commentators stated that

contending that it places an unreasonable regulations provide that, in the case of a development of the land generally does not

administrative burden on taxpayers per- newly-formed trade or business or a tax- begin until the land is acquired and any op-

forming construction activities. The final payer in its first taxable year, the taxpayer tion to acquire land is based on the land’s

regulations, including the example, pro- will satisfy the regular-and-ongoing-basis fair market value. Because developers are

vide that, in such circumstances, the tax- requirement if it reasonably expects to be paying fair market value, the commenta-

payer performing the construction services engaged in a construction trade or business tors suggested that the period for deter-

is not required to allocate gross receipts on a regular and ongoing basis. mining the percentage should not include

to the purchased materials and treat such The IRS and Treasury Department any option period. The IRS and Treasury

gross receipts as non-DPGR, provided the received a comment requesting clar- Department generally agree with the com-

materials and supplies are consumed in the ification of the land safe harbor of mentator’s suggestion, and the final reg-





2006–25 I.R.B. 1073 June 19, 2006

ulations do not include the option period (for example, an appraisal of the land) (that is, the section 861 method, the simpli-

except where the option does not include to allocate gross receipts attributable to fied deduction method, and the small busi-

provisions to adjust the purchase price to the land to non-DPGR, then a taxpayer ness simplified overall method). However,

approximate fair market value. applies the de minimis exception by ex- modifications have been made in the fi-

Example 1 in §1.199–3(m)(5)(iii) of the cluding such gross receipts derived from nal regulations to the qualification require-

proposed regulations provides that X, who the sale, exchange, or other disposition of ments of the simplified deduction method.

is in a construction trade or business under the land from total gross receipts. Under the simplified deduction method,

NAICS Code 23 on a regular and ongoing A commentator requested that the defi- a taxpayer’s expenses, losses, or deduc-

basis, purchases a building and retains Y, nition of construction activities not be lim- tions (deductions) (other than a net op-

a general contractor, to perform construc- ited to direct activities and should include erating loss deduction) are apportioned

tion services in connection with a substan- services incidental to the performance between DPGR and non-DPGR based

tial renovation of the building. The exam- of such activities. As an administrative on relative gross receipts. The proposed

ple concludes that X’s gross receipts de- convenience, the final regulations provide regulations permit a taxpayer to use the

rived from the disposition of the building that construction activities include certain simplified deduction method if it has aver-

are non-DPGR, and that Y’s gross receipts administrative support services such as age annual gross receipts of $25,000,000

from amounts paid to it by X are DPGR. billing and secretarial services performed or less, or total assets at the end of the tax-

In addition, the example illustrates that by the taxpayer. The final regulations able year of $10,000,000 or less. Several

gross receipts of subcontractors hired by Y provide a similar rule for engineering and commentators requested that the aver-

qualify as DPGR. Some commentators in- architectural services. age annual gross receipts threshold for

ferred from this example that the taxpayer the simplified deduction method be ei-

must, at a minimum, be a legally desig- Engineering and Architectural Services ther increased or removed. In response

nated general contractor before its gross to these comments, the IRS and Treasury

receipts may qualify as DPGR. The ex- A commentator suggested that the defi- Department have modified the eligibility

ample was not intended to imply that a nition of engineering and architectural ser- requirements for the simplified deduction

taxpayer must be a licensed general con- vices include services related to the inspec- method. Under the final regulations, a

tractor. The final regulations clarify that tion or evaluation of real property after taxpayer may use the simplified deduc-

activities constituting construction include construction has been completed. The fi- tion method if it has average annual gross

activities typically performed by a gen- nal regulations do not adopt this sugges- receipts of $100,000,000 or less, or total

eral contractor, or that constitute general tion because engineering and architectural assets at the end of the taxable year of

contractor-level work, such as activities services relating to post-construction ac- $10,000,000 or less. The IRS and Trea-

relating to management and oversight of tivities are not activities constituting con- sury Department continue to believe that

the construction process (for example, ap- struction. for taxpayers above these thresholds the

provals, periodic inspection of the progress section 861 method is the appropriate

of the construction project, and required Allocation of Cost of Goods Sold and method for allocating and apportioning

job modifications). The example has been Deductions deductions for purposes of determining

modified in the final regulations to illus- QPAI.

trate that the person hired by the build- A commentator requested clarification Under the land safe harbor provided

ing owner, although not a licensed gen- as to whether a taxpayer’s CGS allocable in §1.199–3(l)(5)(ii) of the proposed reg-

eral contractor, qualifies as engaging in to DPGR is determined using the methods ulations, a taxpayer may allocate gross

construction activities by virtue of provid- of accounting used to compute CGS for the receipts between the proceeds from the

ing management and oversight of the con- taxpayer’s books or financial statements or sale, exchange, or other disposition of

struction process. the methods of accounting used to com- real property constructed by the taxpayer

Several commentators recommended pute CGS in determining Federal taxable and land by reducing its costs related to

that the final regulations provide that, for income. Section 1.199–4(b) of the pro- DPGR under §1.199–4 by the cost of land

purposes of the de minimis exception of posed regulations provides that CGS is de- and other costs capitalized to the land

§1.199–3(l)(5)(ii) (regarding construc- termined under the methods of accounting (land costs) and reducing its DPGR by

tion services), gross receipts attributable that the taxpayer uses to compute Federal those land costs plus a percentage. Un-

to land be disregarded for purposes of taxable income. Accordingly, this section der the small business simplified overall

calculating the de minimis exception. In has not been modified and the final regu- method, a taxpayer’s CGS and deductions

response to the comments, the final reg- lations continue to provide that, in deter- are apportioned between DPGR and other

ulations clarify that, if a taxpayer applies mining CGS allocable to DPGR, CGS is receipts based on relative gross receipts.

the land safe harbor, then the gross re- determined using the methods of account- Commentators have questioned whether

ceipts excluded under the land safe harbor ing that the taxpayer uses to compute its a taxpayer that uses the small business

are excluded in determining total gross Federal taxable income. simplified overall method would have to

receipts under the de minimis exception. Consistent with both the proposed reg- reallocate land costs using the allocation

The final regulations also provide that, if ulations and Notice 2005–14, the final reg- formula provided by that method even

a taxpayer does not apply the land safe ulations continue to provide three methods though such costs have already been al-

harbor and uses any reasonable method for allocating and apportioning deductions located in accordance with the land safe





June 19, 2006 1074 2006–25 I.R.B.

harbor. The final regulations clarify that to compute QPAI twice and, thus, would company transaction rules of §1.1502–13

a taxpayer that uses the land safe harbor not further the policy goals of providing shall be taken into account for purposes

to allocate gross receipts between real de minimis rules to ease a taxpayer’s ad- of determining the QPAI and DPGR of a

property constructed by the taxpayer and ministrative burdens. As a result, the IRS consolidated group.

land does not take into account under the and Treasury Department continue to be- As specifically noted in the preamble

small business simplified overall method lieve that, with respect to a corporation that to the proposed regulations, the regula-

provided in §1.199–4(f) the costs that have is a member of an EAG but not a member tions under §1.1502–13(c) already ensure

already been taken into account for pur- of a consolidated group, the application of that the section 199 deduction cannot be

poses of section 199 pursuant to the land this threshold at the EAG member level is reduced on account of an intercompany

safe harbor. appropriate. transaction. As discussed above concern-

However, with respect to a consolidated ing the application of the de minimis rules

Expanded Affiliated Groups group, §1.1502–13(c)(1)(i) and (c)(4) re- that allow treatment of gross receipts as

quires that the separate entity attributes of DPGR or non-DPGR, §1.1502–13(c)(1)(i)

The proposed regulations provide gen-

a company’s intercompany items or cor- and (c)(4) requires that the separate en-

erally that if a member of an EAG (the

responding items must be redetermined to tity attributes of a company’s intercom-

disposing member) derives gross receipts

the extent necessary to produce the effect pany items or corresponding items must

from the lease, rental, license, sale, ex-

as if the consolidated group members en- be redetermined to the extent necessary to

change, or other disposition of QPP, a

gaged in an intercompany transaction were produce the effect as if the consolidated

qualified film, or utilities MPGE or pro-

divisions of a single corporation. If the de group members engaged in an intercom-

duced by another member or members of

minimis rule were applied at the consoli- pany transaction were divisions of a single

the same EAG, the disposing member is

dated group member level, then a differ- corporation. There is nothing in the pro-

treated as conducting the activities con-

ent result could apply to the consolidated posed regulations that would prevent this

ducted by each other member of the EAG

group than would apply if the consolidated rule from applying. In fact, several ex-

with respect to the QPP, qualified film, or

group members were divisions of a single amples specifically illustrate the applica-

utilities in determining whether its gross

corporation. Accordingly, with respect to tion of these rules. An additional exam-

receipts are DPGR. A question arose as to

a consolidated group, the final regulations ple concerning the license of an intangible

when the determination of whether corpo-

provide that the de minimis rule is applied between members of a consolidated group

rations are members of the same EAG for

at the consolidated group level, rather than has been added to the final regulations.

purposes of the attribution of activities is

at the consolidated group member level. Another commentator requested clarifi-

to be made. The final regulations clarify

Similarly, with respect to a corporation cation of the application of §1.199–7(b)(2)

that attribution of activities between mem-

that is a member of an EAG but not a mem- of the proposed regulations where the

bers of the same EAG is tested at the time

ber of a consolidated group, the new de EAG is comprised of more than one con-

that the disposing member disposes of the

minimis rule that allows a taxpayer to treat solidated group. Section 1.199–7(b)(2) of

QPP, qualified film, or utilities. Examples

all of its gross receipts as non-DPGR if the proposed regulations (§1.199–7(b)(3)

are provided to illustrate this provision.

less than 5 percent of the taxpayer’s to- of the final regulations) provides that,

Section 1.199–1(d) of the proposed reg-

tal gross receipts are DPGR is determined in determining the taxable income of an

ulations provides a de minimis rule that

at the EAG member level, rather than at EAG, if a member of an EAG has an

allows a taxpayer to treat all of its gross

the EAG group level. However, with re- NOL carryback or carryover to the taxable

receipts as DPGR if less than 5 percent

spect to a consolidated group, the final reg- year, then the amount of the NOL used

of the taxpayer’s total gross receipts are

ulations provide that this de minimis rule to offset taxable income cannot exceed

non-DPGR. The proposed regulations pro-

is applied at the consolidated group level, the taxable income of that member. The

vide that the 5 percent threshold is deter-

rather than at the consolidated group mem- final regulations continue to treat a con-

mined at the corporation level, rather than

ber level. solidated group as a single member of

at the EAG or consolidated group level.

the EAG. Accordingly, if a consolidated

Several commentators requested that the Consolidated Groups group has a consolidated NOL (CNOL)

IRS and Treasury Department reconsider

carryback or carryover, the amount of

this position and apply the threshold at the A commentator was concerned that

the CNOL used to offset taxable income

EAG or consolidated group level. the license of an intangible asset between

cannot exceed the consolidated group’s

The de minimis rule is intended to elim- members of a consolidated group could

taxable income, and may not be used to

inate the burden to a taxpayer of allocat- reduce the section 199 deduction available

offset taxable income of other members of

ing gross receipts between DPGR and non- to the members of a consolidated group,

the EAG, whether separate corporations

DPGR when less than 5 percent of its to- because the licensee member’s royalty

or consolidated groups. An example has

tal gross receipts are non-DPGR. Apply- expense would reduce the group’s QPAI,

been provided to illustrate this provision.

ing this de minimis rule at the EAG level but the licensor member’s royalty in-

would create many burdensome issues for come from the license would not increase Trade or Business Requirement

the EAG and its members, including addi- the group’s QPAI. The commentator re-

tional information reporting and circular- quested that language be added to the Pursuant to section 199(d)(5),

ity problems that could require members final regulations to provide that the inter- §§1.199–1 through 1.199–9 are applied







2006–25 I.R.B. 1075 June 19, 2006

by taking into account only items that are duction not otherwise disallowed by the into account in computing the section 199

attributable to the actual conduct of a trade Code), CGS allocated to such items of in- deduction for that taxable year. To the ex-

or business. An individual engaged in come, and gross receipts included in such tent that any of the disallowed losses are

the actual conduct of a trade or business items of income. Generally, section 199 is allowed in a later taxable year, the partner

must apply §§1.199–1 through 1.199–9 applied at the shareholder, partner, or sim- takes into account a proportionate share of

by taking into account in computing QPAI ilar level. For a non-grantor trust or estate, those losses in computing its QPAI for that

only items that are attributable to that this level may refer to one or more benefi- later taxable year.

trade or business (or trades or businesses) ciaries, the trust or estate, or both. In response to comments received, the

and any items allocated from a pass-thru Section 199(d)(1)(A)(iii), however, IRS and Treasury Department intend to

entity engaged in a trade or business. limits the amount of W–2 wages from a issue separate guidance by publication in

Compensation received by an individual partnership or S corporation that may be the Internal Revenue Bulletin regarding

employee for services performed as an used by each partner or shareholder to the treatment of disallowed losses in de-

employee is not considered gross receipts compute the partner’s or shareholder’s termining a taxpayer’s section 199 deduc-

for purposes of computing QPAI under section 199 deduction. Pursuant to the tion. As a matter of administrative conve-

§§1.199–1 through 1.199–9. Similarly, authority granted in section 199(d)(1)(C), nience and to reduce complexity for tax-

any costs or expenses paid or incurred by the final regulations provide that this wage payers, the final regulations clarify that

an individual employee with respect to limitation will apply to non-grantor trusts disallowed losses of the taxpayer that are

those services performed as an employee and estates in the same way it applies to disallowed for taxable years beginning on

are not considered CGS or deductions of partnerships and S corporations. Thus, for or before December 31, 2004, are not taken

that employee for purposes of computing all purposes of this wage limitation, refer- into account in a later taxable year for pur-

QPAI under §§1.199–1 through 1.199–9. ences in the final regulations to pass-thru poses of computing the taxpayer’s QPAI

For purposes of the trade-or-business re- entities include not only partnerships and for that later taxable year regardless of

quirement, a trust or estate is treated as an S corporations, but also all non-grantor whether the disallowed losses are allowed

individual. trusts and estates. for other purposes. The final regulations

The final regulations clarify that the provide that similar rules concerning dis-

Pass-thru Entities section 199 deduction has no effect on a allowed losses apply to taxpayers that are

shareholder’s adjusted basis in the stock of not partners or S corporation shareholders.

As noted above, section 514(b) of an S corporation or a partner’s adjusted ba- See §1.199–8(h).

TIPRA amended section 199(d)(1)(A)(iii) sis in an interest in a partnership because Generally, in the case of a pass-thru

with respect to a partner’s or shareholder’s the section 199 deduction is not described entity, the calculations required to de-

share of W–2 wages from a partnership or in section 1367(a) or section 705(a). How- termine QPAI (that is, the allocation or

S corporation for taxable years beginning ever, the shareholder’s or partner’s propor- apportionment of gross receipts, CGS, or

after May 17, 2006. Section 1.199–9 of tionate or distributive share of the S cor- deductions) are performed at the owner

the final regulations contains guidance poration or partnership items that are in- level. Notice 2005–14 and the proposed

for pass-thru entities with taxable years cluded in computing the shareholder’s or regulations provide that a partnership or

beginning on or before May 17, 2006. A partner’s section 199 deduction will affect S corporation that is a qualifying small

taxpayer must apply §1.199–9 to a taxable the shareholder’s or partner’s adjusted ba- taxpayer may use the small business

year beginning on or before May 17, 2006, sis under the rules of section 1367(a) or simplified overall method to apportion

if that taxpayer applies §§1.199–1 through section 705(a). CGS and deductions between DPGR and

1.199–8 to the taxable year. The portions The proposed regulations provide that non-DPGR. This rule is not included in the

of §1.199–3 relating to qualifying in-kind deductions of a partnership that otherwise final regulations, except that §1.199–9(k)

partnerships and EAG partnerships, and would be taken into account in comput- permits a partnership or S corporation that

all of §1.199–5 relating to pass-thru enti- ing the partner’s section 199 deduction are is a qualifying small taxpayer to use the

ties, in the final regulations are reserved taken into account only if and to the extent small business simplified overall method

for taxable years beginning after May 17, the partner’s distributive share of those de- to apportion CGS and deductions between

2006. The IRS and Treasury Department ductions from all of the partnership’s ac- DPGR and non-DPGR at the entity level

intend to issue regulations that take into tivities is not disallowed by section 465, under §1.199–4(f) of the proposed regula-

account the amendments made to section 469, or 704(d), or any other provision of tions. In addition, §1.199–9(b)(1)(ii) and

199(d)(1)(A)(iii) for pass-thru entities. the Code. If only a portion of the partner’s (c)(1)(ii) of the final regulations provides

Section 199 applies at the owner level distributive share of the losses or deduc- that the Secretary may, by publication in

in a manner consistent with the economic tions is allowed for a taxable year, a pro- the Internal Revenue Bulletin, permit a

arrangement of the owners of the pass-thru portionate share of those allowable losses partnership or S corporation to calculate a

entity. Under the proposed regulations, or deductions that are allocated to the part- partner’s or shareholder’s share of QPAI

each owner computes its section 199 de- ner’s share of the partnership’s qualified at the entity level.

duction by taking into account its distribu- production activities, determined in a man- If a partnership or S corporation cal-

tive or proportionate share of the pass-thru ner consistent with sections 465, 469, and culates a partner’s or shareholder’s share

entity’s items (including items of income 704(d), and any other applicable provision of QPAI at the entity level, the owner’s

and gain, as well as items of loss and de- of the Code (disallowed losses), is taken share of QPAI and W–2 wages from the





June 19, 2006 1076 2006–25 I.R.B.

partnership or S corporation are combined treated as MPGE or producing the prop- nership disposes of the property (in the

with the owner’s QPAI and W–2 wages erty MPGE or produced by the partnership case of property MPGE or produced by an

from other sources. The final regulations that is distributed to that partner. If a part- EAG member or members) or at the time

also clarify that, if a pass-thru entity cal- ner of a qualifying in-kind partnership de- that the member or members of the EAG of

culates QPAI at the entity level, then gen- rives gross receipts from the lease, rental, which the partners of the EAG partnership

erally the owner of the pass-thru entity is license, sale, exchange, or other disposi- are members dispose of the property (in

not permitted to use another cost alloca- tion of the property that was MPGE or pro- the case of property MPGE or produced

tion method to reallocate the costs of the duced by the qualifying in-kind partner- by the EAG partnership). Attribution is

pass-thru entity regardless of the method ship, then, provided such partner is a part- effective only for those taxable years that

used by the pass-thru entity’s owner to ner of the qualifying in-kind partnership at the disposing or producing member is a

allocate or apportion costs. A taxpayer the time the partner disposes of the prop- member of the EAG of which the partners

that receives QPAI from a partnership or erty, the partner is treated as conducting of the EAG partnership are members for

S corporation does not take into account the MPGE or production activities previ- the entire taxable year of the EAG partner-

any gross receipts, income, assets, deduc- ously conducted by the qualifying in-kind ship. The final regulations also clarify that

tions, or other items of the partnership or partnership with respect to that property. EAG partnerships, the partners of which

S corporation when the taxpayer allocates For this purpose, a qualifying in-kind part- are members of the same EAG, may at-

and apportions deductions to determine the nership is defined in §1.199–9(i)(2) of the tribute their production activities between

taxpayer’s QPAI from other sources. final regulations to include only certain themselves on a similar basis, provided

Regarding the rule allowing partner- partnerships operating solely in a desig- that the producing EAG partnership and

ships that extract, refine, or process oil nated industry: oil and gas, petrochemical, the disposing EAG partnership are owned

or natural gas to attribute these activities or electricity generation. Partnerships in by members of the same EAG for the

to their partners, some commentators re- other industries with substantially similar entire taxable year of the respective EAG

quested that the rule be expanded to other historical industry practices may be desig- partnership that includes the date on which

industries that operate in a substantially nated by the IRS and Treasury Department the disposing EAG partnership disposes

similar manner. The exception for the as qualifying in-kind partnerships by pub- of the property.

oil and gas industry was provided in the lication in the Internal Revenue Bulletin. Because the sale of an interest in a pass-

proposed regulations to prevent a clearly The proposed regulations provide that, thru entity does not reflect the realization

qualifying activity from being disquali- if an EAG partnership (as defined in of DPGR by that entity, DPGR generally

fied under section 199 because of several §1.199–9(j)(2) of the final regulations) does not include gain or loss recognized on

decades-long industry practices. Among MPGE or produces property and dis- the sale, exchange or other disposition of

the historical industry practices taken into tributes, leases, rents, licenses, sells, ex- an interest in the entity. However, consis-

account by the IRS and Treasury De- changes, or otherwise disposes of that tent with Notice 2005–14 and the proposed

partment in establishing the oil and gas property to a member of an EAG of which regulations, if section 751(a) or (b) applies,

exception was the fact that for decades the partners of the EAG partnership are then gain or loss attributable to partnership

the oil and gas industry generally has members, then the MPGE or production assets giving rise to ordinary income under

operated in a business model in which a activity conducted by the EAG partnership section 751(a) or (b), the sale, exchange, or

partnership produces qualifying property will be treated as having been conducted other disposition of which would give rise

and distributes such property in-kind to its by the disposing member of the EAG. to an item of DPGR, is taken into account

partners (generally engaged themselves in Similarly, if one or more members of an in computing the partner’s section 199 de-

the production of oil and gas), generally EAG of which the partners of an EAG duction.

the partnership does not derive any gross partnership are members MPGE or pro- One commentator stated that many

receipts from the produced property, the duces property and contributes, leases, commercial real estate developers dispose

property is marketed and sold exclusively rents, licenses, sells, exchanges, or other- of commercial real property by selling in-

and separately by each partner as competi- wise disposes of that property to the EAG terests in special purpose partnerships that

tors, and generally there is no marketing partnership, then the MPGE or production hold commercial real property. Because a

or sale by the partnership of the produced activity conducted by the EAG member sale, exchange or other disposition of the

property, and no joint marketing or sale of (or members) will be treated as having commercial real property may result in

the distributed property by any of the part- been conducted by the EAG partnership. section 1231 gain rather than ordinary in-

ners. In addition, the partnership typically A question arose as to when a corporation come, the commentator suggested that the

qualifies to elect out of subchapter K. needs to be a member of an EAG of which definition of inventory items be expanded

In response to the requests that this attri- the partners of the EAG partnership are for purposes of §1.199–9(e) by treating

bution rule be expanded to industries that members for attribution of MPGE or pro- section 751(d) as not containing the words

historically have operated in a manner sub- duction activities to take place. The final “and other than property described in sec-

stantially similar to the oil and gas indus- regulations clarify that attribution of such tion 1231.” As a result, a sale or exchange

try, the final regulations provide that, if a activities between an EAG partnership and of an interest in a partnership that holds

partnership that MPGE or produces prop- members of the EAG of which the partners commercial real property would gener-

erty is a qualifying in-kind partnership (as of the EAG partnership are members is ate DPGR if a sale or exchange of the

defined later), then each partner may be determined at the time that the EAG part- commercial real property would gener-





2006–25 I.R.B. 1077 June 19, 2006

ate DPGR regardless of whether the sale provides taxpayers automatic consent to ing between entity and owner of informa-

or exchange would result in ordinary in- change certain elections relating to the tion that might not be needed for purposes

come. The final regulations do not include apportionment of interest expense and other than section 199. Both the proposed

the commentator’s suggestion because research and experimental expenditures and the final regulations provide a number

the rule in §1.199–9(e) applies aggregate under the section 861 regulations. It is of safe harbors and de minimis rules that

treatment to a sale or exchange of a part- intended that the automatic consent af- are intended to balance the need for com-

nership interest only to the extent section forded under the revenue procedure will pliance with these statutory requirements

751 specifically allows such treatment. provide taxpayers the consent required by against the burden imposed on taxpayers.

Modifying the explicit terms of section §§1.861–8T(c)(2) and 1.861–9(i)(2), with In the preamble to the proposed regu-

751(d) as suggested would be inconsistent respect to the apportionment of interest lations, the IRS and Treasury Department

with the purposes of section 751 and sec- expense, and by §1.861–17(e), with re- certify that the collection of information

tion 199. spect to the apportionment of research and required under the proposed regulations

experimental expenditures, to change an (relating to information to be provided by

Statistical Sampling election, effective for a taxpayer’s first cooperatives to their patrons) will not have

taxable year beginning after December 31, a significant economic impact on a sub-

In the preamble to the proposed regu-

2004 (the taxpayer’s 2005 taxable year). stantial number of small entities, and there-

lations, the IRS and Treasury Department

In addition, it is intended that the revenue fore that a Regulatory Flexibility Analy-

invited taxpayers to submit comments on

procedure will provide taxpayers the con- sis is not required by the Regulatory Flex-

issues relating to section 199 including

sent required by those regulations for a ibility Act (RFA). One commentator as-

whether taxpayers can apply statistical

taxpayer’s taxable year immediately fol- serted that the certification did not provide

sampling to section 199, what specific

lowing the taxpayer’s 2005 taxable year, sufficient information for small entities to

areas of section 199 statistical sampling

but, in such case, a taxpayer would not be determine the impact the regulations will

could be applied to, and whether appli-

provided automatic consent to change any have on their businesses. The commenta-

cation of statistical sampling should be

election that first took effect with respect tor also contended that the IRS and Trea-

limited to specific areas of section 199.

to the taxpayer’s 2005 taxable year. sury Department, in making the certifica-

Comments were received on statistical

tion, failed to consider burdens imposed by

sampling and the IRS and Treasury De-

Financial and Administrative Burden the proposed regulations on other small en-

partment are considering those comments

tities, such as partnerships and S corpora-

and intend to issue subsequent guidance

Several commentators objected to the tions, that are required under the regula-

addressing the application of statistical

complexity of the proposed regulations, tions to provide certain information to their

sampling for purposes of section 199.

and to the financial and administrative bur- owners.

Elections under the Section 861 den that the commentators believe the reg- The IRS and Treasury Department be-

Regulations ulations will impose on taxpayers (particu- lieve that the certification for the proposed

larly on small businesses). The complexity regulations, as well as for these final reg-

The preamble to the proposed regula- and burden of the regulations are a func- ulations, is appropriate and complies with

tions states that, because the provisions tion of the statutory language and frame- the requirements of the RFA. With respect

of section 199 may cause taxpayers to work of section 199, which are complex to cooperatives, the regulations provide

reconsider previously made elections un- and contain many requirements. For ex- cooperatives with specific rules about the

der §§1.861–8 through 1.861–17 and ample, with the exception of a few specific information they must provide to patrons

§§1.861–8T through 1.861–14T (the sec- services (namely, construction, architec- under section 199. The IRS and Trea-

tion 861 regulations), the IRS and Trea- ture, and engineering) only gross receipts sury Department believe that cooperatives

sury Department intend to issue a revenue derived from certain dispositions of certain have the necessary information to com-

procedure granting taxpayers automatic property qualify under the statute. In ad- ply with this requirement. The IRS and

consent to change certain of those elec- dition, in the case of manufacturing activ- Treasury Department continue to believe

tions. In the proposed regulations, the ities, the property must be manufactured that this requirement is the only collec-

IRS and Treasury Department requested by the taxpayer in whole or in significant tion of information in the regulations that

comments on which elections should be part within the United States. Also, un- is within the scope of the RFA. Certain

included in such a revenue procedure and der section 199, costs must be allocated be- other recordkeeping and reporting require-

the appropriate time period during which tween qualifying and nonqualifying gross ments of the regulations relating to infor-

the automatic consent should apply. Sev- receipts. All of these statutory require- mation sharing between pass-thru entities

eral commentators urged promulgation ments (and others) potentially necessitate (partnerships and S corporations) and their

of such a revenue procedure, and several that taxpayers obtain information, make owners are subsumed within other existing

comments specifically requested that the determinations and computations, and re- income tax regulations that currently re-

revenue procedure provide taxpayers au- tain records that might not otherwise be re- quire that such entities report to their own-

tomatic consent for more than one taxable quired for business purposes. In the case of ers all information that is necessary for the

year to change previously made elections. partnerships and S corporations, the statute owners to determine their tax liability.

The IRS and Treasury Department in- requires that the deduction be computed

tend to issue a revenue procedure that at the owner level, necessitating the shar-





June 19, 2006 1078 2006–25 I.R.B.

Effective Date EFFECT ON OTHER DOCUMENTS Section 1.199–4 also issued under

26 U.S.C. 199(d).

Section 199 applies to taxable years Notice 2005–14, 2005–1 C.B. 498, is Section 1.199–5 also issued under

beginning after December 31, 2004. Sec- obsolete for taxable years beginning on or 26 U.S.C. 199(d).

tions 1.199–1 through 1.199–8 are appli- after June 1, 2006. Section 1.199–6 also issued under

cable for taxable years beginning on or 26 U.S.C. 199(d).

after June 1, 2006. For a taxable year Special Analyses Section 1.199–7 also issued under

beginning on or before May 17, 2006, 26 U.S.C. 199(d).

the enactment date of TIPRA, a taxpayer It has been determined that this Trea- Section 1.199–8 also issued under

may apply §§1.199–1 through 1.199–9 sury decision is not a significant regula- 26 U.S.C. 199(d).

provided that the taxpayer applies all pro- tory action as defined in Executive Or- Section 1.199–9 also issued under

visions in §§1.199–1 through 1.199–9 to der 12866. Therefore, a regulatory assess- 26 U.S.C. 199(d). * * *

the taxable year. For a taxable year begin- ment is not required. It is hereby certified Par. 2. Sections 1.199–0 through

ning after May 17, 2006, and before June that the collection of information in this 1.199–9 are added to read as follows:

1, 2006, a taxpayer may apply §§1.199–1 regulation will not have a significant eco-

through 1.199–8 provided that the tax- nomic impact on a substantial number of §1.199–0 Table of contents.

payer applies all provisions in §§1.199–1 small entities. This certification is based

through 1.199–8 to the taxable year. Sec- upon the fact that any burden on cooper- This section lists the section headings

tion 1.199–9 may not be applied to a atives is minimal. Accordingly, a Regula- that appear in §§1.199–1 through 1.199–9.

taxable year that begins after May 17, tory Flexibility Analysis under the Regula-

2006. tory Flexibility Act (5 U.S.C. chapter 6) is §1.199–1 Income attributable to domestic

For a taxpayer who chooses not to rely not required. Pursuant to section 7805(f) production activities.

on these final regulations for a taxable of the Code, the notice of proposed rule-

(a) In general.

year beginning before June 1, 2006, the making was submitted to the Chief Coun-

(b) Taxable income and adjusted gross

guidance on section 199 that applies to sel for Advocacy of the Small Business

income.

such taxable year is contained in Notice Administration for comment on its impact

(1) In general.

2005–14, 2005–1 C.B. 498. In addition, on small business.

(2) Examples.

a taxpayer also may rely on the provisions

(c) Qualified production activities in-

of REG–105847–05, 2005–47 I.R.B. 987 Drafting Information

come.

(see §601.601(d)(2)) for a taxable year

The principal authors of these reg- (d) Allocation of gross receipts.

beginning before June 1, 2006. If Notice

ulations are Paul Handleman and (1) In general.

2005–14 and REG–105847–05 include

Lauren Ross Taylor, Office of the As- (2) Reasonable method of allocation.

different rules for the same particular is-

sociate Chief Counsel (Passthroughs and (3) De minimis rules.

sue, then a taxpayer may rely on either the

Special Industries), IRS. However, other (i) DPGR.

rule set forth in Notice 2005–14 or the rule

personnel from the IRS and Treasury (ii) Non-DPGR.

set forth in REG–105847–05. However,

Department participated in their develop- (4) Example.

if REG–105847–05 includes a rule that

ment. (e) Certain multiple-year transactions.

was not included in Notice 2005–14, then

(1) Use of historical data.

a taxpayer is not permitted to rely on the ***** (2) Percentage of completion method.

absence of a rule to apply a rule contrary

(3) Examples.

to REG–105847–05. For taxable years Adoption of Amendments to the

beginning after May 17, 2006, and before Regulations §1.199–2 Wage limitation.

June 1, 2006, a taxpayer may not apply

Notice 2005–14, REG–105847–05, or any Accordingly, 26 CFR parts 1 and 602 (a) Rules of application.

other guidance under section 199 in a man- are amended as follows: (1) In general.

ner inconsistent with amendments made to (2) Wages paid by entity other than

section 199 by section 514 of TIPRA. In PART 1—INCOME TAXES common law employer.

determining the deduction under section (3) Requirement that wages must be re-

199, items arising from a taxable year of a Paragraph 1. The authority citation for ported on return filed with the Social Se-

partnership, S corporation, estate, or trust part 1 is amended by adding entries to read, curity Administration.

beginning before January 1, 2005, shall in part, as follows: (i) In general.

not be taken into account for purposes of Authority: 26 U.S.C. 7805 * * * (ii) Corrected return filed to correct a

section 199(d)(1). Members of an EAG Section 1.199–1 also issued under return that was filed within 60 days of the

that are not members of a consolidated 26 U.S.C. 199(d). due date.

group may each apply the effective date Section 1.199–2 also issued under (iii) Corrected return filed to correct a

rules without regard to how other mem- 26 U.S.C. 199(d). return that was filed later than 60 days after

bers of the EAG apply the effective date Section 1.199–3 also issued under the due date.

rules. 26 U.S.C. 199(d). (4) Joint return.





2006–25 I.R.B. 1079 June 19, 2006

(b) Application in the case of a taxpayer (i) Derived from the lease, rental, li- (5) Tangible personal property with

with a short taxable year. cense, sale, exchange, or other disposition. computer software or sound recordings.

(c) Acquisition or disposition of a trade (1) In general. (i) Computer software and sound

or business (or major portion). (i) Definition. recordings.

(d) Non-duplication rule. (ii) Lease income. (ii) Tangible personal property.

(e) Definition of W–2 wages. (iii) Income substitutes. (k) Definition of qualified film.

(1) In general. (iv) Exchange of property. (1) In general.

(2) Limitation on W–2 wages for tax- (A) Taxable exchanges. (2) Tangible personal property with a

able years beginning after May 17, 2006, (B) Safe harbor. film.

the enactment date of the Tax Increase Pre- (C) Eligible property. (i) Film not produced by a taxpayer.

vention and Reconciliation Act of 2005. (2) Examples. (ii) Film produced by a taxpayer.

[Reserved]. (3) Hedging transactions. (A) Qualified film.

(3) Methods for calculating W–2 (i) In general. (B) Nonqualified film.

wages. (ii) Currency fluctuations. (3) Derived from a qualified film.

(iii) Effect of identification and non- (i) In general.

§1.199–3 Domestic production gross identification. (ii) Exceptions.

receipts. (iv) Other rules. (4) Compensation for services.

(4) Allocation of gross receipts. (5) Determination of 50 percent.

(a) In general.

(i) Embedded services and non-quali- (6) Exception.

(b) Related persons.

fied property. (7) Examples.

(1) In general.

(A) In general. (l) Electricity, natural gas, or potable

(2) Exceptions.

(B) Exceptions. water.

(c) Definition of gross receipts.

(ii) Non-DPGR. (1) In general.

(d) Determining domestic production

(iii) Examples. (2) Natural gas.

gross receipts.

(5) Advertising income. (3) Potable water.

(1) In general.

(i) Tangible personal property. (4) Exceptions.

(2) Special rules.

(ii) Qualified film. (i) Electricity.

(3) Exception.

(iii) Examples. (ii) Natural gas.

(4) Examples.

(6) Computer software. (iii) Potable water.

(e) Definition of manufactured, pro-

(i) In general. (iv) De minimis exception.

duced, grown, or extracted.

(ii) through (v) [Reserved]. (A) DPGR.

(1) In general.

(7) Qualifying in-kind partnership for (B) Non-DPGR.

(2) Packaging, repackaging, labeling,

taxable years beginning after May 17, (5) Example.

or minor assembly.

2006, the enactment date of the Tax In- (m) Definition of construction per-

(3) Installing.

crease Prevention and Reconciliation Act formed in the United States.

(4) Consistency with section 263A.

of 2005. [Reserved]. (1) Construction of real property.

(5) Examples.

(8) Partnerships owned by members of (i) In general.

(f) Definition of by the taxpayer.

a single expanded affiliated group for tax- (ii) Regular and ongoing basis.

(1) In general.

able years beginning after May 17, 2006, (A) In general.

(2) Special rule for certain government

the enactment date of the Tax Increase Pre- (B) New trade or business.

contracts.

vention and Reconciliation Act of 2005. (iii) De minimis exception.

(3) Subcontractor.

[Reserved]. (A) DPGR.

(4) Examples.

(9) Non-operating mineral interests. (B) Non-DPGR.

(g) Definition of in whole or in signifi-

(j) Definition of qualifying production (2) Activities constituting construction.

cant part.

property. (i) In general.

(1) In general.

(1) In general. (ii) Tangential services.

(2) Substantial in nature.

(2) Tangible personal property. (iii) Other construction activities.

(3) Safe harbor.

(i) In general. (iv) Administrative support services.

(i) In general.

(ii) Local law. (v) Exceptions.

(ii) Unadjusted depreciable basis.

(iii) Intangible property. (3) Definition of real property.

(iii) Computer software and sound

(3) Computer software. (4) Definition of infrastructure.

recordings.

(i) In general. (5) Definition of substantial renovation.

(4) Special rules.

(ii) Incidental and ancillary rights. (6) Derived from construction.

(i) Contract with unrelated persons.

(iii) Exceptions. (i) In general.

(ii) Aggregation.

(4) Sound recordings. (ii) Qualified construction warranty.

(5) Examples.

(i) In general. (iii) Exceptions.

(h) Definition of United States.

(ii) Exception. (iv) Land safe harbor.

(A) In general.





June 19, 2006 1080 2006–25 I.R.B.

(B) Determining gross receipts and (3) Research and experimental expen- (f) Specified agricultural or horticul-

costs. ditures. tural cooperative.

(v) Examples. (4) Deductions allocated or apportioned (g) Written notice to patrons.

(n) Definition of engineering and archi- to gross receipts treated as domestic pro- (h) Additional rules relating to

tectural services. duction gross receipts. passthrough of section 199 deduction.

(1) In general. (5) Treatment of items from a pass-thru (i) W–2 wages.

(2) Engineering services. entity reporting qualified production activ- (j) Recapture of section 199 deduction.

(3) Architectural services. ities income. (k) Section is exclusive.

(4) Administrative support services. (6) Examples. (l) No double counting.

(5) Exceptions. (e) Simplified deduction method. (m) Examples.

(6) De minimis exception for perfor- (1) In general.

mance of services in the United States. (2) Eligible taxpayer. §1.199–7 Expanded affiliated groups.

(i) DPGR. (3) Total assets.

(a) In general.

(ii) Non-DPGR. (i) In general.

(1) Definition of expanded affiliated

(7) Example. (ii) Members of an expanded affiliated

group.

(o) Sales of certain food and beverages. group.

(2) Identification of members of an ex-

(1) In general. (4) Members of an expanded affiliated

panded affiliated group.

(2) De minimis exception. group.

(i) In general.

(3) Examples. (i) In general.

(ii) Becoming or ceasing to be a mem-

(p) Guaranteed payments. (ii) Exception.

ber of an expanded affiliated group.

(iii) Examples.

§1.199–4 Costs allocable to domestic (3) Attribution of activities.

(f) Small business simplified overall

production gross receipts. (i) In general.

method.

(ii) Special rule.

(1) In general.

(a) In general. (4) Examples.

(2) Qualifying small taxpayer.

(b) Cost of goods sold allocable to do- (5) Anti-avoidance rule.

(3) Total costs for the current taxable

mestic production gross receipts. (b) Computation of expanded affiliated

year.

(1) In general. group’s section 199 deduction.

(i) In general.

(2) Allocating cost of goods sold. (1) In general.

(ii) Land safe harbor.

(i) In general. (2) Example.

(4) Members of an expanded affiliated

(ii) Gross receipts recognized in an ear- (3) Net operating loss carrybacks and

group.

lier taxable year. carryovers.

(i) In general.

(3) Special rules for imported items or (c) Allocation of an expanded affili-

(ii) Exception.

services. ated group’s section 199 deduction among

(iii) Examples.

(4) Rules for inventories valued at mar- members of the expanded affiliated group.

(5) Trusts and estates.

ket or bona fide selling prices. (1) In general.

(g) Average annual gross receipts.

(5) Rules applicable to inventories ac- (2) Use of section 199 deduction to cre-

(1) In general.

counted for under the last-in, first-out ate or increase a net operating loss.

(2) Members of an expanded affiliated

(LIFO) inventory method. (d) Special rules for members of the

group.

(i) In general. same consolidated group.

(ii) LIFO/FIFO ratio method. §1.199–5 Application of section 199 (1) Intercompany transactions.

(iii) Change in relative base-year cost to pass-thru entities for taxable years (2) Attribution of activities in the con-

method. beginning after May 17, 2006, the struction of real property and the perfor-

(6) Taxpayers using the simplified enactment date of the Tax Increase mance of engineering and architectural

production method or simplified resale Prevention and Reconciliation Act of services.

method for additional section 263A costs. 2005. [Reserved]. (3) Application of the simplified deduc-

(7) Examples. tion method and the small business simpli-

(c) Other deductions properly allocable §1.199–6 Agricultural and horticultural fied overall method.

to domestic production gross receipts or cooperatives. (4) Determining the section 199 deduc-

gross income attributable to domestic pro- tion.

duction gross receipts. (a) In general. (i) Expanded affiliated group consists

(1) In general. (b) Cooperative denied section 1382 de- of consolidated group and non-consoli-

(2) Treatment of net operating losses. duction for portion of qualified payments. dated group members.

(3) W–2 wages. (c) Determining cooperative’s taxable (ii) Expanded affiliated group consists

(d) Section 861 method. income. only of members of a single consolidated

(1) In general. (d) Special rule for marketing coopera- group.

(2) Deductions for charitable contribu- tives.

tions. (e) Qualified payment.







2006–25 I.R.B. 1081 June 19, 2006

(5) Allocation of the section 199 de- (4) Computer software provided to cus- (j) Partnerships owned by members of

duction of a consolidated group among its tomers over the Internet. [Reserved]. a single expanded affiliated group.

members. (1) In general.

(e) Examples. §1.199–9 Application of section 199 (2) Attribution of activities.

(f) Allocation of income and loss by a to pass-thru entities for taxable years (i) In general.

corporation that is a member of the ex- beginning on or before May 17, 2006, (ii) Attribution between EAG partner-

panded affiliated group for only a portion the enactment date of the Tax Increase ships.

of the year. Prevention and Reconciliation Act of (iii) Exception to attribution.

(1) In general. 2005. (3) Special rules for distributions.

(i) Pro rata allocation method. (4) Other rules.

(a) In general.

(ii) Section 199 closing of the books (5) Examples.

(b) Partnerships.

method. (k) Effective dates.

(1) In general.

(iii) Making the section 199 closing of

(i) Determination at partner level. §1.199–1 Income attributable to domestic

the books election.

(ii) Determination at entity level. production activities.

(2) Coordination with rules relat-

(2) Disallowed losses or deductions.

ing to the allocation of income under

(3) Partner’s share of W–2 wages. (a) In general. A taxpayer may deduct

§1.1502–76(b).

(4) Transition percentage rule for W–2 an amount equal to 9 percent (3 percent

(g) Total section 199 deduction for a

wages. in the case of taxable years beginning in

corporation that is a member of an ex-

(5) Partnerships electing out of sub- 2005 or 2006, and 6 percent in the case of

panded affiliated group for some or all of

chapter K. taxable years beginning in 2007, 2008, or

its taxable year.

(6) Examples. 2009) of the lesser of the taxpayer’s qual-

(1) Member of the same expanded affil-

(c) S corporations. ified production activities income (QPAI)

iated group for the entire taxable year.

(1) In general. (as defined in paragraph (c) of this section)

(2) Member of the expanded affiliated

(i) Determination at shareholder level. for the taxable year, or the taxpayer’s tax-

group for a portion of the taxable year.

(ii) Determination at entity level. able income for the taxable year (or, in the

(3) Example.

(2) Disallowed losses or deductions. case of an individual, adjusted gross in-

(h) Computation of section 199 deduc-

(3) Shareholder’s share of W–2 wages. come). The amount of the deduction al-

tion for members of an expanded affiliated

(4) Transition percentage rule for W–2 lowable under this paragraph (a) for any

group with different taxable years.

wages. taxable year cannot exceed 50 percent of

(1) In general.

(d) Grantor trusts. the W–2 wages of the employer for the tax-

(2) Example.

(e) Non-grantor trusts and estates. able year (as determined under §1.199–2).

§1.199–8 Other rules. (1) Allocation of costs. The provisions of this section apply solely

(2) Allocation among trust or estate and for purposes of section 199 of the Internal

(a) In general. beneficiaries. Revenue Code.

(b) Individuals. (i) In general. (b) Taxable income and adjusted gross

(c) Trade or business requirement. (ii) Treatment of items from a trust or income—(1) In general. For purposes of

(1) In general. estate reporting qualified production activ- paragraph (a) of this section, the definition

(2) Individuals. ities income. of taxable income under section 63 applies,

(3) Trusts and estates. (3) Beneficiary’s share of W–2 wages. except that taxable income is determined

(d) Coordination with alternative mini- (4) Transition percentage rule for W–2 without regard to section 199 and with-

mum tax. wages. out regard to any amount excluded from

(e) Nonrecognition transactions. (5) Example. gross income pursuant to section 114 or

(1) In general. (f) Gain or loss from the disposition of pursuant to section 101(d) of the Ameri-

(i) Sections 351, 721, and 731. an interest in a pass-thru entity. can Jobs Creation Act of 2004, Public Law

(ii) Exceptions. (g) Section 199(d)(1)(A)(iii) wage lim- 108–357, 118 Stat. 1418 (Act). In the

(A) Section 708(b)(1)(B). itation and tiered structures. case of individuals, adjusted gross income

(B) Transfers by reason of death. (1) In general. for the taxable year is determined after ap-

(2) Section 1031 exchanges. (2) Share of W–2 wages. plying sections 86, 135, 137, 219, 221,

(3) Section 381 transactions. (3) Example. 222, and 469, and without regard to sec-

(f) Taxpayers with a 52–53 week tax- (h) No attribution of qualified activities. tion 199 and without regard to any amount

able year. (i) Qualifying in-kind partnership. excluded from gross income pursuant to

(g) Section 481(a) adjustments. (1) In general. section 114 or pursuant to section 101(d)

(h) Disallowed losses or deductions. (2) Definition of qualifying in-kind of the Act. For purposes of determining

(i) Effective dates. partnership. the tax imposed by section 511, paragraph

(1) In general. (3) Special rules for distributions. (a) of this section is applied using unre-

(2) Pass-thru entities. (4) Other rules. lated business taxable income. Except as

(3) Non-consolidated EAG members. (5) Example. provided in §1.199–7(c)(2), the deduction







June 19, 2006 1082 2006–25 I.R.B.

under section 199 is not taken into account fined in §1.199–3(j)(1)) and in connection DPGR and non-DPGR in accordance with

in computing any net operating loss or the with that lease, also provides services, the paragraph (d)(1) of this section. If a cor-

amount of any net operating loss carryback taxpayer must allocate its gross receipts poration is a member of an EAG, but is

or carryover. from the transaction using any reasonable not a member of a consolidated group,

(2) Examples. The following examples method that is satisfactory to the Secre- then the determination of whether less

illustrate the application of this paragraph tary based on all of the facts and circum- than 5 percent of the taxpayer’s total gross

(b): stances and that accurately identifies the receipts are non-DPGR is made at the

Example 1. X, a corporation that is not part of gross receipts that constitute DPGR and corporation level. If a corporation is a

an expanded affiliated group (EAG) (as defined in non-DPGR. member of a consolidated group, then the

§1.199–7), engages in production activities that gen-

erate QPAI and taxable income (without taking into

(2) Reasonable method of allocation. determination of whether less than 5 per-

account the deduction under this section and an NOL Factors taken into consideration in deter- cent of the taxpayer’s total gross receipts

deduction) of $600 in 2010. During 2010, X incurs mining whether the taxpayer’s method of are non-DPGR is made at the consolidated

W–2 wages as defined in §1.199–2(e) of $300. X has allocating gross receipts between DPGR group level. In the case of an S corpora-

an NOL carryover to 2010 of $500. X’s deduction un- and non-DPGR is reasonable include tion, partnership, trust (to the extent not

der this section for 2010 is $9 (.09 x (lesser of QPAI

of $600 and taxable income of $100 ($600 taxable in-

whether the taxpayer uses the most accu- described in §1.199–9(d)) or estate, or

come - $500 NOL)). Because the wage limitation is rate information available; the relationship other pass-thru entity, the determination of

$150 (50% x $300), X’s deduction is not limited. between the gross receipts and the method whether less than 5 percent of the pass-thru

Example 2. (i) Facts. X, a corporation that is not used; the accuracy of the method chosen entity’s total gross receipts are non-DPGR

part of an EAG, engages in production activities that as compared with other possible methods; is made at the pass-thru entity level. In

generate QPAI and taxable income (without taking

into account the deduction under this section and an

whether the method is used by the tax- the case of an owner of a pass-thru entity,

NOL deduction) of $100 in 2010. X has an NOL car- payer for internal management or other the determination of whether less than 5

ryover to 2010 of $500 that reduces its taxable income business purposes; whether the method is percent of the owner’s total gross receipts

for 2010 to $0. X’s deduction under this section for used for other Federal or state income tax are non-DPGR is made at the owner level,

2010 is $0 (.09 x (lesser of QPAI of $100 and taxable purposes; the time, burden, and cost of us- taking into account all gross receipts of

income of $0)).

(ii) Carryover to 2011. X’s taxable income for

ing alternative methods; and whether the the owner from its other trade or business

purposes of determining its NOL carryover to 2011 taxpayer applies the method consistently activities and the owner’s share of the

is $100. Accordingly, X’s NOL carryover to 2011 is from year to year. Thus, if a taxpayer has gross receipts of the pass-thru entity.

$400 ($500 NOL carryover to 2010 - $100 NOL used the information readily available and can, (ii) Non-DPGR. All of a taxpayer’s

in 2010). without undue burden or expense, specif- gross receipts may be treated as

(c) Qualified production activities in- ically identify whether the gross receipts non-DPGR if less than 5 percent of the

come. QPAI for any taxable year is an derived from an item are DPGR, then the taxpayer’s total gross receipts are DPGR

amount equal to the excess (if any) of the taxpayer must use that specific identifi- (after application of the exceptions pro-

taxpayer’s domestic production gross re- cation to determine DPGR. If a taxpayer vided in §1.199–3(i)(4)(ii), (l)(4)(iv)(B),

ceipts (DPGR) (as defined in §1.199–3) does not have information readily avail- (m)(1)(iii)(B), and (n)(6)(ii) that may

over the sum of— able to specifically identify whether the result in gross receipts being treated as

(1) The cost of goods sold (CGS) that is gross receipts derived from an item are non-DPGR). If a corporation is a mem-

allocable to such receipts; and DPGR or cannot, without undue burden ber of an EAG, but is not a member of a

(2) Other expenses, losses, or deduc- or expense, specifically identify whether consolidated group, then the determina-

tions (other than the deduction allowed un- the gross receipts derived from an item are tion of whether less than 5 percent of the

der this section) that are properly alloca- DPGR, then the taxpayer is not required taxpayer’s total gross receipts are DPGR

ble to such receipts. See §§1.199–3 and to use a method that specifically identifies is made at the corporation level. If a cor-

1.199–4. whether the gross receipts derived from an poration is a member of a consolidated

(d) Allocation of gross receipts—(1) In item are DPGR. group, then the determination of whether

general. A taxpayer must determine the (3) De minimis rules—(i) DPGR. All less than 5 percent of the taxpayer’s total

portion of its gross receipts for the tax- of a taxpayer’s gross receipts may be gross receipts are DPGR is made at the

able year that is DPGR and the portion of treated as DPGR if less than 5 percent consolidated group level. In the case of

its gross receipts that is non-DPGR. Ap- of the taxpayer’s total gross receipts are an S corporation, partnership, trust (to the

plicable Federal income tax principles ap- non-DPGR (after application of the ex- extent not described in §1.199–9(d)) or

ply to determine whether a transaction is, ceptions provided in §1.199–3(i)(4)(i)(B), estate, or other pass-thru entity, the deter-

in substance, a lease, rental, license, sale, (l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), and mination of whether less than 5 percent

exchange, or other disposition the gross (o)(2) that may result in gross receipts of the pass-thru entity’s total gross re-

receipts of which may constitute DPGR being treated as DPGR). If the amount ceipts are DPGR is made at the pass-thru

(assuming all the other requirements of of the taxpayer’s gross receipts that are entity level. In the case of an owner of

§1.199–3 are met), whether it is a service non-DPGR equals or exceeds 5 percent of a pass-thru entity, the determination of

the gross receipts of which may constitute the taxpayer’s total gross receipts, then, whether less than 5 percent of the owner’s

non-DPGR, or some combination thereof. except as provided in paragraph (d)(3)(ii) total gross receipts are DPGR is made at

For example, if a taxpayer leases quali- of this section, the taxpayer is required the owner level, taking into account all

fying production property (QPP) (as de- to allocate all gross receipts between gross receipts of the owner from its other





2006–25 I.R.B. 1083 June 19, 2006

trade or business activities and the owner’s tion for the factors taken into considera- tures within the United States and 50% will be de-

share of the gross receipts of the pass-thru tion in determining whether the taxpayer’s rived from the sale of purchased parts X did not man-

entity. method is reasonable. ufacture and non-qualifying services. Under all of the

facts and circumstances, X’s method of allocation is

(4) Example. The following example (3) Examples. The following examples still a reasonable method. When Y makes its $200

illustrates the application of this para- illustrate the application of this paragraph payment for 2009, X, relying on its updated histori-

graph (d): (e): cal data, properly treats $100 as DPGR in 2009.

Example. X derives its gross receipts from the Example 1. On December 1, 2007, X, a calen-

sale of gasoline refined by X within the United States dar year accrual method taxpayer, sells for $100 a §1.199–2 Wage limitation.

and the sale of refined gasoline that X acquired by one-year computer software maintenance agreement

purchase from an unrelated person. If at least 5% of that provides for (i) computer software updates that X

(a) Rules of application—(1) In gen-

X’s gross receipts are derived from gasoline refined expects to produce in the United States, and (ii) cus-

by X within the United States (that qualify as DPGR tomer support services. At the end of 2007, X uses a

eral. The provisions of this section ap-

if all the other requirements of §1.199–3 are met) and reasonable method that is satisfactory to the Secretary ply solely for purposes of section 199 of

at least 5% of X’s gross receipts are derived from the based on all of the facts and circumstances to allocate the Internal Revenue Code. The amount of

resale of the acquired gasoline (that do not qualify as 60% of the gross receipts ($60) to the computer soft- the deduction allowable under §1.199–1(a)

DPGR), then X does not qualify for the de minimis ware updates and 40% ($40) to the customer support

(section 199 deduction) to a taxpayer for

rules under paragraphs (d)(3)(i) and (ii) of this sec- services. X treats the $60 as DPGR in 2007. At the

tion, and X must allocate its gross receipts between expiration of the one-year agreement on November

any taxable year shall not exceed 50 per-

the gross receipts derived from the sale of gasoline 30, 2008, no computer software updates are provided cent of the W–2 wages (as defined in para-

refined by X within the United States and the gross by X. Pursuant to paragraph (e)(1) of this section, be- graph (e) of this section) of the taxpayer.

receipts derived from the resale of the acquired gaso- cause X used a reasonable method that is satisfactory For this purpose, except as provided in

line. If less than 5% of X’s gross receipts are derived to the Secretary based on all of the facts and circum-

paragraph (a)(3) of this section and para-

from the resale of the acquired gasoline, then, X may stances to identify gross receipts as DPGR, X is not

either allocate its gross receipts between the gross re- required to make any adjustments to its 2007 Federal

graph (b) of this section, the Forms W–2,

ceipts derived from the gasoline refined by X within income tax return (for example, by amended return) “Wage and Tax Statement,” used in deter-

the United States and the gross receipts derived from or in 2008 for the $60 that was properly treated as mining the amount of W–2 wages are those

the resale of the acquired gasoline, or, pursuant to DPGR in 2007, even though no computer software issued for the calendar year ending dur-

paragraph (d)(3)(i) of this section, X may treat all of updates were provided under the contract.

ing the taxpayer’s taxable year for wages

its gross receipts derived from the sale of the refined Example 2. X manufactures automobiles within

gasoline as DPGR. If X’s gross receipts attributable the United States and sells 5-year extended warranties

paid to employees (or former employees)

to the gasoline refined by X within the United States to customers. The sales price of the warranty is based of the taxpayer for employment by the tax-

constitute less than 5% of X’s total gross receipts, on historical data that determines what repairs and payer. For purposes of this section, em-

then, X may either allocate its gross receipts between services are performed on an automobile during the ployees of the taxpayer are limited to em-

the gross receipts derived from the gasoline refined 5-year period. X sells the 5-year warranty to Y for

ployees of the taxpayer as defined in sec-

by X within the United States and the gross receipts $1,000 in 2007. Under X’s method of accounting,

derived from the resale of the acquired gasoline, or, X recognizes warranty revenue when received. Us-

tion 3121(d)(1) and (2) (that is, officers

pursuant to paragraph (d)(3)(ii) of this section, X may ing historical data, X concludes that 60% of the gross of a corporate taxpayer and employees of

treat all of its gross receipts derived from the sale of receipts attributable to a 5-year warranty will be de- the taxpayer under the common law rules).

the refined gasoline as non-DPGR. rived from the sale of parts (QPP) that X manufac- See paragraph (a)(3) of this section for the

(e) Certain multiple-year transac- tures within the United States, and 40% will be de-

requirement that W–2 wages must have

tions—(1) Use of historical data. If a rived from the sale of purchased parts X did not man-

ufacture and non-qualifying services. X’s method of

been included in a return filed with the So-

taxpayer recognizes and reports gross re- allocating its gross receipts with respect to the 5-year cial Security Administration (SSA) within

ceipts from advance payments or other warranty between DPGR and non-DPGR is a reason- 60 days after the due date (including exten-

similar payments on a Federal income tax able method that is satisfactory to the Secretary based sions) of the return.

return for a taxable year, then the tax- on all of the facts and circumstances. Therefore, X

(2) Wages paid by entity other than

payer’s use of historical data in making an properly treats $600 as DPGR in 2007.

