Td 9263

Thursday,
June 1, 2006

Part II

Department of the
Treasury
Internal Revenue Service

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26 CFR Parts 1 and 602
Income Attributable to Domestic
Production Activities; Final Rule

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Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules and Regulations

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 9263]
RIN 1545–BE33

Income Attributable to Domestic
Production Activities
Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
AGENCY:

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SUMMARY: This document contains final
regulations concerning the deduction
for income attributable to domestic
production activities under section 199
of the Internal Revenue Code. Section
199 was enacted as part of the American
Jobs Creation Act of 2004 (Act). The
regulations will affect taxpayers engaged
in certain domestic production
activities.
DATES: Effective Date: These regulations
are effective June 1, 2006.
Date of Applicability: For date of
applicability see §§ 1.199–8(i) and
1.199–9(k).
FOR FURTHER INFORMATION CONTACT:
Concerning §§ 1.199–1, 1.199–3, 1.199–
6, and 1.199–8, Paul Handleman or
Lauren Ross Taylor, (202) 622–3040;
concerning § 1.199–2, Alfred Kelley,
(202) 622–6040; concerning § 1.199–4(c)
and (d), Richard Chewning, (202) 622–
3850; concerning all other provisions of
§ 1.199–4, Jeffery Mitchell, (202) 622–
4970; concerning § 1.199–7, Ken Cohen,
(202) 622–7790; concerning § 1.199–9,
Martin Schaffer, (202) 622–3080 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act
The collection of information
contained in these final regulations has
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork
Reduction Act (44 U.S.C. 3507) under
control number 1545–1966. Responses
to this collection of information are
mandatory so that patrons of
agricultural and horticultural
cooperatives may claim the section 199
deduction.
An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless the collection of information
displays a valid control number
assigned by the Office of Management
and Budget.
The estimated annual burden per
respondent varies from 15 minutes to 10
hours, depending on individual

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circumstances, with an estimated
average of 3 hours.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
the Internal Revenue Service, Attn: IRS
Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP Washington, DC
20224, and to the Office of Management
and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of
Information and Regulatory Affairs,
Washington, DC 20503.
Books or records relating to this
collection of information must be
retained as long as their contents may
become material in the administration
of any internal revenue law. Generally,
tax returns and tax return information
are confidential, as required by 26
U.S.C. 6103.
Background
This document amends 26 CFR part 1
to provide rules relating to the
deduction for income attributable to
domestic production activities under
section 199 of the Internal Revenue
Code (Code). Section 199 was added to
the Code by section 102 of the American
Jobs Creation Act of 2004 (Pub. L. 108–
357, 118 Stat. 1418) (Act), and amended
by section 403(a) of the Gulf
Opportunity Zone Act of 2005 (Pub. L.
109–135, 119 Stat. 25) (GOZA) and
section 514 of the Tax Increase
Prevention and Reconciliation Act of
2005 (Public Law 109–222, 120 Stat.
345) (TIPRA). On January 19, 2005, the
IRS and Treasury Department issued
Notice 2005–14 (2005–1 C.B. 498)
providing interim guidance on section
199. On November 4, 2005, the IRS and
Treasury Department published in the
Federal Register proposed regulations
under section 199 (70 FR 67220)
(proposed regulations). On January 11,
2006, the IRS and Treasury Department
held a public hearing on the proposed
regulations. Written and electronic
comments responding to the proposed
regulations were received. This
preamble describes the most significant
comments received by the IRS and
Treasury Department. Because of the
large volume of comments received,
however, the IRS and Treasury
Department are not able to address all
of the comments in this preamble. After
consideration of all of the comments,
the proposed regulations are adopted as
amended by this Treasury decision.
Contemporaneous with the publication
of these final regulations, temporary and
proposed regulations have been
published involving the treatment under
section 199 of computer software
provided to customers over the Internet.

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General Overview
Section 199(a)(1) allows a deduction
equal to 9 percent (3 percent in the case
of taxable years beginning in 2005 or
2006, and 6 percent in the case of
taxable years beginning in 2007, 2008,
or 2009) of the lesser of (A) the qualified
production activities income (QPAI) of
the taxpayer for the taxable year, or (B)
taxable income (determined without
regard to section 199) for the taxable
year (or, in the case of an individual,
adjusted gross income (AGI)).
Section 199(b)(1) limits the deduction
for a taxable year to 50 percent of the
W–2 wages paid by the taxpayer during
the calendar year that ends in such
taxable year. For this purpose, section
199(b)(2) defines the term W–2 wages to
mean, with respect to any person for
any taxable year of such person, the sum
of the amounts described in section
6051(a)(3) and (8) paid by such person
with respect to employment of
employees by such person during the
calendar year ending during such
taxable year. The term W–2 wages does
not include any amount that is not
properly included in a return filed with
the Social Security Administration on or
before the 60th day after the due date
(including extensions) for the return.
Section 199(b)(3) provides that the
Secretary shall prescribe rules for the
application of section 199(b) in the case
of an acquisition or disposition of a
major portion of either a trade or
business or a separate unit of a trade or
business during the taxable year.
Section 514(a) of TIPRA amended
section 199(b)(2) by excluding from the
term W–2 wages any amount that is not
properly allocable to domestic
production gross receipts (DPGR) for
purposes of section 199(c)(1). The IRS
and Treasury Department plan on
issuing regulations on the amendments
made to section 199(b)(2) by section 514
of TIPRA.
Qualified Production Activities Income
Section 199(c)(1) defines QPAI for any
taxable year as an amount equal to the
excess (if any) of (A) the taxpayer’s
DPGR for such taxable year, over (B) the
sum of (i) the cost of goods sold (CGS)
that are allocable to such receipts; and
(ii) other expenses, losses, or deductions
(other than the deduction under section
199) that are properly allocable to such
receipts.
Section 199(c)(2) provides that the
Secretary shall prescribe rules for the
proper allocation of items described in
section 199(c)(1) for purposes of
determining QPAI. Such rules shall
provide for the proper allocation of

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items whether or not such items are
directly allocable to DPGR.
Section 199(c)(3) provides special
rules for determining costs in
computing QPAI. Under these special
rules, any item or service brought into
the United States is treated as acquired
by purchase, and its cost is treated as
not less than its value immediately after
it enters the United States. A similar
rule applies in determining the adjusted
basis of leased or rented property when
the lease or rental gives rise to DPGR. If
the property has been exported by the
taxpayer for further manufacture, the
increase in cost or adjusted basis must
not exceed the difference between the
value of the property when exported
and its value when brought back into
the United States after further
manufacture.
Section 199(c)(4)(A) defines DPGR to
mean the taxpayer’s gross receipts that
are derived from: (i) Any lease, rental,
license, sale, exchange, or other
disposition of (I) qualifying production
property (QPP) that was manufactured,
produced, grown, or extracted (MPGE)
by the taxpayer in whole or in
significant part within the United
States; (II) any qualified film produced
by the taxpayer; or (III) electricity,
natural gas, or potable water
(collectively, utilities) produced by the
taxpayer in the United States; (ii) in the
case of a taxpayer engaged in the active
conduct of a construction trade or
business, construction of real property
performed in the United States by the
taxpayer in the ordinary course of such
trade or business; or (iii) in the case of
a taxpayer engaged in the active conduct
of an engineering or architectural
services trade or business, engineering
or architectural services performed in
the United States by the taxpayer in the
ordinary course of such trade or
business with respect to the
construction of real property in the
United States.
Section 199(c)(4)(B) excepts from
DPGR gross receipts of the taxpayer that
are derived from: (i) The sale of food
and beverages prepared by the taxpayer
at a retail establishment; (ii) the
transmission or distribution of utilities;
or (iii) the lease, rental, license, sale,
exchange, or other disposition of land.
Section 199(c)(4)(C) provides that
gross receipts derived from the
manufacture or production of any
property described in section
199(c)(4)(A)(i)(I) shall be treated as
meeting the requirements of section
199(c)(4)(A)(i) if (i) such property is
manufactured or produced by the
taxpayer pursuant to a contract with the
Federal Government, and (ii) the
Federal Acquisition Regulation requires

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that title or risk of loss with respect to
such property be transferred to the
Federal Government before the
manufacture or production of such
property is complete.
Section 199(c)(4)(D) provides that for
purposes of section 199(c)(4), if all of
the interests in the capital and profits of
a partnership are owned by members of
a single expanded affiliated group (EAG)
at all times during the taxable year of
such partnership, the partnership and
all members of such group shall be
treated as a single taxpayer during such
period.
Section 199(c)(5) defines QPP to
mean: (A) Tangible personal property;
(B) any computer software; and (C) any
property described in section 168(f)(4)
(certain sound recordings).
Section 199(c)(6) defines a qualified
film to mean any property described in
section 168(f)(3) if not less than 50
percent of the total compensation
relating to production of the property is
compensation for services performed in
the United States by actors, production
personnel, directors, and producers. The
term does not include property with
respect to which records are required to
be maintained under 18 U.S.C. 2257
(generally, films, videotapes, or other
matter that depict actual sexually
explicit conduct and are produced in
whole or in part with materials that
have been mailed or shipped in
interstate or foreign commerce, or are
shipped or transported or are intended
for shipment or transportation in
interstate or foreign commerce).
Section 199(c)(7) provides that DPGR
does not include any gross receipts of
the taxpayer derived from property
leased, licensed, or rented by the
taxpayer for use by any related person.
However, DPGR may include such
property if the property is held for
sublease, sublicense, or rent, or is
subleased, sublicensed, or rented, by the
related person to an unrelated person
for the ultimate use of the unrelated
person. See footnote 29 of H.R. Conf.
Rep. No. 755, 108th Cong. 2d Sess. 260
(2004) (Conference Report). A person is
treated as related to another person if
both persons are treated as a single
employer under either section 52(a) or
(b) (without regard to section 1563(b)),
or section 414(m) or (o).
Pass-Thru Entities
Section 199(d)(1)(A) provides that, in
the case of a partnership or S
corporation, (i) section 199 shall be
applied at the partner or shareholder
level, (ii) each partner or shareholder
shall take into account such person’s
allocable share of each item described in
section 199(c)(1)(A) or (B) (determined

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without regard to whether the items
described in section 199(c)(1)(A) exceed
the items described in section
199(c)(1)(B)), and (iii) each partner or
shareholder shall be treated for
purposes of section 199(b) as having W–
2 wages for the taxable year in an
amount equal to the lesser of (I) such
person’s allocable share of the W–2
wages of the partnership or S
corporation for the taxable year (as
determined under regulations
prescribed by the Secretary), or (II) 2
times 9 percent (3 percent in the case of
taxable years beginning in 2005 or 2006,
and 6 percent in the case of taxable
years beginning in 2007, 2008, or 2009)
of so much of such person’s QPAI as is
attributable to items allocated under
section 199(d)(1)(A)(ii) for the taxable
year.
Section 514(b) of TIPRA amended
section 199(d)(1)(A)(iii) to provide
instead that each partner or shareholder
shall be treated for purposes of section
199(b) as having W–2 wages for the
taxable year equal to such person’s
allocable share of the W–2 wages of the
partnership or S corporation for the
taxable year (as determined under
regulations prescribed by the Secretary).
The IRS and Treasury Department plan
on issuing regulations on the
amendments made to section
199(d)(1)(A)(iii) by section 514 of
TIPRA.
Section 199(d)(1)(B) provides that, in
the case of a trust or estate, (i) the items
referred to in section 199(d)(1)(A)(ii) (as
determined therein) and the W–2 wages
of the trust or estate for the taxable year,
shall be apportioned between the
beneficiaries and the fiduciary (and
among the beneficiaries) under
regulations prescribed by the Secretary,
and (ii) for purposes of section
199(d)(2), AGI of the trust or estate shall
be determined as provided in section
67(e) with the adjustments described in
such paragraph.
Section 199(d)(1)(C) provides that the
Secretary may prescribe rules requiring
or restricting the allocation of items and
wages under section 199(d)(1) and may
prescribe such reporting requirements
as the Secretary determines appropriate.
Individuals
In the case of an individual, section
199(d)(2) provides that the deduction is
equal to the applicable percent of the
lesser of the taxpayer’s (A) QPAI for the
taxable year, or (B) AGI for the taxable
year determined after applying sections
86, 135, 137, 219, 221, 222, and 469,
and without regard to section 199.

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Patrons of Certain Cooperatives
Section 199(d)(3)(A) provides that any
person who receives a qualified
payment from a specified agricultural or
horticultural cooperative shall be
allowed for the taxable year in which
such payment is received a deduction
under section 199(a) equal to the
portion of the deduction allowed under
section 199(a) to such cooperative
which is (i) allowed with respect to the
portion of the QPAI to which such
payment is attributable, and (ii)
identified by such cooperative in a
written notice mailed to such person
during the payment period described in
section 1382(d).
Section 199(d)(3)(B) provides that the
taxable income of a specified
agricultural or horticultural cooperative
shall not be reduced under section 1382
by reason of that portion of any
qualified payment as does not exceed
the deduction allowable under section
199(d)(3)(A) with respect to such
payment.
Section 199(d)(3)(C) provides that, for
purposes of section 199, the taxable
income of a specified agricultural or
horticultural cooperative shall be
computed without regard to any
deduction allowable under section
1382(b) or (c) (relating to patronage
dividends, per-unit retain allocations,
and nonpatronage distributions).
Section 199(d)(3)(D) provides that, for
purposes of section 199, a specified
agricultural or horticultural cooperative
described in section 199(d)(3)(F)(ii)
shall be treated as having MPGE in
whole or in significant part any QPP
marketed by the organization that its
patrons have so MPGE.
Section 199(d)(3)(E) provides that, for
purposes of section 199(d)(3), the term
qualified payment means, with respect
to any person, any amount that (i) is
described in section 1385(a)(1) or (3),
(ii) is received by such person from a
specified agricultural or horticultural
cooperative, and (iii) is attributable to
QPAI with respect to which a deduction
is allowed to such cooperative under
section 199(a).
Section 199(d)(3)(F) provides that, for
purposes of section 199(d)(3), the term
specified agricultural or horticultural
cooperative means an organization to
which part I of subchapter T applies
that is engaged (i) in the MPGE in whole
or in significant part of any agricultural
or horticultural product, or (ii) in the
marketing of agricultural or
horticultural products.
Expanded Affiliated Group
Section 199(d)(4)(A) provides that all
members of an EAG are treated as a

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single corporation for purposes of
section 199. Section 199(d)(4)(B)
provides that an EAG is an affiliated
group as defined in section 1504(a),
determined by substituting ‘‘more than
50 percent’’ for ‘‘at least 80 percent’’
each place it appears and without regard
to section 1504(b)(2) and (4).
Section 199(d)(4)(C) provides that,
except as provided in regulations, the
section 199 deduction is allocated
among the members of the EAG in
proportion to each member’s respective
amount (if any) of QPAI.
Trade or Business Requirement
Section 199(d)(5) provides that
section 199 is applied by taking into
account only items that are attributable
to the actual conduct of a trade or
business.
Alternative Minimum Tax
Section 199(d)(6) provides that, for
purposes of determining the alternative
minimum taxable income under section
55, (A) QPAI shall be determined
without regard to any adjustments
under sections 56 through 59, and (B) in
the case of a corporation, section
199(a)(1)(B) shall be applied by
substituting ‘‘alternative minimum
taxable income’’ for ‘‘taxable income.’’
Unrelated Business Taxable Income
Section 199(d)(7) provides that, for
purposes of determining the tax
imposed by section 511, section
199(a)(1)(B) shall be applied by
substituting ‘‘unrelated business taxable
income’’ for ‘‘taxable income.’’
Authority To Prescribe Regulations
Section 199(d)(8) authorizes the
Secretary to prescribe such regulations
as are necessary to carry out the
purposes of section 199, including
regulations that prevent more than one
taxpayer from being allowed a
deduction under section 199 with
respect to any activity described in
section 199(c)(4)(A)(i).
Effective Date
The effective date of section 199 in
section 102(e) of the Act was amended
by section 403(a)(19) of the GOZA.
Section 102(e)(1) of the Act provides
that the amendments made by section
102 of the Act shall apply to taxable
years beginning after December 31,
2004. Section 102(e)(2) of the Act
provides that, in determining the
deduction under section 199, items
arising from a taxable year of a
partnership, S corporation, estate, or
trust beginning before January 1, 2005,
shall not be taken into account for
purposes of section 199(d)(1). Section

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514(c) of TIPRA provides that the
amendments made by section 514 apply
to taxable years beginning after May 17,
2006, the enactment date of TIPRA.
Summary of Comments and
Explanation of Provisions
Taxable Income
The section 199 deduction is not
taken into account in computing any net
operating loss (NOL) or the amount of
any NOL carryback or carryover. Thus,
except as otherwise provided in
§ 1.199–7(c)(2) of the final regulations
(concerning the portion of a section 199
deduction allocated to a member of an
EAG), the section 199 deduction cannot
create, or increase, the amount of an
NOL deduction.
For purposes of section 199(a)(1)(B),
taxable income is determined without
regard to section 199 and without regard
to any amount excluded from gross
income pursuant to section 114 of the
Code or pursuant to section 101(d) of
the Act. Thus, any extraterritorial
income exclusion or amount excluded
from gross income pursuant to section
101(d) of the Act does not reduce
taxable income for purposes of section
199(a)(1)(B), even though such excluded
amounts are taken into account in
determining QPAI.
Wage Limitation
The final regulations give the
Secretary authority to provide for
methods of calculating W–2 wages.
Contemporaneous with the publication
of these final regulations, Rev. Proc.
2006–22 (2006–22 I.R.B.) has been
published and provides for taxable years
beginning on or before May 17, 2006,
the enactment date of TIPRA, the same
three methods of calculating W–2 wages
as were contained in Notice 2005–14
and the proposed regulations. It is
expected that any new revenue
procedure applicable for taxable years
beginning after May 17, 2006, will
contain methods for calculating W–2
wages similar to the three methods in
Rev. Proc. 2006–22. The methods are
included in a revenue procedure rather
than the final regulations so that if
changes are made to Form W–2, ‘‘Wage
and Tax Statement,’’ a new revenue
procedure can be issued reflecting those
changes more promptly than an
amendment to the final regulations.
Taxpayers have inquired whether
remuneration paid to employees for
domestic services in a private home of
the employer, which remuneration may
be reported on Schedule H (Form 1040),
‘‘Household Employment Taxes,’’ or,
under certain conditions, on Form 941,
‘‘Employer’s Quarterly Federal Tax

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Return,’’ are included in W–2 wages.
Such remuneration is generally
excepted from wages for income tax
withholding purposes by section
3401(a)(3) of the Code. Section 199(b)(5)
provides that section 199 shall be
applied by only taking into account
items that are attributable to the actual
conduct of a trade or business.
Payments to employees of a taxpayer for
domestic services in a private home of
the taxpayer are not attributable to the
actual conduct of a trade or business of
the taxpayer. Accordingly, such
payments are not included in W–2
wages for purposes of section 199(b)(2).
The IRS and Treasury Department
have also received numerous inquiries
concerning whether amounts paid to
workers who receive Forms W–2 from
professional employer organizations
(PEOs), or employee leasing firms, may
be included in the W–2 wages of the
clients of the PEOs or employee leasing
firms. In order for wages reported on a
Form W–2 to be included in the
determination of W–2 wages of a
taxpayer, the Form W–2 must be for
employment by the taxpayer. Employees
of the taxpayer are defined in § 1.199–
2(a)(1) of the final regulations as
including only common law employees
of the taxpayer and officers of a
corporate taxpayer. Thus, the issue of
whether the payments to the employees
are included in W–2 wages depends on
an application of the common law rules
in determining whether the PEO, the
employee leasing firm, or the client is
the employer of the worker. As noted in
§ 1.199–2(a)(2) of the final regulations,
taxpayers may take into account wages
reported on Forms W–2 issued by other
parties provided that the wages reported
on the Forms W–2 were paid to
employees of the taxpayer for
employment by the taxpayer. However,
with respect to individuals who
taxpayers assert are their common law
employees for purposes of section 199,
taxpayers are reminded of their duty to
file returns and apply the tax law on a
consistent basis.
Commentators also raised the issue of
whether an individual filing as part of
a joint return may include wages paid
by his or her spouse to employees of his
or her spouse in determining the
amount of the individual’s W–2 wages
for purposes of the section 199
deduction. The example given was an
individual who had a trade or business
reported on Schedule C (Form 1040)
with QPAI but no W–2 wages, and the
individual’s spouse had W–2 wages in
a second trade or business reported on
Schedule C (Form 1040) but no QPAI.
Section 1.199–2(a)(4) of the final
regulations provides that married

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individuals who file a joint return are
treated as one taxpayer for purposes of
determining W–2 wages. Therefore, an
individual filing as part of a joint return
may take into account wages paid to
employees of his or her spouse in
determining the amount of W–2 wages
provided the wages are paid in a trade
or business of the spouse and the other
requirements of the final regulations are
met. In contrast, if the taxpayer and the
taxpayer’s spouse file separate returns,
the taxpayer may not use the spouse’s
wages in determining the taxpayer’s W–
2 wages for purposes of the taxpayer’s
section 199 deduction because they are
not considered one taxpayer.
Domestic Production Gross Receipts
Commentators suggested that rules
similar to the de minimis rules provided
in §§ 1.199–1(d)(2) (gross receipts
allocation), 1.199–3(h)(4) (embedded
services), 1.199–3(l)(1)(ii) (construction
services), and 1.199–3(m)(4)
(engineering or architectural services) of
the proposed regulations, under which
taxpayers may treat de minimis amounts
of non-DPGR as DPGR, should be
available in the opposite situation.
Thus, for example, if a taxpayer’s gross
receipts that are allocable to DPGR are
less than 5 percent of its overall gross
receipts for the taxable year, the
commentators suggested that the final
regulations allow the taxpayer to treat
those gross receipts as non-DPGR. The
IRS and Treasury Department agree with
this suggestion, and the final regulations
provide such rules for the provisions
discussed above as well as under
§ 1.199–3(l)(4)(iv)(B) for utilities.
Several comments were received
regarding the burden imposed by the
requirement in the proposed regulations
that QPAI be computed on an item-byitem basis (rather than on a division-bydivision, or product line-by-product line
basis). Several commentators urged the
IRS and Treasury Department to limit
the item-by-item standard to the
requirements of § 1.199–3 in
determining DPGR (that is, the lease,
rental, license, sale, exchange, or other
disposition requirement, the in-wholeor-in-significant-part requirement, etc.).
Specifically, the commentators argued
that the item-by-item standard is
inconsistent with the cost allocation
methods provided in § 1.199–4. The IRS
and Treasury Department agree with
this comment. Therefore, the final
regulations clarify that the item-by-item
standard applies solely for purposes of
the requirements of § 1.199–3 noted
above in determining whether the gross
receipts derived from an item are DPGR.
The final regulations also provide that a
taxpayer must determine, using any

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reasonable method that is satisfactory to
the Secretary based on all of the facts
and circumstances, whether gross
receipts qualify as DPGR on an item-byitem basis.
The proposed regulations provide that
an item is defined as the property
offered for lease, rental, license, sale,
exchange or other disposition to
customers that meets the requirements
of section 199. The proposed regulations
also provide several examples to
illustrate this rule. Some commentators
observed that the examples involving a
manufacturer of toy cars that sold the
cars to toy stores appear to imply that,
in the case of property offered for lease,
rental, license, sale, exchange or other
disposition by a wholesaler, the item is
defined with reference to the property
offered for sale to retail consumers by
the wholesaler’s customer. The rules for
defining an item, and the related
examples, have been clarified in the
final regulations to provide that an item
is defined with reference to the property
offered by the taxpayer for lease, rental,
license, sale, exchange or other
disposition to the taxpayer’s customers
in the normal course of the taxpayer’s
business, whether the taxpayer is a
wholesaler or a retailer.
The proposed regulations provide
that, if the property offered for lease,
rental, license, sale, exchange or other
disposition by the taxpayer does not
meet the requirements of section 199,
then the taxpayer must treat as the item
any portion of that property that does
meet those requirements. In a case
where two or more portions of the
property meet the requirements of
section 199, commentators inquired
whether the two or more portions are
properly treated as a single item or as
two or more items. The final regulations
generally are consistent with the rules of
the proposed regulations, and provide
that if the gross receipts derived from
the lease, rental, license, sale, exchange
or other disposition of the property
offered in the normal course of a
taxpayer’s business do not qualify as
DPGR, then any component of such
property is treated as the item, provided
the gross receipts attributable to the
component qualify as DPGR. Allowing
more than one component to be treated
as a single item would effectively permit
taxpayers to define an item as any
combination of components that, in the
aggregate, meets the requirements of
section 199, a result that the IRS and
Treasury Department believe could lead
to significant distortions. Thus, the IRS
and Treasury Department believe that
treating two or more components of the
property offered for lease, rental,
license, sale, exchange or other

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disposition by the taxpayer as separate
items is the appropriate result. The final
regulations clarify that, if the property
offered for lease, rental, license, sale,
exchange or other disposition by the
taxpayer does not meet the requirements
of section 199, then each component
that meets the requirements of § 1.199–
3 must be treated as a separate item and
such component may not be combined
with a component that does not meet
the requirements to be treated as an
item. The final regulations provide
examples illustrating this rule. It follows
that the de minimis rule for embedded
services and nonqualifying property, as
well as any other de minimis exception
that is applied at the item level, must be
applied separately to each component of
the property that is treated as a separate
item.
The proposed regulations provide that
gross receipts derived from a lease,
rental, license, sale, exchange or other
disposition of qualifying property
constitute DPGR even if the taxpayer
has already recognized gross receipts
from a previous lease, rental, license,
sale, exchange or other disposition of
the property. The IRS and Treasury
Department recognize that in some
cases, such as where the original item
(for example, steel) that was MPGE or
produced by the taxpayer within the
United States is disposed of by the
taxpayer, and incorporated by another
person into other property (for example,
an automobile) that is subsequently
acquired by the taxpayer, it would be
extremely difficult for the taxpayer to
identify the item the gross receipts of
which constitute DPGR upon lease,
rental, license, sale, exchange or other
disposition of the acquired property.
Therefore, the final regulations provide
that if a taxpayer cannot reasonably
determine without undue burden and
expense whether the acquired property
contains any of the original qualifying
property, or the amount, grade, or kind
of the original qualifying property, that
the taxpayer MPGE or produced within
the United States, then the taxpayer is
not required to determine whether any
portion of the acquired property
qualifies as an item. In such cases, the
taxpayer may treat any gross receipts
derived from the disposition of the
acquired property that are attributable to
the original qualifying property as nonDPGR.
The proposed regulations provide
that, for purposes of the requirement to
allocate gross receipts between DPGR
and non-DPGR, if a taxpayer can,
without undue burden or expense,
specifically identify where an item was
manufactured, or if the taxpayer uses a
specific identification method for other

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purposes, then the taxpayer must use
that specific identification method to
determine DPGR. One commentator
observed that Notice 2005–14 applies a
readily available rather than an undue
burden or expense standard for this
purpose, and questioned whether the
proposed regulations were intended to
impose a substantively different
standard. The standard was changed in
the proposed regulations in response to
comments received on Notice 2005–14.
The commentators were concerned that
taxpayers would be required under
Notice 2005–14 to use specific
identification to allocate gross receipts
under section 199 if their information
systems contained the information
necessary to use specific identification,
even if capturing such information
would require costly system
reconfigurations. The undue burden and
expense standard, however, was not
intended to expand the scope of the
requirement to use specific
identification to include taxpayers for
whom the information necessary to use
that method is not readily available in
their existing systems. Accordingly, the
final regulations utilize both terms.
Commentators were concerned that
the disposition of qualifying property
would not give rise to DPGR if provided
as part of a service related contract.
However, the proposed regulations in
Example 4 in § 1.199–3(d)(5) already
address this issue by illustrating a
qualifying disposition resulting in DPGR
as part of a service related contract. In
that example, Y is hired to reconstruct
and refurbish unrelated customers’
tangible personal property. Y installs
the replacement parts (QPP) that Y
MPGE within the United States. The
example concludes that Y’s gross
receipts from the MPGE of the
replacement parts are DPGR. The final
regulations retain this example and
include other examples of service
related contracts that also involve the
disposition of qualifying property giving
rise to DPGR if all of the other section
199 requirements are met.
The proposed regulations provide
that, if a taxpayer recognizes and reports
on a Federal income tax return for a
taxable year gross receipts that the
taxpayer identifies as DPGR, then the
taxpayer must treat the CGS related to
such receipts as relating to DPGR, even
if they are incurred in a subsequent
taxable year. The final regulations retain
this rule in § 1.199–4(b)(2). One
commentator questioned whether this
rule applies to CGS incurred in a taxable
year to which section 199 applies, if the
gross receipts were recognized in a
taxable year prior to the effective date of
section 199 but would have qualified as

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DPGR in that taxable year if section 199
had been in effect. The IRS and
Treasury Department believe that all
gross receipts and costs must be
allocated between DPGR and non-DPGR
on a year-by-year basis, and the final
regulations provide that for taxpayers
using the section 861 method or the
simplified deduction method, CGS that
relates to gross receipts recognized in a
taxable year prior to the effective date of
section 199 must be allocated to nonDPGR.
For items that are disposed of under
contracts that span two or more taxable
years, the final regulations permit the
use of historical data to allocate gross
receipts between DPGR and non-DPGR.
If a taxpayer makes allocations using
historical data, and subsequently
updates the data, then the taxpayer must
use the more recent or updated data,
starting in the taxable year in which the
update is made.
Two commentators suggested that the
final regulations permit taxpayers to
classify multi-year contracts for
purposes of section 199 with reference
to their classification under section 460.
For example, if a contract is classified
as a construction contract under section
460, the commentators suggested that
the contract also be classified as a
construction contract under section 199.
The IRS and Treasury Department have
determined, however, that the statutory
requirements under sections 199 and
460, and the regulations thereunder, are
sufficiently different that it would not
be appropriate for the final regulations
to permit the classification of multi-year
contracts under section 460 to
determine whether the requirements of
section 199 are met with respect to that
contract. Accordingly, the final
regulations do not adopt this suggestion.
By the Taxpayer
One commentator suggested a
simplifying convention to determine
which party to a contract manufacturing
arrangement has the benefits and
burdens of ownership under Federal
income tax principles. The commentator
requested that the final regulations
permit unrelated parties to a contract
manufacturing arrangement to
designate, through a written and signed
agreement between the parties, which of
them shall be treated for purposes of
section 199 as engaging in MPGE
activities conducted pursuant to the
arrangement. The final regulations do
not adopt the commentator’s suggestion.
The IRS and Treasury Department
continue to believe that the benefits and
burdens of ownership must be
determined based on all of the facts and
circumstances and a designation of

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Government Contracts
Section 403(a)(7) of the GOZA added
new section 199(c)(4)(C), which
contains a special rule for certain
government contracts. The final
regulations clarify that the special rule
for government contracts also applies to
gross receipts derived from certain
subcontracts to manufacture or produce
property for the Federal government.
See The Joint Committee on Taxation
Staff, Technical Explanation of the
Revenue Provisions of H.R. 4440, The
Gulf Opportunity Zone Act of 2005,
109th Cong., 1st Sess. 77 (2005).
In Whole or in Significant Part
The proposed regulations, like Notice
2005–14, provide generally that QPP is
MPGE in whole or in significant part by
the taxpayer within the United States
only if the taxpayer’s MPGE activity in
the United States is substantial in
nature. Although some language in the
section 199 substantial-in-nature
requirement bears similarities to
language in the definition of
manufacture in § 1.954–3(a)(4), the two
standards are different both in purpose
and in substance. Whether operations
are substantial in nature is relevant
under section 954 in determining
whether manufacturing has occurred.
By contrast, the substantial-in-nature
requirement under section 199 is
relevant in determining whether the
MPGE activity, already determined to
have occurred under the requirement
provided in § 1.199–3(d) of the
proposed regulations (§ 1.199–3(e) of the
final regulations), was performed in
whole or in significant part by the
taxpayer within the United States.
Accordingly, as stated in the preamble
to Notice 2005–14, case law and other
precedent under section 954 are not
relevant for purposes of the substantialin-nature requirement under section
199. Nor are they relevant for purposes
of determining whether an activity is an
MPGE activity under section 199.
Similarly, the regulations under section
199 are not relevant for purposes of
section 954.
Because the substantial-in-nature
requirement is generally applied by
taking into account all of the facts and
circumstances, both the proposed
regulations and Notice 2005–14 provide
a safe harbor under which the in-wholeor-in-significant-part requirement is
satisfied if the taxpayer’s conversion
costs (that is, direct labor and related
factory burden) are 20 percent or more
of the taxpayer’s CGS with respect to the
property. Commentators expressed

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confusion concerning the related factory
burden component of this safe harbor,
and suggested that overhead be
substituted for related factory burden in
the final regulations. Commentators
further noted that not all transactions
yielding DPGR under section 199
involve CGS (for example, a lease,
rental, or license of QPP). In response to
these comments, the IRS and Treasury
Department have changed the safe
harbor in the final regulations. The final
regulations provide that the in-wholeor-in-significant-part requirement is
satisfied if the taxpayer’s direct labor
and overhead to MPGE the QPP within
the United States account for 20 percent
or more of the taxpayer’s CGS, or in a
transaction without CGS (for example, a
lease, rental, or license) account for 20
percent or more of the taxpayer’s
unadjusted depreciable basis of the
QPP. No inference is intended regarding
any similar safe harbor under the Code,
including the safe harbor in § 1.954–
3(a)(4)(iii). For taxpayers subject to
section 263A, overhead is all costs
required to be capitalized under section
263A except direct materials and direct
labor. For taxpayers not subject to
section 263A, overhead may be
computed using any reasonable method
that is satisfactory to the Secretary based
on all of the facts and circumstances,
but may not include any cost, or amount
of any cost, that would not be required
to be capitalized under section 263A if
the taxpayer were subject to section
263A. In no event are section 174 costs,
and the cost of creating intangible
assets, attributable to tangible personal
property ever treated as direct labor and
overhead, and taxpayers should exclude
such costs from their CGS or unadjusted
depreciable basis, as applicable.
However, the final regulations also
clarify that, in the case of computer
software and sound recordings, research
and experimental expenditures under
section 174 relating to the computer
software or sound recordings, the cost of
creating intangible assets for computer
software or sound recordings, and (in
the case of computer software) costs of
developing the computer software that
are described in Rev. Proc. 2000–50
(2000–1 C.B. 601) (software
development costs), are included in
both direct labor and overhead and CGS
or unadjusted depreciable basis for
purposes of the safe harbor, even if the
costs are incurred in a prior taxable
year. In addition, the final regulations
also clarify that this is the case whether
the computer software or sound
recording is itself the item for purposes
of section 199, or is affixed or added to
tangible personal property and the

