Instructions to Forms 8903, 1120S, and 1065
IRS has issued instructions to new Form 8903 (Domestic Production Activities Deduction). These instructions, along with revised instructions to Form 1120S (U.S. Income Tax Return for an S Corporation) and Form 1065 (U.S. Partnership Return of Income) carry additional guidance on some, but not all, aspects of the new-for-tax-year 2005 Code Sec. 199 deduction.
Background. Starting with tax years beginning in 2005, taxpayers may claim a deduction for a percentage of the income earned from production activities undertaken in the U.S. Eligible activities include manufacturing, food production, software development, film and music production, production of electricity, natural gas or water, construction, and engineering and architectural services. (Code Sec. 199)
The Code Sec. 199 deduction equals the lesser of:
(1) a percentage of the smaller of-
(a) the taxpayer's "qualified production activities income" (QPAI) for the tax year, or
(b) the taxpayer's taxable income (modified adjusted gross income, for individual taxpayers), without regard to the Code Sec. 199 deduction, for the tax year.
The percentage is 3% for tax years beginning in 2005 and 2006, 6% for tax years beginning in 2007-2009, and 9% in later years.
(2) 50% of the W-2 wages paid by the employer to its employees for the tax year.
The Code Sec. 199 deduction is based on the taxpayer's QPAI, which, for any tax year, equals the excess (if any) of:
(1) domestic production gross receipts for that tax year, over
(2) the sum of:
(a) the cost of goods sold that are allocable to those receipts; and
(b) other expenses, losses, or deductions (other than the Code Sec. 199 deduction) which are properly allocable to those receipts. ( Code Sec. 199(c)(1) )
Domestic production gross receipts are the taxpayer's gross receipts derived from:
- any sale, exchange or other disposition, or any lease, rental or license of qualifying production property that was manufactured, produced, grown or extracted "by the taxpayer" in whole or "in significant part" within the U.S.;
- any qualifying disposition of qualified films produced by the taxpayer;
- any qualifying disposition of electricity, natural gas, or potable water produced by the taxpayer in the U.S.;
- construction activities performed in the U.S. by a taxpayer in the active conduct of a construction trade or business; or
- engineering or architectural services, performed in the U.S. for construction projects located in the U.S., by a taxpayer engaged in the active conduct of an engineering or architectural services trade or business. (Code Sec. 199(c)(4))
The main sources of IRS guidance on the domestic production activities deduction (called the DPAD in the instructions to Form 8903) are Notice 2005-14 and proposed reliance regs. In general, where the two authorities include different rules for the same particular issue, the taxpayer may rely on either the rule set forth in the proposed regs or the rule set forth in the Notice. (Preamble to Prop Reg 10/20/2005) But if the proposed regs include a rule that was not included in the notice, taxpayers can't rely on the absence of a rule to apply a rule contrary to the proposed regs. (Prop Reg § 1.199-8(g)) Overall, positions taken by IRS in the proposed reliance regs assumed that Congress would enact technical corrections to Code Sec. 199 . Late last year, Congress followed through by including numerous retroactively effective technical corrections to Code Sec. 199 in the GO Zone Act (P.L. 109-135).
Here are highlights of the additional guidance on Code Sec. 199 carried in the new Form 8903 instructions, as well as in the instructions to other key forms.
Coordination with other deductions. The instructions to Form 8903 say that "expenses that would otherwise be taken into account for figuring the DPAD are only taken into account if and to the extent the losses and deductions from all of your [the taxpayer's] activities are not disallowed by":
- the partnership and S corp basis limit on losses;
- the Code Sec. 465 at-risk rules;
- the Code Sec. 469 passive activity rules; or
- "any other provision" of the Code.
Where only a part of a taxpayer's losses or deductions are allowed in the current year, a proportionate share of the losses or deductions reflecting expenses allocated to the taxpayer's qualified production activities, after applying the above provisions, may be taken into account for purposes of figuring the DPAD for the current tax year. (The proposed reliance regs carried similar rules for partners (Prop Reg § 1.199-5(a)(2)) and S shareholders (Prop Reg § 1.199-5(b)(2)), but did not expressly say these rules applied to all taxpayers.)