Example 3. The facts are the same as in Example

common law employer. In determining

allocation of gross receipts from the trans- 2 except that in 2009 X updates its historical data. W–2 wages, a taxpayer may take into ac-

action between DPGR and non-DPGR The updated historical data show that 50% of the count any wages paid by another entity and

may constitute a reasonable method. If a gross receipts attributable to a 5-year warranty will reported by the other entity on Forms W–2

taxpayer makes allocations using histor- be derived from the sale of parts (QPP) that X man-

with the other entity as the employer listed

ical data, and subsequently updates the ufactures within the United States and 50% will be

derived from the sale of purchased parts X did not

in Box c of the Forms W–2, provided that

data, then the taxpayer must use the more manufacture and non-qualifying services. In 2009, X the wages were paid to employees of the

recent or updated data, starting in the tax- sells a 5-year warranty for $1,000 to Z. Under all of taxpayer for employment by the taxpayer.

able year in which the update is made. the facts and circumstances, X’s method of allocation If the taxpayer is treated as an employer

(2) Percentage of completion method. is still a reasonable method. Relying on its updated

described in section 3401(d)(1) because

A taxpayer using a percentage of comple- historical data, X properly treats $500 as DPGR in

2009.

of control of the payment of wages (that

tion method under section 460 must deter- Example 4. The facts are the same as in Exam- is, the taxpayer is not the common law

mine the ratio of DPGR and non-DPGR ple 2 except that Y pays for the 5-year warranty over employer of the payee of the wages), the

using a reasonable method that is satis- time ($200 a year for 5 years). Under X’s method payment of wages may not be included in

factory to the Secretary based on all of of accounting, X recognizes each $200 payment as

determining W–2 wages of the taxpayer.

the facts and circumstances that accurately it is received. In 2009, X updates its historical data

and the updated historical data show that 50% of the

If the taxpayer is paying wages as an agent

identifies the gross receipts that constitute gross receipts attributable to a 5-year warranty will of another entity to individuals who are

DPGR. See paragraph (d)(2) of this sec- be derived from the sale of QPP that X manufac- not employees of the taxpayer, the wages





June 19, 2006 1084 2006–25 I.R.B.

may not be included in determining the second calendar month following the pe- with SSA on or before the 60th day af-

W–2 wages of the taxpayer. riod for which the final return is filed. ter the due date (including extensions) of

(3) Requirement that wages must be (ii) Corrected return filed to correct a the information return including the Form

reported on return filed with the Social return that was filed within 60 days of the W–2), then the information return includ-

Security Administration—(i) In general. due date. If a corrected information re- ing this Form W–2c (or corrected Form

The term W–2 wages shall not include any turn (Return B) is filed with SSA on or W–2) shall not be considered to have been

amount that is not properly included in a before the 60th day after the due date (in- filed with SSA on or before the 60th day

return filed with SSA on or before the 60th cluding extensions) of Return B to correct after the due date (including extensions)

day after the due date (including exten- an information return (Return A) that was for this information return including the

sions) for such return. Under §31.6051–2 filed with SSA on or before the 60th day Form W–2c (or corrected Form W–2), re-

of this chapter, each Form W–2 and the after the due date (including extensions) gardless of when the information return in-

transmittal Form W–3, “Transmittal of of the information return (Return A) and cluding the Form W–2c (or corrected Form

Wage and Tax Statements,” together con- paragraph (a)(3)(ii) of this section does not W–2) is filed.

stitute an information return to be filed apply, then the wage information on Re- (4) Joint return. An individual and his

with SSA. Similarly, each Form W–2c, turn B must be included in determining or her spouse are considered one taxpayer

“Corrected Wage and Tax Statement,” W–2 wages. If a corrected information re- for purposes of determining the amount of

and the transmittal Form W–3 or W–3c, turn (Return D) is filed with SSA later than W–2 wages for a taxable year, provided

“Transmittal of Corrected Wage and Tax the 60th day after the due date (including that they file a joint return for the taxable

Statements,” together constitute an infor- extensions) of Return D to correct an in- year. Thus, an individual filing as part of

mation return to be filed with SSA. In formation return (Return C) that was filed a joint return may include the wages of

determining whether any amount has been with SSA on or before the 60th day after employees of his or her spouse in deter-

properly included in a return filed with the due date (including extensions) of the mining W–2 wages, provided the employ-

SSA on or before the 60th day after the information return (Return C), then if Re- ees are employed in a trade or business

due date (including extensions) for such turn D reports an increase (or increases) in of the spouse and the other requirements

return, each Form W–2 together with its wages included in determining W–2 wages of this section are met. However, a mar-

accompanying Form W–3 shall be con- from the wage amounts reported on Return ried taxpayer filing a separate return from

sidered a separate information return and C, then such increase (or increases) on Re- his or her spouse for the taxable year may

each Form W–2c together with its accom- turn D shall be disregarded in determining not include the wages of employees of the

panying Form W–3 or Form W–3c shall W–2 wages (and only the wage amounts taxpayer’s spouse in determining the tax-

be considered a separate information re- on Return C may be included in determin- payer’s W–2 wages for the taxable year.

turn. Section 31.6071(a)–1(a)(3) of this ing W–2 wages). If Return D reports a de- (b) Application in the case of a taxpayer

chapter provides that each information crease (or decreases) in wages included in with a short taxable year. In the case of

return in respect of wages as defined in the determining W–2 wages from the amounts a taxpayer with a short taxable year, sub-

Federal Insurance Contributions Act or of reported on Return C, then, in determining ject to the rules of paragraph (a) of this sec-

income tax withheld from wages which W–2 wages, the wages reported on Return tion, the W–2 wages of the taxpayer for the

is required to be made under §31.6051–2 C must be reduced by the decrease (or de- short taxable year shall include only those

of this chapter shall be filed on or before creases) reflected on Return D. wages paid during the short taxable year

the last day of February (March 31 if filed (iii) Corrected return filed to correct a to employees of the taxpayer, only those

electronically) of the year following the return that was filed later than 60 days af- elective deferrals (within the meaning of

calendar year for which it is made, except ter the due date. If an information return section 402(g)(3)) made during the short

that if a tax return under §31.6011(a)–5(a) (Return F) is filed to correct an informa- taxable year by employees of the taxpayer

of this chapter is filed as a final return for tion return (Return E) that was not filed and only compensation actually deferred

a period ending prior to December 31, the with SSA on or before the 60th day after under section 457 during the short taxable

information statement shall be filed on or the due date (including extensions) of Re- year with respect to employees of the tax-

before the last day of the second calendar turn E, then Return F (and any subsequent payer. The Secretary shall have the au-

month following the period for which the information returns filed with respect to thority to issue published guidance setting

tax return is filed. Corrected Forms W–2 Return E) will not be considered filed on forth the method that is used to calculate

are required to be filed with SSA on or or before the 60th day after the due date W–2 wages in case of a taxpayer with a

before the last day of February (March (including extensions) of Return F (or the short taxable year. See paragraph (e)(3) of

31 if filed electronically) of the year fol- subsequent corrected information return). this section.

lowing the year in which the correction Thus, if a Form W–2c (or corrected Form (c) Acquisition or disposition of a trade

is made, except that if a tax return under W–2) is filed to correct a Form W–2 that or business (or major portion). If a tax-

§31.6011(a)–5(a) is filed as a final return was not filed with SSA on or before the payer (a successor) acquires a trade or

for a period ending prior to December 31 60th day after the due date (including ex- business, the major portion of a trade or

for the period in which the correction is tensions) of the information return includ- business, or the major portion of a separate

made, the corrected Forms W–2 are re- ing the Form W–2 (or to correct a Form unit of a trade or business from another

quired to be filed by the last day of the W–2c relating to a information return in- taxpayer (a predecessor), then, for pur-

cluding a Form W–2 that had not been filed poses of computing the respective section





2006–25 I.R.B. 1085 June 19, 2006

199 deduction of the successor and of the §1.199–3 Domestic production gross is an unrelated person for purposes of

predecessor, the W–2 wages paid for that receipts. §§1.199–1 through 1.199–9.

calendar year shall be allocated between (2) Exceptions. Notwithstanding para-

the successor and the predecessor based (a) In general. The provisions of this graph (b)(1) of this section, gross receipts

on whether the wages are for employment section apply solely for purposes of sec- derived from any QPP or qualified film

by the successor or for employment by the tion 199 of the Internal Revenue Code leased or rented by the taxpayer to a re-

predecessor. Thus, in this situation, the (Code). Domestic production gross re- lated person may qualify as DPGR if the

W–2 wages are allocated based on whether ceipts (DPGR) are the gross receipts (as QPP or qualified film is held for sublease

the wages are for employment for a period defined in paragraph (c) of this section) of or rent, or is subleased or rented, by the re-

during which the employee was employed the taxpayer that are— lated person to an unrelated person for the

by the predecessor or for employment for (1) Derived from any lease, rental, li- ultimate use of the unrelated person. Sim-

a period during which the employee was cense, sale, exchange, or other disposition ilarly, notwithstanding paragraph (b)(1) of

employed by the successor, regardless of (as defined in paragraph (i) of this section) this section, gross receipts derived from

which permissible method for Form W–2 of— the license of QPP or a qualified film to

reporting is used. (i) Qualifying production property a related person for reproduction and sale,

(d) Non-duplication rule. Amounts that (QPP) (as defined in paragraph (j)(1) of exchange, lease, rental, or sublicense to an

are treated as W–2 wages for a taxable this section) that is manufactured, pro- unrelated person for the ultimate use of the

year under any method shall not be treated duced, grown, or extracted (MPGE) (as unrelated person may qualify as DPGR.

as W–2 wages of any other taxable year. defined in paragraph (e) of this section) (c) Definition of gross receipts. The

Also, an amount shall not be treated as by the taxpayer (as defined in paragraph term gross receipts means the taxpayer’s

W–2 wages by more than one taxpayer. (f) of this section) in whole or in signifi- receipts for the taxable year that are rec-

(e) Definition of W–2 wages—(1) In cant part (as defined in paragraph (g) of ognized under the taxpayer’s methods of

general. Under section 199(b)(2), the term this section) within the United States (as accounting used for Federal income tax

W–2 wages means, with respect to any per- defined in paragraph (h) of this section); purposes for the taxable year. If the gross

son for any taxable year of such person, (ii) Any qualified film (as defined in receipts are recognized in an intercom-

the sum of the amounts described in sec- paragraph (k) of this section) produced by pany transaction within the meaning of

tion 6051(a)(3) and (8) paid by such per- the taxpayer; or §1.1502–13, see also §1.199–7(d). For this

son with respect to employment of em- (iii) Electricity, natural gas, or potable purpose, gross receipts include total sales

ployees by such person during the calen- water (as defined in paragraph (l) of this (net of returns and allowances) and all

dar year ending during such taxable year. section) (collectively, utilities) produced amounts received for services. In addition,

Thus, the term W–2 wages includes the by the taxpayer in the United States; gross receipts include any income from

total amount of wages as defined in sec- (2) Derived from, in the case of a tax- investments and from incidental or out-

tion 3401(a); the total amount of elec- payer engaged in the active conduct of a side sources. For example, gross receipts

tive deferrals (within the meaning of sec- construction trade or business, construc- include interest (including original issue

tion 402(g)(3)); the compensation deferred tion of real property (as defined in para- discount and tax-exempt interest within

under section 457; and for taxable years graph (m) of this section) performed in the the meaning of section 103), dividends,

beginning after December 31, 2005, the United States by the taxpayer in the ordi- rents, royalties, and annuities, regardless

amount of designated Roth contributions nary course of such trade or business; or of whether the amounts are derived in the

(as defined in section 402A). (3) Derived from, in the case of a tax- ordinary course of the taxpayer’s trade of

(2) Limitation on W–2 wages for tax- payer engaged in the active conduct of an business. Gross receipts are not reduced

able years beginning after May 17, 2006, engineering or architectural services trade by cost of goods sold (CGS) or by the

the enactment date of the Tax Increase Pre- or business, engineering or architectural cost of property sold if such property is

vention and Reconciliation Act of 2005. services (as defined in paragraph (n) of this described in section 1221(a)(1), (2), (3),

[Reserved]. section) performed in the United States (4), or (5). Gross receipts do not include

(3) Methods for calculating W–2 wages. by the taxpayer in the ordinary course of the amounts received in repayment of a

The Secretary may provide by publication such trade or business with respect to the loan or similar instrument (for example,

in the Internal Revenue Bulletin (see construction of real property in the United a repayment of the principal amount of a

§601.601(d)(2)(ii)(b) of this chapter) for States. loan held by a commercial lender) and,

methods to be used in calculating W–2 (b) Related persons—(1) In general. except to the extent of gain recognized,

wages, including W–2 wages for short DPGR does not include any gross receipts do not include gross receipts derived from

taxable years. For example, see Rev. of the taxpayer derived from property a non-recognition transaction, such as a

Proc. 2006–22, 2006–23 I.R.B. 1033) (see leased, licensed, or rented by the taxpayer section 1031 exchange. Finally, gross re-

§601.601(d)(2) of this chapter). for use by any related person. A person ceipts do not include amounts received by

is treated as related to another person if the taxpayer with respect to sales tax or

both persons are treated as a single em- other similar state and local taxes if, under

ployer under either section 52(a) or (b) the applicable state or local law, the tax

(without regard to section 1563(b)), or is legally imposed on the purchaser of the

section 414(m) or (o). Any other person good or service and the taxpayer merely





June 19, 2006 1086 2006–25 I.R.B.

collects and remits the tax to the taxing au- tectural services, a taxpayer may use any box of 50 (or fewer) pairs of shoes as an item, be-

thority. If, in contrast, the tax is imposed reasonable method that is satisfactory to cause Q offers the shoes for sale in the normal course

on the taxpayer under the applicable law, the Secretary based on all of the facts and of Q’s business in individual pairs.

Example 3. R manufactures toy cars in the United

then gross receipts include the amounts circumstances to determine what construc- States. R also purchases cars that were manufactured

received that are allocable to the payment tion activities and services or engineering by unrelated persons. R offers the cars for sale to

of such tax. or architectural services constitute an item. customers, in the normal course of R’s business, in

(d) Determining domestic production (3) Exception. If a taxpayer MPGE sets of three, and requires no minimum quantity or-

gross receipts—(1) In general. For pur- QPP within the United States or produces der. R sells the three-car sets to toy stores. A three-car

set may contain some cars manufactured by R and

poses of §§1.199–1 through 1.199–9, a a qualified film or produces utilities in the some cars purchased by R. If the gross receipts de-

taxpayer determines, using any reasonable United States that it disposes of, and the rived from the sale of the three-car sets do not qualify

method that is satisfactory to the Secretary taxpayer leases, rents, licenses, purchases, as DPGR under this section, then, under paragraph

based on all of the facts and circum- or otherwise acquires property that con- (d)(1)(ii) of this section, R must treat a toy car in the

stances, whether gross receipts qualify as tains or may contain the QPP, qualified three-car set as the item, provided the gross receipts

derived from the sale of the toy car qualify as DPGR

DPGR on an item-by-item basis (and not, film, or the utilities (or a portion thereof), under this section.

for example, on a division-by-division, and the taxpayer cannot reasonably de- Example 4. The facts are the same as Example 3

product line-by-product line, or transac- termine, without undue burden and ex- except that R offers the toy cars for sale individually

tion-by-transaction basis). pense, whether the acquired property con- to customers in the normal course of R’s business,

(i) The term item means the property of- tains any of the original QPP, qualified rather than in sets of three. R’s customers resell the

individual toy cars at three for $10. Frequently, this

fered by the taxpayer in the normal course film, or utilities MPGE or produced by the results in retail customers purchasing three individual

of the taxpayer’s business for lease, rental, taxpayer, then the taxpayer is not required cars in one transaction. In determining R’s DPGR,

license, sale, exchange, or other disposi- to determine whether any portion of the under paragraph (d)(2)(i) of this section, each toy car

tion (for purposes of this paragraph (d), acquired property qualifies as an item for is an item and R cannot treat three individual toy cars

collectively referred to as disposition) to purposes of paragraph (d)(1) of this sec- as one item, because the individual toy cars are not

offered for sale in sets of three by R in the normal

customers, if the gross receipts from the tion. Therefore, the gross receipts derived course of R’s business.

disposition of such property qualify as from the disposition of the acquired prop- Example 5. The facts are the same as in Example

DPGR; or erty may be treated as non-DPGR. Simi- 3 except that R offers the toy cars for sale to customers

(ii) If paragraph (d)(1)(i) of this sec- larly, the preceding sentences shall apply if in the normal course of R’s business both individually

tion does not apply to the property, then the taxpayer can reasonably determine that and in sets of three. The results are the same as Ex-

ample 3 with respect to the three-car sets. The results

any component of the property described the acquired property contains QPP, a qual- are the same as in Example 4 with respect to the indi-

in paragraph (d)(1)(i) of this section is ified film, or utilities (or a portion thereof) vidual toy cars that are not included in the three-car

treated as the item, provided that the gross MPGE or produced by the taxpayer, but sets and offered for sale individually. Thus, R has two

receipts from the disposition of the prop- cannot reasonably determine, without un- items, an individual toy car and a set of three toy cars.

erty described in paragraph (d)(1)(i) of due burden or expense, how much, or what Example 6. S produces television sets in the

United States. S also produces the same model of

this section that are attributable to such type, grade, etc., of the QPP, qualified film, television set outside the United States. In both

component qualify as DPGR. Each com- or utilities MPGE or produced by the tax- cases, S packages the sets one to a box. S sells the

ponent that meets the requirements under payer the acquired property contains. television sets to large retail consumer electronics

this paragraph (d)(1)(ii) must be treated (4) Examples. The following examples stores. S requires that its customers purchase a min-

as a separate item and a component that illustrate the application of paragraph (d) imum of 100 television sets per order. With respect

to a particular order by a customer of 100 television

meets the requirements under this para- of this section: sets, some were manufactured by S in the United

graph (d)(1)(ii) may not be combined with Example 1. Q manufactures leather and rubber

States, and some were manufactured by S outside

a component that does not meet these re- shoe soles in the United States. Q imports shoe up-

the United States. Under paragraph (d)(2)(i) of this

pers, which are the parts of the shoe above the sole.

quirements. section, a minimum order of 100 television sets is the

Q manufactures shoes for sale by sewing or otherwise

(2) Special rules. The following spe- item provided that the gross receipts derived from

attaching the soles to the imported uppers. Q offers

the sale of the 100 television sets qualify as DPGR.

cial rules apply for purposes of paragraph the shoes for sale to customers in the normal course

Example 7. T produces in bulk form in the

(d)(1) of this section: of Q’s business. If the gross receipts derived from the

United States the active ingredient for a pharmaceu-

(i) For purposes of paragraph (d)(1)(i) sale of the shoes do not qualify as DPGR under this

tical product. T sells the active ingredient in bulk

section, then under paragraph (d)(1)(ii) of this sec-

of this section, in no event may a single form to FX, a foreign corporation. This sale qualifies

tion, Q must treat the sole as the item if the gross

item consist of two or more properties un- as DPGR assuming all the other requirements of this

receipts derived from the sale of the sole qualify as

section are met. FX uses the active ingredient to

less those properties are offered for dis- DPGR under this section.

produce the finished dosage form drug. FX sells the

position, in the normal course of the tax- Example 2. The facts are the same as in Exam-

drug in finished dosage to T, which sells the drug to

payer’s business, as a single item (regard- ple 1 except that Q also buys some finished shoes

customers. Assume that T knows how much of the

from unrelated persons and resells them to retail shoe

less of how the properties are packaged). active ingredient is in the finished dosage. Under

stores. Q offers all shoes (manufactured and pur-

(ii) In the case of property customarily paragraph (d)(1)(ii) of this section, if T’s gross re-

chased) for sale to customers, in the normal course

ceipts derived from the sale of the finished dosage do

sold by weight or by volume, the item is of Q’s business, in individual pairs, and requires no

not qualify as DPGR under this section, then T must

determined using the custom of the indus- minimum quantity order. Q ships the shoes in boxes,

treat the active ingredient component as the item

try (for example, barrels of oil). each box containing as many as 50 pairs of shoes. A

because the gross receipts attributable to the active

full, or partially full, box may contain some shoes that

(iii) In the case of construction activi- ingredient qualify as DPGR under this section. The

Q manufactured, and some that Q purchased. Under

ties and services or engineering and archi- exception in paragraph (d)(3) of this section does not

paragraph (d)(2)(i) of this section, Q cannot treat a







2006–25 I.R.B. 1087 June 19, 2006

apply because T can reasonably determine without (e) Definition of manufactured, pro- section 263A. A taxpayer that currently is

undue burden or expense that the finished dosage duced, grown, or extracted—(1) In gen- not properly accounting for its production

contains the active ingredient and the quantity of the eral. Except as provided in paragraphs activities under section 263A, and wishes

active ingredient in the finished dosage.

Example 8. U produces steel within the United

(e)(2) and (3) of this section, the term to change its method of accounting to

States and sells its steel to a variety of customers, in- MPGE includes manufacturing, produc- comply with the producer requirements

cluding V, an unrelated person, who uses the steel for ing, growing, extracting, installing, de- of section 263A, must follow the appli-

the manufacture of equipment. V also purchases steel veloping, improving, and creating QPP; cable administrative procedures issued

from other steel producers. For its steel operations, U making QPP out of scrap, salvage, or junk under §1.446–1(e)(3)(ii) for obtaining

purchases equipment from V that may contain steel

produced by U. U sells the equipment after 5 years.

material as well as from new or raw mate- the Commissioner’s consent to a change

If U cannot reasonably determine without undue bur- rial by processing, manipulating, refining, in accounting method (for further guid-

den and expense whether the equipment contains any or changing the form of an article, or by ance, for example, see Rev. Proc. 97–27,

steel produced by U, then, under paragraph (d)(3) of combining or assembling two or more 1997–1 C.B. 680, or Rev. Proc. 2002–9,

this section, U may treat the gross receipts derived articles; cultivating soil, raising livestock, 2002–1 C.B. 327, whichever applies (see

from sale of the equipment as non-DPGR.

Example 9. The facts are the same as in Example

fishing, and mining minerals. The term §601.601(d)(2) of this chapter)).

8 except that U knows that the equipment purchased MPGE also includes storage, handling, (5) Examples. The following examples

from V does contain some amount of steel produced or other processing activities (other than illustrate the application of this paragraph

by U. If U cannot reasonably determine without un- transportation activities) within the United (e):

due burden and expense how much steel produced States related to the sale, exchange, or Example 1. A, B, and C are unrelated persons and

by U the equipment contains, then, under paragraph are not cooperatives to which Part I of subchapter T

(d)(3) of this section, U may treat the gross receipts

other disposition of agricultural products,

of the Code applies. B grows agricultural products in

derived from sale of the equipment as non-DPGR. provided the products are consumed in the United States and sells them to A, who owns agri-

Example 10. W manufactures sunroofs, stereos, connection with or incorporated into the cultural storage bins in the United States. A stores the

and tires within the United States. W purchases auto- MPGE of QPP, whether or not by the tax- agricultural products and has the benefits and burdens

mobiles from unrelated persons and installs the man- payer. Pursuant to paragraph (f)(1) of this of ownership under Federal income tax principles of

ufactured components in the automobiles. W, in the the agricultural products while they are being stored.

normal course of W’s business, sells the automobiles

section, the taxpayer must have the bene-

A sells the agricultural products to C, who processes

with the components to customers. If the gross re- fits and burdens of ownership of the QPP them into refined agricultural products in the United

ceipts derived from the sale of the automobiles with under Federal income tax principles dur- States. The gross receipts from A’s, B’s, and C’s ac-

the components do not qualify as DPGR under this ing the period the MPGE activity occurs tivities are DPGR from the MPGE of QPP.

section, then under paragraph (d)(1)(ii) of this sec- in order for gross receipts derived from Example 2. The facts are the same as in Ex-

tion, W must treat each component (sunroofs, stereos, ample 1 except that B grows the agricultural prod-

and tires) that it manufactures as a separate item if the

the MPGE of QPP to qualify as DPGR.

ucts outside the United States and C processes them

gross receipts derived from the sale of each compo- (2) Packaging, repackaging, labeling, into refined agricultural products outside the United

nent qualify as DPGR under this section. or minor assembly. If a taxpayer pack- States. Pursuant to paragraph (e)(1) of this section,

Example 11. X manufacturers leather soles ages, repackages, labels, or performs mi- the gross receipts derived by A from its sale of the

within the United States. X purchases shoe uppers, nor assembly of QPP and the taxpayer en- agricultural products to C are DPGR from the MPGE

metal eyelets, and laces. X manufactures shoes by of QPP within the United States. B’s and C’s re-

sewing or otherwise attaching the soles to the uppers;

gages in no other MPGE activity with re-

spective MPGE activities occur outside the United

attaching the metal eyelets to the shoes; and thread- spect to that QPP, the taxpayer’s packag- States and, therefore, their respective gross receipts

ing the laces through the eyelets. X, in the normal ing, repackaging, labeling, or minor as- are non-DPGR.

course of X’s business, sells the shoes to customers. sembly does not qualify as MPGE with re- Example 3. Y is hired to reconstruct and refur-

If the gross receipts derived from the sale of the spect to that QPP. bish unrelated customers’ tangible personal property.

shoes do not qualify as DPGR under this section, As part of the reconstruction and refurbishment, Y

then under paragraph (d)(1)(ii) of this section, X

(3) Installing. If a taxpayer installs

installs purchased replacement parts that constitute

must treat the sole as the item if the gross receipts QPP and engages in no other MPGE ac- QPP in the customers’ property. Y’s installation

derived from the sale of the sole qualify as DPGR tivity with respect to the QPP, the tax- of purchased replacement parts does not qualify as

under this section. X may not treat the shoe upper, payer’s installing activity does not qual- MPGE pursuant to paragraph (e)(3) of this section

metal eyelets or laces as part of the item because ify as an MPGE activity. Notwithstanding because Y did not MPGE the replacement parts.

under paragraph (d)(1)(ii) of this section the sole is Example 4. The facts are the same as in Example

the component that is treated as the item.

paragraph (i)(4)(i)(B)(4) of this section, if

3 except that Y manufactures the replacement parts it

Example 12. Y manufactures glass windshields the taxpayer installs QPP MPGE by the uses for the reconstruction and refurbishment of cus-

for automobiles within the United States. Y pur- taxpayer and, except as provided in para- tomers’ tangible personal property. Y has the bene-

chases automobiles from unrelated persons and in- graph (f)(2) of this section, the taxpayer fits and burdens of ownership under Federal income

stalls the windshields in the automobiles. Y, in the has the benefits and burdens of ownership tax principles of the replacement parts during the re-

normal course of Y’s business, sells the automobiles construction and refurbishment activity and while in-

with the windshields to customers. If the automobiles

of the QPP under Federal income tax prin-

stalling the parts. Y’s gross receipts derived from

with the windshields do not meet the requirements for ciples during the period the installing ac- the MPGE of the replacement parts and Y’s gross re-

being an item, then, under paragraph (d)(1)(ii) of this tivity occurs, then the portion of the in- ceipts derived from the installation of the replacement

section, Y must treat each windshield that it manu- stalling activity that relates to the QPP is parts, which is an MPGE activity pursuant to para-

factures as an item if the gross receipts derived from an MPGE activity. graph (e)(3) of this section, are DPGR (assuming all

the sale of the windshield qualify as DPGR under this the other requirements of this section are met).

section. Y may not treat any other portion of the au-

(4) Consistency with section 263A. A

Example 5. Z MPGE QPP within the United

tomobile as part of the item because under paragraph taxpayer that has MPGE QPP for the tax- States. The following activities are performed by

(d)(1)(ii) of this section the windshield is the compo- able year should treat itself as a producer Z as part of the MPGE of the QPP while Z has the

nent. under section 263A with respect to the benefits and burdens of ownership under Federal

QPP unless the taxpayer is not subject to income tax principles: materials analysis and selec-







June 19, 2006 1088 2006–25 I.R.B.

tion, subcontractor inspections and qualifications, film, or utilities under Federal income legal title to the machines is not transferred to X until

testing of component parts, assisting customers in tax principles during the period in which final manufacturing of the machines has been com-

their review and approval of the QPP, routine produc- the qualifying activity occurs is treated as pleted. Based on all of the facts and circumstances,

tion inspections, product documentation, diagnosis pursuant to paragraph (f)(1) of this section Y has the

and correction of system failure, and packaging for

engaging in the qualifying activity. benefits and burdens of ownership of the machines

shipment to customers. Because Z MPGE the QPP, (2) Special rule for certain government under Federal income tax principles during the period

these activities performed by Z are part of the MPGE contracts. Gross receipts derived from the the manufacturing occurs and, as a result, Y is treated

of the QPP. MPGE of QPP in whole or in significant as the manufacturer of the machines.

Example 6. X purchases automobiles from part within the United States will be treated Example 2. X designs and engineers machines

unrelated persons and customizes them by adding that it sells to customers. X contracts with Y, an un-

ground effects, spoilers, custom wheels, specialized

as gross receipts derived from the lease, related person, for the manufacture of the machines.

paint and decals, sunroofs, roof racks, and similar rental, license, sale, exchange, or other dis- The contract between X and Y is a cost-reimbursable

accessories. X does not manufacture any of the position of QPP MPGE by the taxpayer type contract. Assume that X has the benefits and

accessories. X’s activity is minor assembly under in whole or in significant part within the burdens of ownership of the machines under Federal

paragraph (e)(2) of this section which is not an United States notwithstanding the require- income tax principles during the period the manufac-

MPGE activity. turing occurs except that legal title to the machines is

Example 7. Y manufactures furniture in the

ments of paragraph (f)(1) of this section not transferred to X until final manufacturing of the

United States that it sells to unrelated persons. Y if— machines is completed. Based on all of the facts and

also engraves customers’ names on pens and pencils (i) The QPP is MPGE by the taxpayer circumstances, X is treated as the manufacturer of the

purchased from unrelated persons and sells the pens within the United States pursuant to a con- machines under paragraph (f)(1) of this section.

and pencils to such customers. Although Y’s sales tract with the Federal government; and Example 3. X manufactures machines within the

of furniture qualify as DPGR if all the other require- United States pursuant to a contract with the Federal

ments of this section are met, Y must determine

(ii) The Federal Acquisition Regulation government and the Federal Acquisition Regulation

whether its gross receipts derived from the sale of (Title 48, Code of Federal Regulations) re- requires that the title or risk of loss with respect to the

the pens and pencils qualify as DPGR. Y’s status as quires that title or risk of loss with respect machines be transferred to the Federal government

a manufacturer of furniture in the United States does to the QPP be transferred to the Federal before X completes manufacture of the machines. X

not carry over to its other activities. government before the MPGE of the QPP subcontracts with Y, an unrelated person, for the man-

Example 8. X produces computer software within ufacture of components for the machines that Y man-

the United States. In 2007, X enters into an agree-

is completed. ufactures within the United States. Assume that the

ment with Y, an unrelated person, under which X will (3) Subcontractor. If a taxpayer (sub- machines manufactured by X, and the components for

manage Y’s networks using computer software that contractor) enters into a contract or agree- the machines manufactured by Y, are QPP. Both the

X produced. Pursuant to the terms of the agreement, ment to MPGE QPP on behalf of a tax- machines and components are subject to the Federal

X also provides to Y for Y’s use on Y’s own hard- payer to which paragraph (f)(2) of this sec- Acquisition Regulation that requires title or risk of

ware computer software that X produced (additional loss with respect to the machines and components be

computer software). Assume that, based on all of the

tion applies, and the QPP under the con- transferred to the Federal government before manu-

facts and circumstances, the transaction between X tract or agreement is subject to paragraph facturing of the machines and components are com-

and Y relating to the additional computer software is (f)(2)(ii) of this section, then, notwith- plete. Under paragraph (f)(2) of this section, the gross

a lease or sale of the additional computer software. standing the requirements of paragraph receipts derived by X from the manufacture within

Y pays X monthly fees of $100 under the agreement (f)(1) of this section, the subcontractor’s the United States of the machines for the Federal gov-

during 2007. No separate charge for the additional ernment are treated as having been derived from the

computer software is stated in the agreement or in the

gross receipts derived from the MPGE of lease, rental, license, sale, exchange, or other dispo-

monthly invoices that X provides to Y. The portion the QPP in whole or in significant part sition of the machines manufactured by X in whole

of X’s gross receipts that is derived from the lease or within the United States will be treated or in significant part within the United States. Under

sale of the additional computer software is DPGR (as- as gross receipts derived from the lease, paragraph (f)(3) of this section, the gross receipts de-

suming all the other requirements of this section are rental, license, sale, exchange, or other rived by Y from the manufacture within the United

met). States of the components for X are also treated as

disposition of QPP MPGE by the sub- having been derived from the lease, rental, license,

(f) Definition of by the taxpayer—(1)

contractor in whole or in significant part sale, exchange, or other disposition of the compo-

In general. With the exception of the rules

within the United States. nents manufactured by Y in whole or in significant

applicable to an expanded affiliated group part within the United States.

(4) Examples. The following examples

(EAG) under §1.199–7, qualifying in-kind (g) Definition of in whole or in signif-

illustrate the application of this paragraph

partnerships under §1.199–9(i), EAG part- icant part—(1) In general. QPP must be

(f):

nerships under §1.199–9(j), and govern- Example 1. X designs machines that it uses in its MPGE in whole or in significant part by

ment contracts under paragraph (f)(2) of trade or business. X contracts with Y, an unrelated the taxpayer and in whole or in significant

this section, only one taxpayer may claim person, for the manufacture of the machines. The

part within the United States to qualify un-

the deduction under §1.199–1(a) with contract between X and Y is a fixed-price contract.

The contract specifies that the machines will be man-

der section 199(c)(4)(A)(i)(I). If a taxpayer

respect to any qualifying activity under enters into a contract with an unrelated per-

ufactured in the United States using X’s design. X

paragraphs (e)(1), (k)(1), and (l)(1) of this owns the intellectual property attributable to the de- son for the unrelated person to MPGE QPP

section performed in connection with the sign and provides it to Y with a restriction that Y may for the taxpayer and the taxpayer has the

same QPP, or the production of a qualified only use it during the manufacturing process and has

benefits and burdens of ownership of the

film or utilities. If one taxpayer performs a no right to exploit the intellectual property. The con-

tract specifies that Y controls the details of the man-

QPP under applicable Federal income tax

qualifying activity under paragraph (e)(1), principles during the period the MPGE ac-

ufacturing process while the machines are being pro-

(k)(1), or (l)(1) of this section pursuant to duced; Y bears the risk of loss or damage during man- tivity occurs, then, pursuant to paragraph

a contract with another party, then only ufacturing of the machines; and Y has the economic (f)(1) of this section, the taxpayer is con-

the taxpayer that has the benefits and bur- loss or gain upon the sale of the machines based on

sidered to MPGE the QPP under this sec-

dens of ownership of the QPP, qualified the difference between Y’s costs and the fixed price.

Y has legal title during the manufacturing process and

tion. The unrelated person must perform





2006–25 I.R.B. 1089 June 19, 2006

the MPGE activity on behalf of the tax- based on all of the facts and circumstances, computer software or sound recordings

payer in whole or in significant part within but may not include any cost, or amount of over more than one taxable year, the costs

the United States in order for the taxpayer any cost, that would not be required to be of developing computer software as de-

to satisfy the requirements of this para- capitalized under section 263A if the tax- scribed in Rev. Proc. 2000–50, 2000–2

graph (g)(1). payer were subject to section 263A. Re- C.B. 601, research and experimental ex-

(2) Substantial in nature. QPP will search and experimental expenditures un- penditures under section 174, and any

be treated as MPGE in significant part der section 174 and the costs of creating other costs of creating intangible assets

by the taxpayer within the United States intangible assets are not taken into account for computer software and sound record-

for purposes of paragraph (g)(1) of this in determining direct labor or overhead for ings must be allocated over the estimated

section if the MPGE of the QPP by the any tangible personal property. However, number of units that the taxpayer expects

taxpayer within the United States is sub- for a special rule regarding computer soft- to lease, rent, license, sell, exchange, or

stantial in nature taking into account all of ware and sound recordings, see paragraph otherwise dispose of.

the facts and circumstances, including the (g)(3)(iii) of this section. In the case of (4) Special rules—(i) Contract with an

relative value added by, and relative cost tangible personal property (as defined in unrelated person. If a taxpayer enters into

of, the taxpayer’s MPGE activity within paragraph (j)(2) of this section), research a contract with an unrelated person for the

the United States, the nature of the QPP, and experimental expenditures under sec- unrelated person to MPGE QPP within the

and the nature of the MPGE activity that tion 174 and any other costs incurred in United States for the taxpayer, and the tax-

the taxpayer performs within the United the creation of intangible assets may be payer is considered to MPGE the QPP pur-

States. The MPGE of a key component of excluded from CGS or unadjusted depre- suant to paragraph (f)(1) of this section,

QPP does not, in itself, meet the substan- ciable basis for purposes of determining then, for purposes of the substantial-in-na-

tial-in-nature requirement with respect to whether the taxpayer meets the safe harbor ture requirement under paragraph (g)(2)

the QPP under this paragraph (g)(2). In under this paragraph (g)(3). of this section and the safe harbor un-

the case of tangible personal property (as (ii) Unadjusted depreciable basis. The der paragraph (g)(3)(i) of this section, the

defined in paragraph (j)(2) of this section), term unadjusted depreciable basis means taxpayer’s MPGE or production activities

research and experimental activities under the basis of property for purposes of sec- or direct labor and overhead shall include

section 174 and the creation of intangi- tion 1011 without regard to any adjust- both the taxpayer’s MPGE or production

ble assets are not taken into account in ments described in section 1016(a)(2) and activities or direct labor and overhead to

determining whether the MPGE of QPP (3). This basis does not reflect the reduc- MPGE the QPP within the United States as

is substantial in nature for any QPP other tion in basis for— well as the MPGE or production activities

than computer software (as defined in (A) Any portion of the basis the tax- or direct labor and overhead of the unre-

paragraph (j)(3) of this section) and sound payer properly elects to treat as an expense lated person to MPGE the QPP within the

recordings (as defined in paragraph (j)(4) under section 179 or 179C; or United States under the contract.

of this section). Thus, for example, a tax- (B) Any adjustments to basis provided (ii) Aggregation. In determining

payer may take into account its design and by other provisions of the Code and the whether the substantial-in-nature require-

development activities when determining regulations under the Code (for example, ment under paragraph (g)(2) of this section

whether its MPGE of computer software a reduction in basis by the amount of the or the safe harbor under paragraph (g)(3)(i)

is substantial in nature. disabled access credit pursuant to section of this section is met at the time the tax-

(3) Safe harbor—(i) In general. A tax- 44(d)(7)). payer disposes of an item of QPP—

payer will be treated as having MPGE QPP (iii) Computer software and sound (A) An EAG member must take into ac-

in whole or in significant part within the recordings. In determining direct labor count all of the previous MPGE or produc-

United States for purposes of paragraph and overhead under paragraph (g)(3)(i) of tion activities or direct labor and overhead

(g)(1) of this section if, in connection with this section, the costs of direct labor and of the other members of the EAG;

the QPP, the direct labor and overhead of overhead for developing computer soft- (B) An EAG partnership (as defined in

such taxpayer to MPGE the QPP within ware as described in Rev. Proc. 2000–50, §1.199–9(j)) must take into account all of

the United States account for 20 percent or 2000–2 C.B. 601 (see §601.601(d)(2) of the previous MPGE or production activ-

more of the taxpayer’s CGS of the QPP, this chapter), research and experimental ities or direct labor and overhead of all

or in a transaction without CGS (for ex- expenditures under section 174, and any members of the EAG in which the partners

ample, a lease, rental, or license) account other costs of creating intangible assets for of the EAG partnership are members (as

for 20 percent or more of the taxpayer’s computer software and sound recordings well as the previous MPGE or production

unadjusted depreciable basis (as defined are treated as direct labor and overhead. activities of any other EAG partnerships

in paragraph (g)(3)(ii) of this section) in These costs must be included in the tax- owned by members of the same EAG);

the QPP. For taxpayers subject to section payer’s CGS or unadjusted depreciable (C) A member of an EAG in which

263A, overhead is all costs required to be basis of computer software and sound the partners of an EAG partnership are

capitalized under section 263A except di- recordings for purposes of determining members must take into account all of the

rect materials and direct labor. For taxpay- whether the taxpayer meets the safe harbor previous MPGE or production activities

ers not subject to section 263A, overhead under paragraph (g)(3)(i) of this section. If or direct labor and overhead of the EAG

may be computed using any reasonable the taxpayer expects to lease, rent, license, partnership (as well as those of any other

method that is satisfactory to the Secretary sell, exchange, or otherwise dispose of members of the EAG and any previous





June 19, 2006 1090 2006–25 I.R.B.

MPGE or production activities of any Example 1. X purchases from Y, an unrelated per- Example 3. (i) Facts. X operates an automobile

other EAG partnerships owned by mem- son, unrefined oil extracted outside the United States. assembly plant in the United States. In connection

bers of the same EAG); and X refines the oil in the United States. The refining of with such activity, X purchases assembled engines,

the oil by X is an MPGE activity that is substantial in transmissions, and certain other components from Y,

(D) A partner of a qualifying in-kind nature. an unrelated person, and X assembles all of the com-

partnership (as defined in §1.199–9(i)) Example 2. X purchases gemstones and precious ponent parts into an automobile. X also conducts

must take into account all of the previous metal from outside the United States and then uses stamping, machining, and subassembly operations,

MPGE or production activities or direct la- these materials to produce jewelry within the United and X uses tools, jigs, welding equipment, and other

bor and overhead of the qualifying in-kind States by cutting and polishing the gemstones, melt- machinery and equipment in the assembly of automo-

ing and shaping the metal, and combining the finished biles. On a per-unit basis, X ’s selling price and costs

partnership. materials. X’s MPGE activities are substantial in na- of such automobiles are as follows:

(5) Examples. The following examples ture under paragraph (g)(2) of this section. Therefore,

illustrate the application of this paragraph X has MPGE the jewelry in significant part within the

(g): United States.







Selling price: $2,500

Cost of goods sold:

Material — Acquired from Y: $1,475

Direct labor and overhead: $325

Total cost of goods sold: $1,800

Gross profit: $700

Administrative and selling expenses: $300

Taxable income: $400





(ii) Analysis. Although X’s direct labor and over- pipe tobacco are non-DPGR because the aging of the fore, X has not MPGE the shirts in significant part

head are less than 20% of total CGS ($325/$1,800, cigars and pipe tobacco while being displayed and of- within the United States.

or 18%) and X is not within the safe harbor under fered for sale by X does not qualify as an MPGE ac- Example 10. X manufactures computer chips

paragraph (g)(3)(i) of this section, the activities con- tivity that is substantial in nature. within the United States. X installs the computer

ducted by X in connection with the assembly of an Example 7. X incurs $1,000,000 in computer chips that it manufactures in computers that X pur-

automobile are substantial in nature under paragraph software development costs in direct labor and over- chases from unrelated persons and sells the finished

(g)(2) of this section taking into account the nature head to develop computer software. X begins pro- computers individually to customers. The computer

of X’s activity and the relative value of X’s activity. ducing the computer software and expects to license chips are key components of the computers and

Therefore, X’s automobiles will be treated as MPGE one million copies of the computer software. In de- the computers will not operate without them. The

in significant part by X within the United States for termining its direct labor and overhead for the com- manufacture of the computer chips is not, in itself,

purposes of paragraph (g)(1) of this section. puter software under paragraph (g)(3)(i) of this sec- substantial in nature with respect to the finished

Example 4. X imports into the United States tion, X must allocate under paragraph (g)(3)(iii) of computers. Therefore, the taxpayer’s MPGE ac-

QPP that is partially manufactured. Assume that X this section the $1,000,000 to the computer software tivities must meet either the substantial-in-nature

completes the manufacture of the QPP within the X expects to produce. Thus, for each copy of the requirement under paragraph (g)(2) of this section,

United States and X’s completion of the manufac- computer software produced by X, $1 ($1,000,000 in or the safe harbor under paragraph (g)(3) of this sec-

turing of the QPP within the United States satisfies computer software development costs/one million es- tion, in order to qualify with respect to the finished

the in-whole-or-in-significant-part requirement un- timated number of units to be licensed) in computer computers.

der paragraph (g)(1) of this section. Therefore, X’s software development costs are treated as direct labor (h) Definition of United States. For

gross receipts from the lease, rental, license, sale, and overhead. purposes of this section, the term United

exchange, or other disposition of the QPP qualify as Example 8. X creates computer software for mi-

DPGR if all other applicable requirements under this crowave ovens. X also manufactures the electric mo-

States includes the 50 states, the District

section are met. tors used in the ovens. X purchases the other compo- of Columbia, the territorial waters of the

Example 5. X manufactures QPP in significant nents of the microwave ovens from unrelated persons. United States, and the seabed and subsoil

part within the United States and exports the QPP for X sells each microwave oven individually to cus- of those submarine areas that are adjacent

further manufacture outside the United States. X re- tomers. Assume that X’s assembly of the finished mi- to the territorial waters of the United States

tains title to the QPP while the QPP is being further crowave ovens is not minor assembly. To determine

manufactured outside the United States. Assuming whether the manufacture of the microwave ovens sat-

and over which the United States has ex-

X meets all the requirements under this section for isfies the safe harbor under paragraph (g)(3)(i) of this clusive rights, in accordance with interna-

the QPP after the further manufacturing, X’s gross section, X’s direct labor and overhead include X’s tional law, with respect to the exploration

receipts derived from the lease, rental, license, sale, direct labor and overhead for creating the computer and exploitation of natural resources. The

exchange, or other disposition of the QPP will be con- software, manufacturing the electric motors, and as-

term United States does not include pos-

sidered DPGR, regardless of whether the QPP is im- sembling the finished microwave ovens that are of-

ported back into the United States prior to the lease, fered for sale.

sessions and territories of the United States

rental, license, sale, exchange, or other disposition of Example 9. X designs shirts within the United or the airspace or space over the United

the QPP. States, but X cuts and sews the shirts outside of the States and these areas.

Example 6. X is a retailer within the United States United States. Because X’s design activity is the cre- (i) Derived from the lease, rental, li-

that sells cigars and pipe tobacco that X purchases ation of an intangible, its design activity is not taken

cense, sale, exchange, or other disposi-

from an unrelated person. While being displayed and into account in determining whether the manufacture

offered for sale by X, the cigars and pipe tobacco age of the shirts is substantial in nature under paragraph

tion—(1) In general—(i) Definition. The

on X’s shelves in a room with controlled temperature (g)(2) of this section, and the costs X incurs in creat- term derived from the lease, rental, license,

and humidity. Although X’s cigars and pipe tobacco ing the design of the shirts are not direct labor or over- sale, exchange, or other disposition is de-

may become more valuable as they age, the gross re- head under paragraph (g)(3)(i) of this section. There- fined as, and limited to, the gross receipts

ceipts derived by X from the sale of the cigars and

directly derived from the lease, rental, li-





2006–25 I.R.B. 1091 June 19, 2006

cense, sale, exchange, or other disposition fined in paragraph (i)(1)(iv)(C) of this (assuming all the other requirements of this section

of QPP, a qualified film, or utilities, even if section) received in a taxable exchange, are met).

the taxpayer has already recognized gross net of any adjustments between the par- Example 3. X MPGE QPP within the United

States and sells the QPP to Y, an unrelated person,

receipts from a previous lease, rental, li- ties involved in the taxable exchange to for $25,000. X finances Y’s purchase of the QPP and

cense, sale, exchange, or other disposition account for differences in the eligible receives total payments of $35,000, of which $10,000

of the same QPP, qualified film, or utili- property exchanged (for example, location relates to interest and finance charges. The $25,000

ties. Applicable Federal income tax prin- differentials and product differentials), qualifies as DPGR, but the $10,000 in interest and

ciples apply to determine whether a trans- may be treated as the value of the eligible finance charges do not qualify as DPGR because the

$10,000 is not derived from the MPGE of QPP within

action is, in substance, a lease, rental, li- property received by the taxpayer in the the United States, but rather from X’s lending activ-

cense, sale, exchange, or other disposition, taxable exchange. For purposes of the ity.

whether it is a service, or whether it is some preceding sentence, the taxable exchange Example 4. Cable company X charges sub-

combination thereof. is deemed to occur on the date of the scribers $15 a month for its basic cable television. Y,

(ii) Lease income. The financing and sale of the eligible property received in an unrelated person, produces a qualified film within

the meaning of paragraph (k)(1) of this section that

interest components of a lease of QPP or a the taxable exchange by the taxpayer, to it licenses to X for $.10 per subscriber per month.

qualified film are considered to be derived the extent the sale occurs no later than The gross receipts derived by Y are derived from the

from the lease of such QPP or qualified the last day of the month following the license of a qualified film produced by Y and are

film. However, any portion of the lease month in which the exchanged eligible DPGR (assuming all the other requirements of this

income that is attributable to services or property is received by the taxpayer. In section are met).