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31273

taxpayer treats the combined property
as computer software or a sound
recording under the rules of § 1.199–
3(i)(5)). In the case where the taxpayer
produces computer software and
manufactures part of the tangible
personal property to which the
computer software is affixed, the
taxpayer may combine the direct labor
and overhead for the computer software
and tangible personal property
produced or manufactured by the
taxpayer in determining whether it
meets the safe harbor.
The final regulations provide that, in
applying the safe harbor to an item for
the taxable year, all computer software
development costs, any cost of creating
intangible assets for computer software
or sound recordings, and section 174
costs (for computer software or sound
recordings), including those paid or
incurred in a prior taxable year, must be
allocated over the estimated number of
units of the item of which the taxpayer
expects to dispose. An example of this
rule is provided in the final regulations.
The proposed regulations provide that
an EAG member must take into account
all of the previous MPGE or production
activities of the other members of the
EAG in determining whether its MPGE
or production activities are substantial
in nature. It has been suggested that this
rule be modified to allow the EAG
member to take into account all MPGE
or production activities of the other
EAG members rather than just the
previous MPGE or production activities
of the members. The final regulations do
not adopt this suggestion because the
IRS and Treasury Department believe
that the EAG member must determine
whether its MPGE or production
activities meet the substantial-in-nature
requirement at or before the time EAG
member disposes of the property.
Similar rules apply for purposes of the
safe harbor under § 1.199–3(g)(3)(i).
Section 3.04(5)(d) of Notice 2005–14
generally provides that design and
development activities must be
disregarded in applying the general
substantial-in-nature requirement and
the safe harbor for tangible personal
property. The proposed regulations
clarify that research and experimental
activities under section 174 and the
creation of intangibles do not qualify as
substantial in nature. A commentator
questioned whether, with respect to
tangible personal property, activities
that constitute both an MPGE activity as
well as a section 174 activity must
nonetheless be excluded from the
determination of whether the taxpayer’s
MPGE of the QPP is substantial in
nature because all section 174 activities
are disregarded in making such a

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determination. The IRS and Treasury
Department continue to believe that,
with the exception of computer software
and sound recordings, it is not
appropriate to include any section 174
activities in the determination of
whether the MPGE of QPP is substantial
in nature. However, the IRS and
Treasury Department recognize that,
although section 174 costs are not
required to be capitalized under section
263A to the produced property, a
taxpayer may capitalize such costs to
the QPP under section 263A.
Accordingly, the final regulations
permit, as a matter of administrative
convenience, a taxpayer to include such
costs as CGS or unadjusted depreciable
basis for purposes of the 20 percent safe
harbor.
A commentator asked that the final
regulations clarify that gross receipts
relating to computer software updates
that are provided as part of a computer
software maintenance contract qualify
as DPGR if all of the requirements of
section 199(c)(4) are met. The final
regulations include an example
demonstrating that gross receipts
relating to computer software updates
may qualify as DPGR even if the
computer software updates are provided
pursuant to a computer software
maintenance agreement.
The preamble to the proposed
regulations states that the creation and
licensing of copyrighted business
information reports do not constitute
the MPGE of QPP because the database
is not QPP. However, it has come to the
attention of the IRS and Treasury
Department that some business
information reports published by the
taxpayer may qualify as QPP, for
example, business information reports
published by the taxpayer in books that
qualify as QPP. Therefore, no inference
should be drawn from the preamble to
the proposed regulations as to whether
business information reports qualify for
the section 199 deduction.
The proposed regulations provide in
§ 1.199–3(f)(2) that QPP will be treated
as MPGE in significant part by the
taxpayer within the United States if the
MPGE of the QPP by the taxpayer
within the United States is substantial
in nature taking into account all of the
facts and circumstances, including the
relative value added by, and relative
cost of, the taxpayer’s MPGE activity
within the United States, the nature of
the property, and the nature of the
MPGE activity that the taxpayer
performs within the United States.
One commentator suggested that, if a
taxpayer manufactures a key component
of QPP and purchases the rest of the
components, the fact that the taxpayer

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manufactured the key component
should satisfy the substantial-in-nature
requirement with respect to the QPP
that incorporates the key component.
For example, X manufactures computer
chips within the United States. X
installs the computer chips that it
manufactures in computers that X
purchases from unrelated persons and
sells the finished computers
individually to customers. Although the
computer chips are key components of
the computers and the computers will
not operate without them, the
manufacture of the key components
does not, by itself, satisfy the
substantial-in-nature requirement with
respect to the finished computers and
the taxpayer’s activities with respect to
the finished computers must meet either
the substantial-in-nature requirement
under § 1.199–3(g)(2) or the safe harbor
under § 1.199–3(g)(3) of the final
regulations. The final regulations
contain an example to illustrate this
rule.
In Example 4 in § 1.199–3(f)(4) of the
proposed regulations, X licenses a
qualified film to Y for duplication of the
film onto DVDs. Y purchases the DVDs
from an unrelated person. The example
concludes that unless Y satisfies the safe
harbor under § 1.199–3(f)(3) of the
proposed regulations, Y’s income for
duplicating X’s qualified film onto
DVDs is non-DPGR because the
duplication is not substantial in nature
relative to the DVD with the film. One
commentator disagreed with the
conclusion in this example because
duplicating a DVD may involve
considerable activities. This example
and other examples illustrating the
substantial-in-nature requirement have
been removed from the final regulations
because the determination of what is
substantial in nature is determined
based on all the facts and
circumstances. No inference should be
drawn as to whether an activity is, or is
not, substantial in nature by the removal
of any example.
Derived From a Lease, Rental, License,
Sale, Exchange, or Other Disposition
Section 1.199–3(h)(1) of the proposed
regulations provides that applicable
Federal income tax principles apply to
determine whether a transaction is, in
substance, a lease, rental, license, sale,
exchange, or other disposition of QPP,
whether it is a service, or whether it is
some combination thereof. In the
preamble to the proposed regulations,
the IRS and Treasury Department
acknowledge that the short-term nature
of a transaction does not, by itself,
render the transaction a service for
purposes of section 199 and that many

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transactions include both service and
property rental elements. The preamble
further states that not every transaction
in which property is used in connection
with providing a service to customers,
however, constitutes a mixture of
services and rental for which allocation
of gross receipts is appropriate and
provides an example of a video arcade
that features video game machines that
the taxpayer MPGE. The machines
remain in the taxpayer’s possession
during the customers’ use. The example
concludes that gross receipts derived
from customers’ use of the machines at
the taxpayer’s arcade are not derived
from the lease, rental, license, sale,
exchange, or other disposition of the
machines. Rather, the machines are
used to provide a service and, thus, the
gross receipts are non-DPGR. While the
general rule stated in § 1.199–3(h)(1) of
the proposed regulations is retained in
the final regulations under § 1.199–
(3)(I)(1), the preamble example is not
included in the final regulations
because the determination of whether a
transaction is a service or a rental is
based upon all the facts and
circumstances. No inference should be
drawn as to whether the transaction
constitutes a service or rental (or some
combination thereof) by the removal of
the example.
Section 1.199–3(h)(1) of the proposed
regulations provides that the value of
property received by a taxpayer in a
taxable exchange of QPP MPGE in
whole or in significant part within the
United States, a qualified film produced
by the taxpayer, or utilities produced by
the taxpayer in the United States, for an
unrelated person’s property is DPGR for
the taxpayer. However, unless the
taxpayer meets all of the requirements
under section 199 with respect to any
further MPGE by the taxpayer of the
QPP or any further production by the
taxpayer of the film or utilities received
in the taxable exchange, any gross
receipts derived from the sale by the
taxpayer of the property received in the
taxable exchange are non-DPGR,
because the taxpayer did not MPGE or
produce such property, even if the
property was QPP, a qualified film, or
utilities in the hands of the other party
to the transaction.
A commentator requested that, with
regard to certain taxable exchanges, the
final regulations provide a safe harbor
that would accommodate long-standing
industry accounting practices for these
exchanges. The final regulations provide
a safe harbor whereby the gross receipts
derived by the taxpayer from the sale of
eligible property (as defined later)
received in a taxable exchange, net of
any adjustments between the parties

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involved in the taxable exchange to
account for differences in the eligible
property exchanged (for example,
location differentials and product
differentials), may be treated as the
value of the eligible property received
by the taxpayer in the taxable exchange.
In addition, if the taxpayer engages in
any further MPGE or production activity
with respect to the eligible property
received in the taxable exchange, then,
unless the taxpayer meets the in-wholeor-in significant-part requirement under
§ 1.199–3(g)(1) with respect to the
property sold, the taxpayer must also
value the property sold without taking
into account the gross receipts
attributable to the further MPGE or
production activity. The final
regulations define eligible property as
oil, natural gas, and petrochemicals, or
products derived from oil, natural gas,
petrochemicals, or any other property or
product designated by publication in
the Internal Revenue Bulletin. Under
the safe harbor, the taxable exchange is
deemed to occur on the date of the sale
of the eligible property received in the
exchange to the extent that the sale
occurs no later than the last day of the
month following the month in which
the exchanged eligible property is
received by the taxpayer.
The proposed regulations provide
that, in the case of gross receipts derived
from a lease of QPP or a qualified film,
the entire amount of the lease income,
including any interest that is not
separately stated, is considered derived
from the lease of the QPP or qualified
film. Commentators noted that many
leases of personal property separately
state a finance or interest component.
The IRS and Treasury Department
believe that Congress intended for all
financing or interest components of a
lease of qualifying property to be
considered DPGR (assuming all the
other requirements of section 199 are
met). Accordingly, the final regulations
provide that all financing and interest
components of a lease of qualifying
property are considered to be derived
from the lease of such qualifying
property.
Section 1.199–3(h)(4) of the proposed
regulations provides exceptions to the
general rule that DPGR does not include
gross receipts derived from services or
nonqualifying property. The exceptions
are for embedded qualified warranties,
delivery, operating manuals, and
installation. The final regulations retain
these exceptions and provide a new
exception for embedded computer
software maintenance contracts. None of
these exceptions, which allow gross
receipts attributable to such embedded
services and nonqualifying property to

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be treated as DPGR, is available if, in the
normal course of the taxpayer’s trade or
business, the price for the service or
nonqualifying property is separately
stated or is separately offered to the
customer.
One commentator asked for
clarification concerning the meaning of
the term normal course of a taxpayer’s
trade or business and when something
would be considered to be separately
stated or separately offered to a
customer. The purpose of the exceptions
is to reduce the burden on a taxpayer of
having to allocate a portion of its gross
receipts to these commonly occurring
types of services and property if the
taxpayer does not normally price or
offer such items separately. Whether a
taxpayer separately offers or states the
price for such an item in the normal
course of its trade or business depends
on the facts and circumstances. If, for
example, a taxpayer separately states the
price for installation for a few of its
customers on a case by case basis, then
the taxpayer may be considered to have
not separately stated the price of
installation in the normal course of its
trade or business. The requirements
have been changed in the final
regulations to clarify that the normalcourse-of-trade-or-business requirement
applies to both the separately stated
price prong and the separately offered
prong of the embedded services and
nonqualifying property rules.
Several comments were received
concerning the rule in the proposed
regulations under which gross receipts
attributable to advertising in
newspapers, magazines, telephone
directories, or periodicals may qualify
as DPGR to the extent that the gross
receipts, if any, derived from the
disposition of those printed materials
qualifies as DPGR. The final regulations
clarify that this list is not limited to
these four types of printed materials,
and that the rule applies to other similar
printed materials.
Section 3 of Notice 2005–14 explains
that the basis for the rule relating to
advertising income is that such income
is inextricably linked to the gross
receipts (if any) derived from the
disposition of the printed materials
listed in the proposed regulations. After
considering the comments received, the
IRS and Treasury Department believe
that the same reasoning applies in the
case of a qualified film (for example, a
television program). Accordingly, the
rule for advertising has been extended
in the final regulations to apply to
qualified films. The wording of the
advertising rule has been changed to
clarify that the amount of gross receipts
attributable to the disposition of the

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printed materials or qualified film does
not limit the amount of gross receipts
attributable to the advertising that may
be treated as DPGR under the rule. In
addition, the final regulations clarify
that there need be no gross receipts
attributable to the disposition of the
printed materials or qualified film for
the gross receipts from the advertising to
qualify as DPGR.
One commentator requested that the
final regulations recognize that gross
receipts derived from the sale of
advertising slots in live or delayed
television broadcasts (that are produced
by the taxpayer and that otherwise meet
the requirements for a qualified film) are
DPGR. While live and delayed
television programming may otherwise
meet the requirements to be treated as
a qualified film, in order for the gross
receipts derived from advertising slots
to be DPGR, there must also be a
qualifying disposition of the qualified
film. The IRS and Treasury Department
continue to believe that a live or
delayed television broadcast of a
qualified film is not a lease, rental,
license, sale, exchange or other
disposition of the qualified film.
Commentators noted, however, that if
the live or delayed television
programming is licensed to an unrelated
cable company, then the license of the
programming is a qualifying disposition
that gives rise to DPGR and if the rule
for advertising were extended to
qualified films, then the portion of the
advertising receipts relating to the
license of the qualified film would also
be DPGR. The IRS and Treasury
Department agree with these comments,
and the final regulations provide
examples to clarify these points.
Qualifying Production Property
Under § 1.199–3(i)(5)(i) of the
proposed regulations, if a taxpayer
MPGE computer software or sound
recordings that is affixed or added to
tangible personal property by the
taxpayer (for example, a computer
diskette or an appliance), then the
taxpayer may treat the tangible personal
property as computer software or sound
recordings, as applicable. A
commentator questioned whether this
rule should apply if, for example, a
taxpayer hires an unrelated person to
affix computer software or sound
recordings produced by the taxpayer to
a compact disc. In response to this
comment, the final regulations have
dropped the by-the-taxpayer
requirement in this context. A similar
rule has been provided for qualified
films.

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Qualified Films

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Section § 1.199–3(j)(1) of the proposed
regulations provides that, a qualified
film means any motion picture film or
video tape under section 168(f)(3), or
live or delayed television programming,
if not less than 50 percent of the total
compensation paid to all actors,
production personnel, directors, and
producers relating to the production of
the motion picture film, video tape, or
television programming is
compensation for services performed in
the United States by those individuals.
One commentator was concerned that
the list of production personnel
described under § 1.199–3(j)(1) of the
proposed regulations diminishes the
general rule under § 1.199–3(j)(5) that
compensation for services includes all
direct and indirect compensation costs
required to be capitalized under section
263A for film producers under
§ 1.263A–1(e)(2) and (3). The
commentator also stated that it may be
difficult to determine which persons are
production personnel. The final
regulations under § 1.199–3(k)(1) clarify
that the list of production personnel is
not exclusive, and that compensation
for services includes all direct and
indirect compensation costs required to
be capitalized under § 1.263A–1(e)(2)
and (3).
In response to questions received by
the IRS and Treasury Department, the
final regulations clarify that actors may
include players, newscasters, or any
other persons performing in a qualified
film. The final regulations also clarify
that the not-less-than-50-percent-of-thetotal-compensation requirement is
determined by reference to all
compensation paid in the production of
the film and is calculated using a
fraction. The numerator of the fraction
is the compensation paid by the
taxpayer to actors, production
personnel, directors, and producers for
services relating to the production of the
film (production services) performed in
the United States, and the denominator
is the sum of the total compensation
paid by the taxpayer to all such
individuals regardless of where the
production services are performed and
the total compensation paid by others to
all such individuals regardless of where
the production services are performed.
The final regulations provide an
example of this calculation.
Tangible Personal Property and Real
Property
Commentators requested that the final
regulations define tangible personal
property and real property for purposes
of section 199. The final regulations

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define tangible personal property as any
tangible property other than land, real
property described in the construction
rules in § 1.199–3(m)(1), computer
software described in § 1.199–3(j)(3),
sound recordings described in § 1.199–
3(j)(4), a qualified film described in
§ 1.199–3(k)(1), and utilities described
in § 1.199–3(l). In response to
commentators’ suggestions, the final
regulations further define tangible
personal property as also including any
gas (other than natural gas described in
§ 1.199–3(l)(2)), chemicals, and similar
property, for example, steam, oxygen,
hydrogen, and nitrogen.
The final regulations define the term
real property to mean buildings
(including items that are structural
components of such buildings),
inherently permanent structures (as
defined in § 1.263A–8(c)(3)) other than
machinery (as defined in § 1.263A–
8(c)(4)) (including items that are
structural components of such
inherently permanent structures),
inherently permanent land
improvements, oil and gas wells, and
infrastructure (as defined in § 1.199–
3(m)(4)). Property MPGE by a taxpayer
that is not real property in the hands of
such taxpayer, but that may be
incorporated into real property by
another taxpayer, is not treated as real
property by the producing taxpayer (for
example, bricks, nails, paint, and
windowpanes). Structural components
of buildings and inherently permanent
structures include property such as
walls, partitions, doors, wiring,
plumbing, central air conditioning and
heating systems, pipes and ducts,
elevators and escalators, and other
similar property. In addition, an entire
utility plant including both the shell
and the interior will be treated as an
inherently permanent structure.
Construction of Real Property
One commentator recommended that
DPGR derived from the construction of
real property as well as DPGR from
engineering and architectural services
for a construction project include W–2
wages earned as an employee. At the
time the taxpayer performs construction
activities, or engineering or architectural
services, the taxpayer must be engaged
in a trade or business that is considered
construction, engineering or
architectural services for purposes of the
North American Industry Classification
System (NAICS). W–2 wages earned by
an employee are not earned in
connection with a trade or business that
is considered construction, or
engineering or architectural services, for
purposes of the NAICS. Consequently,

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this recommendation has not been
adopted in the final regulations.
The proposed regulations include
within the definition of construction
services activities relating to drilling an
oil well and mining pursuant to which
the taxpayer could deduct intangible
drilling and development costs under
section 263(c) and § 1.612–4, and
development expenditures for a mine or
natural deposit under section 616. The
IRS and Treasury Department are aware
that in many situations taxpayers
provide these services with respect to
property owned by another party, and
therefore such taxpayers are ineligible to
claim the deductions for such costs
under the provisions described above.
The language of the final regulations has
been changed to clarify that taxpayers
providing such services are engaging in
construction services that may qualify
under section 199.
The preamble to the proposed
regulations states that commentators
requested that qualifying construction
activities include construction activities
related to oil and gas wells. The
preamble further states that the
proposed regulations provide as a
matter of administrative grace that
qualifying construction activities
include activities relating to drilling an
oil well. Similarly, under § 1.199–3(l)(2)
of the proposed regulations,
construction activities include activities
relating to drilling an oil well. A
commentator noted the inadvertent
omission of gas wells and the final
regulations correct the omission.
The proposed regulations provide that
DPGR does not include gross receipts
attributable to the sale or other
disposition of land (including zoning,
planning, entitlement costs, and other
costs capitalized into the land such as
grading and demolition of structures
under section 280B). Commentators
contended that grading and demolition
are construction-related activities, and
that gross receipts attributable to these
activities should qualify as DPGR. After
considering the comments, the IRS and
Treasury Department believe it is
appropriate to apply to grading and
demolition activities the same rule that
the proposed regulations apply to other
construction activities, such as
landscaping and painting. Accordingly,
services such as grading, demolition,
clearing, excavating, and any other
activities that physically transform the
land are activities constituting
construction only if these services are
performed in connection with other
activities (whether or not by the same
taxpayer) that constitute the erection or
substantial renovation of real property.
The IRS and Treasury Department

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Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules and Regulations
continue to believe that gross receipts
attributable to the sale or other
disposition of land (including zoning,
planning, and entitlement costs) are
properly considered gross receipts
attributable to the land, not to a
qualifying construction activity, and,
therefore, are non-DPGR.
In response to a suggestion by a
commentator, the final regulations
provide that a taxpayer engaged in a
construction activity must make a
reasonable inquiry or a reasonable
determination whether the activity
relates to the erection or substantial
renovation of real property in the
United States.
The proposed regulations contain an
example of an electrical contractor who
purchases wires, conduits, and other
electrical materials that the contractor
installs in construction projects in the
United States and that are considered
structural components. The example
concludes that the gross receipts that
the contractor derives from installing
these materials are derived from
construction, but that the gross receipts
attributable to the purchased materials
are not. Commentators objected to this
result, contending that it places an
unreasonable administrative burden on
taxpayers performing construction
activities. The final regulations,
including the example, provide that, in
such circumstances, the taxpayer
performing the construction services is
not required to allocate gross receipts to
the purchased materials and treat such
gross receipts as non-DPGR, provided
the materials and supplies are
consumed in the construction project or
become part of the constructed real
property.
Section 199(c)(4)(A), as amended by
the GOZA, requires that a taxpayer be
engaged in the active conduct of a
construction trade or business for the
taxpayer’s construction activity to
qualify under section 199. The proposed
regulations provide that a taxpayer may
not treat as DPGR gross receipts derived
from construction unless the taxpayer is
engaged in a construction trade or
business on a regular and ongoing basis.
Commentators expressed concern that
this requirement would preclude
construction project-specific joint
ventures or partnerships, a common
business structure in the construction
industry, from qualifying under section
199. Typically, such entities are formed
for the purpose of a specific
construction project, and are terminated
or dissolved when the project is
completed. The final regulations
continue to require that a taxpayer be
engaged in a regular and ongoing
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provide a safe harbor rule under which
entities formed specifically for purposes
of a particular construction project may
qualify. Under the safe harbor rule, if a
taxpayer is engaged in a construction
trade or business, then the taxpayer will
be considered to be engaged in such
trade or business on a regular and
ongoing basis if the taxpayer derives
gross receipts from an unrelated person
by selling or exchanging the constructed
real property within 60 months of the
date on which construction is complete.
Commentators also expressed concern
that taxpayers would not meet the
requirement of being engaged in a
construction business on a regular and
ongoing basis if the taxpayer is newlyformed or otherwise is in the first
taxable year of a new construction trade
or business. Although some taxpayers
may meet the regular-and-ongoingbusiness requirement under the safe
harbor rule discussed previously, the
final regulations provide that, in the
case of a newly-formed trade or business
or a taxpayer in its first taxable year, the
taxpayer will satisfy the regular-andongoing-basis requirement if it
reasonably expects to be engaged in a
construction trade or business on a
regular and ongoing basis.
The IRS and Treasury Department
received a comment requesting
clarification of the land safe harbor of
§ 1.199–3(l)(5)(ii) of the proposed
regulations. Under the land safe harbor,
the taxpayer is permitted to allocate
gross receipts between real property
other than land, and land, according to
a formula. The taxpayer must reduce
gross receipts by the costs of the land
and any other costs capitalized to the
land, plus a percentage of those costs,
and costs related to DPGR must be
reduced by the costs of the land and any
other costs capitalized to the land. The
percentage ranges from 5 to 15 percent,
depending upon the length of time the
taxpayer held the land. The
commentator asked whether the holding
period of a previous owner of the land
would be attributed to the new owner,
and what rules apply for purposes of
computing the new owner’s cost basis.
Generally, if an existing provision of the
Code or regulations would apply to
require attribution of the holding period
of a previous owner of property to a new
owner, the same rules will apply in the
case of a previous owner’s holding
period in land for purposes of the land
safe harbor rule of section 199. For
example, the holding period of the
previous owner (P) would carry over to
the new owner (N) under existing
Federal income tax principles if P were
a partner in partnership N, and P
contributed the land to N. The same

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result would apply if, instead, the land
was distributed by partnership P to N,
its partner. In the case of partnership or
other pass-thru entity, the land safe
harbor is applied at the partnership or
other pass-thru entity level and is not
applied at the partner or owner level.
With regard to the land safe harbor
discussed in the preceding paragraph,
the proposed regulations state that the
length of time a taxpayer is deemed to
hold the land begins on the date the
taxpayer acquires the land, including
the date the taxpayer enters into the first
option to acquire all or a portion of the
land, and ends on the date the taxpayer
sells each item of real property on the
land. Commentators stated that
development of the land generally does
not begin until the land is acquired and
any option to acquire land is based on
the land’s fair market value. Because
developers are paying fair market value,
the commentators suggested that the
period for determining the percentage
should not include any option period.
The IRS and Treasury Department
generally agree with the commentator’s
suggestion, and the final regulations do
not include the option period except
where the option does not include
provisions to adjust the purchase price
to approximate fair market value.
Example 1 in § 1.199–3(m)(5)(iii) of
the proposed regulations provides that
X, who is in a construction trade or
business under NAICS Code 23 on a
regular and ongoing basis, purchases a
building and retains Y, a general
contractor, to perform construction
services in connection with a
substantial renovation of the building.
The example concludes that X’s gross
receipts derived from the disposition of
the building are non-DPGR, and that Y’s
gross receipts from amounts paid to it
by X are DPGR. In addition, the example
illustrates that gross receipts of
subcontractors hired by Y qualify as
DPGR. Some commentators inferred
from this example that the taxpayer
must, at a minimum, be a legally
designated general contractor before its
gross receipts may qualify as DPGR. The
example was not intended to imply that
a taxpayer must be a licensed general
contractor. The final regulations clarify
that activities constituting construction
include activities typically performed
by a general contractor, or that
constitute general contractor-level work,
such as activities relating to
management and oversight of the
construction process (for example,
approvals, periodic inspection of the
progress of the construction project, and
required job modifications). The
example has been modified in the final
regulations to illustrate that the person

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hired by the building owner, although
not a licensed general contractor,
qualifies as engaging in construction
activities by virtue of providing
management and oversight of the
construction process.
Several commentators recommended
that the final regulations provide that,
for purposes of the de minimis
exception of § 1.199–3(l)(5)(ii)
(regarding construction services), gross
receipts attributable to land be
disregarded for purposes of calculating
the de minimis exception. In response
to the comments, the final regulations
clarify that, if a taxpayer applies the
land safe harbor, then the gross receipts
excluded under the land safe harbor are
excluded in determining total gross
receipts under the de minimis
exception. The final regulations also
provide that, if a taxpayer does not
apply the land safe harbor and uses any
reasonable method (for example, an
appraisal of the land) to allocate gross
receipts attributable to the land to nonDPGR, then a taxpayer applies the de
minimis exception by excluding such
gross receipts derived from the sale,
exchange, or other disposition of the
land from total gross receipts.
A commentator requested that the
definition of construction activities not
be limited to direct activities and should
include services incidental to the
performance of such activities. As an
administrative convenience, the final
regulations provide that construction
activities include certain administrative
support services such as billing and
secretarial services performed by the
taxpayer. The final regulations provide
a similar rule for engineering and
architectural services.

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Engineering and Architectural Services
A commentator suggested that the
definition of engineering and
architectural services include services
related to the inspection or evaluation of
real property after construction has been
completed. The final regulations do not
adopt this suggestion because
engineering and architectural services
relating to post-construction activities
are not activities constituting
construction.
Allocation of Cost of Goods Sold and
Deductions
A commentator requested clarification
as to whether a taxpayer’s CGS allocable
to DPGR is determined using the
methods of accounting used to compute
CGS for the taxpayer’s books or
financial statements or the methods of
accounting used to compute CGS in
determining Federal taxable income.
Section 1.199–4(b) of the proposed

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regulations provides that CGS is
determined under the methods of
accounting that the taxpayer uses to
compute Federal taxable income.
Accordingly, this section has not been
modified and the final regulations
continue to provide that, in determining
CGS allocable to DPGR, CGS is
determined using the methods of
accounting that the taxpayer uses to
compute its Federal taxable income.
Consistent with both the proposed
regulations and Notice 2005–14, the
final regulations continue to provide
three methods for allocating and
apportioning deductions (that is, the
section 861 method, the simplified
deduction method, and the small
business simplified overall method).
However, modifications have been made
in the final regulations to the
qualification requirements of the
simplified deduction method.
Under the simplified deduction
method, a taxpayer’s expenses, losses,
or deductions (deductions) (other than a
net operating loss deduction) are
apportioned between DPGR and nonDPGR based on relative gross receipts.
The proposed regulations permit a
taxpayer to use the simplified deduction
method if it has average annual gross
receipts of $25,000,000 or less, or total
assets at the end of the taxable year of
$10,000,000 or less. Several
commentators requested that the
average annual gross receipts threshold
for the simplified deduction method be
either increased or removed. In response
to these comments, the IRS and
Treasury Department have modified the
eligibility requirements for the
simplified deduction method. Under the
final regulations, a taxpayer may use the
simplified deduction method if it has
average annual gross receipts of
$100,000,000 or less, or total assets at
the end of the taxable year of
$10,000,000 or less. The IRS and
Treasury Department continue to
believe that for taxpayers above these
thresholds the section 861 method is the
appropriate method for allocating and
apportioning deductions for purposes of
determining QPAI.
Under the land safe harbor provided
in § 1.199–3(l)(5)(ii) of the proposed
regulations, a taxpayer may allocate
gross receipts between the proceeds
from the sale, exchange, or other
disposition of real property constructed
by the taxpayer and land by reducing its
costs related to DPGR under § 1.199–4
by the cost of land and other costs
capitalized to the land (land costs) and
reducing its DPGR by those land costs
plus a percentage. Under the small
business simplified overall method, a
taxpayer’s CGS and deductions are

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apportioned between DPGR and other
receipts based on relative gross receipts.
Commentators have questioned whether
a taxpayer that uses the small business
simplified overall method would have
to reallocate land costs using the
allocation formula provided by that
method even though such costs have
already been allocated in accordance
with the land safe harbor. The final
regulations clarify that a taxpayer that
uses the land safe harbor to allocate
gross receipts between real property
constructed by the taxpayer and land
does not take into account under the
small business simplified overall
method provided in § 1.199–4(f) the
costs that have already been taken into
account for purposes of section 199
pursuant to the land safe harbor.
Expanded Affiliated Groups
The proposed regulations provide
generally that if a member of an EAG
(the disposing member) derives gross
receipts from the lease, rental, license,
sale, exchange, or other disposition of
QPP, a qualified film, or utilities MPGE
or produced by another member or
members of the same EAG, the
disposing member is treated as
conducting the activities conducted by
each other member of the EAG with
respect to the QPP, qualified film, or
utilities in determining whether its
gross receipts are DPGR. A question
arose as to when the determination of
whether corporations are members of
the same EAG for purposes of the
attribution of activities is to be made.
The final regulations clarify that
attribution of activities between
members of the same EAG is tested at
the time that the disposing member
disposes of the QPP, qualified film, or
utilities. Examples are provided to
illustrate this provision.
Section 1.199–1(d) of the proposed
regulations provides a de minimis rule
that allows a taxpayer to treat all of its
gross receipts as DPGR if less than 5
percent of the taxpayer’s total gross
receipts are non-DPGR. The proposed
regulations provide that the 5 percent
threshold is determined at the
corporation level, rather than at the EAG
or consolidated group level. Several
commentators requested that the IRS
and Treasury Department reconsider
this position and apply the threshold at
the EAG or consolidated group level.
The de minimis rule is intended to
eliminate the burden to a taxpayer of
allocating gross receipts between DPGR
and non-DPGR when less than 5 percent
of its total gross receipts are non-DPGR.
Applying this de minimis rule at the
EAG level would create many
burdensome issues for the EAG and its

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members, including additional
information reporting and circularity
problems that could require members to
compute QPAI twice and, thus, would
not further the policy goals of providing
de minimis rules to ease a taxpayer’s
administrative burdens. As a result, the
IRS and Treasury Department continue
to believe that, with respect to a
corporation that is a member of an EAG
but not a member of a consolidated
group, the application of this threshold
at the EAG member level is appropriate.
However, with respect to a
consolidated group, § 1.1502–13(c)(1)(i)
and (c)(4) requires that the separate
entity attributes of a company’s
intercompany items or corresponding
items must be redetermined to the
extent necessary to produce the effect as
if the consolidated group members
engaged in an intercompany transaction
were divisions of a single corporation. If
the de minimis rule were applied at the
consolidated group member level, then
a different result could apply to the
consolidated group than would apply if
the consolidated group members were
divisions of a single corporation.
Accordingly, with respect to a
consolidated group, the final regulations
provide that the de minimis rule is
applied at the consolidated group level,
rather than at the consolidated group
member level.
Similarly, with respect to a
corporation that is a member of an EAG
but not a member of a consolidated
group, the new de minimis rule that
allows a taxpayer to treat all of its gross
receipts as non-DPGR if less than 5
percent of the taxpayer’s total gross
receipts are DPGR is determined at the
EAG member level, rather than at the
EAG group level. However, with respect
to a consolidated group, the final
regulations provide that this de minimis
rule is applied at the consolidated group
level, rather than at the consolidated
group member level.
Consolidated Groups
A commentator was concerned that
the license of an intangible asset
between members of a consolidated
group could reduce the section 199
deduction available to the members of a
consolidated group, because the
licensee member’s royalty expense
would reduce the group’s QPAI, but the
licensor member’s royalty income from
the license would not increase the
group’s QPAI. The commentator
requested that language be added to the
final regulations to provide that the
intercompany transaction rules of
§ 1.1502–13 shall be taken into account
for purposes of determining the QPAI
and DPGR of a consolidated group.