Arriving at qualified production activities income. There are three ways to allocate deductions other than cost of goods sold to domestic production gross receipts:
(1) the small business simplified overall method for qualified small taxpayers;
(2) the simplified deduction method for taxpayers with average annual gross receipts of $25 million or less; or
(3) the "section 861 method." (Prop Reg § 1.199-4(c)(1); Notice 2005-14, Sec. 4.05(3)(a))
The instructions to Form 8903 say the small business simplified overall method may be used if the taxpayer (a) is a farmer who isn't required to use the accrual method of accounting; (b) has average annual gross receipts (generally, for the preceding 3 tax years) of $5 million or less; or (c) is eligible to use the cash method of accounting under Rev Proc 2002-28 . (The instructions create a taxpayer-favorable blend of the guidance in the proposed reliance regs and Notice 2005-14, Sec. 4.05(4)(b). )
Under the proposed reliance regs, a qualifying small taxpayer is one that:
(1) has both -
(a) average annual gross receipts of $5 million or less; and
(b) total cost of goods sold and deductions for the current tax year of $5 million or less; or
(2) is engaged in the trade or business of farming that is not required to use the accrual method of accounting; or
(3) is eligible to use the cash method as provided in Rev Proc 2002-28 (that is, any taxpayer with average annual gross receipts of $10 million or less that is not prohibited from using the cash method under Code Sec. 448, including a partnership, an S corporation, a C corporation, or an individual). (Prop Reg § 1.199-4(f)(2))
Under Notice 2005-14, a qualifying small taxpayer is a taxpayer that satisfies either requirement (1)(a) or (3) above. (Notice 2005-14, Sec. 4.05(4)(b)) (In other words, the instructions sanction the first alternate condition as formulated by the Notice, the second created by the proposed regs, and the third carried in both the proposed regs and the Notice. )
Passthroughs and their owners. The instructions to Form 8903 make it clear that S corporations and partnerships can't use the simplified deduction or "section 861" method to allocate deductions other than cost of goods sold to domestic production gross receipts. Thus, the only method potentially available to an S corporation or partnership, and determined at the entity level, is the small business simplified overall method. This result may be inferred from, but is not clearly stated in, the proposed reliance regs. Additionally, the instructions to Form 1120S and Form 1065 clarify that if the S corporation or partnership does not use the small business simplified overall method, it is to provide the following information for its beneficial owners to enable them to figure the Code Sec. 199 deduction:
- domestic production gross receipts (DPGR);
- gross receipts from all sources;
- cost of goods sold from all sources;
- total deductions, expenses, and losses directly allocable to DPGR;
- total deductions, expenses, and losses directly allocable to a non-DPGR class of income;
- other deductions, expenses, and losses not directly allocable to DPGR or another class of income; and
- Form W-2 wages.
The instructions to Form 8903 also make it clear that an S corporation's or partnership's use of the small business simplified overall method isn't binding on its shareholders or partners. They may figure QPAI using any method they qualify for.
QPAI of S corporations and partnerships. When applying the 50%-of-W-2-wages limit on Code Sec. 199 deduction available to an S shareholder or partner, each is treated as having W-2 wages for the tax year in an amount equal to the lesser of:
- that person's allocable share of the W-2 wages of the entity, or
- two times the specified percentage (for tax years beginning in 2005 or 2006, 3%) of the QPAI allocated to that person for the tax year. (Code Sec. 199(d)(2)(B))
The instructions to Form 8903 spell out that for tax years beginning in 2005, when figuring the DPAD of an S shareholder or partner, his allowable share of Form W-2 wages from the entity is limited to 6% of his share of any QPAI derived from the entity.
Under the proposed reliance regs, when a shareholder/partner applies the above special W-2 limit, he calculates his allocable share of the entity's QPAI by using the same cost allocation method that he uses in calculating his DPAD. W-2 wages are allocated to the partner/shareholder in the same way as wage expense (and then he adds that share to his W-2 wages from other sources). However, if the entity uses the small business simplified overall method, the QPAI used by each shareholder/partner to determine the 50%-of-W-2-wages limit is the same as the share of QPAI allocated to the shareholder/partner. (Prop Reg § 1.199-5(a)(3))
As does Prop Reg § 1.199-5(a)(3), the instructions to Form 8903 say that if an S shareholder's or partner's share of QPAI derived from the entity is zero or less, he cannot use any of its Form W-2 wages to figure his DPAD.
What the instructions do not explain is how to handle the situation of a passthrough that has QPAI, but zero W-2 wages. This can happen where a partnership's business is run by its partners and there are no employees (what is paid to the partners is treated as self-employment income, not wages). Can the entity still pass through QPAI to its partners? Additionally, suppose one of the partners is in another business that pays W-2 wages. Can he claim a Code Sec. 199 deduction for his share of qualified production activities income from the partnership on the strength of the non-partnership W-2 wages?
Although the instructions don't address this point, according to the proposed reliance regs, the answer appears to be "yes" to both questions. They say that a partner aggregates his share of the items needed to compute qualified production activities income, to the extent they are not otherwise disallowed, with those items he incurs outside the partnership for purposes of allocating and apportioning deductions to domestic production gross receipts and computing the partner's QPAI. (Prop Reg § 1.199-5(a)(1)) Additionally, a partner must compute his share of W-2 wages from the entity and then add that share to his share of W-2 wages paid from other sources, if any. (Prop Reg § 1.199-5(a)(3)) Moreover, the preamble to the proposed reliance regs says that "the proposed regulations make it clear that, when determining its section 199 deduction, an owner of a pass-thru entity aggregates items of income and expense from the entity (including W-2 wages) with its own items of income and expense (including W-2 wages) for purposes of allocating and apportioning deductions to DPGR" [domestic production gross receipts].
Further support can be found in Example (3) of Prop Reg § 1.199-5(a)(4). It addresses the situation of a partnership that generates positive QPAI, but where one of partners winds up with a Code Sec. 199(d)(1)(B) W-2 wage limit of zero due to special allocations. The partner salvages a Code Sec. 199 deduction on the strength of wages paid in connection with a non-partnership venture. What's more, the example makes it clear that the wages paid in connection with the non-partnership venture do not have to be derived from a business that generates domestic production gross receipts.
Source: RIA Federal Taxes Weekly Alert (preview) 03/02/2006, Volume 52, No. 09