Example 5. X manufactures cars within the

non-qualified property as defined in para- addition, if the taxpayer engages in any United States. X also manufactures replacement

graph (i)(4) of this section is not derived further MPGE or production activity with parts within the United States. The replacement parts

from the lease of QPP or a qualified film. respect to the eligible property received are QPP under paragraph (j)(1) of this section. X

(iii) Income substitutes. The proceeds in the taxable exchange, then, unless the offers extended warranties to its customers. X sells

from business interruption insurance, gov- taxpayer meets the in-whole-or-in-signif- a car to Y. Y purchases an extended warranty and

brings the car to X’s service department for mainte-

ernmental subsidies, and governmental icant-part requirement under paragraph nance. X repairs the car and replaces damaged parts

payments not to produce are treated as (g)(1) of this section with respect to the with replacement parts that X manufactured within

gross receipts derived from the lease, property sold, for purposes of this para- the United States. The portion of X’s gross receipts

rental, license, sale, exchange, or other graph (i)(1)(iv)(B), the taxpayer must also derived from the sale of the extended warranty relat-

disposition to the extent that they are value the property sold without taking into ing to the manufactured parts are DPGR.



substitutes for gross receipts that would account the gross receipts attributable to (3) Hedging transactions—(i) In gen-

qualify as DPGR. the further MPGE or production activity. eral. For purposes of this section, pro-

(iv) Exchange of property—(A) Tax- (C) Eligible property. For purposes of vided that the risk being hedged relates

able exchanges. Except as provided in paragraph (i)(1)(iv)(B) of this section, eli- to QPP described in section 1221(a)(1)

paragraph (i)(1)(iv)(B) of this section, the gible property is— or relates to property described in section

value of property received by a taxpayer (1) Oil, natural gas (as described in 1221(a)(8) consumed in an activity giv-

in a taxable exchange of QPP MPGE in paragraph (l)(2) of this section), or petro- ing rise to DPGR, and provided that the

whole or in significant part by the taxpayer chemicals, or products derived from oil, transaction is a hedging transaction within

within the United States, a qualified film natural gas, or petrochemicals; or the meaning of section 1221(b)(2)(A) and

produced by the taxpayer, or utilities pro- (2) Any other property or product des- §1.1221–2(b) and is properly identified as

duced by the taxpayer within the United ignated by publication in the Internal Rev- a hedging transaction in accordance with

States is DPGR for the taxpayer (assuming enue Bulletin (see §601.601(d)(2)(ii)(b) of §1.1221–2(f), then—

all the other requirements of this section this chapter). (A) In the case of a hedge of pur-

are met). However, unless the taxpayer (2) Examples. The following exam- chases of property described in section

meets all of the requirements under this ples illustrate the application of paragraph 1221(a)(1), gain or loss on the hedging

section with respect to any further MPGE (i)(1) of this section: transaction must be taken into account in

by the taxpayer of the QPP or any further Example 1. X MPGE QPP in whole or in signif- determining CGS;

production by the taxpayer of the film or icant part within the United States and uses the QPP (B) In the case of a hedge of sales of

in its business. After several years X sells the QPP property described in section 1221(a)(1),

utilities received in the taxable exchange, that it MPGE to Y. The gross receipts derived from

any gross receipts derived from the sale gain or loss on the hedging transaction

the sale of the QPP to Y are DPGR (assuming all the

by the taxpayer of the property received in other requirements of this section are met).

must be taken into account in determining

the taxable exchange are non-DPGR, be- Example 2. X MPGE QPP within the United DPGR; and

cause the taxpayer did not MPGE or pro- States and sells the QPP to Y, an unrelated person. Y (C) In the case of a hedge of pur-

leases the QPP for 3 years to Z, a taxpayer unrelated chases of property described in section

duce such property, even if the property to both X and Y, and shortly after Y enters into the

was QPP, a qualified film, or utilities in the 1221(a)(8), gain or loss on the hedging

lease with Z, X repurchases the QPP from Y subject

hands of the other party to the transaction. to the lease. At the end of the lease term, Z purchases

transaction must be taken into account in

(B) Safe harbor. For purposes of para- the QPP from X. X’s proceeds derived from the sale determining DPGR.

graph (i)(1)(iv)(A) of this section, the of the QPP to Y, from the lease to Z (including any (ii) Currency fluctuations. For pur-

financing and interest components of the lease), and poses of this section, in the case of a trans-

gross receipts derived by the taxpayer from the sale of the QPP to Z all qualify as DPGR

from the sale of eligible property (as de- action that manages the risk of currency





June 19, 2006 1092 2006–25 I.R.B.

fluctuations, the determination of whether business, is not separately stated from gained for with customers (that is, a cus-

the transaction is a hedging transaction the amount charged for the lease, rental, tomer cannot purchase the QPP, qualified

within the meaning of §1.1221–2(b) is license, sale, exchange, or other disposi- film, or utilities without the warranty);

made without regard to whether the trans- tion of QPP, a qualified film, or utilities, (2) A qualified delivery, that is, a de-

action is a section 988 transaction. See DPGR include only the gross receipts de- livery or distribution service that is pro-

§1.1221–2(a)(4). The preceding sentence rived from the lease, rental, license, sale, vided in connection with the lease, rental,

applies only to the extent that §1.988–5(b) exchange, or other disposition of QPP, a license, sale, exchange, or other disposi-

does not apply. qualified film, or utilities (assuming all tion of QPP if, in the normal course of the

(iii) Effect of identification and non- the other requirements of this section are taxpayer’s business—

identification. If a taxpayer does not make met) and not any receipts attributable to (i) The price for the delivery or distri-

an identification that satisfies all of the re- the embedded service. In addition, DPGR bution service is not separately stated from

quirements of §1.1221–2(f) but the tax- does not include the gross receipts derived the amount charged for the lease, rental, li-

payer has no reasonable grounds for treat- from the lease, rental, license, sale, ex- cense, sale, exchange, or other disposition

ing the transaction as other than a hedging change, or other disposition of property of the QPP; and

transaction, then a loss from the transac- that does not meet all of the requirements (ii) The delivery or distribution service

tion is taken into account under this para- under this section (non-qualified prop- is neither separately offered by the tax-

graph (i)(3). If the inadvertent identifica- erty). The allocation of the gross receipts payer nor separately bargained for with

tion rule of §1.1221–2(g)(1)(ii) or the in- attributable to the embedded services or customers (that is, a customer cannot pur-

advertent error rule of §1.1221–2(g)(2)(ii) non-qualified property will be deemed chase the QPP without the delivery or dis-

applies, then the taxpayer is treated as not to be reasonable if the allocation reflects tribution service);

having identified the transaction as a hedg- the fair market value of the embedded (3) A qualified operating manual, that

ing transaction or as having identified the services or non-qualified property. For is, a manual of instructions (including elec-

transaction as a hedging transaction, as the example, gross receipts derived from the tronic instructions) that is provided in con-

case may be. If a taxpayer identifies a lease, rental, license, sale, exchange, or nection with the lease, rental, license, sale,

transaction as a hedging transaction in ac- other disposition of a replacement part that exchange, or other disposition of QPP, a

cordance with §1.1221–2(f)(1), then— is non-qualified property does not qualify qualified film or utilities if, in the normal

(A) That identification is binding with as DPGR. In addition, see §1.199–1(e) course of the taxpayer’s business—

respect to loss for purposes of this para- for other instances when an allocation of (i) The price for the manual is not sep-

graph (i)(3), whether or not all of the gross receipts attributable to embedded arately stated from the amount charged for

requirements of §1.1221–2(f) are satis- services or non-qualified property will be the lease, rental, license, sale, exchange,

fied and whether or not the transaction is deemed reasonable. or other disposition of the QPP, qualified

in fact a hedging transaction within the (B) Exceptions. There are six ex- film, or utilities;

meaning of section 1221(b)(2)(A) and ceptions to the rules under paragraph (ii) The manual is neither separately of-

§1.1221–2(b), and (i)(4)(i)(A) of this section regarding em- fered by the taxpayer nor separately bar-

(B) This paragraph (i)(3) does not ap- bedded services and non-qualified prop- gained for with customers (that is, a cus-

ply to require gain to be taken into ac- erty. A taxpayer may include in DPGR, if tomer cannot purchase the QPP, qualified

count in determining CGS or DPGR, if all the other requirements of this section film, or utilities without the manual); and

the transaction is not in fact a hedging are met with respect to the underlying (iii) The manual is not provided in

transaction within the meaning of section item of QPP, qualified films, or utilities to connection with a training course for cus-

1221(b)(2)(A) and §1.1221–2(b). which the embedded services or non-qual- tomers;

(iv) Other rules. See §1.1221–2(e) for ified property relate, the gross receipts (4) A qualified installation, that is, an

rules applicable to hedging by members derived from— installation service (including minor as-

of a consolidated group and §1.446–4 for (1) A qualified warranty, that is, a sembly) for tangible personal property that

rules regarding the timing of income, de- warranty (other than a computer software is provided in connection with the lease,

ductions, gains, or losses with respect to maintenance agreement described in para- rental, license, sale, exchange, or other dis-

hedging transactions. graph (i)(4)(i)(B)(5) of this section) that position of the tangible personal property

(4) Allocation of gross receipts—(i) is provided in connection with the lease, if, in the normal course of the taxpayer’s

Embedded services and non-qualified rental, license, sale, exchange, or other business—

property—(A) In general. Except as oth- disposition of QPP, a qualified film, or (i) The price for the installation service

erwise provided in paragraph (i)(4)(i)(B), utilities if, in the normal course of the is not separately stated from the amount

paragraph (m) (relating to construction), taxpayer’s business— charged for the lease, rental, license, sale,

and paragraph (n) (relating to engineer- (i) The price for the warranty is not sep- exchange, or other disposition of the tan-

ing and architectural services) of this arately stated from the amount charged for gible personal property; and

section, gross receipts derived from the the lease, rental, license, sale, exchange, (ii) The installation is neither separately

performance of services do not qualify as or other disposition of the QPP, qualified offered by the taxpayer nor separately bar-

DPGR. In the case of an embedded ser- film, or utilities; and gained for with customers (that is, a cus-

vice, that is, a service the price of which, (ii) The warranty is neither separately tomer cannot purchase the tangible per-

in the normal course of the taxpayer’s offered by the taxpayer nor separately bar-





2006–25 I.R.B. 1093 June 19, 2006

sonal property without the installation ser- exception does not apply if the price of a Example 3. X MPGE QPP within the United

vice); service or non-qualified property is sepa- States. As part of the sale of the QPP to retailers,

(5) Services performed pursuant to a rately stated by the taxpayer, or if the ser- X charges a fee for delivering the QPP. In the nor-

mal course of X’s business, the price of the QPP and

qualified computer software maintenance vice or non-qualified property is separately the delivery fee are separately stated in X’s sales con-

agreement. A qualified computer software offered or separately bargained for with the tracts. Because, in the normal course of X’s busi-

maintenance agreement is an agreement customer (that is, the customer can pur- ness, the delivery fee is separately stated, the deliv-

provided in connection with the lease, chase the QPP, qualified film, or utilities ery fee does not qualify as DPGR under the qualified

rental, license, sale, exchange, or other without the service or non-qualified prop- delivery exception in paragraph (i)(4)(i)(B)(2) of this

section or the de minimis exception under paragraph

disposition of the computer software that erty). (i)(4)(i)(B)(6) of this section. The result would be the

entitles the customer to receive future (ii) Non-DPGR. All of a taxpayer’s same even if the retailer’s customers cannot purchase

updates, cyclical releases, rewrites of the gross receipts derived from the lease, the QPP without paying the delivery fee.

underlying software, or customer support rental, license, sale, exchange or other dis- Example 4. (i) Facts. X manufactures indus-

services for the computer software if, in position of an item of QPP, qualified films, trial sewing machines within the United States that

X offers for sale individually to customers. X en-

the normal course of the taxpayer’s busi- or utilities may be treated as non-DPGR ters into a single, lump-sum priced contract with Y,

ness— if less than 5 percent of the taxpayer’s an unrelated person, and the contract has the follow-

(i) The price for the agreement is not total gross receipts derived from the lease, ing terms: X will manufacture industrial sewing ma-

separately stated from the amount charged rental, license, sale, exchange or other chines within the United States for Y; X will deliver

for the lease, rental, license, sale, ex- disposition of that item are DPGR. In the the industrial sewing machines to Y; X will provide a

one-year warranty on the industrial sewing machines;

change, or other disposition of the com- case of gross receipts derived from the X will provide operating manuals with the industrial

puter software; and lease, rental, license, sale, exchange, or sewing machines; X will provide 100 hours of train-

(ii) The agreement is neither separately other disposition of QPP, a qualified film, ing and training manuals to Y’s employees on the use

offered by the taxpayer nor separately bar- and utilities that are received over a period and maintenance of the industrial sewing machines;

gained for with customers (that is, a cus- of time (for example, a multi-year lease or X will provide purchased spare parts for the industrial

sewing machines; and X will provide a 3-year service

tomer cannot purchase the computer soft- installment sale), this paragraph (i)(4)(ii) agreement for the industrial sewing machines. In the

ware without the agreement); and is applied by taking into account the total normal course of X’s business, none of the services or

(6) A de minimis amount of gross re- gross receipts for the entire period derived property described above are separately stated, sepa-

ceipts from embedded services and non- (and to be derived) from the lease, rental, rately offered or separately bargained for.

qualified property for each item of QPP, license, sale, exchange, or other disposi- (ii) Analysis. The receipts for the manufacture

of the industrial sewing machines are DPGR under

qualified films, or utilities. For purposes tion of the item of QPP, qualified films, paragraphs (e)(1) and (g) of this section (assuming

of the preceding sentence, a de minimis or utilities. For purposes of the preceding all the other requirements of this section are met). X

amount of gross receipts from embedded sentence, if a taxpayer treats gross receipts may include in DPGR the gross receipts derived from

services and non-qualified property is less as non-DPGR under this de minimis ex- delivering the industrial sewing machines, which is

than 5 percent of the total gross receipts de- ception, then the taxpayer must treat the a qualified delivery under paragraph (i)(4)(i)(B)(2)

of this section; the gross receipts derived from the

rived from the lease, rental, license, sale, gross receipts recognized in each taxable one-year warranty, which is a qualified warranty

exchange, or other disposition of each item year consistently as non-DPGR. under paragraph (i)(4)(i)(B)(1) of this section; and

of QPP, qualified films, or utilities. In (iii) Examples. The following examples the gross receipts derived from the operating man-

the case of gross receipts derived from the illustrate the application of this paragraph uals, which is a qualified operating manual under

lease, rental, license, sale, exchange, or (i)(4): paragraph (i)(4)(i)(B)(3) of this section. If the gross

receipts allocable to each industrial sewing machine

other disposition of QPP, a qualified film, Example 1. X MPGE QPP within the United

for the embedded services consisting of the employee

or utilities that are received over a period States. As part of the sale of the QPP to Z, X trains

Z’s employees on how to use and operate the QPP. No training and 3-year service agreement, and for the

of time (for example, a multi-year lease or other services or property are provided to Z in con-

non-qualified property consisting of the purchased

installment sale), this de minimis excep- spare parts and the employee training manuals, which

nection with the sale of the QPP to Z. In the normal

tion is applied by taking into account the course of X’s business, the QPP and training services are not qualified operating manuals, are in total less

than 5% of the gross receipts derived from the sale

total gross receipts for the entire period de- are separately stated in the sales contract. Because,

of each industrial sewing machine to Y (after apply-

rived (and to be derived) from the lease, in the normal course of the X’s business, the training

services are separately stated, the training services are ing the exceptions under paragraphs (i)(4)(i)(B)(1)

rental, license, sale, exchange, or other not treated as embedded services under the de min-

through (5) of this section), then those gross receipts

disposition of the item of QPP, qualified may be included in DPGR under the de minimis

imis exception in paragraph (i)(4)(i)(B)(6) of this sec-

films, or utilities. For purposes of the pre- exception in paragraph (i)(4)(i)(B)(6) of this section.

tion.

If, however, the gross receipts allocable to each

ceding sentence, if a taxpayer treats gross Example 2. The facts are the same as in Exam-

industrial sewing machine for the embedded services

receipts as DPGR under this de minimis ple 1 except that, in the normal course of X’s busi-

and non-qualified property consisting of employee

ness, the training services are not separately stated in

exception, then the taxpayer must treat the the sales contract and the customer cannot purchase

training, the 3-year service agreement, purchased

gross receipts recognized in each taxable spare parts, and employee training manuals equal

the QPP without the training services. If the gross re-

year consistently as DPGR. The gross re- or exceed, in total, 5% of the gross receipts derived

ceipts for the embedded training services are less than

from the sale of each industrial sewing machine to

ceipts that the taxpayer treats as DPGR un- 5% of the gross receipts derived from the sale of X’s

Y (after applying the exceptions under paragraphs

der paragraphs (i)(4)(i)(B)(1), (2), (3), (4), QPP to Z, after applying the exceptions under para-

(i)(4)(i)(B)(1) through (5) of this section), then those

graphs (i)(4)(i)(B)(1) through (5) of this section, then

and (5) and (l)(4)(iv)(A) of this section are the gross receipts may be included in DPGR under

gross receipts do not qualify as DPGR under the de

treated as DPGR for purposes of applying minimis exception in paragraph (i)(4)(i)(B)(6) of this

the de minimis exception in paragraph (i)(4)(i)(B)(6)

this de minimis exception. This de minimis of this section.







June 19, 2006 1094 2006–25 I.R.B.

section (and X must allocate gross receipts between this section does not apply because Z’s broadcast of (i) Tangible personal property (as de-

DPGR and non-DPGR under §1.199–1(d)(1)). the second television program on Z’s television sta- fined in paragraph (j)(2) of this section);

(5) Advertising income—(i) Tangible tion is not a lease, rental, license, sale, exchange, or (ii) Computer software (as defined in

other disposition of the second television program.

personal property. A taxpayer’s gross paragraph (j)(3) of this section); and

As a result, pursuant to paragraph (i)(5)(ii) of this sec-

receipts that are derived from the lease, tion, none of X’s product placement and advertising (iii) Sound recordings (as defined in

rental, license, sale, exchange, or other income for the second television program is treated paragraph (j)(4) of this section).

disposition of newspapers, magazines, as gross receipts derived from the qualified film. (2) Tangible personal property—(i) In

telephone directories, periodicals, and Example 4. The facts are the same as in Example general. The term tangible personal prop-

3 except that Z sublicenses to an unrelated person the

other similar printed publications that are erty is any tangible property other than

television program instead of broadcasting the tele-

MPGE in whole or in significant part vision program on its station. The gross receipts de- land, real property described in paragraph

within the United States include advertis- rived by X from licensing the television program to Z (m)(3) of this section, and any property de-

ing income from advertisements placed in are DPGR under paragraph (b)(2) of this section. As scribed in paragraph (j)(3), (j)(4), (k)(1),

those media, but only if the gross receipts, a result, pursuant to paragraph (i)(5)(ii) of this sec- or (l) of this section. For purposes of

tion, X’s product placement and advertising income

if any, derived from the lease, rental, li- the preceding sentence, tangible personal

for the television program licensed to Z is treated as

cense, sale, exchange, or other disposition gross receipts derived from the qualified film. In ad- property also includes any gas (other than

of the newspapers, magazines, telephone dition, Z’s receipts from the sublicense of the quali- natural gas described in paragraph (l)(2)

directories, or periodicals are (or would fied film are DPGR under §1.199–7(a)(3)(i). of this section), chemical, and similar

be) DPGR. Example 5. X produces television programs that property, for example, steam, oxygen, hy-

are qualified films. X licenses the qualified films

(ii) Qualified film. A taxpayer’s gross drogen, and nitrogen. Property such as

to Y, an unrelated person, and the license agreement

receipts that are derived from the lease, provides that X will receive advertising time slots as machinery, printing presses, transporta-

rental, license, sale, exchange, or other dis- part of its payments from Y under the license agree- tion and office equipment, refrigerators,

position of a qualified film include adver- ment. X’s gross receipts derived from the license of grocery counters, testing equipment, dis-

tising income and product-placement in- the qualified films to Y include income attributable to play racks and shelves, and neon and other

the advertising time slots and are DPGR under para-

come with respect to that qualified film, signs that are contained in or attached to

graph (b)(2) of this section.

that is, compensation for placing or inte- a building constitutes tangible personal

(6) Computer software—(i) In general.

grating advertising or a product into the property for purposes of this paragraph

DPGR include the gross receipts of the

qualified film, but only if the gross re- (j)(2)(i). Except as provided in paragraphs

taxpayer that are derived from the lease,

ceipts, if any, derived from the qualified (j)(5)(ii) and (k)(2)(i) of this section, com-

rental, license, sale, exchange, or other dis-

film are (or would be) DPGR. puter software, sound recordings, and

position of computer software MPGE by

(iii) Examples. The following examples qualified films are not treated as tangible

the taxpayer in whole or in significant part

illustrate the application of this paragraph personal property regardless of whether

within the United States. Such gross re-

(i)(5): they are affixed to a tangible medium.

Example 1. X MPGE, and sells, newspapers

ceipts qualify as DPGR even if the cus-

tomer provides the computer software to However, the tangible medium to which

within the United States. X’s gross receipts from

the newspapers include gross receipts derived from its employees or others over the Internet. such property may be affixed (for exam-

the sale of newspapers to customers and payments (ii) through (v). [Reserved]. For further ple, a videocassette, a computer diskette,

from advertisers to publish display advertising or

guidance, see §1.199–3T(i)(6)(ii) through or other similar tangible item) is tangible

classified advertisements in X’s newspapers. X’s personal property.

gross receipts described above are DPGR derived

(v).

(7) Qualifying in-kind partnership for (ii) Local law. In determining whether

from the sale of X’s newspapers.

Example 2. The facts are the same as in Exam- taxable years beginning after May 17, property is tangible personal property, lo-

ple 1 except that X disposes of the newspapers free 2006, the enactment date of the Tax In- cal law is not controlling.

of charge to customers, rather than selling them. X’s

crease Prevention and Reconciliation Act (iii) Intangible property. The term tan-

gross receipts from the display advertising or classi- gible personal property does not include

fied advertisements are DPGR.

of 2005. [Reserved].

(8) Partnerships owned by members of property in a form other than in a tangi-

Example 3. X produces two live television pro-

grams that are qualified films. X licenses the first a single expanded affiliated group for tax- ble medium. For example, mass-produced

television program to Y’s television station and X li- able years beginning after May 17, 2006, books are tangible personal property, but

censes the second television program to Z’s televi-

the enactment date of the Tax Increase Pre- neither the rights to the underlying manu-

sion station. Z broadcasts the second television pro- script nor an online version of the book is

gram on its station. Both television programs con-

vention and Reconciliation Act of 2005.

[Reserved]. tangible personal property.

tain product placements and advertising for which X

received compensation. X and Y are unrelated per- (9) Non-operating mineral interests. (3) Computer software—(i) In general.

sons. X and Z are non-consolidated members of an DPGR does not include gross receipts de- The term computer software means any

EAG. The gross receipts derived by X from licensing

rived from non-operating mineral interests program or routine or any sequence of

the first television program to Y are DPGR. As a re- machine-readable code that is designed

sult, pursuant to paragraph (i)(5)(ii) of this section, all

(for example, interests other than operat-

ing mineral interests within the meaning to cause a computer to perform a de-

of X’s product placement and advertising income for

the first television program is treated as gross receipts of §1.614–2(b)). sired function or set of functions, and the

that are derived from the license of the qualified film. (j) Definition of qualifying production documentation required to describe and

The gross receipts derived by X from licensing the

property—(1) In general. QPP means— maintain that program or routine. Thus,

second television program to Z are non-DPGR under for example, an electronic book available

paragraph (b)(1) of this section. Paragraph (b)(2) of online or for download is not computer





2006–25 I.R.B. 1095 June 19, 2006

software. For purposes of this paragraph which the dictionary feature is maintained software are treated as direct labor and

(j)(3), computer software also includes the or stored. overhead. These costs must be included in

machine-readable code for video games (4) Sound recordings—(i) In general. the taxpayer’s CGS of the computer soft-

and similar programs, for equipment that The term sound recordings means any ware for purposes of determining whether

is an integral part of other property, and works that result from the fixation of a the taxpayer meets the safe harbor under

for typewriters, calculators, adding and series of musical, spoken, or other sounds paragraph (g)(3)(i) of this section. How-

accounting machines, copiers, duplicating under section 168(f)(4). The definition of ever, any costs under section 174, and the

equipment, and similar equipment, regard- sound recordings is limited to the master costs to create intangible assets, attribut-

less of whether the code is designed to op- copy of the recordings (or other copy from able to the tangible personal property are

erate on a computer (as defined in section which the holder is licensed to make and not considered in determining whether the

168(i)(2)(B)). Computer programs of all produce copies), and, except as provided taxpayer’s activity is substantial in nature

classes, for example, operating systems, in paragraph (j)(5) of this section, if the under paragraph (g)(2) of this section and

executive systems, monitors, compilers medium (such as compact discs, tapes, are not direct labor and overhead under

and translators, assembly routines, and or other phonorecordings) in which the paragraph (g)(3)(i) of this section; and

utility programs, as well as application sounds may be embodied is tangible, then (B) The sound recordings and the tan-

programs, are included. Except as pro- the medium is considered tangible per- gible personal property with the sound

vided in paragraph (j)(5) of this section, sonal property for purposes of paragraph recordings may be treated by the taxpayer

if the medium in which the software is (j)(2) of this section. as sound recordings. If the taxpayer treats

contained, whether written, magnetic, or (ii) Exception. The term sound record- the sound recordings and the tangible

otherwise, is tangible, then such medium ings does not include the creation of copy- personal property as sound recordings,

is considered tangible personal property righted material in a form other than a activities giving rise to research and ex-

for purposes of this section. sound recording, such as lyrics or music perimental expenditures under section 174

(ii) Incidental and ancillary rights. composition. and the creation of intangible assets for

Computer software also includes any (5) Tangible personal property with sound recordings are considered in de-

incidental and ancillary rights that are computer software or sound record- termining whether the taxpayer’s MPGE

necessary to effect the acquisition of the ings—(i) Computer software and sound activity is substantial in nature under para-

title to, the ownership of, or the right to recordings. If a taxpayer MPGE in whole graph (g)(2) of this section. In determining

use the computer software, and that are or in significant part computer software direct labor and overhead under paragraph

used only in connection with that specific or sound recordings within the United (g)(3)(i) of this section, research and ex-

computer software. Such incidental and States that is affixed or added to tangible perimental expenditures under section 174

ancillary rights are not included in the personal property (for example, a com- and any other costs of creating intangible

definition of trademark or trade name un- puter diskette, or an appliance), whether assets for sound recordings are treated as

der §1.197–2(b)(10)(i). For example, a or not the taxpayer MPGE such tangible direct labor and overhead. These costs

trademark or trade name that is ancillary personal property in whole or in signifi- must be included in the taxpayer’s CGS

to the ownership or use of a specific com- cant part within the United States, then for of sound recordings for purposes of de-

puter software program in the taxpayer’s purposes of this section— termining whether the taxpayer meets the

trade or business and is not acquired for (A) The computer software and the tan- safe harbor under paragraph (g)(3)(i) of

the purpose of marketing the computer gible personal property may be treated by this section. However, any costs under

software is included in the definition of the taxpayer as computer software. If the section 174, and the costs to create intan-

computer software and is not included in taxpayer treats the computer software and gible assets, attributable to the tangible

the definition of trademark or trade name. the tangible personal property as computer personal property are not considered in

(iii) Exceptions. Computer software software, activities the cost of which are determining whether the taxpayer’s activ-

does not include any data or information described in Rev. Proc. 2000–50, 2000–2 ity is substantial in nature under paragraph

base unless the data or information base C.B. 601, activities giving rise to research (g)(2) of this section and are not direct la-

is in the public domain and is incidental and experimental expenditures under sec- bor and overhead under paragraph (g)(3)(i)

to a computer program. For this purpose, tion 174, and the creation of intangible of this section.

a copyrighted or proprietary data or infor- assets for computer software are consid- (ii) Tangible personal property. If a tax-

mation base is treated as in the public do- ered in determining whether the taxpayer’s payer MPGE tangible personal property

main if its availability through the com- MPGE activity is substantial in nature un- (for example, a computer diskette or an

puter program does not contribute signif- der paragraph (g)(2) of this section. In de- appliance) in whole or in significant part

icantly to the cost of the program. For ex- termining direct labor and overhead under within the United States but not the com-

ample, if a word-processing program in- paragraph (g)(3)(i) of this section, the costs puter software or sound recordings that

cludes a dictionary feature that may be of direct labor and overhead for develop- is affixed or added to such tangible per-

used to spell-check a document or any ing the computer software as described in sonal property, then for purposes of this

portion thereof, then the entire program Rev. Proc. 2000–50, 2000–2 C.B. 601, re- section the tangible personal property with

(including the dictionary feature) is com- search and experimental expenditures un- the computer software or sound recordings

puter software regardless of the form in der section 174, and any other costs of may be treated by the taxpayer as tangible

creating intangible assets for the computer personal property under paragraph (j)(2)





June 19, 2006 1096 2006–25 I.R.B.

of this section. Any costs under section the lease, rental, license, sale, exchange, film-themed merchandise is revenue from

174, and the costs to create intangible as- or other disposition of the tangible per- the sale of tangible personal property and

sets, attributable to the tangible personal sonal property with the affixed film are not gross receipts derived from a qualified

property are not considered in determin- DPGR is made under the rules of this sec- film. Gross receipts derived from a license

ing whether the taxpayer’s activity is sub- tion. For purposes of paragraph (g)(2) of of the right to use or exploit the film char-

stantial in nature under paragraph (g)(2) of this section, in determining whether the acters are not gross receipts derived from

this section and are not direct labor or over- taxpayer’s MPGE activity is substantial a qualified film.

head under paragraph (g)(3)(i) of this sec- in nature, the taxpayer must consider the (4) Compensation for services. The

tion. For purposes of paragraph (g)(3) of value of the licensed film. For purposes term compensation for services means all

this section, the taxpayer’s CGS (or unad- of paragraph (g)(3) of this section, the payments for services performed by actors

justed depreciable basis, if applicable) for taxpayer’s CGS (or unadjusted deprecia- (as described in paragraph (k)(1) of this

each item of tangible personal property in- ble basis, as applicable) for each item of section), production personnel, directors,

cludes the taxpayer’s cost of leasing, rent- tangible personal property includes the and producers, including participations

ing, licensing, buying, or otherwise acquir- taxpayer’s cost of leasing, renting, licens- and residuals. In the case of a taxpayer

ing the computer software or sound record- ing, buying, or otherwise acquiring the that uses the income forecast method of

ings. film. section 167(g) and capitalizes participa-

(k) Definition of qualified film—(1) In (ii) Film produced by a taxpayer. If a tions and residuals into the adjusted basis

general. The term qualified film means taxpayer produces a film and the film is of the qualified film, the taxpayer must

any motion picture film or video tape un- affixed to tangible personal property (for use the same estimate of participations

der section 168(f)(3), or live or delayed example, a DVD), then for purposes of this and residuals for services performed by

television programming, if not less than section— actors, production personnel, directors,

50 percent of the total compensation paid (A) Qualified film. If the film is a and producers for purposes of this section.

to actors, production personnel, directors, qualified film, the taxpayer may treat the In the case of a taxpayer that excludes

and producers relating to the production tangible personal property, whether or not participations and residuals from the ad-

of the motion picture film, video tape, or the taxpayer MPGE such tangible personal justed basis of the qualified film under

television programming is compensation property, to which the qualified film is af- section 167(g)(7)(D)(i), the taxpayer must

paid by the taxpayer for services relating fixed as part of the qualified film; and determine the compensation expected to

to the production of the film performed (B) Nonqualified film. If the film is be paid for services performed by ac-

in the United States by those individuals. not a qualified film (nonqualified film), a tors, production personnel, directors, and

For purposes of this paragraph (k), ac- taxpayer cannot treat the tangible personal producers as participations and residu-

tors include players, newscasters, or any property to which the nonqualified film is als based on the total forecasted income

other persons performing in a qualified affixed as part of the nonqualified film. used in determining income forecast de-

film. The term production personnel in- (3) Derived from a qualified film—(i) preciation. Compensation for services

cludes, for example, writers, choreogra- In general. DPGR include the gross re- includes all direct and indirect compensa-

phers and composers providing services ceipts of a taxpayer that are derived from tion costs required to be capitalized under

during the production of a film, casting any lease, rental, license, sale, exchange, section 263A for film producers under

agents, camera operators, set designers, or other disposition of any qualified film §1.263A–1(e)(2) and (3). Compensation

lighting technicians, make-up artists, and produced by such taxpayer. for services is not limited to W–2 wages

others whose activities are directly related (ii) Exceptions. The showing of a qual- and includes compensation paid to inde-

to the production of the film. Except as ified film (for example, in a movie theater pendent contractors.

provided in paragraph (k)(2) of this sec- or by broadcast on a television station) by a (5) Determination of 50 percent.

tion, the definition of qualified film does taxpayer is not a lease, rental, license, sale, The not-less-than–50-percent-of-the-to-

not include tangible personal property em- exchange, or other disposition of the qual- tal-compensation requirement under para-

bodying the qualified film, such as DVDs ified film by such taxpayer. Ticket sales graph (k)(1) of this section is determined

or videocassettes. for viewing a qualified film do not con- by reference to all compensation paid in

(2) Tangible personal property with a stitute DPGR because the gross receipts the production of the film and is calcu-

film—(i) Film not produced by a taxpayer. are not derived from the lease, rental, li- lated using a fraction. The numerator of

If a taxpayer MPGE tangible personal cense, sale, exchange, or other disposi- the fraction is the compensation paid by

property (for example, a DVD) in whole tion of a qualified film. Because a tax- the taxpayer to actors, production person-

or in significant part in the United States payer that merely writes a screenplay or nel, directors, and producers for services

and a film not produced by a taxpayer is other similar material is not considered to relating to the production of the film (pro-

affixed to the tangible personal property, have produced a qualified film under para- duction services) performed in the United

then the taxpayer may treat the tangible graph (k)(1) of this section, the amounts States, and the denominator is the sum

personal property with the affixed film that the taxpayer receives from the sale of the total compensation paid by the

as tangible personal property, regardless of the script or screenplay, even if the taxpayer to all such individuals regard-

of whether the film is a qualified film. script is developed into a qualified film, are less of where the production services are

The determination of whether the gross not gross receipts derived from a qualified performed and the total compensation

receipts of such a taxpayer derived from film. In addition, revenue from the sale of paid by others to all such individuals re-





2006–25 I.R.B. 1097 June 19, 2006

gardless of where the production services showing a qualified film on a television station is not and Z to actors, production personnel, directors, and

are performed. A taxpayer may use any a lease, rental, license, sale, exchange, or other dispo- producers for the production of the scenes used by X

reasonable method that is satisfactory to sition pursuant to paragraph (k)(3)(ii) of this section, in creating its television program.

the advertising income X receives from advertisers (l) Electricity, natural gas, or potable

the Secretary based on all of the facts is not derived from the lease, rental, license, sale, ex-

and circumstances, including all historic water—(1) In general. DPGR include

change, or other disposition of the qualified films and

information available, to determine the is non-DPGR.

gross receipts derived from any lease,

compensation for services performed in Example 4. The facts are the same as in Example rental, license, sale, exchange, or other

the United States by actors (as described in 3 except that X also licenses the qualified films to Y, disposition of utilities produced by the

an unrelated cable company that broadcasts X’s qual- taxpayer in the United States if all other

paragraph (k)(1) of this section), produc- ified films. As part of the license agreement, X can

tion personnel, directors, and producers, requirements of this section are met. In the

sell advertising time slots. Because X’s gross receipts

and the total compensation paid to those from Y are derived from the licensing of qualified

case of an integrated producer that both

individuals for services relating to the pro- films pursuant to paragraph (k)(3)(i) of this section, produces and delivers utilities, see para-

duction of the film. Among the factors X’s gross receipts derived from licensing the quali- graph (l)(4) of this section that describes

fied film are DPGR. In addition, the gross receipts certain gross receipts that do not qualify

to be considered in determining whether derived from the advertising income X receives that

a taxpayer’s method of allocating com- as DPGR.

is related to the qualified films licensed to Y is DPGR

pensation is reasonable is whether the pursuant to paragraph (i)(5)(ii) of this section. Be-

(2) Natural gas. The term natural gas

taxpayer uses that method consistently cause showing a qualified film on a television station includes only natural gas extracted from a

from one taxable year to another. is not a lease, rental, license, sale, exchange, or other natural deposit and does not include, for

disposition pursuant to paragraph (k)(3)(ii) of this example, methane gas extracted from a

(6) Exception. A qualified film does section, the portion of the advertising income X de-

not include property with respect to which landfill. In the case of natural gas, pro-

rives from advertisers for the qualified films it broad-

records are required to be maintained un- casts on its own television station is not derived from

duction activities include all activities

der 18 U.S.C. 2257. Section 2257 of Title the lease, rental, license, sale, exchange, or other dis- involved in extracting natural gas from

18 requires maintenance of certain records position of the qualified films and is non-DPGR. the ground and processing the gas into

Example 5. X produces a qualified film and con- pipeline quality gas.

with respect to any book, magazine, pe- tracts with Y, an unrelated person, to duplicate the

riodical, film, videotape, or other matter (3) Potable water. The term potable

film onto DVDs. Y manufactures blank DVDs within

that— the United States, duplicates X’s film onto the DVDs

water means unbottled drinking water. In

(i) Contains one or more visual depic- in the United States, and sells the DVDs with the the case of potable water, production ac-

tions made after November 1, 1990, of ac- qualified film to X who then sells them to customers. tivities include the acquisition, collection,

Y has all of the benefits and burdens of ownership un- and storage of raw water (untreated water),

tual sexually explicit conduct; and der Federal income tax principles of the DVDs dur-

(ii) Is produced in whole or in part with transportation of raw water to a water treat-

ing the MPGE and duplication process. Assume Y’s

materials that have been mailed or shipped activities relating to manufacture of the blank DVDs

ment facility, and treatment of raw water

in interstate or foreign commerce, or is and duplicating the film onto the DVDs collectively at such a facility. Gross receipts attribut-

shipped or transported or is intended for satisfy the safe harbor under paragraph (g)(3) of this able to any of these activities are included

section. Y’s gross receipts from manufacturing the in DPGR if all other requirements of this

shipment or transportation in interstate or DVDs and duplicating the film onto the DVDs are

foreign commerce. section are met.

DPGR (assuming all the other requirements of this

(7) Examples. The following examples section are met). X’s gross receipts from the sale of

(4) Exceptions—(i) Electricity. Gross

illustrate the application of this paragraph the DVDs to customers are DPGR (assuming all the receipts attributable to the transmission of

(k): other requirements of this section are met). electricity from the generating facility to

Example 6. X creates a television program in a point of local distribution and gross re-

Example 1. X produces a qualified film and du-

the United States that includes scenes from films li-

plicates the film onto purchased DVDs. X sells the ceipts attributable to the distribution of

DVDs with the qualified film to customers. Under censed by X from unrelated persons Y and Z. Assume

that Y and Z produced the films licensed by X. The

electricity to customers are non-DPGR.

paragraph (k)(2)(ii)(A) of this section, X treats the

not-less-than–50-percent-of-the-total-compensation (ii) Natural gas. Gross receipts attrib-

DVD with the qualified film as a qualified film. Ac-

cordingly, X’s gross receipts derived from the sale of requirement under paragraph (k)(1) of this section is utable to the transmission of pipeline qual-

determined by reference to all compensation paid in ity gas from a natural gas field (or, if treat-

the qualified film to customers are DPGR (assuming

the production of the television program, including

all the other requirements of this section are met). ment at a natural gas processing plant is

Example 2. The facts are the same as in Example the films licensed by X from Y and Z, and is cal-

culated using a fraction as described in paragraph

necessary to produce pipeline quality gas,

1 except that the film is a nonqualified film because

(k)(5) of this section. The numerator of the fraction from a natural gas processing plant) to a

the film does not satisfy the not-less-than–50-per-

cent-of-the-total-compensation requirement under is the compensation paid by X to actors, production local distribution company’s citygate (or

personnel, directors, and producers for production to another customer) are non-DPGR. Like-

(k)(1) of this section and X manufactures the DVDs

services performed in the United States, and the

in the United States. Under paragraph (k)(2)(ii)(B) wise, gross receipts of a local gas distri-

of this section, X cannot treat the DVD as part of the denominator is the sum of the total compensation

paid by X to such individuals regardless of where

bution company attributable to distribution

nonqualified film. X’s gross receipts (not including

the production services are performed and the total from the citygate to the local customers are

the gross receipts attributable to the nonqualified

film) derived from the sale of the tangible personal compensation paid by Y and Z to actors, production non-DPGR.

personnel, directors, and producers relating to the (iii) Potable water. Gross receipts at-

property are DPGR (assuming all the other require-

production of the films licensed by X (regardless

ments of this section are met). tributable to the storage of potable wa-

Example 3. X produces live television programs of where the services are performed). However, for

purposes of calculating the denominator, in deter-

ter after completion of treatment of the

that are qualified films. X shows the programs on its

mining the total compensation paid by Y and Z, X potable water, as well as gross receipts at-

own television station. X sells advertising time slots

to advertisers for the television programs. Because need only include the total compensation paid by Y







June 19, 2006 1098 2006–25 I.R.B.

tributable to the transmission and distribu- (5) Example. The following example property is real property under local law

tion of potable water, are non-DPGR. illustrates the application of this paragraph is not controlling. Conversely, property

(iv) De minimis exception—(A) DPGR. (l): may be real property for purposes of this

Notwithstanding paragraphs (l)(4)(i), (ii), Example. X owns a wind turbine in the United paragraph (m)(1)(i) even though under lo-

and (iii) of this section, if less than 5 per- States that generates electricity and Y owns a high cal law the property is considered tangible

voltage transmission line that passes near X’s wind

cent of a taxpayer’s gross receipts derived turbine and ends near the system of local distribu-

personal property.

from a sale, exchange, or other disposi- tion lines of Z. X sells the electricity produced at (ii) Regular and ongoing basis—(A)

tion of utilities are attributable to the trans- the wind turbine to Z and contracts with Y to trans- In general. For purposes of paragraph

mission or distribution of the utilities and mit the electricity produced at the wind turbine to Z (m)(1)(i) of this section, a taxpayer en-

the storage of potable water after comple- who sells the electricity to customers using Z’s dis- gaged in a construction trade or business

tribution network. The gross receipts received by X

tion of treatment of the potable water, then from the sale of electricity produced at the wind tur-

will be considered to be engaged in such

the gross receipts derived from the lease, bine are DPGR. The gross receipts of Y derived from trade or business on a regular and ongoing

rental, license, sale, exchange, or other dis- transporting X’s electricity to Z are non-DPGR under basis if the taxpayer derives gross receipts

position of the utilities that are attributable paragraph (l)(4)(i) of this section. Likewise, the gross from an unrelated person by selling or

to the transmission and distribution of the receipts of Z derived from distributing the electricity exchanging the constructed real property

are non-DPGR under paragraph (l)(4)(i) of this sec-

utilities and the storage of potable water af- tion. If X made direct sales of electricity to customers

described in paragraph (m)(3) of this sec-

ter completion of treatment of the potable in Z’s service area and Z receives remuneration for tion within 60 months of the date on which

water may be treated as being DPGR (as- the distribution of electricity, the gross receipts of Z construction is complete (for example, on

suming all other requirements of this sec- are non-DPGR under paragraph (l)(4)(i) of this sec- the date a certificate of occupancy is is-

tion are met). In the case of gross receipts tion. If X, Y, and Z are related persons (as defined in sued for the property).

paragraph (b) of this section), then X, Y, and Z must

derived from the lease, rental, license, sale, allocate gross receipts among the production activi-

(B) New trade or business. In the case

exchange, or other disposition of utilities ties (that are DPGR), and the transmission and distri- of a newly-formed trade or business or a

that are received over a period of time (for bution activities (that are non-DPGR). taxpayer in its first taxable year, the tax-

example, a multi-year lease or installment (m) Definition of construction per- payer is considered to be engaged in a trade

sale), this de minimis exception is applied formed in the United States—(1) Con- or business on a regular and ongoing basis

by taking into account the total gross re- struction of real property—(i) In general. if the taxpayer reasonably expects that it

ceipts for the entire period derived (and to The term construction means activities will engage in a trade or business on a reg-

be derived) from the lease, rental, license, and services relating to the construction ular and ongoing basis.

sale, exchange, or other disposition of the or erection of real property (as defined in (iii) De minimis exception—(A) DPGR.

utilities. For purposes of the preceding paragraph (m)(3) of this section) in the For purposes of paragraph (m)(1)(i) of this

sentence, if a taxpayer treats gross receipts United States by a taxpayer that, at the section, if less than 5 percent of the total

as DPGR under this de minimis exception, time the taxpayer constructs the real prop- gross receipts derived by a taxpayer from a

then the taxpayer must treat the gross re- erty, is engaged in a trade or business (but construction project (as described in para-

ceipts recognized in each taxable year con- not necessarily its primary, or only, trade graph (m)(1)(i) of this section) are derived

sistently as DPGR. or business) that is considered construc- from activities other than the construction

(B) Non-DPGR. If less than 5 percent of tion for purposes of the North American of real property in the United States (for

a taxpayer’s gross receipts derived from a Industry Classification System (NAICS) example, from non-construction activities

sale, exchange, or other disposition of util- on a regular and ongoing basis. A trade or the sale of tangible personal property or

ities are DPGR, then the gross receipts de- or business that is considered construction land), then the total gross receipts derived

rived from the sale, exchange, or other dis- under the NAICS means a construction by the taxpayer from the project may be

position of the utilities may be treated as activity under the two-digit NAICS code treated as DPGR from construction. If a

non-DPGR. In the case of gross receipts of 23 and any other construction activity taxpayer applies the land safe harbor un-

derived from the lease, rental, license, sale, in any other NAICS code provided the der paragraph (m)(6)(iv) of this section,

exchange, or other disposition of utilities construction activity relates to the con- for a construction project (as described in

that are received over a period of time (for struction of real property such as NAICS paragraph (m)(1)(i) of this section), then

example, a multi-year lease or installment code 213111 (drilling oil and gas wells) the gross receipts excluded under the land

sale), this de minimis exception is applied and 213112 (support activities for oil and safe harbor are excluded in determining

by taking into account the total gross re- gas operations). For purposes of this para- total gross receipts under this paragraph

ceipts for the entire period derived (and graph (m), the term construction project (m)(1)(iii)(A). If a taxpayer does not apply

to be derived) from the lease, rental, li- means the construction activities and ser- the land safe harbor and uses any reason-

cense, sale, exchange, or other disposition vices treated as the item under paragraph able method (for example, an appraisal of

of the utilities. For purposes of the preced- (d)(2)(iii) of this section. Tangible per- the land) to allocate gross receipts attribut-

ing sentence, if a taxpayer treats gross re- sonal property (for example, appliances, able to the land to non-DPGR, then a tax-

ceipts as non-DPGR under this de minimis furniture, and fixtures) that is sold as part payer applies this paragraph (m)(1)(iii)(A)

exception, then the taxpayer must treat the of a construction project is not considered by excluding such gross receipts derived

gross receipts recognized in each taxable real property for purposes of this para- from the sale, exchange, or other disposi-

year consistently as non-DPGR. graph (m)(1)(i). In determining whether tion of the land from total gross receipts.

property is real property, the fact that In the case of gross receipts derived from





2006–25 I.R.B. 1099 June 19, 2006

construction that are received over a pe- (iii) Other construction activities. Im- §1.263A–8(c)(3)) other than machinery

riod of time (for example, an installment provements to land that are not capitaliz- (as defined in §1.263A–8(c)(4)) (includ-

sale), this de minimis exception is applied able to the land (for example, landscap- ing items that are structural components

by taking into account the total gross re- ing) and painting are activities constitut- of such inherently permanent structures),

ceipts for the entire period derived (and to ing construction only if these activities are inherently permanent land improvements,

be derived) from construction. For pur- performed in connection with other activi- oil and gas wells, and infrastructure (as de-

poses of the preceding sentence, if a tax- ties (whether or not by the same taxpayer) fined in paragraph (m)(4) of this section).

payer treats gross receipts as DPGR un- that constitute the erection or substantial For purposes of the preceding sentence,

der this de minimis exception, then the tax- renovation of real property and provided an entire utility plant including both the

payer must treat the gross receipts recog- the taxpayer meets the requirements under shell and the interior will be treated as an

nized in each taxable year consistently as paragraph (m)(1) of this section. Services inherently permanent structure. Property

DPGR. such as grading, demolition (including de- produced by a taxpayer that is not real

(B) Non-DPGR. For purposes of para- molition of structures under section 280B), property in the hands of that taxpayer, but

graph (m)(1)(i) of this section, if less than clearing, excavating, and any other activi- that may be incorporated into real property

5 percent of the total gross receipts de- ties that physically transform the land are by another taxpayer, is not treated as real

rived by a taxpayer from a construction activities constituting construction only if property by the producing taxpayer (for

project qualify as DPGR, then the total these services are performed in connection example, bricks, nails, paint, and window-

gross receipts derived by the taxpayer from with other activities (whether or not by the panes). For purposes of this paragraph

the construction project may be treated as same taxpayer) that constitute the erection (m)(3), structural components of build-

non-DPGR. In the case of gross receipts or substantial renovation of real property ings and inherently permanent structures

derived from construction that are received and provided the taxpayer meets the re- include property such as walls, partitions,

over a period of time (for example, an in- quirements under paragraph (m)(1) of this doors, wiring, plumbing, central air con-

stallment sale), this de minimis exception section. A taxpayer engaged in these ac- ditioning and heating systems, pipes and

is applied by taking into account the to- tivities must make a reasonable inquiry or ducts, elevators and escalators, and other

tal gross receipts for the entire period de- a reasonable determination as to whether similar property.

rived (and to be derived) from construc- the activity relates to the erection or sub- (4) Definition of infrastructure. The

tion. For purposes of the preceding sen- stantial renovation of real property in the term infrastructure includes roads, power

tence, if a taxpayer treats gross receipts as United States. Construction activities also lines, water systems, railroad spurs, com-

non-DPGR under this de minimis excep- include activities relating to drilling an oil munications facilities, sewers, sidewalks,

tion, then the taxpayer must treat the gross or gas well and mining and include any cable, and wiring. The term also includes

receipts recognized in each taxable year activities the cost of which are intangible inherently permanent oil and gas plat-

consistently as non-DPGR. drilling and development costs within the forms.

(2) Activities constituting construc- meaning of §1.612–4 or development ex- (5) Definition of substantial renovation.

tion—(i) In general. Activities constitut- penditures for a mine or natural deposit un- The term substantial renovation means the

ing construction are activities performed der section 616. renovation of a major component or sub-

in connection with a project to erect or sub- (iv) Administrative support services. If stantial structural part of real property that

stantially renovate real property, including the taxpayer performing construction ac- materially increases the value of the prop-

activities performed by a general contrac- tivities also provides, in connection with erty, substantially prolongs the useful life

tor or that constitute activities typically the construction project, administrative of the property, or adapts the property to a

performed by a general contractor, for ex- support services (for example, billing and new or different use.

ample, activities relating to management secretarial services) incidental and nec- (6) Derived from construction—(i) In

and oversight of the construction process essary to such construction project, then general. Assuming all the requirements

such as approvals, periodic inspection of these administrative support services are of this section are met, DPGR derived

the progress of the construction project, considered construction activities. from the construction of real property

and required job modifications. (v) Exceptions. The lease, license, or performed in the United States includes

(ii) Tangential services. Activities con- rental of equipment, for example, bulldoz- the proceeds from the sale, exchange, or

stituting construction do not include tan- ers, generators, or computers, for use in other disposition of real property con-

gential services such as hauling trash and the construction of real property is not a structed by the taxpayer in the United

debris, and delivering materials, even if the construction activity under this paragraph States (whether or not the property is sold

tangential services are essential for con- (m)(2). The term construction does not in- immediately after construction is com-

struction. However, if the taxpayer per- clude any activity that is within the defini- pleted and whether or not the construction

forming construction also, in connection tion of engineering and architectural ser- project is completed). DPGR derived

with the construction project, provides tan- vices under paragraph (n) of this section. from the construction of real property in-

gential services such as delivering materi- (3) Definition of real property. The cludes compensation for the performance

als to the construction site and removing term real property means buildings (in- of construction services by the taxpayer

its construction debris, then the gross re- cluding items that are structural com- in the United States. DPGR derived from

ceipts derived from the tangential services ponents of such buildings), inherently the construction of real property includes

are DPGR. permanent structures (as defined in gross receipts derived from materials and





June 19, 2006 1100 2006–25 I.R.B.

supplies consumed in the construction and by reducing its DPGR by those land or other disposition of land, and costs al-

project or that become part of the con- costs plus a percentage. Generally, the per- located to the land, pursuant to the land

structed real property, assuming all the centage is based on the number of months safe harbor under paragraph (m)(6)(iv)(A)

requirements of this section are met. that elapse between the date the taxpayer of this section, are not taken into account

(ii) Qualified construction warranty. acquires the land (not including any op- by the pass-thru entity or its owner or

DPGR derived from the construction of tions to acquire the land) and ends on the owners for purposes of computing QPAI

real property includes gross receipts from date the taxpayer sells each item of real under §§1.199–1 through 1.199–9. For

any qualified construction warranty, that property on the land. However, a taxpayer purposes of the preceding sentence, in

is, a warranty that is provided in connec- will be deemed, for purposes of this para- determining whether the pass-thru entity

tion with the constructed real property graph (m)(6)(iv)(A), to acquire the land on would be eligible for the small business

if, in the normal course of the taxpayer’s the date the taxpayer entered into an option simplified overall method of cost alloca-

business— agreement to acquire the land if the tax- tion, the gross receipts excluded pursuant

(A) The price for the construction war- payer acquired the land pursuant to such to the land safe harbor under paragraph

ranty is not separately stated from the option agreement and the purchase price of (m)(6)(iv)(A) of this section are taken

amount charged for the constructed real the land under the option agreement does into account for determining eligibility for

property; and not approximate the fair market value of that method of cost allocation. All other

(B) The construction warranty is nei- the land. In the case of a sale or dispo- pass-thru entities (including all trusts and

ther separately offered by the taxpayer nor sition of land between related persons (as estates described in §1.199–9(e)) must

separately bargained for with customers defined in paragraph (b)(1) of this section) treat the gross receipts attributable to the

(that is, the customer cannot purchase the for less than fair market value, for pur- sale, exchange, or other disposition of

constructed real property without the con- poses of determining the percentage, the land, pursuant to the land safe harbor

struction warranty). purchaser or transferee of the land must under paragraph (m)(6)(iv)(A) of this sec-

(iii) Exceptions. DPGR derived from include the months during which the land tion, as non-DPGR.

the construction of real property per- was held by the seller or transferor. The (v) Examples. The following examples

formed in the United States does not percentage is 5 percent for land held not illustrate the application of this paragraph

include gross receipts derived from the more than 60 months, 10 percent for land (m)(6):

sale, exchange, or other disposition of held more than 60 months but not more Example 1. A, who is in the trade or business

real property acquired by the taxpayer than 120 months, and 15 percent for land of construction under NAICS code 23 on a regular

and ongoing basis, purchases a building in the United

even if the taxpayer originally constructed held more than 120 months but not more States and retains B, an unrelated person, to oversee

the property. In addition, DPGR derived than 180 months. Land held by a taxpayer a substantial renovation of the building (within the

from the construction of real property for more than 180 months is not eligible meaning of paragraph (m)(5) of this section). Al-

does not include gross receipts from the for the safe harbor under this paragraph though not licensed as a general contractor, B per-

lease or rental of real property constructed (m)(6)(iv)(A). forms general contractor level work and activities re-

lating to management and oversight of the construc-

by the taxpayer or, except as provided (B) Determining gross receipts and tion process such as approvals, periodic inspection of

in paragraph (m)(2)(iii) of this section, costs. In the case of a taxpayer that uses the the progress of the construction project, and required

gross receipts derived from the sale or small business simplified overall method job modifications. B retains C (a general contractor)

other disposition of land (including zon- of cost allocation under §1.199–4(f), gross to oversee day-to-day operations and hire subcontrac-

ing, planning, entitlement costs, and other receipts derived from the sale, exchange, tors. C hires D (a subcontractor) to install a new elec-

trical system in the building as part of that substan-

costs capitalized to the land). or other disposition of land, and costs at- tial renovation. The amounts that B receives from A

(iv) Land safe harbor—(A) In general. tributable to the land, pursuant to the land for construction services, the amounts that C receives

For purposes of paragraph (m)(6)(i) of this safe harbor under paragraph (m)(6)(iv)(A) from B for construction services, and the amounts

section, a taxpayer may allocate gross re- of this section, are not taken into account that D receives from C for construction services qual-

ceipts between the gross receipts derived for purposes of computing QPAI under ify as DPGR under paragraph (m)(6)(i) of this section

provided B, C, and D meet all of the requirements of

from the sale, exchange, or other disposi- §§1.199–1 through 1.199–9 except that paragraph (m)(1) of this section. The gross receipts

tion of real property constructed by the tax- the gross receipts are taken into account that A receives from the subsequent sale of the build-

payer and the gross receipts derived from for determining eligibility for that method ing do not qualify as DPGR because A did not engage

the sale, exchange, or other disposition of of cost allocation. All other taxpayers in any activity constituting construction under para-

land by reducing its costs related to DPGR must treat the gross receipts derived from graph (m)(2) of this section even though A is in the

trade or business of construction. The results would

under §1.199–4 by the costs of the land the sale, exchange, or other disposition be the same if A, B, C, and D were members of the

and any other costs capitalized to the land of land, pursuant to the land safe har- same EAG under §1.199–7(a). However, if A, B, C,

(collectively, land costs) (including zon- bor under paragraph (m)(6)(iv)(A) of this and D were members of the same consolidated group,

ing, planning, entitlement costs, and other section, as non-DPGR. In the case of a see §1.199–7(d)(2).

costs capitalized to the land (except costs pass-thru entity, if the pass-thru entity Example 2. X is engaged as an electrical con-

tractor under NAICS code 238210 on a regular and

for activities listed in paragraph (m)(2)(iii) would be eligible to use the small busi- ongoing basis. X purchases the wires, conduits, and

of this section) and land costs in any com- ness simplified overall method of cost other electrical materials that it installs in construc-

mon improvements as defined in section allocation if the method were applied at tion projects in the United States. In a particular con-

2.01 of Rev. Proc. 92–29, 1992–1 C.B. the pass-thru entity level, then the gross struction project, all of the wires, conduits, and other

748, (see §601.601(d)(2) of this chapter)) receipts derived from the sale, exchange, electrical materials installed by X for the operation







2006–25 I.R.B. 1101 June 19, 2006

of that building are considered structural components costs for the lot), which are reduced by land costs X’s DPGR for houses sold between January 31, 2012,

of the building. X’s gross receipts derived from in- of $60,000). X calculates the DPGR for each house and June 1, 2012, in Example 5. Y’s costs for each

stalling that property are derived from the construc- sold by taking the gross receipts of $300,000 and house do not have to be redetermined because Y’s

tion of real property under paragraph (m)(1) of this reducing that amount by land costs of $60,000 plus costs are $195,000, the same as the costs would be if

section. In addition, pursuant to paragraph (m)(6)(i) a percentage of $60,000. As X acquired the land X and Y were divisions of a single corporation. For

of this section, X’s gross receipts derived from the on June 1, 2007, for each house sold on the land each house sold between June 2, 2012, and June 1,

purchased materials qualify as DPGR because the between January 31, 2012, and June 1, 2012, the 2017, Y’s DPGR are redetermined to be $234,000,

wires, conduits, and other electrical materials are con- percentage reduction for X is 5% because X has held the same as X’s DPGR for each house sold between

sumed during the construction of the building or be- the land for not more than 60 months from the date June 2, 2012, and June 1, 2017, in Example 5. Y’s

come structural components of the building. of acquisition. Thus, X’s DPGR for each house is costs for each house do not have to be redetermined

Example 3. X is engaged in a trade or business on $237,000 ($300,000 - $60,000 - $3,000) with costs because Y’s costs are $195,000, the same as the costs

a regular and ongoing basis that is considered con- for each house of $195,000 ($255,000 - $60,000). would be if X and Y were divisions of a single cor-

struction under the two-digit NAICS code of 23. X For each house sold on the land between June 2, poration.

buys unimproved land in the United States. X gets the 2012 and June 1, 2017, the percentage reduction Example 8. X, who is engaged in the trade or

land zoned for residential housing through an entitle- for X is 10% because X has held the land for more business of construction under NAICS code 23 on a

ment process. X grades the land and sells the land to than 60 months but not more than 120 months from regular and ongoing basis, purchases land for devel-

home builders who construct houses on the land. The the date of acquisition. Thus, of the $300,000 of opment and builds an office building on the land. Y

gross receipts that X derives from the sale of the land gross receipts, X’s DPGR for each house is $234,000 enters into a contract with X to purchase the office

that are attributable to the grading qualify as DPGR ($300,000 - $60,000 - $6,000) with costs for each building. As part of the contract, X is required to fur-

under paragraphs (m)(2)(iii) and (6)(i) of this section house of $195,000 ($255,000 - $60,000). nish the office space with desks, chairs, and lamps.

because those services are undertaken in connection Example 6. The facts are the same as in Example Upon completion of the sale of the building, X uses

with a construction project in the United States. X’s 5 except that on December 31, 2007, after X received the land safe harbor under paragraph (m)(6)(iv) of

gross receipts derived from the land including cap- the permits to begin construction, X sold the entitled this section to account for the land. After applica-

italized costs of entitlements (including zoning) do land to Y, an unrelated corporation, for $75,000,000. tion of the land safe harbor, X uses the de minimis

not qualify as DPGR under paragraph (m)(6)(i) of Y is engaged in a trade or business on a regular exception under paragraph (m)(1)(iii)(A) of this sec-

this section because the gross receipts are not derived and ongoing basis that is considered construction tion in determining whether the gross receipts derived

from the construction of real property. under NAICS code 23. Y subsequently incurred from the sale of the desks, chairs, and lamps qualify

Example 4. The facts are the same as in Example the construction costs and the costs of the common as DPGR. If the gross receipts derived from the sale

3 except that X constructs roads, sewers, and side- improvements, and Y sold the houses. Because X of the desks, chairs, and lamps are less than 5% of

walks, and installs power and water lines on the land. did not perform any construction activities, none of the total gross receipts derived by X from the sale of

X conveys the roads, sewers, sidewalks, and power X’s $75,000,000 in gross receipts derived from Y are the furnished office building (excluding any gross re-

and water lines to the local government and utilities. DPGR and none of X’s costs are allocable to DPGR. ceipts taken into account under the land safe harbor

The gross receipts that X derives from the sale of Pursuant to the land safe harbor under paragraph pursuant to paragraph (m)(6)(iv)(B) of this section),

lots that are attributable to grading, and the construc- (m)(6)(iv) of this section, Y calculates the basis for then all of the gross receipts derived from the sale of

tion of the roads, sewers, sidewalks, and power and each house sold as $195,000 (total costs of $270,000 the furnished office building, after the reduction un-

water lines (that qualify as infrastructure under para- ($170,000 in construction costs plus $62,500 in der the land safe harbor, may be treated as DPGR.