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As specifically noted in the preamble
to the proposed regulations, the
regulations under § 1.1502–13(c) already
ensure that the section 199 deduction
cannot be reduced on account of an
intercompany transaction. As discussed
above concerning the application of the
de minimis rules that allow treatment of
gross receipts as DPGR or non-DPGR,
§ 1.1502–13(c)(1)(i) and (c)(4) requires
that the separate entity attributes of a
company’s intercompany items or
corresponding items must be
redetermined to the extent necessary to
produce the effect as if the consolidated
group members engaged in an
intercompany transaction were
divisions of a single corporation. There
is nothing in the proposed regulations
that would prevent this rule from
applying. In fact, several examples
specifically illustrate the application of
these rules. An additional example
concerning the license of an intangible
between members of a consolidated
group has been added to the final
regulations.
Another commentator requested
clarification of the application of
§ 1.199–7(b)(2) of the proposed
regulations where the EAG is comprised
of more than one consolidated group.
Section 1.199–7(b)(2) of the proposed
regulations (§ 1.199–7(b)(3) of the final
regulations) provides that, in
determining the taxable income of an
EAG, if a member of an EAG has an
NOL carryback or carryover to the
taxable year, then the amount of the
NOL used to offset taxable income
cannot exceed the taxable income of
that member. The final regulations
continue to treat a consolidated group as
a single member of the EAG.
Accordingly, if a consolidated group has
a consolidated NOL (CNOL) carryback
or carryover, the amount of the CNOL
used to offset taxable income cannot
exceed the consolidated group’s taxable
income, and may not be used to offset
taxable income of other members of the
EAG, whether separate corporations or
consolidated groups. An example has
been provided to illustrate this
provision.
Trade or Business Requirement
Pursuant to section 199(d)(5),
§§ 1.199–1 through 1.199–9 are applied
by taking into account only items that
are attributable to the actual conduct of
a trade or business. An individual
engaged in the actual conduct of a trade
or business must apply §§ 1.199–1
through 1.199–9 by taking into account
in computing QPAI only items that are
attributable to that trade or business (or
trades or businesses) and any items
allocated from a pass-thru entity

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engaged in a trade or business.
Compensation received by an individual
employee for services performed as an
employee is not considered gross
receipts for purposes of computing
QPAI under §§ 1.199–1 through 1.199–
9. Similarly, any costs or expenses paid
or incurred by an individual employee
with respect to those services performed
as an employee are not considered CGS
or deductions of that employee for
purposes of computing QPAI under
§§ 1.199–1 through 1.199–9. For
purposes of the trade-or-business
requirement, a trust or estate is treated
as an individual.
Pass-Thru Entities
As noted above, section 514(b) of
TIPRA amended section 199(d)(1)(A)(iii)
with respect to a partner’s or
shareholder’s share of W–2 wages from
a partnership or S corporation for
taxable years beginning after May 17,
2006. Section 1.199–9 of the final
regulations contains guidance for passthru entities with taxable years
beginning on or before May 17, 2006. A
taxpayer must apply § 1.199–9 to a
taxable year beginning on or before May
17, 2006, if that taxpayer applies
§§ 1.199–1 through 1.199–8 to the
taxable year. The portions of § 1.199–3
relating to qualifying in-kind
partnerships and EAG partnerships, and
all of § 1.199–5 relating to pass-thru
entities, in the final regulations are
reserved for taxable years beginning
after May 17, 2006. The IRS and
Treasury Department intend to issue
regulations that take into account the
amendments made to section
199(d)(1)(A)(iii) for pass-thru entities.
Section 199 applies at the owner level
in a manner consistent with the
economic arrangement of the owners of
the pass-thru entity. Under the proposed
regulations, each owner computes its
section 199 deduction by taking into
account its distributive or proportionate
share of the pass-thru entity’s items
(including items of income and gain, as
well as items of loss and deduction not
otherwise disallowed by the Code), CGS
allocated to such items of income, and
gross receipts included in such items of
income. Generally, section 199 is
applied at the shareholder, partner, or
similar level. For a non-grantor trust or
estate, this level may refer to one or
more beneficiaries, the trust or estate, or
both.
Section 199(d)(1)(A)(iii), however,
limits the amount of W–2 wages from a
partnership or S corporation that may be
used by each partner or shareholder to
compute the partner’s or shareholder’s
section 199 deduction. Pursuant to the
authority granted in section

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199(d)(1)(C), the final regulations
provide that this wage limitation will
apply to non-grantor trusts and estates
in the same way it applies to
partnerships and S corporations. Thus,
for all purposes of this wage limitation,
references in the final regulations to
pass-thru entities include not only
partnerships and S corporations, but
also all non-grantor trusts and estates.
The final regulations clarify that the
section 199 deduction has no effect on
a shareholder’s adjusted basis in the
stock of an S corporation or a partner’s
adjusted basis in an interest in a
partnership because the section 199
deduction is not described in section
1367(a) or section 705(a). However, the
shareholder’s or partner’s proportionate
or distributive share of the S corporation
or partnership items that are included in
computing the shareholder’s or partner’s
section 199 deduction will affect the
shareholder’s or partner’s adjusted basis
under the rules of section 1367(a) or
section 705(a).
The proposed regulations provide that
deductions of a partnership that
otherwise would be taken into account
in computing the partner’s section 199
deduction are taken into account only if
and to the extent the partner’s
distributive share of those deductions
from all of the partnership’s activities is
not disallowed by section 465, 469, or
704(d), or any other provision of the
Code. If only a portion of the partner’s
distributive share of the losses or
deductions is allowed for a taxable year,
a proportionate share of those allowable
losses or deductions that are allocated to
the partner’s share of the partnership’s
qualified production activities,
determined in a manner consistent with
sections 465, 469, and 704(d), and any
other applicable provision of the Code
(disallowed losses), is taken into
account in computing the section 199
deduction for that taxable year. To the
extent that any of the disallowed losses
are allowed in a later taxable year, the
partner takes into account a
proportionate share of those losses in
computing its QPAI for that later taxable
year.
In response to comments received, the
IRS and Treasury Department intend to
issue separate guidance by publication
in the Internal Revenue Bulletin
regarding the treatment of disallowed
losses in determining a taxpayer’s
section 199 deduction. As a matter of
administrative convenience and to
reduce complexity for taxpayers, the
final regulations clarify that disallowed
losses of the taxpayer that are
disallowed for taxable years beginning
on or before December 31, 2004, are not
taken into account in a later taxable year

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for purposes of computing the
taxpayer’s QPAI for that later taxable
year regardless of whether the
disallowed losses are allowed for other
purposes. The final regulations provide
that similar rules concerning disallowed
losses apply to taxpayers that are not
partners or S corporation shareholders.
See § 1.199–8(h).
Generally, in the case of a pass-thru
entity, the calculations required to
determine QPAI (that is, the allocation
or apportionment of gross receipts, CGS,
or deductions) are performed at the
owner level. Notice 2005–14 and the
proposed regulations provide that a
partnership or S corporation that is a
qualifying small taxpayer may use the
small business simplified overall
method to apportion CGS and
deductions between DPGR and nonDPGR. This rule is not included in the
final regulations, except that § 1.199–
9(k) permits a partnership or S
corporation that is a qualifying small
taxpayer to use the small business
simplified overall method to apportion
CGS and deductions between DPGR and
non-DPGR at the entity level under
§ 1.199–4(f) of the proposed regulations.
In addition, § 1.199–9(b)(1)(ii) and
(c)(1)(ii) of the final regulations provides
that the Secretary may, by publication
in the Internal Revenue Bulletin, permit
a partnership or S corporation to
calculate a partner’s or shareholder’s
share of QPAI at the entity level.
If a partnership or S corporation
calculates a partner’s or shareholder’s
share of QPAI at the entity level, the
owner’s share of QPAI and W–2 wages
from the partnership or S corporation
are combined with the owner’s QPAI
and W–2 wages from other sources. The
final regulations also clarify that, if a
pass-thru entity calculates QPAI at the
entity level, then generally the owner of
the pass-thru entity is not permitted to
use another cost allocation method to
reallocate the costs of the pass-thru
entity regardless of the method used by
the pass-thru entity’s owner to allocate
or apportion costs. A taxpayer that
receives QPAI from a partnership or S
corporation does not take into account
any gross receipts, income, assets,
deductions, or other items of the
partnership or S corporation when the
taxpayer allocates and apportions
deductions to determine the taxpayer’s
QPAI from other sources.
Regarding the rule allowing
partnerships that extract, refine, or
process oil or natural gas to attribute
these activities to their partners, some
commentators requested that the rule be
expanded to other industries that
operate in a substantially similar
manner. The exception for the oil and

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gas industry was provided in the
proposed regulations to prevent a
clearly qualifying activity from being
disqualified under section 199 because
of several decades-long industry
practices. Among the historical industry
practices taken into account by the IRS
and Treasury Department in
establishing the oil and gas exception
was the fact that for decades the oil and
gas industry generally has operated in a
business model in which a partnership
produces qualifying property and
distributes such property in-kind to its
partners (generally engaged themselves
in the production of oil and gas),
generally the partnership does not
derive any gross receipts from the
produced property, the property is
marketed and sold exclusively and
separately by each partner as
competitors, and generally there is no
marketing or sale by the partnership of
the produced property, and no joint
marketing or sale of the distributed
property by any of the partners. In
addition, the partnership typically
qualifies to elect out of subchapter K.
In response to the requests that this
attribution rule be expanded to
industries that historically have
operated in a manner substantially
similar to the oil and gas industry, the
final regulations provide that, if a
partnership that MPGE or produces
property is a qualifying in-kind
partnership (as defined later), then each
partner may be treated as MPGE or
producing the property MPGE or
produced by the partnership that is
distributed to that partner. If a partner
of a qualifying in-kind partnership
derives gross receipts from the lease,
rental, license, sale, exchange, or other
disposition of the property that was
MPGE or produced by the qualifying inkind partnership, then, provided such
partner is a partner of the qualifying inkind partnership at the time the partner
disposes of the property, the partner is
treated as conducting the MPGE or
production activities previously
conducted by the qualifying in-kind
partnership with respect to that
property. For this purpose, a qualifying
in-kind partnership is defined in
§ 1.199–9(i)(2) of the final regulations to
include only certain partnerships
operating solely in a designated
industry: oil and gas, petrochemical, or
electricity generation. Partnerships in
other industries with substantially
similar historical industry practices may
be designated by the IRS and Treasury
Department as qualifying in-kind
partnerships by publication in the
Internal Revenue Bulletin.
The proposed regulations provide
that, if an EAG partnership (as defined

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in § 1.199–9(j)(2) of the final
regulations) MPGE or produces property
and distributes, leases, rents, licenses,
sells, exchanges, or otherwise disposes
of that property to a member of an EAG
of which the partners of the EAG
partnership are members, then the
MPGE or production activity conducted
by the EAG partnership will be treated
as having been conducted by the
disposing member of the EAG.
Similarly, if one or more members of an
EAG of which the partners of an EAG
partnership are members MPGE or
produces property and contributes,
leases, rents, licenses, sells, exchanges,
or otherwise disposes of that property to
the EAG partnership, then the MPGE or
production activity conducted by the
EAG member (or members) will be
treated as having been conducted by the
EAG partnership. A question arose as to
when a corporation needs to be a
member of an EAG of which the
partners of the EAG partnership are
members (and vice versa) for attribution
of MPGE or production activities to take
place. The final regulations clarify that
attribution of such activities between an
EAG partnership and members of the
EAG of which the partners of the EAG
partnership are members is determined
at the time that the EAG partnership
disposes of the property (in the case of
property MPGE or produced by an EAG
member or members) or at the time that
the member or members of the EAG of
which the partners of the EAG
partnership are members dispose of the
property (in the case of property MPGE
or produced by the EAG partnership).
Attribution is effective only for those
taxable years that the disposing or
producing member is a member of the
EAG of which the partners of the EAG
partnership are members for the entire
taxable year of the EAG partnership.
The final regulations also clarify that
EAG partnerships, the partners of which
are members of the same EAG, may
attribute their production activities
between themselves on a similar basis,
provided that the producing EAG
partnership and the disposing EAG
partnership are owned by members of
the same EAG for the entire taxable year
of the respective EAG partnership that
includes the date on which the
disposing EAG partnership disposes of
the property.
Because the sale of an interest in a
pass-thru entity does not reflect the
realization of DPGR by that entity,
DPGR generally does not include gain or
loss recognized on the sale, exchange or
other disposition of an interest in the
entity. However, consistent with Notice
2005–14 and the proposed regulations,

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if section 751(a) or (b) applies, then gain
or loss attributable to partnership assets
giving rise to ordinary income under
section 751(a) or (b), the sale, exchange,
or other disposition of which would
give rise to an item of DPGR, is taken
into account in computing the partner’s
section 199 deduction.
One commentator stated that many
commercial real estate developers
dispose of commercial real property by
selling interests in special purpose
partnerships that hold commercial real
property. Because a sale, exchange or
other disposition of the commercial real
property may result in section 1231 gain
rather than ordinary income, the
commentator suggested that the
definition of inventory items be
expanded for purposes of § 1.199–9(e)
by treating section 751(d) as not
containing the words ‘‘and other than
property described in section 1231.’’ As
a result, a sale or exchange of an interest
in a partnership that holds commercial
real property would generate DPGR if a
sale or exchange of the commercial real
property would generate DPGR
regardless of whether the sale or
exchange would result in ordinary
income. The final regulations do not
include the commentator’s suggestion
because the rule in § 1.199–9(e) applies
aggregate treatment to a sale or exchange
of a partnership interest only to the
extent section 751 specifically allows
such treatment. Modifying the explicit
terms of section 751(d) as suggested
would be inconsistent with the
purposes of section 751 and section 199.
Statistical Sampling
In the preamble to the proposed
regulations, the IRS and Treasury
Department invited taxpayers to submit
comments on issues relating to section
199 including whether taxpayers can
apply statistical sampling to section
199, what specific areas of section 199
statistical sampling could be applied to,
and whether application of statistical
sampling should be limited to specific
areas of section 199. Comments were
received on statistical sampling and the
IRS and Treasury Department are
considering those comments and intend
to issue subsequent guidance addressing
the application of statistical sampling
for purposes of section 199.
Elections Under the Section 861
Regulations
The preamble to the proposed
regulations states that, because the
provisions of section 199 may cause
taxpayers to reconsider previously made
elections under §§ 1.861–8 through
1.861–17 and §§ 1.861–8T through
1.861–14T (the section 861 regulations),

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the IRS and Treasury Department intend
to issue a revenue procedure granting
taxpayers automatic consent to change
certain of those elections. In the
proposed regulations, the IRS and
Treasury Department requested
comments on which elections should be
included in such a revenue procedure
and the appropriate time period during
which the automatic consent should
apply. Several commentators urged
promulgation of such a revenue
procedure, and several comments
specifically requested that the revenue
procedure provide taxpayers automatic
consent for more than one taxable year
to change previously made elections.
The IRS and Treasury Department
intend to issue a revenue procedure that
provides taxpayers automatic consent to
change certain elections relating to the
apportionment of interest expense and
research and experimental expenditures
under the section 861 regulations. It is
intended that the automatic consent
afforded under the revenue procedure
will provide taxpayers the consent
required by §§ 1.861–8T(c)(2) and
1.861–9(i)(2), with respect to the
apportionment of interest expense, and
by § 1.861–17(e), with respect to the
apportionment of research and
experimental expenditures, to change an
election, effective for a taxpayer’s first
taxable year beginning after December
31, 2004 (the taxpayer’s 2005 taxable
year). In addition, it is intended that the
revenue procedure will provide
taxpayers the consent required by those
regulations for a taxpayer’s taxable year
immediately following the taxpayer’s
2005 taxable year, but, in such case, a
taxpayer would not be provided
automatic consent to change any
election that first took effect with
respect to the taxpayer’s 2005 taxable
year.
Financial and Administrative Burden
Several commentators objected to the
complexity of the proposed regulations,
and to the financial and administrative
burden that the commentators believe
the regulations will impose on taxpayers
(particularly on small businesses). The
complexity and burden of the
regulations are a function of the
statutory language and framework of
section 199, which are complex and
contain many requirements. For
example, with the exception of a few
specific services (namely, construction,
architecture, and engineering) only
gross receipts derived from certain
dispositions of certain property qualify
under the statute. In addition, in the
case of manufacturing activities, the
property must be manufactured by the
taxpayer in whole or in significant part

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within the United States. Also, under
section 199, costs must be allocated
between qualifying and nonqualifying
gross receipts. All of these statutory
requirements (and others) potentially
necessitate that taxpayers obtain
information, make determinations and
computations, and retain records that
might not otherwise be required for
business purposes. In the case of
partnerships and S corporations, the
statute requires that the deduction be
computed at the owner level,
necessitating the sharing between entity
and owner of information that might not
be needed for purposes other than
section 199. Both the proposed and the
final regulations provide a number of
safe harbors and de minimis rules that
are intended to balance the need for
compliance with these statutory
requirements against the burden
imposed on taxpayers.
In the preamble to the proposed
regulations, the IRS and Treasury
Department certify that the collection of
information required under the
proposed regulations (relating to
information to be provided by
cooperatives to their patrons) will not
have a significant economic impact on
a substantial number of small entities,
and therefore that a Regulatory
Flexibility Analysis is not required by
the Regulatory Flexibility Act (RFA).
One commentator asserted that the
certification did not provide sufficient
information for small entities to
determine the impact the regulations
will have on their businesses. The
commentator also contended that the
IRS and Treasury Department, in
making the certification, failed to
consider burdens imposed by the
proposed regulations on other small
entities, such as partnerships and S
corporations, that are required under the
regulations to provide certain
information to their owners.
The IRS and Treasury Department
believe that the certification for the
proposed regulations, as well as for
these final regulations, is appropriate
and complies with the requirements of
the RFA. With respect to cooperatives,
the regulations provide cooperatives
with specific rules about the
information they must provide to
patrons under section 199. The IRS and
Treasury Department believe that
cooperatives have the necessary
information to comply with this
requirement. The IRS and Treasury
Department continue to believe that this
requirement is the only collection of
information in the regulations that is
within the scope of the RFA. Certain
other recordkeeping and reporting
requirements of the regulations relating

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to information sharing between passthru entities (partnerships and S
corporations) and their owners are
subsumed within other existing income
tax regulations that currently require
that such entities report to their owners
all information that is necessary for the
owners to determine their tax liability.
Effective Date
Section 199 applies to taxable years
beginning after December 31, 2004.
Sections 1.199–1 through 1.199–8 are
applicable for taxable years beginning
on or after June 1, 2006. For a taxable
year beginning on or before May 17,
2006, the enactment date of TIPRA, a
taxpayer may apply §§ 1.199–1 through
1.199–9 provided that the taxpayer
applies all provisions in §§ 1.199–1
through 1.199–9 to the taxable year. For
a taxable year beginning after May 17,
2006, and before June 1, 2006, a
taxpayer may apply §§ 1.199–1 through
1.199–8 provided that the taxpayer
applies all provisions in §§ 1.199–1
through 1.199–8 to the taxable year.
Section 1.199–9 may not be applied to
a taxable year that begins after May 17,
2006.
For a taxpayer who chooses not to
rely on these final regulations for a
taxable year beginning before June 1,
2006, the guidance on section 199 that
applies to such taxable year is contained
in Notice 2005–14 (2005–1 C.B. 498). In
addition, a taxpayer also may rely on
the provisions of REG–105847–05
(2005–47 I.R.B. 987) (see § 601.601(d)(2)
of this chapter) for a taxable year
beginning before June 1, 2006. If Notice
2005–14 and REG–105847–05 include
different rules for the same particular
issue, then a taxpayer may rely on either
the rule set forth in Notice 2005–14 or
the rule set forth in REG–105847–05.
However, if REG–105847–05 includes a
rule that was not included in Notice
2005–14, then a taxpayer is not
permitted to rely on the absence of a
rule to apply a rule contrary to REG–
105847–05. For taxable years beginning
after May 17, 2006, and before June 1,
2006, a taxpayer may not apply Notice
2005–14, REG–105847–05, or any other
guidance under section 199 in a manner
inconsistent with amendments made to
section 199 by section 514 of TIPRA. In
determining the deduction under
section 199, items arising from a taxable
year of a partnership, S corporation,
estate, or trust beginning before January
1, 2005, shall not be taken into account
for purposes of section 199(d)(1).
Members of an EAG that are not
members of a consolidated group may
each apply the effective date rules
without regard to how other members of
the EAG apply the effective date rules.

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Effect on Other Documents
Notice 2005–14 (2005–1 C.B. 498) is
obsolete for taxable years beginning on
or after June 1, 2006.
Special Analyses
It has been determined that this
Treasury decision is not a significant
regulatory action as defined in
Executive Order 12866. Therefore, a
regulatory assessment is not required. It
is hereby certified that the collection of
information in this regulation will not
have a significant economic impact on
a substantial number of small entities.
This certification is based upon the fact
that any burden on cooperatives is
minimal. Accordingly, a Regulatory
Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C.
chapter 6) is not required. Pursuant to
section 7805(f) of the Code, the notice
of proposed rulemaking was submitted
to the Chief Counsel for Advocacy of the
Small Business Administration for
comment on its impact on small
business.
Drafting Information
The principal authors of these
regulations are Paul Handleman and
Lauren Ross Taylor, Office of the
Associate Chief Counsel (Passthroughs
and Special Industries), IRS. However,
other personnel from the IRS and
Treasury Department participated in
their development.
List of Subjects
26 CFR Part I
Income taxes, Reporting and
recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping
requirements.
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:

■

PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by adding entries
to read, in part, as follows:

■

Authority: 26 U.S.C. 7805 * * *
Section 1.199–1 also issued under 26
U.S.C. 199(d).
Section 1.199–2 also issued under 26
U.S.C. 199(d).
Section 1.199–3 also issued under 26
U.S.C. 199(d).
Section 1.199–4 also issued under 26
U.S.C. 199(d).
Section 1.199–5 also issued under 26
U.S.C. 199(d).
Section 1.199–6 also issued under 26
U.S.C. 199(d).

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Section 1.199–7 also issued under 26
U.S.C. 199(d).
Section 1.199–8 also issued under 26
U.S.C. 199(d).
Section 1.199–9 also issued under 26
U.S.C. 199(d). * * *
■ Par. 2. Sections 1.199–0 through
1.199–9 are added to read as follows:

§ 1.199–0

Table of contents.

This section lists the section headings
that appear in §§ 1.199–1 through
1.199–9.
§ 1.199–1 Income attributable to domestic
production activities.
(a) In general.
(b) Taxable income and adjusted gross
income.
(1) In general.
(2) Examples.
(c) Qualified production activities income.
(d) Allocation of gross receipts.
(1) In general.
(2) Reasonable method of allocation.
(3) De minimis rules.
(i) DPGR.
(ii) Non-DPGR.
(4) Example.
(e) Certain multiple-year transactions.
(1) Use of historical data.
(2) Percentage of completion method.
(3) Examples.

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§ 1.199–2 Wage limitation.
(a) Rules of application.
(1) In general.
(2) Wages paid by entity other than
common law employer.
(3) Requirement that wages must be
reported on return filed with the Social
Security Administration.
(i) In general.
(ii) Corrected return filed to correct a
return that was filed within 60 days of the
due date.
(iii) Corrected return filed to correct a
return that was filed later than 60 days after
the due date.
(4) Joint return.
(b) Application in the case of a taxpayer
with a short taxable year.
(c) Acquisition or disposition of a trade or
business (or major portion).
(d) Non-duplication rule.
(e) Definition of W–2 wages.
(1) In general.
(2) Limitation on W–2 wages for taxable
years beginning after May 17, 2006, the
enactment date of the Tax Increase
Prevention and Reconciliation Act of 2005.
[Reserved].
(3) Methods for calculating W–2 wages.
§ 1.199–3 Domestic production gross
receipts.
(a) In general.
(b) Related persons.
(1) In general.
(2) Exceptions.
(c) Definition of gross receipts.
(d) Determining domestic production gross
receipts.
(1) In general.
(2) Special rules.

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(3) Exception.
(4) Examples.
(e) Definition of manufactured, produced,
grown, or extracted.
(1) In general.
(2) Packaging, repackaging, labeling, or
minor assembly.
(3) Installing.
(4) Consistency with section 263A.
(5) Examples.
(f) Definition of by the taxpayer.
(1) In general.
(2) Special rule for certain government
contracts.
(3) Subcontractor.
(4) Examples.
(g) Definition of in whole or in significant
part.
(1) In general.
(2) Substantial in nature.
(3) Safe harbor.
(i) In general.
(ii) Unadjusted depreciable basis.
(iii) Computer software and sound
recordings.
(4) Special rules.
(i) Contract with unrelated persons.
(ii) Aggregation.
(5) Examples.
(h) Definition of United States.
(i) Derived from the lease, rental, license,
sale, exchange, or other disposition.
(1) In general.
(i) Definition.
(ii) Lease income.
(iii) Income substitutes.
(iv) Exchange of property.
(A) Taxable exchanges.
(B) Safe harbor.
(C) Eligible property.
(2) Examples.
(3) Hedging transactions.
(i) In general.
(ii) Currency fluctuations.
(iii) Effect of identification and
nonidentification.
(iv) Other rules.
(4) Allocation of gross receipts.
(i) Embedded services and non-qualified
property.
(A) In general.
(B) Exceptions.
(ii) Non-DPGR.
(iii) Examples.
(5) Advertising income.
(i) Tangible personal property.
(ii) Qualified film.
(iii) Examples.
(6) Computer software.
(i) In general.
(ii) through (v) [Reserved].
(7) Qualifying in-kind partnership for
taxable years beginning after May 17, 2006,
the enactment date of the Tax Increase
Prevention and Reconciliation Act of 2005.
[Reserved].
(8) Partnerships owned by members of a
single expanded affiliated group for taxable
years beginning after May 17, 2006, the
enactment date of the Tax Increase
Prevention and Reconciliation Act of 2005.
[Reserved].
(9) Non-operating mineral interests.
(j) Definition of qualifying production
property.
(1) In general.

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(2) Tangible personal property.
(i) In general.
(ii) Local law.
(iii) Intangible property.
(3) Computer software.
(i) In general.
(ii) Incidental and ancillary rights.
(iii) Exceptions.
(4) Sound recordings.
(i) In general.
(ii) Exception.
(5) Tangible personal property with
computer software or sound recordings.
(i) Computer software and sound
recordings.
(ii) Tangible personal property.
(k) Definition of qualified film.
(1) In general.
(2) Tangible personal property with a film.
(i) Film not produced by a taxpayer.
(ii) Film produced by a taxpayer.
(A) Qualified film.
(B) Nonqualified film.
(3) Derived from a qualified film.
(i) In general.
(ii) Exceptions.
(4) Compensation for services.
(5) Determination of 50 percent.
(6) Exception.
(7) Examples.
(l) Electricity, natural gas, or potable water.
(1) In general.
(2) Natural gas.
(3) Potable water.
(4) Exceptions.
(i) Electricity.
(ii) Natural gas.
(iii) Potable water.
(iv) De minimis exception.
(A) DPGR.
(B) Non-DPGR.
(5) Example.
(m) Definition of construction performed in
the United States.
(1) Construction of real property.
(i) In general.
(ii) Regular and ongoing basis.
(A) In general.
(B) New trade or business.
(iii) De minimis exception.
(A) DPGR.
(B) Non-DPGR.
(2) Activities constituting construction.
(i) In general.
(ii) Tangential services.
(iii) Other construction activities.
(iv) Administrative support services.
(v) Exceptions.
(3) Definition of real property.
(4) Definition of infrastructure.
(5) Definition of substantial renovation.
(6) Derived from construction.
(i) In general.
(ii) Qualified construction warranty.
(iii) Exceptions.
(iv) Land safe harbor.
(A) In general.
(B) Determining gross receipts and costs.
(v) Examples.
(n) Definition of engineering and
architectural services.
(1) In general.
(2) Engineering services.
(3) Architectural services.
(4) Administrative support services.
(5) Exceptions.

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(6) De minimis exception for performance
of services in the United States.
(i) DPGR.
(ii) Non-DPGR.
(7) Example.
(o) Sales of certain food and beverages.
(1) In general.
(2) De minimis exception.
(3) Examples.
(p) Guaranteed payments.
§ 1.199–4 Costs allocable to domestic
production gross receipts.
(a) In general.
(b) Cost of goods sold allocable to domestic
production gross receipts.
(1) In general.
(2) Allocating cost of goods sold.
(i) In general.
(ii) Gross receipts recognized in an earlier
taxable year.
(3) Special rules for imported items or
services.
(4) Rules for inventories valued at market
or bona fide selling prices.
(5) Rules applicable to inventories
accounted for under the last-in, first-out
(LIFO) inventory method.
(i) In general.
(ii) LIFO/FIFO ratio method.
(iii) Change in relative base-year cost
method.
(6) Taxpayers using the simplified
production method or simplified resale
method for additional section 263A costs.
(7) Examples.
(c) Other deductions properly allocable to
domestic production gross receipts or gross
income attributable to domestic production
gross receipts.
(1) In general.
(2) Treatment of net operating losses.
(3) W–2 wages.
(d) Section 861 method.
(1) In general.
(2) Deductions for charitable contributions.
(3) Research and experimental
expenditures.
(4) Deductions allocated or apportioned to
gross receipts treated as domestic production
gross receipts.
(5) Treatment of items from a pass-thru
entity reporting qualified production
activities income.
(6) Examples.
(e) Simplified deduction method.
(1) In general.
(2) Eligible taxpayer.
(3) Total assets.
(i) In general.
(ii) Members of an expanded affiliated
group.
(4) Members of an expanded affiliated
group.
(i) In general.
(ii) Exception.
(iii) Examples.
(f) Small business simplified overall
method.
(1) In general.
(2) Qualifying small taxpayer.
(3) Total costs for the current taxable year.
(i) In general.
(ii) Land safe harbor.
(4) Members of an expanded affiliated
group.

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(i) In general.
(ii) Exception.
(iii) Examples.
(5) Trusts and estates.
(g) Average annual gross receipts.
(1) In general.
(2) Members of an expanded affiliated
group.
§ 1.199–5 Application of section 199 to
pass-thru entities for taxable years
beginning after May 17, 2006, the enactment
date of the Tax Increase Prevention and
Reconciliation Act of 2005. [Reserved].
§ 1.199–6 Agricultural and horticultural
cooperatives.
(a) In general.
(b) Cooperative denied section 1382
deduction for portion of qualified payments.
(c) Determining cooperative’s taxable
income.
(d) Special rule for marketing cooperatives.
(e) Qualified payment.
(f) Specified agricultural or horticultural
cooperative.
(g) Written notice to patrons.
(h) Additional rules relating to passthrough
of section 199 deduction.
(i) W–2 wages.
(j) Recapture of section 199 deduction.
(k) Section is exclusive.
(l) No double counting.
(m) Examples.
§ 1.199–7 Expanded affiliated groups.
(a) In general.
(1) Definition of expanded affiliated group.
(2) Identification of members of an
expanded affiliated group.
(i) In general.
(ii) Becoming or ceasing to be a member of
an expanded affiliated group.
(3) Attribution of activities.
(i) In general.
(ii) Special rule.
(4) Examples.
(5) Anti-avoidance rule.
(b) Computation of expanded affiliated
group’s section 199 deduction.
(1) In general.
(2) Example.
(3) Net operating loss carrybacks and
carryovers.
(c) Allocation of an expanded affiliated
group’s section 199 deduction among
members of the expanded affiliated group.
(1) In general.
(2) Use of section 199 deduction to create
or increase a net operating loss.
(d) Special rules for members of the same
consolidated group.
(1) Intercompany transactions.
(2) Attribution of activities in the
construction of real property and the
performance of engineering and architectural
services.
(3) Application of the simplified deduction
method and the small business simplified
overall method.
(4) Determining the section 199 deduction.
(i) Expanded affiliated group consists of
consolidated group and non-consolidated
group members.
(ii) Expanded affiliated group consists only
of members of a single consolidated group.

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(5) Allocation of the section 199 deduction
of a consolidated group among its members.
(e) Examples.
(f) Allocation of income and loss by a
corporation that is a member of the expanded
affiliated group for only a portion of the year.
(1) In general.
(i) Pro rata allocation method.
(ii) Section 199 closing of the books
method.
(iii) Making the section 199 closing of the
books election.
(2) Coordination with rules relating to the
allocation of income under § 1.1502–76(b).
(g) Total section 199 deduction for a
corporation that is a member of an expanded
affiliated group for some or all of its taxable
year.
(1) Member of the same expanded affiliated
group for the entire taxable year.
(2) Member of the expanded affiliated
group for a portion of the taxable year.
(3) Example.
(h) Computation of section 199 deduction
for members of an expanded affiliated group
with different taxable years.
(1) In general.
(2) Example.
§ 1.199–8 Other rules.
(a) In general.
(b) Individuals.
(c) Trade or business requirement.
(1) In general.
(2) Individuals.
(3) Trusts and estates.
(d) Coordination with alternative minimum
tax.
(e) Nonrecognition transactions.
(1) In general.
(i) Sections 351, 721, and 731.
(ii) Exceptions.
(A) Section 708(b)(1)(B).
(B) Transfers by reason of death.
(2) Section 1031 exchanges.
(3) Section 381 transactions.
(f) Taxpayers with a 52–53 week taxable
year.
(g) Section 481(a) adjustments.
(h) Disallowed losses or deductions.
(i) Effective dates.
(1) In general.
(2) Pass-thru entities.
(3) Non-consolidated EAG members.
(4) Computer software provided to
customers over the Internet. [Reserved].
§ 1.199–9 Application of section 199 to
pass-thru entities for taxable years
beginning on or before May 17, 2006, the
enactment date of the Tax Increase
Prevention and Reconciliation Act of 2005.
(a) In general.
(b) Partnerships.
(1) In general.
(i) Determination at partner level.
(ii) Determination at entity level.
(2) Disallowed losses or deductions.
(3) Partner’s share of W–2 wages.
(4) Transition percentage rule for W–2
wages.
(5) Partnerships electing out of subchapter
K.
(6) Examples.
(c) S corporations.
(1) In general.

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(i) Determination at shareholder level.
(ii) Determination at entity level.
(2) Disallowed losses or deductions.
(3) Shareholder’s share of W–2 wages.
(4) Transition percentage rule for W–2
wages.
(d) Grantor trusts.
(e) Non-grantor trusts and estates.
(1) Allocation of costs.
(2) Allocation among trust or estate and
beneficiaries.
(i) In general.
(ii) Treatment of items from a trust or estate
reporting qualified production activities
income.
(3) Beneficiary’s share of W–2 wages.
(4) Transition percentage rule for W–2
wages.
(5) Example.
(f) Gain or loss from the disposition of an
interest in a pass-thru entity.
(g) Section 199(d)(1)(A)(iii) wage limitation
and tiered structures.
(1) In general.
(2) Share of W–2 wages.
(3) Example.
(h) No attribution of qualified activities.
(i) Qualifying in-kind partnership.
(1) In general.
(2) Definition of qualifying in-kind
partnership.
(3) Special rules for distributions.
(4) Other rules.
(5) Example.
(j) Partnerships owned by members of a
single expanded affiliated group.
(1) In general.
(2) Attribution of activities.
(i) In general.
(ii) Attribution between EAG partnerships.
(iii) Exception to attribution.
(3) Special rules for distributions.
(4) Other rules.
(5) Examples.
(k) Effective dates.

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§ 1.199–1 Income attributable to domestic
production activities.

(a) In general. A taxpayer may deduct
an amount equal to 9 percent (3 percent
in the case of taxable years beginning in
2005 or 2006, and 6 percent in the case
of taxable years beginning in 2007,
2008, or 2009) of the lesser of the
taxpayer’s qualified production
activities income (QPAI) (as defined in
paragraph (c) of this section) for the
taxable year, or the taxpayer’s taxable
income for the taxable year (or, in the
case of an individual, adjusted gross
income). The amount of the deduction
allowable under this paragraph (a) for
any taxable year cannot exceed 50
percent of the W–2 wages of the
employer for the taxable year (as
determined under § 1.199–2). The
provisions of this section apply solely
for purposes of section 199 of the
Internal Revenue Code.
(b) Taxable income and adjusted
gross income—(1) In general. For
purposes of paragraph (a) of this section,
the definition of taxable income under

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section 63 applies, except that taxable
income is determined without regard to
section 199 and without regard to any
amount excluded from gross income
pursuant to section 114 or pursuant to
section 101(d) of the American Jobs
Creation Act of 2004, Public Law 108–
357, 118 Stat. 1418 (Act). In the case of
individuals, adjusted gross income for
the taxable year is determined after
applying sections 86, 135, 137, 219, 221,
222, and 469, and without regard to
section 199 and without regard to any
amount excluded from gross income
pursuant to section 114 or pursuant to
section 101(d) of the Act. For purposes
of determining the tax imposed by
section 511, paragraph (a) of this section
is applied using unrelated business
taxable income. Except as provided in
§ 1.199–7(c)(2), the deduction under
section 199 is not taken into account in
computing any net operating loss or the
amount of any net operating loss
carryback or carryover.
(2) Examples. The following examples
illustrate the application of this
paragraph (b):
Example 1. X, a corporation that is not
part of an expanded affiliated group (EAG)
(as defined in § 1.199–7), engages in
production activities that generate QPAI and
taxable income (without taking into account
the deduction under this section and an NOL
deduction) of $600 in 2010. During 2010, X
incurs W–2 wages as defined in § 1.199–2(e)
of $300. X has an NOL carryover to 2010 of
$500. X’s deduction under this section for
2010 is $9 (.09 × (lesser of QPAI of $600 and
taxable income of $100 ($600 taxable
income—$500 NOL)). Because the wage
limitation is $150 (50% × $300), X’s
deduction is not limited.
Example 2. (i) Facts. X, a corporation that
is not part of an EAG, engages in production
activities that generate QPAI and taxable
income (without taking into account the
deduction under this section and an NOL
deduction) of $100 in 2010. X has an NOL
carryover to 2010 of $500 that reduces its
taxable income for 2010 to $0. X’s deduction
under this section for 2010 is $0 (.09 × (lesser
of QPAI of $100 and taxable income of $0)).
(ii) Carryover to 2011. X’s taxable income
for purposes of determining its NOL
carryover to 2011 is $100. Accordingly, X’s
NOL carryover to 2011 is $400 ($500 NOL
carryover to 2010—$100 NOL used in 2010).

(c) Qualified production activities
income. QPAI for any taxable year is an
amount equal to the excess (if any) of
the taxpayer’s domestic production
gross receipts (DPGR) (as defined in
§ 1.199–3) over the sum of—
(1) The cost of goods sold (CGS) that
is allocable to such receipts; and
(2) Other expenses, losses, or
deductions (other than the deduction
allowed under this section) that are
properly allocable to such receipts. See
§§ 1.199–3 and 1.199–4.

