The domestic production activities deduction, also known as the Code Section 199 deduction, is a relatively new tax break that applies to a surprising number of businesses, large and small.  For small businesses, computing the amount of the deduction to which each business owner is entitled has been a stumbling block to more aggressive use of this tax break. Many small businesses that operate as “pass-throughs” (that is, as partnerships or S corporations) have asked for simplification of the deduction and now the IRS has provided that simplification.

Background

For 2007, the Code Sec. 199 deduction equals six percent of the lesser of qualified production activities income (QPAI) or taxable income (adjusted gross income for an individual). The deduction is limited to 50 percent of the W-2 wages paid by the taxpayer in connection with Code Sec. 199 activities.

Generally, the deduction is applied at the partner or shareholder level of a pass-through entity. All items applicable to the deduction are passed through to the partner or shareholder for deduction on their individual income tax returns. Regulations allow the IRS to permit an eligible entity to calculate a partner's or shareholder's share of QPAI and W-2 wages at the entity level using a particular methodology to allocate to each partner or shareholder its share of QPAI and wages. The IRS now has followed through on that authority by publishing Rev. Proc. 2007-34.

Eligible entities

Eligible entities and the appropriate cost allocation method assigned to each, as now specified in Rev. Proc. 2007-34, include:

• Code Sec. 861 method (described in Reg. §1.199-4(d)) for a Code Sec. 861 partnership;
• Simplified deduction method (described in Reg. §1.199-4(e)) for a widely-held pass-through entity; and
• Small business simplified overall method (as described in Reg. §1.199-4(f)) for a small pass-through entity.

Generally, QPAI must be allocated among partners or shareholders in the same proportion as gross income is allocated to partners or shareholders. W-2 wages are allocated among partners or shareholders by determining the amount of W-2 wages properly allocable to domestic production gross receipts. The W-2 wages are then allocated in the same manner as wage expense among partners or shareholders.

If you’d like further advice on how your business can maximize its Section 199 deduction without complicated administrative costs, please call this office for details.

(Rev. Proc. 2007-34)