graph (m)(4) of this section) are DPGR. X’s gross common improvements (including $37,500 in land (n) Definition of engineering and archi-

receipts derived from the land including capitalized costs) plus $37,500 in land costs for the lot), which

tectural services—(1) In general. DPGR

costs of entitlements (including zoning) do not qual- are reduced by land costs of $75,000). Y calculates

ify as DPGR under paragraph (m)(6)(i) of this sec- the DPGR for each house sold by taking the gross re-

include gross receipts derived from en-

tion because the gross receipts are not derived from ceipts of $300,000 and reducing that amount by land gineering or architectural services per-

the construction of real property. costs of $75,000 plus a percentage of $75,000. As formed in the United States for a con-

Example 5. (i) Facts. X, who is engaged in the Y acquired the land on December 31, 2007, for the struction project described in paragraph

trade or business of construction under NAICS code houses sold on the land between January 31, 2012,

(m)(1)(i) of this section. At the time

23 on a regular and ongoing basis, constructs housing and December 31, 2012, the percentage reduction for

that is real property under paragraph (m)(3) of this Y is 5% because Y held the land for not more than

the taxpayer performs the engineering

section. On June 1, 2007, X pays $50,000,000 and 60 months from the date of acquisition. Thus, of the or architectural services, the taxpayer

acquires 1,000 acres of land that X will develop as a $300,000 of gross receipts, the DPGR for each house must be engaged in a trade or business

new housing development. In November 2007, after is $221,250 ($300,000 - $75,000 - $3,750) with costs (but not necessarily its primary, or only,

the expenditure of $10,000,000 for entitlement costs, for each house of $195,000. For the houses sold on

trade or business) that is considered engi-

X receives permits to begin construction. After this the land between January 1, 2013, and December 31,

expenditure, X’s land costs total $60,000,000. The 2017, the percentage reduction for Y is 10% because

neering or architectural services for pur-

development consists of 1,000 houses to be built on Y held the land for more than 60 months but not more poses of the NAICS, for example NAICS

half-acre lots over 5 years. On January 31, 2012, the than 120 months from the date of acquisition. Thus, codes 541330 (engineering services) or

first house is sold for $300,000. Construction costs of the $300,000 of gross receipts, the DPGR for each 541310 (architectural services), on a reg-

for each house are $170,000. Common improve- house is $217,500 ($300,000 - $75,000 - $7,500)

ular and ongoing basis. In the case of a

ments consisting of streets, sidewalks, sewer lines, with costs for each house of $195,000. The results

playgrounds, clubhouses, tennis courts, and swim- would be the same if X and Y were members of the

newly-formed trade or business or a tax-

ming pools that X is contractually obligated or re- same EAG, provided X and Y were not members of payer in its first taxable year, a taxpayer

quired by law to provide cost $55,000 per lot. The the same consolidated group. is considered to be engaged in a trade or

common improvements of $55,000 per lot include Example 7. The facts are the same as in Exam- business on a regular and ongoing basis

$30,000 in land costs underlying the common im- ple 6 except that Y is a member of the same consol-

if the taxpayer reasonably expects that it

provements. idated group as X. Pursuant to §1.1502–13(c)(1)(ii),

(ii) Land safe harbor. Pursuant to the land safe Y’s holding period in the land includes the period of

will engage in a trade or business on a

harbor under paragraph (m)(6)(iv) of this section, X time X held the land. In order to produce the same regular and ongoing basis. DPGR include

calculates the basis for each house sold as $195,000 effect as if X and Y were divisions of a single corpo- gross receipts derived from engineering

(total costs of $255,000 ($170,000 in construction ration (see §1.1502–13(c)(1)(i)), for each house sold or architectural services, including fea-

costs plus $55,000 in common improvements (in- between January 31, 2012, and June 1, 2012, Y’s

sibility studies for a construction project

cluding $30,000 in land costs) plus $30,000 in land DPGR are redetermined to be $237,000, the same as







June 19, 2006 1102 2006–25 I.R.B.

in the United States, even if the planned of gross receipts derived from engineering tail establishment. A retail establishment

construction project is not undertaken or or architectural services that are received is defined as tangible property (both real

is not completed. over a period of time (for example, an in- and personal) owned, leased, occupied, or

(2) Engineering services. Engineering stallment sale), this de minimis exception otherwise used by the taxpayer in its trade

services in connection with any con- is applied by taking into account the total or business of selling food or beverages to

struction project include any professional gross receipts for the entire period derived the public at which retail sales are made.

services requiring engineering educa- (and to be derived) from engineering or In addition, a facility that prepares food

tion, training, and experience and the architectural services. For purposes of the and beverages for take out service or deliv-

application of special knowledge of the preceding sentence, if a taxpayer treats ery is a retail establishment (for example,

mathematical, physical, or engineering gross receipts as DPGR under this de min- a caterer). If a taxpayer’s facility is a retail

sciences to those professional services imis exception, then the taxpayer must establishment, then, for purposes of this

such as consultation, investigation, eval- treat the gross receipts recognized in each section, the taxpayer may allocate its gross

uation, planning, design, or responsible taxable year consistently as DPGR. receipts between the gross receipts derived

supervision of construction (for the pur- (ii) Non-DPGR. If less than 5 percent from the retail sale of the food and bever-

pose of assuring compliance with plans, of the total gross receipts derived by a ages prepared and sold at the retail estab-

specifications, and design) or erection, in taxpayer from engineering or architectural lishment (that are non-DPGR) and gross

connection with any construction project. services performed in the United States for receipts derived from the wholesale sale of

(3) Architectural services. Architec- a construction project qualify as DPGR, the food and beverages prepared and sold

tural services in connection with any then the total gross receipts derived by the at the retail establishment (that are DPGR

construction project include the offering taxpayer from engineering or architectural assuming all the other requirements of sec-

or furnishing of any professional services services performed in the United States for tion 199 are met). Wholesale sales are de-

such as consultation, planning, aesthetic the construction project may be treated as fined as food and beverages held for resale

and structural design, drawings and spec- non-DPGR. In the case of gross receipts by the purchaser. The exception for sales

ifications, or responsible supervision of derived from engineering or architectural of certain food and beverages also applies

construction (for the purpose of assuring services that are received over a period to food and beverages for non-human con-

compliance with plans, specifications, and of time (for example, an installment sale), sumption. A retail establishment does not

design) or erection, in connection with any this de minimis exception is applied by tak- include the bonded premises of a distilled

construction project. ing into account the total gross receipts spirits plant or wine cellar, or the premises

(4) Administrative support services. for the entire period derived (and to be of a brewery (other than a tavern on the

If the taxpayer performing engineering derived) from engineering or architectural brewery premises). See Chapter 51 of Ti-

or architectural services also provides ad- services. For purposes of the preceding tle 26 of the United States Code and the

ministrative support services (for example, sentence, if a taxpayer treats gross receipts implementing regulations thereunder.

billing and secretarial services) inciden- as non-DPGR under this de minimis ex- (2) De minimis exception. A taxpayer

tal and necessary to such engineering or ception, then the taxpayer must treat the may treat a facility at which food or bev-

architectural services, then these admin- gross receipts recognized in each taxable erages are prepared as not being a retail

istrative support services are considered year consistently as non-DPGR. establishment if less than 5 percent of the

engineering or architectural services. (7) Example. The following example gross receipts derived from the sale of food

(5) Exceptions. Engineering or archi- illustrates the application of this paragraph or beverages at that facility during the tax-

tectural services do not include post-con- (n): able year are attributable to retail sales.

struction services such as annual audits Example. X is engaged in the trade or business (3) Examples. The following examples

and inspections. of providing engineering services under NAICS code illustrate the application of this paragraph

541330 on a regular and ongoing basis. Y buys unim-

(6) De minimis exception for perfor- proved land. Y hires X to provide engineering ser-

(o):

mance of services in the United States—(i) Example 1. X buys coffee beans and roasts those

vices for roads, sewers, sidewalks, and power and wa-

DPGR. If less than 5 percent of the to- beans at a facility in the United States, the only activ-

ter lines that qualify as infrastructure under paragraph

ity of which is the roasting and packaging of coffee

tal gross receipts derived by a taxpayer (m)(4) of this section and that will be constructed on

beans. X sells the roasted coffee beans through a va-

from engineering or architectural services Y’s land. X’s gross receipts from engineering ser-

riety of unrelated third-party vendors and also sells

vices for the infrastructure are DPGR. X’s gross re-

performed in the United States for a con- ceipts from engineering services relating to land (ex-

roasted coffee beans at X’s retail establishments. At

struction project (described in paragraph X’s retail establishments, X prepares brewed coffee

cept as provided in paragraph (m)(2)(iii) of this sec-

(m)(1)(i) of this section) are derived from and other foods. To the extent that the gross receipts

tion) do not qualify as DPGR under paragraph (n)(1)

of X’s retail establishments are derived from the sale

services not relating to a construction of this section because the gross receipts are not de-

of coffee beans roasted at the facility, the receipts are

project (for example, the services are per- rived from engineering services for a construction

DPGR (assuming all the other requirements of this

project described in paragraph (m)(1)(i) of this sec-

formed outside the United States or in tion.

section are met). To the extent the gross receipts of

connection with property other than real X’s retail establishments are derived from the retail

(o) Sales of certain food and bever- sale of brewed coffee or food prepared at the retail es-

property), then the total gross receipts de- ages—(1) In general. DPGR does not in- tablishments, the receipts are non-DPGR. However,

rived by the taxpayer may be treated as clude gross receipts of the taxpayer that pursuant to §1.199–1(d)(1)(ii), X must allocate part

DPGR from engineering or architectural are derived from the sale of food or bev- of the receipts from the retail sale of the brewed cof-

services performed in the United States erages prepared by the taxpayer at a re- fee as DPGR to the extent of the value of the coffee

for the construction project. In the case





2006–25 I.R.B. 1103 June 19, 2006

beans that were roasted at the facility and that were (b) Cost of goods sold allocable to do- must be allocated to such non-DPGR. See

used to brew coffee. mestic production gross receipts—(1) In §1.199–3(m)(6)(iv) for rules relating to

Example 2. Y operates a bonded winery within general. When determining its QPAI, a treatment of certain costs in the case of

the United States. Bottles of wine produced by Y at

the bonded winery are sold to consumers at the tax-

taxpayer must subtract from DPGR the a taxpayer that uses the land safe harbor

paid premises. Pursuant to paragraph (o)(1) of this CGS allocable to DPGR. A taxpayer de- under that paragraph.

section, the bonded premises is not considered a re- termines its CGS allocable to DPGR in (2) Allocating cost of goods sold—(i) In

tail establishment and is treated as separate and apart accordance with this paragraph (b) or, if general. A taxpayer must use a reasonable

from the taxpaid premises, which is considered a re- applicable, paragraph (f) of this section. method that is satisfactory to the Secretary

tail establishment for purposes of paragraph (o)(1) of

this section. Accordingly, the wine produced by Y in

In the case of a sale, exchange, or other based on all of the facts and circumstances

the bonded premises and sold by Y from the taxpaid disposition of inventory, CGS is equal to allocate CGS between DPGR and non-

premises is not considered to have been produced at to beginning inventory plus purchases DPGR. Whether an allocation method is

a retail establishment, and the gross receipts derived and production costs incurred during the reasonable is based on all of the facts and

from the sales of the wine are DPGR (assuming all taxable year and included in inventory circumstances including whether the tax-

the other requirements of this section are met).

costs, less ending inventory. CGS is de- payer uses the most accurate information

(p) Guaranteed payments. DPGR

termined under the methods of accounting available; the relationship between CGS

does not include guaranteed payments

that the taxpayer uses to compute taxable and the method used; the accuracy of the

under section 707(c). Thus, partners,

income. See sections 263A, 471, and method chosen as compared with other

including partners in partnerships de-

472. If section 263A requires a taxpayer possible methods; whether the method is

scribed in §1.199–9(i) and (j), may not

to include additional section 263A costs used by the taxpayer for internal manage-

treat guaranteed payments as DPGR. See

(as defined in §1.263A–1(d)(3)) in inven- ment or other business purposes; whether

§1.199–9(b)(6) Example 5.

tory, additional section 263A costs must the method is used for other Federal or

§1.199–4 Costs allocable to domestic be included in determining CGS. CGS state income tax purposes; the availability

production gross receipts. allocable to DPGR also includes inventory of costing information; the time, burden,

valuation adjustments such as writedowns and cost of using alternative methods; and

(a) In general. The provisions of this under the lower of cost or market method. whether the taxpayer applies the method

section apply solely for purposes of sec- In the case of a sale, exchange, or other consistently from year to year. Depend-

tion 199 of the Internal Revenue Code disposition (including, for example, theft, ing on the facts and circumstances, reason-

(Code). To determine its qualified produc- casualty, or abandonment) of non-inven- able methods may include methods based

tion activities income (QPAI) (as defined tory property, CGS for purposes of this on gross receipts, number of units sold,

in §1.199–1(c)) for a taxable year, a tax- section includes the adjusted basis of the number of units produced, or total produc-

payer must subtract from its domestic property. CGS allocable to DPGR for a tion costs. Ordinarily, if a taxpayer uses a

production gross receipts (DPGR) (as de- taxable year may include the inventory method to allocate gross receipts between

fined in §1.199–3(a)) the cost of goods cost and adjusted basis of qualifying pro- DPGR and non-DPGR, then the use of a

sold (CGS) allocable to DPGR and other duction property (QPP) (as defined in different method to allocate CGS that is

expenses, losses, or deductions (deduc- §1.199–3(j)(1)), a qualified film (as de- not demonstrably more accurate than the

tions), other than the deduction allowed fined in §1.199–3(k)(1)), or electricity, method used to allocate gross receipts will

under section 199, that are properly allo- natural gas, and potable water (as defined not be considered reasonable. However, if

cable to such receipts. Paragraph (b) of in §1.199–3(l)) (collectively, utilities) that a taxpayer has information readily avail-

this section provides rules for determining will generate (or have generated) DPGR able to specifically identify CGS allocable

CGS allocable to DPGR. Paragraph (c) of notwithstanding that the gross receipts at- to DPGR and can specifically identify that

this section provides rules for determining tributable to the sale, lease, rental, license, amount without undue burden or expense,

the deductions that are properly allocable exchange, or other disposition of the QPP, CGS allocable to DPGR is that amount ir-

to DPGR. Paragraph (d) of this section qualified film, or utilities will be, or have respective of whether the taxpayer uses an-

provides that a taxpayer generally must been, included in the computation of gross other allocation method to allocate gross

determine deductions allocable to DPGR income for a different taxable year. For ex- receipts between DPGR and non-DPGR.

or to gross income attributable to DPGR ample, advance payments that are DPGR A taxpayer that does not have information

using §§1.861–8 through 1.861–17 and may be included in gross income under readily available to specifically identify

§§1.861–8T through 1.861–14T (the sec- §1.451–5(b)(1)(i) in a different taxable CGS allocable to DPGR and that cannot,

tion 861 regulations), subject to the rules year than the related CGS allocable to without undue burden or expense, specif-

in paragraph (d) of this section (the section that DPGR. If gross receipts are treated ically identify that amount is not required

861 method). Paragraph (e) of this sec- as DPGR pursuant to §1.199–1(d)(3)(i) to use a method that specifically identifies

tion provides that certain taxpayers may or §1.199–3(i)(4)(i)(B)(6), (l)(4)(iv)(A), CGS allocable to DPGR.

apportion deductions to DPGR using the (m)(1)(iii)(A), (n)(6)(i), or (o)(2), then (ii) Gross receipts recognized in an ear-

simplified deduction method. Paragraph CGS must be allocated to such DPGR. lier taxable year. If a taxpayer (other than

(f) of this section provides a small business Similarly, if gross receipts are treated as a taxpayer that uses the small business sim-

simplified overall method that a qualifying non-DPGR pursuant to §1.199–1(d)(3)(ii) plified overall method of paragraph (f) of

small taxpayer may use to apportion CGS or §1.199–3(i)(4)(ii), (l)(4)(iv)(B), this section) recognizes and reports gross

and deductions to DPGR. (m)(1)(iii)(B), or (n)(6)(ii), then CGS receipts on a Federal income tax return for





June 19, 2006 1104 2006–25 I.R.B.

a taxable year, and incurs CGS related to retary based on all of the facts and cir- graph (b)(5)(iii) of this section, then the

such gross receipts in a subsequent taxable cumstances. Factors taken into account taxpayer must use that method for all in-

year, then regardless of whether the gross in determining whether the method is rea- ventory accounted for under the LIFO

receipts ultimately qualify as DPGR, the sonable include whether the taxpayer uses method.

taxpayer must allocate the CGS to— the most accurate information available; (ii) LIFO/FIFO ratio method. A tax-

(A) DPGR if the taxpayer identified the the relationship between the adjustment payer using the specific goods LIFO

related gross receipts as DPGR in the prior and the allocation base chosen; the accu- method or the dollar-value LIFO method

taxable year; or racy of the method chosen as compared may use the LIFO/FIFO ratio method.

(B) Non-DPGR if the taxpayer iden- with other possible methods; whether the The LIFO/FIFO ratio method is applied

tified the related gross receipts as non- method is used by the taxpayer for in- with respect to all LIFO inventory of a

DPGR in the prior taxable year or if the ternal management or other business pur- taxpayer on a grouping-by-grouping or

taxpayer recognized under the taxpayer’s poses; whether the method is used for other pool-by-pool basis. Under the LIFO/FIFO

methods of accounting those gross receipts Federal or state income tax purposes; the ratio method, a taxpayer computes the

in a taxable year to which section 199 does time, burden, and cost of using alterna- CGS of a grouping or pool allocable to

not apply. tive methods; and whether the taxpayer ap- DPGR by multiplying the CGS of QPP,

(3) Special rules for imported items plies the method consistently from year to qualified films, or utilities in the grouping

or services. The cost of any item or ser- year. If a taxpayer has information read- or pool that produced DPGR computed

vice brought into the United States (as ily available to specifically identify the using the first-in, first-out (FIFO) method

defined in §1.199–3(h)) without an arm’s proper amount of inventory valuation ad- by the LIFO/FIFO ratio of the grouping or

length transfer price may not be treated justments allocable to DPGR, then the tax- pool. The LIFO/FIFO ratio of a grouping

as less than its value immediately after payer must allocate that amount to DPGR. or pool is equal to the total CGS of the

it entered the United States for purposes A taxpayer that does not have information grouping or pool computed using the LIFO

of determining the CGS to be used in the readily available to specifically identify method over the total CGS of the grouping

computation of QPAI. Similarly, the ad- the proper amount of inventory valuation or pool computed using the FIFO method.

justed basis of leased or rented property adjustments allocable to DPGR and that (iii) Change in relative base-year cost

that gives rise to DPGR that has been cannot, without undue burden or expense, method. A taxpayer using the dollar-value

brought into the United States (as defined specifically identify the proper amount of LIFO method may use the change in rela-

in §1.199–3(h)) without an arm’s length inventory valuation adjustments allocable tive base-year cost method. The change in

transfer price may not be treated as less to DPGR, is not required to use a method relative base-year cost method is applied

than its value immediately after it entered that specifically identifies inventory valu- with respect to all LIFO inventory of a tax-

the United States. When an item or ser- ations adjustments to DPGR. payer on a pool-by-pool basis. The change

vice is imported into the United States (5) Rules applicable to inventories ac- in relative base-year cost method deter-

that had been exported by the taxpayer for counted for under the last-in, first-out mines the CGS allocable to DPGR by in-

further manufacture, the increase in cost (LIFO) inventory method—(i) In gen- creasing or decreasing the total production

may not exceed the difference between the eral. This paragraph applies to inventories costs (section 471 costs and additional sec-

value of the property when exported and accounted for using the specific goods tion 263A costs) of QPP, a qualified film,

the value of the property when imported last-in, first-out (LIFO) method or the or utilities that generate DPGR by a por-

back into the United States after further dollar-value LIFO method. Whenever a tion of any increment or liquidation of the

manufacture. For this purpose, the value specific goods grouping or a dollar-value dollar-value pool. The portion of an incre-

of property is its customs value as defined pool contains QPP, qualified films, or ment or liquidation allocable to DPGR is

in section 1059A(b)(1). utilities that produces DPGR and goods determined by multiplying the LIFO value

(4) Rules for inventories valued at mar- that do not, the taxpayer must allocate of the increment or liquidation (expressed

ket or bona fide selling prices. If part CGS attributable to that grouping or pool as a positive number) by the ratio of the

of CGS is attributable to inventory valu- between DPGR and non-DPGR using a change in total base-year cost (expressed

ation adjustments, then CGS allocable to reasonable method that is satisfactory to as a positive number) of the QPP, qualified

DPGR includes inventory adjustments to the Secretary based on all of the facts film, or utilities that will generate DPGR

QPP that is MPGE in whole or in sig- and circumstances. Whether a method in ending inventory to the change in to-

nificant part within the United States, a of allocating CGS between DPGR and tal base-year cost (expressed as a positive

qualified film produced by the taxpayer, non-DPGR is reasonable must be deter- number) of all goods in the ending inven-

or utilities produced by the taxpayer in the mined in accordance with paragraph (b)(2) tory. The portion of an increment or liq-

United States. Accordingly, taxpayers that of this section. In addition, this paragraph uidation allocable to DPGR may be zero

value inventory under §1.471–4 (invento- (b)(5) provides methods that a taxpayer but cannot exceed the amount of the incre-

ries at cost or market, whichever is lower) may use to allocate CGS for inventories ment or liquidation. Thus, a ratio in excess

or §1.471–2(c) (subnormal goods at bona accounted for using the LIFO method. of 1.0 must be treated as 1.0.

fide selling prices) must allocate a proper If a taxpayer uses the LIFO/FIFO ratio (6) Taxpayers using the simplified

share of such adjustments (for example, method provided in paragraph (b)(5)(ii) production method or simplified resale

writedowns) to DPGR based on a reason- of this section or the change in relative method for additional section 263A costs.

able method that is satisfactory to the Sec- base-year cost method provided in para- A taxpayer that uses the simplified produc-





2006–25 I.R.B. 1105 June 19, 2006

tion method or simplified resale method States. Under its method of accounting, T includes DPGR. X uses the FIFO inventory method to account

to allocate additional section 263A costs, advance payments and other gross receipts derived for its inventory and determines the cost of item A

as defined in §1.263A–1(d)(3), to end- from the sale of furniture in gross income when the using a standard cost method. At the beginning of

payments are received. In December 2007, T receives its 2007 taxable year, X’s inventory contains 2,000

ing inventory must follow the rules in an advance payment of $5,000 from X with respect units of item A at a standard cost of $5 per unit. X

paragraph (b)(2) of this section to deter- to an order of furniture to be manufactured for a to- did not incur significant cost variances in previous

mine the amount of additional section tal price of $20,000. In 2008, T produces and sells taxable years. During the 2007 taxable year, X pro-

263A costs allocable to DPGR. Alloca- the furniture to X. In 2008, T incurs $14,000 of sec- duces 8,000 units of item A at a standard cost of $6

ble additional section 263A costs include tion 471 and additional section 263A costs to produce per unit. X determines that with regard to its pro-

the furniture ordered by X. T receives the remaining duction of item A it has incurred a significant cost

additional section 263A costs included in $15,000 of the contract price from X in 2008. As- variance. When X reallocates the cost variance to the

beginning inventory as well as additional suming that in 2007, T can reasonably determine that units of item A that it has produced, the production

section 263A costs incurred during the all the requirements of §§1.199–1 and 1.199–3 will cost of item A is $7 per unit. X sells 7,000 units of

taxable year. Ordinarily, if a taxpayer uses be met with respect to the furniture, the advance pay- item A during the taxable year. X can identify from

the simplified production method or the ment qualifies as DPGR in 2007. Assuming further its books and records that CGS related to the sales of

that all the requirements of §§1.199–1 and 1.199–3 item A during the taxable year are $45,000 ((2,000 x

simplified resale method, the additional are met with respect to the furniture in 2008, the re- $5) + (5,000 x $7)). Accordingly, X has CGS alloca-

section 263A costs should be allocated in maining $15,000 of the contract price must be in- ble to DPGR of $45,000.

the same proportion as section 471 costs cluded in income and DPGR when received by T Example 3. Change in relative base-year cost

are allocated. in 2008. T must include the $14,000 it incurred to method. (i) Y elects, beginning with the calendar

(7) Examples. The following examples produce the furniture in CGS and CGS allocable to year 2007, to compute its inventories using the dol-

DPGR in 2008. See §1.199–4(b)(2)(ii) for rules re- lar-value, LIFO method under section 472. Y estab-

illustrate the application of this paragraph garding gross receipts and costs recognized in differ- lishes a pool for items A and B. Y produces item A

(b) and assume that the taxpayer does not ent taxable years. within the United States and the sales of item A gen-

use the small business simplified overall Example 2. Use of standard cost method. X, a erate DPGR. Y does not produce item B within the

method provided in paragraph (f) of this calendar year taxpayer, manufactures item A in a fac- United States and the sale of item B does not gener-

section: tory located in the United States and item B in a fac- ate DPGR. The composition of the inventory for the

tory located in Country Y. Item A is produced by X pool at the base date, January 1, 2007, is as follows:

Example 1. Advance payments. T, a calendar year

within the United States and the sale of A generates

taxpayer, is a manufacturer of furniture in the United





Item Unit Unit cost Total cost

A 2,000 $5.00 $10,000

B 1,250 4.00 5,000

Total $15,000







(ii) Y uses a standard cost method to allocate all to produce 10,000 units of item A and $114,000 of units of item B. The closing inventory of the pool

direct and indirect costs (section 471 and additional section 471 costs and additional section 263A costs at December 31, 2007, shown at base-year and cur-

section 263A costs) to the units of item A and item to produce 20,000 units of item B. rent-year cost is as follows:

B that it produces. During 2007, Y incurs $52,500 of (iii) The closing inventory of the pool at Decem-

section 471 costs and additional section 263A costs ber 31, 2007, contains 3,000 units of item A and 2,500





Base-year Current-year

Item Quantity cost Amount cost Amount

A 3,000 $5.00 $15,000 $5.25 $15,750

B 2,500 4.00 10,000 5.70 14,250

Totals $25,000 $30,000







(iv) The base-year cost of the closing LIFO in- of the current-year cost of the pool to total base-year year cost) of the total inventory is $10,000 ($25,000

ventory at December 31, 2007, amounts to $25,000, cost of the pool (that is, $30,000/$25,000, or 120%). - $15,000). The ratio of the change in base-year cost

and exceeds the $15,000 base-year cost of the open- The increment stated at current-year cost is $12,000 of item A to the change in base-year cost of the total

ing inventory for the taxable year by $10,000 (the ($10,000 x 120%). inventory is 50% ($5,000/$10,000).

increment stated at base-year cost). The increment (v) The change in relative base-year cost of item (vi) CGS allocable to DPGR is $46,500, com-

valued at current-year cost is computed by multiply- A is $5,000 ($15,000 - $10,000). The change in rel- puted as follows:

ing the increment stated at base-year cost by the ratio ative base-year cost (the increment stated at base-





Current-year production costs related to DPGR $52,500

Less: Increment stated at current-year cost $12,000

Ratio 50%

Total ( 6,000)

Total $46,500







June 19, 2006 1106 2006–25 I.R.B.

Example 4. Change in relative base-year cost tion 263A costs to produce 12,000 units of item A and units of item B. The closing inventory of the pool at

method. (i) The facts are the same as in Example 3 $150,000 of section 471 costs and additional section December 31, 2008, shown at base-year and current-

except that, during the calendar year 2008, Y expe- 263A costs to produce 25,000 units of item B. year cost is as follows:

riences an inventory decrement. During 2008, Y in- (ii) The closing inventory of the pool at December

curs $66,000 of section 471 costs and additional sec- 31, 2008, contains 2,000 units of item A and 2,500





Base-year Current-year

Item Quantity cost Amount cost Amount

A 2,000 $5.00 $10,000 $5.50 $11,000

B 2,500 4.00 10,000 6.00 15,000

Totals $20,000 $26,000







(iii) The base-year cost of the closing LIFO inven- inventory for that taxable year by $5,000 (the decre- ment. The LIFO value of the inventory at December

tory at December 31, 2008, amounts to $20,000, and ment stated at base-year cost). This liquidation is 31, 2008 is:

is less than the $25,000 base-year cost of the opening reflected by reducing the most recent layer of incre-





Base cost Index LIFO value

January 1, 2008, base cost $15,000 1.00 $15,000

December 31, 2008, increment 5,000 1.20 6,000

Total $21,000







(iv) The change in relative base-year cost of item ($25,000 - $20,000). The ratio of the change in base- (v) CGS allocable to DPGR is $72,000, computed

A is $5,000 ($15,000 - $10,000). The change in rel- year cost of item A to the change in base-year cost of as follows:

ative base-year cost of the total inventory is $5,000 the total inventory is 100% ($5,000/$5,000).





Current-year production costs related to DPGR $66,000

Plus: LIFO value of decrement $6,000

Ratio 100%

Total 6,000

Total $72,000







Example 5. LIFO/FIFO ratio method. (i) The production costs of $216,000 less ending inventory of this section provides a small business sim-

facts are the same as in Example 3 except that Y uses $21,000). plified overall method that may be used

the LIFO/FIFO ratio method to determine its CGS (iv) Y’s total CGS computed on a FIFO basis is by a qualifying small taxpayer, as defined

allocable to DPGR. $220,000 (beginning inventory of $30,000 plus total

(ii) Y’s CGS related to item A on a FIFO basis is production costs of $216,000 less ending inventory of

in that paragraph. A taxpayer using the

$46,750 ((2,000 units at $5) + (7,000 units at $5.25)). $26,000). simplified deduction method or the small

(iii) Y’s total CGS computed on a LIFO basis is (v) The ratio of Y’s CGS computed using the business simplified overall method must

$154,500 (beginning inventory of $15,000 plus total LIFO method to its CGS computed using the FIFO use that method for all deductions. A tax-

production costs of $166,500 less ending inventory of method is 101% ($222,000/$220,000). Y’s CGS re- payer eligible to use the small business

$27,000). lated to DPGR computed using the LIFO/FIFO ratio

(iv) Y’s total CGS computed on a FIFO basis is method is $71,457 ($70,750 x 101%).

simplified overall method may choose at

$151,500 (beginning inventory of $15,000 plus total (c) Other deductions properly alloca- any time for any taxable year to use the

production costs of $166,500 less ending inventory of

ble to domestic production gross receipts small business simplified overall method,

$30,000). the simplified deduction method, or the

(v) The ratio of Y’s CGS computed using the

or gross income attributable to domestic

production gross receipts—(1) In general. section 861 method for a taxable year. A

LIFO method to its CGS computed using the FIFO

method is 102% ($154,500/$151,500). Y’s CGS re- In determining its QPAI, a taxpayer must taxpayer eligible to use the simplified de-

lated to DPGR computed using the LIFO/FIFO ratio subtract from its DPGR, in addition to its duction method may choose at any time for

method is $47,685 ($46,750 x 102%).

CGS allocable to DPGR, the deductions any taxable year to use the simplified de-

Example 6. LIFO/FIFO ratio method. (i) The duction method or the section 861 method

facts are the same as in Example 4 except that Y uses

that are properly allocable to DPGR. A tax-

payer generally must allocate and appor- for a taxable year.

the LIFO/FIFO ratio method to compute CGS alloca-

ble to DPGR. tion these deductions using the rules of the (2) Treatment of net operating losses. A

(ii) Y’s CGS related to item A on a FIFO basis section 861 method. In lieu of the sec- deduction under section 172 for a net op-

is $70,750 ((3,000 units at $5.25) + (10,000 units at

tion 861 method, certain taxpayers may ap- erating loss is not allocated or apportioned

$5.50)). to DPGR or gross income attributable to

(iii) Y’s total CGS computed on a LIFO basis is

portion these deductions using the simpli-

fied deduction method provided in para- DPGR.

$222,000 (beginning inventory of $27,000 plus total

graph (e) of this section. Paragraph (f) of





2006–25 I.R.B. 1107 June 19, 2006

(3) W–2 wages. Although only W–2 ratably apportioned between gross income such partnership (and, where relevant

wages as described in §1.199–2 are taken attributable to DPGR and gross income at- in apportioning the taxpayer’s interest

into account in computing the W–2 wage tributable to non-DPGR based on the rela- expense, the partnership’s assets), the tax-

limitation, all wages paid (or incurred in tive amounts of gross income. payer’s shares in such S corporation, or

the case of an accrual method taxpayer) (3) Research and experimental expendi- the taxpayer’s interest in such trust shall

in a taxpayer’s trade or business during tures. Research and experimental expendi- be disregarded.

the taxable year are taken into account in tures must be allocated and apportioned in (6) Examples. The following examples

computing QPAI for that taxable year. accordance with §1.861–17 without taking illustrate the operation of the section 861

(d) Section 861 method—(1) In gen- into account the exclusive apportionment method. Assume in the following exam-

eral. Under the section 861 method, a rule of §1.861–17(b). ples that all corporations are calendar year

taxpayer must allocate and apportion its (4) Deductions allocated or ap- taxpayers, that all taxpayers have suffi-

deductions using the allocation and appor- portioned to gross receipts treated cient W–2 wages as defined in §1.199–2(e)

tionment rules provided under the section as domestic production gross re- so that the section 199 deduction is not

861 regulations under which section 199 ceipts. If gross receipts are treated as limited under section 199(b)(1), and that,

is treated as an operative section de- DPGR pursuant to §1.199–1(d)(3)(i) or with respect to the allocation and appor-

scribed in §1.861–8(f). Accordingly, the §1.199–3(i)(4)(i)(B)(6), (l)(4)(iv)(A), tionment of interest expense, §1.861–10T

taxpayer applies the rules of the section (m)(1)(iii)(A), (n)(6)(i), or (o)(2), then does not apply.

861 regulations to allocate and appor- deductions must be allocated or appor- Example 1. Section 861 method and no EAG. (i)

tion deductions (including, if applicable, tioned to the gross income attributable to Facts. X, a United States corporation that is not a

member of an expanded affiliated group (EAG) (as

its distributive share of deductions from such DPGR. Similarly, if gross receipts defined in §1.199–7), engages in activities that gener-

pass-thru entities) to gross income attrib- are treated as non-DPGR pursuant to ate both DPGR and non-DPGR. All of X’s production

utable to DPGR. Gross receipts that are §1.199–1(d)(3)(ii) or §1.199–3(i)(4)(ii), activities that generate DPGR are within Standard

allocable to land under the safe harbor pro- (l)(4)(iv)(B), (m)(1)(iii)(B), or (n)(6)(ii), Industrial Classification (SIC) Industry Group AAA

vided in §1.199–3(m)(6)(iv) are treated as then deductions must be allocated or ap- (SIC AAA). All of X’s production activities that gen-

erate non-DPGR are within SIC Industry Group BBB

non-DPGR. See §1.199–3(m)(6)(iv)(B). portioned to the gross income attributable (SIC BBB). X is able to specifically identify CGS al-

If the taxpayer applies the allocation and to such non-DPGR. locable to DPGR and to non-DPGR. X incurs $900

apportionment rules of the section 861 (5) Treatment of items from a pass-thru of research and experimentation expenses (R&E) that

regulations for section 199 and another entity reporting qualified production are deductible under section 174, $300 of which are

operative section, then the taxpayer must activities income. If, pursuant to performed with respect to SIC AAA and $600 of

which are performed with respect to SIC BBB. None

use the same method of allocation and §1.199–9(e)(2) or to the authority granted of the R&E is legally mandated R&E as described in

the same principles of apportionment for in §1.199–9(b)(1)(ii) or (c)(1)(ii), a tax- §1.861–17(a)(4) and none of the R&E is included in

purposes of all operative sections (subject payer must combine QPAI and W–2 wages CGS. X incurs section 162 selling expenses that are

to the rules provided in paragraphs (c)(2) from a partnership, S corporation, trust (to not includible in CGS and are definitely related to all

and (d)(2) and (3) of this section). See the extent not described in §1.199–9(d)) or of X’s gross income. For 2010, the adjusted basis of

X’s assets is $5,000, $4,000 of which generates gross

§1.861–8(f)(2)(i). estate with the taxpayer’s total QPAI and income attributable to DPGR and $1,000 of which

(2) Deductions for charitable contribu- W–2 wages from other sources, then for generates gross income attributable to non-DPGR.

tions. Deductions for charitable contribu- purposes of apportioning the taxpayer’s For 2010, X’s taxable income is $1,380 based on the

tions (as allowed under section 170 and interest expense under this paragraph following Federal income tax items:

section 873(b)(2) or 882(c)(1)(B)) must be §1.199–4(d), the taxpayer’s interest in



DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

Non-DPGR (all from sales of products within SIC BBB). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS allocable to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)

CGS allocable to non-DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,800)

Section 162 selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($840)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)

Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

Charitable contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($180)

X’s taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,380





(ii) X’s QPAI. X allocates and apportions its de- portionment of those expenses between DPGR and gross income attributable to DPGR (DPGR of $3,000

ductions to gross income attributable to DPGR un- non-DPGR on the basis of X’s gross receipts is appro- - CGS of $600 allocated based on X’s books and

der the section 861 method of this paragraph (d). In priate. For purposes of apportioning R&E, X elects records). X’s QPAI for 2010 is $1,320, as shown be-

this case, the section 162 selling expenses are defi- to use the sales method as described in §1.861–17(c). low:

nitely related to all of X’s gross income. Based on X elects to apportion interest expense under the tax

the facts and circumstances of this specific case, ap- book value method of §1.861–9T(g). X has $2,400 of









June 19, 2006 1108 2006–25 I.R.B.

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS allocable to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)

Section 162 selling expenses

($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($420)

Interest expense (not included in CGS)

($300 x ($4,000 (X’s DPGR assets)/

$5,000 (X’s total assets))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($240)

Charitable contributions (not included in CGS)

($180 x ($2,400 gross income attributable to DPGR/

$3,600 total gross income)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($120)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320





(iii) Section 199 deduction determination. X’s and Y are not members of an affiliated group as de- try Group AAA (SIC AAA). All of Y’s activities that

tentative deduction under §1.199–1(a) is $119 (.09 fined in section 1504(a). Accordingly, the rules of generate non-DPGR are within SIC Industry Group

x (lesser of QPAI of $1,320 and taxable income of §1.861–14T do not apply to X’s and Y’s selling ex- BBB (SIC BBB). None of X’s and Y’s sales are to

$1,380)). Because the facts of this example assume penses, R&E, and charitable contributions. X and Y each other. Y is not able to specifically identify CGS

that X’s W–2 wages as defined in §1.199–2(e) are are, however, members of an affiliated group for pur- allocable to DPGR and non-DPGR. In this case, be-

sufficient to avoid a limitation on the section 199 de- poses of allocating and apportioning interest expense cause CGS is definitely related under the facts and

duction, X’s section 199 deduction for 2010 is $119. (see §1.861–11T(d)(6)) and are also members of an circumstances to all of Y’s gross receipts, apportion-

Example 2. Section 861 method and EAG. (i) EAG. For 2010, the adjusted basis of Y’s assets is ment of CGS between DPGR and non-DPGR based

Facts. The facts are the same as in Example 1 ex- $45,000, $21,000 of which generates gross income on gross receipts is appropriate. For 2010, Y’s tax-

cept that X owns stock in Y, a United States corpora- attributable to DPGR and $24,000 of which generates able income is $1,910 based on the following Federal

tion, equal to 75% of the total voting power of stock gross income attributable to non-DPGR. All of Y’s income tax items:

of Y and 80% of the total value of stock of Y. X activities that generate DPGR are within SIC Indus-





DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

Non-DPGR (all from sales of products within SIC BBB). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS allocated to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,200)

CGS allocated to non-DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,200)

Section 162 selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($840)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($100)

Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($200)

Interest expense (not included in CGS and not subject to

§1.861–10T). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($500)

Charitable contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($50)

Y’s taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,910





(ii) QPAI. (A) X’s QPAI. Determination of X’s is apportioned to gross income attributable to DPGR assets. See §1.861–11T(c). Accordingly, X’s QPAI

QPAI is the same as in Example 1 except that interest based on the combined adjusted bases of X’s and Y’s for 2010 is $1,410, as shown below:





DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS allocated to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)

Section 162 selling expenses

($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($420)

Interest expense (not included in CGS and not subject to

§1.861–10T) ($300 x ($25,000 (tax book value of X’s

and Y’s DPGR assets)/$50,000 (tax book value

of X’s and Y’s total assets))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($150)

Charitable contributions (not included in CGS)

($180 x ($2,400 gross income attributable to DPGR/

$3,600 total gross income)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($120)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,410





(B) Y’s QPAI. Y makes the same elections under gross income attributable to DPGR (DPGR of $3,000 ceipts). Y’s QPAI for 2010 is $1,005, as shown be-

the section 861 method as does X. Y has $1,800 of - CGS of $1,200 allocated based on Y’s gross re- low:









2006–25 I.R.B. 1109 June 19, 2006

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS allocated to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,200)

Section 162 selling expenses

($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($420)

Interest expense (not included in CGS and not subject to

§1.861–10T) ($500 x ($25,000 (tax book value of X’s

and Y’s DPGR assets)/$50,000 (tax book value of X’s

and Y’s total assets))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($250)

Charitable contributions (not included in CGS)

($50 x ($1,800 gross income attributable to DPGR/

$3,600 total gross income)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($25)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($100)

Y’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,005





(iii) Section 199 deduction determination. The ing its distributive or allocable share of idated group is treated as one member of

section 199 deduction of the X and Y EAG is de- those items of any lower-tier entity, prior the EAG.

termined by aggregating the separately determined to any charitable or distribution deduction. (4) Members of an expanded affiliated

QPAI, taxable income, and W–2 wages of X and Y.

See §1.199–7(b). Accordingly, the X and Y EAG’s

Whether the owner of a pass-thru entity group—(i) In general. Whether the mem-

tentative section 199 deduction is $217 (.09 x (lesser may use the simplified deduction method bers of an EAG may use the simplified

of combined taxable incomes of X and Y of $3,290 is determined at the level of the entity’s deduction method is determined by refer-

(X’s taxable income of $1,380 plus Y’s taxable in- owner. If the owner of a pass-thru entity ence to all the members of the EAG. If the

come of $1,910) and combined QPAI of $2,415 (X’s qualifies and uses the simplified deduc- average annual gross receipts of the EAG

QPAI of $1,410 plus Y’s QPAI of $1,005)). Because

the facts of this example assume that the W–2 wages

tion method, then the simplified deduction are less than or equal to $100,000,000 or

of X and Y are sufficient to avoid a limitation on the method is applied at the level of the owner the total assets of the EAG are less than

section 199 deduction, X and Y EAG’s section 199 of the pass-thru entity taking into account or equal to $10,000,000, then each mem-

deduction for 2010 is $217. The $217 is allocated to the owner’s DPGR, non-DPGR, and other ber of the EAG may individually deter-

X and Y in proportion to their QPAI. See §1.199–7(c). items from all sources including its dis- mine whether to use the simplified deduc-

(e) Simplified deduction method—(1) tributive or allocable share of those items tion method, regardless of the cost alloca-

In general. An eligible taxpayer may use of the pass-thru entity. tion method used by the other members.

the simplified deduction method to ap- (2) Eligible taxpayer. For purposes of (ii) Exception. Notwithstanding para-

portion deductions between DPGR and this paragraph (e), an eligible taxpayer is— graph (e)(4)(i) of this section, all members

non-DPGR. The simplified deduction (i) A taxpayer that has average annual of the same consolidated group must use

method does not apply to CGS. Under the gross receipts (as defined in paragraph (g) the same cost allocation method.

simplified deduction method, a taxpayer’s of this section) of $100,000,000 or less; or (iii) Examples. The following examples

deductions (except the net operating loss (ii) A taxpayer that has total assets (as illustrate the application of paragraph (e)

deduction as provided in paragraph (c)(2) defined in paragraph (e)(3) of this section) of this section:

of this section) are ratably apportioned of $10,000,000 or less. Example 1. Corporations X, Y, and Z are the

between DPGR and non-DPGR based (3) Total assets—(i) In general. For only three members of an EAG. Neither X, Y, nor Z

on relative gross receipts. Accordingly, is a member of a consolidated group. X, Y, and Z

purposes of the simplified deduction have average annual gross receipts of $20,000,000,

the amount of deductions for the cur- method, total assets means the total as- $70,000,000, and $5,000,000, respectively. X, Y,

rent taxable year apportioned to DPGR sets the taxpayer has at the end of the and Z each have total assets at the end of the taxable

is equal to the same proportion of the taxable year. In the case of a C corpo- year of $5,000,000. Because the average annual

total deductions for the current taxable ration, the corporation’s total assets at gross receipts of the EAG are less than or equal to

year that the amount of DPGR bears to $100,000,000, each of X, Y, and Z may use either

the end of the taxable year is the amount the simplified deduction method or the section 861

total gross receipts. Gross receipts that are required to be reported on Schedule L of method.

allocable to land under the safe harbor pro- Form 1120, “United States Corporation Example 2. The facts are the same as in Example

vided in §1.199–3(m)(6)(iv) are treated as Income Tax Return,” in accordance with 1 except that X and Y are members of the same con-

non-DPGR. See §1.199–3(m)(6)(iv)(B). the Form 1120 instructions. solidated group. X, Y, and Z may use either the sim-

Whether a trust (to the extent not de- plified deduction method or the section 861 method.

(ii) Members of an expanded affiliated However, X and Y must use the same cost allocation

scribed in §1.199–9(d)) or an estate may group. To compute the total assets of an method.

use the simplified deduction method is EAG, the total assets at the end of the Example 3. The facts are the same as in Example

determined at the trust or estate level. If taxable year of each corporation that is a 1 except that Z’s average annual gross receipts are

a trust or estate qualifies to use the sim- member of the EAG at the end of the tax- $15,000,000. Because the average annual gross re-

plified deduction method, the simplified ceipts of the EAG are greater than $100,000,000 and

able year that ends with or within the tax- the total assets of the EAG at the end of the taxable

deduction method must be applied at the able year of the computing member (as year are greater than $10,000,000, X, Y, and Z must

trust or estate level, taking into account described in §1.199–7(h)) are aggregated. each use the section 861 method.

the trust’s or estate’s DPGR, non-DPGR, For purposes of this paragraph, a consol- (f) Small business simplified overall

and other items from all sources, includ- method—(1) In general. A qualifying





June 19, 2006 1110 2006–25 I.R.B.

small taxpayer may use the small business §1.199–3(m)(2)(iii)) prior to applying the $5,000,000, L, M, and N are all ineligible to use the

simplified overall method to apportion small business simplified overall method. small business simplified overall method.

CGS and deductions between DPGR and See §1.199–3(m)(6)(iv)(B). For example, (5) Trusts and estates. Trusts and es-

non-DPGR. Under the small business if a taxpayer has $1,000 of total costs tates under §1.199–9(e) may not use the

simplified overall method, a taxpayer’s for the current taxable year and $600 of small business simplified overall method.

total costs for the current taxable year such costs is attributable to land under (g) Average annual gross receipts—(1)

(as defined in paragraph (f)(3) of this the land safe harbor, then only $400 of In general. For purposes of the simplified

section) are apportioned between DPGR such costs is apportioned between DPGR deduction method and the small busi-

and non-DPGR based on relative gross and non-DPGR under the small business ness simplified overall method, average

receipts. Accordingly, the amount of simplified overall method. annual gross receipts means the average

total costs for the current taxable year (4) Members of an expanded affiliated annual gross receipts of the taxpayer (in-

apportioned to DPGR is equal to the group—(i) In general. Whether the mem- cluding gross receipts attributable to the

same proportion of total costs for the bers of an EAG may use the small business sale, exchange, or other disposition of

current taxable year that the amount of simplified overall method is determined by land under the land safe harbor provided

DPGR bears to total gross receipts. To- reference to all the members of the EAG. in §1.199–3(m)(6)(iv)) for the 3 taxable

tal gross receipts for this purpose do If the average annual gross receipts of the years (or, if fewer, the taxable years dur-

not include gross receipts that are allo- EAG are less than or equal to $5,000,000, ing which the taxpayer was in existence)

cated to land under the land safe harbor the EAG (viewed as a single corporation) preceding the current taxable year, even if

provided in §1.199–3(m)(6)(iv). See is engaged in the trade or business of farm- one or more of such taxable years began

§1.199–3(m)(6)(iv)(B). ing that is not required to use the accrual before the effective date of section 199. In

(2) Qualifying small taxpayer. Except method of accounting under section 447, the case of any taxable year of less than 12

as provided in paragraph (f)(5), for pur- or the EAG (viewed as a single corpora- months (a short taxable year), the gross re-

poses of this paragraph (f), a qualifying tion) is eligible to use the cash method as ceipts shall be annualized by multiplying

small taxpayer is— provided in Rev. Proc. 2002–28, then the gross receipts for the short period by

(i) A taxpayer that has average annual each member of the EAG may individually 12 and dividing the result by the number

gross receipts (as defined in paragraph (g) determine whether to use the small busi- of months in the short period.

of this section) of $5,000,000 or less; ness simplified overall method, regardless (2) Members of an expanded affiliated

(ii) A taxpayer that is engaged in the of the cost allocation method used by the group. To compute the average annual

trade or business of farming that is not re- other members. gross receipts of an EAG, the gross re-

quired to use the accrual method of ac- (ii) Exception. Notwithstanding para- ceipts, for the entire taxable year, of each

counting under section 447; or graph (f)(4)(i) of this section, all members corporation that is a member of the EAG

(iii) A taxpayer that is eligible to use of the same consolidated group must use at the end of its taxable year that ends with

the cash method as provided in Rev. Proc. the same cost allocation method. or within the taxable year of the comput-

2002–28, 2002–1 C.B. 815 (that is, cer- (iii) Examples. The following examples ing member are aggregated. For purposes

tain taxpayers with average annual gross illustrate the application of paragraph (f) of of this paragraph, a consolidated group is

receipts of $10,000,000 or less that are this section: treated as one member of the EAG.

not prohibited from using the cash method Example 1. Corporations L, M, and N are the only

three members of an EAG. Neither L, M, nor N is a §1.199–5 Application of section 199

under section 448, including partnerships,

member of a consolidated group. L, M, and N have to pass-thru entities for taxable years

S corporations, C corporations, or individ- average annual gross receipts for the current taxable beginning after May 17, 2006, the

uals). See §601.601(d)(2) of this chapter. year of $1,000,000, $1,500,000, and $2,000,000, re-

enactment date of the Tax Increase

(3) Total costs for the current taxable spectively. Because the average annual gross receipts

of the EAG are less than or equal to $5,000,000, each Prevention and Reconciliation Act of

year—(i) In general. For purposes of the

of L, M, and N may use the small business simplified 2005. [Reserved].

small business simplified overall method,

overall method, the simplified deduction method, or

total costs for the current taxable year the section 861 method. §1.199–6 Agricultural and horticultural

means the total CGS and deductions (ex- Example 2. The facts are the same as in Exam- cooperatives.

cluding the net operating loss deduction ple 1 except that M and N are members of the same

as provided in paragraph (c)(2) of this consolidated group. L, M, and N may use the small (a) In general. A patron who receives

section) for the current taxable year. Total business simplified overall method, the simplified de-

a qualified payment (as defined in para-

duction method, or the section 861 method. However,

costs for the current taxable year are de- M and N must use the same cost allocation method. graph (e) of this section) from a speci-

termined under the methods of accounting Example 3. The facts are the same as in Example fied agricultural or horticultural coopera-

that the taxpayer uses to compute taxable 1 except that N has average annual gross receipts of tive (cooperative) (as defined in paragraph

income. $4,000,000. Unless the EAG, viewed as a single cor- (f) of this section) is allowed a deduc-

(ii) Land safe harbor. A taxpayer poration, is engaged in the trade or business of farm-

tion under §1.199–1(a) (section 199 de-

ing that is not required to use the accrual method of

that uses the land safe harbor provided in accounting under section 447, or the EAG, viewed as duction) for the taxable year the quali-

§1.199–3(m)(6)(iv) must reduce total costs a single corporation, is eligible to use the cash method fied payment is received for the portion

for the current taxable year by the costs of as provided in Rev. Proc. 2002–28, because the aver- of the cooperative’s section 199 deduction

land and any other costs capitalized to the age annual gross receipts of the EAG are greater than passed through to the patron and identi-

land (except costs for activities listed in fied by the cooperative in a written no-





2006–25 I.R.B. 1111 June 19, 2006

tice mailed to the person during the pay- ucts also include fertilizer, diesel fuel, and on an amended return, then recapture of the

ment period described in section 1382(d). other supplies used in agricultural or hor- excess will occur at the cooperative level

The provisions of this section apply solely ticultural production. in the taxable year the cooperative took the

for purposes of section 199 of the Internal (g) Written notice to patrons. In order excess section 199 deduction amount into

Revenue Code (Code). for a patron to qualify for the section 199 account.

(b) Cooperative denied section 1382 deduction, paragraph (a) of this section re- (k) Section is exclusive. This section

deduction for portion of qualified pay- quires that the cooperative identify in a is the exclusive method for cooperatives

ments. A cooperative must reduce its sec- written notice the patron’s portion of the and their patrons to compute the amount of

tion 1382 deduction by an amount equal section 199 deduction that is attributable the section 199 deduction. Thus, a patron

to the portion of any qualified payment to the portion of the cooperative’s QPAI may not deduct any amount with respect

that is attributable to the cooperative’s for which the cooperative is allowed a sec- to a patronage dividend or a per-unit retain

section 199 deduction passed through to tion 199 deduction. This written notice allocation unless the requirements of this

the patron. must be mailed by the cooperative to its section are satisfied.

(c) Determining cooperative’s taxable patrons no later than the 15th day of the (l) No double counting. To the extent a

income. For purposes of determining its ninth month following the close of the tax- cooperative passes through the section 199

section 199 deduction, the cooperative’s able year. The cooperative may use the deduction to a patron, a qualified payment

taxable income is computed without taking same written notice, if any, that it uses to received by the patron of the cooperative

into account any deduction allowable un- notify patrons of their respective alloca- is not taken in account for purposes of sec-

der section 1382(b) or (c) (relating to pa- tions of patronage dividends, or may use a tion 199.

tronage dividends, per-unit retain alloca- separate timely written notice(s) to comply (m) Examples. The following examples

tions, and nonpatronage distributions). with this section. The cooperative must illustrate the application of this section:

(d) Special rule for marketing coopera- report the amount of the patron’s section Example 1. (i) Cooperative X markets corn

tives. In the case of a cooperative engaged 199 deduction on Form 1099-PATR, “Tax- grown by its members within the United States for

sale to retail grocers. For its calendar year ended De-

in the marketing of agricultural and/or able Distributions Received From Cooper- cember 31, 2007, Cooperative X has gross receipts of

horticultural products described in para- atives,” issued to the patron. $1,500,000, all derived from the sale of corn grown

graph (f) of this section, the cooperative is (h) Additional rules relating to by its members within the United States. Cooper-

treated as having manufactured, produced, passthrough of section 199 deduction. ative X pays $370,000 for its members’ corn and

grown, or extracted (MPGE) (as defined The cooperative may, at its discretion, its W–2 wages (as defined in §1.199–2(e)) for 2007

total $130,000. Cooperative X has no other costs.

in §1.199–3(e)) in whole or in significant pass through all, some, or none of the Patron A is a member of Cooperative X. Patron A is

part (as defined in §1.199–3(g)) within the section 199 deduction to its patrons. How- a cash basis taxpayer and files Federal income tax

United States (as defined in §1.199–3(h)) ever, the cooperative may not apply sec- returns on a calendar year basis. All corn grown by

any agricultural or horticultural products tion 199(d)(3) and this section to any Patron A in 2007 is sold through Cooperative X and

marketed by the cooperative that its pa- portion of the section 199 deduction that Patron A is eligible to share in patronage dividends

paid by Cooperative X for that year.

trons have MPGE. is not passed through to its patrons. A (ii) Cooperative X is a cooperative described in

(e) Qualified payment. The term quali- cooperative member of a federated coop- paragraph (f) of this section. Accordingly, this sec-

fied payment means any amount of a pa- erative may pass through the section 199 tion applies to Cooperative X and its patrons and all

tronage dividend or per-unit retain allo- deduction it receives from the federated of Cooperative X’s gross receipts from the sale of its

cation, as described in section 1385(a)(1) cooperative to its member patrons. Pa- patrons’ corn qualify as domestic production gross

receipts (as defined §1.199–3(a)). Cooperative X’s

or (3) received by a patron from a co- trons may claim the section 199 deduction QPAI is $1,000,000. Cooperative X’s section 199 de-

operative, that is attributable to the por- for the taxable year in which they receive duction for its taxable year 2007 is $60,000 (.06 x

tion of the cooperative’s qualified produc- the written notice from the cooperative $1,000,000). Because this amount is less than 50%

tion activities income (QPAI) (as defined informing them of the section 199 amount of Cooperative X’s W–2 wages, the entire amount is

in §1.199–1(c)), for which the coopera- without regard to the taxable income limi- allowed as a section 199 deduction subject to the rules

of section 199(d)(3) and this section.

tive is allowed a section 199 deduction. tation under §1.199–1(a) and (b). Example 2. (i) The facts are the same as in Ex-

For this purpose, patronage dividends and (i) W–2 wages. The W–2 wage limita- ample 1 except that Cooperative X decides to pass

per-unit retain allocations include any ad- tion described in §1.199–2 shall be applied its entire section 199 deduction through to its mem-

vances on patronage and per-unit retains at the cooperative level whether or not the bers. Cooperative X declares a patronage dividend

paid in money during the taxable year. cooperative chooses to pass through some for its 2007 taxable year of $1,000,000, which it pays

on March 15, 2008. Pursuant to paragraph (g) of this

(f) Specified agricultural or horticul- or all of the section 199 deduction. Any section, Cooperative X notifies members in written

tural cooperative. A specified agricultural section 199 deduction that has been passed notices that accompany the patronage dividend noti-

or horticultural cooperative means a coop- through by a cooperative to its patrons is fication that it is allocating to them the section 199 de-

erative to which Part I of subchapter T of not subject to the W–2 wage limitation a duction it is entitled to claim in the taxable year 2007.

the Code applies and the cooperative has second time at the patron level. On March 15, 2008, Patron A receives a $10,000 pa-

tronage dividend that is a qualified payment under

MPGE in whole or significant part within (j) Recapture of section 199 deduction. paragraph (e) of this section from Cooperative X. In

the United States any agricultural or hor- If the amount of the section 199 deduction the notice that accompanies the patronage dividend,

ticultural product, or has marketed agri- that was passed through to patrons exceeds Patron A is designated a $600 section 199 deduction.

cultural or horticultural products. For this the amount allowable as a section 199 de- Under paragraph (a) of this section, Patron A must

purpose, agricultural or horticultural prod- duction as determined on audit or reported claim a $600 section 199 deduction for the taxable







June 19, 2006 1112 2006–25 I.R.B.

year ending December 31, 2008, without regard to dated group, see paragraph (d) of this sec- or other disposition, the disposing member

the taxable income limitation under §1.199–1(a) and tion. is treated as having disposed of the QPP,

(b). Cooperative X must report the amount of Patron (1) Definition of expanded affiliated qualified film, or utilities on the date on

A’s section 199 deduction on Form 1099-PATR, “Tax-

able Distributions Received From Cooperatives,” is-

group. An EAG is an affiliated group as which it ceases to own the QPP, qualified

sued to Patron A for the calendar year 2008. defined in section 1504(a), determined by film, or utilities for Federal income tax

(ii) Under paragraph (b) of this section, Cooper- substituting more than 50 percent for at purposes, even if no gain or loss is taken

ative X is required to reduce its patronage dividend least 80 percent each place it appears and into account.

deduction of $1,000,000 by the $60,000 section 199 without regard to section 1504(b)(2) and (ii) Special rule. Attribution of ac-

deduction passed through to members (whether or not

Cooperative X pays patronage on book or Federal in-

(4). tivities does not apply for purposes of

come tax net earnings). As a consequence, Cooper- (2) Identification of members of an ex- the construction of real property under

ative X is entitled to a patronage dividend deduction panded affiliated group—(i) In general. A §1.199–3(m) or the performance of engi-

for the taxable year ending December 31, 2007, in corporation must determine if it is a mem- neering and architectural services under

the amount of $940,000 ($1,000,000 - $60,000) and ber of an EAG on a daily basis. §1.199–3(n). A member of an EAG must

to a section 199 deduction in the amount of $60,000

($1,000,000 x .06). Its taxable income for 2007 is $0.