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(d) Allocation of gross receipts—(1) In
general. A taxpayer must determine the
portion of its gross receipts for the
taxable year that is DPGR and the
portion of its gross receipts that is nonDPGR. Applicable Federal income tax
principles apply to determine whether a
transaction is, in substance, a lease,
rental, license, sale, exchange, or other
disposition the gross receipts of which
may constitute DPGR (assuming all the
other requirements of § 1.199–3 are
met), whether it is a service the gross
receipts of which may constitute nonDPGR, or some combination thereof. For
example, if a taxpayer leases qualifying
production property (QPP) (as defined
in § 1.199–3(j)(1)) and in connection
with that lease, also provides services,
the taxpayer must allocate its gross
receipts from the transaction using any
reasonable method that is satisfactory to
the Secretary based on all of the facts
and circumstances and that accurately
identifies the gross receipts that
constitute DPGR and non-DPGR.
(2) Reasonable method of allocation.
Factors taken into consideration in
determining whether the taxpayer’s
method of allocating gross receipts
between DPGR and non-DPGR is
reasonable include whether the taxpayer
uses the most accurate information
available; the relationship between the
gross receipts and the method used; the
accuracy of the method chosen as
compared with other possible methods;
whether the method is used by the
taxpayer for internal management or
other business purposes; whether the
method is used for other Federal or state
income tax purposes; the time, burden,
and cost of using alternative methods;
and whether the taxpayer applies the
method consistently from year to year.
Thus, if a taxpayer has the information
readily available and can, without
undue burden or expense, specifically
identify whether the gross receipts
derived from an item are DPGR, then the
taxpayer must use that specific
identification to determine DPGR. If a
taxpayer does not have information
readily available to specifically identify
whether the gross receipts derived from
an item are DPGR or cannot, without
undue burden or expense, specifically
identify whether the gross receipts
derived from an item are DPGR, then the
taxpayer is not required to use a method
that specifically identifies whether the
gross receipts derived from an item are
DPGR.
(3) De minimis rules—(i) DPGR. All of
a taxpayer’s gross receipts may be
treated as DPGR if less than 5 percent
of the taxpayer’s total gross receipts are
non-DPGR (after application of the
exceptions provided in § 1.199–

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3(i)(4)(i)(B), (l)(4)(iv)(A), (m)(1)(iii)(A),
(n)(6)(i), and (o)(2) that may result in
gross receipts being treated as DPGR). If
the amount of the taxpayer’s gross
receipts that are non-DPGR equals or
exceeds 5 percent of the taxpayer’s total
gross receipts, then, except as provided
in paragraph (d)(3)(ii) of this section, the
taxpayer is required to allocate all gross
receipts between DPGR and non-DPGR
in accordance with paragraph (d)(1) of
this section. If a corporation is a
member of an EAG, but is not a member
of a consolidated group, then the
determination of whether less than 5
percent of the taxpayer’s total gross
receipts are non-DPGR is made at the
corporation level. If a corporation is a
member of a consolidated group, then
the determination of whether less than
5 percent of the taxpayer’s total gross
receipts are non-DPGR is made at the
consolidated group level. In the case of
an S corporation, partnership, trust (to
the extent not described in § 1.199–9(d))
or estate, or other pass-thru entity, the
determination of whether less than 5
percent of the pass-thru entity’s total
gross receipts are non-DPGR is made at
the pass-thru entity level. In the case of
an owner of a pass-thru entity, the
determination of whether less than 5
percent of the owner’s total gross
receipts are non-DPGR is made at the
owner level, taking into account all
gross receipts of the owner from its
other trade or business activities and the
owner’s share of the gross receipts of the
pass-thru entity.
(ii) Non-DPGR. All of a taxpayer’s
gross receipts may be treated as nonDPGR if less than 5 percent of the
taxpayer’s total gross receipts are DPGR
(after application of the exceptions
provided in § 1.199–3(i)(4)(ii),
(l)(4)(iv)(B), (m)(1)(iii)(B), and (n)(6)(ii)
that may result in gross receipts being
treated as non-DPGR). If a corporation is
a member of an EAG, but is not a
member of a consolidated group, then
the determination of whether less than
5 percent of the taxpayer’s total gross
receipts are DPGR is made at the
corporation level. If a corporation is a
member of a consolidated group, then
the determination of whether less than
5 percent of the taxpayer’s total gross
receipts are DPGR is made at the
consolidated group level. In the case of
an S corporation, partnership, trust (to
the extent not described in § 1.199–9(d))
or estate, or other pass-thru entity, the
determination of whether less than 5
percent of the pass-thru entity’s total
gross receipts are DPGR is made at the
pass-thru entity level. In the case of an
owner of a pass-thru entity, the
determination of whether less than 5

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percent of the owner’s total gross
receipts are DPGR is made at the owner
level, taking into account all gross
receipts of the owner from its other
trade or business activities and the
owner’s share of the gross receipts of the
pass-thru entity.
(4) Example. The following example
illustrates the application of this
paragraph (d):

on all of the facts and circumstances
that accurately identifies the gross
receipts that constitute DPGR. See
paragraph (d)(2) of this section for the
factors taken into consideration in
determining whether the taxpayer’s
method is reasonable.
(3) Examples. The following examples
illustrate the application of this
paragraph (e):

Example. X derives its gross receipts from
the sale of gasoline refined by X within the
United States and the sale of refined gasoline
that X acquired by purchase from an
unrelated person. If at least 5% of X’s gross
receipts are derived from gasoline refined by
X within the United States (that qualify as
DPGR if all the other requirements of
§ 1.199–3 are met) and at least 5% of X’s
gross receipts are derived from the resale of
the acquired gasoline (that do not qualify as
DPGR), then X does not qualify for the de
minimis rules under paragraphs (d)(3)(i) and
(ii) of this section, and X must allocate its
gross receipts between the gross receipts
derived from the sale of gasoline refined by
X within the United States and the gross
receipts derived from the resale of the
acquired gasoline. If less than 5% of X’s gross
receipts are derived from the resale of the
acquired gasoline, then, X may either allocate
its gross receipts between the gross receipts
derived from the gasoline refined by X within
the United States and the gross receipts
derived from the resale of the acquired
gasoline, or, pursuant to paragraph (d)(3)(i) of
this section, X may treat all of its gross
receipts derived from the sale of the refined
gasoline as DPGR. If X’s gross receipts
attributable to the gasoline refined by X
within the United States constitute less than
5% of X’s total gross receipts, then, X may
either allocate its gross receipts between the
gross receipts derived from the gasoline
refined by X within the United States and the
gross receipts derived from the resale of the
acquired gasoline, or, pursuant to paragraph
(d)(3)(ii) of this section, X may treat all of its
gross receipts derived from the sale of the
refined gasoline as non-DPGR.

Example 1. On December 1, 2007, X, a
calendar year accrual method taxpayer, sells
for $100 a one-year computer software
maintenance agreement that provides for (i)
computer software updates that X expects to
produce in the United States, and (ii)
customer support services. At the end of
2007, X uses a reasonable method that is
satisfactory to the Secretary based on all of
the facts and circumstances to allocate 60%
of the gross receipts ($60) to the computer
software updates and 40% ($40) to the
customer support services. X treats the $60
as DPGR in 2007. At the expiration of the
one-year agreement on November 30, 2008,
no computer software updates are provided
by X. Pursuant to paragraph (e)(1) of this
section, because X used a reasonable method
that is satisfactory to the Secretary based on
all of the facts and circumstances to identify
gross receipts as DPGR, X is not required to
make any adjustments to its 2007 Federal
income tax return (for example, by amended
return) or in 2008 for the $60 that was
properly treated as DPGR in 2007, even
though no computer software updates were
provided under the contract.
Example 2. X manufactures automobiles
within the United States and sells 5-year
extended warranties to customers. The sales
price of the warranty is based on historical
data that determines what repairs and
services are performed on an automobile
during the 5-year period. X sells the 5-year
warranty to Y for $1,000 in 2007. Under X’s
method of accounting, X recognizes warranty
revenue when received. Using historical data,
X concludes that 60% of the gross receipts
attributable to a 5-year warranty will be
derived from the sale of parts (QPP) that X
manufactures within the United States, and
40% will be derived from the sale of
purchased parts X did not manufacture and
non-qualifying services. X’s method of
allocating its gross receipts with respect to
the 5-year warranty between DPGR and nonDPGR is a reasonable method that is
satisfactory to the Secretary based on all of
the facts and circumstances. Therefore, X
properly treats $600 as DPGR in 2007.
Example 3. The facts are the same as in
Example 2 except that in 2009 X updates its
historical data. The updated historical data
show that 50% of the gross receipts
attributable to a 5-year warranty will be
derived from the sale of parts (QPP) that X
manufactures within the United States and
50% will be derived from the sale of
purchased parts X did not manufacture and
non-qualifying services. In 2009, X sells a 5year warranty for $1,000 to Z. Under all of
the facts and circumstances, X’s method of
allocation is still a reasonable method.
Relying on its updated historical data, X
properly treats $500 as DPGR in 2009.

(e) Certain multiple-year
transactions—(1) Use of historical data.
If a taxpayer recognizes and reports
gross receipts from advance payments or
other similar payments on a Federal
income tax return for a taxable year,
then the taxpayer’s use of historical data
in making an allocation of gross receipts
from the transaction between DPGR and
non-DPGR may constitute a reasonable
method. If a taxpayer makes allocations
using historical data, and subsequently
updates the data, then the taxpayer must
use the more recent or updated data,
starting in the taxable year in which the
update is made.
(2) Percentage of completion method.
A taxpayer using a percentage of
completion method under section 460
must determine the ratio of DPGR and
non-DPGR using a reasonable method
that is satisfactory to the Secretary based

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Example 4. The facts are the same as in
Example 2 except that Y pays for the 5-year
warranty over time ($200 a year for 5 years).
Under X’s method of accounting, X
recognizes each $200 payment as it is
received. In 2009, X updates its historical
data and the updated historical data show
that 50% of the gross receipts attributable to
a 5-year warranty will be derived from the
sale of QPP that X manufactures within the
United States and 50% will be derived from
the sale of purchased parts X did not
manufacture and non-qualifying services.
Under all of the facts and circumstances, X’s
method of allocation is still a reasonable
method. When Y makes its $200 payment for
2009, X, relying on its updated historical
data, properly treats $100 as DPGR in 2009.

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§ 1.199–2

Wage limitation.

(a) Rules of application—(1) In
general. The provisions of this section
apply solely for purposes of section 199
of the Internal Revenue Code. The
amount of the deduction allowable
under § 1.199–1(a) (section 199
deduction) to a taxpayer for any taxable
year shall not exceed 50 percent of the
W–2 wages (as defined in paragraph (e)
of this section) of the taxpayer. For this
purpose, except as provided in
paragraph (a)(3) of this section and
paragraph (b) of this section, the Forms
W–2, ‘‘Wage and Tax Statement,’’ used
in determining the amount of W–2
wages are those issued for the calendar
year ending during the taxpayer’s
taxable year for wages paid to
employees (or former employees) of the
taxpayer for employment by the
taxpayer. For purposes of this section,
employees of the taxpayer are limited to
employees of the taxpayer as defined in
section 3121(d)(1) and (2) (that is,
officers of a corporate taxpayer and
employees of the taxpayer under the
common law rules). See paragraph (a)(3)
of this section for the requirement that
W–2 wages must have been included in
a return filed with the Social Security
Administration (SSA) within 60 days
after the due date (including extensions)
of the return.
(2) Wages paid by entity other than
common law employer. In determining
W–2 wages, a taxpayer may take into
account any wages paid by another
entity and reported by the other entity
on Forms W–2 with the other entity as
the employer listed in Box c of the
Forms W–2, provided that the wages
were paid to employees of the taxpayer
for employment by the taxpayer. If the
taxpayer is treated as an employer
described in section 3401(d)(1) because
of control of the payment of wages (that
is, the taxpayer is not the common law
employer of the payee of the wages), the
payment of wages may not be included
in determining W–2 wages of the
taxpayer. If the taxpayer is paying wages

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as an agent of another entity to
individuals who are not employees of
the taxpayer, the wages may not be
included in determining the W–2 wages
of the taxpayer.
(3) Requirement that wages must be
reported on return filed with the Social
Security Administration—(i) In general.
The term W–2 wages shall not include
any amount that is not properly
included in a return filed with SSA on
or before the 60th day after the due date
(including extensions) for such return.
Under § 31.6051–2 of this chapter, each
Form W–2 and the transmittal Form W–
3, ‘‘Transmittal of Wage and Tax
Statements,’’ together constitute an
information return to be filed with SSA.
Similarly, each Form W–2c, ‘‘Corrected
Wage and Tax Statement,’’ and the
transmittal Form W–3 or W–3c,
‘‘Transmittal of Corrected Wage and Tax
Statements,’’ together constitute an
information return to be filed with SSA.
In determining whether any amount has
been properly included in a return filed
with SSA on or before the 60th day after
the due date (including extensions) for
such return, each Form W–2 together
with its accompanying Form W–3 shall
be considered a separate information
return and each Form W–2c together
with its accompanying Form W–3 or
Form W–3c shall be considered a
separate information return. Section
31.6071(a)–1(a)(3) of this chapter
provides that each information return in
respect of wages as defined in the
Federal Insurance Contributions Act or
of income tax withheld from wages
which is required to be made under
§ 31.6051–2 of this chapter shall be filed
on or before the last day of February
(March 31 if filed electronically) of the
year following the calendar year for
which it is made, except that if a tax
return under § 31.6011(a)–5(a) of this
chapter is filed as a final return for a
period ending prior to December 31, the
information statement shall be filed on
or before the last day of the second
calendar month following the period for
which the tax return is filed. Corrected
Forms W–2 are required to be filed with
SSA on or before the last day of
February (March 31 if filed
electronically) of the year following the
year in which the correction is made,
except that if a tax return under
§ 31.6011(a)–5(a) is filed as a final
return for a period ending prior to
December 31 for the period in which the
correction is made, the corrected Forms
W–2 are required to be filed by the last
day of the second calendar month
following the period for which the final
return is filed.
(ii) Corrected return filed to correct a
return that was filed within 60 days of

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the due date. If a corrected information
return (Return B) is filed with SSA on
or before the 60th day after the due date
(including extensions) of Return B to
correct an information return (Return A)
that was filed with SSA on or before the
60th day after the due date (including
extensions) of the information return
(Return A) and paragraph (a)(3)(ii) of
this section does not apply, then the
wage information on Return B must be
included in determining W–2 wages. If
a corrected information return (Return
D) is filed with SSA later than the 60th
day after the due date (including
extensions) of Return D to correct an
information return (Return C) that was
filed with SSA on or before the 60th day
after the due date (including extensions)
of the information return (Return C),
then if Return D reports an increase (or
increases) in wages included in
determining W–2 wages from the wage
amounts reported on Return C, then
such increase (or increases) on Return D
shall be disregarded in determining W–
2 wages (and only the wage amounts on
Return C may be included in
determining W–2 wages). If Return D
reports a decrease (or decreases) in
wages included in determining W–2
wages from the amounts reported on
Return C, then, in determining W–2
wages, the wages reported on Return C
must be reduced by the decrease (or
decreases) reflected on Return D.
(iii) Corrected return filed to correct a
return that was filed later than 60 days
after the due date. If an information
return (Return F) is filed to correct an
information return (Return E) that was
not filed with SSA on or before the 60th
day after the due date (including
extensions) of Return E, then Return F
(and any subsequent information
returns filed with respect to Return E)
will not be considered filed on or before
the 60th day after the due date
(including extensions) of Return F (or
the subsequent corrected information
return). Thus, if a Form W–2c (or
corrected Form W–2) is filed to correct
a Form W–2 that was not filed with SSA
on or before the 60th day after the due
date (including extensions) of the
information return including the Form
W–2 (or to correct a Form W–2c relating
to an information return including a
Form W–2 that had not been filed with
SSA on or before the 60th day after the
due date (including extensions) of the
information return including the Form
W–2), then the information return
including this Form W–2c (or corrected
Form W–2) shall not be considered to
have been filed with SSA on or before
the 60th day after the due date
(including extensions) for this

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information return including the Form
W–2c (or corrected Form W–2),
regardless of when the information
return including the Form W–2c (or
corrected Form W–2) is filed.
(4) Joint return. An individual and his
or her spouse are considered one
taxpayer for purposes of determining
the amount of W–2 wages for a taxable
year, provided that they file a joint
return for the taxable year. Thus, an
individual filing as part of a joint return
may include the wages of employees of
his or her spouse in determining W–2
wages, provided the employees are
employed in a trade or business of the
spouse and the other requirements of
this section are met. However, a married
taxpayer filing a separate return from
his or her spouse for the taxable year
may not include the wages of employees
of the taxpayer’s spouse in determining
the taxpayer’s W–2 wages for the taxable
year.
(b) Application in the case of a
taxpayer with a short taxable year. In
the case of a taxpayer with a short
taxable year, subject to the rules of
paragraph (a) of this section, the W–2
wages of the taxpayer for the short
taxable year shall include only those
wages paid during the short taxable year
to employees of the taxpayer, only those
elective deferrals (within the meaning of
section 402(g)(3)) made during the short
taxable year by employees of the
taxpayer and only compensation
actually deferred under section 457
during the short taxable year with
respect to employees of the taxpayer.
The Secretary shall have the authority to
issue published guidance setting forth
the method that is used to calculate W–
2 wages in case of a taxpayer with a
short taxable year. See paragraph (e)(3)
of this section.
(c) Acquisition or disposition of a
trade or business (or major portion). If
a taxpayer (a successor) acquires a trade
or business, the major portion of a trade
or business, or the major portion of a
separate unit of a trade or business from
another taxpayer (a predecessor), then,
for purposes of computing the
respective section 199 deduction of the
successor and of the predecessor, the
W–2 wages paid for that calendar year
shall be allocated between the successor
and the predecessor based on whether
the wages are for employment by the
successor or for employment by the
predecessor. Thus, in this situation, the
W–2 wages are allocated based on
whether the wages are for employment
for a period during which the employee
was employed by the predecessor or for
employment for a period during which
the employee was employed by the
successor, regardless of which

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permissible method for Form W–2
reporting is used.
(d) Non-duplication rule. Amounts
that are treated as W–2 wages for a
taxable year under any method shall not
be treated as W–2 wages of any other
taxable year. Also, an amount shall not
be treated as W–2 wages by more than
one taxpayer.
(e) Definition of W–2 wages—(1) In
general. Under section 199(b)(2), the
term W–2 wages means, with respect to
any person for any taxable year of such
person, the sum of the amounts
described in section 6051(a)(3) and (8)
paid by such person with respect to
employment of employees by such
person during the calendar year ending
during such taxable year. Thus, the term
W–2 wages includes the total amount of
wages as defined in section 3401(a); the
total amount of elective deferrals
(within the meaning of section
402(g)(3)); the compensation deferred
under section 457; and for taxable years
beginning after December 31, 2005, the
amount of designated Roth
contributions (as defined in section
402A).
(2) Limitation on W–2 wages for
taxable years beginning after May 17,
2006, the enactment date of the Tax
Increase Prevention and Reconciliation
Act of 2005. [Reserved].
(3) Methods for calculating W–2
wages. The Secretary may provide by
publication in the Internal Revenue
Bulletin (see § 601.601(d)(2)(ii)(b) of this
chapter) for methods to be used in
calculating W–2 wages, including W–2
wages for short taxable years. For
example, see Rev. Proc. 2006–22 (2006–
22 I.R.B.) (see § 601.601(d)(2) of this
chapter).
§ 1.199–3
receipts.

Domestic production gross

(a) In general. The provisions of this
section apply solely for purposes of
section 199 of the Internal Revenue
Code (Code). Domestic production gross
receipts (DPGR) are the gross receipts
(as defined in paragraph (c) of this
section) of the taxpayer that are—
(1) Derived from any lease, rental,
license, sale, exchange, or other
disposition (as defined in paragraph (i)
of this section) of—
(i) Qualifying production property
(QPP) (as defined in paragraph (j)(1) of
this section) that is manufactured,
produced, grown, or extracted (MPGE)
(as defined in paragraph (e) of this
section) by the taxpayer (as defined in
paragraph (f) of this section) in whole or
in significant part (as defined in
paragraph (g) of this section) within the
United States (as defined in paragraph
(h) of this section);

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(ii) Any qualified film (as defined in
paragraph (k) of this section) produced
by the taxpayer; or
(iii) Electricity, natural gas, or potable
water (as defined in paragraph (l) of this
section) (collectively, utilities) produced
by the taxpayer in the United States;
(2) Derived from, in the case of a
taxpayer engaged in the active conduct
of a construction trade or business,
construction of real property (as defined
in paragraph (m) of this section)
performed in the United States by the
taxpayer in the ordinary course of such
trade or business; or
(3) Derived from, in the case of a
taxpayer engaged in the active conduct
of an engineering or architectural
services trade or business, engineering
or architectural services (as defined in
paragraph (n) of this section) performed
in the United States by the taxpayer in
the ordinary course of such trade or
business with respect to the
construction of real property in the
United States.
(b) Related persons—(1) In general.
DPGR does not include any gross
receipts of the taxpayer derived from
property leased, licensed, or rented by
the taxpayer for use by any related
person. A person is treated as related to
another person if both persons are
treated as a single employer under
either section 52(a) or (b) (without
regard to section 1563(b)), or section
414(m) or (o). Any other person is an
unrelated person for purposes of
§§ 1.199–1 through 1.199–9.
(2) Exceptions. Notwithstanding
paragraph (b)(1) of this section, gross
receipts derived from any QPP or
qualified film leased or rented by the
taxpayer to a related person may qualify
as DPGR if the QPP or qualified film is
held for sublease or rent, or is subleased
or rented, by the related person to an
unrelated person for the ultimate use of
the unrelated person. Similarly,
notwithstanding paragraph (b)(1) of this
section, gross receipts derived from the
license of QPP or a qualified film to a
related person for reproduction and
sale, exchange, lease, rental, or
sublicense to an unrelated person for
the ultimate use of the unrelated person
may qualify as DPGR.
(c) Definition of gross receipts. The
term gross receipts means the taxpayer’s
receipts for the taxable year that are
recognized under the taxpayer’s
methods of accounting used for Federal
income tax purposes for the taxable
year. If the gross receipts are recognized
in an intercompany transaction within
the meaning of § 1.1502–13, see also
§ 1.199–7(d). For this purpose, gross
receipts include total sales (net of
returns and allowances) and all amounts

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Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules and Regulations
received for services. In addition, gross
receipts include any income from
investments and from incidental or
outside sources. For example, gross
receipts include interest (including
original issue discount and tax-exempt
interest within the meaning of section
103), dividends, rents, royalties, and
annuities, regardless of whether the
amounts are derived in the ordinary
course of the taxpayer’s trade of
business. Gross receipts are not reduced
by cost of goods sold (CGS) or by the
cost of property sold if such property is
described in section 1221(a)(1), (2), (3),
(4), or (5). Gross receipts do not include
the amounts received in repayment of a
loan or similar instrument (for example,
a repayment of the principal amount of
a loan held by a commercial lender)
and, except to the extent of gain
recognized, do not include gross
receipts derived from a non-recognition
transaction, such as a section 1031
exchange. Finally, gross receipts do not
include amounts received by the
taxpayer with respect to sales tax or
other similar state and local taxes if,
under the applicable state or local law,
the tax is legally imposed on the
purchaser of the good or service and the
taxpayer merely collects and remits the
tax to the taxing authority. If, in
contrast, the tax is imposed on the
taxpayer under the applicable law, then
gross receipts include the amounts
received that are allocable to the
payment of such tax.
(d) Determining domestic production
gross receipts—(1) In general. For
purposes of §§ 1.199–1 through 1.199–9,
a taxpayer determines, using any
reasonable method that is satisfactory to
the Secretary based on all of the facts
and circumstances, whether gross
receipts qualify as DPGR on an item-byitem basis (and not, for example, on a
division-by-division, product line-byproduct line, or transaction-bytransaction basis).
(i) The term item means the property
offered by the taxpayer in the normal
course of the taxpayer’s business for
lease, rental, license, sale, exchange, or
other disposition (for purposes of this
paragraph (d), collectively referred to as
disposition) to customers, if the gross
receipts from the disposition of such
property qualify as DPGR; or
(ii) If paragraph (d)(1)(i) of this section
does not apply to the property, then any
component of the property described in
paragraph (d)(1)(i) of this section is
treated as the item, provided that the
gross receipts from the disposition of
the property described in paragraph
(d)(1)(i) of this section that are
attributable to such component qualify
as DPGR. Each component that meets

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the requirements under this paragraph
(d)(1)(ii) must be treated as a separate
item and a component that meets the
requirements under this paragraph
(d)(1)(ii) may not be combined with a
component that does not meet these
requirements.
(2) Special rules. The following
special rules apply for purposes of
paragraph (d)(1) of this section:
(i) For purposes of paragraph (d)(1)(i)
of this section, in no event may a single
item consist of two or more properties
unless those properties are offered for
disposition, in the normal course of the
taxpayer’s business, as a single item
(regardless of how the properties are
packaged).
(ii) In the case of property customarily
sold by weight or by volume, the item
is determined using the custom of the
industry (for example, barrels of oil).
(iii) In the case of construction
activities and services or engineering
and architectural services, a taxpayer
may use any reasonable method that is
satisfactory to the Secretary based on all
of the facts and circumstances to
determine what construction activities
and services or engineering or
architectural services constitute an item.
(3) Exception. If a taxpayer MPGE
QPP within the United States or
produces a qualified film or produces
utilities in the United States that it
disposes of, and the taxpayer leases,
rents, licenses, purchases, or otherwise
acquires property that contains or may
contain the QPP, qualified film, or the
utilities (or a portion thereof), and the
taxpayer cannot reasonably determine,
without undue burden and expense,
whether the acquired property contains
any of the original QPP, qualified film,
or utilities MPGE or produced by the
taxpayer, then the taxpayer is not
required to determine whether any
portion of the acquired property
qualifies as an item for purposes of
paragraph (d)(1) of this section.
Therefore, the gross receipts derived
from the disposition of the acquired
property may be treated as non-DPGR.
Similarly, the preceding sentences shall
apply if the taxpayer can reasonably
determine that the acquired property
contains QPP, a qualified film, or
utilities (or a portion thereof) MPGE or
produced by the taxpayer, but cannot
reasonably determine, without undue
burden or expense, how much, or what
type, grade, etc., of the QPP, qualified
film, or utilities MPGE or produced by
the taxpayer the acquired property
contains.
(4) Examples. The following examples
illustrate the application of paragraph
(d) of this section:

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Example 1. Q manufactures leather and
rubber shoe soles in the United States. Q
imports shoe uppers, which are the parts of
the shoe above the sole. Q manufactures
shoes for sale by sewing or otherwise
attaching the soles to the imported uppers. Q
offers the shoes for sale to customers in the
normal course of Q’s business. If the gross
receipts derived from the sale of the shoes do
not qualify as DPGR under this section, then
under paragraph (d)(1)(ii) of this section, Q
must treat the sole as the item if the gross
receipts derived from the sale of the sole
qualify as DPGR under this section.
Example 2. The facts are the same as in
Example 1 except that Q also buys some
finished shoes from unrelated persons and
resells them to retail shoe stores. Q offers all
shoes (manufactured and purchased) for sale
to customers, in the normal course of Q’s
business, in individual pairs, and requires no
minimum quantity order. Q ships the shoes
in boxes, each box containing as many as 50
pairs of shoes. A full, or partially full, box
may contain some shoes that Q
manufactured, and some that Q purchased.
Under paragraph (d)(2)(i) of this section, Q
cannot treat a box of 50 (or fewer) pairs of
shoes as an item, because Q offers the shoes
for sale in the normal course of Q’s business
in individual pairs.
Example 3. R manufactures toy cars in the
United States. R also purchases cars that
were manufactured by unrelated persons. R
offers the cars for sale to customers, in the
normal course of R’s business, in sets of
three, and requires no minimum quantity
order. R sells the three-car sets to toy stores.
A three-car set may contain some cars
manufactured by R and some cars purchased
by R. If the gross receipts derived from the
sale of the three-car sets do not qualify as
DPGR under this section, then, under
paragraph (d)(1)(ii) of this section, R must
treat a toy car in the three-car set as the item,
provided the gross receipts derived from the
sale of the toy car qualify as DPGR under this
section.
Example 4. The facts are the same as
Example 3 except that R offers the toy cars
for sale individually to customers in the
normal course of R’s business, rather than in
sets of three. R’s customers resell the
individual toy cars at three for $10.
Frequently, this results in retail customers
purchasing three individual cars in one
transaction. In determining R’s DPGR, under
paragraph (d)(2)(i) of this section, each toy
car is an item and R cannot treat three
individual toy cars as one item, because the
individual toy cars are not offered for sale in
sets of three by R in the normal course of R’s
business.
Example 5. The facts are the same as in
Example 3 except that R offers the toy cars
for sale to customers in the normal course of
R’s business both individually and in sets of
three. The results are the same as Example
3 with respect to the three-car sets. The
results are the same as in Example 4 with
respect to the individual toy cars that are not
included in the three-car sets and offered for
sale individually. Thus, R has two items, an
individual toy car and a set of three toy cars.
Example 6. S produces television sets in
the United States. S also produces the same

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model of television set outside the United
States. In both cases, S packages the sets one
to a box. S sells the television sets to large
retail consumer electronics stores. S requires
that its customers purchase a minimum of
100 television sets per order. With respect to
a particular order by a customer of 100
television sets, some were manufactured by
S in the United States, and some were
manufactured by S outside the United States.
Under paragraph (d)(2)(i) of this section, a
minimum order of 100 television sets is the
item provided that the gross receipts derived
from the sale of the 100 television sets
qualify as DPGR.
Example 7. T produces in bulk form in the
United States the active ingredient for a
pharmaceutical product. T sells the active
ingredient in bulk form to FX, a foreign
corporation. This sale qualifies as DPGR
assuming all the other requirements of this
section are met. FX uses the active ingredient
to produce the finished dosage form drug. FX
sells the drug in finished dosage to T, which
sells the drug to customers. Assume that T
knows how much of the active ingredient is
in the finished dosage. Under paragraph
(d)(1)(ii) of this section, if T’s gross receipts
derived from the sale of the finished dosage
do not qualify as DPGR under this section,
then T must treat the active ingredient
component as the item because the gross
receipts attributable to the active ingredient
qualify as DPGR under this section. The
exception in paragraph (d)(3) of this section
does not apply because T can reasonably
determine without undue burden or expense
that the finished dosage contains the active
ingredient and the quantity of the active
ingredient in the finished dosage.
Example 8. U produces steel within the
United States and sells its steel to a variety
of customers, including V, an unrelated
person, who uses the steel for the
manufacture of equipment. V also purchases
steel from other steel producers. For its steel
operations, U purchases equipment from V
that may contain steel produced by U. U sells
the equipment after 5 years. If U cannot
reasonably determine without undue burden
and expense whether the equipment contains
any steel produced by U, then, under
paragraph (d)(3) of this section, U may treat
the gross receipts derived from sale of the
equipment as non-DPGR.
Example 9. The facts are the same as in
Example 8 except that U knows that the
equipment purchased from V does contain
some amount of steel produced by U. If U
cannot reasonably determine without undue
burden and expense how much steel
produced by U the equipment contains, then,
under paragraph (d)(3) of this section, U may
treat the gross receipts derived from sale of
the equipment as non-DPGR.
Example 10. W manufactures sunroofs,
stereos, and tires within the United States. W
purchases automobiles from unrelated
persons and installs the manufactured
components in the automobiles. W, in the
normal course of W’s business, sells the
automobiles with the components to
customers. If the gross receipts derived from
the sale of the automobiles with the
components do not qualify as DPGR under
this section, then under paragraph (d)(1)(ii)

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of this section, W must treat each component
(sunroofs, stereos, and tires) that it
manufactures as a separate item if the gross
receipts derived from the sale of each
component qualify as DPGR under this
section.
Example 11. X manufacturers leather soles
within the United States. X purchases shoe
uppers, metal eyelets, and laces. X
manufactures shoes by sewing or otherwise
attaching the soles to the uppers; attaching
the metal eyelets to the shoes; and threading
the laces through the eyelets. X, in the
normal course of X’s business, sells the shoes
to customers. If the gross receipts derived
from the sale of the shoes do not qualify as
DPGR under this section, then under
paragraph (d)(1)(ii) of this section, X must
treat the sole as the item if the gross receipts
derived from the sale of the sole qualify as
DPGR under this section. X may not treat the
shoe upper, metal eyelets or laces as part of
the item because under paragraph (d)(1)(ii) of
this section the sole is the component that is
treated as the item.
Example 12. Y manufactures glass
windshields for automobiles within the
United States. Y purchases automobiles from
unrelated persons and installs the
windshields in the automobiles. Y, in the
normal course of Y’s business, sells the
automobiles with the windshields to
customers. If the automobiles with the
windshields do not meet the requirements for
being an item, then, under paragraph
(d)(1)(ii) of this section, Y must treat each
windshield that it manufactures as an item if
the gross receipts derived from the sale of the
windshield qualify as DPGR under this
section. Y may not treat any other portion of
the automobile as part of the item because
under paragraph (d)(1)(ii) of this section the
windshield is the component.