(ii) Becoming or ceasing to be a mem- engage in a construction activity under

Example 3. (i) The facts are the same as in Ex- ber of an expanded affiliated group. If §1.199–3(m)(2), provide engineering ser-

ample 1 except that Cooperative X paid out $500,000 a corporation becomes or ceases to be a vices under §1.199–3(n)(2), or provide ar-

to its patrons as advances on expected patronage net member of an EAG, the corporation is chitectural services under §1.199–3(n)(3)

earnings. In 2007, Cooperative X pays its patrons a treated as becoming or ceasing to be a in order for the member’s gross receipts to

$500,000 ($1,000,000 - $500,000 already paid) pa-

tronage dividend in cash or a combination of cash and

member of the EAG at the end of the day be derived from construction, engineering,

qualified written notices of allocation. Under para- on which its status as a member changes. or architectural services.

graph (b) of this section and section 1382, Cooper- (3) Attribution of activities—(i) In (4) Examples. The following exam-

ative X is allowed a patronage dividend deduction general. If a member of an EAG (the ples illustrate the application of paragraph

of $440,000 ($500,000 - $60,000 section 199 deduc- disposing member) derives gross receipts (a)(3) of this section. Assume that all tax-

tion), whether patronage net earnings are distributed

on book or Federal income tax net earnings.

(as defined in §1.199–3(c)) from the lease, payers are calendar year taxpayers. The

(ii) The patrons will have received a gross amount rental, license, sale, exchange, or other examples are as follows:

of $1,000,000 in qualified payments under paragraph disposition (as defined in §1.199–3(i)) of Example 1. Corporations M and N are members

(e) of this section from Cooperative X ($500,000 paid qualifying production property (QPP) (as of the same EAG. M is engaged solely in the trade

during the taxable year as advances and the additional or business of manufacturing furniture in the United

defined in §1.199–3(j)) that was manu- States that it sells to unrelated persons. N is engaged

$500,000 paid as patronage dividends). If Coopera-

tive X passes through its entire section 199 deduction

factured, produced, grown or extracted solely in the trade or business of engraving compa-

to its members by providing the notice required by (MPGE) (as defined in §1.199–3(e)), in nies’ names on pens and pencils purchased from un-

paragraph (g) of this section, then the patrons will be whole or in significant part (as defined related persons and then selling the pens and pencils

allowed a $60,000 section 199 deduction, resulting in §1.199–3(g)) in the United States (as to such companies. For purposes of this example, as-

in a net $940,000 taxable distribution from Coopera- sume that if N was not a member of an EAG, its ac-

defined in §1.199–3(h)), a qualified film tivities would not qualify as MPGE. Accordingly, al-

tive X. Pursuant to paragraph (l) of this section, the

$1,000,000 received by the patrons from Cooperative

(as defined in §1.199–3(k)), or electricity, though M’s sales of the furniture qualify as DPGR

X is not taken into account for purposes of section 199 natural gas, or potable water (as defined (assuming all the other requirements of §1.199–3 are

in the hands of the patrons. in §1.199–3(l)) (collectively, utilities) that met), N’s sales of the engraved pens and pencils do

was produced in the United States, such not qualify as DPGR because neither N nor another

§1.199–7 Expanded affiliated groups. member of the EAG MPGE the pens and pencils.

property was MPGE or produced by an- Example 2. For the entire 2007 year, Corpora-

other corporation (or corporations), and tions A and B are members of the same EAG. A is

(a) In general. The provisions of this

the disposing member is a member of the engaged solely in the trade or business of MPGE ma-

section apply solely for purposes of sec- chinery in the United States. A and B each own 45%

same EAG as the other corporation (or

tion 199 of the Internal Revenue Code of partnership C and unrelated persons own the re-

corporations) at the time that the disposing

(Code). All members of an expanded affil- maining 10%. C is engaged solely in the trade or

member disposes of the QPP, qualified business of MPGE the same type of machinery in the

iated group (EAG) are treated as a single

film, or utilities, then the disposing mem- United States as A. In 2007, B purchases and then re-

corporation for purposes of section 199.

ber is treated as conducting the previous sells the machinery MPGE in 2007 by A and C. B also

Notwithstanding the preceding sentence, resells machinery it purchases from unrelated per-

activities conducted by such other corpo-

except as otherwise provided in the Code sons. If only B’s activities were considered, B would

ration (or corporations) with respect to the

and regulations (see, for example, sections not qualify for the deduction under §1.199–1(a) (sec-

QPP, qualified film, or utilities in deter- tion 199 deduction). However, because at the time

199(c)(7) and 267, §1.199–3(b), paragraph

mining whether its gross receipts are do- B disposes of the machinery B is a member of the

(a)(3) of this section, and the consolidated

mestic production gross receipts (DPGR) EAG that includes A, B is treated as conducting A’s

return regulations), each member of an previous MPGE activities in determining whether B’s

(as defined in §1.199–3(a)). With respect

EAG is a separate taxpayer that computes gross receipts from the sale of the machinery MPGE

to a lease, rental, or license, the disposing

its own taxable income or loss, qualified by A are DPGR. C is not a member of the EAG and

member is treated as having disposed of thus C’s MPGE activities are not attributed to B in

production activities income (QPAI) (as

the QPP, qualified film, or utilities on the determining whether B’s gross receipts from the sale

defined in §1.199–1(c)), and W–2 wages

date or dates on which it takes into account of the machinery MPGE by C are DPGR. Accord-

(as defined in §1.199–2(e)). If members ingly, B’s gross receipts attributable to its sale of the

the gross receipts derived from the lease,

of an EAG are also members of a consoli- machinery it purchases from A are DPGR (assuming

rental, or license under its methods of ac-

all the other requirements of §1.199–3 are met). B’s

counting. With respect to a sale, exchange,





2006–25 I.R.B. 1113 June 19, 2006

gross receipts attributable to its sale of the machin- (b) Computation of expanded affiliated if a member of an EAG, prior to the allo-

ery it purchases from C and from the unrelated per- group’s section 199 deduction—(1) In cation of some or all of the EAG’s section

sons are non-DPGR because no member of the EAG general. The section 199 deduction for an 199 deduction to the member, has an NOL

MPGE the machinery and because C does not qualify

as an EAG partnership.

EAG is determined by the EAG by aggre- for the taxable year, the portion of the

Example 3. The facts are the same as in Example gating each member’s taxable income or EAG’s section 199 deduction allocated to

2 except that rather than reselling the machinery, B loss, QPAI, and W–2 wages, if any. For the member will increase the member’s

rents the machinery to unrelated persons and B takes purposes of this determination, a mem- NOL.

the gross receipts attributable to the rental of the ma- ber’s QPAI may be positive or negative. (d) Special rules for members of the

chinery into account under its methods of accounting

in 2007, 2008, and 2009. In addition, as of the close

A member’s taxable income or loss and same consolidated group—(1) Intercom-

of business on December 31, 2008, A and B cease to QPAI shall be determined by reference to pany transactions. In the case of an in-

be members of the same EAG. With respect to the ma- the member’s methods of accounting. tercompany transaction between consoli-

chinery acquired from C and the unrelated persons, (2) Example. The following example dated group members S and B (as the terms

B’s gross receipts attributable to the rental of the ma- illustrates the application of paragraph intercompany transaction, S, and B are de-

chinery in 2007, 2008, and 2009 are non-DPGR be-

cause no member of the EAG MPGE the machinery

(b)(1) of this section: fined in §1.1502–13(b)(1)), S takes the

Example. Corporations X, Y, and Z, calendar intercompany transaction into account in

and because C does not qualify as an EAG partner-

year taxpayers, are the only members of an EAG computing the section 199 deduction at the

ship. With respect to machinery acquired from A,

and are not members of a consolidated group. X

B’s gross receipts in 2007 and 2008 attributable to same time and in the same proportion as S

has taxable income of $50,000, QPAI of $15,000,

the rental of the machinery are DPGR because at the takes into account the income, gain, deduc-

and W–2 wages of $1,000. Y has taxable income

time B takes into account the gross receipts derived

from the rental of the machinery under its methods of

of ($20,000), QPAI of ($1,000), and W–2 wages of tion, or loss from the intercompany trans-

$750. Z has $0 taxable income and $0 QPAI, but has action under §1.1502–13.

accounting, B is a member of the same EAG as A and

W–2 wages of $2,000. In determining the EAG’s (2) Attribution of activities in the con-

B is treated as conducting A’s previous MPGE activ-

section 199 deduction, the EAG aggregates each

ities. However, with respect to the rental receipts in struction of real property and the perfor-

member’s taxable income or loss, QPAI, and W–2

2009, because A and B are not members of the same mance of engineering and architectural

wages. Accordingly, the EAG has taxable income

EAG in 2009, B’s rental receipts are non-DPGR.

Example 4. For the entire 2007 year, Corpora-

of $30,000 ($50,000 + ($20,000) + $0), QPAI of services. Notwithstanding paragraph

$14,000 ($15,000 + ($1,000) + $0), and W–2 wages (a)(3)(ii) of this section, a disposing mem-

tion P owns over 50% of the stock of Corporation

of $3,750 ($1,000 + $750 + $2,000). ber (as described in paragraph (a)(3)(i)

S. In 2007, P MPGE QPP in the United States and

transfers the QPP to S. On February 28, 2008, P dis- (3) Net operating loss carrybacks and of this section) is treated as conducting

poses of stock of S, reducing P’s ownership of S be- carryovers. In determining the taxable in- the previous activities conducted by each

low 50% and P and S cease to be members of the same come of an EAG, if a member of an EAG

EAG. On June 30, 2008, S sells the QPP to an unre-

other member of its consolidated group

has a net operating loss (NOL) carryback with respect to the construction of real

lated person. Unless P’s transfer of the QPP to S took

place in a transaction to which section 381(a) applies

or carryover to the taxable year, then the property under §1.199–3(m) and the per-

(see §1.199–8(e)(3)), because S is not a member of amount of the NOL used to offset taxable formance of engineering and architectural

the same EAG as P on June 30, 2008, S is not treated income cannot exceed the taxable income services under §1.199–3(n), but only with

as conducting the activities conducted by P in deter- of that member.

mining if S’s receipts are DPGR, notwithstanding that

respect to activities performed during the

(c) Allocation of an expanded af- period of consolidation.

P and S were members of the same EAG when P

MPGE the QPP and when P transferred the QPP to

filiated group’s section 199 deduction (3) Application of the simplified de-

S. among members of the expanded affiliated duction method and the small business

Example 5. For the entire 2007 year, Corpora- group—(1) In general. An EAG’s section simplified overall method. For purposes of

tions X and Y are unrelated corporations. In 2007, X 199 deduction as determined in paragraph

MPGE QPP in the United States and sells the QPP to

applying the simplified deduction method

(b)(1) of this section is allocated among under §1.199–4(e) and the small busi-

Y. On August 31, 2008, X acquires over 50% of the

stock of Y, thus making X and Y members of the same

the members of the EAG in proportion ness simplified overall method under

EAG. On November 30, 2008, Y sells the QPP to an to each member’s QPAI, regardless of §1.199–4(f), a consolidated group deter-

unrelated person. Because X and Y are members of whether the EAG member has taxable in- mines its QPAI using its members’ DPGR,

the same EAG on November 30, 2008, Y is treated as come or loss or W–2 wages for the taxable

conducting the activities conducted by X in 2007 in

non-DPGR, cost of goods sold (CGS), and

year. For this purpose, if a member has all other deductions, expenses, or losses

determining if Y’s receipts are DPGR, notwithstand-

ing that X and Y were not members of the same EAG

negative QPAI, the QPAI of the member (deductions), determined after application

when X MPGE the QPP nor when X sold the QPP to shall be treated as zero. of §1.1502–13.

Y. (2) Use of section 199 deduction to (4) Determining the section 199 deduc-

(5) Anti-avoidance rule. If a transaction create or increase a net operating loss. tion—(i) Expanded affiliated group con-

between members of an EAG is engaged Notwithstanding §1.199–1(b), if a mem- sists of consolidated group and non-con-

in or structured with a principal purpose ber of an EAG has some or all of the solidated group members. In determining

of qualifying for, or increasing the amount EAG’s section 199 deduction allocated the section 199 deduction, if an EAG

of, the section 199 deduction of the EAG to it under paragraph (c)(1) of this sec- includes corporations that are members

or the portion of the section 199 deduction tion and the amount allocated exceeds the of the same consolidated group and cor-

allocated to one or more members of the member’s taxable income (determined porations that are not members of the

EAG, adjustments must be made to elim- prior to allocation of the section 199 de- same consolidated group, the consoli-

inate the effect of the transaction on the duction), the section 199 deduction will dated taxable income or loss, QPAI, and

computation of the section 199 deduction. create an NOL for the member. Similarly, W–2 wages, if any, of the consolidated





June 19, 2006 1114 2006–25 I.R.B.

group (and not the separate taxable in- ample take place during the same taxable year. X asset in manufacturing QPP within the United States.

come or loss, QPAI, and W–2 wages of and Y each use the section 861 method described in S incurs $2,000 of additional costs in manufacturing

the members of the consolidated group), §1.199–4(d) for allocating and apportioning their de- the QPP. On December 31, 2008, S sells the QPP to

ductions. X incurs $5,000 in costs in manufacturing unrelated persons for $10,000. Because on December

are aggregated with the taxable income or a machine, all of which are capitalized. X is entitled 31, 2007, P anticipates that it will license the intan-

loss, QPAI, and W–2 wages, if any, of the to a $1,000 depreciation deduction for the machine in gible asset to S, a related person, and also because

non-consolidated group members. For ex- the current taxable year. X rents the machine to Y for the intangible asset is not QPP, P’s license receipts

ample, if A, B, C, S1, and S2 are members $1,500. Y uses the machine in manufacturing QPP from S will be non-DPGR. Accordingly, P’s research

of the same EAG, and A, S1, and S2 are within the United States. Y incurs $1,400 of CGS in and development expenses in 2007 are not attribut-

manufacturing the QPP. Y sells the QPP to unrelated able to DPGR. In 2008, S has $5,500 of QPAI (S’s

members of the same consolidated group persons for $7,500. Pursuant to section 199(c)(7) and $10,000 DPGR received from unrelated persons - S’s

(the A consolidated group), then the A §1.199–3(b), X’s rental income is non-DPGR (and its $2,000 additional costs in manufacturing the QPP -

consolidated group is treated as one mem- related costs are not attributable to DPGR). Accord- S’s $2,500 of license expense), P has $0 of QPAI, and

ber of the EAG. Accordingly, the EAG is ingly, Y has $4,600 of QPAI (Y’s $7,500 DPGR re- the EAG has $5,500 of QPAI.

considered to have three members, the A ceived from unrelated persons - Y’s $1,400 CGS allo- Example 4. (i) Determination of consolidated

cable to such receipts - Y’s $1,500 of rental expense), group’s QPAI. The facts are the same as in Example

consolidated group, B, and C. The consol- X has $0 of QPAI, and the EAG has $4,600 of QPAI. 3 except that P and S are members of the same con-

idated taxable income or loss, QPAI, and Example 2. The facts are the same as in Example solidated group. Pursuant to section 199(c)(7) and

W–2 wages, if any, of the A consolidated 1 except that X and Y are members of the same con- §1.199–3(b), and also because the intangible asset is

group are aggregated with the taxable in- solidated group. Pursuant to section 199(c)(7) and not QPP, P’s license income ordinarily would not be

come or loss, QPAI, and W–2 wages, if §1.199–3(b), X’s rental income ordinarily would not DPGR (and its related costs would not be allocable

be DPGR (and its related costs would not be allocable to DPGR). However, because P and S are members

any, of B and C in determining the EAG’s to DPGR). However, because X and Y are members of the same consolidated group, §1.1502–13(c)(1)(i)

section 199 deduction. of the same consolidated group, §1.1502–13(c)(1)(i) provides that the separate entity attributes of P’s inter-

(ii) Expanded affiliated group consists provides that the separate entity attributes of X’s company items or S’s corresponding items, or both,

only of members of a single consolidated intercompany items or Y’s corresponding items, may be redetermined in order to produce the same ef-

group. If all the members of an EAG are or both, may be redetermined in order to produce fect as if P and S were divisions of a single corpora-

the same effect as if X and Y were divisions of a tion. If P and S were divisions of a single corporation,

members of the same consolidated group, single corporation. If X and Y were divisions of in 2007 the single corporation would have $1,000 of

the consolidated group’s section 199 de- a single corporation, X and Y would have QPAI expenses allocable to the anticipated DPGR from the

duction is determined using the consoli- of $5,100 ($7,500 DPGR received from unrelated sale of the QPP to unrelated persons, resulting in a

dated group’s consolidated taxable income persons - $1,400 CGS allocable to such receipts negative QPAI (from this individual item) of $1,000.

or loss, QPAI, and W–2 wages, rather than - $1,000 depreciation deduction). To obtain this In 2008, the single corporation would have QPAI of

same result for the consolidated group, X’s rental $8,000 ($10,000 DPGR received from unrelated per-

the separate taxable income or loss, QPAI, income is redetermined as DPGR, which results sons - $2,000 additional costs in manufacturing the

and W–2 wages of its members. in the consolidated group having $9,000 of DPGR QPP). To obtain this same result for the consolidated

(5) Allocation of the section 199 de- (the sum of Y’s DPGR of $7,500 + X’s DPGR of group, P’s license income from S is redetermined as

duction of a consolidated group among its $1,500) and $3,900 of costs allocable to DPGR DPGR. P’s research and development expenses are

members. The section 199 deduction of a (the sum of Y’s $1,400 CGS + Y’s $1,500 rental allocable to DPGR. This results in the consolidated

expense + X’s $1,000 depreciation expense). For group having negative QPAI in 2007 (from the re-

consolidated group (or the section 199 de- purposes of determining how much of the consoli- search and development expense) of $1,000. In 2008,

duction allocated to a consolidated group dated group’s section 199 deduction is allocated to the consolidated group has $12,500 of DPGR (the

that is a member of an EAG) is allocated X and Y, pursuant to paragraph (d)(5) of this section, sum of S’s DPGR of $10,000 + P’s DPGR of $2,500)

to the members of the consolidated group the redetermination of X’s rental income as DPGR and $4,500 of costs allocable to DPGR (the sum of

in proportion to each consolidated group under §1.1502–13(c)(1)(i) is not taken into account S’s $2,000 additional costs + S’s $2,500 license ex-

(X’s costs are considered to be allocable to DPGR pense), resulting in $8,000 of QPAI in 2008.

member’s QPAI, regardless of whether the because they are allocable to the consolidated group (ii) Allocation of deduction. Since the consoli-

consolidated group member has separate deriving DPGR). Accordingly, for this purpose, X dated group has no QPAI in 2007, there is no section

taxable income or loss or W–2 wages for is deemed to have ($1,000) of QPAI (X’s $0 DPGR 199 deduction to be allocated between P and S in

the taxable year. In allocating the sec- - X’s $1,000 depreciation deduction). Because X 2007. In 2008, the consolidated group has $8,000

tion 199 deduction of a consolidated group is deemed to have negative QPAI, also pursuant to of QPAI and, assuming that the group has positive

paragraph (d)(5) of this section, X’s QPAI is treated taxable income and W–2 wages, the consolidated

among its members, any redetermination as zero. Y has $4,600 of QPAI (Y’s $7,500 DPGR group will have a section 199 deduction. For pur-

of a corporation’s receipts, CGS, or other - Y’s $1,400 CGS allocable to such receipts - Y’s poses of determining how much of the consolidated

deductions from an intercompany trans- $1,500 of rental expense). Accordingly, X is allo- group’s section 199 deduction is allocated to P and

action under §1.1502–13(c)(1)(i) or (c)(4) cated $0/($0 + $4,600) of the consolidated group’s S, pursuant to paragraph (d)(5) of this section, the re-

for purposes of section 199 is not taken section 199 deduction and Y is allocated $4,600/($0 determination of P’s license income as DPGR under

+ $4,600) of the consolidated group’s section 199 §1.1502–13(c)(1)(i) is not taken into account. Ac-

into account. Also, for purposes of this al- deduction. cordingly, for purposes of allocating the consolidated

location, if a consolidated group member Example 3. Corporations P and S are members group’s section 199 deduction between P and S, P is

has negative QPAI, the QPAI of the mem- of the same EAG but are not members of a consoli- deemed to have $0 DPGR and $0 QPAI in 2008. S

ber shall be treated as zero. dated group. P and S each use the section 861 method has $5,500 of QPAI (S’s $10,000 DPGR - S’s $2,000

(e) Examples. The following examples for allocating and apportioning their deductions and in additional costs allocable to such receipts - S’s

are both calendar year taxpayers. In 2007, P incurs $2,500 of license expense). Accordingly, P is allo-

illustrate the application of paragraphs (a) $1,000 in research and development expenses in cre- cated $0/($0 + $5,500) of the consolidated group’s

through (d) of this section: ating an intangible asset and deducts these expenses section 199 deduction in 2008 and S is allocated

Example 1. Corporations X and Y are members in 2007. P anticipates that it will license the intan- $5,500/($0 + $5,500) of the consolidated group’s

of the same EAG but are not members of a consoli- gible asset to S. On January 1, 2008, P licenses the section 199 deduction.

dated group. All the activities described in this ex- intangible asset to S for $2,500. S uses the intangible







2006–25 I.R.B. 1115 June 19, 2006

Example 5. (i) Facts. Corporations A and B from its $10,000,000 DPGR. Under the simplified the simplified deduction method, A apportions its

are the only two members of an EAG but are not deduction method, the consolidated group appor- remaining $1,000,000 of deductions in proportion

members of a consolidated group. A and B each file tions its remaining $4,000,000 of deductions to to the ratio of its DPGR to total receipts. Thus,

Federal income tax returns on a calendar year basis. DPGR in proportion to the ratio of its DPGR to $400,000 ($1,000,000 x $2,000,000/$5,000,000) is

The average annual gross receipts of the EAG are less total gross receipts. Thus, $3,076,923 ($4,000,000 x allocated to DPGR. Thus, A’s QPAI is $100,000

than or equal to $100,000,000 and A and B each use $10,000,000/$13,000,000) is allocated to DPGR. Ac- ($2,000,000 DPGR - $1,500,000 CGS - $400,000

the simplified deduction method under §1.199–4(e). cordingly, the consolidated group’s QPAI for 2007 is deductions allocated to its DPGR).

In 2007, A MPGE televisions within the United $2,423,077 ($10,000,000 DPGR - $4,500,000 CGS - (B) B’s QPAI. B’s DPGR and its total gross

States. A has $10,000,000 of DPGR from sales of $3,076,923 deductions apportioned to its DPGR). receipts are each $4,100,000. For purposes of

televisions to unrelated persons and $2,000,000 of (iii) Allocation of consolidated group’s 2007 sec- allocating the consolidated group’s section 199 de-

DPGR from sales of televisions to B. In addition, tion 199 deduction to its members. Because B’s only duction to its members, pursuant to paragraph (d)(5)

A has gross receipts from computer consulting ser- activity during 2007 is the purchase of televisions of this section, the redetermination of B’s $2,000,000

vices with unrelated persons of $3,000,000. A has from A, B has no DPGR or deductions and thus, no CGS as not allocable to DPGR is disregarded. In

CGS of $6,000,000. A is able to determine from its QPAI, in 2007. Accordingly, the entire section 199 determining B’s QPAI, B subtracts its $2,000,000

books and records that $4,500,000 of its CGS are deduction in 2007 for the consolidated group will be CGS from the televisions purchased from A from

attributable to televisions sold to unrelated persons allocated to A. its $4,100,000 DPGR. Under the simplified deduc-

and $1,500,000 are attributable to televisions sold to (iv) Consolidated group’s 2008 QPAI. Pursuant to tion method, B apportions its remaining $100,000

B (see §1.199–4(b)(2)). A has other deductions of paragraph (d)(1) of this section and §1.1502–13(c), deductions in proportion to the ratio of its DPGR

$4,000,000. A has no other items of income, gain, A’s sale of televisions to B in 2007 is taken into to total receipts. Thus, all $100,000 ($100,000

or deductions. In 2007, B sells the televisions it pur- account in 2008 when B sells the televisions to unre- x $4,100,000/$4,100,000) is allocated to DPGR.

chased from A to unrelated persons for $4,100,000. lated persons. However, because A and B are mem- Thus, B’s QPAI is $2,000,000 ($4,100,000 DPGR -

B also pays $100,000 for administrative services bers of a consolidated group, §1.1502–13(c)(1)(i) $2,000,000 CGS - $100,000 deductions allocated to

performed in 2007. B has no other items of income, provides that the separate entity attributes of A’s its DPGR).

gain, or deductions. intercompany items or B’s corresponding items, or (C) Allocation to A and B. Pursuant to para-

(ii) QPAI. (A) A’s QPAI. In order to determine both, may be redetermined in order to produce the graph (d)(5) of this section, the consolidated

A’s QPAI, A subtracts its $6,000,000 CGS from its same effect as if A and B were divisions of a single group’s section 199 deduction for 2008 is allo-

$12,000,000 DPGR. Under the simplified deduction corporation. Accordingly, A’s $2,000,000 of gross cated $100,000/($100,000 + $2,000,000) to A and

method, A then apportions its remaining $4,000,000 receipts are redetermined to be non-DPGR and as not $2,000,000/($100,000 + $2,000,000) to B.

of deductions to DPGR in proportion to the ratio being gross receipts for purposes of allocating costs Example 7. Corporations S and B are members of

of its DPGR to total gross receipts. Thus, of A’s between DPGR and non-DPGR, and B’s $2,000,000 the same consolidated group that files its Federal in-

$4,000,000 of deductions, $3,200,000 is apportioned CGS are redetermined to be not allocable to DPGR. come tax returns on a calendar year basis. In 2007, S

to DPGR ($4,000,000 x $12,000,000/$15,000,000). Notwithstanding that A’s receipts are redetermined manufactures office furniture for B to use in B’s cor-

Accordingly, A’s QPAI is $2,800,000 ($12,000,000 to be non-DPGR and as not being gross receipts porate headquarters and S sells the office furniture to

DPGR - $6,000,000 CGS - $3,200,000 deductions for purposes of allocating costs between DPGR B. S and B have no other activities in the taxable year.

apportioned to its DPGR). and non-DPGR, A’s CGS are still considered to be If S and B were not members of a consolidated group,

(B) B’s QPAI. Although B did not MPGE the allocable to DPGR because they are allocable to S’s gross receipts from the sale of the office furniture

televisions it sold, pursuant to paragraph (a)(3) of the consolidated group deriving DPGR. Accord- to B would be DPGR (assuming all the other require-

this section, B is treated as conducting A’s MPGE of ingly, the consolidated group’s DPGR in 2008 is ments of §1.199–3 are met) and S’s CGS or other de-

the televisions in determining whether B’s gross re- $4,100,000 from B’s sales of televisions, and its ductions, expenses, or losses from the sale to B would

ceipts are DPGR. Thus, B has $4,100,000 of DPGR. total receipts are $7,100,000 ($4,100,000 DPGR be allocable to S’s DPGR. However, because S and

In order to determine B’s QPAI, B subtracts its plus $3,000,000 non-DPGR from A’s computer B are members of a consolidated group, the separate

$2,000,000 CGS from its $4,100,000 DPGR. Under consulting services). To determine the consolidated entity attributes of S’s intercompany items or B’s cor-

the simplified deduction method, B then apportions group’s QPAI, the consolidated group subtracts A’s responding items, or both, may be redetermined un-

its remaining $100,000 of deductions to DPGR in $1,500,000 CGS from the televisions sold to B from der §1.1502–13(c)(1)(i) or (c)(4) in order to produce

proportion to the ratio of its DPGR to total gross its $4,100,000 DPGR. Under the simplified deduc- the same effect as if S and B were divisions of a sin-

receipts. Thus, because B has no other gross receipts, tion method, the consolidated group apportions its gle corporation. If S and B were divisions of a single

all of B’s $100,000 of deductions is apportioned remaining $1,100,000 of deductions ($1,000,000 corporation, there would be no DPGR with respect to

to DPGR ($100,000 x $4,100,000/$4,100,000). from A and $100,000 from B) to DPGR in propor- the office furniture because there would be no lease,

Accordingly, B’s QPAI is $2,000,000 ($4,100,000 tion to the consolidated group’s ratio of its DPGR to rental, license, sale, exchange, or other disposition of

DPGR - $2,000,000 CGS - $100,000 deductions total gross receipts. Thus, $635,211 ($1,100,000 x the furniture by the single corporation (and no CGS or

apportioned to its DPGR). $4,100,000/$7,100,000) is allocated to DPGR. Ac- other deductions allocable to DPGR). Thus, in order

Example 6. (i) Facts. The facts are the same cordingly, the consolidated group’s QPAI for 2008 to produce the same effect as if S and B were divisions

as in Example 5 except that A and B are members is $1,964,789 ($4,100,000 DPGR - $1,500,000 CGS of a single corporation, S’s gross receipts are redeter-

of the same consolidated group, B does not sell the - $635,211 deductions apportioned to its DPGR), mined as non-DPGR. Accordingly, the consolidated

televisions purchased from A until 2008, and B’s the same QPAI that would result if A and B were group has no DPGR (and no CGS or other deductions

$100,000 paid for administrative services are paid divisions of a single corporation. allocated or apportioned to DPGR) and receives no

in 2008 for services performed in 2008. In addition, (v) Allocation of consolidated group’s 2008 sec- section 199 deduction in 2007.

in 2008, A has $3,000,000 in gross receipts from tion 199 deduction to its members. (A) A’s QPAI. Example 8. (i) Facts. A and B are members of the

computer consulting services with unrelated persons For purposes of allocating the consolidated group’s same consolidated group that files its Federal income

and $1,000,000 in related deductions. section 199 deduction to its members, pursuant to tax returns on a calendar year basis. On January 1,

(ii) Consolidated group’s 2007 QPAI. The con- paragraph (d)(5) of this section, the redetermination 2007, A MPGE QPP which is 10-year recovery prop-

solidated group’s DPGR and total gross receipts of A’s $2,000,000 in receipts is disregarded. Accord- erty for $100 and depreciates it under the straight-line

in 2007 are $10,000,000 and $13,000,000, respec- ingly, for this purpose, A’s DPGR are $2,000,000 method. On January 1, 2009, A sells the property to

tively, because, pursuant to paragraph (d)(1) of this (receipts from the sale of televisions to B taken into B for $130. Under section 168(i)(7), B is treated as

section and §1.1502–13, the sale of the televisions account in 2008) and its total receipts are $5,000,000 A for purposes of section 168 to the extent B’s $130

from A to B is not taken into account in 2007. In ($2,000,000 DPGR + $3,000,000 non-DPGR from basis does not exceed A’s adjusted basis at the time of

order to determine the consolidated group’s QPAI, its computer consulting services). In determining A’s the sale. B’s additional basis is treated as new 10-year

the consolidated group subtracts its $4,500,000 QPAI, A subtracts its $1,500,000 CGS from the tele- recovery property for which B elects the straight-line

CGS from the televisions sold to unrelated persons visions sold to B from its $2,000,000 DPGR. Under







June 19, 2006 1116 2006–25 I.R.B.

method of recovery. (To simplify the example, the Example 9. Corporations X, Y, and Z are mem- many years. The X and P consolidated groups each

half-year convention is disregarded.) bers of the same EAG but are not members of a con- file their consolidated Federal income tax returns on

(ii) Depreciation; intercompany gain. A claims solidated group. X, Y, and Z each files Federal in- a calendar year basis. X, Y, P and S are members

$10 of depreciation for each taxable year 2007 and come tax returns on a calendar year basis. Assume of the same EAG in 2008. In 2007, the X consoli-

2008 and has an $80 basis at the time of the sale to that the EAG has W–2 wages in excess of the sec- dated group incurred a consolidated net operating loss

B. Thus, A has a $50 intercompany gain from its sale tion 199(b) wage limitation. Prior to 2007, X had (CNOL) of $25,000, none of which was carried back

to B. For each taxable year 2009 through 2016, B has no taxable income or loss. In 2007, X has $0 of and used to offset taxable income of prior taxable

$10 of depreciation with respect to $80 of its basis taxable income and $2,000 of QPAI, Y has $4,000 years. Neither P nor S (nor the P consolidated group)

(the portion of its $130 basis not exceeding A’s ad- of taxable income and $3,000 of QPAI, and Z has has ever incurred an NOL. In 2008, the X consoli-

justed basis) and $5 of depreciation with respect to $4,000 of taxable income and $5,000 of QPAI. Ac- dated group has (prior to the deduction under section

the $50 of its additional basis that exceeds A’s ad- cordingly, the EAG has taxable income of $8,000, 172) taxable income of $8,000 and the P consolidated

justed basis. For each taxable year 2017 and 2018, B the sum of X’s taxable income of $0, Y’s taxable in- group has taxable income of $20,000. The X consol-

has $5 of depreciation with respect to the $50 of its come of $4,000, and Z’s taxable income of $4,000. idated group uses $8,000 of its CNOL from 2007 to

additional basis that exceeds A’s adjusted basis. The EAG has QPAI of $10,000, the sum of X’s QPAI offset the X consolidated group’s taxable income in

(iii) Timing. A’s $50 gain is taken into account of $2,000, Y’s QPAI of $3,000, and Z’s QPAI of 2008. None of the X consolidated group’s remaining

to reflect the difference for each consolidated return $5,000. Because X’s, Y’s, and Z’s taxable years all CNOL may be used to offset taxable income of the

year between B’s depreciation taken into account began in 2007, the transition percentage under sec- P consolidated group under paragraph (b)(3) of this

with respect to the property and the depreciation that tion 199(a)(2) is 6%. Thus, the EAG’s section 199 section. Accordingly, for purposes of determining the

would have been taken into account if A and B were deduction for 2007 is $480 (6% of the lesser of the EAG’s section 199 deduction, the EAG has taxable

divisions of a single corporation. For each taxable EAG’s taxable income of $8,000 or the EAG’s QPAI income of $20,000 (the X consolidated group’s tax-

year 2009 through 2016, B takes into account $15 of $10,000). Pursuant to paragraph (c)(1) of this sec- able income (after the deduction under section 172)

of depreciation rather than the $10 of depreciation tion, the $480 section 199 deduction is allocated to X, of $0 plus the P consolidated group’s taxable income

that would have been taken into account if A and Y, and Z in proportion to their respective amounts of of $20,000).

B were divisions of a single corporation. For each QPAI, that is $96 to X ($480 x $2,000/$10,000), $144 (f) Allocation of income and loss by a

taxable year 2017 and 2018, B takes into account to Y ($480 x $3,000/$10,000), and $240 to Z ($480

corporation that is a member of the ex-

$5 of depreciation rather than the $0 of depreciation x $5,000/$10,000). Although X’s taxable income for

that would have been taken into account if A and 2007 determined prior to allocation of a portion of the

panded affiliated group for only a portion

B were divisions of a single corporation (the QPP EAG’s section 199 deduction to it was $0, pursuant to of the year—(1) In general. A corporation

would have been fully depreciated after the 2016 paragraph (c)(2) of this section X will have an NOL that becomes or ceases to be a member of

taxable year if A and B were divisions of a single for 2007 equal to $96. Because X’s NOL for 2007 an EAG during its taxable year must allo-

corporation). Thus, A takes $5 of gain into account cannot be carried back to a previous taxable year, X’s

cate its taxable income or loss, QPAI, and

in each of the 2009 through 2018 taxable years (10% NOL carryover to 2008 will be $96.

of its $50 gain). Pursuant to §1.199–7(d)(1), A takes Example 10. (i) Facts. Corporation P owns all

W–2 wages between the portion of the tax-

its sale to B into account in computing the section of the stock of Corporations S and T, and P, S, and able year that it is a member of the EAG

199 deduction at the same time and in the same T file a consolidated Federal income tax return on a and the portion of the taxable year that it is

proportion as A takes into account the income, gain, calendar year basis. In 2007, P MPGE QPP in the not a member of the EAG. In general, this

deduction, or loss from the intercompany transaction United States at a cost of $1,000. On November 30,

allocation of items is made by using the pro

under §1.1502–13. Thus, in each taxable year 2009 2007, P sells the QPP to S for $2,500. On February

through 2018, A takes into account $13 of gross 28, 2008, P disposes of 60% of the stock of S. On

rata allocation method described in para-

receipts (10% of its $130 gross receipts) from the June 30, 2008, S sells the QPP to an unrelated person graph (f)(1)(i) of this section. However,

sale to B. The group’s income in each taxable year for $3,000. a corporation may elect to use the section

2009 through 2016 is a $10 loss ($5 gain - $15 de- (ii) Analysis. Because P and S are members 199 closing of the books method described

preciation), the same net amount it would have been of a consolidated group in 2007, pursuant to

in paragraph (f)(1)(ii) of this section. Nei-

if A and B were divisions of a single corporation. §1.199–7(d)(1) and §1.1502–13, neither P’s $1,500

The group’s income in each taxable year 2017 and of gain on the sale of QPP to S nor P’s $2,500 gross

ther the pro rata allocation method nor the

2018 is $0 ($5 gain - $5 depreciation), the same net receipts from the sale are taken into account in 2007. section 199 closing of the books method is

amount it would have been if A and B were divisions Under §1.1502–13(d), P takes the intercompany a method of accounting.

of a single corporation. transaction into account immediately before S be- (i) Pro rata allocation method. Under

(iv) Attributes. If A and B were not members comes a non-member of the consolidated group. In

the pro rata allocation method, an equal

of a consolidated group, A’s gross receipts on the order to produce the same effect as if P and S were

sale of the QPP to B would be DPGR (assuming all divisions of a single corporation, P’s gross receipts

portion of a corporation’s taxable income

the other requirements of §1.199–3 are met). How- from the sale of the QPP to S are redetermined under or loss, QPAI, and W–2 wages for the tax-

ever, because A and B are members of a consolidated §1.1502–13(c)(1)(i) as non-DPGR. Further, because able year is assigned to each day of the cor-

group, the separate entity attributes of A’s DPGR may P and S are not members of the same EAG when S poration’s taxable year. Those items as-

be redetermined under §1.1502–13(c)(1)(i) or (c)(4) sells the QPP to the unrelated person, and because

signed to those days that the corporation

in order to produce the same effect as if A and B P’s transfer of the QPP to S did not take place in a

were divisions of a single corporation. If A and B transaction to which section 381(a) applies, S is not

was a member of the EAG are then aggre-

were divisions of a single corporation, there would treated as conducting the activities conducted by P in gated.

be no DPGR with respect to the QPP because there determining if S’s receipts are DPGR, notwithstand- (ii) Section 199 closing of the books

would be no lease, rental, license, sale, exchange, or ing that P and S were members of the same EAG method. Under the section 199 closing

other disposition of the QPP by the single corporation when P MPGE the QPP and when P sold the QPP to

of the books method, a corporation’s tax-

(and no CGS or other deductions allocable to DPGR). S. Accordingly, neither the P consolidated group nor

Thus, in order to produce the same effect as if A and S will have DPGR with respect to the QPP.

able income or loss, QPAI, and W–2 wages

B were divisions of a single corporation, A’s $13 of Example 11. Corporation X is the common parent for the period during which the corpora-

gross receipts taken into account in each year is re- of a consolidated group, consisting of X and Y, which tion was a member of an EAG are com-

determined as non-DPGR. Accordingly, the consoli- has filed a consolidated Federal income tax return for puted by treating the corporation’s taxable

dated group has no DPGR (and no CGS or other de- many years. Corporation P is the common parent of

year as two separate taxable years, the first

ductions allocable or apportioned to DPGR) and re- a consolidated group, consisting of P and S, which

ceives no section 199 deduction. has filed a consolidated Federal income tax return for

of which ends at the close of the day on







2006–25 I.R.B. 1117 June 19, 2006

which the corporation’s status as a mem- Example. Corporations X and Y, calendar year (ii) In computing X’s and Y’s respective sec-

ber of the EAG changes and the second of corporations, are members of the same EAG for the tion 199 deductions for their taxable years ending

which begins at the beginning of the day entire 2007 taxable year. Corporation Z, also a cal- December 31, 2007, X’s and Y’s taxable income,

endar year corporation, is a member of the EAG of QPAI, and W–2 wages from their respective taxable

after the corporation’s status as a member which X and Y are members for the first half of 2007 years ending December 31, 2007, are aggregated.

of the EAG changes. and not a member of any EAG for the second half of The EAG’s QPAI for this purpose is $2,000 (X’s

(iii) Making the section 199 closing of 2007. During the 2007 taxable year, Z does not join QPAI of $8,000 + Y’s QPAI of ($6,000)). Because

the books election. A corporation makes in the filing of a consolidated return. Z makes a sec- the taxable years of the computing members, X and

the section 199 closing of the books elec- tion 199 closing of the books election. As a result, Y, began in 2007, the transition percentage under

Z has $80 of taxable income and $100 of QPAI that section 199(a)(2) is 6%. Accordingly, the EAG’s

tion by making the following statement: is allocated to the first half of 2007 and a $150 tax- section 199 deduction is $120 ($2,000 x .06). The

“The section 199 closing of the books able loss and ($200) of QPAI that is allocated to the $120 deduction is allocated to each of X and Y in

election is hereby made with respect to second half of 2007. Taking into account Z’s taxable proportion to their respective QPAI as a percentage

[insert name of corporation and its em- income, QPAI, and W–2 wages allocated to the first of the QPAI of each member of the EAG that was

ployer identification number] with respect half of 2007 pursuant to the section 199 closing of taken into account in computing the EAG’s section

the books election, the EAG has positive taxable in- 199 deduction. Pursuant to paragraph (c)(1) of

to the following periods [insert dates of come and QPAI for 2007 and W–2 wages in excess of this section, in allocating the section 199 deduction

the two periods between which items are the section 199(b) wage limitation. Because the EAG between X and Y, because Y’s QPAI is negative, Y’s

allocated pursuant to the closing of the has both positive taxable income and QPAI and suf- QPAI is treated as being $0. Accordingly, X’s section

books method].” The statement must be ficient W–2 wages, and because Z has positive QPAI 199 deduction for its taxable year ending December

filed with the corporation’s timely filed for the first half of 2007, a portion of the EAG’s sec- 31, 2007, is $120 ($120 x $8,000/($8,000 + $0)).

tion 199 deduction is allocated to Z. Because Z has Y’s section 199 deduction for its taxable year ending

(including extensions) Federal income tax negative QPAI for the second half of 2007, Z is al- December 31, 2007, is $0 ($120 x $0/($8,000 + $0)).

return for the taxable year that includes lowed no section 199 deduction for the second half of (iii) In computing Z’s section 199 deduction for

the periods that are subject to the election. 2007. Thus, despite the fact that Z has a $70 taxable its taxable year ending June 30, 2008, X’s and Y’s

Once made, a section 199 closing of the loss and ($100) of QPAI for the entire 2007 taxable items from their respective taxable years ending De-

books election is irrevocable. year, Z is entitled to a section 199 deduction for 2007 cember 31, 2007, are taken into account. Therefore,

equal to the section 199 deduction allocated to Z as a X’s and Y’s taxable income or loss, determined with-

(2) Coordination with rules relat- member of the EAG. out regard to the section 199 deduction, QPAI, and

ing to the allocation of income under (h) Computation of section 199 deduc- W–2 wages from their taxable years ending Decem-

§1.1502–76(b). If §1.1502–76(b) (relating tion for members of an expanded affiliated ber 31, 2007, are aggregated with Z’s taxable in-

to items included in a consolidated return) come or loss, QPAI, and W–2 wages from its tax-

group with different taxable years—(1) In able year ending June 30, 2008. The EAG’s QPAI is

applies to a corporation that is a member general. If members of an EAG have dif- $4,000 (X’s QPAI of $8,000 + Y’s QPAI of ($6,000)

of an EAG, then any allocation of items ferent taxable years, in determining the + Z’s QPAI of $2,000). Because the taxable year of

required under this paragraph (f) is made section 199 deduction of a member (the the computing member, Z, began in 2007, the transi-

only after the allocation of the corpora- computing member), the computing mem- tion percentage under section 199(a)(2) is 6%. Ac-

tion’s items pursuant to §1.1502–76(b). cordingly, the EAG’s section 199 deduction is $240

ber is required to take into account the tax- ($4,000 x .06). A portion of the $240 deduction is

(g) Total section 199 deduction for a able income or loss, determined without allocated to Z in proportion to its QPAI as a percent-

corporation that is a member of an ex- regard to the section 199 deduction, QPAI, age of the QPAI of each member of the EAG that was

panded affiliated group for some or all of and W–2 wages of each other group mem- taken into account in computing the EAG’s section

its taxable year—(1) Member of the same ber that are both— 199 deduction. Pursuant to paragraph (c)(1) of this

expanded affiliated group for the entire section, in allocating a portion of the $240 deduc-

(i) Attributable to the period that each tion to Z, because Y’s QPAI is negative, Y’s QPAI

taxable year. If a corporation is a mem- other member of the EAG and the comput- is treated as being $0. Z’s section 199 deduction for

ber of the same EAG for its entire taxable ing member are members of the EAG; and its taxable year ending June 30, 2008, is $48 ($240 x

year, the corporation’s section 199 deduc- (ii) Taken into account in a taxable year $2,000/($8,000 + $0 + $2,000)).

tion for the taxable year is the amount of that begins after the effective date of sec-

the section 199 deduction allocated to the §1.199–8 Other rules.

tion 199 and such taxable year ends with

corporation by the EAG under paragraph or within the taxable year of the computing

(c)(1) of this section. (a) In general. The provisions of this

member with respect to which the section section apply solely for purposes of sec-

(2) Member of the expanded affiliated 199 deduction is computed.

group for a portion of the taxable year. If tion 199 of the Internal Revenue Code

(2) Example. The following example (Code). When calculating the deduction

a corporation is a member of an EAG only illustrates the application of this paragraph

for a portion of its taxable year and is either under §1.199–1(a) (section 199 deduc-

(h): tion), taxpayers are required to make

not a member of any EAG or is a member Example. (i) Corporations X, Y, and Z are mem-

of another EAG, or both, for another por- bers of the same EAG. Neither X, Y, nor Z is a mem-

numerous allocations under §§1.199–1

tion of the taxable year, the corporation’s ber of a consolidated group. X and Y are calendar through 1.199–9. In making these alloca-

section 199 deduction for the taxable year year taxpayers and Z is a June 30 fiscal year taxpayer. tions, taxpayers may use any reasonable

Z came into existence on July 1, 2007. Each corpo- method that is satisfactory to the Secretary

is the sum of its section 199 deductions for ration has taxable income that exceeds its QPAI and

each portion of the taxable year. based on all of the facts and circumstances,

has sufficient W–2 wages to avoid the limitation un-

(3) Example. The following example der section 199(b). For the taxable year ending De-

unless the regulations under §§1.199–1

illustrates the application of paragraphs (f) cember 31, 2007, X’s QPAI is $8,000 and Y’s QPAI through 1.199–9 specify a method. A

and (g) of this section: is ($6,000). For its taxable year ending June 30, 2008, change in a taxpayer’s method of allocat-

Z’s QPAI is $2,000. ing or apportioning gross receipts, cost of





June 19, 2006 1118 2006–25 I.R.B.

goods sold (CGS), expenses, losses, or de- ject to tax under section 511(a)), a taxpayer fying in-kind partnership (as defined in

ductions (deductions) does not constitute a must deduct an amount equal to 9 percent §1.199–9(i)) and an EAG partnership, if

change in method of accounting to which (3 percent in the case of taxable years property is transferred by a partnership to

the provisions of sections 446 and 481 and beginning in 2005 or 2006, and 6 percent a partner in a transaction to which section

the regulations thereunder apply. in the case of taxable years beginning in 731 applies, then whether gross receipts

(b) Individuals. In the case of an in- 2007, 2008, or 2009) of the lesser of the derived by the partner are DPGR shall be

dividual, the section 199 deduction is taxpayer’s QPAI for the taxable year, or determined based on the activities per-

equal to the applicable percentage of the the taxpayer’s AMTI for the taxable year, formed by the partner without regard to

lesser of the taxpayer’s qualified produc- determined without regard to the section the activities performed by the partnership

tion activities income (QPAI) (as defined 199 deduction. For purposes of comput- before the distribution of the property to

in §1.199–1(c)) for the taxable year, or ing AMTI, QPAI is determined without the partner.

adjusted gross income (AGI) for the tax- regard to any adjustments under sections (ii) Exceptions—(A) Section 708(b)

able year determined after applying sec- 56 through 59. In the case of an individ- (1)(B). If property is deemed to be con-

tions 86, 135, 137, 219, 221, 222, and 469, ual or a non-grantor trust or estate, AGI tributed by a partnership (transferor part-

and without regard to section 199. and taxable income are also determined nership) to another partnership (transferee

(c) Trade or business requirement—(1) without regard to any adjustments under partnership) as a result of a termina-

In general. Sections 1.199–1 through sections 56 through 59. The amount of the tion under section 708(b)(1)(B), then the

1.199–9 are applied by taking into account deduction allowable under this paragraph transferee partnership shall be treated as

only items that are attributable to the ac- (d) for any taxable year cannot exceed 50 performing those activities performed by

tual conduct of a trade or business. percent of the W–2 wages of the employer the transferor partnership with respect to

(2) Individuals. An individual engaged for the taxable year (as determined under the transferred property of the transferor

in the actual conduct of a trade or business §1.199–2). The section 199 deduction is partnership.

must apply §§1.199–1 through 1.199–9 not taken into account in determining the (B) Transfers by reason of death. If

by taking into account in computing QPAI amount of the alternative tax net operating property is transferred upon or by reason

only items that are attributable to that loss deduction (ATNOL) allowed under of the death of an individual (decedent),

trade or business (or trades or businesses) section 56(a)(4). For example, assume that then the decedent’s successor(s) in interest

and any items allocated from a pass-thru for the calendar year 2007, a corporation shall be treated as having performed those

entity engaged in a trade or business. has both AMTI (before the NOL deduction activities performed by or deemed to have

Compensation received by an individual and before the section 199 deduction) and been performed (pursuant to §1.199–9(i))

employee for services performed as an QPAI of $1,000,000, and has an ATNOL by the decedent with respect to the trans-

employee is not considered gross receipts carryover to 2007 of $5,000,000. Assume ferred property. For this purpose, a transfer

for purposes of computing QPAI under that the taxpayer has W–2 wages in ex- shall include without limitation the passing

§§1.199–1 through 1.199–9. Similarly, cess of the section 199(b) wage limitation. of the property by bequest, contractual pro-

any costs or expenses paid or incurred by Under section 56(d), the ATNOL deduc- vision, beneficiary designation, or opera-

an individual employee with respect to tion for 2007 is $900,000 (90 percent of tion of law, and successor in interest shall

those services performed as an employee $1,000,000), reducing AMTI to $100,000. include without limitation the decedent’s

are not considered CGS or deductions of The taxpayer must then further reduce heirs or legatees, the decedent’s estate or

that employee for purposes of computing the AMTI by the section 199 deduction trust, or the beneficiary or beneficiaries of

QPAI under §§1.199–1 through 1.199–9. of $6,000 (six percent of the lesser of the decedent’s estate or trust.

(3) Trusts and estates. For purposes of $1,000,000 or $100,000) to $94,000. The (2) Section 1031 exchanges. If a tax-

this paragraph (c), a trust or estate is treated ATNOL carryover to 2008 is $4,100,000. payer exchanges property for replacement

as an individual. (e) Nonrecognition transactions—(1) property in a transaction to which section

(d) Coordination with alternative min- In general—(i) Sections 351, 721, and 1031 applies, then whether the gross re-

imum tax. For purposes of determin- 731. Except as provided for an EAG ceipts derived from the lease, rental, li-

ing alternative minimum taxable income partnership (as defined in §1.199–9(j)) cense, sale, exchange, or other disposi-

(AMTI) under section 55, a taxpayer that and an expanded affiliated group (EAG) tion of the replacement property are DPGR

is not a corporation must deduct an amount (as defined in §1.199–7), if property is shall be determined based solely on the ac-

equal to 9 percent (3 percent in the case of transferred by the taxpayer to an entity tivities performed by the taxpayer with re-

taxable years beginning in 2005 or 2006, in a transaction to which section 351 or spect to the replacement property.

and 6 percent in the case of taxable years 721 applies, then whether the gross re- (3) Section 381 transactions. If a

beginning in 2007, 2008, or 2009) of the ceipts derived by the entity are domestic corporation (the acquiring corporation)

lesser of the taxpayer’s QPAI for the tax- production gross receipts (DPGR) (as de- acquires the assets of another corporation

able year, or the taxpayer’s taxable income fined in §1.199–3) shall be determined (the target corporation) in a transaction

for the taxable year, determined without based solely on the activities performed to which section 381(a) applies, then the

regard to the section 199 deduction (or in by the entity without regard to the ac- acquiring corporation shall be treated as

the case of an individual, AGI). For pur- tivities performed by the taxpayer prior performing those activities of the target

poses of determining AMTI in the case of to the contribution of the property to the corporation with respect to the acquired

a corporation (including a corporation sub- entity. Except as provided for a quali- assets of the target corporation. Therefore,





2006–25 I.R.B. 1119 June 19, 2006

to the extent that the acquired assets of the taxpayer changes its overall method taxpayer must use the section 861 method

the target corporation would have given of accounting from an accrual method to to allocate and apportion half the section

rise to DPGR if leased, rented, licensed, the cash method) and the section 481(a) 481(a) adjustment for that taxable year

sold, exchanged, or otherwise disposed adjustment cannot be specifically identi- between DPGR and non-DPGR for that

of by the target corporation, such assets fied with either gross receipts, CGS, or taxable year.

will give rise to DPGR if leased, rented, deductions, then the section 481(a) ad- (h) Disallowed losses or deduc-

licensed, sold, exchanged, or otherwise justment, whether positive or negative, tions. Except as provided by publica-

disposed of by the acquiring corporation must be attributed to, or among, gross tion in the Internal Revenue Bulletin (see

(assuming all the other requirements of receipts, CGS, or deductions using any §601.601(d)(2)(ii)(b) of this chapter),

§1.199–3 are met). reasonable method that is satisfactory to losses or deductions of a taxpayer that

(f) Taxpayers with a 52–53 week tax- the Secretary based on all of the facts and otherwise would be taken into account

able year. For purposes of applying circumstances, and then allocated or ap- in computing the taxpayer’s section 199

§1.441–2(c)(1) in the case of a taxpayer portioned between DPGR and non-DPGR deduction are taken into account only if

using a 52–53 week taxable year, any ref- using the same methods the taxpayer uses and to the extent the deductions are not

erence in section 199(a)(2) (the phase-in to allocate or apportion gross receipts, disallowed by section 465 or 469, or any

rule), §§1.199–1 through 1.199–9 to a CGS, or deductions between DPGR and other provision of the Code. If only a por-

taxable year beginning after a particular non-DPGR for the taxable year or taxable tion of the taxpayer’s share of the losses or

calendar year means a taxable year be- years that the section 481(a) adjustment deductions is allowed for a taxable year,

ginning after December 31st of that year. is taken into account. Factors taken into the proportionate share of those allowable

Similarly, any reference to a taxable year consideration in determining whether the losses or deductions that are allocated to

beginning in a particular calendar year method is reasonable include whether the the taxpayer’s qualified production activ-

means a taxable year beginning after De- taxpayer uses the most accurate informa- ities, determined in a manner consistent

cember 31st of the preceding calendar tion available; the relationship between with sections 465 and 469, and any other

year. For example, a 52–53 week taxable the section 481(a) adjustment and the ap- applicable provision of the Code, is taken

year that begins on December 26, 2006, is portionment base chosen; the accuracy of into account in computing QPAI for pur-

deemed to begin on January 1, 2007, and the method chosen as compared with other poses of the section 199 deduction for that

the transition percentage for that taxable possible methods; and the time, burden, taxable year. To the extent that any of

year is 6 percent. and cost of using alternative methods. the disallowed losses or deductions are al-

(g) Section 481(a) adjustments. For If a section 481(a) adjustment is spread lowed in a later taxable year, the taxpayer

purposes of determining QPAI, a section over more than one taxable year, then a takes into account a proportionate share

481(a) adjustment, whether positive or taxpayer must attribute the section 481(a) of those losses or deductions in comput-

negative, taken into account by a taxpayer adjustment among gross receipts, CGS, ing its QPAI for that later taxable year.

during the taxable year that is solely at- or deductions, as applicable, in the same Losses or deductions of the taxpayer that

tributable to either the taxpayer’s gross amount for each taxable year within the are disallowed for taxable years beginning

receipts, CGS, or deductions must be al- spread period. For example, if a taxpayer, on or before December 31, 2004, are not

located or apportioned between DPGR using a reasonable method that is satisfac- taken into account in a later taxable year

and non-DPGR using the methods used by tory to the Secretary based on all of the for purposes of computing the taxpayer’s

a taxpayer to allocate or apportion gross facts and circumstances, determines that a QPAI and the wage limitation of sec-

receipts, CGS, and deductions between section 481(a) adjustment that is required tion 199(d)(1)(A)(iii) under §1.199–9 for

DPGR and non-DPGR for the current tax- to be spread over four taxable years should that taxable year, regardless of whether the

able year. See §§1.199–1 and 1.199–4 be attributed half to gross receipts and half losses or deductions are allowed for other

for rules related to the allocation and ap- to deductions, then the taxpayer must at- purposes. For taxpayers that are partners

portionment of gross receipts, CGS, and tribute the section 481(a) adjustment half in partnerships, see §1.199–9(b)(2). For

deductions, respectively. For example, to gross receipts and half to deductions taxpayers that are shareholders in S corpo-

if a taxpayer changes its method of ac- in each of the four taxable years of the rations, see §1.199–9(c)(2).

counting for inventories from the last-in, spread period. Further, if such taxpayer (i) Effective dates—(1) In general. Sec-

first-out (LIFO) method to the first-in, uses the simplified deduction method to tion 199 applies to taxable years begin-

first-out (FIFO) method and the taxpayer apportion deductions between DPGR and ning after December 31, 2004. Sections

uses the small business simplified over- non-DPGR in the first taxable year of the 1.199–1 through 1.199–8 are applicable

all method to apportion CGS between spread period, then the taxpayer must use for taxable years beginning on or after

DPGR and non-DPGR, the taxpayer is the simplified deduction method to ap- June 1, 2006. For a taxable year be-

required to apportion the resulting section portion half the section 481(a) adjustment ginning on or before May 17, 2006, the

481(a) adjustment, whether positive or for that taxable year between DPGR and enactment date of the Tax Increase Pre-

negative, between DPGR and non-DPGR non-DPGR for that taxable year. Simi- vention and Reconciliation Act of 2005

using the small business simplified overall larly, if in the second taxable year of the (Public Law 109–222, 120 Stat. 345), a

method. If a section 481(a) adjustment is spread period the taxpayer uses the section taxpayer may apply §§1.199–1 through

not solely attributable to either gross re- 861 method to apportion and allocate costs 1.199–9 provided that the taxpayer ap-

ceipts, CGS, or deductions (for example, between DPGR and non-DPGR, then the plies all provisions in §§1.199–1 through





June 19, 2006 1120 2006–25 I.R.B.

1.199–9 to the taxable year. For a taxable Prevention and Reconciliation Act of in the Internal Revenue Bulletin (see

year beginning after May 17, 2006, and 2005. §601.601(d)(2)(ii)(b) of this chapter), per-

before June 1, 2006, a taxpayer may ap- mit a partnership to calculate a partner’s

ply §§1.199–1 through 1.199–8 provided (a) In general. The provisions of this share of QPAI at the entity level, instead

that the taxpayer applies all provisions section apply solely for purposes of section of allocating, in accordance with sections

in §§1.199–1 through 1.199–8 to the tax- 199 of the Internal Revenue Code (Code). 702 and 704, the partner’s share of part-

able year. For a taxpayer who chooses (b) Partnerships—(1) In general—(i) nership items (including items of income,

not to rely on these final regulations for Determination at partner level. The de- gain, loss, and deduction). If a partnership

a taxable year beginning before June 1, duction with respect to the qualified pro- does calculate QPAI at the entity level—

2006, the guidance under section 199 that duction activities of the partnership allow- (A) The partner is allocated its share

applies to such taxable year is contained able under §1.199–1(a) (section 199 de- of QPAI and W–2 wages (as defined in

in Notice 2005–14, 2005–1 C.B. 498 (see duction) is determined at the partner level. §1.199–2(e)), which (subject to the lim-

§601.601(d)(2) of this chapter). In ad- As a result, each partner must compute its itations of paragraph (b)(2) of this sec-

dition, a taxpayer also may rely on the deduction separately. The section 199 de- tion and section 199(d)(1)(A)(iii), respec-

provisions of REG–105847–05, 2005–47 duction has no effect on the adjusted ba- tively) are combined with the partner’s

I.R.B. 987 (see §601.601(d)(2) of this sis of the partner’s interest in the part- QPAI and W–2 wages from other sources;

chapter), for a taxable year beginning nership. Except as provided by publi- (B) For purposes of computing QPAI

before June 1, 2006. If Notice 2005–14 cation pursuant to paragraph (b)(1)(ii) of under §§1.199–1 through 1.199–9, a part-

and REG–105847–05 include different this section, for purposes of this section, ner does not take into account the items

rules for the same particular issue, then a each partner is allocated, in accordance from such a partnership (for example, a

taxpayer may rely on either the rule set with sections 702 and 704, its share of partner does not take into account items

forth in Notice 2005–14 or the rule set partnership items (including items of in- from such a partnership in determining

forth in REG–105847–05. However, if come, gain, loss, and deduction), cost of whether a threshold or de minimis rule ap-

REG–105847–05 includes a rule that was goods sold (CGS) allocated to such items plies or when the partner allocates and ap-

not included in Notice 2005–14, then a of income, and gross receipts that are in- portions deductions in calculating its QPAI

taxpayer is not permitted to rely on the cluded in such items of income, even if the from other sources);

absence of a rule in Notice 2005–14 to partner’s share of CGS and other deduc- (C) A partner generally does not recom-

apply a rule contrary to REG–105847–05. tions and losses exceeds domestic produc- pute its share of QPAI from the partnership

For taxable years beginning after May tion gross receipts (DPGR) (as defined in using another method; however, the part-

17, 2006, and before June 1, 2006, a tax- §1.199–3(a)) and regardless of the amount ner might have to adjust its share of QPAI

payer may not apply Notice 2005–14, of the partner’s share of W–2 wages (as from the partnership to take into account

REG–105847–05, or any other guidance defined in §1.199–2(e)) of the partnership certain disallowed losses or deductions, or

under section 199 in a manner inconsistent for the taxable year. A partnership may the allowance of suspended losses or de-

with amendments made to section 199 by specially allocate items of income, gain, ductions; and

section 514 of the Tax Increase Prevention loss, or deduction to its partners, subject (D) A partner’s distributive share of

and Reconciliation Act of 2005. to the rules of section 704(b) and the sup- QPAI from a partnership may be less than

(2) Pass-thru entities. In determining porting regulations. Guaranteed payments zero.

the deduction under section 199, items under section 707(c) are not considered al- (2) Disallowed losses or deduc-

arising from a taxable year of a part- locations of partnership income for pur- tions. Except as provided by publica-

nership, S corporation, estate, or trust poses of this section. Guaranteed pay- tion in the Internal Revenue Bulletin (see

beginning before January 1, 2005, shall ments under section 707(c) are deductions §601.601(d)(2)(ii)(b) of this chapter),

not be taken into account for purposes of by the partnership that must be taken into losses or deductions of a partnership that

section 199(d)(1). account under the rules of §1.199–4. See otherwise would be taken into account in

(3) Non-consolidated EAG members. A §1.199–3(p) and paragraph (b)(6) Example computing the partner’s section 199 de-

member of an EAG that is not a member 5 of this section. Except as provided in duction for a taxable year are taken into

of a consolidated group may apply para- paragraph (b)(1)(ii) of this section, to de- account in that year only if and to the

graph (i)(1) of this section without regard termine its section 199 deduction for the extent the partner’s distributive share of

to how other members of the EAG apply taxable year, a partner aggregates its dis- those losses or deductions from all of the

paragraph (i)(1) of this section. tributive share of such items, to the extent partnership’s activities is not disallowed

(4) Computer software provided to cus- they are not otherwise disallowed by the by section 465, 469, or 704(d), or any

tomers over the Internet. [Reserved]. For Code, with those items it incurs outside the other provision of the Code. If only a

further guidance, see §1.199–8T(i)(4). partnership (whether directly or indirectly) portion of the partner’s distributive share

for purposes of allocating and apportion- of the losses or deductions is allowed for

§1.199–9 Application of section 199 ing deductions to DPGR and computing a taxable year, a proportionate share of

to pass-thru entities for taxable years its qualified production activities income those allowable losses or deductions that

beginning on or before May 17, 2006, (QPAI) (as defined in §1.199–1(c)). are allocated to the partnership’s quali-

the enactment date of the Tax Increase (ii) Determination at entity level. fied production activities, determined in

The Secretary may, by publication a manner consistent with sections 465,





2006–25 I.R.B. 1121 June 19, 2006

469, and 704(d), and any other applicable in the same manner as wage expense. The (5) Partnerships electing out of sub-

provision of the Code, is taken into ac- partner must add the partner’s share of chapter K. For purposes of §§1.199–1

count in computing QPAI and the wage the W–2 wages from the partnership, as through 1.199–9, the rules of paragraph

limitation of section 199(d)(1)(A)(iii) for limited by section 199(d)(1)(A)(iii), to the (b) of this section shall apply to all partner-

that taxable year. To the extent that any partner’s W–2 wages from other sources, ships, including those partnerships elect-

of the disallowed losses or deductions are if any. If QPAI, computed by taking into ing under section 761(a) to be excluded,

allowed in a later taxable year, the partner account only the items of the partnership in whole or in part, from the application of

takes into account a proportionate share allocated to the partner for the taxable subchapter K of chapter 1 of the Code.

of those losses or deductions in comput- year (as required by the wage limitation (6) Examples. The following examples

ing its QPAI for that later taxable year. of section 199(d)(1)(A)(iii)) is not greater illustrate the application of this paragraph

Losses or deductions of the partnership than zero, then the partner may not take (b). Assume that each partner has suf-

that are disallowed for taxable years be- into account any W–2 wages of the part- ficient adjusted gross income or taxable

ginning on or before December 31, 2004, nership in applying the wage limitation income so that the section 199 deduction

are not taken into account in a later tax- of §1.199–2 (but the partner will, never- is not limited under section 199(a)(1)(B);

able year for purposes of computing the theless, aggregate its distributive share of that the partnership and each of its partners

partner’s QPAI or the wage limitation of partnership items including wage expense (whether individual or corporate) are cal-

section 199(d)(1)(A)(iii) for that taxable with those items not from the partnership endar year taxpayers; and that the amount

year, regardless of whether the losses or in computing its QPAI when determining of the partnership’s W–2 wages equals

deductions are allowed for other purposes. its section 199 deduction). See §1.199–2 wage expense for each taxable year. The

(3) Partner’s share of W–2 wages. for the computation of W–2 wages, and examples are as follows:

Under section 199(d)(1)(A)(iii), a part- paragraph (g) of this section for rules Example 1. Section 861 method with interest ex-

ner’s share of W–2 wages of a partnership regarding pass-thru entities in a tiered pense. (i) Partnership Federal income tax items. X

and Y, unrelated United States corporations, are each

for purposes of determining the part- structure. 50% partners in PRS, a partnership that engages in

ner’s section 199(b) wage limitation is (4) Transition percentage rule for W–2 production activities that generate both DPGR and

the lesser of the partner’s allocable share wages. With regard to partnerships, for non-DPGR. X and Y share all items of income, gain,

of those wages (without regard to sec- purposes of section 199(d)(1)(A)(iii)(II) loss, deduction, and credit 50% each. Both X and Y

tion 199(d)(1)(A)(iii)), or 2 times 3 per- the transition percentages determined un- are engaged in a trade or business. PRS is not able

to specifically identify CGS allocable to DPGR and

cent of the QPAI computed by taking into der section 199(a)(2) shall be determined non-DPGR. In this case, because CGS is definitely re-

account only the items of the partnership by reference to the partnership’s taxable lated under the facts and circumstances to all of PRS’s

allocated to the partner for the taxable year year. Thus, if a partner uses a calendar gross income, apportionment of CGS between DPGR

of the partnership. Except as provided by year taxable year, and owns an interest and non-DPGR based on gross receipts is appropriate.

publication in the Internal Revenue Bul- in a partnership that has a taxable year For 2006, the adjusted basis of PRS’s business as-

sets is $5,000, $4,000 of which generate gross income

letin (see §601.601(d)(2)(ii)(b) of this ending on April 30, the partner’s section attributable to DPGR and $1,000 of which generate

chapter), this QPAI calculation is per- 199(d)(1)(A)(iii) wage limitation for the gross income attributable to non-DPGR. For 2006,

formed by the partner using the same cost partnership’s taxable year beginning on PRS has the following Federal income tax items:

allocation method that the partner uses May 1, 2006, would be calculated using 3

in calculating the partner’s section 199 percent, even though the partner includes

deduction. The partnership must allocate the partner’s distributive share of partner-

W–2 wages (prior to the application of ship items from that taxable year on the

the wage limitation) among the partners partner’s 2007 Federal income tax return.



DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

Non-DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS (includes $200 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,240

Section 162 selling expenses (includes $300 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200

Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300





(ii) Allocation of PRS’s items of income, gain, the following distributive share of PRS’s items of in- come, gain, loss, deduction or credit, as determined

loss, deduction, or credit. X and Y each receive under the principles of §1.704–1(b)(1)(vii):





Gross income attributable to DPGR

($1,500 (DPGR) - $810 (allocable CGS,

includes $50 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $690

Gross income attributable to non-DPGR

($1,500 (non-DPGR) - $810 (allocable CGS,

includes $50 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $690

Section 162 selling expenses (includes $150 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600

Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150







June 19, 2006 1122 2006–25 I.R.B.

(iii) Determination of QPAI. (A) X’s QPAI. Be- are investment assets, is $10,000. X’s only gross re- of this specific case, apportionment of those expenses

cause the section 199 deduction is determined at the ceipts for 2006 are those attributable to the allocation between DPGR and non-DPGR on the basis of PRS’s

partner level, X determines its QPAI by aggregating, of gross income from PRS. X allocates and apportions gross receipts is appropriate. X elects to apportion

to the extent necessary, its distributive share of PRS’s its deductible items to gross income attributable to its distributive share of interest expense under the tax

Federal income tax items with all other such items DPGR under the section 861 method of §1.199–4(d). book value method of §1.861–9T(g). X’s QPAI for

from all other, non-PRS-related activities. For 2006, In this case, the section 162 selling expenses (includ- 2006 is $366, as shown below:

X does not have any other such items. For 2006, the ing W–2 wages) are definitely related to all of PRS’s

adjusted basis of X’s non-PRS assets, all of which gross receipts. Based on the facts and circumstances





DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

CGS allocable to DPGR (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($810)

Section 162 selling expenses (includes $75 of W–2 wages)

($600 x $1,500/$3,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

Interest expense (not included in CGS)

($150 x $2,000 (X’s share of PRS’s DPGR assets)/

$12,500 (X’s non-PRS assets ($10,000) and X’s share

of PRS assets ($2,500))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($24)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $366





(B) Y’s QPAI. (1) For 2006, in addition to the ac- to non-DPGR. For 2006, the adjusted basis of Y’s Y has no other assets. Y has the following Federal

tivities of PRS, Y engages in production activities non-PRS assets attributable to its production activi- income tax items relating to its non-PRS activities:

that generate both DPGR and non-DPGR. Y is able ties that generate DPGR is $8,000 and to other pro-

to specifically identify CGS allocable to DPGR and duction activities that generate non-DPGR is $2,000.





Gross income attributable to DPGR

($1,500 (DPGR) - $900 (allocable CGS,

includes $70 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600

Gross income attributable to non-DPGR

($3,000 (other gross receipts) - $1,620

(allocable CGS, includes $150 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,380

Section 162 selling expenses (includes $30 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540

Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $90





(2) Y determines its QPAI in the same general PRS’s section 162 selling expenses (including W–2 book value method of §1.861–9T(g). Y has $1,290

manner as X. However, because Y has other trade wages), as well as those selling expenses from Y’s of gross income attributable to DPGR ($3,000 DPGR

or business activities outside of PRS, Y must aggre- non-PRS activities, are definitely related to all of its ($1,500 from PRS and $1,500 from non-PRS activi-

gate its distributive share of PRS’s Federal income gross income. Based on the facts and circumstances ties) - $1,710 CGS ($810 from PRS and $900 from

tax items with its own such items. Y allocates and of this specific case, apportionment of those expenses non-PRS activities)). Y’s QPAI for 2006 is $642, as

apportions its deductible items to gross income at- between DPGR and non-DPGR on the basis of Y’s shown below:

tributable to DPGR under the section 861 method of gross receipts is appropriate. Y elects to apportion

§1.199–4(d). In this case, Y’s distributive share of its distributive share of interest expense under the tax





DPGR ($1,500 from PRS and $1,500 from

non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS allocable to DPGR ($810 from PRS and $900 from

non-PRS activities) (includes $120 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,710)

Section 162 selling expenses (includes $180 of W–2 wages)

($1,140 ($600 from PRS and $540 from non-PRS

activities) x ($1,500 PRS DPGR + $1,500 non-PRS

DPGR)/($3,000 PRS total gross receipts + $4,500

non-PRS total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($456)

Interest expense (not included in CGS)

($240 ($150 from PRS and $90 from non-PRS

activities) x $10,000 (Y’s non-PRS DPGR assets

($8,000) and Y’s share of PRS DPGR assets

($2,000))/$12,500 (Y’s non-PRS assets ($10,000) and

Y’s share of PRS assets ($2,500))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($192)

Y’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $642





(iv) PRS W–2 wages allocated to X and Y un- them under section 199(d)(1)(A)(iii) for purposes of the items of PRS allocated to them. X and Y must use

der section 199(d)(1)(A)(iii). Solely for purposes of the wage limitation of section 199(b), X and Y must the same methods of allocation and apportionment

calculating the PRS W–2 wages that are allocated to separately determine QPAI taking into account only that they use to determine their QPAI in paragraphs







2006–25 I.R.B. 1123 June 19, 2006

(iii)(A) and (B) of this Example 1, respectively. Ac- terest expense according to the tax book value method of PRS gross income of $690 attributable to DPGR

cordingly, X and Y must apportion deductible section of §1.861–9T(g). ($1,500 DPGR - $810 CGS, apportioned based on

162 selling expenses that include W–2 wage expense (A) QPAI of X and Y, solely for this purpose, is gross receipts). Thus, QPAI of X and Y solely for

on the basis of gross receipts, and must apportion in- determined by allocating and apportioning each part- this purpose is $270, as shown below:

ner’s share of PRS expenses to each partner’s share





DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

CGS allocable to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($810)

Section 162 selling expenses (including W–2 wages)

($600 x ($1,500/$3,000)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

Interest expense (not included in CGS)

($150 x $2,000 (partner’s share of adjusted basis of

PRS’s DPGR assets)/$2,500 (partner’s share of

adjusted basis of total PRS assets)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($120)

QPAI. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $270





(B) X’s and Y’s shares of PRS’s W–2 wages de- from PRS and $250 from non-PRS activities)). Ac- is not able to specifically identify CGS allocable to

termined under section 199(d)(1)(A)(iii) for purposes cordingly, Y’s section 199 deduction for 2006 is $19. DPGR and to non-DPGR and, therefore, apportions

of the wage limitation of section 199(b) are $16, the Example 2. Section 861 method with R&E ex- CGS to DPGR and non-DPGR based on its gross

lesser of $250 (partner’s allocable share of PRS’s pense. (i) Partnership items of income, gain, loss, receipts. PRS incurs $900 of research and experi-

W–2 wages ($100 included in total CGS, and $150 deduction or credit. X and Y, unrelated United States mentation expenses (R&E) that are deductible under

included in selling expenses) and $16 (2 x ($270 x corporations each of which is engaged in a trade section 174, $300 of which are performed with re-

.03)). or business, are partners in PRS, a partnership that spect to SIC AAA and $600 of which are performed

(v) Section 199 deduction determination. (A) X’s engages in production activities that generate both with respect to SIC BBB. None of the R&E is legally

tentative section 199 deduction is $11 (.03 x $366 DPGR and non-DPGR. Neither X nor Y is a member mandated R&E as described in §1.861–17(a)(4) and

(that is, QPAI determined at partner level)) subject to of an affiliated group. X and Y share all items of in- none is included in CGS. PRS incurs section 162

the wage limitation of $8 (50% x $16). Accordingly, come, gain, loss, deduction, and credit 50% each. All selling expenses (that include W–2 wage expense)

X’s section 199 deduction for 2006 is $8. of PRS’s domestic production activities that generate that are not includible in CGS and are definitely

(B) Y’s tentative section 199 deduction is $19 (.03 DPGR are within Standard Industrial Classification related to all of PRS’s gross income. For 2006, PRS

x $642 (that is, QPAI determined at the partner level) (SIC) Industry Group AAA (SIC AAA). All of PRS’s has the following Federal income tax items:

subject to the wage limitation of $133 (50% x ($16 production activities that generate non-DPGR are

within SIC Industry Group BBB (SIC BBB). PRS





DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

Non-DPGR (all from sales of products within SIC BBB). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS (includes $200 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400

Section 162 selling expenses (includes $100 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $840

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300

Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600





(ii) Allocation of PRS’s items of income, gain, the following distributive share of PRS’s items of in- come, gain, loss, deduction, or credit, as determined

loss, deduction, or credit. X and Y each receive under the principles of §1.704–1(b)(1)(vii):





Gross income attributable to DPGR

($1,500 (DPGR) - $600 (CGS, includes

$50 of W–2 wages)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900

Gross income attributable to non-DPGR

($1,500 (other gross receipts) - $600 (CGS,

includes $50 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900

Section 162 selling expenses (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $420

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150

Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300





(iii) Determination of QPAI. (A) X’s QPAI. Be- erate DPGR are within SIC AAA. X allocates and sales method as described in §1.861–17(c). Because

cause the section 199 deduction is determined at the apportions its deductible items to gross income at- X has no direct sales of products, and because all

partner level, X determines its QPAI by aggregat- tributable to DPGR under the section 861 method of of PRS’s SIC AAA sales attributable to X’s share

ing, to the extent necessary, its distributive shares of §1.199–4(d). In this case, the section 162 selling ex- of PRS’s gross income generate DPGR, all of X’s

PRS’s Federal income tax items with all other such penses (including W–2 wages) are definitely related share of PRS’s section 174 R&E attributable to SIC

items from all other, non-PRS-related activities. For to all of PRS’s gross income. Based on the facts and AAA is taken into account for purposes of determin-

2006, X does not have any other such tax items. X’s circumstances of this specific case, apportionment of ing X’s QPAI. Thus, X’s total QPAI for 2006 is $540,

only gross receipts for 2006 are those attributable to those expenses between DPGR and non-DPGR on as shown below:

the allocation of gross income from PRS. As stated, the basis of PRS’s gross receipts is appropriate. For

all of PRS’s domestic production activities that gen- purposes of apportioning R&E, X elects to use the







June 19, 2006 1124 2006–25 I.R.B.

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

CGS (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)

Section 162 selling expenses (including W–2 wages)

($420 x ($1,500 DPGR/$3,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($210)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($150)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540





(B) Y’s QPAI. (1) For 2006, in addition to the ac- to non-DPGR. In this case, because CGS is definitely gross receipts is appropriate. For 2006, Y has the fol-

tivities of PRS, Y engages in domestic production related under the facts and circumstances to all of Y’s lowing non-PRS Federal income tax items:

activities that generate both DPGR and non-DPGR. non-PRS gross receipts, apportionment of CGS be-

With respect to those non-PRS activities, Y is not able tween DPGR and non-DPGR based on Y’s non-PRS

to specifically identify CGS allocable to DPGR and





DPGR (from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

DPGR (from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

Non-DPGR (from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS (allocated to DPGR within SIC AAA)

(includes $56 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750

CGS (allocated to DPGR within SIC BBB)

(includes $56 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750

CGS (allocated to non-DPGR within SIC BBB)

(includes $113 of W–2 wages). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

Section 162 selling expenses (includes $30 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300

Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $450





(2) Because Y has DPGR as a result of activi- apportionment of such expenses between DPGR of the sales in SIC AAA generate DPGR, all of Y’s

ties outside PRS, Y must aggregate its distributive and non-DPGR on the basis of Y’s gross receipts share of PRS’s section 174 R&E attributable to SIC

share of PRS’s Federal income tax items with such is appropriate. For purposes of apportioning R&E, AAA and the section 174 R&E attributable to SIC

items from all its other, non-PRS-related activities. Y elects to use the sales method as described in AAA that Y incurs in its non-PRS activities are taken

Y allocates and apportions its deductible items to §1.861–17(c). into account for purposes of determining Y’s QPAI.

gross income attributable to DPGR under the section (3) With respect to sales that generate DPGR, Y Because only a portion of the sales within SIC BBB

861 method of §1.199–4(d). In this case, the section has gross income of $2,400 ($4,500 DPGR ($1,500 generate DPGR, only a portion of the section 174

162 selling expenses (including W–2 wages) are from PRS and $3,000 from non-PRS activities) - R&E attributable to SIC BBB is taken into account

definitely related to all of Y’s gross income. Based $2,100 CGS ($600 from sales of products by PRS in determining Y’s QPAI. Thus, Y’s QPAI for 2006

on the facts and circumstances of the specific case, and $1,500 from non-PRS activities)). Because all is $1,282, as shown below:





DPGR ($4,500 DPGR ($1,500 from PRS and $3,000

from non-PRS activities)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,500

CGS ($600 from sales of products by PRS and $1,500

from non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($2,100)

Section 162 selling expenses (including W–2 wages)

($420 from PRS + $540 from non-PRS activities) x

($4,500 DPGR/$9,000 total gross receipts) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($480)

Section 174 R&E-SIC AAA ($150 from PRS and $300

from non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($450)

Section 174 R&E-SIC BBB ($300 from PRS + $450

from non-PRS activities) x ($1,500 DPGR/$6,000

total gross receipts allocated to SIC BBB ($1,500

from PRS and $4,500 from non-PRS activities)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($188)

Y’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,282





(iv) PRS W–2 wages allocated to X and Y under tively. Accordingly, X and Y must apportion sec- gross receipts). Because all of PRS’s SIC AAA sales

section 199(d)(1)(A)(iii). Solely for purposes of cal- tion 162 selling expenses that include W–2 wage ex- generate DPGR, all of X’s and Y’s shares of PRS’s

culating the PRS W–2 wages that are allocated to X pense on the basis of gross receipts, and apportion section 174 R&E attributable to SIC AAA is taken

and Y under section 199(d)(1)(A)(iii) for purposes of section 174 R&E expense under the sales method as into account for purposes of determining X’s and Y’s

the wage limitation of section 199(b), X and Y must described in §1.861–17(c). QPAI. None of PRS’s section 174 R&E attributable

separately determine QPAI taking into account only (A) QPAI of X and Y, solely for this purpose, is to SIC BBB is taken into account because PRS has

the items of PRS allocated to them. X and Y must determined by allocating and apportioning each part- no DPGR within SIC BBB. Thus, X and Y each has

use the same methods of allocation and apportion- ner’s share of PRS expenses to each partner’s share QPAI, solely for this purpose, of $540, as shown be-

ment that they use to determine their QPAI in para- of PRS gross income of $900 attributable to DPGR low:

graphs (iii)(A) and (B) of this Example 2, respec- ($1,500 DPGR - $600 CGS, allocated based on PRS’s







2006–25 I.R.B. 1125 June 19, 2006

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500

CGS (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)

Section 162 selling expenses (including W–2 wages)

($420 x $1,500/$3,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($210)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($150)

QPAI. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540





(B) X’s and Y’s shares of PRS’s W–2 wages de- ($1,800 x ($3,000 DPGR/$4,000 total gross receipts Example 5. Guaranteed payment. (i) Facts. The

termined under section 199(d)(1)(A)(iii) for purposes from PRS)). Accordingly, X’s QPAI for purposes facts are the same as Example 4 except that in 2006

of the wage limitation of section 199(b) are $32, the of the section 199(d)(1)(A)(iii) wage limitation is PRS also makes a guaranteed payment of $200 to A

lesser of $150 (partner’s allocable share of PRS’s $0 ($3,000 DPGR - $1,750 CGS - $1,350 of deduc- for services, and PRS pays $200 of W–2 wages to

W–2 wages ($100 included in CGS, and $50 included tions). X’s share of PRS’s W–2 wages is $0, the PRS employees, which is included within the $400

in selling expenses)) and $32 (2 x ($540 x .03)). lesser of $1,600 (X’s 80% allocable share of $2,000 of CGS. See section 707(c). This guaranteed pay-

(v) Section 199 deduction determination. (A) X’s of wage expense for marketing) and $0 (2 x ($0 QPAI ment is taxable to A as ordinary income and is prop-

tentative section 199 deduction is $16 (.03 x $540 x .03)). X’s tentative deduction is $2 ($50 QPAI x erly deducted by PRS under section 162. Pursuant

(QPAI determined at partner level)) subject to the .03), subject to the section 199(b)(1) wage limitation to §1.199–3(p), A may not treat any part of this pay-

wage limitation of $16 (50% x $32). Accordingly, of $100 (50% x $200 ($0 of PRS-related W–2 wages ment as DPGR. Accordingly, PRS has total gross re-

X’s section 199 deduction for 2006 is $16. + $200 of non-PRS W–2 wages)). Accordingly, X’s ceipts of $2,000 ($1,000 of which is DPGR), CGS

(B) Y’s tentative section 199 deduction is $38 (.03 section 199 deduction for the 2006 taxable year is $2. of $400 (including $200 of W–2 wages) and deduc-

x $1,282 (QPAI determined at partner level) subject Example 4. Partnership with no W–2 wages. (i) tions of $1,000 (including the $200 guaranteed pay-

to the wage limitation of $144 (50% x $287 ($32 from Facts. A, an individual, and B, an individual, are ment) for the 2006 taxable year. A’s distributive share

PRS + $255 from non-PRS activities)). Accordingly, partners in PRS. PRS is a partnership that engages of the items of the partnership is $500 DPGR, $500

Y’s section 199 deduction for 2006 is $38. in manufacturing activities that generate both DPGR non-DPGR, $200 CGS, and $500 of deductions.

Example 3. Partnership with special allocations. and non-DPGR. A and B share all items of income, (ii) Section 199(d)(1)(A)(iii) wage limitation. A’s

(i) In general. X and Y are unrelated corporate part- gain, loss, deduction, and credit equally. In the 2006 CGS and deductions apportioned to DPGR from

ners in PRS and each is engaged in a trade or busi- taxable year, PRS has total gross receipts of $2,000 PRS equal $350 (($200 CGS + $500 of other deduc-

ness. PRS is a partnership that engages in a domestic ($1,000 of which is DPGR), CGS of $400 and deduc- tions) x ($500 DPGR/$1,000 total gross receipts)).

production activity and other activities. In general, tions of $800. PRS has no W–2 wages. A and B each Accordingly, for purposes of the wage limitation of

X and Y share all partnership items of income, gain, use the small business simplified overall method un- section 199(d)(1)(A)(iii), A’s QPAI is $150 ($500

loss, deduction, and credit equally, except that 80% der §1.199–4(f). A has trade or business activities DPGR - $350 CGS and other deductions). A’s share

of the wage expense of PRS and 20% of PRS’s other outside of PRS. With respect to those activities, A of partnership W–2 wages after application of the

expenses are specially allocated to X (substantial eco- has total gross receipts of $1,000 ($500 of which is section 199(d)(1)(A)(iii) limitation is $9, the lesser

nomic effect under section 704(b) is presumed). In DPGR), CGS of $400 (including $50 of W–2 wages) of $100 (A’s 50% allocable share of PRS’s $200 of

the 2006 taxable year, PRS’s only wage expense is and deductions of $200 for the 2006 taxable year. B W–2 wages) or $9 (2 x ($150 QPAI x .03)). B’s share

$2,000 for marketing, which is not included in CGS. has no trade or business activities outside of PRS and of PRS’s W–2 wages after application of section

PRS has $8,000 of gross receipts ($6,000 of which pays $0 of W–2 wages directly for the 2006 taxable 199(d)(1)(A)(iii) also is $9.

is DPGR), $4,000 of CGS ($3,500 of which is al- year. A’s distributive share of the items of the part- (iii) A’s section 199 deduction computation. A’s

locable to DPGR), and $3,000 of deductions (com- nership is $500 DPGR, $500 non-DPGR, $200 CGS, total CGS and deductions apportioned to DPGR equal

prised of $2,000 of wages for marketing and $1,000 and $400 of deductions. $591 (($200 PRS CGS + $400 outside trade or busi-

of other expenses). X qualifies for and uses the sim- (ii) Section 199(d)(1)(A)(iii) wage limitation. A’s ness CGS + $500 PRS deductions + $200 outside

plified deduction method under §1.199–4(e). Y does CGS and deductions apportioned to DPGR from PRS trade or business deductions) x ($1,000 total DPGR

not qualify to use that method and, therefore, must equal $300 (($200 CGS + $400 of other deductions) ($500 from PRS + $500 from outside trade or busi-

use the section 861 method under §1.199–4(d). In the x ($500 DPGR/$1,000 total gross receipts)). Accord- ness)/$2,200 total gross receipts ($1,000 from PRS

2006 taxable year, X has gross receipts attributable to ingly, for purposes of the wage limitation of section + $200 guaranteed payment + $1,000 from outside

non-partnership trade or business activities of $1,000 199(d)(1)(A)(iii), A’s QPAI is $200 ($500 DPGR - trade or business)). Accordingly, A’s QPAI is $409

and wages of $200. None of X’s non-PRS gross re- $300 CGS and other deductions). A’s share of part- ($1,000 DPGR - $591 CGS and other deductions).

ceipts is DPGR. nership W–2 wages after application of the section A’s tentative deduction is $12 ($409 QPAI x .03), sub-

(ii) Allocation and apportionment of costs. Un- 199(d)(1)(A)(iii) limitation is $0, the lesser of $0 (A’s ject to the section 199(b)(1) wage limitation of $30

der the partnership agreement, X’s distributive share 50% allocable share of PRS’s $0 of W–2 wages) or (50% x $59 ($9 PRS W–2 wages + $50 W–2 wages

of the items of PRS is $1,250 of gross income $12 (2 x ($200 QPAI x .03)). B’s share of PRS’s W–2 from A’s trade or business activities outside of PRS)).

attributable to DPGR ($3,000 DPGR - $1,750 al- wages also is $0. A’s section 199 deduction for the 2006 taxable year

locable CGS), $750 of gross income attributable (iii) Section 199 deduction computation. A’s to- is $12.

to non-DPGR ($1,000 non-DPGR - $250 alloca- tal CGS and deductions apportioned to DPGR equal (iv) B’s section 199 deduction computation. B’s

ble CGS), and $1,800 of deductions (comprised of $600 (($200 PRS CGS + $400 outside trade or busi- QPAI is $150 ($500 DPGR - $350 CGS and other de-

X’s special allocations of $1,600 of wage expense ness CGS + $400 PRS deductions + $200 outside ductions). B’s tentative deduction is $5 ($150 QPAI

($2,000 x 80%) for marketing and $200 of other trade or business deductions) x ($1,000 total DPGR x .03), subject to the section 199(b)(1) wage limita-

expenses ($1,000 x 20%)). Under the simplified ($500 from PRS + $500 from outside trade or busi- tion of $5 (50% x $9). Assuming that B engages in

deduction method, X apportions $1,200 of other ness)/$2,000 total gross receipts ($1,000 from PRS + no other activities generating DPGR, B’s section 199

deductions to DPGR ($2,000 ($1,800 from the part- $1,000 from outside trade or business)). Accordingly, deduction for the 2006 taxable year is $5.

nership and $200 from non-partnership activities) x A’s QPAI is $400 ($1,000 DPGR - $600 CGS and de- (c) S corporations—(1) In gen-

($3,000 DPGR/$5,000 total gross receipts)). Accord- ductions). A’s tentative deduction is $12 ($400 QPAI

eral—(i) Determination at shareholder

ingly, X’s QPAI is $50 ($3,000 DPGR - $1,750 CGS x .03), subject to the section 199(b)(1) wage limita-

- $1,200 of deductions). However, in determining tion of $25 (50% x $50 total W–2 wages). A’s section

level. The section 199 deduction with

the section 199(d)(1)(A)(iii) wage limitation, QPAI 199 deduction for the 2006 taxable year is $12. B’s respect to the qualified production activ-

is computed taking into account only the items of total section 199 deduction for the 2006 taxable year ities of an S corporation is determined at

PRS allocated to X for the taxable year of PRS. is $0 because B has no W–2 wages for the 2006 tax- the shareholder level. As a result, each

Thus, X apportions $1,350 of deductions to DPGR able year.

shareholder must compute its deduction





June 19, 2006 1126 2006–25 I.R.B.

separately. The section 199 deduction will (C) A shareholder generally does not tion 199(d)(1)(A)(iii)), or 2 times 3 per-

have no effect on the basis of a share- recompute its share of QPAI from the cent of the QPAI computed by taking into

holder’s stock in an S corporation. Ex- S corporation using another method; how- account only the items of the S corporation

cept as provided by publication pursuant ever, the shareholder might have to adjust allocated to the shareholder for the taxable

to paragraph (c)(1)(ii) of this section, its share of QPAI from the S corporation year of the S corporation. Except as pro-

for purposes of this section, each share- to take into account certain disallowed vided by publication in the Internal Rev-

holder is allocated, in accordance with losses or deductions, or the allowance of enue Bulletin (see §601.601(d)(2)(ii)(b) of

section 1366, its pro rata share of S corpo- suspended losses or deductions; and this chapter), this QPAI calculation is per-

ration items (including items of income, (D) A shareholder’s share of QPAI from formed by the shareholder using the same

gain, loss, and deduction), CGS allocated an S corporation may be less than zero. cost allocation method that the shareholder

to such items of income, and gross re- (2) Disallowed losses or deduc- uses in calculating the shareholder’s sec-

ceipts included in such items of income, tions. Except as provided by publica- tion 199 deduction. The S corporation

even if the shareholder’s share of CGS tion in the Internal Revenue Bulletin (see must allocate W–2 wages (prior to the

and other deductions and losses exceeds §601.601(d)(2)(ii)(b) of this chapter), application of the wage limitation) among

DPGR, and regardless of the amount of losses or deductions of the S corpora- the shareholders in the same manner as

the shareholder’s share of the W–2 wages tion that otherwise would be taken into wage expense. The shareholder must add

of the S corporation for the taxable year. account in computing the shareholder’s the shareholder’s share of W–2 wages

Except as provided by publication under section 199 deduction for a taxable year from the S corporation, as limited by sec-

paragraph (c)(1)(ii) of this section, to de- are taken into account in that year only if tion 199(d)(1)(A)(iii), to the shareholder’s

termine its section 199 deduction for the and to the extent the shareholder’s pro rata W–2 wages from other sources, if any. If

taxable year, the shareholder aggregates share of the losses or deductions from all QPAI, computed by taking into account

its pro rata share of such items, to the ex- of the S corporation’s activities is not dis- only the items of the S corporation allo-

tent they are not otherwise disallowed by allowed by section 465, 469, or 1366(d), cated to the shareholder for the taxable

the Code, with those items it incurs out- or any other provision of the Code. If year (as required by the wage limitation

side the S corporation (whether directly only a portion of the shareholder’s share of section 199(d)(1)(A)(iii)), is not greater

or indirectly) for purposes of allocating of the losses or deductions is allowed for than zero, then the shareholder may not

and apportioning deductions to DPGR and a taxable year, a proportionate share of take into account any W–2 wages of the

computing its QPAI. those allowable losses or deductions that S corporation in applying the wage lim-

(ii) Determination at entity level. are allocated to the S corporation’s quali- itation of §1.199–2 (but the shareholder

The Secretary may, by publication fied production activities, determined in a will, nevertheless, aggregate its distribu-

in the Internal Revenue Bulletin (see manner consistent with sections 465, 469, tive share of S corporation items including

§601.601(d)(2)(ii)(b) of this chapter), per- and 1366(d), and any other applicable pro- wage expense with those items not from

mit an S corporation to calculate a share- vision of the Code, is taken into account the S corporation in computing its QPAI

holder’s share of QPAI at the entity level, in computing the QPAI and the wage lim- when determining its section 199 deduc-

instead of allocating, in accordance with itation of section 199(d)(1)(A)(iii) for that tion). See §1.199–2 for the computation

section 1366, the shareholder’s pro rata taxable year. To the extent that any of of W–2 wages, and paragraph (g) of this

share of S corporation items (including the disallowed losses or deductions are section for rules regarding pass-thru enti-

items of income, gain, loss, and deduc- allowed in a later taxable year, the share- ties in a tiered structure.

tion). If an S corporation does calculate holder takes into account a proportionate (4) Transition percentage rule for W–2

QPAI at the entity level— share of those losses or deductions in com- wages. With regard to S corporations, for

(A) Each shareholder is allocated its puting its QPAI for that later taxable year. purposes of section 199(d)(1)(A)(iii)(II)

share of QPAI and W–2 wages, which Losses or deductions of the S corporation the transition percentages determined un-

(subject to the limitations under para- that are disallowed for taxable years be- der section 199(a)(2) shall be determined

graph (c)(2) of this section and section ginning on or before December 31, 2004, by reference to the S corporation’s taxable

199(d)(1)(A)(iii), respectively) are com- are not taken into account in a later taxable year. Thus, if an S corporation share-

bined with the shareholder’s QPAI and year for purposes of computing the share- holder uses a calendar year taxable year,

W–2 wages from other sources; holder’s QPAI or the wage limitation of and owns stock in an S corporation that

(B) For purposes of computing QPAI section 199(d)(1)(A)(iii) for that taxable has a taxable year ending on April 30,

under §§1.199–1 through 1.199–9, a share- year, regardless of whether the losses or the shareholder’s section 199(d)(1)(A)(iii)

holder does not take into account the items deductions are allowed for other purposes. wage limitation for the S corporation’s

from such an S corporation (for example, (3) Shareholder’s share of W–2 wages. taxable year beginning on May 1, 2006,

a shareholder does not take into account Under section 199(d)(1)(A)(iii), an would be calculated using 3 percent, even

items from such an S corporation in deter- S corporation shareholder’s share of though the shareholder includes the share-

mining whether a threshold or de minimis the W–2 wages of the S corporation holder’s pro rata share of S corporation

rule applies or when the shareholder allo- for purposes of determining the share- items from that taxable year on the share-

cates and apportions deductions in calcu- holder’s section 199(b) limitation is the holder’s 2007 Federal income tax return.

lating its QPAI from other sources); lesser of the shareholder’s allocable share (d) Grantor trusts. To the extent that

of those wages (without regard to sec- the grantor or another person is treated as





2006–25 I.R.B. 1127 June 19, 2006

owning all or part (the owned portion) of a entity is not directly attributable to any into account the beneficiary’s distributive

trust under sections 671 through 679, such class of income (whether or not those share of the estate’s gross receipts, gross

person (owner) computes its QPAI with re- other expenses are directly attributable to income, or deductions when the benefi-

spect to the owned portion of the trust as the aggregate pass-thru gross income as a ciary determines whether a threshold or de

if that QPAI had been generated by activi- class for purposes other than section 199). minimis rule applies or when the benefi-

ties performed directly by the owner. Sim- A trust or estate may not use the small ciary allocates and apportions deductions

ilarly, for purposes of the section 199(b) business simplified overall method for in calculating its QPAI from other sources.

wage limitation, the owner of the trust computing its QPAI. See §1.199–4(f)(5). (3) Beneficiary’s share of W–2 wages.

takes into account the owner’s share of the (2) Allocation among trust or estate and The trust or estate must compute each

W–2 wages of the trust that are attribut- beneficiaries—(i) In general. The QPAI beneficiary’s share of W–2 wages from

able to the owned portion of the trust. The of a trust or estate (which will be less the trust or estate in accordance with sec-

section 199(d)(1)(A)(iii) wage limitation than zero if the CGS and deductions allo- tion 199(d)(1)(A)(iii), as if the beneficiary

is not applicable to the owned portion of cated and apportioned to DPGR exceed the were a partner in a partnership. The ap-

the trust. The provisions of paragraph (e) trust’s or estate’s DPGR) and W–2 wages plication of section 199(d)(1)(A)(iii) to

of this section do not apply to the owned of the trust or estate are allocated to each each trust and estate therefore means that

portion of a trust. beneficiary and to the trust or estate based if QPAI, computed by taking into account

(e) Non-grantor trusts and estates—(1) on the relative proportion of the trust’s or only the items of the trust or estate allo-

Allocation of costs. The trust or estate estate’s distributable net income (DNI), as cated to the beneficiary for the taxable

calculates each beneficiary’s share (as defined by section 643(a), for the taxable year, is not greater than zero, then the

well as the trust’s or estate’s own share, year that is distributed or required to be beneficiary may not take into account any

if any) of QPAI and W–2 wages from the distributed to the beneficiary or is retained W–2 wages of the trust or estate in ap-

trust or estate at the trust or estate level. by the trust or estate. To the extent that plying the wage limitation of §1.199–2

The beneficiary of a trust or estate is not the trust or estate has no DNI for the tax- (but the beneficiary will, nevertheless,

permitted to use another cost allocation able year, any QPAI and W–2 wages are aggregate its QPAI from the trust or estate

method to recompute its share of QPAI allocated entirely to the trust or estate. A with its QPAI from other sources when

from the trust or estate or to reallocate trust or estate is allowed the section 199 determining the beneficiary’s section 199

the costs of the trust or estate. Except as deduction in computing its taxable income deduction). See paragraph (g) of this

provided in paragraph (d) of this section, to the extent that QPAI and W–2 wages section for rules applicable to pass-thru

the QPAI of a trust or estate must be com- are allocated to the trust or estate. A ben- entities in a tiered structure.

puted by allocating expenses described eficiary of a trust or estate is allowed the (4) Transition percentage rule for

in section 199(d)(5) in one of two ways, section 199 deduction in computing its tax- W–2 wages. With regard to trusts

depending on the classification of those able income based on its share of QPAI and and estates, for purposes of section

expenses under §1.652(b)–3. Specifically, W–2 wages from the trust or estate, which 199(d)(1)(A)(iii)(II), the transition per-

directly attributable expenses within the (subject to the wage limitation as described centages determined under section

meaning of §1.652(b)–3 are allocated pur- in paragraph (e)(3) of this section) are ag- 199(a)(2) shall be determined by refer-

suant to §1.652(b)–3, and expenses not gregated with the beneficiary’s QPAI and ence to the taxable year of the trust or

directly attributable within the meaning of W–2 wages from other sources. estate.

§1.652(b)–3 (other expenses) are allocated (ii) Treatment of items from a trust or (5) Example. The following example

under the simplified deduction method of estate reporting qualified production ac- illustrates the application of this para-

§1.199–4(e) (unless the trust or estate does tivities income. When, pursuant to this graph (e) and paragraph (g) of this section.

not qualify to use the simplified deduc- paragraph (e), a taxpayer must combine Assume that the partnership, trust, and

tion method, in which case it must use QPAI and W–2 wages from a trust or es- trust beneficiary all are calendar year tax-

the section 861 method of §1.199–4(d) tate with the taxpayer’s total QPAI and payers.

with respect to such other expenses). For W–2 wages from other sources, the tax- Example. (i) Computation of DNI and inclusion

this purpose, depletion and depreciation payer, when applying §§1.199–1 through and deduction amounts. (A) Trust’s distributive

share of partnership items. Trust, a complex trust,

deductions described in section 642(e) and 1.199–9 to determine the taxpayer’s to- is a partner in PRS, a partnership that engages in

amortization deductions described in sec- tal QPAI and W–2 wages from such other activities that generate DPGR and non-DPGR. In

tion 642(f) are treated as other expenses sources, does not take into account the 2006, PRS distributes $10,000 cash to Trust. Trust’s

described in section 199(d)(5). Also for items from such trust or estate. Thus, for distributive share of PRS items, which are properly

this purpose, the trust’s or estate’s share of example, a beneficiary of an estate that re- included in Trust’s DNI, is as follows:



other expenses from a lower-tier pass-thru ceives QPAI from the estate does not take









June 19, 2006 1128 2006–25 I.R.B.

Gross income attributable to DPGR

($15,000 DPGR - $5,000 CGS

(including W–2 wages of $1,000)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Gross income attributable to non-DPGR

($5,000 other gross receipts - $0 CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000

Selling expenses (includes W–2 wages of $2,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

Other expenses (includes W–2 wages of $1,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000





(B) Trust’s direct activities. In addition to its cash the following items which are properly included in

distribution in 2006 from PRS, Trust also directly has Trust’s DNI:





Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Tax-exempt interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Rents from commercial real property operated by Trust

as a business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Real estate taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000

Trustee commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

State income and personal property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000

W–2 wages for rental business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000

Other business expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000





(C) Allocation of deductions under §1.652(b)–3. of tax-exempt interest. Trust includes $20,222 in its Trust and B each has QPAI from PRS for purposes

(1) Directly attributable expenses. In computing adjusted total income and deducts $10,111 under sec- of the section 199 deduction of $2,000.

Trust’s DNI for the taxable year, the distributive tion 661(a) in computing its taxable income. (B) Section 199(d)(1)(A)(iii) wage limitation.

share of expenses of PRS are directly attributable (ii) Section 199 deduction. (A) Simplified de- The wage limitation under section 199(d)(1)(A)(iii)

under §1.652(b)–3(a) to the distributive share of duction method. For purposes of computing the must be applied both at the Trust level and at B’s

income of PRS. Accordingly, the $5,000 of CGS, section 199 deduction for the taxable year, assume level. After applying this limitation to the Trust’s

$3,000 of selling expenses, and $2,000 of other ex- Trust qualifies for the simplified deduction method share of PRS’s W–2 wages, Trust is allocated $330

penses are subtracted from the gross receipts from under §1.199–4(e). The determination of Trust’s of W–2 wages from PRS (the lesser of Trust’s

PRS ($20,000), resulting in net income from PRS of QPAI under the simplified deduction method re- allocable share of PRS’s W–2 wages ($4,000)

$10,000. With respect to the Trust’s direct expenses, quires multiple steps to allocate costs. First, the or 2 x 3% of Trust’s QPAI from PRS ($5,500)).

$1,000 of the trustee commissions, the $1,000 of real Trust’s expenses directly attributable to DPGR un- Trust’s QPAI from PRS for purposes of the section

estate taxes, and the $2,000 of W–2 wages are di- der §1.652(b)–3(a) are subtracted from the Trust’s 199(d)(1)(A)(iii) limitation is determined by taking

rectly attributable under §1.652(b)–3(a) to the rental DPGR. In this step, the directly attributable $5,000 into account only the items of PRS allocated to Trust

income. of CGS and selling expenses of $3,000 are subtracted ($15,000 DPGR - ($5,000 of CGS + $3,000 selling

(2) Non-directly attributable expenses. Under from the $15,000 of DPGR from PRS. Next, Trust expenses + $1,500 of other expenses)). For this

§1.652(b)–3(b), the trustee must allocate a portion must identify its other trade or business expenses purpose, the $1,500 of other expenses is determined

of the sum of the balance of the trustee commissions directly related to non-DPGR trade or business in- by multiplying $2,000 of other expenses from PRS

($2,000), state income and personal property taxes come. In this example, the portion of the trustee by $15,000 of DPGR from PRS, divided by $20,000

($5,000), and the other business expenses ($1,000) to commissions not directly attributable to the rental of total gross receipts from PRS. Trust adds this $330

the $10,000 of tax-exempt interest. The portion to be operation ($2,000), as well as the portion of the of W–2 wages to Trust’s own $2,000 of W–2 wages

attributed to tax-exempt interest is $2,222 ($8,000 x state income and personal property taxes not directly (thus, $2,330). Because the $14,000 Trust distribu-

($10,000 tax-exempt interest/$36,000 gross receipts attributable to either the PRS interests or the rental tion to B equals one-half of Trust’s DNI, Trust and

net of direct expenses)), resulting in $7,778 ($10,000 operation, are not trade or business expenses and, B each has W–2 wages of $1,165. After applying

- $2,222) of net tax-exempt interest. Pursuant to thus, are ignored in computing QPAI. The portion the section 199(d)(1)(A)(iii) wage limitation to B’s

its authority recognized under §1.652(b)–3(b), the of the state income and personal property taxes share of the W–2 wages allocated from Trust, B has

trustee allocates the entire amount of the remaining that is treated as other trade or business expenses W–2 wages of $120 from Trust (lesser of $1,165

$5,778 of trustee commissions, state income and is $3,000 ($5,000 x $30,000 total trade or business (allocable share of W–2 wages) or 2 x .03 x $2,000

personal property taxes, and other business expenses gross receipts/$50,000 total gross receipts). Trust (B’s share of Trust’s QPAI)). B has W–2 wages of

to the $6,000 of net rental income, resulting in $222 then allocates its other trade or business expenses on $100 from non-Trust activities for a total of $220 of

($6,000 - $5,778) of net rental income. the basis of its total gross receipts from the conduct W–2 wages.

(D) Amounts included in taxable income. For of a trade or business ($20,000 from PRS + $10,000 (C) Section 199 deduction computation. (1) B’s

2006, Trust has DNI of $28,000 (net dividend in- rental income). Trust then combines its non-di- computation. B is eligible to use the small business

come of $10,000 + net PRS income of $10,000 + net rectly attributable (other) business expenses ($2,000 simplified overall method. Assume that B has suf-

rental income of $222 + net tax-exempt income of from PRS + $4,000 ($1,000 of other expenses + ficient adjusted gross income so that the section 199

$7,778). Pursuant to Trust’s governing instrument, $3,000 of income and property taxes) from its own deduction is not limited under section 199(a)(1)(B).