(e) Definition of manufactured,
produced, grown, or extracted—(1) In
general. Except as provided in
paragraphs (e)(2) and (3) of this section,
the term MPGE includes manufacturing,
producing, growing, extracting,
installing, developing, improving, and
creating QPP; making QPP out of scrap,
salvage, or junk material as well as from
new or raw material by processing,
manipulating, refining, or changing the
form of an article, or by combining or
assembling two or more articles;
cultivating soil, raising livestock,
fishing, and mining minerals. The term
MPGE also includes storage, handling,
or other processing activities (other than
transportation activities) within the
United States related to the sale,
exchange, or other disposition of
agricultural products, provided the
products are consumed in connection
with or incorporated into the MPGE of
QPP, whether or not by the taxpayer.
Pursuant to paragraph (f)(1) of this
section, the taxpayer must have the
benefits and burdens of ownership of
the QPP under Federal income tax
principles during the period the MPGE
activity occurs in order for gross

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receipts derived from the MPGE of QPP
to qualify as DPGR.
(2) Packaging, repackaging, labeling,
or minor assembly. If a taxpayer
packages, repackages, labels, or
performs minor assembly of QPP and
the taxpayer engages in no other MPGE
activity with respect to that QPP, the
taxpayer’s packaging, repackaging,
labeling, or minor assembly does not
qualify as MPGE with respect to that
QPP.
(3) Installing. If a taxpayer installs
QPP and engages in no other MPGE
activity with respect to the QPP, the
taxpayer’s installing activity does not
qualify as an MPGE activity.
Notwithstanding paragraph (i)(4)(i)(B)(4)
of this section, if the taxpayer installs
QPP MPGE by the taxpayer and, except
as provided in paragraph (f)(2) of this
section, the taxpayer has the benefits
and burdens of ownership of the QPP
under Federal income tax principles
during the period the installing activity
occurs, then the portion of the installing
activity that relates to the QPP is an
MPGE activity.
(4) Consistency with section 263A. A
taxpayer that has MPGE QPP for the
taxable year should treat itself as a
producer under section 263A with
respect to the QPP unless the taxpayer
is not subject to section 263A. A
taxpayer that currently is not properly
accounting for its production activities
under section 263A, and wishes to
change its method of accounting to
comply with the producer requirements
of section 263A, must follow the
applicable administrative procedures
issued under § 1.446–1(e)(3)(ii) for
obtaining the Commissioner’s consent to
a change in accounting method (for
further guidance, for example, see Rev.
Proc. 97–27 (1997–1 C.B. 680), or Rev.
Proc. 2002–9 (2002–1 C.B. 327),
whichever applies (see § 601.601(d)(2)
of this chapter)).
(5) Examples. The following examples
illustrate the application of this
paragraph (e):
Example 1. A, B, and C are unrelated
persons and are not cooperatives to which
Part I of subchapter T of the Code applies.
B grows agricultural products in the United
States and sells them to A, who owns
agricultural storage bins in the United States.
A stores the agricultural products and has the
benefits and burdens of ownership under
Federal income tax principles of the
agricultural products while they are being
stored. A sells the agricultural products to C,
who processes them into refined agricultural
products in the United States. The gross
receipts from A’s, B’s, and C’s activities are
DPGR from the MPGE of QPP.
Example 2. The facts are the same as in
Example 1 except that B grows the
agricultural products outside the United

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States and C processes them into refined
agricultural products outside the United
States. Pursuant to paragraph (e)(1) of this
section, the gross receipts derived by A from
its sale of the agricultural products to C are
DPGR from the MPGE of QPP within the
United States. B’s and C’s respective MPGE
activities occur outside the United States
and, therefore, their respective gross receipts
are non-DPGR.
Example 3. Y is hired to reconstruct and
refurbish unrelated customers’ tangible
personal property. As part of the
reconstruction and refurbishment, Y installs
purchased replacement parts that constitute
QPP in the customers’ property. Y’s
installation of purchased replacement parts
does not qualify as MPGE pursuant to
paragraph (e)(3) of this section because Y did
not MPGE the replacement parts.
Example 4. The facts are the same as in
Example 3 except that Y manufactures the
replacement parts it uses for the
reconstruction and refurbishment of
customers’ tangible personal property. Y has
the benefits and burdens of ownership under
Federal income tax principles of the
replacement parts during the reconstruction
and refurbishment activity and while
installing the parts. Y’s gross receipts derived
from the MPGE of the replacement parts and
Y’s gross receipts derived from the
installation of the replacement parts, which
is an MPGE activity pursuant to paragraph
(e)(3) of this section, are DPGR (assuming all
the other requirements of this section are
met).
Example 5. Z MPGE QPP within the
United States. The following activities are
performed by Z as part of the MPGE of the
QPP while Z has the benefits and burdens of
ownership under Federal income tax
principles: materials analysis and selection,
subcontractor inspections and qualifications,
testing of component parts, assisting
customers in their review and approval of the
QPP, routine production inspections, product
documentation, diagnosis and correction of
system failure, and packaging for shipment to
customers. Because Z MPGE the QPP, these
activities performed by Z are part of the
MPGE of the QPP.
Example 6. X purchases automobiles from
unrelated persons and customizes them by
adding ground effects, spoilers, custom
wheels, specialized paint and decals,
sunroofs, roof racks, and similar accessories.
X does not manufacture any of the
accessories. X’s activity is minor assembly
under paragraph (e)(2) of this section which
is not an MPGE activity.
Example 7. Y manufactures furniture in the
United States that it sells to unrelated
persons. Y also engraves customers’ names
on pens and pencils purchased from
unrelated persons and sells the pens and
pencils to such customers. Although Y’s sales
of furniture qualify as DPGR if all the other
requirements of this section are met, Y must
determine whether its gross receipts derived
from the sale of the pens and pencils qualify
as DPGR. Y’s status as a manufacturer of
furniture in the United States does not carry
over to its other activities.
Example 8. X produces computer software
within the United States. In 2007, X enters

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into an agreement with Y, an unrelated
person, under which X will manage Y’s
networks using computer software that X
produced. Pursuant to the terms of the
agreement, X also provides to Y for Y’s use
on Y’s own hardware computer software that
X produced (additional computer software).
Assume that, based on all of the facts and
circumstances, the transaction between X
and Y relating to the additional computer
software is a lease or sale of the additional
computer software. Y pays X monthly fees of
$100 under the agreement during 2007. No
separate charge for the additional computer
software is stated in the agreement or in the
monthly invoices that X provides to Y. The
portion of X’s gross receipts that is derived
from the lease or sale of the additional
computer software is DPGR (assuming all the
other requirements of this section are met).

taxpayer to which paragraph (f)(2) of
this section applies, and the QPP under
the contract or agreement is subject to
paragraph (f)(2)(ii) of this section, then,
notwithstanding the requirements of
paragraph (f)(1) of this section, the
subcontractor’s gross receipts derived
from the MPGE of the QPP in whole or
in significant part within the United
States will be treated as gross receipts
derived from the lease, rental, license,
sale, exchange, or other disposition of
QPP MPGE by the subcontractor in
whole or in significant part within the
United States.
(4) Examples. The following examples
illustrate the application of this
paragraph (f):

(f) Definition of by the taxpayer—(1)
In general. With the exception of the
rules applicable to an expanded
affiliated group (EAG) under § 1.199–7,
qualifying in-kind partnerships under
§ 1.199–9(i), EAG partnerships under
§ 1.199–9(j), and government contracts
under paragraph (f)(2) of this section,
only one taxpayer may claim the
deduction under § 1.199–1(a) with
respect to any qualifying activity under
paragraphs (e)(1), (k)(1), and (l)(1) of this
section performed in connection with
the same QPP, or the production of a
qualified film or utilities. If one
taxpayer performs a qualifying activity
under paragraph (e)(1), (k)(1), or (l)(1) of
this section pursuant to a contract with
another party, then only the taxpayer
that has the benefits and burdens of
ownership of the QPP, qualified film, or
utilities under Federal income tax
principles during the period in which
the qualifying activity occurs is treated
as engaging in the qualifying activity.
(2) Special rule for certain
government contracts. Gross receipts
derived from the MPGE of QPP in whole
or in significant part within the United
States will be treated as gross receipts
derived from the lease, rental, license,
sale, exchange, or other disposition of
QPP MPGE by the taxpayer in whole or
in significant part within the United
States notwithstanding the requirements
of paragraph (f)(1) of this section if—
(i) The QPP is MPGE by the taxpayer
within the United States pursuant to a
contract with the Federal government;
and
(ii) The Federal Acquisition
Regulation (Title 48, Code of Federal
Regulations) requires that title or risk of
loss with respect to the QPP be
transferred to the Federal government
before the MPGE of the QPP is
completed.
(3) Subcontractor. If a taxpayer
(subcontractor) enters into a contract or
agreement to MPGE QPP on behalf of a

Example 1. X designs machines that it uses
in its trade or business. X contracts with Y,
an unrelated person, for the manufacture of
the machines. The contract between X and Y
is a fixed-price contract. The contract
specifies that the machines will be
manufactured in the United States using X’s
design. X owns the intellectual property
attributable to the design and provides it to
Y with a restriction that Y may only use it
during the manufacturing process and has no
right to exploit the intellectual property. The
contract specifies that Y controls the details
of the manufacturing process while the
machines are being produced; Y bears the
risk of loss or damage during manufacturing
of the machines; and Y has the economic loss
or gain upon the sale of the machines based
on the difference between Y’s costs and the
fixed price. Y has legal title during the
manufacturing process and legal title to the
machines is not transferred to X until final
manufacturing of the machines has been
completed. Based on all of the facts and
circumstances, pursuant to paragraph (f)(1) of
this section Y has the benefits and burdens
of ownership of the machines under Federal
income tax principles during the period the
manufacturing occurs and, as a result, Y is
treated as the manufacturer of the machines.
Example 2. X designs and engineers
machines that it sells to customers. X
contracts with Y, an unrelated person, for the
manufacture of the machines. The contract
between X and Y is a cost-reimbursable type
contract. Assume that X has the benefits and
burdens of ownership of the machines under
Federal income tax principles during the
period the manufacturing occurs except that
legal title to the machines is not transferred
to X until final manufacturing of the
machines is completed. Based on all of the
facts and circumstances, X is treated as the
manufacturer of the machines under
paragraph (f)(1) of this section.
Example 3. X manufactures machines
within the United States pursuant to a
contract with the Federal government and the
Federal Acquisition Regulation requires that
the title or risk of loss with respect to the
machines be transferred to the Federal
government before X completes manufacture
of the machines. X subcontracts with Y, an
unrelated person, for the manufacture of
components for the machines that Y
manufactures within the United States.

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Assume that the machines manufactured by
X, and the components for the machines
manufactured by Y, are QPP. Both the
machines and components are subject to the
Federal Acquisition Regulation that requires
title or risk of loss with respect to the
machines and components be transferred to
the Federal government before manufacturing
of the machines and components are
complete. Under paragraph (f)(2) of this
section, the gross receipts derived by X from
the manufacture within the United States of
the machines for the Federal government are
treated as having been derived from the lease,
rental, license, sale, exchange, or other
disposition of the machines manufactured by
X in whole or in significant part within the
United States. Under paragraph (f)(3) of this
section, the gross receipts derived by Y from
the manufacture within the United States of
the components for X are also treated as
having been derived from the lease, rental,
license, sale, exchange, or other disposition
of the components manufactured by Y in
whole or in significant part within the United
States.

(g) Definition of in whole or in
significant part—(1) In general. QPP
must be MPGE in whole or in significant
part by the taxpayer and in whole or in
significant part within the United States
to qualify under section
199(c)(4)(A)(i)(I). If a taxpayer enters
into a contract with an unrelated person
for the unrelated person to MPGE QPP
for the taxpayer and the taxpayer has
the benefits and burdens of ownership
of the QPP under applicable Federal
income tax principles during the period
the MPGE activity occurs, then,
pursuant to paragraph (f)(1) of this
section, the taxpayer is considered to
MPGE the QPP under this section. The
unrelated person must perform the
MPGE activity on behalf of the taxpayer
in whole or in significant part within
the United States in order for the
taxpayer to satisfy the requirements of
this paragraph (g)(1).
(2) Substantial in nature. QPP will be
treated as MPGE in significant part by
the taxpayer within the United States
for purposes of paragraph (g)(1) of this
section if the MPGE of the QPP by the
taxpayer within the United States is
substantial in nature taking into account
all of the facts and circumstances,
including the relative value added by,
and relative cost of, the taxpayer’s
MPGE activity within the United States,
the nature of the QPP, and the nature of
the MPGE activity that the taxpayer
performs within the United States. The
MPGE of a key component of QPP does
not, in itself, meet the substantial-innature requirement with respect to the
QPP under this paragraph (g)(2). In the
case of tangible personal property (as
defined in paragraph (j)(2) of this
section), research and experimental
activities under section 174 and the

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creation of intangible assets are not
taken into account in determining
whether the MPGE of QPP is substantial
in nature for any QPP other than
computer software (as defined in
paragraph (j)(3) of this section) and
sound recordings (as defined in
paragraph (j)(4) of this section). Thus,
for example, a taxpayer may take into
account its design and development
activities when determining whether its
MPGE of computer software is
substantial in nature.
(3) Safe harbor—(i) In general. A
taxpayer will be treated as having MPGE
QPP in whole or in significant part
within the United States for purposes of
paragraph (g)(1) of this section if, in
connection with the QPP, the direct
labor and overhead of such taxpayer to
MPGE the QPP within the United States
account for 20 percent or more of the
taxpayer’s CGS of the QPP, or in a
transaction without CGS (for example, a
lease, rental, or license) account for 20
percent or more of the taxpayer’s
unadjusted depreciable basis (as
defined in paragraph (g)(3)(ii) of this
section) in the QPP. For taxpayers
subject to section 263A, overhead is all
costs required to be capitalized under
section 263A except direct materials
and direct labor. For taxpayers not
subject to section 263A, overhead may
be computed using any reasonable
method that is satisfactory to the
Secretary based on all of the facts and
circumstances, but may not include any
cost, or amount of any cost, that would
not be required to be capitalized under
section 263A if the taxpayer were
subject to section 263A. Research and
experimental expenditures under
section 174 and the costs of creating
intangible assets are not taken into
account in determining direct labor or
overhead for any tangible personal
property. However, for a special rule
regarding computer software and sound
recordings, see paragraph (g)(3)(iii) of
this section. In the case of tangible
personal property (as defined in
paragraph (j)(2) of this section), research
and experimental expenditures under
section 174 and any other costs incurred
in the creation of intangible assets may
be excluded from CGS or unadjusted
depreciable basis for purposes of
determining whether the taxpayer meets
the safe harbor under this paragraph
(g)(3).
(ii) Unadjusted depreciable basis. The
term unadjusted depreciable basis
means the basis of property for purposes
of section 1011 without regard to any
adjustments described in section
1016(a)(2) and (3). This basis does not
reflect the reduction in basis for—

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(A) Any portion of the basis the
taxpayer properly elects to treat as an
expense under section 179 or 179C; or
(B) Any adjustments to basis provided
by other provisions of the Code and the
regulations under the Code (for
example, a reduction in basis by the
amount of the disabled access credit
pursuant to section 44(d)(7)).
(iii) Computer software and sound
recordings. In determining direct labor
and overhead under paragraph (g)(3)(i)
of this section, the costs of direct labor
and overhead for developing computer
software as described in Rev. Proc.
2000–50 (2000–1 C.B. 601) (see
§ 601.601(d)(2) of this chapter), research
and experimental expenditures under
section 174, and any other costs of
creating intangible assets for computer
software and sound recordings are
treated as direct labor and overhead.
These costs must be included in the
taxpayer’s CGS or unadjusted
depreciable basis of computer software
and sound recordings for purposes of
determining whether the taxpayer meets
the safe harbor under paragraph (g)(3)(i)
of this section. If the taxpayer expects to
lease, rent, license, sell, exchange, or
otherwise dispose of computer software
or sound recordings over more than one
taxable year, the costs of developing
computer software as described in Rev.
Proc. 2000–50 (2000–1 C.B. 601),
research and experimental expenditures
under section 174, and any other costs
of creating intangible assets for
computer software and sound
recordings must be allocated over the
estimated number of units that the
taxpayer expects to lease, rent, license,
sell, exchange, or otherwise dispose of.
(4) Special rules—(i) Contract with an
unrelated person. If a taxpayer enters
into a contract with an unrelated person
for the unrelated person to MPGE QPP
within the United States for the
taxpayer, and the taxpayer is considered
to MPGE the QPP pursuant to paragraph
(f)(1) of this section, then, for purposes
of the substantial-in-nature requirement
under paragraph (g)(2) of this section
and the safe harbor under paragraph
(g)(3)(i) of this section, the taxpayer’s
MPGE or production activities or direct
labor and overhead shall include both
the taxpayer’s MPGE or production
activities or direct labor and overhead to
MPGE the QPP within the United States
as well as the MPGE or production
activities or direct labor and overhead of
the unrelated person to MPGE the QPP
within the United States under the
contract.
(ii) Aggregation. In determining
whether the substantial-in-nature
requirement under paragraph (g)(2) of
this section or the safe harbor under

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paragraph (g)(3)(i) of this section is met
at the time the taxpayer disposes of an
item of QPP—
(A) An EAG member must take into
account all of the previous MPGE or
production activities or direct labor and
overhead of the other members of the
EAG;
(B) An EAG partnership (as defined in
§ 1.199–9(j)) must take into account all
of the previous MPGE or production
activities or direct labor and overhead of
all members of the EAG in which the
partners of the EAG partnership are
members (as well as the previous MPGE
or production activities of any other
EAG partnerships owned by members of
the same EAG);
(C) A member of an EAG in which the
partners of an EAG partnership are
members must take into account all of
the previous MPGE or production
activities or direct labor and overhead of
the EAG partnership (as well as those of
any other members of the EAG and any
previous MPGE or production activities
of any other EAG partnerships owned
by members of the same EAG); and
(D) A partner of a qualifying in-kind
partnership (as defined in § 1.199–9(i))
must take into account all of the
previous MPGE or production activities
or direct labor and overhead of the
qualifying in-kind partnership.
(5) Examples. The following examples
illustrate the application of this
paragraph (g):
Example 1. X purchases from Y, an
unrelated person, unrefined oil extracted
outside the United States. X refines the oil in
the United States. The refining of the oil by
X is an MPGE activity that is substantial in
nature.
Example 2. X purchases gemstones and
precious metal from outside the United
States and then uses these materials to
produce jewelry within the United States by
cutting and polishing the gemstones, melting
and shaping the metal, and combining the
finished materials. X’s MPGE activities are
substantial in nature under paragraph (g)(2)
of this section. Therefore, X has MPGE the
jewelry in significant part within the United
States.
Example 3. (i) Facts. X operates an
automobile assembly plant in the United
States. In connection with such activity, X
purchases assembled engines, transmissions,
and certain other components from Y, an
unrelated person, and X assembles all of the
component parts into an automobile. X also
conducts stamping, machining, and
subassembly operations, and X uses tools,
jigs, welding equipment, and other
machinery and equipment in the assembly of
automobiles. On a per-unit basis, X ’s selling
price and costs of such automobiles are as
follows:
Selling price: $ 2,500
Cost of goods sold:
Material—Acquired from Y: $ 1,475
Direct labor and overhead: $325

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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
overhead are less than 20% of total CGS
($325/$1,800, or 18%) and X is not within
the safe harbor under paragraph (g)(3)(i) of
this section, the activities conducted by X in
connection with the assembly of an
automobile are substantial in nature under
paragraph (g)(2) of this section taking into
account the nature of X’s activity and the
relative value of X’s activity. Therefore, X’s
automobiles will be treated as MPGE in
significant part by X within the United States
for purposes of paragraph (g)(1) of this
section.
Example 4. X imports into the United
States QPP that is partially manufactured.
Assume that X completes the manufacture of
the QPP within the United States and X’s
completion of the manufacturing of the QPP
within the United States satisfies the inwhole-or-in-significant-part requirement
under paragraph (g)(1) of this section.
Therefore, X’s gross receipts from the lease,
rental, license, sale, exchange, or other
disposition of the QPP qualify as DPGR if all
other applicable requirements under this
section are met.
Example 5. X manufactures QPP in
significant part within the United States and
exports the QPP for further manufacture
outside the United States. X retains title to
the QPP while the QPP is being further
manufactured outside the United States.
Assuming X meets all the requirements
under this section for the QPP after the
further manufacturing, X’s gross receipts
derived from the lease, rental, license, sale,
exchange, or other disposition of the QPP
will be considered DPGR, regardless of
whether the QPP is imported back into the
United States prior to the lease, rental,
license, sale, exchange, or other disposition
of the QPP.
Example 6. X is a retailer within the United
States that sells cigars and pipe tobacco that
X purchases from an unrelated person. While
being displayed and offered for sale by X, the
cigars and pipe tobacco age on X’s shelves in
a room with controlled temperature and
humidity. Although X’s cigars and pipe
tobacco may become more valuable as they
age, the gross receipts derived by X from the
sale of the cigars and pipe tobacco are nonDPGR because the aging of the cigars and
pipe tobacco while being displayed and
offered for sale by X does not qualify as an
MPGE activity that is substantial in nature.
Example 7. X incurs $1,000,000 in
computer software development costs in
direct labor and overhead to develop
computer software. X begins producing the
computer software and expects to license one
million copies of the computer software. In
determining its direct labor and overhead for
the computer software under paragraph
(g)(3)(i) of this section, X must allocate under
paragraph (g)(3)(iii) of this section the
$1,000,000 to the computer software X
expects to produce. Thus, for each copy of
the computer software produced by X, $1
($1,000,000 in computer software
development costs/one million estimated

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number of units to be licensed) in computer
software development costs are treated as
direct labor and overhead.
Example 8. X creates computer software for
microwave ovens. X also manufactures the
electric motors used in the ovens. X
purchases the other components of the
microwave ovens from unrelated persons. X
sells each microwave oven individually to
customers. Assume that X’s assembly of the
finished microwave ovens is not minor
assembly. To determine whether the
manufacture of the microwave ovens satisfies
the safe harbor under paragraph (g)(3)(i) of
this section, X’s direct labor and overhead
include X’s direct labor and overhead for
creating the computer software,
manufacturing the electric motors, and
assembling the finished microwave ovens
that are offered for sale.
Example 9. X designs shirts within the
United States, but X cuts and sews the shirts
outside of the United States. Because X’s
design activity is the creation of an
intangible, its design activity is not taken into
account in determining whether the
manufacture of the shirts is substantial in
nature under paragraph (g)(2) of this section,
and the costs X incurs in creating the design
of the shirts are not direct labor or overhead
under paragraph (g)(3)(i) of this section.
Therefore, X has not MPGE the shirts in
significant part within the United States.
Example 10. X manufactures computer
chips within the United States. X installs the
computer chips that it manufactures in
computers that X purchases from unrelated
persons and sells the finished computers
individually to customers. The computer
chips are key components of the computers
and the computers will not operate without
them. The manufacture of the computer
chips is not, in itself, substantial in nature
with respect to the finished computers.
Therefore, the taxpayer’s MPGE activities
must meet either the substantial-in-nature
requirement under paragraph (g)(2) of this
section, or the safe harbor under paragraph
(g)(3) of this section, in order to qualify with
respect to the finished computers.

(h) Definition of United States. For
purposes of this section, the term United
States includes the 50 states, the District
of Columbia, the territorial waters of the
United States, and the seabed and
subsoil of those submarine areas that are
adjacent to the territorial waters of the
United States and over which the
United States has exclusive rights, in
accordance with international law, with
respect to the exploration and
exploitation of natural resources. The
term United States does not include
possessions and territories of the United
States or the airspace or space over the
United States and these areas.
(i) Derived from the lease, rental,
license, sale, exchange, or other
disposition—(1) In general—(i)
Definition. The term derived from the
lease, rental, license, sale, exchange, or
other disposition is defined as, and
limited to, the gross receipts directly

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derived from the lease, rental, license,
sale, exchange, or other disposition of
QPP, a qualified film, or utilities, even
if the taxpayer has already recognized
gross receipts from a previous lease,
rental, license, sale, exchange, or other
disposition of the same QPP, qualified
film, or utilities. Applicable Federal
income tax principles apply to
determine whether a transaction is, in
substance, a lease, rental, license, sale,
exchange, or other disposition, whether
it is a service, or whether it is some
combination thereof.
(ii) Lease income. The financing and
interest components of a lease of QPP or
a qualified film are considered to be
derived from the lease of such QPP or
qualified film. However, any portion of
the lease income that is attributable to
services or non-qualified property as
defined in paragraph (i)(4) of this
section is not derived from the lease of
QPP or a qualified film.
(iii) Income substitutes. The proceeds
from business interruption insurance,
governmental subsidies, and
governmental payments not to produce
are treated as gross receipts derived
from the lease, rental, license, sale,
exchange, or other disposition to the
extent that they are substitutes for gross
receipts that would qualify as DPGR.
(iv) Exchange of property—(A)
Taxable exchanges. Except as provided
in paragraph (i)(1)(iv)(B) of this section,
the value of property received by a
taxpayer in a taxable exchange of QPP
MPGE in whole or in significant part by
the taxpayer within the United States, a
qualified film produced by the taxpayer,
or utilities produced by the taxpayer
within the United States is DPGR for the
taxpayer (assuming all the other
requirements of this section are met).
However, unless the taxpayer meets all
of the requirements under this section
with respect to any further MPGE by the
taxpayer of the QPP or any further
production by the taxpayer of the film
or utilities received in the taxable
exchange, any gross receipts derived
from the sale by the taxpayer of the
property received in the taxable
exchange are non-DPGR, because the
taxpayer did not MPGE or produce such
property, even if the property was QPP,
a qualified film, or utilities in the hands
of the other party to the transaction.
(B) Safe harbor. For purposes of
paragraph (i)(1)(iv)(A) of this section,
the gross receipts derived by the
taxpayer from the sale of eligible
property (as defined in paragraph
(i)(1)(iv)(C) of this section) received in a
taxable exchange, net of any
adjustments between the parties
involved in the taxable exchange to
account for differences in the eligible

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property exchanged (for example,
location differentials and product
differentials), may be treated as the
value of the eligible property received
by the taxpayer in the taxable exchange.
For purposes of the preceding sentence,
the taxable exchange is deemed to occur
on the date of the sale of the eligible
property received in the taxable
exchange by the taxpayer, to the extent
the sale occurs no later than the last day
of the month following the month in
which the exchanged eligible property
is received by the taxpayer. In addition,
if the taxpayer engages in any further
MPGE or production activity with
respect to the eligible property received
in the taxable exchange, then, unless the
taxpayer meets the in-whole-or-insignificant-part requirement under
paragraph (g)(1) of this section with
respect to the property sold, for
purposes of this paragraph (i)(1)(iv)(B),
the taxpayer must also value the
property sold without taking into
account the gross receipts attributable to
the further MPGE or production activity.
(C) Eligible property. For purposes of
paragraph (i)(1)(iv)(B) of this section,
eligible property is—
(1) Oil, natural gas (as described in
paragraph (l)(2) of this section), or
petrochemicals, or products derived
from oil, natural gas, or petrochemicals;
or
(2) Any other property or product
designated by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter).
(2) Examples. The following examples
illustrate the application of paragraph
(i)(1) of this section:
Example 1. X MPGE QPP in whole or in
significant part within the United States and
uses the QPP in its business. After several
years X sells the QPP that it MPGE to Y. The
gross receipts derived from the sale of the
QPP to Y are DPGR (assuming all the other
requirements of this section are met).
Example 2. X MPGE QPP within the
United States and sells the QPP to Y, an
unrelated person. Y leases the QPP for 3
years to Z, a taxpayer unrelated to both X and
Y, and shortly after Y enters into the lease
with Z, X repurchases the QPP from Y
subject to the lease. At the end of the lease
term, Z purchases the QPP from X. X’s
proceeds derived from the sale of the QPP to
Y, from the lease to Z (including any
financing and interest components of the
lease), and from the sale of the QPP to Z all
qualify as DPGR (assuming all the other
requirements of this section are met).
Example 3. X MPGE QPP within the
United States and sells the QPP to Y, an
unrelated person, for $25,000. X finances Y’s
purchase of the QPP and receives total
payments of $35,000, of which $10,000
relates to interest and finance charges. The
$25,000 qualifies as DPGR, but the $10,000
in interest and finance charges do not qualify

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as DPGR because the $10,000 is not derived
from the MPGE of QPP within the United
States, but rather from X’s lending activity.
Example 4. Cable company X charges
subscribers $15 a month for its basic cable
television. Y, an unrelated person, produces
a qualified film within the meaning of
paragraph (k)(1) of this section that it licenses
to X for $.10 per subscriber per month. The
gross receipts derived by Y are derived from
the license of a qualified film produced by
Y and are DPGR (assuming all the other
requirements of this section are met).
Example 5. X manufactures cars within the
United States. X also manufactures
replacement parts within the United States.
The replacement parts are QPP under
paragraph (j)(1) of this section. X offers
extended warranties to its customers. X sells
a car to Y. Y purchases an extended warranty
and brings the car to X’s service department
for maintenance. X repairs the car and
replaces damaged parts with replacement
parts that X manufactured within the United
States. The portion of X’s gross receipts
derived from the sale of the extended
warranty relating to the manufactured parts
are DPGR.

(3) Hedging transactions—(i) In
general. For purposes of this section,
provided that the risk being hedged
relates to QPP described in section
1221(a)(1) or relates to property
described in section 1221(a)(8)
consumed in an activity giving rise to
DPGR, and provided that the transaction
is a hedging transaction within the
meaning of section 1221(b)(2)(A) and
§ 1.1221–2(b) and is properly identified
as a hedging transaction in accordance
with § 1.1221–2(f), then—
(A) In the case of a hedge of purchases
of property described in section
1221(a)(1), gain or loss on the hedging
transaction must be taken into account
in determining CGS;
(B) In the case of a hedge of sales of
property described in section 1221(a)(1),
gain or loss on the hedging transaction
must be taken into account in
determining DPGR; and
(C) In the case of a hedge of purchases
of property described in section
1221(a)(8), gain or loss on the hedging
transaction must be taken into account
in determining DPGR.
(ii) Currency fluctuations. For
purposes of this section, in the case of
a transaction that manages the risk of
currency fluctuations, the determination
of whether the transaction is a hedging
transaction within the meaning of
§ 1.1221–2(b) is made without regard to
whether the transaction is a section 988
transaction. See § 1.1221–2(a)(4). The
preceding sentence applies only to the
extent that § 1.988–5(b) does not apply.
(iii) Effect of identification and
nonidentification. If a taxpayer does not
make an identification that satisfies all
of the requirements of § 1.1221–2(f) but

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the taxpayer has no reasonable grounds
for treating the transaction as other than
a hedging transaction, then a loss from
the transaction is taken into account
under this paragraph (i)(3). If the
inadvertent identification rule of
§ 1.1221–2(g)(1)(ii) or the inadvertent
error rule of § 1.1221–2(g)(2)(ii) applies,
then the taxpayer is treated as not
having identified the transaction as a
hedging transaction or as having
identified the transaction as a hedging
transaction, as the case may be. If a
taxpayer identifies a transaction as a
hedging transaction in accordance with
§ 1.1221–2(f)(1), then—
(A) That identification is binding with
respect to loss for purposes of this
paragraph (i)(3), whether or not all of
the requirements of § 1.1221–2(f) are
satisfied and whether or not the
transaction is in fact a hedging
transaction within the meaning of
section 1221(b)(2)(A) and § 1.1221–2(b),
and
(B) This paragraph (i)(3) does not
apply to require gain to be taken into
account in determining CGS or DPGR, if
the transaction is not in fact a hedging
transaction within the meaning of
section 1221(b)(2)(A) and § 1.1221–2(b).
(iv) Other rules. See § 1.1221–2(e) for
rules applicable to hedging by members
of a consolidated group and § 1.446–4
for rules regarding the timing of income,
deductions, gains, or losses with respect
to hedging transactions.
(4) Allocation of gross receipts—(i)
Embedded services and non-qualified
property—(A) In general. Except as
otherwise provided in paragraph
(i)(4)(i)(B), paragraph (m) (relating to
construction), and paragraph (n)
(relating to engineering and
architectural services) of this section,
gross receipts derived from the
performance of services do not qualify
as DPGR. In the case of an embedded
service, that is, a service the price of
which, in the normal course of the
taxpayer’s business, is not separately
stated from the amount charged for the
lease, rental, license, sale, exchange, or
other disposition of QPP, a qualified
film, or utilities, DPGR include only the
gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition of QPP, a qualified film, or
utilities (assuming all the other
requirements of this section are met)
and not any receipts attributable to the
embedded service. In addition, DPGR
does not include the gross receipts
derived from the lease, rental, license,
sale, exchange, or other disposition of
property that does not meet all of the
requirements under this section (nonqualified property). The allocation of
the gross receipts attributable to the

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embedded services or non-qualified
property will be deemed to be
reasonable if the allocation reflects the
fair market value of the embedded
services or non-qualified property. For
example, gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of a replacement part
that is non-qualified property does not
qualify as DPGR. In addition, see
§ 1.199–1(e) for other instances when an
allocation of gross receipts attributable
to embedded services or non-qualified
property will be deemed reasonable.
(B) Exceptions. There are six
exceptions to the rules under paragraph
(i)(4)(i)(A) of this section regarding
embedded services and non-qualified
property. A taxpayer may include in
DPGR, if all the other requirements of
this section are met with respect to the
underlying item of QPP, qualified films,
or utilities to which the embedded
services or non-qualified property
relate, the gross receipts derived from—
(1) A qualified warranty, that is, a
warranty (other than a computer
software maintenance agreement
described in paragraph (i)(4)(i)(B)(5) of
this section) that is provided in
connection with the lease, rental,
license, sale, exchange, or other
disposition of QPP, a qualified film, or
utilities if, in the normal course of the
taxpayer’s business—
(i) The price for the warranty is not
separately stated from the amount
charged for the lease, rental, license,
sale, exchange, or other disposition of
the QPP, qualified film, or utilities; and
(ii) The warranty is neither separately
offered by the taxpayer nor separately
bargained for with customers (that is, a
customer cannot purchase the QPP,
qualified film, or utilities without the
warranty);
(2) A qualified delivery, that is, a
delivery or distribution service that is
provided in connection with the lease,
rental, license, sale, exchange, or other
disposition of QPP if, in the normal
course of the taxpayer’s business—
(i) The price for the delivery or
distribution service is not separately
stated from the amount charged for the
lease, rental, license, sale, exchange, or
other disposition of the QPP; and
(ii) The delivery or distribution
service is neither separately offered by
the taxpayer nor separately bargained
for with customers (that is, a customer
cannot purchase the QPP without the
delivery or distribution service);
(3) A qualified operating manual, that
is, a manual of instructions (including
electronic instructions) that is provided
in connection with the lease, rental,
license, sale, exchange, or other
disposition of QPP, a qualified film or

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31295

utilities if, in the normal course of the
taxpayer’s business—
(i) The price for the manual is not
separately stated from the amount
charged for the lease, rental, license,
sale, exchange, or other disposition of
the QPP, qualified film, or utilities;
(ii) The manual is neither separately
offered by the taxpayer nor separately
bargained for with customers (that is, a
customer cannot purchase the QPP,
qualified film, or utilities without the
manual); and
(iii) The manual is not provided in
connection with a training course for
customers;
(4) A qualified installation, that is, an
installation service (including minor
assembly) for tangible personal property
that is provided in connection with the
lease, rental, license, sale, exchange, or
other disposition of the tangible
personal property if, in the normal
course of the taxpayer’s business—
(i) The price for the installation
service is not separately stated from the
amount charged for the lease, rental,
license, sale, exchange, or other
disposition of the tangible personal
property; and
(ii) The installation is neither
separately offered by the taxpayer nor
separately bargained for with customers
(that is, a customer cannot purchase the
tangible personal property without the
installation service);
(5) Services performed pursuant to a
qualified computer software
maintenance agreement. A qualified
computer software maintenance
agreement is an agreement provided in
connection with the lease, rental,
license, sale, exchange, or other
disposition of the computer software
that entitles the customer to receive
future updates, cyclical releases,
rewrites of the underlying software, or
customer support services for the
computer software if, in the normal
course of the taxpayer’s business—
(i) The price for the agreement is not
separately stated from the amount
charged for the lease, rental, license,
sale, exchange, or other disposition of
the computer software; and
(ii) The agreement is neither
separately offered by the taxpayer nor
separately bargained for with customers
(that is, a customer cannot purchase the
computer software without the
agreement); and
(6) A de minimis amount of gross
receipts from embedded services and
non-qualified property for each item of
QPP, qualified films, or utilities. For
purposes of the preceding sentence, a de
minimis amount of gross receipts from
embedded services and non-qualified
property is less than 5 percent of the

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total gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of each item of QPP,
qualified films, or utilities. In the case
of gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition of QPP, a qualified film, or
utilities that are received over a period
of time (for example, a multi-year lease
or installment sale), this de minimis
exception is applied by taking into
account the total gross receipts for the
entire period derived (and to be derived)
from the lease, rental, license, sale,
exchange, or other disposition of the
item of QPP, qualified films, or utilities.
For purposes of the preceding sentence,
if a taxpayer treats gross receipts as
DPGR under this de minimis exception,
then the taxpayer must treat the gross
receipts recognized in each taxable year
consistently as DPGR. The gross receipts
that the taxpayer treats as DPGR under
paragraphs (i)(4)(i)(B)(1), (2), (3), (4),
and (5) and (l)(4)(iv)(A) of this section
are treated as DPGR for purposes of
applying this de minimis exception.
This de minimis exception does not
apply if the price of a service or nonqualified property is separately stated
by the taxpayer, or if the service or nonqualified property is separately offered
or separately bargained for with the
customer (that is, the customer can
purchase the QPP, qualified film, or
utilities without the service or nonqualified property).
(ii) Non-DPGR. All of a taxpayer’s
gross receipts derived from the lease,
rental, license, sale, exchange or other
disposition of an item of QPP, qualified
films, or utilities may be treated as nonDPGR if less than 5 percent of the
taxpayer’s total gross receipts derived
from the lease, rental, license, sale,
exchange or other disposition of that
item are DPGR. In the case of gross
receipts derived from the lease, rental,
license, sale, exchange, or other
disposition of QPP, a qualified film, and
utilities that are received over a period
of time (for example, a multi-year lease
or installment sale), this paragraph
(i)(4)(ii) is applied by taking into
account the total gross receipts for the
entire period derived (and to be derived)
from the lease, rental, license, sale,
exchange, or other disposition of the
item of QPP, qualified films, or utilities.
For purposes of the preceding sentence,
if a taxpayer treats gross receipts as nonDPGR under this de minimis exception,
then the taxpayer must treat the gross
receipts recognized in each taxable year
consistently as non-DPGR.
(iii) Examples. The following
examples illustrate the application of
this paragraph (i)(4):

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Example 1. X MPGE QPP within the
United 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 other services or
property are provided to Z in connection
with the sale of the QPP to Z. In the normal
course of X’s business, the QPP and training
services are separately stated in the sales
contract. Because, in the normal course of the
X’s business, the training services are
separately stated, the training services are not
treated as embedded services under the de
minimis exception in paragraph (i)(4)(i)(B)(6)
of this section.
Example 2. The facts are the same as in
Example 1 except that, in the normal course
of X’s business, the training services are not
separately stated in the sales contract and the
customer cannot purchase the QPP without
the training services. If the gross receipts for
the embedded training services are less than
5% of the gross receipts derived from the sale
of X’s QPP to Z, after applying the exceptions
under paragraphs (i)(4)(i)(B)(1) through (5) of
this section, then the gross receipts may be
included in DPGR under the de minimis
exception in paragraph (i)(4)(i)(B)(6) of this
section.
Example 3. X MPGE QPP within the
United States. As part of the sale of the QPP
to retailers, X charges a fee for delivering the
QPP. In the normal course of X’s business,
the price of the QPP and the delivery fee are
separately stated in X’s sales contracts.
Because, in the normal course of X’s
business, the delivery fee is separately stated,
the delivery fee does not qualify as DPGR
under the qualified delivery exception in
paragraph (i)(4)(i)(B)(2) of this section or the
de minimis exception under paragraph
(i)(4)(i)(B)(6) of this section. The result would
be the same even if the retailer’s customers
cannot purchase the QPP without paying the
delivery fee.
Example 4. (i) Facts. X manufactures
industrial sewing machines within the
United States that X offers for sale
individually to customers. X enters into a
single, lump-sum priced contract with Y, an
unrelated person, and the contract has the
following terms: X will manufacture
industrial sewing machines within the
United States for Y; X will deliver the
industrial sewing machines to Y; X will
provide a one-year warranty on the industrial
sewing machines; X will provide operating
manuals with the industrial sewing
machines; X will provide 100 hours of
training and training manuals to Y’s
employees on the use and maintenance of the
industrial sewing machines; X will provide
purchased spare parts for the industrial
sewing machines; and X will provide a 3-year
service agreement for the industrial sewing
machines. In the normal course of X’s
business, none of the services or property
described above are separately stated,
separately offered or separately bargained for.
(ii) Analysis. The receipts for the
manufacture of the industrial sewing
machines are DPGR under paragraphs (e)(1)
and (g) of this section (assuming all the other
requirements of this section are met). X may
include in DPGR the gross receipts derived
from delivering the industrial sewing
machines, which is a qualified delivery

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under paragraph (i)(4)(i)(B)(2) of this section;
the gross receipts derived from the one-year
warranty, which is a qualified warranty
under paragraph (i)(4)(i)(B)(1) of this section;
and the gross receipts derived from the
operating manuals, which is a qualified
operating manual under paragraph
(i)(4)(i)(B)(3) of this section. If the gross
receipts allocable to each industrial sewing
machine for the embedded services
consisting of the employee training and 3year service agreement, and for the nonqualified property consisting of the
purchased spare parts and the employee
training manuals, which are not qualified
operating manuals, are in total less than 5%
of the gross receipts derived from the sale of
each industrial sewing machine to Y (after
applying the exceptions under paragraphs
(i)(4)(i)(B)(1) through (5) of this section), then
those gross receipts may be included in
DPGR under the de minimis exception in
paragraph (i)(4)(i)(B)(6) of this section. If,
however, the gross receipts allocable to each
industrial sewing machine for the embedded
services and non-qualified property
consisting of employee training, the 3-year
service agreement, purchased spare parts,
and employee training manuals equal or
exceed, in total, 5% of the gross receipts
derived from the sale of each industrial
sewing machine to Y (after applying the
exceptions under paragraphs (i)(4)(i)(B)(1)
through (5) of this section), then those gross
receipts do not qualify as DPGR under the de
minimis exception in paragraph (i)(4)(i)(B)(6)
of this section (and X must allocate gross
receipts between DPGR and non-DPGR under
§ 1.199–1(d)(1)).

(5) Advertising income—(i) Tangible
personal property. A taxpayer’s gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other
disposition of newspapers, magazines,
telephone directories, periodicals, and
other similar printed publications that
are MPGE in whole or in significant part
within the United States include
advertising income from advertisements
placed in those media, but only if the
gross receipts, if any, derived from the
lease, rental, license, sale, exchange, or
other disposition of the newspapers,
magazines, telephone directories, or
periodicals are (or would be) DPGR.
(ii) Qualified film. A taxpayer’s gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other
disposition of a qualified film include
advertising income and productplacement income with respect to that
qualified film, that is, compensation for
placing or integrating advertising or a
product into the qualified film, but only
if the gross receipts, if any, derived from
the qualified film are (or would be)
DPGR.
(iii) Examples. The following
examples illustrate the application of
this paragraph (i)(5):
Example 1. X MPGE, and sells, newspapers
within the United States. X’s gross receipts

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from the newspapers include gross receipts
derived from the sale of newspapers to
customers and payments from advertisers to
publish display advertising or classified
advertisements in X’s newspapers. X’s gross
receipts described above are DPGR derived
from the sale of X’s newspapers.
Example 2. The facts are the same as in
Example 1 except that X disposes of the
newspapers free of charge to customers,
rather than selling them. X’s gross receipts
from the display advertising or classified
advertisements are DPGR.
Example 3. X produces two live television
programs that are qualified films. X licenses
the first television program to Y’s television
station and X licenses the second television
program to Z’s television station. Z
broadcasts the second television program on
its station. Both television programs contain
product placements and advertising for
which X received compensation. X and Y are
unrelated persons. X and Z are nonconsolidated members of an EAG. The gross
receipts derived by X from licensing the first
television program to Y are DPGR. As a
result, pursuant to paragraph (i)(5)(ii) of this
section, all of X’s product placement and
advertising income for the first television
program is treated as gross receipts that are
derived from the license of the qualified film.
The gross receipts derived by X from
licensing the second television program to Z
are non-DPGR under paragraph (b)(1) of this
section. Paragraph (b)(2) of this section does
not apply because Z’s broadcast of the second
television program on Z’s television station is
not a lease, rental, license, sale, exchange, or
other disposition of the second television
program. As a result, pursuant to paragraph
(i)(5)(ii) of this section, none of X’s product
placement and advertising income for the
second television program is treated as gross
receipts derived from the qualified film.
Example 4. The facts are the same as in
Example 3 except that Z sublicenses to an
unrelated person the television program
instead of broadcasting the television
program on its station. The gross receipts
derived by X from licensing the television
program to Z are DPGR under paragraph
(b)(2) of this section. As a result, pursuant to
paragraph (i)(5)(ii) of this section, X’s
product placement and advertising income
for the television program licensed to Z is
treated as gross receipts derived from the
qualified film. In addition, Z’s receipts from
the sublicense of the qualified film are DPGR
under § 1.199–7(a)(3)(i).
Example 5. X produces television programs
that are qualified films. X licenses the
qualified films to Y, an unrelated person, and
the license agreement provides that X will
receive advertising time slots as part of its
payments from Y under the license
agreement. X’s gross receipts derived from
the license of the qualified films to Y include
income attributable to the advertising time
slots and are DPGR under paragraph (b)(2) of
this section.

(6) Computer software—(i) In general.
DPGR include the gross receipts of the
taxpayer that are derived from the lease,
rental, license, sale, exchange, or other
disposition of computer software MPGE

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by the taxpayer in whole or in
significant part within the United
States. Such gross receipts qualify as
DPGR even if the customer provides the
computer software to its employees or
others over the Internet.
(ii) through (v). [Reserved]. For further
guidance see § 1.199–3T(i)(6)(ii) through
(v).
(7) Qualifying in-kind partnership for
taxable years beginning after May 17,
2006, the enactment date of the Tax
Increase Prevention and Reconciliation
Act of 2005. [Reserved].
(8) Partnerships owned by members of
a single expanded affiliated group for
taxable years beginning after May 17,
2006, the enactment date of the Tax
Increase Prevention and Reconciliation
Act of 2005. [Reserved].
(9) Non-operating mineral interests.
DPGR does not include gross receipts
derived from non-operating mineral
interests (for example, interests other
than operating mineral interests within
the meaning of § 1.614–2(b)).
(j) Definition of qualifying production
property—(1) In general. QPP means—
(i) Tangible personal property (as
defined in paragraph (j)(2) of this
section);
(ii) Computer software (as defined in
paragraph (j)(3) of this section); and
(iii) Sound recordings (as defined in
paragraph (j)(4) of this section).
(2) Tangible personal property—(i) In
general. The term tangible personal
property is any tangible property other
than land, real property described in
paragraph (m)(3) of this section, and any
property described in paragraph (j)(3),
(j)(4), (k)(1), or (l) of this section. For
purposes of the preceding sentence,
tangible personal property also includes
any gas (other than natural gas
described in paragraph (l)(2) of this
section), chemical, and similar property,
for example, steam, oxygen, hydrogen,
and nitrogen. Property such as
machinery, printing presses,
transportation and office equipment,
refrigerators, grocery counters, testing
equipment, display racks and shelves,
and neon and other signs that are
contained in or attached to a building
constitutes tangible personal property
for purposes of this paragraph (j)(2)(i).
Except as provided in paragraphs
(j)(5)(ii) and (k)(2)(i) of this section,
computer software, sound recordings,
and qualified films are not treated as
tangible personal property regardless of
whether they are affixed to a tangible
medium. However, the tangible medium
to which such property may be affixed
(for example, a videocassette, a
computer diskette, or other similar
tangible item) is tangible personal
property.

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(ii) Local law. In determining whether
property is tangible personal property,
local law is not controlling.
(iii) Intangible property. The term
tangible personal property does not
include property in a form other than in
a tangible medium. For example, massproduced books are tangible personal
property, but neither the rights to the
underlying manuscript nor an online
version of the book is tangible personal
property.
(3) Computer software—(i) In general.
The term computer software means any
program or routine or any sequence of
machine-readable code that is designed
to cause a computer to perform a
desired function or set of functions, and
the documentation required to describe
and maintain that program or routine.
Thus, for example, an electronic book
available online or for download is not
computer software. For purposes of this
paragraph (j)(3), computer software also
includes the machine-readable code for
video games and similar programs, for
equipment that is an integral part of
other property, and for typewriters,
calculators, adding and accounting
machines, copiers, duplicating
equipment, and similar equipment,
regardless of whether the code is
designed to operate on a computer (as
defined in section 168(i)(2)(B)).
Computer programs of all classes, for
example, operating systems, executive
systems, monitors, compilers and
translators, assembly routines, and
utility programs, as well as application
programs, are included. Except as
provided in paragraph (j)(5) of this
section, if the medium in which the
software is contained, whether written,
magnetic, or otherwise, is tangible, then
such medium is considered tangible
personal property for purposes of this
section.
(ii) Incidental and ancillary rights.
Computer software also includes any
incidental and ancillary rights that are
necessary to effect the acquisition of the
title to, the ownership of, or the right to
use the computer software, and that are
used only in connection with that
specific computer software. Such
incidental and ancillary rights are not
included in the definition of trademark
or trade name under § 1.197–2(b)(10)(i).
For example, a trademark or trade name
that is ancillary to the ownership or use
of a specific computer software program
in the taxpayer’s trade or business and
is not acquired for the purpose of
marketing the computer software is
included in the definition of computer
software and is not included in the
definition of trademark or trade name.
(iii) Exceptions. Computer software
does not include any data or

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information base unless the data or
information base is in the public
domain and is incidental to a computer
program. For this purpose, a
copyrighted or proprietary data or
information base is treated as in the
public domain if its availability through
the computer program does not
contribute significantly to the cost of the
program. For example, if a wordprocessing program includes a
dictionary feature that may be used to
spell-check a document or any portion
thereof, then the entire program
(including the dictionary feature) is
computer software regardless of the
form in which the dictionary feature is
maintained or stored.
(4) Sound recordings—(i) In general.
The term sound recordings means any
works that result from the fixation of a
series of musical, spoken, or other
sounds under section 168(f)(4). The
definition of sound recordings is limited
to the master copy of the recordings (or
other copy from which the holder is
licensed to make and produce copies),
and, except as provided in paragraph
(j)(5) of this section, if the medium
(such as compact discs, tapes, or other
phonorecordings) in which the sounds
may be embodied is tangible, then the
medium is considered tangible personal
property for purposes of paragraph (j)(2)
of this section.
(ii) Exception. The term sound
recordings does not include the creation
of copyrighted material in a form other
than a sound recording, such as lyrics
or music composition.
(5) Tangible personal property with
computer software or sound
recordings—(i) Computer software and
sound recordings. If a taxpayer MPGE in
whole or in significant part computer
software or sound recordings within the
United States that is affixed or added to
tangible personal property (for example,
a computer diskette, or an appliance),
whether or not the taxpayer MPGE such
tangible personal property in whole or
in significant part within the United
States, then for purposes of this
section—
(A) The computer software and the
tangible personal property may be
treated by the taxpayer as computer
software. If the taxpayer treats the
computer software and the tangible
personal property as computer software,
activities the cost of which are
described in Rev. Proc. 2000–50 (2000–
1 C.B. 601), activities giving rise to
research and experimental expenditures
under section 174, and the creation of
intangible assets for computer software
are considered in determining whether
the taxpayer’s MPGE activity is
substantial in nature under paragraph

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(g)(2) of this section. In determining
direct labor and overhead under
paragraph (g)(3)(i) of this section, the
costs of direct labor and overhead for
developing the computer software as
described in Rev. Proc. 2000–50 (2000–
1 C.B. 601), research and experimental
expenditures under section 174, and
any other costs of creating intangible
assets for the computer software are
treated as direct labor and overhead.
These costs must be included in the
taxpayer’s CGS of the computer software
for purposes of determining whether the
taxpayer meets the safe harbor under
paragraph (g)(3)(i) of this section.
However, any costs under section 174,
and the costs to create intangible assets,
attributable to the tangible personal
property are not considered in
determining whether the taxpayer’s
activity is substantial in nature under
paragraph (g)(2) of this section and are
not direct labor and overhead under
paragraph (g)(3)(i) of this section; and
(B) The sound recordings and the
tangible personal property with the
sound recordings may be treated by the
taxpayer as sound recordings. If the
taxpayer treats the sound recordings and
the tangible personal property as sound
recordings, activities giving rise to
research and experimental expenditures
under section 174 and the creation of
intangible assets for sound recordings
are considered in determining whether
the taxpayer’s MPGE activity is
substantial in nature under paragraph
(g)(2) of this section. In determining
direct labor and overhead under
paragraph (g)(3)(i) of this section,
research and experimental expenditures
under section 174 and any other costs
of creating intangible assets for sound
recordings are treated as direct labor
and overhead. These costs must be
included in the taxpayer’s CGS of sound
recordings for purposes of determining
whether the taxpayer meets the safe
harbor under paragraph (g)(3)(i) of this
section. However, any costs under
section 174, and the costs to create
intangible assets, attributable to the
tangible personal property are not
considered in determining whether the
taxpayer’s activity is substantial in
nature under paragraph (g)(2) of this
section and are not direct labor and
overhead under paragraph (g)(3)(i) of
this section.
(ii) Tangible personal property. If a
taxpayer MPGE tangible personal
property (for example, a computer
diskette or an appliance) in whole or in
significant part within the United States
but not the computer software or sound
recordings that is affixed or added to
such tangible personal property, then
for purposes of this section the tangible

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personal property with the computer
software or sound recordings may be
treated by the taxpayer as tangible
personal property under paragraph (j)(2)
of this section. Any costs under section
174, and the costs to create intangible
assets, attributable to the tangible
personal property are not considered in
determining whether the taxpayer’s
activity is substantial in nature under
paragraph (g)(2) of this section and are
not direct labor or overhead under
paragraph (g)(3)(i) of this section. For
purposes of paragraph (g)(3) of this
section, the taxpayer’s CGS (or
unadjusted depreciable basis, if
applicable) for each item of tangible
personal property includes the
taxpayer’s cost of leasing, renting,
licensing, buying, or otherwise
acquiring the computer software or
sound recordings.
(k) Definition of qualified film—(1) In
general. The term qualified film means
any motion picture film or video tape
under section 168(f)(3), or live or
delayed television programming, if not
less than 50 percent of the total
compensation paid to actors, production
personnel, directors, and producers
relating to the production of the motion
picture film, video tape, or television
programming is compensation paid by
the taxpayer for services relating to the
production of the film performed in the
United States by those individuals. For
purposes of this paragraph (k), actors
include players, newscasters, or any
other persons performing in a qualified
film. The term production personnel
includes, for example, writers,
choreographers and composers
providing services during the
production of a film, casting agents,
camera operators, set designers, lighting
technicians, make-up artists, and others
whose activities are directly related to
the production of the film. Except as
provided in paragraph (k)(2) of this
section, the definition of qualified film
does not include tangible personal
property embodying the qualified film,
such as DVDs or videocassettes.
(2) Tangible personal property with a
film—(i) Film not produced by a
taxpayer. If a taxpayer MPGE tangible
personal property (for example, a DVD)
in whole or in significant part in the
United States and a film not produced
by a taxpayer is affixed to the tangible
personal property, then the taxpayer
may treat the tangible personal property
with the affixed film as tangible
personal property, regardless of whether
the film is a qualified film. The
determination of whether the gross
receipts of such a taxpayer derived from
the lease, rental, license, sale, exchange,
or other disposition of the tangible

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personal property with the affixed film
are DPGR is made under the rules of this
section. For purposes of paragraph (g)(2)
of this section, in determining whether
the taxpayer’s MPGE activity is
substantial in nature, the taxpayer must
consider the value of the licensed film.
For purposes of paragraph (g)(3) of this
section, the taxpayer’s CGS (or
unadjusted depreciable basis, as
applicable) for each item of tangible
personal property includes the
taxpayer’s cost of leasing, renting,
licensing, buying, or otherwise
acquiring the film.
(ii) Film produced by a taxpayer. If a
taxpayer produces a film and the film is
affixed to tangible personal property (for
example, a DVD), then for purposes of
this section—
(A) Qualified film. If the film is a
qualified film, the taxpayer may treat
the tangible personal property, whether
or not the taxpayer MPGE such tangible
personal property, to which the
qualified film is affixed as part of the
qualified film; and
(B) Nonqualified film. If the film is
not a qualified film (nonqualified film),
a taxpayer cannot treat the tangible
personal property to which the
nonqualified film is affixed as part of
the nonqualified film.
(3) Derived from a qualified film—(i)
In general. DPGR include the gross
receipts of a taxpayer that are derived
from any lease, rental, license, sale,
exchange, or other disposition of any
qualified film produced by such
taxpayer.
(ii) Exceptions. The showing of a
qualified film (for example, in a movie
theater or by broadcast on a television
station) by a taxpayer is not a lease,
rental, license, sale, exchange, or other
disposition of the qualified film by such
taxpayer. Ticket sales for viewing a
qualified film do not constitute DPGR
because the gross receipts are not
derived from the lease, rental, license,
sale, exchange, or other disposition of a
qualified film. Because a taxpayer that
merely writes a screenplay or other
similar material is not considered to
have produced a qualified film under
paragraph (k)(1) of this section, the
amounts that the taxpayer receives from
the sale of the script or screenplay, even
if the script is developed into a qualified
film, are not gross receipts derived from
a qualified film. In addition, revenue
from the sale of film-themed
merchandise is revenue from the sale of
tangible personal property and not gross
receipts derived from a qualified film.
Gross receipts derived from a license of
the right to use or exploit the film
characters are not gross receipts derived
from a qualified film.

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(4) Compensation for services. The
term compensation for services means
all payments for services performed by
actors (as described in paragraph (k)(1)
of this section), production personnel,
directors, and producers, including
participations and residuals. In the case
of a taxpayer that uses the income
forecast method of section 167(g) and
capitalizes participations and residuals
into the adjusted basis of the qualified
film, the taxpayer must use the same
estimate of participations and residuals
for services performed by actors,
production personnel, directors, and
producers for purposes of this section.
In the case of a taxpayer that excludes
participations and residuals from the
adjusted basis of the qualified film
under section 167(g)(7)(D)(i), the
taxpayer must determine the
compensation expected to be paid for
services performed by actors,
production personnel, directors, and
producers as participations and
residuals based on the total forecasted
income used in determining income
forecast depreciation. Compensation for
services includes all direct and indirect
compensation costs required to be
capitalized under section 263A for film
producers under § 1.263A–1(e)(2) and
(3). Compensation for services is not
limited to W–2 wages and includes
compensation paid to independent
contractors.
(5) Determination of 50 percent. The
not-less-than-50-percent-of-the-totalcompensation requirement under
paragraph (k)(1) of this section is
determined by reference to all
compensation paid in the production of
the film and is calculated using a
fraction. The numerator of the fraction
is the compensation paid by the
taxpayer to actors, production
personnel, directors, and producers for
services relating to the production of the
film (production services) performed in
the United States, and the denominator
is the sum of the total compensation
paid by the taxpayer to all such
individuals regardless of where the
production services are performed and
the total compensation paid by others to
all such individuals regardless of where
the production services are performed.
A taxpayer may use any reasonable
method that is satisfactory to the
Secretary based on all of the facts and
circumstances, including all historic
information available, to determine the
compensation for services performed in
the United States by actors (as described
in paragraph (k)(1) of this section),
production personnel, directors, and
producers, and the total compensation
paid to those individuals for services

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relating to the production of the film.
Among the factors to be considered in
determining whether a taxpayer’s
method of allocating compensation is
reasonable is whether the taxpayer uses
that method consistently from one
taxable year to another.
(6) Exception. A qualified film does
not include property with respect to
which records are required to be
maintained under 18 U.S.C. 2257.
Section 2257 of Title 18 requires
maintenance of certain records with
respect to any book, magazine,
periodical, film, videotape, or other
matter that—
(i) Contains one or more visual
depictions made after November 1,
1990, of actual sexually explicit
conduct; and
(ii) Is produced in whole or in part
with materials that have been mailed or
shipped in interstate or foreign
commerce, or is shipped or transported
or is intended for shipment or
transportation in interstate or foreign
commerce.
(7) Examples. The following examples
illustrate the application of this
paragraph (k):
Example 1. X produces a qualified film and
duplicates the film onto purchased DVDs. X
sells the DVDs with the qualified film to
customers. Under paragraph (k)(2)(ii)(A) of
this section, X treats the DVD with the
qualified film as a qualified film.
Accordingly, X’s gross receipts derived from
the sale of the qualified film to customers are
DPGR (assuming all the other requirements of
this section are met).
Example 2. The facts are the same as in
Example 1 except that the film is a
nonqualified film because the film does not
satisfy the not-less-than-50-percent-of-thetotal-compensation requirement under (k)(1)
of this section and X manufactures the DVDs
in the United States. Under paragraph
(k)(2)(ii)(B) of this section, X cannot treat the
DVD as part of the nonqualified film. X’s
gross receipts (not including the gross
receipts attributable to the nonqualified film)
derived from the sale of the tangible personal
property are DPGR (assuming all the other
requirements of this section are met).
Example 3. X produces live television
programs that are qualified films. X shows
the programs on its own television station. X
sells advertising time slots to advertisers for
the television programs. Because showing a
qualified film on a television station is not
a lease, rental, license, sale, exchange, or
other disposition pursuant to paragraph
(k)(3)(ii) of this section, the advertising
income X receives from advertisers is not
derived from the lease, rental, license, sale,
exchange, or other disposition of the
qualified films and is non-DPGR.
Example 4. The facts are the same as in
Example 3 except that X also licenses the
qualified films to Y, an unrelated cable
company that broadcasts X’s qualified films.
As part of the license agreement, X can sell

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advertising time slots. Because X’s gross
receipts from Y are derived from the
licensing of qualified films pursuant to
paragraph (k)(3)(i) of this section, X’s gross
receipts derived from licensing the qualified
film are DPGR. In addition, the gross receipts
derived from the advertising income X
receives that is related to the qualified films
licensed to Y is DPGR pursuant to paragraph
(i)(5)(ii) of this section. Because showing a
qualified film on a television station is not
a lease, rental, license, sale, exchange, or
other disposition pursuant to paragraph
(k)(3)(ii) of this section, the portion of the
advertising income X derives from
advertisers for the qualified films it
broadcasts on its own television station is not
derived from the lease, rental, license, sale,
exchange, or other disposition of the
qualified films and is non-DPGR.
Example 5. X produces a qualified film and
contracts with Y, an unrelated person, to
duplicate the film onto DVDs. Y
manufactures blank DVDs within the United
States, duplicates X’s film onto the DVDs in
the United States, and sells the DVDs with
the qualified film to X who then sells them
to customers. Y has all of the benefits and
burdens of ownership under Federal income
tax principles of the DVDs during the MPGE
and duplication process. Assume Y’s
activities relating to manufacture of the blank
DVDs and duplicating the film onto the DVDs
collectively satisfy the safe harbor under
paragraph (g)(3) of this section. Y’s gross
receipts from manufacturing the DVDs and
duplicating the film onto the DVDs are DPGR
(assuming all the other requirements of this
section are met). X’s gross receipts from the
sale of the DVDs to customers are DPGR
(assuming all the other requirements of this
section are met).
Example 6. X creates a television program
in the United States that includes scenes
from films licensed by X from unrelated
persons Y and Z. Assume that Y and Z
produced the films licensed by X. The notless-than-50-percent-of-the-totalcompensation requirement under paragraph
(k)(1) of this section is determined by
reference to all compensation paid in the
production of the television program,
including the films licensed by X from Y and
Z, and is calculated using a fraction as
described in paragraph (k)(5) of this section.
The numerator of the fraction is the
compensation paid by X to actors, production
personnel, directors, and producers for
production services performed in the United
States, and the denominator is the sum of the
total compensation paid by X to such
individuals regardless of where the
production services are performed and the
total compensation paid by Y and Z to actors,
production personnel, directors, and
producers relating to the production of the
films licensed by X (regardless of where the
services are performed). However, for
purposes of calculating the denominator, in
determining the total compensation paid by
Y and Z, X need only include the total
compensation paid by Y and Z to actors,
production personnel, directors, and
producers for the production of the scenes
used by X in creating its television program.

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(l) Electricity, natural gas, or potable
water—(1) In general. DPGR include
gross receipts derived from any lease,
rental, license, sale, exchange, or other
disposition of utilities produced by the
taxpayer in the United States if all other
requirements of this section are met. In
the case of an integrated producer that
both produces and delivers utilities, see
paragraph (l)(4) of this section that
describes certain gross receipts that do
not qualify as DPGR.
(2) Natural gas. The term natural gas
includes only natural gas extracted from
a natural deposit and does not include,
for example, methane gas extracted from
a landfill. In the case of natural gas,
production activities include all
activities involved in extracting natural
gas from the ground and processing the
gas into pipeline quality gas.
(3) Potable water. The term potable
water means unbottled drinking water.
In the case of potable water, production
activities include the acquisition,
collection, and storage of raw water
(untreated water), transportation of raw
water to a water treatment facility, and
treatment of raw water at such a facility.
Gross receipts attributable to any of
these activities are included in DPGR if
all other requirements of this section are
met.
(4) Exceptions—(i) Electricity. Gross
receipts attributable to the transmission
of electricity from the generating facility
to a point of local distribution and gross
receipts attributable to the distribution
of electricity to customers are nonDPGR.
(ii) Natural gas. Gross receipts
attributable to the transmission of
pipeline quality gas from a natural gas
field (or, if treatment at a natural gas
processing plant is necessary to produce
pipeline quality gas, from a natural gas
processing plant) to a local distribution
company’s citygate (or to another
customer) are non-DPGR. Likewise,
gross receipts of a local gas distribution
company attributable to distribution
from the citygate to the local customers
are non-DPGR.
(iii) Potable water. Gross receipts
attributable to the storage of potable
water after completion of treatment of
the potable water, as well as gross
receipts attributable to the transmission
and distribution of potable water, are
non-DPGR.
(iv) De minimis exception—(A) DPGR.
Notwithstanding paragraphs (l)(4)(i),
(ii), and (iii) of this section, if less than
5 percent of a taxpayer’s gross receipts
derived from a sale, exchange, or other
disposition of utilities are attributable to
the transmission or distribution of the
utilities and the storage of portable
water after completion of treatment of

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the potable water, then the gross
receipts derived from the lease, rental,
license, sale, exchange, or other
disposition of the utilities that are
attributable to the transmission and
distribution of the utilities and the
storage of portable water after
completion of treatment of the potable
water may be treated as being DPGR
(assuming all other requirements of this
section are met). In the case of gross
receipts derived from the lease, rental,
license, sale, exchange, or other
disposition of utilities that are received
over a period of time (for example, a
multi-year lease or installment sale),
this de minimis exception is applied by
taking into account the total gross
receipts for the entire period derived
(and to be derived) from the lease,
rental, license, sale, exchange, or other
disposition of the utilities. For purposes
of the preceding sentence, if a taxpayer
treats gross receipts as DPGR under this
de minimis exception, then the taxpayer
must treat the gross receipts recognized
in each taxable year consistently as
DPGR.
(B) Non-DPGR. If less than 5 percent
of a taxpayer’s gross receipts derived
from a sale, exchange, or other
disposition of utilities are DPGR, then
the gross receipts derived from the sale,
exchange, or other disposition of the
utilities may be treated as non-DPGR. In
the case of gross receipts derived from
the lease, rental, license, sale, exchange,
or other disposition of utilities that are
received over a period of time (for
example, a multi-year lease or
installment sale), this de minimis
exception is applied by taking into
account the total gross receipts for the
entire period derived (and to be derived)
from the lease, rental, license, sale,
exchange, or other disposition of the
utilities. For purposes of the preceding
sentence, if a taxpayer treats gross
receipts as non-DPGR under this de
minimis exception, then the taxpayer
must treat the gross receipts recognized
in each taxable year consistently as nonDPGR.
(5) Example. The following example
illustrates the application of this
paragraph (l):
Example. X owns a wind turbine in the
United States that generates electricity and Y
owns a high voltage transmission line that
passes near X’s wind turbine and ends near
the system of local distribution lines of Z. X
sells the electricity produced at the wind
turbine to Z and contracts with Y to transmit
the electricity produced at the wind turbine
to Z who sells the electricity to customers
using Z’s distribution network. The gross
receipts received by X from the sale of
electricity produced at the wind turbine are
DPGR. The gross receipts of Y derived from
transporting X’s electricity to Z are non-

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DPGR under paragraph (l)(4)(i) of this
section. Likewise, the gross receipts of Z
derived from distributing the electricity are
non-DPGR under paragraph (l)(4)(i) of this
section. If X made direct sales of electricity
to customers in Z’s service area and Z
receives remuneration for the distribution of
electricity, the gross receipts of Z are nonDPGR under paragraph (l)(4)(i) of this
section. If X, Y, and Z are related persons (as
defined in paragraph (b) of this section), then
X, Y, and Z must allocate gross receipts
among the production activities (that are
DPGR), and the transmission and distribution
activities (that are non-DPGR).

(m) Definition of construction
performed in the United States—(1)
Construction of real property—(i) In
general. The term construction means
activities and services relating to the
construction or erection of real property
(as defined in paragraph (m)(3) of this
section) in the United States by a
taxpayer that, at the time the taxpayer
constructs the real property, is engaged
in a trade or business (but not
necessarily its primary, or only, trade or
business) that is considered
construction for purposes of the North
American Industry Classification
System (NAICS) on a regular and
ongoing basis. A trade or business that
is considered construction under the
NAICS means a construction activity
under the two-digit NAICS code of 23
and any other construction activity in
any other NAICS code provided the
construction activity relates to the
construction of real property such as
NAICS code 213111 (drilling oil and gas
wells) and 213112 (support activities for
oil and gas operations). For purposes of
this paragraph (m), the term
construction project means the
construction activities and services
treated as the item under paragraph
(d)(2)(iii) of this section. Tangible
personal property (for example,
appliances, furniture, and fixtures) that
is sold as part of a construction project
is not considered real property for
purposes of this paragraph (m)(1)(i). In
determining whether property is real
property, the fact that property is real
property under local law is not
controlling. Conversely, property may
be real property for purposes of this
paragraph (m)(1)(i) even though under
local law the property is considered
tangible personal property.
(ii) Regular and ongoing basis—(A) In
general. For purposes of paragraph
(m)(1)(i) of this section, a taxpayer
engaged in a construction trade or
business will be considered to be
engaged in such trade or business on a
regular and ongoing basis if the taxpayer
derives gross receipts from an unrelated
person by selling or exchanging the
constructed real property described in

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paragraph (m)(3) of this section within
60 months of the date on which
construction is complete (for example,
on the date a certificate of occupancy is
issued for the property).
(B) New trade or business. In the case
of a newly-formed trade or business or
a taxpayer in its first taxable year, the
taxpayer is considered to be engaged in
a trade or business on a regular and
ongoing basis if the taxpayer reasonably
expects that it will engage in a trade or
business on a regular and ongoing basis.
(iii) De minimis exception—(A)
DPGR. For purposes of paragraph
(m)(1)(i) of this section, if less than 5
percent of the total gross receipts
derived by a taxpayer from a
construction project (as described in
paragraph (m)(1)(i) of this section) are
derived from activities other than the
construction of real property in the
United States (for example, from nonconstruction activities or the sale of
tangible personal property or land), then
the total gross receipts derived by the
taxpayer from the project may be treated
as DPGR from construction. If a taxpayer
applies the land safe harbor under
paragraph (m)(6)(iv) of this section, for
a construction project (as described in
paragraph (m)(1)(i) of this section), then
the gross receipts excluded under the
land safe harbor are excluded in
determining total gross receipts under
this paragraph (m)(1)(iii)(A). If a
taxpayer does not apply the land safe
harbor and uses any reasonable method
(for example, an appraisal of the land)
to allocate gross receipts attributable to
the land to non-DPGR, then a taxpayer
applies this paragraph (m)(1)(iii)(A) by
excluding such gross receipts derived
from the sale, exchange, or other
disposition of the land from total gross
receipts. In the case of gross receipts
derived from construction that are
received over a period of time (for
example, an installment sale), this de
minimis exception is applied by taking
into account the total gross receipts for
the entire period derived (and to be
derived) from construction. For
purposes of the preceding sentence, if a
taxpayer treats gross receipts as DPGR
under this de minimis exception, then
the taxpayer must treat the gross
receipts recognized in each taxable year
consistently as DPGR.
(B) Non-DPGR. For purposes of
paragraph (m)(1)(i) of this section, if less
than 5 percent of the total gross receipts
derived by a taxpayer from a
construction project qualify as DPGR,
then the total gross receipts derived by
the taxpayer from the construction
project may be treated as non-DPGR. In
the case of gross receipts derived from
construction that are received over a

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31301

period of time (for example, an
installment sale), this de minimis
exception is applied by taking into
account the total gross receipts for the
entire period derived (and to be derived)
from construction. For purposes of the
preceding sentence, if a taxpayer treats
gross receipts as non-DPGR under this
de minimis exception, then the taxpayer
must treat the gross receipts recognized
in each taxable year consistently as nonDPGR.
(2) Activities constituting
construction—(i) In general.
Activities constituting construction
are activities performed in connection
with a project to erect or substantially
renovate real property, including
activities performed by a general
contractor or that constitute activities
typically performed by a general
contractor, for example, activities
relating to management and oversight of
the construction process such as
approvals, periodic inspection of the
progress of the construction project, and
required job modifications.
(ii) Tangential services. Activities
constituting construction do not include
tangential services such as hauling trash
and debris, and delivering materials,
even if the tangential services are
essential for construction. However, if
the taxpayer performing construction
also, in connection with the
construction project, provides tangential
services such as delivering materials to
the construction site and removing its
construction debris, then the gross
receipts derived from the tangential
services are DPGR.
(iii) Other construction activities.
Improvements to land that are not
capitalizable to the land (for example,
landscaping) and painting are activities
constituting construction only if these
activities are performed in connection
with other activities (whether or not by
the same taxpayer) that constitute the
erection or substantial renovation of real
property and provided the taxpayer
meets the requirements under paragraph
(m)(1) of this section. Services such as
grading, demolition (including
demolition of structures under section
280B), clearing, excavating, and any
other activities that physically transform
the land are activities constituting
construction only if these services are
performed in connection with other
activities (whether or not by the same
taxpayer) that constitute the erection or
substantial renovation of real property
and provided the taxpayer meets the
requirements under paragraph (m)(1) of
this section. A taxpayer engaged in
these activities must make a reasonable
inquiry or a reasonable determination as
to whether the activity relates to the

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erection or substantial renovation of real
property in the United States.
Construction activities also include
activities relating to drilling an oil or gas
well and mining and include any
activities the cost of which are
intangible drilling and development
costs within the meaning of § 1.612–4 or
development expenditures for a mine or
natural deposit under section 616.
(iv) Administrative support services. If
the taxpayer performing construction
activities also provides, in connection
with the construction project,
administrative support services (for
example, billing and secretarial
services) incidental and necessary to
such construction project, then these
administrative support services are
considered construction activities.
(v) Exceptions. The lease, license, or
rental of equipment, for example,
bulldozers, generators, or computers, for
use in the construction of real property
is not a construction activity under this
paragraph (m)(2). The term construction
does not include any activity that is
within the definition of engineering and
architectural services under paragraph
(n) of this section.
(3) Definition of real property. The
term real property means buildings
(including items that are structural
components of such buildings),
inherently permanent structures (as
defined in § 1.263A–8(c)(3)) other than
machinery (as defined in § 1.263A–
8(c)(4)) (including items that are
structural components of such
inherently permanent structures),
inherently permanent land
improvements, oil and gas wells, and
infrastructure (as defined in paragraph
(m)(4) of this section). For purposes of
the preceding sentence, an entire utility
plant including both the shell and the
interior will be treated as an inherently
permanent structure. Property produced
by a taxpayer that is not real property
in the hands of that taxpayer, but that
may be incorporated into real property
by another taxpayer, is not treated as
real property by the producing taxpayer
(for example, bricks, nails, paint, and
windowpanes). For purposes of this
paragraph (m)(3), structural components
of buildings and inherently permanent
structures include property such as
walls, partitions, doors, wiring,
plumbing, central air conditioning and
heating systems, pipes and ducts,
elevators and escalators, and other
similar property.
(4) Definition of infrastructure. The
term infrastructure includes roads,
power lines, water systems, railroad
spurs, communications facilities,
sewers, sidewalks, cable, and wiring.