Trustee distributes 50%, or $14,000, of that DNI to activities) and then apportions this total between B has $1,000 of QPAI from non-Trust activities that

B, an individual who is a discretionary beneficiary of DPGR and other receipts on the basis of Trust’s total is added to the $2,000 QPAI from Trust for a total of

Trust. Assume that there are no separate shares under trade or business gross receipts ($6,000 x $15,000 $3,000 of QPAI. B’s tentative deduction is $90 (.03 x

Trust, and no distributions are made to any other ben- DPGR/$30,000 total trade or business gross receipts $3,000), but it is limited under section 199(b) to $110

eficiary that year. Consequently, with respect to the = $3,000). Thus, for purposes of computing Trust’s (50% x $220 W–2 wages). Accordingly, B’s section

$14,000 distribution B receives from Trust, B prop- and B’s section 199 deduction, Trust’s QPAI is 199 deduction for 2006 is $90.

erly includes in B’s gross income $5,000 of income $4,000 ($7,000 - $3,000). Because the distribution (2) Trust’s computation. Trust has sufficient ad-

from PRS, $111 of rents, and $5,000 of dividends, of Trust’s DNI to B equals one-half of Trust’s DNI, justed gross income so that the section 199 deduction

and properly excludes from B’s gross income $3,889 is not limited under section 199(a)(1)(B). Trust’s ten-







2006–25 I.R.B. 1129 June 19, 2006

tative deduction is $60 (.03 x $2,000 QPAI), but it is tity (or the entity on behalf of the owner) All partnership items are allocated in proportion to

limited under section 199(b) to $583 (50% x $1,165 calculates the amounts described in sec- these ownership percentages. LTP has $900 DPGR,

W–2 wages). Accordingly, Trust’s section 199 de- tions 199(d)(1)(A)(iii)(I) (owner’s alloca- $450 CGS (which includes W–2 wages of $100), and

duction for 2006 is $60. $50 other deductions. Before taking into account its

ble share) and 199(d)(1)(A)(iii)(II) (twice share of items from LTP, UTP has $500 DPGR, $500

(f) Gain or loss from the disposition of

the applicable percentage of the owner’s CGS (which includes W–2 wages of $200), and $500

an interest in a pass-thru entity. DPGR

QPAI from that entity) separately with re- other deductions. UTP chooses to compute its share

generally does not include gain or loss rec- of QPAI attributable to items from LTP for purposes

gard to its interest in that pass-thru entity.

ognized on the sale, exchange, or other dis- of section 199(d)(1)(A)(iii)(II) by applying the small

(2) Share of W–2 wages. For purposes

position of an interest in a pass-thru entity. business simplified overall method described in

of section 199(d)(1)(A)(iii) and section §1.199–4(f). For purposes of the wage limitation of

However, with respect to a partnership, if

199(b), the W–2 wages of the owner of section 199(d)(1)(A)(iii), UTP’s distributive share of

section 751(a) or (b) applies, then gain or

an interest in a pass-thru entity (upper-tier LTP’s QPAI is $200 ($450 DPGR - $250 CGS and

loss attributable to assets of the partnership other deductions).

entity) that owns an interest in one or

giving rise to ordinary income under sec- (ii) UTP’s share of LTP’s W–2 wages for pur-

more pass-thru entities (lower-tier enti-

tion 751(a) or (b), the sale, exchange, or poses of the section 199(d)(1)(A)(iii) limitation is

ties) are equal to the sum of the owner’s $12, the lesser of $50 (UTP’s 50% allocable share

other disposition of which would give rise

allocable share of W–2 wages of the up- of LTP’s $100 of W–2 wages) or $12 (2 x ($200

to DPGR, is taken into account in com-

per-tier entity, as limited in accordance QPAI x .03)). After taking into account its share of

puting the partner’s section 199 deduc- items from LTP, UTP has $950 DPGR, $725 CGS,

with section 199(d)(1)(A)(iii), and the

tion. Accordingly, to the extent that cash and $525 other deductions. A is eligible for and

owner’s own W–2 wages. The upper-tier

or property received by a partner in a sale uses the simplified deduction method described in

entity’s W–2 wages are equal to the sum §1.199–4(e). For purposes of the wage limitation of

or exchange for all or part of its partner-

of the upper-tier entity’s allocable share section 199(d)(1)(A)(iii), A’s distributive share of

ship interest is attributable to unrealized

of W–2 wages of the next lower-tier en- UTP’s QPAI is ($151) ($475 DPGR - $363 CGS -

receivables or inventory items within the $263 other deductions). A’s wage limitation under

tity, as limited in accordance with section

meaning of section 751(c) or (d), respec- section 199(d)(1)(A)(iii) with respect to A’s interest

199(d)(1)(A)(iii), and the upper-tier en-

tively, and the sale or exchange of the unre- in UTP is $0, the lesser of $106 (A’s 50% allocable

tity’s own W–2 wages. The W–2 wages of share of UTP’s $212 of W–2 wages) or $0 (because

alized receivable or inventory items would

each lower-tier entity in a tiered structure, A’s share of UTP’s QPAI ($151), is less than zero).

give rise to DPGR if sold, exchanged, or

in turn, is computed as described in the (h) No attribution of qualified activ-

otherwise disposed of by the partnership,

preceding sentence. Except as provided ities. Except as provided in paragraph

the cash or property received by the part-

by publication in the Internal Revenue (i) of this section regarding qualifying

ner is taken into account by the partner

Bulletin (see §601.601(d)(2)(ii)(b) of this in-kind partnerships and paragraph (j)

in determining its DPGR for the taxable

chapter)— of this section regarding EAG partner-

year. Likewise, to the extent that a dis-

(i) An upper-tier entity may compute its ships, an owner of a pass-thru entity is

tribution of property to a partner is treated

share of QPAI attributable to items from not treated as conducting the qualified

under section 751(b) as a sale or exchange

a lower-tier entity solely for purposes of production activities of the pass-thru en-

of property between the partnership and

section 199(d)(1)(A)(iii)(II) by applying tity, and vice versa. For example, if a

the distributee partner, and any property

either the section 861 method described partnership MPGE QPP within the United

deemed sold or exchanged would give rise

in §1.199–4(d) or the simplified deduc- States, or produces a qualified film or

to DPGR if sold, exchanged, or otherwise

tion method described in §1.199–4(e), pro- produces utilities in the United States, and

disposed of by the partnership, the deemed

vided the upper tier entity would otherwise distributes or leases, rents, licenses, sells,

sale or exchange of the property must be

qualify to use such method. exchanges, or otherwise disposes of such

taken into account in determining the part-

(ii) Alternatively, the upper-tier entity property to a partner who then, without

nership’s and distributee partner’s DPGR

(other than a trust or estate described in performing its own qualifying MPGE or

to the extent not taken into account under

paragraph (e) of this section) may com- other production, leases, rents, licenses,

the qualifying in-kind partnership rules.

pute its share of QPAI attributable to items sells, exchanges, or otherwise disposes

See §1.751–1(b) and paragraph (i) of this

from a lower-tier entity solely for pur- of such property, then the partner’s gross

section.

poses of section 199(d)(1)(A)(iii)(II) by receipts from this latter lease, rental, li-

(g) Section 199(d)(1)(A)(iii) wage lim-

applying the small business simplified cense, sale, exchange, or other disposition

itation and tiered structures—(1) In gen-

overall method described in §1.199–4(f), are treated as non-DPGR. In addition, if

eral. If a pass-thru entity owns an interest,

regardless of whether such upper-tier en- a partner MPGE QPP within the United

directly or indirectly, in one or more pass-

tity would otherwise qualify to use the States, or produces a qualified film or

thru entities, then the wage limitation of

small business simplified overall method. produces utilities in the United States, and

section 199(d)(1)(A)(iii) must be applied

(3) Example. The following example contributes or leases, rents, licenses, sells,

at each tier (that is, separately for each

illustrates the application of this para- exchanges, or otherwise disposes of such

entity). For purposes of this wage limi-

graph (g). Assume that each partnership property to a partnership which then, with-

tation, references to pass-thru entities in-

and each partner (whether or not an indi- out performing its own qualifying MPGE

cludes partnerships, S corporations, trusts

vidual) is a calendar year taxpayer. or other production, leases, rents, licenses,

(to the extent not described in paragraph Example. (i) In 2006, A, an individual, owns a

(d) of this section) and estates. Thus, at sells, exchanges, or otherwise disposes of

50% interest in a partnership, UTP, which in turn

each tier, the owner of a pass-thru en- owns a 50% interest in another partnership, LTP.

such property, then the partnership’s gross







June 19, 2006 1130 2006–25 I.R.B.

receipts from this latter disposition are receipts are allocated to that partner, pro- (j) Partnerships owned by members of

treated as non-DPGR. vided that the partner derives gross re- a single expanded affiliated group—(1) In

(i) Qualifying in-kind partnership—(1) ceipts from the distributed property (and general. For purposes of this section, if all

In general. If a partnership is a qualifying takes into account such receipts under its of the interests in the capital and profits of

in-kind partnership described in paragraph method of accounting) during the taxable a partnership are owned by members of a

(i)(2) of this section, then each partner is year of the partner with or within which single EAG at all times during the taxable

treated as MPGE or producing the prop- the partnership’s taxable year (in which year of the partnership (EAG partnership),

erty MPGE or produced by the partnership the distribution occurs) ends. For rules then the EAG partnership and all members

that is distributed to that partner. If a part- for taking costs into account (such as costs of that EAG are treated as a single taxpayer

ner of a qualifying in-kind partnership de- included in the adjusted basis of the dis- for purposes of section 199(c)(4) during

rives gross receipts from the lease, rental, tributed property), see §1.199–4. that taxable year.

license, sale, exchange, or other disposi- (4) Other rules. Except as provided (2) Attribution of activities—(i) In gen-

tion of the property that was MPGE or pro- in this paragraph (i), a qualifying in-kind eral. If a member of an EAG (dispos-

duced by the qualifying in-kind partner- partnership is treated the same as other ing member) derives gross receipts from

ship, then, provided such partner is a part- partnerships for purposes of section 199. the lease, rental, license, sale, exchange,

ner of the qualifying in-kind partnership at Accordingly, a qualifying in-kind partner- or other disposition of property that was

the time the partner disposes of the prop- ship is subject to the rules of this section MPGE or produced by an EAG partner-

erty, the partner is treated as conducting regarding the application of section 199 ship, all the partners of which are mem-

the MPGE or production activities previ- to pass-thru entities, including application bers of the same EAG to which the dis-

ously conducted by the qualifying in-kind of the section 199(d)(1)(A)(iii) wage lim- posing member belongs at the time that

partnership with respect to that property. itation under paragraph (b)(3) of this sec- the disposing member disposes of such

With respect to a lease, rental, or license, tion. In determining whether a qualifying property, then the disposing member is

the partner is treated as having disposed of in-kind partnership or its partners MPGE treated as conducting the MPGE or pro-

the property on the date or dates on which QPP in whole or in significant part within duction activities previously conducted by

it takes into account its gross receipts de- the United States, see §1.199–3(g)(2) and the EAG partnership with respect to that

rived from the lease, rental, or license un- (3). property. The previous sentence applies

der its methods of accounting. With re- (5) Example. The following example only for those taxable years in which the

spect to a sale, exchange, or other dispo- illustrates the application of this paragraph disposing member is a member of the EAG

sition, the partner is treated as having dis- (i). Assume that PRS and X are calendar of which all the partners of the EAG part-

posed of the property on the date on which year taxpayers. nership are members for the entire taxable

it ceases to own the property for Federal in- Example. X, Y and Z are partners in PRS, a qual- year of the EAG partnership. With re-

come tax purposes, even if no gain or loss ifying in-kind partnership described in paragraph spect to a lease, rental, or license, the dis-

(i)(2) of this section. X, Y, and Z are corporations. In

is taken into account. 2006, PRS distributes oil to X that PRS derived from

posing member is treated as having dis-

(2) Definition of qualifying in-kind its oil extraction. PRS incurred $600 of CGS, includ- posed of the property on the date or dates

partnership. For purposes of this para- ing $500 of W–2 wages (as defined in §1.199–2(e)), on which it takes into account its gross re-

graph (i), a qualifying in-kind partnership extracting the oil distributed to X, and X’s adjusted ceipts from the lease, rental, or license un-

is a partnership engaged solely in— basis in the distributed oil is $600. The fair market der its methods of accounting. With re-

value of the oil at the time of the distribution to X

(i) The extraction, refining, or process- is $1,000. X incurs $200 of CGS, including $100

spect to a sale, exchange, or other dis-

ing of oil, natural gas (as described in of W–2 wages, in refining the oil within the United position, the disposing member is treated

§1.199–3(l)(2)), petrochemicals, or prod- States. In 2006, X, while it is a partner in PRS, sells as having disposed of the property on the

ucts derived from oil, natural gas, or petro- the oil to a customer for $1,500, taking the gross re- date on which it ceases to own the prop-

chemicals in whole or in significant part ceipts into account under its method of accounting in erty for Federal income tax purposes, even

the same taxable year. Under paragraph (i)(1) of this

within the United States; section, X is treated as having extracted the oil. The

if no gain or loss is taken into account.

(ii) The production or generation of extraction and refining of the oil qualify as an MPGE Likewise, if an EAG partnership derives

electricity in the United States; or activity under §1.199–3(e)(1). Therefore, X’s $1,500 gross receipts from the lease, rental, li-

(iii) An activity or industry desig- of gross receipts qualify as DPGR. X subtracts from cense, sale, exchange, or other disposition

nated by the Secretary by publication the $1,500 of DPGR the $600 of CGS incurred of property that was MPGE or produced by

by PRS and the $200 of refining costs incurred by

in the Internal Revenue Bulletin (see X. Thus, X’s QPAI is $700 for 2006. In addition,

a member (or members) of the same EAG

§601.601(d)(2)(ii)(b) of this chapter). PRS is treated as having $1,000 of DPGR solely for (the producing member) to which all the

(3) Special rules for distributions. If a purposes of applying the wage limitation in section partners of the EAG partnership belong at

qualifying in-kind partnership distributes 199(d)(1)(A)(iii) based on the applicable percentage the time that the EAG partnership disposes

property to a partner, then, solely for pur- of QPAI. Accordingly, X’s share of PRS’s W–2 of such property, then the EAG partner-

wages determined under section 199(d)(1)(A)(iii) is

poses of section 199(d)(1)(A)(iii)(II), the $24, the lesser of $500 (X’s allocable share of PRS’s

ship is treated as conducting the MPGE or

partnership is treated as having gross re- W–2 wages included in CGS) and $24 (2 x ($400 production activities previously conducted

ceipts in the taxable year of the distribu- ($1,000 deemed DPGR less $600 of CGS) x .03)). by the producing member with respect to

tion equal to the fair market value of the X adds the $24 of PRS W–2 wages to its $100 of that property. The previous sentence ap-

distributed property at the time of distribu- W–2 wages incurred in refining the oil for purposes plies only for those taxable years in which

of section 199(b).

tion to the partner and the deemed gross the producing member is a member of the





2006–25 I.R.B. 1131 June 19, 2006

EAG of which all the partners of the EAG to the fair market value of the property section regarding the application of section 199 to

partnership are members for the entire tax- at the time of distribution to the partner pass-thru entities with respect to the activity of PRS,

able year of the EAG partnership. With re- and the deemed gross receipts are allo- including application of the section 199(d)(1)(A)(iii)

wage limitation under paragraph (b)(3) of this sec-

spect to a lease, rental, or license, the EAG cated to that partner, provided that the part- tion. The results would be the same if PRS sold the

partnership is treated as having disposed of ner derives gross receipts from the dis- property to Z rather than to X.

the property on the date or dates on which tributed property (and takes such receipts Example 3. Lease. X, Y, and Z are the only mem-

it takes into account its gross receipts de- into account under its methods of account- bers of a single EAG for the entire 2005 year. X and

rived from the lease, rental, or license un- ing) during the taxable year of the part- Y each own 50% of the capital and profits interests

in PRS, a partnership, for PRS’s entire 2005 taxable

der its methods of accounting. With re- ner with or within which the partnership’s year. In 2005, PRS MPGE QPP within the United

spect to a sale, exchange, or other dispo- taxable year (in which the distribution oc- States and then sells the property to X for $6,000,

sition, the EAG partnership is treated as curs) ends. For rules for taking costs into its fair market value at the time of the sale. PRS’s

having disposed of the property on the date account (such as costs included in the ad- gross receipts of $6,000 qualify as DPGR. In 2005,

on which it ceases to own the property for justed basis of the distributed property), X rents the QPP it acquired from PRS to customers

unrelated to X. X takes the gross receipts attributable

Federal income tax purposes, even if no see §1.199–4. to the rental of the QPP into account under its meth-

gain or loss is taken into account. See para- (4) Other rules. Except as provided in ods of accounting in 2005 and 2006. On July 1, 2006,

graph (j)(5) Example 3 of this section. this paragraph (j), an EAG partnership is X ceases to be a member of the same EAG to which

(ii) Attribution between EAG partner- treated the same as other partnerships for Y, the other partner in PRS, belongs. For 2005, X is

ships. If an EAG partnership (disposing purposes of section 199. Accordingly, an treated as having MPGE the QPP in the United States,

and its gross receipts derived from the rental of the

partnership) derives gross receipts from EAG partnership is subject to the rules of QPP qualify as DPGR. For 2006, however, because

the lease, rental, license, sale, exchange, this section regarding the application of X and Y, partners in PRS, are no longer members of

or other disposition of property that was section 199 to pass-thru entities, including the same EAG for the entire year, the gross rental re-

MPGE or produced by another EAG part- application of the section 199(d)(1)(A)(iii) ceipts X takes into account in 2006 do not qualify as

nership (producing partnership), then the wage limitation under paragraph (b)(3) of DPGR.

Example 4. Distribution. X and Y are the only

disposing partnership is treated as con- this section. In determining whether a partners in PRS, a partnership, for PRS’s entire 2006

ducting the MPGE or production activities member of an EAG or an EAG partner- taxable year. X and Y are both members of a sin-

previously conducted by the producing ship MPGE QPP in whole or in significant gle EAG for the entire 2006 year. In 2006, PRS

partnership with respect to that property, part within the United States or produced a MPGE QPP within the United States, incurring $600

provided that the producing partnership qualified film or produced utilities within of CGS, including $500 of W–2 wages (as defined

in §1.199–2(e)), and then distributes the QPP to X.

and the disposing partnership are owned the United States, see §1.199–3(g)(2) and X’s adjusted basis in the QPP is $600. At the time

by members of the same EAG for the (3) and Example 5 of paragraph (j)(5) of of the distribution, the fair market value of the QPP

entire taxable year of the respective part- this section. is $1,000. X incurs $200 of directly allocable costs,

nership in which the disposing partnership (5) Examples. The following examples including $100 of W–2 wages, to further MPGE the

disposes of such property. With respect illustrate the rules of this paragraph (j). QPP within the United States. In 2006, X sells the

QPP for $1,500 to an unrelated customer and takes

to a lease, rental, or license, the disposing Assume that PRS, X, Y, and Z all are cal- the gross receipts into account under its method of

partnership is treated as having disposed of endar year taxpayers. accounting in the same taxable year. Under para-

the property on the date or dates on which Example 1. Contribution. X and Y are the only graph (j)(1) of this section, X is treated as having

it takes into account its gross receipts partners in PRS, a partnership, for PRS’s entire 2006 MPGE the QPP within the United States, and X’s

taxable year. X and Y are both members of a single $1,500 of gross receipts qualify as DPGR. In addition,

from the lease, rental, or license under its EAG for the entire 2006 year. In 2006, X MPGE QPP PRS is treated as having DPGR of $1,000 solely for

methods of accounting. With respect to a within the United States and contributes the property purposes of applying the wage limitation in section

sale, exchange, or other disposition, the to PRS. In 2006, PRS sells the QPP for $1,000. Un- 199(d)(1)(A)(iii) based on the applicable percentage

disposing partnership is treated as having der this paragraph (j), PRS is treated as having MPGE of QPAI.

disposed of the property on the date on the QPP within the United States, and PRS’s $1,000 Example 5. Multiple sales. (i) Facts. X and Y are

gross receipts constitute DPGR. PRS, X, and Y must the only partners in PRS, a partnership, for PRS’s en-

which it ceases to own the property for apply the rules of this section regarding the applica- tire 2006 taxable year. X and Y are both non-consol-

Federal income tax purposes, even if no tion of section 199 to pass-thru entities with respect idated members of a single EAG for the entire 2006

gain or loss is taken into account. to the activity of PRS, including application of the year. PRS produces in bulk form in the United States

(iii) Exceptions to attribution. Attri- section 199(d)(1)(A)(iii) wage limitation under para- the active ingredient for a pharmaceutical product.

bution of activities does not apply for graph (b)(3) of this section. Assume that PRS’s own MPGE activity with respect

Example 2. Sale. X, Y, and Z are the only mem- to the active ingredient is not substantial in nature,

purposes of the construction of real prop- bers of a single EAG for the entire 2006 year. X and taking into account all of the facts and circumstances,

erty under §1.199–3(m)(1) and the per- Y each own 50% of the capital and profits interests and PRS’s direct labor and overhead to MPGE the ac-

formance of engineering and architectural in PRS, a partnership, for PRS’s entire 2006 taxable tive ingredient within the United States are $15 and

services under §1.199–3(n)(2) and (3), year. In 2006, PRS MPGE QPP within the United account for 15% of PRS’s $100 CGS of the active

respectively. States and then sells the property to X for $6,000, its ingredient. In 2006, PRS sells the active ingredient

fair market value at the time of the sale. PRS’s gross in bulk form to X. X uses the active ingredient to

(3) Special rules for distributions. If an receipts of $6,000 qualify as DPGR. In 2006, X sells produce the finished dosage form drug. Assume that

EAG partnership distributes property to a the QPP to customers for $10,000, incurring selling X’s own MPGE activity with respect to the drug is

partner, then, solely for purposes of sec- expenses of $2,000. Under this paragraph (j), X is not substantial in nature, taking into account all of

tion 199(d)(1)(A)(iii)(II), the EAG part- treated as having MPGE the QPP within the United the facts and circumstances, and X’s direct labor and

nership is treated as having gross receipts States, and X’s $10,000 of gross receipts qualify as overhead to MPGE the drug within the United States

DPGR. PRS, X and Y must apply the rules of this are $12 and account for 10% of X’s $120 CGS of the

in the taxable year of the distribution equal





June 19, 2006 1132 2006–25 I.R.B.

drug. In 2006, X sells the drug in finished dosage 1.199–9 does not apply to taxable years be- issue, then a taxpayer may rely on either

to Y and Y sells the drug to customers. Assume that ginning after May 17, 2006, the enactment the rule set forth in Notice 2005–14 or the

Y’s own MPGE activity with respect to the drug is date of the Tax Increase Prevention and rule set forth in REG–105847–05. How-

not substantial in nature, taking into account all of

the facts and circumstances, and Y incurs $2 of direct

Reconciliation Act of 2005 (Public Law ever, if REG–105847–05 includes a rule

labor and overhead and Y’s CGS in selling the drug 109–222, 120 Stat. 345). For taxable years that was not included in Notice 2005–14,

to customers is $130. beginning on or before May 17, 2006, a then a taxpayer is not permitted to rely on

(ii) Analysis. PRS’s gross receipts from the sale taxpayer must apply §1.199–9 if the tax- the absence of a rule in Notice 2005–14 to

of the active ingredient to X are non-DPGR because payer applies §§1.199–1 through 1.199–8 apply a rule contrary to REG–105847–05.

PRS’s MPGE activity is not substantial in nature and

PRS does not satisfy the safe harbor described in

to that taxable year. Notwithstanding the For taxable years beginning after May

§1.199–3(g)(3) because PRS’s direct labor and over- preceding sentence, a partnership or S cor- 17, 2006, and before June 1, 2006, a tax-

head account for less than 20% of PRS’s CGS of the poration that is a qualifying small taxpayer payer may not apply Notice 2005–14,

active ingredient. X’s gross receipts from the sale under §1.199–4(f) of REG–105847–05, REG–105847–05, or any other guidance

of the drug to Y are DPGR because X is consid- 2005–47 I.R.B. 987 (see §601.601(d)(2) under section 199 in a manner inconsistent

ered to have MPGE the drug in significant part in the

United States pursuant to the safe harbor described in

of this chapter) may use the small business with amendments made to section 199 by

§1.199–3(g)(3) because the $27 ($15 + $12) of direct simplified overall method to apportion section 514 of the Tax Increase Prevention

labor and overhead incurred by PRS and X equals or CGS and deductions between DPGR and Reconciliation Act of 2005.

exceeds 20% of X’s total CGS ($120) of the drug at and non-DPGR at the entity level under

the time X disposes of the drug to Y. Similarly, Y’s §1.199–4(f) of REG–105847–05 for tax- PART 602—OMB CONTROL

gross receipts from the sale of the drug to customers NUMBERS UNDER THE PAPERWORK

are DPGR because Y is considered to have MPGE

able years beginning on or before May 17,

2006. If a taxpayer chooses not to rely on REDUCTION ACT

the drug in significant part in the United States pur-

suant to the safe harbor described in §1.199–3(g)(3) §§1.199–1 through 1.199–9 (as provided

because the $29 ($15 + $12 + $2) of direct labor and

Par. 3. The authority citation for part

in §1.199–8(i)) for a taxable year begin-

overhead incurred by PRS, X, and Y equals or ex- 602 continues to read as follows:

ning before June 1, 2006, the guidance

ceeds 20% of Y’s total CGS ($130) of the drug at the Authority: 26 U.S.C. 7805.

time Y disposes of the drug to Y’s customers.

under section 199 that applies to taxable

Par. 4. In §602.101, paragraph (b) is

(k) Effective dates. Section 199 applies years beginning before June 1, 2006, is

amended by adding an entry to the table in

to taxable years beginning after December contained in Notice 2005–14, 2005–1 C.B.

numerical order to read, in part, as follows:

31, 2004. In determining the deduction 498 (see §601.601(d)(2) of this chapter).

under section 199, items arising from a tax- In addition, a taxpayer also may rely on the §602.101 OMB Control numbers.

able year of a partnership, S corporation, provisions of REG–105847–05 for taxable

estate, or trust beginning before January 1, years beginning before June 1, 2006. If *****

2005, shall not be taken into account Notice 2005–14 and REG–105847–05 in- (b) * * *

for purposes of section 199(d)(1). Section clude different rules for the same particular







CFR part or section where Current OMB

identified and described control No.

*****

1.199–6 ........................................................... 1545–1966

*****



Mark E. Matthews, Section 851.—Definition of 851(b)(2) of the Code. Rev. Rul. 2006–1

Deputy Commissioner for Regulated Investment modified and clarified.

Services and Enforcement. Company

Rev. Rul. 2006–31

Approved May 2, 2006. 26 CFR 1.851–2: Limitations.

(Also Sections 7704, 7805; 301.7805–1.) Rev. Rul. 2006–1, 2006–2 I.R.B. 261,

Eric Solomon, discusses derivative contracts with respect

Acting Deputy Assistant Secretary Regulated investment company

to a commodity index (“Derivatives”) that

of the Treasury. (RIC). This ruling modifies Rev. Rul.

a regulated investment company (R) enters

2006–1 to extend until September 30,

(Filed by the Office of the Federal Register on May 24, 2006, into under Master Agreements with vari-

2006, the transition period provided by

11:47 a.m., and published in the issue of the Federal Register ous counterparties. Under the Derivatives,

for June 1, 2006, 71 F.R. 31267) that ruling, and clarifies that Rev. Rul.

R will pay an amount equal to the 3-month

2006–1 was not intended to preclude a

U.S. Treasury bill rate plus a spread and

conclusion that income from certain in-

will receive (or pay) an amount based on

struments (such as structured notes) that

the total return gain (or loss) on a com-

create a commodity exposure for the

modity index. The payment obligation on

holder is qualifying income under section

each Derivative is settled monthly by the





2006–25 I.R.B. 1133 June 19, 2006

receipt (in the event of a gain) or pay- been informed that, due to temporary de- for the calendar quarter beginning July 1,

ment (in the event of a loss) of cash, in mand/supply imbalances, some RICs that 2006, will be 8 percent for overpayments

the net amount under the contract, and had previously invested in derivative con- (7 percent in the case of a corporation), 8

each monthly measuring period constitutes tracts similar to the Derivatives described percent for underpayments, and 10 percent

a separate derivative contract under the in Rev. Rul. 2006–1 are having difficulty for large corporate underpayments. The

Master Agreements. in acquiring alternative commodity-linked rate of interest paid on the portion of a

Rev. Rul. 2006–1 holds that a deriva- investments that result in qualifying in- corporate overpayment exceeding $10,000

tive contract with respect to a commod- come for purposes of section 851(b)(2). will be 5.5 percent.

ity index is not a security for purposes of The prospective application of the rul-

section 851(b)(2) of the Internal Revenue ing was intended to apply to all derivative Rev. Rul. 2006–30

Code and that, under the facts stated in contracts with respect to a commodity

the ruling, R’s income from the contract is index or an individual commodity. Ac- Section 6621 of the Internal Revenue

not qualifying income for purposes of sec- cordingly, to alleviate temporary sup- Code establishes the rates for interest

tion 851(b)(2), because the income from ply/demand pressure and to clarify the on tax overpayments and tax underpay-

the contract is not derived with respect to scope of the PROSPECTIVE APPLICA- ments. Under section 6621(a)(1), the

R’s business of investing in stocks, secu- TION section of Rev. Rul. 2006–1, that overpayment rate is the sum of the federal

rities, or currencies. Rev. Rul. 2006–1 section is revised to read: short-term rate plus 3 percentage points (2

further provides that under the authority of percentage points in the case of a corpo-

section 7805(b)(8), the holding of the rev- Under the authority of section ration), except the rate for the portion of

enue ruling will not be applied adversely 7805(b)(8), the holding of this revenue a corporate overpayment of tax exceeding

with respect to amounts of income that a ruling will not be applied adversely $10,000 for a taxable period is the sum of

taxpayer recognizes on or before June 30, with respect to amounts of income the federal short-term rate plus 0.5 of a

2006. that a taxpayer recognizes on or before percentage point for interest computations

It has come to the attention of the Ser- September 30, 2006, from a Deriva- made after December 31, 1994. Under

vice that some taxpayers are questioning tive. Neither will the Service apply the section 6621(a)(2), the underpayment rate

whether the holding of the revenue rul- principles set forth in this revenue rul- is the sum of the federal short-term rate

ing applies to investments by regulated in- ing adversely with respect to amounts plus 3 percentage points.

vestment companies (RICs) in all deriva- of income recognized on or before Section 6621(c) provides that for pur-

tive contracts with respect to a commod- September 30, 2006, by a taxpayer poses of interest payable under section

ity index, including for example structured from a derivative contract (including 6601 on any large corporate underpay-

notes, rather than just to the Derivatives an option, futures or forward contract) ment, the underpayment rate under section

described in the revenue ruling. on a commodity index or an individual 6621(a)(2) is determined by substituting

The ruling was not intended to preclude commodity. “5 percentage points” for “3 percentage

a conclusion that the income from cer- points.” See section 6621(c) and section

tain instruments (such as certain structured EFFECT ON OTHER DOCUMENTS 301.6621–3 of the Regulations on Proce-

notes) that create a commodity exposure dure and Administration for the definition

for the holder is qualifying income under Rev. Rul. 2006–1 is modified and clar- of a large corporate underpayment and

section 851(b)(2). Accordingly, to clar- ified. for the rules for determining the appli-

ify the holding of Rev. Rul. 2006–1, the cable date. Section 6621(c) and section

DRAFTING INFORMATION

HOLDING section is revised to read: 301.6621–3 are generally effective for

periods after December 31, 1990.

The principal author of this revenue

A Derivative is not a security for pur- Section 6621(b)(1) provides that the

ruling is Dale S. Collinson of the Office

poses of section 851(b)(2). Under the Secretary will determine the federal

of the Associate Chief Counsel (Finan-

facts above, R’s income from a Deriva- short-term rate for the first month in each

cial Institutions & Products). For further

tive is not qualifying income for pur- calendar quarter.

information regarding this revenue rul-

poses of section 851(b)(2), because the Section 6621(b)(2)(A) provides that the

ing, contact him at (202) 622–3900 or

income from the contract is not derived federal short-term rate determined under

Susan Thompson Baker at (202) 622–3930

with respect to R’s business of invest- section 6621(b)(1) for any month applies

(not toll-free calls).

ing in stocks, securities, or currencies. during the first calendar quarter beginning

after such month.

In addition, some taxpayers have ques- Section 6621(b)(3) provides that the

tioned whether the prospective application

Section 6621.—Determina- federal short-term rate for any month is

of the ruling is limited to the Derivatives

tion of Rate of Interest the federal short-term rate determined

described in the revenue ruling or includes 26 CFR 301.6621–1: Interest rate. during such month by the Secretary in

all derivative contracts with respect to a accordance with § 1274(d), rounded to the

commodity index or an individual com- Interest rates; underpayments and nearest full percent (or, if a multiple of 1/2

modity, including, for example, commod- overpayments. The rate of interest de- of 1 percent, the rate is increased to the

ity futures contracts. The Service has also termined under section 6621 of the Code next highest full percent).





June 19, 2006 1134 2006–25 I.R.B.

Notice 88–59, 1988–1 C.B. 546, an- payment rate of 8 percent are established Proc. 95–17, 1995–1 C.B. 556, 570, 573,

nounced that, in determining the quarterly for the calendar quarter beginning July 1, 575, and 579.

interest rates to be used for overpayments 2006. The overpayment rate for the por- Annual interest rates to be compounded

and underpayments of tax under section tion of a corporate overpayment exceeding daily pursuant to section 6622 that apply

6621, the Internal Revenue Service will $10,000 for the calendar quarter beginning for prior periods are set forth in the tables

use the federal short-term rate based on July 1, 2006, is 5.5 percent. The under- accompanying this revenue ruling.

daily compounding because that rate is payment rate for large corporate underpay-

most consistent with section 6621 which, ments for the calendar quarter beginning DRAFTING INFORMATION

pursuant to section 6622, is subject to daily July 1, 2006, is 10 percent. These rates ap-

The principal author of this revenue rul-

compounding. ply to amounts bearing interest during that

ing is Crystal Foster of the Office of Asso-

Rounded to the nearest full percent, the calendar quarter.

ciate Chief Counsel (Procedure & Admin-

federal short-term rate based on daily com- Interest factors for daily compound in-

istration). For further information regard-

pounding determined during the month of terest for annual rates of 5.5 percent, 7 per-

ing this revenue ruling, contact Ms. Foster

April 2006 is 5 percent. Accordingly, an cent, 8 percent, and 10 percent are pub-

at (202) 622–7198 (not a toll-free call).

overpayment rate of 8 percent (7 percent lished in Tables 16, 19, 21, and 25 of Rev.

in the case of a corporation) and an under-





TABLE OF INTEREST RATES

PERIODS BEFORE JUL. 1, 1975 — PERIODS ENDING DEC. 31, 1986

OVERPAYMENTS AND UNDERPAYMENTS

In 1995–1 C.B.

PERIOD RATE DAILY RATE TABLE

Before Jul. 1, 1975 6% Table 2, pg. 557

Jul. 1, 1975—Jan. 31, 1976 9% Table 4, pg. 559

Feb. 1, 1976—Jan. 31, 1978 7% Table 3, pg. 558

Feb. 1, 1978—Jan. 31, 1980 6% Table 2, pg. 557

Feb. 1, 1980—Jan. 31, 1982 12% Table 5, pg. 560

Feb. 1, 1982—Dec. 31, 1982 20% Table 6, pg. 560

Jan. 1, 1983—Jun. 30, 1983 16% Table 37, pg. 591

Jul. 1, 1983—Dec. 31, 1983 11% Table 27, pg. 581

Jan. 1, 1984—Jun. 30, 1984 11% Table 75, pg. 629

Jul. 1, 1984—Dec. 31, 1984 11% Table 75, pg. 629

Jan. 1, 1985—Jun. 30, 1985 13% Table 31, pg. 585

Jul. 1, 1985—Dec. 31, 1985 11% Table 27, pg. 581

Jan. 1, 1986—Jun. 30, 1986 10% Table 25, pg. 579

Jul. 1, 1986—Dec. 31, 1986 9% Table 23, pg. 577





TABLE OF INTEREST RATES

FROM JAN. 1, 1987 — DEC. 31, 1998

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.

RATE TABLE PG RATE TABLE PG

Jan. 1, 1987—Mar. 31, 1987 8% 21 575 9% 23 577

Apr. 1, 1987—Jun. 30, 1987 8% 21 575 9% 23 577

Jul. 1, 1987—Sep. 30, 1987 8% 21 575 9% 23 577

Oct. 1, 1987—Dec. 31, 1987 9% 23 577 10% 25 579

Jan. 1, 1988—Mar. 31, 1988 10% 73 627 11% 75 629

Apr. 1, 1988—Jun. 30, 1988 9% 71 625 10% 73 627

Jul. 1, 1988—Sep. 30, 1988 9% 71 625 10% 73 627

Oct. 1, 1988—Dec. 31, 1988 10% 73 627 11% 75 629

Jan. 1, 1989—Mar. 31, 1989 10% 25 579 11% 27 581

Apr. 1, 1989—Jun. 30, 1989 11% 27 581 12% 29 583

Jul. 1, 1989—Sep. 30, 1989 11% 27 581 12% 29 583

Oct. 1, 1989—Dec. 31, 1989 10% 25 579 11% 27 581







2006–25 I.R.B. 1135 June 19, 2006

TABLE OF INTEREST RATES

FROM JAN. 1, 1987 — DEC. 31, 1998 – Continued

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.

RATE TABLE PG RATE TABLE PG

Jan. 1, 1990—Mar. 31, 1990 10% 25 579 11% 27 581

Apr. 1, 1990—Jun. 30, 1990 10% 25 579 11% 27 581

Jul. 1, 1990—Sep. 30, 1990 10% 25 579 11% 27 581

Oct. 1, 1990—Dec. 31, 1990 10% 25 579 11% 27 581

Jan. 1, 1991—Mar. 31, 1991 10% 25 579 11% 27 581

Apr. 1, 1991—Jun. 30, 1991 9% 23 577 10% 25 579

Jul. 1, 1991—Sep. 30, 1991 9% 23 577 10% 25 579

Oct. 1, 1991—Dec. 31, 1991 9% 23 577 10% 25 579

Jan. 1, 1992—Mar. 31, 1992 8% 69 623 9% 71 625

Apr. 1, 1992—Jun. 30, 1992 7% 67 621 8% 69 623

Jul. 1, 1992—Sep. 30, 1992 7% 67 621 8% 69 623

Oct. 1, 1992—Dec. 31, 1992 6% 65 619 7% 67 621

Jan. 1, 1993—Mar. 31, 1993 6% 17 571 7% 19 573

Apr. 1, 1993—Jun. 30, 1993 6% 17 571 7% 19 573

Jul. 1, 1993—Sep. 30, 1993 6% 17 571 7% 19 573

Oct. 1, 1993—Dec. 31, 1993 6% 17 571 7% 19 573

Jan. 1, 1994—Mar. 31, 1994 6% 17 571 7% 19 573

Apr. 1, 1994—Jun. 30, 1994 6% 17 571 7% 19 573

Jul. 1, 1994—Sep. 30, 1994 7% 19 573 8% 21 575

Oct. 1, 1994—Dec. 31, 1994 8% 21 575 9% 23 577

Jan. 1, 1995—Mar. 31, 1995 8% 21 575 9% 23 577

Apr. 1, 1995—Jun. 30, 1995 9% 23 577 10% 25 579

Jul. 1, 1995—Sep. 30, 1995 8% 21 575 9% 23 577

Oct. 1, 1995—Dec. 31, 1995 8% 21 575 9% 23 577

Jan. 1, 1996—Mar. 31, 1996 8% 69 623 9% 71 625

Apr. 1, 1996—Jun. 30, 1996 7% 67 621 8% 69 623

Jul. 1, 1996—Sep. 30, 1996 8% 69 623 9% 71 625

Oct. 1, 1996—Dec. 31, 1996 8% 69 623 9% 71 625

Jan. 1, 1997—Mar. 31, 1997 8% 21 575 9% 23 577

Apr. 1, 1997—Jun. 30, 1997 8% 21 575 9% 23 577

Jul. 1, 1997—Sep. 30, 1997 8% 21 575 9% 23 577

Oct. 1, 1997—Dec. 31, 1997 8% 21 575 9% 23 577

Jan. 1, 1998—Mar. 31, 1998 8% 21 575 9% 23 577

Apr. 1, 1998—Jun. 30, 1998 7% 19 573 8% 21 575

Jul. 1, 1998—Sep. 30, 1998 7% 19 573 8% 21 575

Oct. 1, 1998—Dec. 31, 1998 7% 19 573 8% 21 575





TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT

NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS

1995–1 C.B.

RATE TABLE PG

Jan. 1, 1999—Mar. 31, 1999 7% 19 573

Apr. 1, 1999—Jun. 30, 1999 8% 21 575

Jul. 1, 1999—Sep. 30, 1999 8% 21 575

Oct. 1, 1999—Dec. 31, 1999 8% 21 575

Jan. 1, 2000—Mar. 31, 2000 8% 69 623

Apr. 1, 2000—Jun. 30, 2000 9% 71 625

Jul. 1, 2000—Sep. 30, 2000 9% 71 625

Oct. 1, 2000—Dec. 31, 2000 9% 71 625

Jan. 1, 2001—Mar. 31, 2001 9% 23 577

Apr. 1, 2001—Jun. 30, 2001 8% 21 575







June 19, 2006 1136 2006–25 I.R.B.

TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT – Continued

NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS

1995–1 C.B.

RATE TABLE PG

Jul. 1, 2001—Sep. 30, 2001 7% 19 573

Oct. 1, 2001—Dec. 31, 2001 7% 19 573

Jan. 1, 2002—Mar. 31, 2002 6% 17 571

Apr. 1, 2002—Jun. 30, 2002 6% 17 571

Jul. 1, 2002—Sep. 30, 2002 6% 17 571

Oct. 1, 2002—Dec. 31, 2002 6% 17 571

Jan. 1, 2003—Mar. 31, 2003 5% 15 569

Apr. 1, 2003—Jun. 30, 2003 5% 15 569

Jul. 1, 2003—Sep. 30, 2003 5% 15 569

Oct. 1, 2003—Dec. 31, 2003 4% 13 567

Jan. 1, 2004—Mar. 31, 2004 4% 61 615

Apr. 1, 2004—Jun. 30, 2004 5% 63 617

Jul. 1, 2004—Sep. 30, 2004 4% 61 615

Oct. 1, 2004—Dec. 31, 2004 5% 63 617

Jan. 1, 2005—Mar. 31, 2005 5% 15 569

Apr. 1, 2005—Jun. 30, 2005 6% 17 571

Jul. 1, 2005—Sep. 30, 2005 6% 17 571

Oct. 1, 2005—Dec. 31, 2005 7% 19 573

Jan. 1, 2006—Mar. 31, 2006 7% 19 573

Apr. 1, 2006—Jun. 30, 2006 7% 19 573

Jul. 1, 2006—Sep. 30, 2006 8% 21 575





TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT

CORPORATE OVERPAYMENTS AND UNDERPAYMENTS

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.

RATE TABLE PG RATE TABLE PG

Jan. 1, 1999—Mar. 31, 1999 6% 17 571 7% 19 573

Apr. 1, 1999—Jun. 30, 1999 7% 19 573 8% 21 575

Jul. 1, 1999—Sep. 30, 1999 7% 19 573 8% 21 575

Oct. 1, 1999—Dec. 31, 1999 7% 19 573 8% 21 575

Jan. 1, 2000—Mar. 31, 2000 7% 67 621 8% 69 623

Apr. 1, 2000—Jun. 30, 2000 8% 69 623 9% 71 625

Jul. 1, 2000—Sep. 30, 2000 8% 69 623 9% 71 625

Oct. 1, 2000—Dec. 31, 2000 8% 69 623 9% 71 625

Jan. 1, 2001—Mar. 31, 2001 8% 21 575 9% 23 577

Apr. 1, 2001—Jun. 30, 2001 7% 19 573 8% 21 575

Jul. 1, 2001—Sep. 30, 2001 6% 17 571 7% 19 573

Oct. 1, 2001—Dec. 31, 2001 6% 17 571 7% 19 573

Jan. 1, 2002—Mar. 31, 2002 5% 15 569 6% 17 571

Apr. 1, 2002—Jun. 30, 2002 5% 15 569 6% 17 571

Jul. 1, 2002—Sep. 30, 2002 5% 15 569 6% 17 571

Oct. 1, 2002—Dec. 31, 2002 5% 15 569 6% 17 571

Jan. 1, 2003—Mar. 31, 2003 4% 13 567 5% 15 569

Apr. 1, 2003—Jun. 30, 2003 4% 13 567 5% 15 569

Jul. 1, 2003—Sep. 30, 2003 4% 13 567 5% 15 569

Oct. 1, 2003—Dec. 31, 2003 3% 11 565 4% 13 567

Jan. 1, 2004—Mar. 31, 2004 3% 59 613 4% 61 615

Apr. 1, 2004—Jun. 30, 2004 4% 61 615 5% 63 617

Jul. 1, 2004—Sep. 30, 2004 3% 59 613 4% 61 615







2006–25 I.R.B. 1137 June 19, 2006

TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT – Continued

CORPORATE OVERPAYMENTS AND UNDERPAYMENTS

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.

RATE TABLE PG RATE TABLE PG

Oct. 1, 2004—Dec. 31, 2004 4% 61 615 5% 63 617

Jan. 1, 2005—Mar. 31, 2005 4% 13 567 5% 15 569

Apr. 1, 2005—Jun. 30, 2005 5% 15 569 6% 17 571

Jul. 1, 2005—Sep. 30, 2005 5% 15 569 6% 17 571

Oct. 1, 2005—Dec. 31, 2005 6% 17 571 7% 19 573

Jan. 1, 2006—Mar. 31, 2006 6% 17 571 7% 19 573

Apr. 1, 2006—Jun. 30, 2006 6% 17 571 7% 19 573

Jul. 1, 2006—Sep. 30, 2006 7% 19 573 8% 21 575





TABLE OF INTEREST RATES FOR

LARGE CORPORATE UNDERPAYMENTS

FROM JANUARY 1, 1991 — PRESENT

1995–1 C.B.

RATE TABLE PG

Jan. 1, 1991—Mar. 31, 1991 13% 31 585

Apr. 1, 1991—Jun. 30, 1991 12% 29 583

Jul. 1, 1991—Sep. 30, 1991 12% 29 583

Oct. 1, 1991—Dec. 31, 1991 12% 29 583

Jan. 1, 1992—Mar. 31, 1992 11% 75 629

Apr. 1, 1992—Jun. 30, 1992 10% 73 627

Jul. 1, 1992—Sep. 30, 1992 10% 73 627

Oct. 1, 1992—Dec. 31, 1992 9% 71 625

Jan. 1, 1993—Mar. 31, 1993 9% 23 577

Apr. 1, 1993—Jun. 30, 1993 9% 23 577

Jul. 1, 1993—Sep. 30, 1993 9% 23 577

Oct. 1, 1993—Dec. 31, 1993 9% 23 577

Jan. 1, 1994—Mar. 31, 1994 9% 23 577

Apr. 1, 1994—Jun. 30, 1994 9% 23 577

Jul. 1, 1994—Sep. 30, 1994 10% 25 579

Oct. 1, 1994—Dec. 31, 1994 11% 27 581

Jan. 1, 1995—Mar. 31, 1995 11% 27 581

Apr. 1, 1995—Jun. 30, 1995 12% 29 583

Jul. 1, 1995—Sep. 30, 1995 11% 27 581

Oct. 1, 1995—Dec. 31, 1995 11% 27 581

Jan. 1, 1996—Mar. 31, 1996 11% 75 629

Apr. 1, 1996—Jun. 30, 1996 10% 73 627

Jul. 1, 1996—Sep. 30, 1996 11% 75 629

Oct. 1, 1996—Dec. 31, 1996 11% 75 629

Jan. 1, 1997—Mar. 31, 1997 11% 27 581

Apr. 1, 1997—Jun. 30, 1997 11% 27 581

Jul. 1, 1997—Sep. 30, 1997 11% 27 581

Oct. 1, 1997—Dec. 31, 1997 11% 27 581

Jan. 1, 1998—Mar. 31, 1998 11% 27 581

Apr. 1, 1998—Jun. 30, 1998 10% 25 579

Jul. 1, 1998—Sep. 30, 1998 10% 25 579

Oct. 1, 1998—Dec. 31, 1998 10% 25 579

Jan. 1, 1999—Mar. 31, 1999 9% 23 577

Apr. 1, 1999—Jun. 30, 1999 10% 25 579

Jul. 1, 1999—Sep. 30, 1999 10% 25 579

Oct. 1, 1999—Dec. 31, 1999 10% 25 579

Jan. 1, 2000—Mar. 31, 2000 10% 73 627







June 19, 2006 1138 2006–25 I.R.B.

TABLE OF INTEREST RATES FOR

LARGE CORPORATE UNDERPAYMENTS

FROM JANUARY 1, 1991 — PRESENT – Continued

1995–1 C.B.

RATE TABLE PG

Apr. 1, 2000—Jun. 30, 2000 11% 75 629

Jul. 1, 2000—Sep. 30, 2000 11% 75 629

Oct. 1, 2000—Dec. 31, 2000 11% 75 629

Jan. 1, 2001—Mar. 31, 2001 11% 27 581

Apr. 1, 2001—Jun. 30, 2001 10% 25 579

Jul. 1, 2001—Sep. 30, 2001 9% 23 577

Oct. 1, 2001—Dec. 31, 2001 9% 23 577

Jan. 1, 2002—Mar. 31, 2002 8% 21 575

Apr. 1, 2002—Jun. 30, 2002 8% 21 575

Jul. 1, 2002—Sep. 30, 2002 8% 21 575

Oct. 1, 2002—Dec. 30, 2002 8% 21 575

Jan. 1, 2003—Mar. 31, 2003 7% 19 573

Apr. 1, 2003—Jun. 30, 2003 7% 19 573

Jul. 1, 2003—Sep. 30, 2003 7% 19 573

Oct. 1, 2003—Dec. 31, 2003 6% 17 571

Jan. 1, 2004—Mar. 31, 2004 6% 65 619

Apr. 1, 2004—Jun. 30, 2004 7% 67 621

Jul. 1, 2004—Sep. 30, 2004 6% 65 619

Oct. 1, 2004—Dec. 31, 2004 7% 67 621

Jan. 1, 2005—Mar. 31, 2005 7% 19 573

Apr. 1, 2005—Jun. 30, 2005 8% 21 575

Jul. 1, 2005—Sep. 30, 2005 8% 21 575

Oct. 1, 2005—Dec. 31, 2005 9% 23 577

Jan. 1, 2006—Mar. 31, 2006 9% 23 577

Apr. 1, 2006—Jun. 30, 2006 9% 23 577

Jul. 1, 2006—Sep. 30, 2006 10% 25 579





TABLE OF INTEREST RATES FOR CORPORATE

OVERPAYMENTS EXCEEDING $10,000

FROM JANUARY 1, 1995 — PRESENT



1995–1 C.B.

RATE TABLE PG

Jan. 1, 1995—Mar. 31, 1995 6.5% 18 572

Apr. 1, 1995—Jun. 30, 1995 7.5% 20 574

Jul. 1, 1995—Sep. 30, 1995 6.5% 18 572

Oct. 1, 1995—Dec. 31, 1995 6.5% 18 572

Jan. 1, 1996—Mar. 31, 1996 6.5% 66 620

Apr. 1, 1996—Jun. 30, 1996 5.5% 64 618

Jul. 1, 1996—Sep. 30, 1996 6.5% 66 620

Oct. 1, 1996—Dec. 31, 1996 6.5% 66 620

Jan. 1, 1997—Mar. 31, 1997 6.5% 18 572

Apr. 1, 1997—Jun. 30, 1997 6.5% 18 572

Jul. 1, 1997—Sep. 30, 1997 6.5% 18 572

Oct. 1, 1997—Dec. 31, 1997 6.5% 18 572

Jan. 1, 1998—Mar. 31, 1998 6.5% 18 572

Apr. 1, 1998—Jun. 30, 1998 5.5% 16 570

Jul. 1, 1998—Sep. 30, 1998 5.5% 16 570

Oct. 1, 1998—Dec. 31, 1998 5.5% 16 570

Jan. 1, 1999—Mar. 31, 1999 4.5% 14 568

Apr. 1, 1999—Jun. 30, 1999 5.5% 16 570

Jul. 1, 1999—Sep. 30, 1999 5.5% 16 570

Oct. 1, 1999—Dec. 31, 1999 5.5% 16 570







2006–25 I.R.B. 1139 June 19, 2006

TABLE OF INTEREST RATES FOR CORPORATE

OVERPAYMENTS EXCEEDING $10,000

FROM JANUARY 1, 1995 — PRESENT – Continued



1995–1 C.B.

RATE TABLE PG

Jan. 1, 2000—Mar. 31, 2000 5.5% 64 618

Apr. 1, 2000—Jun. 30, 2000 6.5% 66 620

Jul. 1, 2000—Sep. 30, 2000 6.5% 66 620

Oct. 1, 2000—Dec. 31, 2000 6.5% 66 620

Jan. 1, 2001—Mar. 31, 2001 6.5% 18 572

Apr. 1, 2001—Jun. 30, 2001 5.5% 16 570

Jul. 1, 2001—Sep. 30, 2001 4.5% 14 568

Oct. 1, 2001—Dec. 31, 2001 4.5% 14 568

Jan. 1, 2002—Mar. 31, 2002 3.5% 12 566

Apr. 1, 2002—Jun. 30, 2002 3.5% 12 566

Jul. 1, 2002—Sep. 30, 2002 3.5% 12 566

Oct. 1, 2002—Dec. 31, 2002 3.5% 12 566

Jan. 1, 2003—Mar. 31, 2003 2.5% 10 564

Apr. 1, 2003—Jun. 30, 2003 2.5% 10 564

Jul. 1, 2003—Sep. 30, 2003 2.5% 10 564

Oct. 1, 2003—Dec. 31, 2003 1.5% 8 562

Jan. 1, 2004—Mar. 31, 2004 1.5% 56 610

Apr. 1, 2004—Jun. 30, 2004 2.5% 58 612

Jul. 1, 2004—Sep. 30, 2004 1.5% 56 610

Oct. 1, 2004—Dec. 31, 2004 2.5% 58 612

Jan. 1, 2005—Mar. 31, 2005 2.5% 10 564

Apr. 1, 2005—Jun. 30, 2005 3.5% 12 566

Jul. 1, 2005—Sep. 30, 2005 3.5% 12 566

Oct. 1, 2005—Dec. 31, 2005 4.5% 14 568

Jan. 1, 2006—Mar. 31, 2006 4.5% 14 568

Apr. 1, 2006—Jun. 30, 2006 4.5% 14 568

Jul. 1, 2006—Sep. 30, 2006 5.5% 16 570









June 19, 2006 1140 2006–25 I.R.B.

Part III. Administrative, Procedural, and Miscellaneous

Communications Excise Tax; of amounts paid for communications ser- system area in which the station provided

Toll Telephone Service vices. with this service is located.

(3) Collection of tax. Section 4291 pro- (c) Rev. Rul. 79–404. Rev. Rul.

Notice 2006–50 vides that the tax is collected by the person 79–404, 1979–2 C.B. 382, concludes that

receiving the payment (collector). In most a long distance telephone call for which

SECTION 1. PURPOSE cases, the collector, which is also respon- the charge varies with elapsed transmis-

sible for paying over the tax to the govern- sion time but not with distance is toll tele-

(a) In general. As further described in ment, is the telecommunications company phone service described in § 4252(b)(1).

this notice, the Internal Revenue Service that provides the communications services (d) Notice of proposed rulemaking.

will follow the holdings of Am. Bankers to the taxpayer. In a notice of proposed rulemaking

Ins. Group v. United States, 408 F.3d (b) Definitions—(1) Communications (REG–141097–02, 2003–1 C.B. 807 [68

1328 (11th Cir. 2005) (ABIG); OfficeMax, services. Section 4251(b)(1) provides FR 15690]; April 1, 2003), the Service

Inc. v. United States, 428 F.3d 583 (6th that the term communications services proposed an amendment to the Facilities

Cir. 2005); Nat’l R.R. Passenger Corp. means (A) local telephone service; (B) toll and Services Excise Taxes Regulations

v. United States, 431 F.3d 374 (D.C. Cir. telephone service; and (C) teletypewriter to provide that toll telephone service de-

2005) (Amtrak); Fortis v. United States, exchange service. This notice does not scribed in section 4252(b)(1) may include

2006 U.S. App. LEXIS 10749 (2d Cir. address teletypewriter exchange service. a communication service for which the

Apr. 27, 2006); and Reese Bros. v. United (2) Local telephone service. Section charge does not vary with the distance of

States, 2006 U.S. App. LEXIS 11468 (3d 4252(a) provides that local telephone ser- each individual communication.

Cir. May 9, 2006). These cases hold that a vice means (1) the access to a local tele- (e) Recent litigation. ABIG, OfficeMax,

telephonic communication for which there phone system, and the privilege of tele- Amtrak, and Reese Bros. hold time-only

is a toll charge that varies with elapsed phonic quality communication with sub- service is not toll telephone service as

transmission time and not distance (time- stantially all persons having telephone or defined in § 4252(b)(1). Further, ABIG,

only service) is not taxable toll telephone radio telephone stations constituting a part OfficeMax, and Reese Bros. hold that the

service as defined in § 4252(b)(1) of the In- of such local telephone system; and (2) communications service provided was not

ternal Revenue Code. As a result, amounts any facility or service provided in connec- a service described in § 4252(b)(2) be-

paid for time-only service are not subject tion with such a service. Local telephone cause the end result was not a “periodic

to the tax imposed by § 4251. Accordingly, service does not include any service that charge” based on total elapsed time but

the government will no longer litigate this is a toll telephone service as defined in rather a monthly bill based on a summation

issue and Notice 2005–79, 2005–46 I.R.B. § 4252(b) or a private communications ser- of toll charges for individual communica-

952, which states otherwise, is revoked. vice as defined in § 4252(d). This notice tions. (In Amtrak, toll telephone service

(b) Credits and refunds. Taxpayers may does not address private communications described in § 4252(b)(2) would have been

be entitled to request credit or refund of service. exempt from tax under the common carrier

the excise taxes paid for the services cov- (3) Toll telephone service—(i) Time and exception in § 4253(f).) ABIG, OfficeMax,

ered by this notice. This notice provides distance. Section 4252(b)(1) provides that Amtrak, and Reese Bros. also hold that the

guidance regarding these requests. In ad- toll telephone service includes a telephonic communications services provided were

dition, the Commissioner will authorize quality communication for which there is not local service, notwithstanding the ac-

the scheduling of an overassessment un- a toll charge that varies in amount with cess the services provided to the local

der § 6407 to keep the period of limitations the distance and elapsed transmission time telephone system. (Fortis affirms, in a per

open for these requests. This overassess- of each individual communication and for curiam opinion, a district court decision

ment will apply to all taxpayers and to all which the charge is paid within the United reaching the same results.)

taxes paid for the services covered by this States. (f) Notice 2005–79. Notice 2005–79,

notice beginning with the tax paid on ser- (ii) Periodic charge for a specified 2005–46 I.R.B. 952, states that the Service

vices that were billed to customers after area. Section 4252(b)(2) provides that will continue to assess and collect the tax

February 28, 2003. toll telephone service also includes a ser- imposed by § 4251 on all taxable commu-

vice which entitles the subscriber, upon nications services, including those similar

SECTION 2. BACKGROUND payment of a periodic charge (determined to the services in ABIG.

as a flat amount or upon the basis of total

(a) In general—(1) Tax imposed. Sec- SECTION 3. TERMS DEFINED

elapsed transmission time), to the privilege

tion 4251(a)(1) imposes a tax on amounts

of an unlimited number of telephonic com-

paid for communications services. The following terms are defined solely

munications to or from all or a substantial

(2) Payment of tax. Section 4251(a)(2) for purposes of this notice:

portion of the persons having telephone

provides that the tax imposed shall be (a) Bundled service. Bundled service

or radio telephone stations in a specified

paid by the person paying for the service is local and long distance service pro-

area which is outside the local telephone

(taxpayer). Section 4251(b)(2) provides vided under a plan that does not separately

that the applicable percentage is 3 percent state the charge for the local telephone





2006–25 I.R.B. 1141 June 19, 2006

service. Bundled service includes, for cludes amounts paid for facilities or ser- overpayment amount. Persons that are not

example, Voice over Internet Protocol ser- vices provided in connection with local otherwise required to file a federal income

vice, prepaid telephone cards, and plans telephone service. Thus, for example, tax tax return must nevertheless file a return

that provide both local and long distance will continue to be imposed on amounts to obtain the credit or refund. Except as

service for either a flat monthly fee or a paid by a taxpayer for renting an ampli- provided in section 5(d)(4) of this notice,

charge that varies with the elapsed trans- fier phone provided in connection with lo- a request for this credit or refund on any

mission time for which the service is used. cal telephone service that is subject to tax. other form (such as a Form 720, 843, or

Telecommunications companies provide (c) Effect on collectors. Collectors are 8849) will not be processed by the Service.

bundled service for both landline and directed to cease collecting and paying Taxpayers will be permitted to request the

wireless (cellular) service. over tax under § 4251 on nontaxable ser- safe harbor amount under paragraph (c) of

(b) Local-only service. Local-only ser- vice that is billed after July 31, 2006, and this section only if they have paid all taxes

vice is local telephone service, as defined are not required to report to the IRS any billed by their service provider after Febru-

in § 4252(a), provided under a plan that refusal by their customers to pay any tax ary 28, 2003, and before August 1, 2006.

does not include long distance telephone on nontaxable service that is billed after (3) Guidance on the form. The instruc-

service or that separately states the charge May 25, 2006. Collectors should not pay tions to the respective federal income tax

for local service on its bill to customers. over to the IRS any tax on nontaxable return forms will provide additional guid-

The term also includes services and facil- service that is billed after July 31, 2006. ance. The forms and instructions will re-

ities provided in connection with service The form will require collectors to cer- quire taxpayers to certify that (1) the tax-

described in the preceding sentence even tify that for the third quarter of 2006 the payer has not received from the collector a

though these services and facilities may § 4251 tax reported on the Form 720 does credit or refund of the tax paid on nontax-

also be used with long distance service. not include any tax on nontaxable service able service billed during the relevant pe-

See, for example, Rev. Rul. 72–537, that was billed after July 31, 2006. Con- riod and (2) the taxpayer will not ask the

1972–2 C.B. 574 (telephone amplifier); sequently, the IRS will deny all taxpayer collector for a credit or refund of that tax

Rev. Rul. 73–171, 1973–1 C.B. 445 (au- requests for refund of tax on nontaxable and has withdrawn any such request that

tomatic call distributing equipment); and service that was billed after July 31, 2006. was previously submitted. The instruc-

Rev. Rul. 73–269, 1973–1 C.B. 444 (spe- All such requests should be directed to tions will also require that taxpayers, ex-

cial telephone). the collector. In addition, collectors may cept for those individuals using the safe

(c) Long distance service. Long dis- repay to taxpayers the tax on nontaxable harbor amount, retain records that substan-

tance service is telephonic quality com- service that was billed before August 1, tiate the request. These records should in-

munication with persons whose telephones 2006, but are not required to repay such clude bills from the collector that show the

are outside the local telephone system of tax. Collectors may also request a refund amount of tax charged for nontaxable ser-

the caller. or make an adjustment to their separate vice for each month during the relevant pe-

(d) Nontaxable service. Nontaxable accounts, as appropriate, subject to the riod and receipts, canceled checks, or other

service means bundled service and long provisions of § 6415 and section 5(d)(4) evidence that the amount requested was

distance service. of this notice. Collectors must continue to actually paid.

collect and pay over tax under § 4251 on (b) Period of request. The Commis-

SECTION 4. EFFECT OF ABIG, amounts paid for local only service. sioner will authorize the scheduling of an

OFFICEMAX, AMTRAK, FORTIS, AND overassessment under § 6407 to preserve

REESE BROS. SECTION 5. REQUESTS FOR CREDIT the period of limitations during which tax-

OR REFUND payers may request refunds of the tax on

(a) Tax treatment of communications nontaxable service that was billed to cus-

service after ABIG, OfficeMax, Amtrak, (a) In general—(1) Request must follow tomers after February 28, 2003, and before

Fortis, and Reese Bros. The Service will this notice. The Commissioner agrees to August 1, 2006. Therefore, requests may

follow ABIG, OfficeMax, Amtrak, Fortis, credit or refund the amounts paid for non- be made for credits or refunds of tax paid

and Reese Bros. Accordingly, taxpayers taxable service if the taxpayer requests the for nontaxable service billed after Febru-

are no longer required to pay tax under credit or refund in the manner prescribed ary 28, 2003, and before August 1, 2006.

§ 4251 for nontaxable service. In addition, in this notice. (c) Amount of the request—(1) Re-

collectors or taxpayers may request a re- (2) Form of request. Taxpayers may re- quests by individual taxpayers—(i) Safe

fund of tax paid under § 4251 on nontax- quest a credit or refund of tax on nontax- harbor amount. Individual taxpayers may

able service that was billed to the taxpayers able service that was billed after February request a safe harbor amount. No docu-

during the period after February 28, 2003, 28, 2003, and before August 1, 2006, only mentation will be required to be submitted

and before August 1, 2006 (the relevant pe- on their 2006 Federal income tax returns. or kept to support the safe harbor request.

riod). For this purpose, the 2006 income tax re- However, taxpayers will be permitted to

(b) Tax on local-only service. Collec- turn is the income tax return for calendar request the safe harbor amount only if

tors should continue to collect and pay year 2006 or for the first taxable year in- they have paid all taxes billed by their

over the § 4251 tax on amounts paid for cluding December 31, 2006. Forms 1040 service provider after February 28, 2003,

local-only service. As noted in section (series), 1041, 1065, 1120 (series), and and before August 1, 2006; have not re-

3(b) of this notice, local-only service in- 990–T will include a line for requesting the ceived a credit or refund of these taxes





June 19, 2006 1142 2006–25 I.R.B.

from the service provider, and either have Deductions, Credits, etc., for that taxable any interest on the credit or refund on its

not requested such a credit or refund from year. Form 990–T, Exempt Organization Busi-

the service provider or have withdrawn (iii) S Corporations. An S Corpora- ness Income Tax Return, for the taxable

any such request. The amount of this safe tion, as defined in § 1361, may request year in which received or accrued.

harbor is still under consideration and will a credit or refund of federal excise taxes (vi) Corporations. A corporation, as

be announced in later guidance. paid on nontaxable service only on its 2006 defined in § 7701(a)(3), that is not de-

(ii) Actual amount. Taxpayers that do Form 1120S, U.S. Income Tax Return for scribed in section 5(d)(3)(iii) of this notice

not request the safe harbor amount may an S Corporation. Any amount of the may request a credit or refund of federal

request a credit or refund of the actual credit or refund included in S Corpora- excise taxes paid on nontaxable service

amount of tax they paid. tion income and any interest on the credit only on its 2006 Form 1120 (series) in-

(d) How to file—(1) Requests by in- or refund must be reported on the S Cor- come tax return (generally, Form 1120,

dividual taxpayers. Individual taxpayers poration’s return for the taxable year in U.S. Corporation Income Tax Return).

may request a credit or refund of federal which received or accrued and must be al- Any amount of the credit or refund in-

excise taxes paid on nontaxable service located to its shareholders on the Sched- cluded in the corporation’s income and

only on their 2006 Form 1040, 1040A, ule K–1, Shareholder’s Share of Income, any interest on the credit or refund must

or 1040–EZ, U.S. Individual Income Tax Deductions, Credits, etc., for that taxable be reported on the corporation’s income

Return. Individuals who are not otherwise year. tax return for the taxable year in which

required to file a federal income tax return (iv) Estates and trusts. An estate or received or accrued. Corporations that

must nevertheless file Form 1040EZ–T a trust, as defined in § 301.7701–4(a) of are not otherwise required to file a federal

to request the credit or refund. Individual the Procedure and Administration Regula- income tax return must nevertheless file

taxpayers, including Schedule C filers, tions, may request a credit or refund of fed- Form 1120 (series) to request the credit or

may request either the safe harbor amount eral excise taxes paid on nontaxable ser- refund.

or the actual amount of tax paid for non- vice only on its 2006 Form 1041, U.S. In- (vii) Other nonfiling entities. Entities

taxable service. come Tax Return for Estates and Trusts. that are not otherwise required to file a

(2) Requests by taxpayers other than in- Any amount of the credit or refund in- federal income tax return must file Form

dividual taxpayers. Taxpayers other than cluded in the estate’s or trust’s income and 990–T to request the credit or refund.

individual taxpayers (entities) may request any interest on the credit or refund must (4) Requests and adjustments by col-

only the actual amount of tax paid on non- be reported on the estate’s or trust’s Form lectors—(i) Section 6415 conditions to al-

taxable service billed during the relevant 1041, U.S. Income Tax Return for Estates lowance. The conditions to allowance de-

period. No safe harbor amount is allowed and Trusts, for the taxable year in which scribed in § 6415 apply to all requests and

for entities. received or accrued. However, for a trust adjustments by collectors, as defined by

(3) Requests by entities—(i) In general. that is treated as owned by the grantor or section 2(a)(3) of this notice. Thus, a re-

Entities may request a credit or refund of other person under subpart E (§ 671 and quest by a collector is allowed only if the

federal excise taxes paid on nontaxable following), part I, subchapter J, chapter person that paid over the tax establishes

service only on their 2006 income tax re- 1 of the Internal Revenue Code (grantor that it has repaid the amount of the tax to

turns. Any part of the credit or refund at- trust), the owner of the trust may request the person from whom the tax was col-

tributable to tax payments that were de- a credit or refund of federal excise taxes lected, or obtains the written consent of

ducted as an ordinary and necessary busi- treated as paid by the owner for nontaxable such person to the allowance of the credit

ness expense (including in the determina- service only on its applicable 2006 federal or refund.

tion of unrelated business taxable income) tax return. (ii) Requests for regular method collec-

must be included in income for the tax- (v) Tax exempt organizations. An or- tors—(A) In general. A person that col-

able year in which the refund is received ganization that is described in § 501(a) lected the tax imposed by § 4251 on non-

or accrued to the extent that the tax pay- may request a credit or refund of federal taxable service and paid it over to the gov-

ments reduced the amount of federal in- excise taxes paid on nontaxable service ernment based on amounts actually col-

come tax (or unrelated business income only on its 2006 Form 990–T, Exempt Or- lected under § 40.6302(c)–1(a)(2)(i) of the

tax) imposed. ganization Business Income Tax Return. Excise Tax Procedural Regulations (regu-

(ii) Partnerships. A partnership, as de- Tax exempt organizations that are not oth- lar method collectors) may request a credit

fined in § 7701(a)(2), may request a credit erwise required to file a federal income or refund.

or refund of federal excise taxes paid on tax return must nevertheless file Form (B) Form of the request. Regular

nontaxable service only on its 2006 Form 990–T to request the credit or refund. Any method collectors may use Form 720X,

1065, U.S. Return of Partnership Income. amount of the credit or refund included Amended Quarterly Federal Excise Tax

Any amount of the credit or refund in- in the organization’s unrelated business Return, line 1, IRS No. 22, for credit or

cluded in partnership income and any in- taxable income must be reported on the refund of amounts collected and repaid to

terest on the credit or refund must be re- organization’s Form 990–T, Exempt Or- taxpayers.

ported on the partnership’s return for the ganization Business Income Tax Return, (iii) Account adjustments for alter-

taxable year in which received or accrued for the taxable year in which received or native method collectors. A person that

and must be allocated to its partners on the accrued. An organization that is subject to collected the tax imposed by § 4251 on

Schedule K–1, Partner’s Share of Income, tax on its interest income must also report nontaxable service and paid it over to the





2006–25 I.R.B. 1143 June 19, 2006

government based on amounts considered SECTION 7. DRAFTING reference price for the calendar year in

as collected under § 40.6302(c)–1(a)(2)(ii) INFORMATION which the sale occurs exceeds 8 cents,

(alternative method collectors) may adjust bears to (B) 3 cents. Under § 45(b)(2),

the separate account for the amount of an The principal author of this notice is the 1.5 cent amount in § 45(a), the 8 cent

overpayment. The required adjustment Taylor Cortright of the Office of the As- amount in § 45(b)(1), the $4.375 amount in

to the separate account is described in sociate Chief Counsel (Passthroughs and § 45(e)(8)(A), and in § 45(e)(8)(B)(i) the

§ 40.6302(c)–3(b)(2)(ii)(C). The adjust- Special Industries). For further informa- reference price of fuel used as feedstock

ment is reflected on Form 720, Schedule tion regarding this notice, contact (202) (within the meaning of § 45(c)(7)(A)) in

A, line 2, but may not reduce tax liability 622–3130 (not a toll-free call). 2002 are each adjusted by multiplying the

on Form 720 below zero. amount by the inflation adjustment factor

(e) Interest on the credit or refund in- for the calendar year in which the sale

cluded in income. If a taxpayer requests a Renewable Electricity occurs. If any amount as increased under

credit or refund of the actual amount of tax the preceding sentence is not a multiple

Production Credit and

paid, interest on the credit or refund of the of 0.1 cent, the amount is rounded to the

tax paid for nontaxable service must be in- Refined Coal Production nearest multiple of 0.1 cent.

cluded as income on the taxpayer’s income Credit, Publication of Inflation Section 45(c)(1) defines qualified

tax return for the taxable year in which the Adjustment Factor and energy resources as wind, closed-loop

interest is received or accrued. Thus, indi- Reference Prices for Calendar biomass, open-loop biomass, geother-

viduals are generally required to report the mal energy, solar energy, small irrigation

Year 2006

interest on their 2007 income tax returns. power, municipal solid waste, and quali-

(f) Estimated tax effects. Although the fied hydropower production.

Notice 2006–51

credit or refund allowed to a taxpayer un- Section 45(d)(1) defines a qualified fa-

der this notice will be requested on the tax- This notice publishes the inflation ad- cility using wind to produce electricity as

payer’s income tax return, it is not a credit justment factor and reference prices for any facility owned by the taxpayer that is

against tax for purposes of §§ 6654 and calendar year 2006 for the renewable elec- originally placed in service after Decem-

6655. Accordingly, the taxpayer may not tricity production credit and the refined ber 31, 1993, and before January 1, 2008.

take the credit or refund into account in de- coal production credit under § 45 of the See § 45(e)(7) for rules relating to the in-

termining the amount of the required in- Internal Revenue Code. The 2006 infla- applicability of the credit to electricity sold

stallments of estimated tax for 2006. In tion adjustment factor and reference prices to utilities under certain contracts.

determining the amount of the required in- are used in determining the availability of Section 45(d)(2)(A) defines a qualified

stallments of estimated tax for 2007, the in- the credits. The 2006 inflation adjustment facility using closed-loop biomass to pro-

come attributable to the credit or refund is factor and reference prices apply to calen- duce electricity as any facility (i) owned

taken into account on the date the income dar year 2006 sales of kilowatt-hours of by the taxpayer that is originally placed in

is paid or credited in the case of a cash electricity produced in the United States or service after December 31, 1992, and be-

method taxpayer and on the date the return a possession thereof from qualified energy fore January 1, 2008, or (ii) owned by the

making the request is filed in the case of an resources and to calendar year 2006 sales taxpayer which before January 1, 2008, is

accrual method taxpayer. of refined coal produced in the United originally placed in service and modified

(g) Requests that do not follow the pro- States or a possession thereof. to use closed-loop biomass to co-fire with

visions of this notice. Requests that do coal, with other biomass, or with both,

not follow the provisions of this notice BACKGROUND but only if the modification is approved

(whether filed before or after its publica- under the Biomass Power for Rural De-

tion)— Section 45(a) provides that the renew- velopment Programs or is part of a pilot

(1) Will not be processed to the extent able electricity production credit for any project of the Commodity Credit Corpora-

they relate to the tax paid on nontaxable tax year is an amount equal to the prod- tion as described in 65 Fed. Reg. 63052.

service that was billed after February 28, uct of 1.5 cents multiplied by the kilowatt Section 45(d)(2)(B) provides that in the

2003; and hours of specified electricity produced by case of a qualified facility described in

(2) Will be processed normally to the the taxpayer and sold to an unrelated per- § 45(d)(2)(A)(ii), (i) the 10-year period re-

extent they relate to the tax paid on nontax- son during the tax year. This electricity ferred to in § 45(a) is treated as begin-

able service that was billed before March must be produced from qualified energy ning no earlier than the date of enactment

1, 2003. resources and at a qualified facility during of § 45(d)(2)(B)(i); (ii) the amount of the

the 10-year period beginning on the date credit determined under § 45(a) with re-

SECTION 6. EFFECT ON OTHER the facility was originally placed in ser- spect to the facility is an amount equal

DOCUMENTS vice. to the amount determined without regard

Section 45(b)(1) provides that the to § 45(d)(2)(B)(ii) multiplied by the ratio

Notice 2005–79, 2005–46 I.R.B. 952, amount of the credit determined under of the thermal content of the closed-loop

is revoked. Rev. Rul. 79–404, 1979–2 § 45(a) is reduced by an amount which biomass used in the facility to the thermal

C.B. 382, will be revoked in a later revenue bears the same ratio to the amount of the content of all fuels used in the facility; and

ruling. credit as (A) the amount by which the (iii) if the owner of the facility is not the





June 19, 2006 1144 2006–25 I.R.B.

producer of the electricity, the person eli- creased amount of electricity produced at Section 45(e)(2)(B) defines the infla-

gible for the credit allowable under § 45(a) the facility by reason of such new unit. tion adjustment factor for a calendar year

is the lessee or the operator of the facility. Section 45(d)(8) provides in the case as the fraction the numerator of which is

Section 45(d)(3)(A) defines a qualified of a facility that produces refined coal, the GDP implicit price deflator for the pre-

facility using open-loop biomass to pro- the term “refined coal production facility” ceding calendar year and the denominator

duce electricity as any facility owned by means a facility which is placed in service of which is the GDP implicit price defla-

the taxpayer which (i) in the case of a facil- after the date of enactment of § 45(d)(8) tor for the calendar year 1992. The term

ity using agricultural livestock waste nutri- and before January 1, 2009. “GDP implicit price deflator” means the

ents, (I) is originally placed in service after Section 45(d)(9) defines a qualified most recent revision of the implicit price

the date of enactment of § 45(d)(3)(A)(i)(I) facility producing qualified hydroelec- deflator for the gross domestic product as

and before January 1, 2008, and (II) the tric production described in § 45(c)(8) as computed and published by the Depart-

nameplate capacity rating of which is not (A) any facility producing incremental ment of Commerce before March 15 of the

less than 150 kilowatts; and (ii) in the case hydropower production, but only to the calendar year.

of any other facility, is originally placed in extent of its incremental hydropower pro- Section 45(e)(2)(C) provides that the

service before January 1, 2008. In the case duction attributable to efficiency improve- reference price is the Secretary’s determi-

of any facility described in § 45(d)(3)(A), ments or additions to capacity described nation of the annual average contract price

if the owner of the facility is not the pro- in § 45(c)(8)(B) placed in service after the per kilowatt hour of electricity generated

ducer of the electricity, § 45(d)(3)(B) pro- date of enactment of § 45(d)(9) and before from the same qualified energy resource

vides that the person eligible for the credit January 1, 2008, and (B) any other facility and sold in the previous year in the United

allowable under § 45(a) is the lessee or the placed in service after the date of enact- States. Only contracts entered into af-

operator of the facility. ment of § 45(d)(9) and before January 1, ter December 31, 1989, are taken into ac-

Section 45(d)(4) defines a qualified fa- 2008. Section 45(d)(9)(C) provides that in count.

cility using geothermal or solar energy to the case of a qualified facility described in Under § 45(e)(8)(C), the determination

produce electricity as any facility owned § 45(d)(9)(A), the 10-year period referred of the reference price for fuel used as feed-

by the taxpayer which is originally placed to in § 45(a) is treated as beginning on stock within the meaning of § 45(c)(7)(A)

in service after the date of enactment of the date the efficiency improvements or is made according to rules similar to the

§ 45(d)(4) and before January 1, 2008 (Jan- additions to capacity are placed in service. rules under § 45(e)(2)(C).

uary 1, 2006, in the case of a facility us- Section 45(e)(8)(A) provides that the

ing solar energy). A qualified facility us- refined coal production credit is an amount INFLATION ADJUSTMENT FACTOR

ing geothermal or solar energy does not in- equal to $4.375 per ton of qualified re- AND REFERENCE PRICES

clude any property described in § 48(a)(3) fined coal (i) produced by the taxpayer

The inflation adjustment factor for

the basis of which is taken into account by at a refined coal production facility dur-

calendar year 2006 is 1.2981. The ref-

the taxpayer for purposes of determining ing the 10-year period beginning on the

erence price for calendar year 2006 for

the energy credit under § 48. date the facility was originally placed in

facilities producing electricity from wind

Section 45(d)(5) defines a qualified service, and (ii) sold by the taxpayer (I)

based upon information provided by the

facility using small irrigation power to to an unrelated person and (II) during the

Department of Energy is 2.89 cents per

produce electricity as any facility owned 10-year period and the tax year. Section

kilowatt hour. The reference prices for

by the taxpayer which is originally placed 45(e)(8)(B) provides that the amount of

fuel used as feedstock within the mean-

in service after the date of enactment of credit determined under § 45(e)(8)(A) is

ing of § 45(c)(7)(A), relating to refined

§ 45(d)(5) and before January 1, 2008. reduced by an amount which bears the

coal production (based upon information

Section 45(d)(6) defines a qualified fa- same ratio to the amount of the increase

provided by the Department of Energy)

cility using gas derived from the biodegra- as (i) the amount by which the reference

are $31.90 per ton for calendar year 2002

dation of municipal solid waste to produce price of fuel used as feedstock (within the

and $42.78 per ton for calendar year

electricity as any facility owned by the tax- meaning of § 45(c)(7)(A)) for the calendar

2006. The reference prices for facilities

payer which is originally placed in service year in which the sale occurs exceeds an

producing electricity from closed-loop

after the date of enactment of § 45(d)(6) amount equal to 1.7 multiplied by the ref-

biomass, open-loop biomass, geother-

and before January 1, 2008. erence price for such fuel in 2002, bears to

mal energy, solar energy, small irrigation

Section 45(d)(7) defines a qualified fa- (ii) $8.75.

power, municipal solid waste, and quali-

cility that burns municipal solid waste to Section 45(e)(2)(A) requires the Secre-

fied hydropower production have not been

produce electricity as any facility owned tary to determine and publish in the Fed-

determined for calendar year 2006. The

by the taxpayer which is originally placed eral Register each calendar year the infla-

IRS is exploring methods of determining

in service after the date of enactment of tion adjustment factor and the reference

those reference prices for calendar year

§ 45(d)(7) and before January 1, 2008. A prices for the calendar year. The inflation

2007.

qualified facility burning municipal solid adjustment factor and the reference prices

waste includes a new unit placed in service for the 2006 calendar year were published PHASE-OUT CALCULATION

in connection with a facility placed in ser- in the Federal Register on March 31, 2006

vice on or before the date of enactment of (71 Fed. Reg. 16420), and corrected on Because the 2006 reference price for

§ 45(d)(7), but only to the extent of the in- May 9, 2006 (71 Fed. Reg. 27038). electricity produced from wind does not





2006–25 I.R.B. 1145 June 19, 2006

exceed 8 cents multiplied by the infla- one-half. Under the calculation required average of the rates of interest on 30-year

tion adjustment factor, the phaseout of by § 45(b)(2), the credit for renewable Treasury securities during the four-year

the credit provided in § 45(b)(1) does electricity production for calendar year period ending on the last day before the

not apply to such electricity sold during 2006 under § 45(a) is 1.9 cents per kilo- beginning of the plan year.

calendar year 2006. Because the 2006 ref- watt hour on the sale of electricity pro- Notice 88–73, 1988–2 C.B. 383, pro-

erence price of fuel used as feedstock for duced from the qualified energy resources vides guidelines for determining the

refined coal does not exceed the $31.90 of wind, closed-loop biomass, geothermal weighted average interest rate and the

reference price of such fuel in 2002 mul- energy, and solar energy, and 1.0 cent per resulting permissible range of interest

tiplied by the inflation adjustment factor kilowatt hour on the sale of electricity rates used to calculate current liability for

and 1.7, the phaseout of credit provided produced in open-loop biomass facilities, the purpose of the full funding limitation

in § 45(e)(8)(B) does not apply to re- small irrigation power facilities, landfill of § 412(c)(7) of the Code.

fined coal sold during calendar year 2006. gas facilities, trash combustion facilities, Section 417(e)(3)(A)(ii)(II) defines

Further, for electricity produced from and qualified hydropower facilities. Under the applicable interest rate, which must

closed-loop biomass, open-loop biomass, the calculation required by § 45(b)(2), the be used for purposes of determining the

geothermal energy, solar energy, small credit for refined coal production for cal- minimum present value of a participant’s

irrigation power, municipal solid waste, endar year 2006 under section 45(e)(8)(A) benefit under § 417(e)(1) and (2), as the

and qualified hydropower production, the is $5.679 per ton on the sale of qualified annual rate of interest on 30-year Treasury

phaseout of credit provided in § 45(b)(1) refined coal. securities for the month before the date

does not apply to such electricity sold dur- of distribution or such other time as the

ing calendar year 2006. DRAFTING AND CONTACT Secretary may by regulations prescribe.

INFORMATION Section 1.417(e)–1(d)(3) of the Income

CREDIT AMOUNT BY QUALIFIED Tax Regulations provides that the applica-

ENERGY RESOURCE AND FACILITY The principal author of this notice is

ble interest rate for a month is the annual

AND REFINED COAL David A. Selig of the Office of Associate

interest rate on 30-year Treasury securi-

Chief Counsel (Passthroughs and Special

ties as specified by the Commissioner for

As required by § 45(b)(2), the 1.5 cent Industries). For further information re-

that month in revenue rulings, notices or

amount in § 45(a)(1), the 8 cent amount garding this notice, contact Mr. Selig at

other guidance published in the Internal

in § 45(b)(1), and the $4.375 amount in (202) 622–3040 (not a toll-free call).

Revenue Bulletin.

§ 45(e)(8)(A) are each adjusted by mul-

The rate of interest on 30-year Treasury

tiplying such amount by the inflation

securities for May 2006 is 5.20 percent.

adjustment factor for the calendar year Weighted Average Interest The Service has determined this rate as the

in which the sale occurs. If any amount Rate Update monthly average of the daily determina-

as increased under the preceding sen-

tion of yield on the 30-year Treasury bond

tence is not a multiple of 0.1 cent, such Notice 2006–55 maturing in February 2036.

amount is rounded to the nearest multi-

The following 30-year Treasury rates

ple of 0.1 cent. In the case of electricity Sections 412(b)(5)(B) and 412(l)(7)

were determined for the plan years begin-

produced in open-loop biomass facilities, (C)(i) of the Internal Revenue Code gen-

ning in the month shown below.

small irrigation power facilities, landfill erally provide that the interest rates used

gas facilities, trash combustion facili- to calculate current liability for purposes

ties, and qualified hydropower facilities, of determining the full funding limitation

§ 45(b)(4)(A) requires the amount in ef- under § 412(c)(7) and the required con-

fect under § 45(a)(1) (before rounding tribution under § 412(l) must be within

to the nearest 0.1 cent) to be reduced by a permissible range around the weighted





30-Year

For Plan Years Treasury 90% to 105% 90% to 110%

Beginning in: Weighted Permissible Permissible

Month Year Average Range Range

June 2006 4.82 4.34 to 5.06 4.34 to 5.31



Drafting Information mation regarding this notice, please con- reached at 202–283–9703. Mr. Montanaro

tact the Employee Plans’ taxpayer assis- may be reached at 202–283–9714. The

The principal authors of this notice are tance telephone service at 877–829–5500 telephone numbers in the preceding sen-

Paul Stern and Tony Montanaro of the Em- (a toll-free number), between the hours of tences are not toll-free.

ployee Plans, Tax Exempt and Govern- 8:30 a.m. and 4:30 p.m. Eastern time,

ment Entities Division. For further infor- Monday through Friday. Mr. Stern may be









June 19, 2006 1146 2006–25 I.R.B.

26 CFR 601.105: Examination of returns and claims § 911(d)(1), to exclude foreign earned was present in, a foreign country, if the in-

for refund, credit, or abatement; determination of income and housing cost amounts from dividual left the country during a period

correct tax liability.

(Also: Part I, § 911, 1.911–1.)

gross income. Section 911(c)(3) of the for which the Secretary of the Treasury, af-

Code allows a qualified individual to ter consultation with the Secretary of State,

deduct housing cost amounts from gross determines that individuals were required

Rev. Proc. 2006–28

income. to leave because of war, civil unrest, or

.02 Section 911(d)(1) of the Code de- similar adverse conditions that precluded

SECTION 1. PURPOSE fines the term “qualified individual” as an the normal conduct of business. An in-

individual whose tax home is in a foreign dividual must establish that but for those

.01 This revenue procedure provides country and who is (A) a citizen of the conditions the individual could reasonably

information to any individual who failed United States and establishes to the satis- have been expected to meet the eligibility

to meet the eligibility requirements of faction of the Secretary of the Treasury that requirements.

§ 911(d)(1) of the Internal Revenue Code the individual has been a bona fide resident .04 For 2005, the Secretary of the Trea-

because adverse conditions in a foreign of a foreign country or countries for an un- sury, in consultation with the Secretary

country precluded the individual from interrupted period that includes an entire of State, has determined that war, civil

meeting those requirements for taxable taxable year, or (B) a citizen or resident of unrest, or similar adverse conditions pre-

year 2005. the United States who, during any period cluded the normal conduct of business in

.02 This revenue procedure lists the of 12 consecutive months, is present in a the following country beginning on the

country, for which the eligibility require- foreign country or countries during at least specified date:

ments of § 911(d)(1) are waived for taxable 330 full days.

year 2005. .03 Section 911(d)(4) of the Code pro-

vides an exception to the eligibility re-

SECTION 2. BACKGROUND quirements of § 911(d)(1). An individ-

ual will be treated as a qualified individ-

.01 Section 911(a) of the Code allows ual with respect to a period in which the

a “qualified individual,” as defined in individual was a bona fide resident of, or





Date of Departure

Country On or after

Haiti May 26, 2005



.05 Accordingly, for purposes of § 911 residency, or are first physically present, in or traveling outside the United States, the

of the Code, an individual who left Haiti the foreign country after the date that the nearest overseas IRS office.

on or after May 26, 2005, shall be treated Secretary prescribes shall not be treated

as a qualified individual with respect to the as qualified individuals under § 911(d)(4) SECTION 4. DRAFTING

period during which that individual was of the Code. Therefore, individuals who INFORMATION

present in, or was a bona fide resident of, are first physically present or establish

Haiti, if the individual establishes a reason- residency in Haiti after May 26, 2005, are The principal author of this revenue

able expectation of meeting the require- not eligible to qualify for the exception procedure is Kate Y. Hwa of the Office of

ments of § 911(d) but for those conditions. provided in § 911(d)(4) of the Code for Associate Chief Counsel (International).

.06 To qualify for relief under taxable year 2005. For further information regarding this rev-

§ 911(d)(4) of the Code, an individual enue procedure, contact Kate Y. Hwa at

must have established residency, or have SECTION 3. INQUIRIES (202) 622–3840 (not a toll-free call).

been physically present, in the foreign

country on or prior to the date that the A taxpayer who needs assistance on

Secretary of the Treasury determines that how to claim this exclusion, or on how to

individuals were required to leave the for- file an amended return, should contact a lo-

eign country. Individuals who establish cal IRS Office or, for a taxpayer residing









2006–25 I.R.B. 1147 June 19, 2006

Definition of Terms

Revenue rulings and revenue procedures and B, the prior ruling is modified because of a prior ruling, a combination of terms

(hereinafter referred to as “rulings”) that it corrects a published position. (Compare is used. For example, modified and su-

have an effect on previous rulings use the with amplified and clarified, above). perseded describes a situation where the

following defined terms to describe the ef- Obsoleted describes a previously pub- substance of a previously published ruling

fect: lished ruling that is not considered deter- is being changed in part and is continued

Amplified describes a situation where minative with respect to future transac- without change in part and it is desired to

no change is being made in a prior pub- tions. This term is most commonly used in restate the valid portion of the previously

lished position, but the prior position is be- a ruling that lists previously published rul- published ruling in a new ruling that is self

ing extended to apply to a variation of the ings that are obsoleted because of changes contained. In this case, the previously pub-

fact situation set forth therein. Thus, if in laws or regulations. A ruling may also lished ruling is first modified and then, as

an earlier ruling held that a principle ap- be obsoleted because the substance has modified, is superseded.

plied to A, and the new ruling holds that the been included in regulations subsequently Supplemented is used in situations in

same principle also applies to B, the earlier adopted. which a list, such as a list of the names of

ruling is amplified. (Compare with modi- Revoked describes situations where the countries, is published in a ruling and that

fied, below). position in the previously published ruling list is expanded by adding further names in

Clarified is used in those instances is not correct and the correct position is subsequent rulings. After the original rul-

where the language in a prior ruling is be- being stated in a new ruling. ing has been supplemented several times, a

ing made clear because the language has Superseded describes a situation where new ruling may be published that includes

caused, or may cause, some confusion. the new ruling does nothing more than re- the list in the original ruling and the ad-

It is not used where a position in a prior state the substance and situation of a previ- ditions, and supersedes all prior rulings in

ruling is being changed. ously published ruling (or rulings). Thus, the series.

Distinguished describes a situation the term is used to republish under the Suspended is used in rare situations

where a ruling mentions a previously pub- 1986 Code and regulations the same po- to show that the previous published rul-

lished ruling and points out an essential sition published under the 1939 Code and ings will not be applied pending some

difference between them. regulations. The term is also used when future action such as the issuance of new

Modified is used where the substance it is desired to republish in a single rul- or amended regulations, the outcome of

of a previously published position is being ing a series of situations, names, etc., that cases in litigation, or the outcome of a

changed. Thus, if a prior ruling held that a were previously published over a period of Service study.

principle applied to A but not to B, and the time in separate rulings. If the new rul-

new ruling holds that it applies to both A ing does more than restate the substance





Abbreviations

The following abbreviations in current use ER—Employer. PRS—Partnership.

and formerly used will appear in material ERISA—Employee Retirement Income Security Act. PTE—Prohibited Transaction Exemption.

EX—Executor. Pub. L.—Public Law.

published in the Bulletin.

F—Fiduciary. REIT—Real Estate Investment Trust.

FC—Foreign Country. Rev. Proc.—Revenue Procedure.

A—Individual.

FICA—Federal Insurance Contributions Act. Rev. Rul.—Revenue Ruling.

Acq.—Acquiescence.

B—Individual. FISC—Foreign International Sales Company. S—Subsidiary.

FPH—Foreign Personal Holding Company. S.P.R.—Statement of Procedural Rules.

BE—Beneficiary.

F.R.—Federal Register. Stat.—Statutes at Large.

BK—Bank.

B.T.A.—Board of Tax Appeals. FUTA—Federal Unemployment Tax Act. T—Target Corporation.

FX—Foreign corporation. T.C.—Tax Court.

C—Individual.

G.C.M.—Chief Counsel’s Memorandum. T.D. —Treasury Decision.

C.B.—Cumulative Bulletin.

CFR—Code of Federal Regulations. GE—Grantee. TFE—Transferee.

GP—General Partner. TFR—Transferor.

CI—City.

GR—Grantor. T.I.R.—Technical Information Release.

COOP—Cooperative.

Ct.D.—Court Decision. IC—Insurance Company. TP—Taxpayer.

I.R.B.—Internal Revenue Bulletin. TR—Trust.

CY—County.

LE—Lessee. TT—Trustee.

D—Decedent.

DC—Dummy Corporation. LP—Limited Partner. U.S.C.—United States Code.

LR—Lessor. X—Corporation.

DE—Donee.

M—Minor. Y—Corporation.

Del. Order—Delegation Order.

DISC—Domestic International Sales Corporation. Nonacq.—Nonacquiescence. Z —Corporation.

O—Organization.

DR—Donor.

P—Parent Corporation.

E—Estate.

PHC—Personal Holding Company.

EE—Employee.

PO—Possession of the U.S.

E.O.—Executive Order.

PR—Partner.





June 19, 2006 i 2006–25 I.R.B.

Numerical Finding List1 Notices— Continued: Proposed Regulations— Continued:

2006-8, 2006-5 I.R.B. 386 REG-148568-04, 2006-6 I.R.B. 417

Bulletin 2006–1 through 2006–25 2006-9, 2006-6 I.R.B. 413 REG-106418-05, 2006-7 I.R.B. 461

2006-10, 2006-5 I.R.B. 386 REG-133036-05, 2006-20 I.R.B. 911

Announcements:

2006-11, 2006-7 I.R.B. 457 REG-138879-05, 2006-8 I.R.B. 503

2006-1, 2006-1 I.R.B. 260 2006-12, 2006-7 I.R.B. 458 REG-143244-05, 2006-6 I.R.B. 419

2006-2, 2006-2 I.R.B. 300 2006-13, 2006-8 I.R.B. 496 REG-146384-05, 2006-17 I.R.B. 843

2006-3, 2006-3 I.R.B. 327 2006-14, 2006-8 I.R.B. 498 REG-146459-05, 2006-8 I.R.B. 504

2006-4, 2006-3 I.R.B. 328 2006-15, 2006-8 I.R.B. 501 REG-157271-05, 2006-12 I.R.B. 652

2006-5, 2006-4 I.R.B. 378 2006-16, 2006-9 I.R.B. 538 REG-164247-05, 2006-15 I.R.B. 758

2006-6, 2006-4 I.R.B. 340 2006-17, 2006-10 I.R.B. 559 REG-111578-06, 2006-24 I.R.B. 1060

2006-7, 2006-4 I.R.B. 342 2006-18, 2006-8 I.R.B. 502

Revenue Procedures:

2006-8, 2006-4 I.R.B. 344 2006-19, 2006-9 I.R.B. 539

2006-9, 2006-5 I.R.B. 392 2006-20, 2006-10 I.R.B. 560 2006-1, 2006-1 I.R.B. 1

2006-10, 2006-5 I.R.B. 393 2006-21, 2006-12 I.R.B. 643 2006-2, 2006-1 I.R.B. 89

2006-11, 2006-6 I.R.B. 420 2006-22, 2006-11 I.R.B. 593 2006-3, 2006-1 I.R.B. 122

2006-12, 2006-6 I.R.B. 421 2006-23, 2006-11 I.R.B. 594 2006-4, 2006-1 I.R.B. 132

2006-13, 2006-7 I.R.B. 462 2006-24, 2006-11 I.R.B. 595 2006-5, 2006-1 I.R.B. 174

2006-14, 2006-8 I.R.B. 516 2006-25, 2006-11 I.R.B. 609 2006-6, 2006-1 I.R.B. 204

2006-15, 2006-11 I.R.B. 632 2006-26, 2006-11 I.R.B. 622 2006-7, 2006-1 I.R.B. 242

2006-16, 2006-12 I.R.B. 653 2006-27, 2006-11 I.R.B. 626 2006-8, 2006-1 I.R.B. 245

2006-17, 2006-12 I.R.B. 653 2006-28, 2006-11 I.R.B. 628 2006-9, 2006-2 I.R.B. 278

2006-18, 2006-12 I.R.B. 654 2006-29, 2006-12 I.R.B. 644 2006-10, 2006-2 I.R.B. 293

2006-19, 2006-13 I.R.B. 674 2006-30, 2006-24 I.R.B. 1044 2006-11, 2006-3 I.R.B. 309

2006-20, 2006-13 I.R.B. 675 2006-31, 2006-15 I.R.B. 751 2006-12, 2006-3 I.R.B. 310

2006-21, 2006-14 I.R.B. 703 2006-32, 2006-13 I.R.B. 677 2006-13, 2006-3 I.R.B. 315

2006-22, 2006-16 I.R.B. 779 2006-33, 2006-15 I.R.B. 754 2006-14, 2006-4 I.R.B. 350

2006-23, 2006-14 I.R.B. 729 2006-34, 2006-14 I.R.B. 705 2006-15, 2006-5 I.R.B. 387

2006-24, 2006-16 I.R.B. 820 2006-35, 2006-14 I.R.B. 708 2006-16, 2006-9 I.R.B. 539

2006-25, 2006-18 I.R.B. 871 2006-36, 2006-15 I.R.B. 756 2006-17, 2006-14 I.R.B. 709

2006-26, 2006-18 I.R.B. 871 2006-37, 2006-18 I.R.B. 855 2006-18, 2006-12 I.R.B. 645

2006-27, 2006-18 I.R.B. 871 2006-38, 2006-16 I.R.B. 777 2006-19, 2006-13 I.R.B. 677

2006-28, 2006-18 I.R.B. 873 2006-39, 2006-17 I.R.B. 841 2006-20, 2006-17 I.R.B. 841

2006-29, 2006-19 I.R.B. 879 2006-40, 2006-18 I.R.B. 855 2006-21, 2006-24 I.R.B. 1050

2006-30, 2006-19 I.R.B. 879 2006-41, 2006-18 I.R.B. 857 2006-22, 2006-23 I.R.B. 1033

2006-31, 2006-20 I.R.B. 912 2006-42, 2006-19 I.R.B. 878 2006-23, 2006-20 I.R.B. 900

2006-32, 2006-20 I.R.B. 913 2006-43, 2006-21 I.R.B. 921 2006-24, 2006-22 I.R.B. 943

2006-33, 2006-20 I.R.B. 914 2006-44, 2006-20 I.R.B. 889 2006-25, 2006-21 I.R.B. 926

2006-34, 2006-21 I.R.B. 937 2006-45, 2006-20 I.R.B. 891 2006-26, 2006-21 I.R.B. 936

2006-35, 2006-24 I.R.B. 1061 2006-46, 2006-24 I.R.B. 1044 2006-27, 2006-22 I.R.B. 945

2006-36, 2006-23 I.R.B. 1038 2006-47, 2006-20 I.R.B. 892 2006-28, 2006-25 I.R.B. 1147

2006-37, 2006-23 I.R.B. 1039 2006-48, 2006-21 I.R.B. 922

Revenue Rulings:

2006-38, 2006-24 I.R.B. 1062 2006-49, 2006-22 I.R.B. 943

2006-50, 2006-25 I.R.B. 1141 2006-1, 2006-2 I.R.B. 261

Court Decisions:

2006-51, 2006-25 I.R.B. 1144 2006-2, 2006-2 I.R.B. 261

2081, 2006-13 I.R.B. 656 2006-55, 2006-25 I.R.B. 1146 2006-3, 2006-2 I.R.B. 276

2082, 2006-14 I.R.B. 697 Proposed Regulations: 2006-4, 2006-2 I.R.B. 264

2006-5, 2006-3 I.R.B. 302

Notices:

REG-107722-00, 2006-4 I.R.B. 354 2006-6, 2006-5 I.R.B. 381

2006-1, 2006-4 I.R.B. 347 REG-104385-01, 2006-5 I.R.B. 389 2006-7, 2006-6 I.R.B. 399

2006-2, 2006-2 I.R.B. 278 REG-122380-02, 2006-10 I.R.B. 563 2006-8, 2006-9 I.R.B. 520

2006-3, 2006-3 I.R.B. 306 REG-137243-02, 2006-3 I.R.B. 317 2006-9, 2006-9 I.R.B. 519

2006-4, 2006-3 I.R.B. 307 REG-139059-02, 2006-24 I.R.B. 1052 2006-10, 2006-10 I.R.B. 557

2006-5, 2006-4 I.R.B. 348 REG-144784-02, 2006-23 I.R.B. 1036 2006-11, 2006-12 I.R.B. 635

2006-6, 2006-5 I.R.B. 385 REG-133446-03, 2006-2 I.R.B. 299 2006-12, 2006-12 I.R.B. 637

2006-7, 2006-10 I.R.B. 559 REG-113365-04, 2006-10 I.R.B. 580 2006-13, 2006-13 I.R.B. 656



1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2005–27 through 2005–52 is in Internal Revenue Bulletin

2005–52, dated December 27, 2005.





2006–25 I.R.B. ii June 19, 2006

Revenue Rulings— Continued: Treasury Decisions— Continued:

2006-14, 2006-15 I.R.B. 740 9260, 2006-23 I.R.B. 1001

2006-15, 2006-13 I.R.B. 661 9261, 2006-21 I.R.B. 919

2006-16, 2006-14 I.R.B. 694 9262, 2006-24 I.R.B. 1040

2006-17, 2006-15 I.R.B. 748 9263, 2006-25 I.R.B. 1063

2006-18, 2006-15 I.R.B. 743

2006-19, 2006-15 I.R.B. 749

2006-20, 2006-15 I.R.B. 746

2006-21, 2006-15 I.R.B. 745

2006-22, 2006-14 I.R.B. 687

2006-23, 2006-17 I.R.B. 839

2006-24, 2006-19 I.R.B. 875

2006-25, 2006-20 I.R.B. 882

2006-26, 2006-22 I.R.B. 939

2006-27, 2006-21 I.R.B. 915

2006-28, 2006-22 I.R.B. 938

2006-29, 2006-23 I.R.B. 1031

2006-30, 2006-25 I.R.B. 1134

2006-31, 2006-25 I.R.B. 1133



Tax Conventions:



2006-6, 2006-4 I.R.B. 340

2006-7, 2006-4 I.R.B. 342

2006-8, 2006-4 I.R.B. 344

2006-19, 2006-13 I.R.B. 674

2006-20, 2006-13 I.R.B. 675

2006-21, 2006-14 I.R.B. 703



Treasury Decisions:



9231, 2006-2 I.R.B. 272

9232, 2006-2 I.R.B. 266

9233, 2006-3 I.R.B. 303

9234, 2006-4 I.R.B. 329

9235, 2006-4 I.R.B. 338

9236, 2006-5 I.R.B. 382

9237, 2006-6 I.R.B. 394

9238, 2006-6 I.R.B. 408

9239, 2006-6 I.R.B. 401

9240, 2006-7 I.R.B. 454

9241, 2006-7 I.R.B. 427

9242, 2006-7 I.R.B. 422

9243, 2006-8 I.R.B. 475

9244, 2006-8 I.R.B. 463

9245, 2006-14 I.R.B. 696

9246, 2006-9 I.R.B. 534

9247, 2006-9 I.R.B. 521

9248, 2006-9 I.R.B. 524

9249, 2006-10 I.R.B. 546

9250, 2006-11 I.R.B. 588

9251, 2006-11 I.R.B. 590

9252, 2006-12 I.R.B. 633

9253, 2006-14 I.R.B. 689

9254, 2006-13 I.R.B. 662

9255, 2006-15 I.R.B. 741

9256, 2006-16 I.R.B. 770

9257, 2006-17 I.R.B. 821

9258, 2006-20 I.R.B. 886

9259, 2006-19 I.R.B. 874







June 19, 2006 iii 2006–25 I.R.B.

Finding List of Current Actions on Notices— Continued: Revenue Procedures— Continued:

Previously Published Items1 2005-98 2002-9

Supplemented by Modified by

Bulletin 2006–1 through 2006–25

Notice 2006-7, 2006-10 I.R.B. 559 Rev. Proc. 2006-11, 2006-3 I.R.B. 309

Announcements: Modified and amplified by

Proposed Regulations:

Notice 2006-47, 2006-20 I.R.B. 892

2000-48 Rev. Proc. 2006-12, 2006-3 I.R.B. 310

REG-103829-99

Modified by Rev. Proc. 2006-14, 2006-4 I.R.B. 350

Withdrawn by

Notice 2006-35, 2006-14 I.R.B. 708 Rev. Proc. 2006-16, 2006-9 I.R.B. 539

Ann. 2006-16, 2006-12 I.R.B. 653

Notices: 2002-17

REG-150313-01

Modified by

89-85 Withdrawn by

Rev. Proc. 2006-14, 2006-4 I.R.B. 350

Amplified by Ann. 2006-30, 2006-19 I.R.B. 879

2002-32

Notice 2006-46, 2006-24 I.R.B. 1044 REG-131739-03

Modified by

2001-4 Corrected by

Rev. Proc. 2006-21, 2006-24 I.R.B. 1050

Sections (V)(C), (D), and (E) superseded by Ann. 2006-10, 2006-5 I.R.B. 393

2002-52

T.D. 9253, 2006-14 I.R.B. 689 REG-131264-04

Modified by

2001-11 Withdrawn by

Rev. Proc. 2006-26, 2006-21 I.R.B. 936

Superseded by Ann. 2006-34, 2006-21 I.R.B. 937

2003-31

T.D. 9253, 2006-14 I.R.B. 689 REG-138647-04

Superseded by

2001-43 Corrected by

Rev. Proc. 2006-19, 2006-13 I.R.B. 677

Modified by Ann. 2006-4, 2006-3 I.R.B. 328

2003-38

Notice 2006-35, 2006-14 I.R.B. 708 REG-158080-04

Modified by

Sections 2 and 3 superseded by Corrected by

Rev. Proc. 2006-16, 2006-9 I.R.B. 539

T.D. 9253, 2006-14 I.R.B. 689 Ann. 2006-11, 2006-6 I.R.B. 420

2003-44

2002-35

Revenue Procedures: Modified and superseded by

Clarified and modified by

Rev. Proc. 2006-27, 2006-22 I.R.B. 945

Notice 2006-16, 2006-9 I.R.B. 538 81-17

Obsoleted by 2004-23

2005-14

Rev. Proc. 2006-24, 2006-22 I.R.B. 943 Superseded for certain taxable years by

Obsoleted for taxable years beginning on or after

Rev. Proc. 2006-12, 2006-3 I.R.B. 310

June 1, 2006, by 89-8

T.D. 9263, 2006-25 I.R.B. 1063 Superseded by 2004-40

Rev. Proc. 2006-23, 2006-20 I.R.B. 900 Superseded by

2005-30

Rev. Proc. 2006-9, 2006-2 I.R.B. 278

Modified and superseded by 89-56

Notice 2006-31, 2006-15 I.R.B. 751 Modified by 2005-1

Rev. Proc. 2006-21, 2006-24 I.R.B. 1050 Superseded by

2005-44

Rev. Proc. 2006-1, 2006-1 I.R.B. 1

Supplemented by 90-39

Notice 2006-1, 2006-4 I.R.B. 347 Modified by 2005-2

Rev. Proc. 2006-21, 2006-24 I.R.B. 1050 Superseded by

2005-66

Rev. Proc. 2006-2, 2006-1 I.R.B. 89

Supplemented by 96-52

Notice 2006-20, 2006-10 I.R.B. 560 Superseded by 2005-3

Rev. Proc. 2006-10, 2006-2 I.R.B. 293 Superseded by

2005-73

Rev. Proc. 2006-3, 2006-1 I.R.B. 122

Supplemented by 97-27

Notice 2006-20, 2006-10 I.R.B. 560 Modified by 2005-4

Rev. Proc. 2006-11, 2006-3 I.R.B. 309 Superseded by

2005-79

Modified and amplified by Rev. Proc. 2006-4, 2006-1 I.R.B. 132

Revoked by

Rev. Proc. 2006-12, 2006-3 I.R.B. 310

Notice 2006-50, 2006-25 I.R.B. 1141 2005-5

Superseded by

2005-81

Rev. Proc. 2006-5, 2006-1 I.R.B. 174

Supplemented by

Notice 2006-20, 2006-10 I.R.B. 560 2005-6

Superseded by

Rev. Proc. 2006-6, 2006-1 I.R.B. 204







1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2005–27 through 2005–52 is in Internal Revenue Bulletin 2005–52, dated December 27,

2005.





2006–25 I.R.B. iv June 19, 2006

Revenue Procedures— Continued: Revenue Rulings— Continued:

2005-7 2000-2

Superseded by Modified and superseded by

Rev. Proc. 2006-7, 2006-1 I.R.B. 242 Rev. Rul. 2006-26, 2006-22 I.R.B. 939



2005-8 2006-1

Superseded by Modified and clarified by

Rev. Proc. 2006-8, 2006-1 I.R.B. 245 Rev. Rul. 2006-31, 2006-25 I.R.B. 1133



2005-9 2006-25

Superseded for certain taxable years by Corrected by

Rev. Proc. 2006-12, 2006-3 I.R.B. 310 Ann. 2006-35, 2006-24 I.R.B. 1061



2005-12 Treasury Decisions:

Section 10 modified and superseded by

Rev. Proc. 2006-1, 2006-1 I.R.B. 1 9191

Corrected by

2005-15

Ann. 2006-26, 2006-18 I.R.B. 871

Obsoleted in part by

Rev. Proc. 2006-17, 2006-14 I.R.B. 709 9192

Corrected by

2005-21

Ann. 2006-15, 2006-11 I.R.B. 632

Superseded by

Rev. Proc. 2006-25, 2006-21 I.R.B. 926 9203

Corrected by

2005-22

Ann. 2006-12, 2006-6 I.R.B. 421

Obsoleted by

Rev. Proc. 2006-20, 2006-17 I.R.B. 841 9243

Corrected by

2005-24

Ann. 2006-38, 2006-24 I.R.B. 1062

Modified by

Notice 2006-15, 2006-8 I.R.B. 501 9244

Corrected by

2005-61

Ann. 2006-31, 2006-20 I.R.B. 912

Superseded by

Rev. Proc. 2006-3, 2006-1 I.R.B. 122 9248

Corrected by

2005-68

Ann. 2006-32, 2006-20 I.R.B. 913

Superseded by

Rev. Proc. 2006-1, 2006-1 I.R.B. 1

Rev. Proc. 2006-3, 2006-1 I.R.B. 122



Revenue Rulings:



55-355

Obsoleted by

T.D. 9244, 2006-8 I.R.B. 463



74-503

Revoked by

Rev. Rul. 2006-2, 2006-2 I.R.B. 261



77-230

Obsoleted by

T.D. 9249, 2006-10 I.R.B. 546



91-5

Modified by

T.D. 9250, 2006-11 I.R.B. 588



92-19

Supplemented in part by

Rev. Rul. 2006-25, 2006-20 I.R.B. 882



92-86

Modified by

T.D. 9250, 2006-11 I.R.B. 588









June 19, 2006 v U.S. GPO: 2006—320–797/20063 2006–25 I.R.B.