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The term also includes inherently
permanent oil and gas platforms.
(5) Definition of substantial
renovation. The term substantial
renovation means the renovation of a
major component or substantial
structural part of real property that
materially increases the value of the
property, substantially prolongs the
useful life of the property, or adapts the
property to a new or different use.
(6) Derived from construction—(i) In
general. Assuming all the requirements
of this section are met, DPGR derived
from the construction of real property
performed in the United States includes
the proceeds from the sale, exchange, or
other disposition of real property
constructed by the taxpayer in the
United States (whether or not the
property is sold immediately after
construction is completed and whether
or not the construction project is
completed). DPGR derived from the
construction of real property includes
compensation for the performance of
construction services by the taxpayer in
the United States. DPGR derived from
the construction of real property
includes gross receipts derived from
materials and supplies consumed in the
construction project or that become part
of the constructed real property,
assuming all the requirements of this
section are met.
(ii) Qualified construction warranty.
DPGR derived from the construction of
real property includes gross receipts
from any qualified construction
warranty, that is, a warranty that is
provided in connection with the
constructed real property if, in the
normal course of the taxpayer’s
business—
(A) The price for the construction
warranty is not separately stated from
the amount charged for the constructed
real property; and
(B) The construction warranty is
neither separately offered by the
taxpayer nor separately bargained for
with customers (that is, the customer
cannot purchase the constructed real
property without the construction
warranty).
(iii) Exceptions. DPGR derived from
the construction of real property
performed in the United States does not
include gross receipts derived from the
sale, exchange, or other disposition of
real property acquired by the taxpayer
even if the taxpayer originally
constructed the property. In addition,
DPGR derived from the construction of
real property does not include gross
receipts from the lease or rental of real
property constructed by the taxpayer or,
except as provided in paragraph
(m)(2)(iii) of this section, gross receipts

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derived from the sale or other
disposition of land (including zoning,
planning, entitlement costs, and other
costs capitalized to the land).
(iv) Land safe harbor—(A) In general.
For purposes of paragraph (m)(6)(i) of
this section, a taxpayer may allocate
gross receipts between the gross receipts
derived from the sale, exchange, or
other disposition of real property
constructed by the taxpayer and the
gross receipts derived from the sale,
exchange, or other disposition of land
by reducing its costs related to DPGR
under § 1.199–4 by the costs of the land
and any other costs capitalized to the
land (collectively, land costs) (including
zoning, planning, entitlement costs, and
other costs capitalized to the land
(except costs for activities listed in
paragraph (m)(2)(iii) of this section) and
land costs in any common
improvements as defined in section 2.01
of Rev. Proc. 92–29 (1992–1 C.B. 748)
(see § 601.601(d)(2) of this chapter)) and
by reducing its DPGR by those land
costs plus a percentage. Generally, the
percentage is based on the number of
months that elapse between the date the
taxpayer acquires the land (not
including any options to acquire the
land) and ends on the date the taxpayer
sells each item of real property on the
land. However, a taxpayer will be
deemed, for purposes of this paragraph
(m)(6)(iv)(A), to acquire the land on the
date the taxpayer entered into an option
agreement to acquire the land if the
taxpayer acquired the land pursuant to
such option agreement and the purchase
price of the land under the option
agreement does not approximate the fair
market value of the land. In the case of
a sale or disposition of land between
related persons (as defined in paragraph
(b)(1) of this section) for less than fair
market value, for purposes of
determining the percentage, the
purchaser or transferee of the land must
include the months during which the
land was held by the seller or transferor.
The percentage is 5 percent for land
held not more than 60 months, 10
percent for land held more than 60
months but not more than 120 months,
and 15 percent for land held more than
120 months but not more than 180
months. Land held by a taxpayer for
more than 180 months is not eligible for
the safe harbor under this paragraph
(m)(6)(iv)(A).
(B) Determining gross receipts and
costs. In the case of a taxpayer that uses
the small business simplified overall
method of cost allocation under § 1.199–
4(f), gross receipts derived from the sale,
exchange, or other disposition of land,
and costs attributable to the land,
pursuant to the land safe harbor under

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paragraph (m)(6)(iv)(A) of this section,
are not taken into account for purposes
of computing QPAI under §§ 1.199–1
through 1.199–9 except that the gross
receipts are taken into account for
determining eligibility for that method
of cost allocation. All other taxpayers
must treat the gross receipts derived
from the sale, exchange, or other
disposition of land, pursuant to the land
safe harbor under paragraph
(m)(6)(iv)(A) of this section, as nonDPGR. In the case of a pass-thru entity,
if the pass-thru entity would be eligible
to use the small business simplified
overall method of cost allocation if the
method were applied at the pass-thru
entity level, then the gross receipts
derived from the sale, exchange, or
other disposition of land, and costs
allocated to the land, pursuant to the
land safe harbor under paragraph
(m)(6)(iv)(A) of this section, are not
taken into account by the pass-thru
entity or its owner or owners for
purposes of computing QPAI under
§§ 1.199–1 through 1.199–9. For
purposes of the preceding sentence, in
determining whether the pass-thru
entity would be eligible for the small
business simplified overall method of
cost allocation, the gross receipts
excluded pursuant to the land safe
harbor under paragraph (m)(6)(iv)(A) of
this section are taken into account for
determining eligibility for that method
of cost allocation. All other pass-thru
entities (including all trusts and estates
described in § 1.199–9(e)) must treat the
gross receipts attributable to the sale,
exchange, or other disposition of land,
pursuant to the land safe harbor under
paragraph (m)(6)(iv)(A) of this section,
as non-DPGR.
(v) Examples. The following examples
illustrate the application of this
paragraph (m)(6):
Example 1. A, who is in the trade or
business of construction under NAICS code
23 on a regular and ongoing basis, purchases
a building in the United States and retains B,
an unrelated person, to oversee a substantial
renovation of the building (within the
meaning of paragraph (m)(5) of this section).
Although not licensed as a general
contractor, B performs general contractor
level work and activities relating to
management and oversight of the
construction process such as approvals,
periodic inspection of the progress of the
construction project, and required job
modifications. B retains C (a general
contractor) to oversee day-to-day operations
and hire subcontractors. C hires D (a
subcontractor) to install a new electrical
system in the building as part of that
substantial renovation. The amounts that B
receives from A for construction services, the
amounts that C receives from B for
construction services, and the amounts that
D receives from C for construction services

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qualify as DPGR under paragraph (m)(6)(i) of
this section provided B, C, and D meet all of
the requirements of paragraph (m)(1) of this
section. The gross receipts that A receives
from the subsequent sale of the building do
not qualify as DPGR because A did not
engage in any activity constituting
construction under paragraph (m)(2) of this
section even though A is in the trade or
business of construction. The results would
be the same if A, B, C, and D were members
of the same EAG under § 1.199–7(a).
However, if A, B, C, and D were members of
the same consolidated group, see § 1.199–
7(d)(2).
Example 2. X is engaged as an electrical
contractor under NAICS code 238210 on a
regular and ongoing basis. X purchases the
wires, conduits, and other electrical materials
that it installs in construction projects in the
United States. In a particular construction
project, all of the wires, conduits, and other
electrical materials installed by X for the
operation of that building are considered
structural components of the building. X’s
gross receipts derived from installing that
property are derived from the construction of
real property under paragraph (m)(1) of this
section. In addition, pursuant to paragraph
(m)(6)(i) of this section, X’s gross receipts
derived from the purchased materials qualify
as DPGR because the wires, conduits, and
other electrical materials are consumed
during the construction of the building or
become structural components of the
building.
Example 3. X is engaged in a trade or
business on a regular and ongoing basis that
is considered construction under the twodigit NAICS code of 23. X buys unimproved
land in the United States. X gets the land
zoned for residential housing through an
entitlement process. X grades the land and
sells the land to home builders who construct
houses on the land. The gross receipts that
X derives from the sale of the land that are
attributable to the grading qualify as DPGR
under paragraphs (m)(2)(iii) and (6)(i) of this
section because those services are undertaken
in connection with a construction project in
the United States. X’s gross receipts derived
from the land including capitalized costs of
entitlements (including zoning) do not
qualify as DPGR under paragraph (m)(6)(i) of
this section because the gross receipts are not
derived from the construction of real
property.
Example 4. The facts are the same as in
Example 3 except that X constructs roads,
sewers, and sidewalks, and installs power
and water lines on the land. X conveys the
roads, sewers, sidewalks, and power and
water lines to the local government and
utilities. The gross receipts that X derives
from the sale of lots that are attributable to
grading, and the construction of the roads,
sewers, sidewalks, and power and water lines
(that qualify as infrastructure under
paragraph (m)(4) of this section) are DPGR.
X’s gross receipts derived from the land
including capitalized costs of entitlements
(including zoning) do not qualify as DPGR
under paragraph (m)(6)(i) of this section
because the gross receipts are not derived
from the construction of real property.
Example 5. (i) Facts. X, who is engaged in
the trade or business of construction under

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NAICS code 23 on a regular and ongoing
basis, constructs housing that is real property
under paragraph (m)(3) of this section. On
June 1, 2007, X pays $50,000,000 and
acquires 1,000 acres of land that X will
develop as a new housing development. In
November 2007, after the expenditure of
$10,000,000 for entitlement costs, X receives
permits to begin construction. After this
expenditure, X’s land costs total $60,000,000.
The development consists of 1,000 houses to
be built on half-acre lots over 5 years. On
January 31, 2012, the first house is sold for
$300,000. Construction costs for each house
are $170,000. Common improvements
consisting of streets, sidewalks, sewer lines,
playgrounds, clubhouses, tennis courts, and
swimming pools that X is contractually
obligated or required by law to provide cost
$55,000 per lot. The common improvements
of $55,000 per lot include $30,000 in land
costs underlying the common improvements.
(ii) Land safe harbor. Pursuant to the land
safe harbor under paragraph (m)(6)(iv) of this
section, X calculates the basis for each house
sold as $195,000 (total costs of $255,000
($170,000 in construction costs plus $55,000
in common improvements (including
$30,000 in land costs) plus $30,000 in land
costs for the lot), which are reduced by land
costs of $60,000). X calculates the DPGR for
each house sold by taking the gross receipts
of $300,000 and reducing that amount by
land costs of $60,000 plus a percentage of
$60,000. As X acquired the land on June 1,
2007, for each house sold on the land
between January 31, 2012, and June 1, 2012,
the percentage reduction for X is 5% because
X has held the land for not more than 60
months from the date of acquisition. Thus,
X’s DPGR for each house is $237,000
($300,000¥$60,000¥$3,000) with costs for
each house of $195,000 ($255,000¥$60,000).
For each house sold on the land between
June 2, 2012 and June 1, 2017, the percentage
reduction for X is 10% because X has held
the land for more than 60 months but not
more than 120 months from the date of
acquisition. Thus, of the $300,000 of gross
receipts, X’s DPGR for each house is
$234,000 ($300,000¥$60,000¥$6,000) with
costs for each house of $195,000
($255,000¥$60,000).
Example 6. The facts are the same as in
Example 5 except that on December 31, 2007,
after X received the permits to begin
construction, X sold the entitled land to Y,
an unrelated corporation, for $75,000,000. Y
is engaged in a trade or business on a regular
and ongoing basis that is considered
construction under NAICS code 23. Y
subsequently incurred the construction costs
and the costs of the common improvements,
and Y sold the houses. Because X did not
perform any construction activities, none of
X’s $75,000,000 in gross receipts derived
from Y are DPGR and none of X’s costs are
allocable to DPGR. Pursuant to the land safe
harbor under paragraph (m)(6)(iv) of this
section, Y calculates the basis for each house
sold as $195,000 (total costs of $270,000
($170,000 in construction costs plus $62,500
in common improvements (including
$37,500 in land costs) plus $37,500 in land
costs for the lot), which are reduced by land
costs of $75,000). Y calculates the DPGR for

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each house sold by taking the gross receipts
of $300,000 and reducing that amount by
land costs of $75,000 plus a percentage of
$75,000. As Y acquired the land on December
31, 2007, for the houses sold on the land
between January 31, 2012, and December 31,
2012, the percentage reduction for Y is 5%
because Y held the land for not more than
60 months from the date of acquisition. Thus,
of the $300,000 of gross receipts, the DPGR
for each house is $221,250
($300,000¥$75,000¥$3,750) with costs for
each house of $195,000. For the houses sold
on the land between January 1, 2013, and
December 31, 2017, the percentage reduction
for Y is 10% because Y held the land for
more than 60 months but not more than 120
months from the date of acquisition. Thus, of
the $300,000 of gross receipts, the DPGR for
each house is $217,500
($300,000¥$75,000¥$7,500) with costs for
each house of $195,000. The results would be
the same if X and Y were members of the
same EAG, provided X and Y were not
members of the same consolidated group.
Example 7. The facts are the same as in
Example 6 except that Y is a member of the
same consolidated group as X. Pursuant to
§ 1.1502–13(c)(1)(ii), Y’s holding period in
the land includes the period of time X held
the land. In order to produce the same effect
as if X and Y were divisions of a single
corporation (see § 1.1502–13(c)(1)(i)), for
each house sold between January 31, 2012,
and June 1, 2012, Y’s DPGR are redetermined
to be $237,000, the same as X’s DPGR for
houses sold between January 31, 2012, and
June 1, 2012, in Example 5. Y’s costs for each
house do not have to be redetermined
because Y’s costs are $195,000, the same as
the costs would be if X and Y were divisions
of a single corporation. For each house sold
between June 2, 2012, and June 1, 2017, Y’s
DPGR are redetermined to be $234,000, the
same as X’s DPGR for each house sold
between June 2, 2012, and June 1, 2017, in
Example 5. Y’s costs for each house do not
have to be redetermined because Y’s costs are
$195,000, the same as the costs would be if
X and Y were divisions of a single
corporation.
Example 8. X, who is engaged in the trade
or business of construction under NAICS
code 23 on a regular and ongoing basis,
purchases land for development and builds
an office building on the land. Y enters into
a contract with X to purchase the office
building. As part of the contract, X is
required to furnish the office space with
desks, chairs, and lamps. Upon completion of
the sale of the building, X uses the land safe
harbor under paragraph (m)(6)(iv) of this
section to account for the land. After
application of the land safe harbor, X uses
the de minimis exception under paragraph
(m)(1)(iii)(A) of this section in determining
whether the gross receipts derived from the
sale of the desks, chairs, and lamps qualify
as DPGR. If the gross receipts derived from
the sale of the desks, chairs, and lamps are
less than 5% of the total gross receipts
derived by X from the sale of the furnished
office building (excluding any gross receipts
taken into account under the land safe harbor
pursuant to paragraph (m)(6)(iv)(B) of this
section), then all of the gross receipts derived

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from the sale of the furnished office building,
after the reduction under the land safe
harbor, may be treated as DPGR.

(n) Definition of engineering and
architectural services—(1) In general.
DPGR include gross receipts derived
from engineering or architectural
services performed in the United States
for a construction project described in
paragraph (m)(1)(i) of this section. At
the time the taxpayer performs the
engineering or architectural services, the
taxpayer must be engaged in a trade or
business (but not necessarily its
primary, or only, trade or business) that
is considered engineering or
architectural services for purposes of the
NAICS, for example NAICS codes
541330 (engineering services) or 541310
(architectural services), on a regular and
ongoing basis. In the case of a newlyformed trade or business or a taxpayer
in its first taxable year, a taxpayer is
considered to be engaged in a trade or
business on a regular and ongoing basis
if the taxpayer reasonably expects that
it will engage in a trade or business on
a regular and ongoing basis. DPGR
include gross receipts derived from
engineering or architectural services,
including feasibility studies for a
construction project in the United
States, even if the planned construction
project is not undertaken or is not
completed.
(2) Engineering services. Engineering
services in connection with any
construction project include any
professional services requiring
engineering education, training, and
experience and the application of
special knowledge of the mathematical,
physical, or engineering sciences to
those professional services such as
consultation, investigation, evaluation,
planning, design, or responsible
supervision of construction (for the
purpose of assuring compliance with
plans, specifications, and design) or
erection, in connection with any
construction project.
(3) Architectural services.
Architectural services in connection
with any construction project include
the offering or furnishing of any
professional services such as
consultation, planning, aesthetic and
structural design, drawings and
specifications, or responsible
supervision of construction (for the
purpose of assuring compliance with
plans, specifications, and design) or
erection, in connection with any
construction project.
(4) Administrative support services. If
the taxpayer performing engineering or
architectural services also provides
administrative support services (for
example, billing and secretarial

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services) incidental and necessary to
such engineering or architectural
services, then these administrative
support services are considered
engineering or architectural services.
(5) Exceptions. Engineering or
architectural services do not include
post-construction services such as
annual audits and inspections.
(6) De minimis exception for
performance of services in the United
States—(i) DPGR. If less than 5 percent
of the total gross receipts derived by a
taxpayer from engineering or
architectural services performed in the
United States for a construction project
(described in paragraph (m)(1)(i) of this
section) are derived from services not
relating to a construction project (for
example, the services are performed
outside the United States or in
connection with property other than
real property), then the total gross
receipts derived by the taxpayer may be
treated as DPGR from engineering or
architectural services performed in the
United States for the construction
project. In the case of gross receipts
derived from engineering or
architectural services that are received
over a period of time (for example, an
installment sale), this de minimis
exception is applied by taking into
account the total gross receipts for the
entire period derived (and to be derived)
from engineering or architectural
services. For purposes of the preceding
sentence, if a taxpayer treats gross
receipts as DPGR under this de minimis
exception, then the taxpayer must treat
the gross receipts recognized in each
taxable year consistently as DPGR.
(ii) Non-DPGR. If less than 5 percent
of the total gross receipts derived by a
taxpayer from engineering or
architectural services performed in the
United States for a construction project
qualify as DPGR, then the total gross
receipts derived by the taxpayer from
engineering or architectural services
performed in the United States for the
construction project may be treated as
non-DPGR. In the case of gross receipts
derived from engineering or
architectural services that are received
over a period of time (for example, an
installment sale), this de minimis
exception is applied by taking into
account the total gross receipts for the
entire period derived (and to be derived)
from engineering or architectural
services. For purposes of the preceding
sentence, if a taxpayer treats gross
receipts as non-DPGR under this de
minimis exception, then the taxpayer
must treat the gross receipts recognized
in each taxable year consistently as nonDPGR.

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(7) Example. The following example
illustrates the application of this
paragraph (n):

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Example. X is engaged in the trade or
business of providing engineering services
under NAICS code 541330 on a regular and
ongoing basis. Y buys unimproved land. Y
hires X to provide engineering services for
roads, sewers, sidewalks, and power and
water lines that qualify as infrastructure
under paragraph (m)(4) of this section and
that will be constructed on Y’s land. X’s gross
receipts from engineering services for the
infrastructure are DPGR. X’s gross receipts
from engineering services relating to land
(except as provided in paragraph (m)(2)(iii) of
this section) do not qualify as DPGR under
paragraph (n)(1) of this section because the
gross receipts are not derived from
engineering services for a construction
project described in paragraph (m)(1)(i) of
this section.

(o) Sales of certain food and
beverages—(1) In general. DPGR does
not include gross receipts of the
taxpayer that are derived from the sale
of food or beverages prepared by the
taxpayer at a retail establishment. A
retail establishment is defined as
tangible property (both real and
personal) owned, leased, occupied, or
otherwise used by the taxpayer in its
trade or business of selling food or
beverages to the public at which retail
sales are made. In addition, a facility
that prepares food and beverages for
take out service or delivery is a retail
establishment (for example, a caterer). If
a taxpayer’s facility is a retail
establishment, then, for purposes of this
section, the taxpayer may allocate its
gross receipts between the gross receipts
derived from the retail sale of the food
and beverages prepared and sold at the
retail establishment (that are non-DPGR)
and gross receipts derived from the
wholesale sale of the food and beverages
prepared and sold at the retail
establishment (that are DPGR assuming
all the other requirements of section 199
are met). Wholesale sales are defined as
food and beverages held for resale by
the purchaser. The exception for sales of
certain food and beverages also applies
to food and beverages for non-human
consumption. A retail establishment
does not include the bonded premises of
a distilled spirits plant or wine cellar, or
the premises of a brewery (other than a
tavern on the brewery premises). See
Chapter 51 of Title 26 of the United
States Code and the implementing
regulations thereunder.
(2) De minimis exception. A taxpayer
may treat a facility at which food or
beverages are prepared as not being a
retail establishment if less than 5
percent of the gross receipts derived
from the sale of food or beverages at that

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facility during the taxable year are
attributable to retail sales.
(3) Examples. The following examples
illustrate the application of this
paragraph (o):
Example 1. X buys coffee beans and roasts
those beans at a facility in the United States,
the only activity of which is the roasting and
packaging of coffee beans. X sells the roasted
coffee beans through a variety of unrelated
third-party vendors and also sells roasted
coffee beans at X’s retail establishments. At
X’s retail establishments, X prepares brewed
coffee and other foods. To the extent that the
gross receipts of X’s retail establishments are
derived from the sale of coffee beans roasted
at the facility, the receipts are DPGR
(assuming all the other requirements of this
section are met). To the extent the gross
receipts of X’s retail establishments are
derived from the retail sale of brewed coffee
or food prepared at the retail establishments,
the receipts are non-DPGR. However,
pursuant to § 1.199–1(d)(1)(ii), X must
allocate part of the receipts from the retail
sale of the brewed coffee as DPGR to the
extent of the value of the coffee beans that
were roasted at the facility and that were
used to brew coffee.
Example 2. Y operates a bonded winery
within the United States. Bottles of wine
produced by Y at the bonded winery are sold
to consumers at the taxpaid premises.
Pursuant to paragraph (o)(1) of this section,
the bonded premises is not considered a
retail establishment and is treated as separate
and apart from the taxpaid premises, which
is considered a retail establishment for
purposes of paragraph (o)(1) of this section.
Accordingly, the wine produced by Y in the
bonded premises and sold by Y from the
taxpaid premises is not considered to have
been produced at a retail establishment, and
the gross receipts derived from the sales of
the wine are DPGR (assuming all the other
requirements of this section are met).

(p) Guaranteed payments. DPGR does
not include guaranteed payments under
section 707(c). Thus, partners, including
partners in partnerships described in
§ 1.199–9(i) and (j), may not treat
guaranteed payments as DPGR. See
§ 1.199–9(b)(6) Example 5.
§ 1.199–4 Costs allocable to domestic
production gross receipts.

(a) In general. The provisions of this
section apply solely for purposes of
section 199 of the Internal Revenue
Code (Code). To determine its qualified
production activities income (QPAI) (as
defined in § 1.199–1(c)) for a taxable
year, a taxpayer must subtract from its
domestic production gross receipts
(DPGR) (as defined in § 1.199–3(a)) the
cost of goods sold (CGS) allocable to
DPGR and other expenses, losses, or
deductions (deductions), other than the
deduction allowed under section 199,
that are properly allocable to such
receipts. Paragraph (b) of this section
provides rules for determining CGS

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31305

allocable to DPGR. Paragraph (c) of this
section provides rules for determining
the deductions that are properly
allocable to DPGR. Paragraph (d) of this
section provides that a taxpayer
generally must determine deductions
allocable to DPGR or to gross income
attributable to DPGR using §§ 1.861–8
through 1.861–17 and §§ 1.861–8T
through 1.861–14T (the section 861
regulations), subject to the rules in
paragraph (d) of this section (the section
861 method). Paragraph (e) of this
section provides that certain taxpayers
may apportion deductions to DPGR
using the simplified deduction method.
Paragraph (f) of this section provides a
small business simplified overall
method that a qualifying small taxpayer
may use to apportion CGS and
deductions to DPGR.
(b) Cost of goods sold allocable to
domestic production gross receipts—(1)
In general. When determining its QPAI,
a taxpayer must subtract from DPGR the
CGS allocable to DPGR. A taxpayer
determines its CGS allocable to DPGR in
accordance with this paragraph (b) or, if
applicable, paragraph (f) of this section.
In the case of a sale, exchange, or other
disposition of inventory, CGS is equal to
beginning inventory plus purchases and
production costs incurred during the
taxable year and included in inventory
costs, less ending inventory. CGS is
determined under the methods of
accounting that the taxpayer uses to
compute taxable income. See sections
263A, 471, and 472. If section 263A
requires a taxpayer to include additional
section 263A costs (as defined in
§ 1.263A–1(d)(3)) in inventory,
additional section 263A costs must be
included in determining CGS. CGS
allocable to DPGR also includes
inventory valuation adjustments such as
writedowns under the lower of cost or
market method. In the case of a sale,
exchange, or other disposition
(including, for example, theft, casualty,
or abandonment) of non-inventory
property, CGS for purposes of this
section includes the adjusted basis of
the property. CGS allocable to DPGR for
a taxable year may include the
inventory cost and adjusted basis of
qualifying production property (QPP)
(as defined in § 1.199–3(j)(1)), a
qualified film (as defined in § 1.199–
3(k)(1)), or electricity, natural gas, and
potable water (as defined in § 1.199–
3(l)) (collectively, utilities) that will
generate (or have generated) DPGR
notwithstanding that the gross receipts
attributable to the sale, lease, rental,
license, exchange, or other disposition
of the QPP, qualified film, or utilities
will be, or have been, included in the

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computation of gross income for a
different taxable year. For example,
advance payments that are DPGR may
be included in gross income under
§ 1.451–5(b)(1)(i) in a different taxable
year than the related CGS allocable to
that DPGR. If gross receipts are treated
as DPGR pursuant to § 1.199–1(d)(3)(i)
or § 1.199–3(i)(4)(i)(B)(6), (l)(4)(iv)(A),
(m)(1)(iii)(A), (n)(6)(i), or (o)(2), then
CGS must be allocated to such DPGR.
Similarly, if gross receipts are treated as
non-DPGR pursuant to § 1.199–
1(d)(3)(ii) or § 1.199–3(i)(4)(ii),
(l)(4)(iv)(B), (m)(1)(iii)(B), or (n)(6)(ii),
then CGS must be allocated to such nonDPGR. See § 1.199–3(m)(6)(iv) for rules
relating to treatment of certain costs in
the case of a taxpayer that uses the land
safe harbor under that paragraph.
(2) Allocating cost of goods sold—(i)
In general. A taxpayer must use a
reasonable method that is satisfactory to
the Secretary based on all of the facts
and circumstances to allocate CGS
between DPGR and non-DPGR. Whether
an allocation method is reasonable is
based on all of the facts and
circumstances including whether the
taxpayer uses the most accurate
information available; the relationship
between CGS and the method used; the
accuracy of the method chosen as
compared with other possible methods;
whether the method is used by the
taxpayer for internal management or
other business purposes; whether the
method is used for other Federal or state
income tax purposes; the availability of
costing information; the time, burden,
and cost of using alternative methods;
and whether the taxpayer applies the
method consistently from year to year.
Depending on the facts and
circumstances, reasonable methods may
include methods based on gross
receipts, number of units sold, number
of units produced, or total production
costs. Ordinarily, if a taxpayer uses a
method to allocate gross receipts
between DPGR and non-DPGR, then the
use of a different method to allocate
CGS that is not demonstrably more
accurate than the method used to
allocate gross receipts will not be
considered reasonable. However, if a
taxpayer has information readily
available to specifically identify CGS
allocable to DPGR and can specifically
identify that amount without undue
burden or expense, CGS allocable to
DPGR is that amount irrespective of
whether the taxpayer uses another
allocation method to allocate gross
receipts between DPGR and non-DPGR.
A taxpayer that does not have
information readily available to
specifically identify CGS allocable to

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DPGR and that cannot, without undue
burden or expense, specifically identify
that amount is not required to use a
method that specifically identifies CGS
allocable to DPGR.
(ii) Gross receipts recognized in an
earlier taxable year. If a taxpayer (other
than a taxpayer that uses the small
business simplified overall method of
paragraph (f) of this section) recognizes
and reports gross receipts on a Federal
income tax return for a taxable year, and
incurs CGS related to such gross
receipts in a subsequent taxable year,
then regardless of whether the gross
receipts ultimately qualify as DPGR, the
taxpayer must allocate the CGS to—
(A) DPGR if the taxpayer identified
the related gross receipts as DPGR in the
prior taxable year; or
(B) Non-DPGR if the taxpayer
identified the related gross receipts as
non-DPGR in the prior taxable year or if
the taxpayer recognized under the
taxpayer’s methods of accounting those
gross receipts in a taxable year to which
section 199 does not apply.
(3) Special rules for imported items or
services. The cost of any item or service
brought into the United States (as
defined in § 1.199–3(h)) without an
arm’s length transfer price may not be
treated as less than its value
immediately after it entered the United
States for purposes of determining the
CGS to be used in the computation of
QPAI. Similarly, the adjusted basis of
leased or rented property that gives rise
to DPGR that has been brought into the
United States (as defined in § 1.199–
3(h)) without an arm’s length transfer
price may not be treated as less than its
value immediately after it entered the
United States. When an item or service
is imported into the United States that
had been exported by the taxpayer for
further manufacture, the increase in cost
may not exceed the difference between
the value of the property when exported
and the value of the property when
imported back into the United States
after further manufacture. For this
purpose, the value of property is its
customs value as defined in section
1059A(b)(1).
(4) Rules for inventories valued at
market or bona fide selling prices. If part
of CGS is attributable to inventory
valuation adjustments, then CGS
allocable to DPGR includes inventory
adjustments to QPP that is MPGE in
whole or in significant part within the
United States, a qualified film produced
by the taxpayer, or utilities produced by
the taxpayer in the United States.
Accordingly, taxpayers that value
inventory under § 1.471–4 (inventories
at cost or market, whichever is lower) or
§ 1.471–2(c) (subnormal goods at bona

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fide selling prices) must allocate a
proper share of such adjustments (for
example, writedowns) to DPGR based
on a reasonable method that is
satisfactory to the Secretary based on all
of the facts and circumstances. Factors
taken into account in determining
whether the method is reasonable
include whether the taxpayer uses the
most accurate information available; the
relationship between the adjustment
and the allocation base chosen; the
accuracy of the method chosen as
compared with other possible methods;
whether the method is used by the
taxpayer for internal management or
other business purposes; whether the
method is used for other Federal or state
income tax purposes; the time, burden,
and cost of using alternative methods;
and whether the taxpayer applies the
method consistently from year to year.
If a taxpayer has information readily
available to specifically identify the
proper amount of inventory valuation
adjustments allocable to DPGR, then the
taxpayer must allocate that amount to
DPGR. A taxpayer that does not have
information readily available to
specifically identify the proper amount
of inventory valuation adjustments
allocable to DPGR and that cannot,
without undue burden or expense,
specifically identify the proper amount
of inventory valuation adjustments
allocable to DPGR, is not required to use
a method that specifically identifies
inventory valuations adjustments to
DPGR.
(5) Rules applicable to inventories
accounted for under the last-in, first-out
(LIFO) inventory method—(i) In general.
This paragraph applies to inventories
accounted for using the specific goods
last-in, first-out (LIFO) method or the
dollar-value LIFO method. Whenever a
specific goods grouping or a dollarvalue pool contains QPP, qualified
films, or utilities that produces DPGR
and goods that do not, the taxpayer
must allocate CGS attributable to that
grouping or pool between DPGR and
non-DPGR using a reasonable method
that is satisfactory to the Secretary based
on all of the facts and circumstances.
Whether a method of allocating CGS
between DPGR and non-DPGR is
reasonable must be determined in
accordance with paragraph (b)(2) of this
section. In addition, this paragraph
(b)(5) provides methods that a taxpayer
may use to allocate CGS for inventories
accounted for using the LIFO method. If
a taxpayer uses the LIFO/FIFO ratio
method provided in paragraph (b)(5)(ii)
of this section or the change in relative
base-year cost method provided in
paragraph (b)(5)(iii) of this section, then

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the taxpayer must use that method for
all inventory accounted for under the
LIFO method.
(ii) LIFO/FIFO ratio method. A
taxpayer using the specific goods LIFO
method or the dollar-value LIFO method
may use the LIFO/FIFO ratio method.
The LIFO/FIFO ratio method is applied
with respect to all LIFO inventory of a
taxpayer on a grouping-by-grouping or
pool-by-pool basis. Under the LIFO/
FIFO ratio method, a taxpayer computes
the CGS of a grouping or pool allocable
to DPGR by multiplying the CGS of
QPP, qualified films, or utilities in the
grouping or pool that produced DPGR
computed using the first-in, first-out
(FIFO) method by the LIFO/FIFO ratio
of the grouping or pool. The LIFO/FIFO
ratio of a grouping or pool is equal to
the total CGS of the grouping or pool
computed using the LIFO method over
the total CGS of the grouping or pool
computed using the FIFO method.
(iii) Change in relative base-year cost
method. A taxpayer using the dollarvalue LIFO method may use the change
in relative base-year cost method. The
change in relative base-year cost method
is applied with respect to all LIFO
inventory of a taxpayer on a pool-bypool basis. The change in relative baseyear cost method determines the CGS
allocable to DPGR by increasing or
decreasing the total production costs
(section 471 costs and additional section
263A costs) of QPP, a qualified film, or
utilities that generate DPGR by a portion
of any increment or liquidation of the
dollar-value pool. The portion of an
increment or liquidation allocable to
DPGR is determined by multiplying the
LIFO value of the increment or
liquidation (expressed as a positive
number) by the ratio of the change in
total base-year cost (expressed as a
positive number) of the QPP, qualified
film, or utilities that will generate DPGR
in ending inventory to the change in
total base-year cost (expressed as a

positive number) of all goods in the
ending inventory. The portion of an
increment or liquidation allocable to
DPGR may be zero but cannot exceed
the amount of the increment or
liquidation. Thus, a ratio in excess of
1.0 must be treated as 1.0.
(6) Taxpayers using the simplified
production method or simplified resale
method for additional section 263A
costs. A taxpayer that uses the
simplified production method or
simplified resale method to allocate
additional section 263A costs, as
defined in § 1.263A–1(d)(3), to ending
inventory must follow the rules in
paragraph (b)(2) of this section to
determine the amount of additional
section 263A costs allocable to DPGR.
Allocable additional section 263A costs
include additional section 263A costs
included in beginning inventory as well
as additional section 263A costs
incurred during the taxable year.
Ordinarily, if a taxpayer uses the
simplified production method or the
simplified resale method, the additional
section 263A costs should be allocated
in the same proportion as section 471
costs are allocated.
(7) Examples. The following examples
illustrate the application of this
paragraph (b) and assume that the
taxpayer does not use the small business
simplified overall method provided in
paragraph (f) of this section:
Example 1. Advance payments. T, a
calendar year taxpayer, is a manufacturer of
furniture in the United States. Under its
method of accounting, T includes advance
payments and other gross receipts derived
from the sale of furniture in gross income
when the payments are received. In
December 2007, T receives an advance
payment of $5,000 from X with respect to an
order of furniture to be manufactured for a
total price of $20,000. In 2008, T produces
and sells the furniture to X. In 2008, T incurs
$14,000 of section 471 and additional section
263A costs to produce the furniture ordered
by X. T receives the remaining $15,000 of the

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Item

31307

contract price from X in 2008. Assuming that
in 2007, T can reasonably determine that all
the requirements of §§ 1.199–1 and 1.199–3
will be met with respect to the furniture, the
advance payment qualifies as DPGR in 2007.
Assuming further that all the requirements of
§§ 1.199–1 and 1.199–3 are met with respect
to the furniture in 2008, the remaining
$15,000 of the contract price must be
included in income and DPGR when received
by T in 2008. T must include the $14,000 it
incurred to produce the furniture in CGS and
CGS allocable to DPGR in 2008. See § 1.199–
4(b)(2)(ii) for rules regarding gross receipts
and costs recognized in different taxable
years.
Example 2. Use of standard cost method.
X, a calendar year taxpayer, manufactures
item A in a factory located in the United
States and item B in a factory located in
Country Y. Item A is produced by X within
the United States and the sale of A generates
DPGR. X uses the FIFO inventory method to
account for its inventory and determines the
cost of item A using a standard cost method.
At the beginning of its 2007 taxable year, X’s
inventory contains 2,000 units of item A at
a standard cost of $5 per unit. X did not incur
significant cost variances in previous taxable
years. During the 2007 taxable year, X
produces 8,000 units of item A at a standard
cost of $6 per unit. X determines that with
regard to its production of item A it has
incurred a significant cost variance. When X
reallocates the cost variance to the units of
item A that it has produced, the production
cost of item A is $7 per unit. X sells 7,000
units of item A during the taxable year. X can
identify from its books and records that CGS
related to the sales of item A during the
taxable year are $45,000 ((2,000 × $5) +
(5,000 × $7)). Accordingly, X has CGS
allocable to DPGR of $45,000.
Example 3. Change in relative base-year
cost method. (i) Y elects, beginning with the
calendar year 2007, to compute its
inventories using the dollar-value, LIFO
method under section 472. Y establishes a
pool for items A and B. Y produces item A
within the United States and the sales of item
A generate DPGR. Y does not produce item
B within the United States and the sale of
item B does not generate DPGR. The
composition of the inventory for the pool at
the base date, January 1, 2007, is as follows:
Unit

Unit cost

Total cost

A ...................................................................................................................................................
B ...................................................................................................................................................

2,000
1,250

$5.00
4.00

$10,000
5,000

Total ......................................................................................................................................

........................

........................

15,000

(ii) Y uses a standard cost method to
allocate all direct and indirect costs
(section 471 and additional section
263A costs) to the units of item A and
item B that it produces. During 2007, Y
incurs $52,500 of section 471 costs and

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additional section 263A costs to
produce 10,000 units of item A and
$114,000 of section 471 costs and
additional section 263A costs to
produce 20,000 units of item B.

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(iii) The closing inventory of the pool
at December 31, 2007, contains 3,000
units of item A and 2,500 units of item
B. The closing inventory of the pool at
December 31, 2007, shown at base-year
and current-year cost is as follows:

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Item

Quantity

Base-year cost

Current-year
cost

Amount

A ...........................................................................................
B ...........................................................................................

3,000
2,500

$5.00
4.00

$15,000
10,000

$5.25
5.70

$15,750
14,250

Totals ............................................................................

........................

........................

25,000

........................

30,000

(iv) The base-year cost of the closing
LIFO inventory at December 31, 2007,
amounts to $25,000, and exceeds the
$15,000 base-year cost of the opening
inventory for the taxable year by
$10,000 (the increment stated at baseyear cost). The increment valued at
current-year cost is computed by
multiplying the increment stated at

base-year cost by the ratio of the
current-year cost of the pool to total
base-year cost of the pool (that is,
$30,000/$25,000, or 120%). The
increment stated at current-year cost is
$12,000 ($10,000 × 120%).
(v) The change in relative base-year
cost of item A is $5,000
($15,000¥$10,000). The change in

relative base-year cost (the increment
stated at base-year cost) of the total
inventory is $10,000
($25,000¥$15,000). The ratio of the
change in base-year cost of item A to the
change in base-year cost of the total
inventory is 50% ($5,000/$10,000).
(vi) CGS allocable to DPGR is $46,500,
computed as follows:

Current-year production costs related to DPGR ...................................................................................................
Less:
Increment stated at current-year cost ............................................................................................................
Ratio ...............................................................................................................................................................
Total ................................................................................................................................................................

........................
$12,000
50%
........................

(6,000)

Total .........................................................................................................................................................

........................

46,500

Example 4. Change in relative base-year
cost method. (i) The facts are the same as in
Example 3 except that, during the calendar
year 2008, Y experiences an inventory
decrement. During 2008, Y incurs $66,000 of
section 471 costs and additional section

263A costs to produce 12,000 units of item
A and $150,000 of section 471 costs and
additional section 263A costs to produce
25,000 units of item B.
(ii) The closing inventory of the pool at
December 31, 2008, contains 2,000 units of

Item

Quantity

Base-year cost

$52,500

item A and 2,500 units of item B. The closing
inventory of the pool at December 31, 2008,
shown at base-year and current-year cost is
as follows:

Amount

Current-year
cost

Amount

A ...........................................................................................
B ...........................................................................................

2,000
2,500

$5.00
4.00

$10,000
10,000

$5.50
6.00

$11,000
15,000

Totals ............................................................................

........................

........................

20,000

........................

26,000

(iii) The base-year cost of the closing
LIFO inventory at December 31, 2008,
amounts to $20,000, and is less than the
$25,000 base-year cost of the opening

inventory for that taxable year by $5,000
(the decrement stated at base-year cost).
This liquidation is reflected by reducing
the most recent layer of increment. The

LIFO value of the inventory at December
31, 2008 is:

Base cost

Index

LIFO value

January 1, 2008, base cost .........................................................................................................
December 31, 2008, increment ...................................................................................................

$15,000
5,000

1.00
1.20

$15,000
6,000

Total ......................................................................................................................................

........................

........................

21,000

(iv) The change in relative base-year
cost of item A is $5,000
($15,000¥$10,000). The change in
relative base-year cost of the total

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Amount

inventory is $5,000 ($25,000¥$20,000).
The ratio of the change in base-year cost
of item A to the change in base-year cost

of the total inventory is 100% ($5,000/
$5,000).
(v) CGS allocable to DPGR is $72,000,
computed as follows:

Current-year production costs related to DPGR .....................................................................................................
Plus:
LIFO value of decrement ..................................................................................................................................
Ratio .................................................................................................................................................................
Total ..................................................................................................................................................................

........................

$66,000

$6,000
100%
........................

6,000

Total ...........................................................................................................................................................

........................

72,000

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Example 5. LIFO/FIFO ratio method. (i)
The facts are the same as in Example 3
except that Y uses the LIFO/FIFO ratio
method to determine its CGS allocable to
DPGR.
(ii) Y’s CGS related to item A on a FIFO
basis is $46,750 ((2,000 units at $5) + (7,000
units at $5.25)).
(iii) Y’s total CGS computed on a LIFO
basis is $154,500 (beginning inventory of
$15,000 plus total production costs of
$166,500 less ending inventory of $27,000).
(iv) Y’s total CGS computed on a FIFO
basis is $151,500 (beginning inventory of
$15,000 plus total production costs of
$166,500 less ending inventory of $30,000).
(v) The ratio of Y’s CGS computed using
the LIFO method to its CGS computed using
the FIFO method is 102% ($154,500/
$151,500). Y’s CGS related to DPGR
computed using the LIFO/FIFO ratio method
is $47,685 ($46,750 × 102%).
Example 6. LIFO/FIFO ratio method. (i)
The facts are the same as in Example 4
except that Y uses the LIFO/FIFO ratio
method to compute CGS allocable to DPGR.
(ii) Y’s CGS related to item A on a FIFO
basis is $70,750 ((3,000 units at $5.25) +
(10,000 units at $5.50)).
(iii) Y’s total CGS computed on a LIFO
basis is $222,000 (beginning inventory of
$27,000 plus total production costs of
$216,000 less ending inventory of $21,000).
(iv) Y’s total CGS computed on a FIFO
basis is $220,000 (beginning inventory of
$30,000 plus total production costs of
$216,000 less ending inventory of $26,000).
(v) The ratio of Y’s CGS computed using
the LIFO method to its CGS computed using
the FIFO method is 101% ($222,000/
$220,000). Y’s CGS related to DPGR
computed using the LIFO/FIFO ratio method
is $71,457 ($70,750 × 101%).

(c) Other deductions properly
allocable to domestic production gross
receipts or gross income attributable to
domestic production gross receipts—(1)
In general. In determining its QPAI, a
taxpayer must subtract from its DPGR,
in addition to its CGS allocable to
DPGR, the deductions that are properly
allocable to DPGR. A taxpayer generally
must allocate and apportion these
deductions using the rules of the section
861 method. In lieu of the section 861
method, certain taxpayers may
apportion these deductions using the
simplified deduction method provided
in paragraph (e) of this section.
Paragraph (f) of this section provides a
small business simplified overall
method that may be used by a qualifying
small taxpayer, as defined in that
paragraph. A taxpayer using the
simplified deduction method or the
small business simplified overall
method must use that method for all
deductions. A taxpayer eligible to use
the small business simplified overall
method may choose at any time for any
taxable year to use the small business
simplified overall method, the
simplified deduction method, or the

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section 861 method for a taxable year.
A taxpayer eligible to use the simplified
deduction method may choose at any
time for any taxable year to use the
simplified deduction method or the
section 861 method for a taxable year.
(2) Treatment of net operating losses.
A deduction under section 172 for a net
operating loss is not allocated or
apportioned to DPGR or gross income
attributable to DPGR.
(3) W–2 wages. Although only W–2
wages as described in § 1.199–2 are
taken into account in computing the W–
2 wage limitation, all wages paid (or
incurred in the case of an accrual
method taxpayer) in a taxpayer’s trade
or business during the taxable year are
taken into account in computing QPAI
for that taxable year.
(d) Section 861 method—(1) In
general. Under the section 861 method,
a taxpayer must allocate and apportion
its deductions using the allocation and
apportionment rules provided under the
section 861 regulations under which
section 199 is treated as an operative
section described in § 1.861–8(f).
Accordingly, the taxpayer applies the
rules of the section 861 regulations to
allocate and apportion deductions
(including, if applicable, its distributive
share of deductions from pass-thru
entities) to gross income attributable to
DPGR. Gross receipts that are allocable
to land under the safe harbor provided
in § 1.199–3(m)(6)(iv) are treated as nonDPGR. See § 1.199–3(m)(6)(iv)(B). If the
taxpayer applies the allocation and
apportionment rules of the section 861
regulations for section 199 and another
operative section, then the taxpayer
must use the same method of allocation
and the same principles of
apportionment for purposes of all
operative sections (subject to the rules
provided in paragraphs (c)(2) and (d)(2)
and (3) of this section). See § 1.861–
8(f)(2)(i).
(2) Deductions for charitable
contributions. Deductions for charitable
contributions (as allowed under section
170 and section 873(b)(2) or
882(c)(1)(B)) must be ratably
apportioned between gross income
attributable to DPGR and gross income
attributable to non-DPGR based on the
relative amounts of gross income.
(3) Research and experimental
expenditures. Research and
experimental expenditures must be
allocated and apportioned in
accordance with § 1.861–17 without
taking into account the exclusive
apportionment rule of § 1.861–17(b).
(4) Deductions allocated or
apportioned to gross receipts treated as
domestic production gross receipts. If
gross receipts are treated as DPGR

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pursuant to § 1.199–1(d)(3)(i) or § 1.199–
3(i)(4)(i)(B)(6), (l)(4)(iv)(A),
(m)(1)(iii)(A), (n)(6)(i), or (o)(2), then
deductions must be allocated or
apportioned to the gross income
attributable to such DPGR. Similarly, if
gross receipts are treated as non-DPGR
pursuant to § 1.199–1(d)(3)(ii) or
§ 1.199–3(i)(4)(ii), (l)(4)(iv)(B),
(m)(1)(iii)(B), or (n)(6)(ii), then
deductions must be allocated or
apportioned to the gross income
attributable to such non-DPGR.
(5) Treatment of items from a passthru entity reporting qualified
production activities income. If,
pursuant to § 1.199–9(e)(2) or to the
authority granted in § 1.199–9(b)(1)(ii)
or (c)(1)(ii), a taxpayer must combine
QPAI and W–2 wages from a
partnership, S corporation, trust (to the
extent not described in § 1.199–9(d)) or
estate with the taxpayer’s total QPAI
and W–2 wages from other sources, then
for purposes of apportioning the
taxpayer’s interest expense under this
paragraph § 1.199–4(d), the taxpayer’s
interest in such partnership (and, where
relevant in apportioning the taxpayer’s
interest expense, the partnership’s
assets), the taxpayer’s shares in such S
corporation, or the taxpayer’s interest in
such trust shall be disregarded.
(6) Examples. The following examples
illustrate the operation of the section
861 method. Assume in the following
examples that all corporations are
calendar year taxpayers, that all
taxpayers have sufficient W–2 wages as
defined in § 1.199–2(e) so that the
section 199 deduction is not limited
under section 199(b)(1), and that, with
respect to the allocation and
apportionment of interest expense,
§ 1.861–10T does not apply.
Example 1. Section 861 method and no
EAG. (i) Facts. X, a United States corporation
that is not a member of an expanded
affiliated group (EAG) (as defined in § 1.199–
7), engages in activities that generate both
DPGR and non-DPGR. All of X’s production
activities that generate DPGR are within
Standard Industrial Classification (SIC)
Industry Group AAA (SIC AAA). All of X’s
production activities that generate non-DPGR
are within SIC Industry Group BBB (SIC
BBB). X is able to identify from its books and
records CGS allocable to DPGR and to nonDPGR. X incurs $900 of research and
experimentation expenses (R&E) that are
deductible under section 174, $300 of which
are performed with respect to SIC AAA and
$600 of which are performed with respect to
SIC BBB. None of the R&E is legally
mandated R&E as described in § 1.861–
17(a)(4) and none of the R&E is included in
CGS. X incurs section 162 selling expenses
that are not includible in CGS and not
properly allocable to any gross income. For
2010, the adjusted basis of X’s assets is
$5,000, $4,000 of which generates gross

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income attributable to DPGR and $1,000 of
which generates gross income attributable to
non-DPGR. For 2010, X’s taxable income is

$1,380 based on the following Federal
income tax items:

DPGR (all from sales of products within SIC AAA) ..........................................................................................................................
Non-DPGR (all from sales of products within SIC BBB) ..................................................................................................................
CGS allocable to DPGR ....................................................................................................................................................................
CGS allocable to non-DPGR .............................................................................................................................................................
Section 162 selling expenses ............................................................................................................................................................
Section 174 R&E–SIC AAA ...............................................................................................................................................................
Section 174 R&E–SIC BBB ...............................................................................................................................................................
Interest expense (not included in CGS) ............................................................................................................................................
Charitable contributions .....................................................................................................................................................................

$3,000
3,000
(600)
(1,800)
(840)
(300)
(600)
(300)
(180)

X’s taxable income ............................................................................................................................................................................

1,380

(ii) X’s QPAI. X allocates and apportions its
deductions to gross income attributable to
DPGR under the section 861 method of this
paragraph (d). In this case, the section 162
selling expenses are definitely related to all
of X’s gross income. Based on the facts and

circumstances of this specific case,
apportionment of those expenses between
DPGR and non-DPGR on the basis of X’s
gross receipts is appropriate. For purposes of
apportioning R&E, X elects to use the sales
method as described in § 1.861–17(c). X

elects to apportion interest expense under the
tax book value method of § 1.861–9T(g). X
has $2,400 of gross income attributable to
DPGR (DPGR of $3,000—CGS of $600
allocated based on X’s books and records).
X’s QPAI for 2010 is $1,320, as shown below:

DPGR (all from sales of products within SIC AAA) ..........................................................................................................................
CGS allocable to DPGR ....................................................................................................................................................................
Section 162 selling expenses ($840 × ($3,000 DPGR/$6,000 total gross receipts)) .......................................................................
Interest expense (not included in CGS) ($300 × ($4,000 (X’s DPGR assets)/ $5,000 (X’s total assets))) .....................................
Charitable contributions (not included in CGS) ($180 × ($2,400 gross income attributable to DPGR/$3,600 total gross income))
Section 174 R&E–SIC AAA ...............................................................................................................................................................
X’s QPAI .....................................................................................................................................................................................

(iii) Section 199 deduction determination.
X’s tentative deduction under § 1.199–1(a) is
$119 (.09 × (lesser of QPAI of $1,320 and
taxable income of $1,380)). Because the facts
of this example assume that X’s W–2 wages
as defined in § 1.199–2(e) are sufficient to
avoid a limitation on the section 199
deduction, X’s section 199 deduction for
2010 is $119.
Example 2. Section 861 method and EAG.
(i) Facts. The facts are the same as in
Example 1 except that X owns stock in Y, a
United States corporation, equal to 75% of
the total voting power of stock of Y and 80%

of the total value of stock of Y. X and Y are
not members of an affiliated group as defined
in section 1504(a). Accordingly, the rules of
§ 1.861–14T do not apply to X’s and Y’s
selling expenses, R&E, and charitable
contributions. X and Y are, however,
members of an affiliated group for purposes
of allocating and apportioning interest
expense (see § 1.861–11T(d)(6)) and are also
members of an EAG. For 2010, the adjusted
basis of Y’s assets is $45,000, $21,000 of
which generates gross income attributable to
DPGR and $24,000 of which generates gross
income attributable to non-DPGR. All of Y’s

Y’s taxable income .....................................................................................................................................................................

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attributable to DPGR based on the combined
adjusted bases of X’s and Y’s assets. See

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$3,000
3,000
(1,200)
(1,200)
(840)
(100)
(200)
(500)
(50)
1,910

§ 1.861–11T(c). Accordingly, X’s QPAI for
2010 is $1,410, as shown below:

DPGR (all from sales of products within SIC AAA) ..........................................................................................................................
CGS allocated to DPGR ....................................................................................................................................................................
Section 162 selling expenses ($840 × ($3,000 DPGR/$6,000 total gross receipts)) .......................................................................
Interest expense (not included in CGS and not subject to § 1.861–10T) ($300 × ($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))) .....................................................................................................
Charitable contributions (not included in CGS) ($180 × ($2,400 gross income attributable to DPGR/$3,600 total gross income))

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1,320

activities that generate DPGR are within SIC
Industry Group AAA (SIC AAA). All of Y’s
activities that generate non-DPGR are within
SIC Industry Group BBB (SIC BBB). None of
X’s and Y’s sales are to each other. Y is not
able to identify from its books and records
CGS allocable to DPGR and non-DPGR. In
this case, because CGS is definitely related
under the facts and circumstances to all of
Y’s gross receipts, apportionment of CGS
between DPGR and non-DPGR based on gross
receipts is appropriate. For 2010, Y’s taxable
income is $1,910 based on the following
Federal income tax items:

DPGR (all from sales of products within SIC AAA) ..........................................................................................................................
Non-DPGR (all from sales of products within SIC BBB) ..................................................................................................................
CGS allocated to DPGR ....................................................................................................................................................................
CGS allocated to non-DPGR .............................................................................................................................................................
Section 162 selling expenses ............................................................................................................................................................
Section 174 R&E–SIC AAA ...............................................................................................................................................................
Section 174 R&E–SIC BBB ...............................................................................................................................................................
Interest expense (not included in CGS and not subject to § 1.861–10T) .........................................................................................
Charitable contributions .....................................................................................................................................................................

(ii) QPAI. (A) X’s QPAI. Determination of
X’s QPAI is the same as in Example 1 except
that interest is apportioned to gross income

$3,000
(600)
(420)
(240)
(120)
(300)

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31311

Section 174 R&E–SIC AAA ...............................................................................................................................................................

(300)

X’s QPAI .....................................................................................................................................................................................

(B) Y’s QPAI. Y makes the same elections
under the section 861 method as does X. Y

has $1,800 of gross income attributable to
DPGR (DPGR of $3,000—CGS of $1,200

allocated based on Y’s gross receipts). Y’s
QPAI for 2010 is $1,005, as shown below:

DPGR (all from sales of products within SIC AAA) ..........................................................................................................................
CGS allocated to DPGR ....................................................................................................................................................................
Section 162 selling expenses ($840 × ($3,000 DPGR/$6,000 total gross receipts)) .......................................................................
Interest expense (not included in CGS and not subject to § 1.861–10T) ($500 × ($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))) .....................................................................................................
Charitable contributions (not included in CGS) ($50 × ($1,800 gross income attributable to DPGR/$3,600 total gross income))
Section 174 R&E–SIC AAA ...............................................................................................................................................................
Y’s QPAI .....................................................................................................................................................................................

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(iii) Section 199 deduction determination.
The section 199 deduction of the X and Y
EAG is determined by aggregating the
separately determined QPAI, taxable income,
and W–2 wages of X and Y. See § 1.199–7(b).
Accordingly, the X and Y EAG’s tentative
section 199 deduction is $217 (.09 × (lesser
of combined taxable incomes of X and Y of
$3,290 (X’s taxable income of $1,380 plus Y’s
taxable income of $1,910) and combined
QPAI of $2,415 (X’s QPAI of $1,410 plus Y’s
QPAI of $1,005)). Because the facts of this
example assume that the W–2 wages of X and
Y are sufficient to avoid a limitation on the
section 199 deduction, X and Y EAG’s
section 199 deduction for 2010 is $217. The
$217 is allocated to X and Y in proportion
to their QPAI. See § 1.199–7(c).

(e) Simplified deduction method—(1)
In general. An eligible taxpayer may use
the simplified deduction method to
apportion deductions between DPGR
and non-DPGR. The simplified
deduction method does not apply to
CGS. Under the simplified deduction
method, a taxpayer’s deductions (except
the net operating loss deduction as
provided in paragraph (c)(2) of this
section) are ratably apportioned
between DPGR and non-DPGR based on
relative gross receipts. Accordingly, the
amount of deductions for the current
taxable year apportioned to DPGR is
equal to the same proportion of the total
deductions for the current taxable year
that the amount of DPGR bears to total
gross receipts. Gross receipts that are
allocable to land under the safe harbor
provided in § 1.199–3(m)(6)(iv) are
treated as non-DPGR. See § 1.199–
3(m)(6)(iv)(B). Whether a trust (to the
extent not described in § 1.199–9(d)) or
an estate may use the simplified
deduction method is determined at the
trust or estate level. If a trust or estate
qualifies to use the simplified deduction
method, the simplified deduction
method must be applied at the trust or
estate level, taking into account the
trust’s or estate’s DPGR, non-DPGR, and
other items from all sources, including
its distributive or allocable share of

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those items of any lower-tier entity,
prior to any charitable or distribution
deduction. Whether the owner of a passthru entity may use the simplified
deduction method is determined at the
level of the entity’s owner. If the owner
of a pass-thru entity qualifies and uses
the simplified deduction method, then
the simplified deduction method is
applied at the level of the owner of the
pass-thru entity taking into account the
owner’s DPGR, non-DPGR, and other
items from all sources including its
distributive or allocable share of those
items of the pass-thru entity.
(2) Eligible taxpayer. For purposes of
this paragraph (e), an eligible taxpayer
is—
(i) A taxpayer that has average annual
gross receipts (as defined in paragraph
(g) of this section) of $100,000,000 or
less; or
(ii) A taxpayer that has total assets (as
defined in paragraph (e)(3) of this
section) of $10,000,000 or less.
(3) Total assets—(i) In general. For
purposes of the simplified deduction
method, total assets means the total
assets the taxpayer has at the end of the
taxable year. In the case of a C
corporation, the corporation’s total
assets at the end of the taxable year is
the amount required to be reported on
Schedule L of Form 1120, ‘‘United
States Corporation Income Tax Return,’’
in accordance with the Form 1120
instructions.
(ii) Members of an expanded affiliated
group. To compute the total assets of an
EAG, the total assets at the end of the
taxable year of each corporation that is
a member of the EAG at the end of the
taxable year that ends with or within the
taxable year of the computing member
(as described in § 1.199–7(h)) are
aggregated. For purposes of this
paragraph, a consolidated group is
treated as one member of the EAG.
(4) Members of an expanded affiliated
group—(i) In general. Whether the

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1,410

$3,000
(1,200)
(420)
(250)
(25)
(100)
$1,005

members of an EAG may use the
simplified deduction method is
determined by reference to all the
members of the EAG. If the average
annual gross receipts of the EAG are less
than or equal to $100,000,000 or the
total assets of the EAG are less than or
equal to $10,000,000, then each member
of the EAG may individually determine
whether to use the simplified deduction
method, regardless of the cost allocation
method used by the other members.
(ii) Exception. Notwithstanding
paragraph (e)(4)(i) of this section, all
members of the same consolidated
group must use the same cost allocation
method.
(iii) Examples. The following
examples illustrate the application of
paragraph (e) of this section:
Example 1. Corporations X, Y, and Z are
the only three members of an EAG. Neither
X, Y, nor Z is a member of a consolidated
group. X, Y, and Z have average annual gross
receipts of $20,000,000, $70,000,000, and
$5,000,000, respectively. X, Y, and Z each
have total assets at the end of the taxable year
of $5,000,000. Because the average annual
gross receipts of the EAG are less than or
equal to $100,000,000, each of X, Y, and Z
may use either the simplified deduction
method or the section 861 method.
Example 2. The facts are the same as in
Example 1 except that X and Y are members
of the same consolidated group. X, Y, and Z
may use either the simplified deduction
method or the section 861 method. However,
X and Y must use the same cost allocation
method.
Example 3. The facts are the same as in
Example 1 except that Z’s average annual
gross receipts are $15,000,000. Because the
average annual gross receipts of the EAG are
greater than $100,000,000 and the total assets
of the EAG at the end of the taxable year are
greater than $10,000,000, X, Y, and Z must
each use the section 861 method.

(f) Small business simplified overall
method—(1) In general. A qualifying
small taxpayer may use the small
business simplified overall method to
apportion CGS and deductions between

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DPGR and non-DPGR. Under the small
business simplified overall method, a
taxpayer’s total costs for the current
taxable year (as defined in paragraph
(f)(3) of this section) are apportioned
between DPGR and non-DPGR based on
relative gross receipts. Accordingly, the
amount of total costs for the current
taxable year apportioned to DPGR is
equal to the same proportion of total
costs for the current taxable year that
the amount of DPGR bears to total gross
receipts. Total gross receipts for this
purpose do not include gross receipts
that are allocated to land under the land
safe harbor provided in § 1.199–
3(m)(6)(iv). See § 1.199–3(m)(6)(iv)(B).
(2) Qualifying small taxpayer. Except
as provided in paragraph (f)(5), for
purposes of this paragraph (f), a
qualifying small taxpayer is—
(i) A taxpayer that has average annual
gross receipts (as defined in paragraph
(g) of this section) of $5,000,000 or less;
(ii) A taxpayer that is engaged in the
trade or business of farming that is not
required to use the accrual method of
accounting under section 447; or
(iii) A taxpayer that is eligible to use
the cash method as provided in Rev.
Proc. 2002–28 (2002–1 C.B. 815) (that is,
certain taxpayers with average annual
gross receipts of $10,000,000 or less that
are not prohibited from using the cash
method under section 448, including
partnerships, S corporations, C
corporations, or individuals). See
§ 601.601(d)(2) of this chapter.
(3) Total costs for the current taxable
year—(i) In general. For purposes of the
small business simplified overall
method, total costs for the current
taxable year means the total CGS and
deductions (excluding the net operating
loss deduction as provided in paragraph
(c)(2) of this section) for the current
taxable year. Total costs for the current
taxable year are determined under the
methods of accounting that the taxpayer
uses to compute taxable income.
(ii) Land safe harbor. A taxpayer that
uses the land safe harbor provided in
§ 1.199–3(m)(6)(iv) must reduce total
costs for the current taxable year by the
costs of land and any other costs
capitalized to the land (except costs for
activities listed in § 1.199–3(m)(2)(iii))
prior to applying the small business
simplified overall method. See § 1.199–
3(m)(6)(iv)(B). For example, if a
taxpayer has $1,000 of total costs for the
current taxable year and $600 of such
costs is attributable to land under the
land safe harbor, then only $400 of such
costs is apportioned between DPGR and
non-DPGR under the small business
simplified overall method.
(4) Members of an expanded affiliated
group—(i) In general. Whether the

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members of an EAG may use the small
business simplified overall method is
determined by reference to all the
members of the EAG. If the average
annual gross receipts of the EAG are less
than or equal to $5,000,000, the EAG
(viewed as a single corporation) is
engaged in the trade or business of
farming that is not required to use the
accrual method of accounting under
section 447, or the EAG (viewed as a
single corporation) is eligible to use the
cash method as provided in Rev. Proc.
2002–28, then each member of the EAG
may individually determine whether to
use the small business simplified
overall method, regardless of the cost
allocation method used by the other
members.
(ii) Exception. Notwithstanding
paragraph (f)(4)(i) of this section, all
members of the same consolidated
group must use the same cost allocation
method.
(iii) Examples. The following
examples illustrate the application of
paragraph (f) of this section:
Example 1. Corporations L, M, and N are
the only three members of an EAG. Neither
L, M, nor N is a member of a consolidated
group. L, M, and N have average annual gross
receipts for the current taxable year of
$1,000,000, $1,500,000, and $2,000,000,
respectively. Because the average annual
gross receipts of the EAG are less than or
equal to $5,000,000, each of L, M, and N may
use the small business simplified overall
method, the simplified deduction method, or
the section 861 method.
Example 2. The facts are the same as in
Example 1 except that M and N are members
of the same consolidated group. L, M, and N
may use the small business simplified overall
method, the simplified deduction method, or
the section 861 method. However, M and N
must use the same cost allocation method.
Example 3. The facts are the same as in
Example 1 except that N has average annual
gross receipts of $4,000,000. Unless the EAG,
viewed as a single corporation, is engaged in
the trade or business of farming that is not
required to use the accrual method of
accounting under section 447, or the EAG,
viewed as a single corporation, is eligible to
use the cash method as provided in Rev.
Proc. 2002–28, because the average annual
gross receipts of the EAG are greater than
$5,000,000, L, M, and N are all ineligible to
use the small business simplified overall
method.

(5) Trusts and estates. Trusts and
estates under § 1.199–9(e) may not use
the small business simplified overall
method.
(g) Average annual gross receipts—(1)
In general. For purposes of the
simplified deduction method and the
small business simplified overall
method, average annual gross receipts
means the average annual gross receipts
of the taxpayer (including gross receipts

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attributable to the sale, exchange, or
other disposition of land under the land
safe harbor provided in § 1.199–
3(m)(6)(iv)) for the 3 taxable years (or,
if fewer, the taxable years during which
the taxpayer was in existence) preceding
the current taxable year, even if one or
more of such taxable years began before
the effective date of section 199. In the
case of any taxable year of less than 12
months (a short taxable year), the gross
receipts shall be annualized by
multiplying the gross receipts for the
short period by 12 and dividing the
result by the number of months in the
short period.
(2) Members of an expanded affiliated
group. To compute the average annual
gross receipts of an EAG, the gross
receipts, for the entire taxable year, of
each corporation that is a member of the
EAG at the end of its taxable year that
ends with or within the taxable year of
the computing member are aggregated.
For purposes of this paragraph, a
consolidated group is treated as one
member of the EAG.
§ 1.199–5 Application of section 199 to
pass-thru entities for taxable years
beginning after May 17, 2006, the enactment
date of the Tax Increase Prevention and
Reconciliation Act of 2005. [Reserved].
§ 1.199–6 Agricultural and horticultural
cooperatives.

(a) In general. A patron who receives
a qualified payment (as defined in
paragraph (e) of this section) from a
specified agricultural or horticultural
cooperative (cooperative) (as defined in
paragraph (f) of this section) is allowed
a deduction under § 1.199–1(a) (section
199 deduction) for the taxable year the
qualified payment is received for the
portion of the cooperative’s section 199
deduction passed through to the patron
and identified by the cooperative in a
written notice mailed to the person
during the payment period described in
section 1382(d). The provisions of this
section apply solely for purposes of
section 199 of the Internal Revenue
Code (Code).
(b) Cooperative denied section 1382
deduction for portion of qualified
payments. A cooperative must reduce
its section 1382 deduction by an amount
equal to the portion of any qualified
payment that is attributable to the
cooperative’s section 199 deduction
passed through to the patron.
(c) Determining cooperative’s taxable
income. For purposes of determining its
section 199 deduction, the cooperative’s
taxable income is computed without
taking into account any deduction
allowable under section 1382(b) or (c)
(relating to patronage dividends, per-

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unit retain allocations, and
nonpatronage distributions).
(d) Special rule for marketing
cooperatives. In the case of a
cooperative engaged in the marketing of
agricultural and/or horticultural
products described in paragraph (f) of
this section, the cooperative is treated as
having manufactured, produced, grown,
or extracted (MPGE) (as defined in
§ 1.199–3(e)) in whole or in significant
part (as defined in § 1.199–3(g)) within
the United States (as defined in § 1.199–
3(h)) any agricultural or horticultural
products marketed by the cooperative
that its patrons have MPGE.
(e) Qualified payment. The term
qualified payment means any amount of
a patronage dividend or per-unit retain
allocation, as described in section
1385(a)(1) or (3) received by a patron
from a cooperative, that is attributable to
the portion of the cooperative’s
qualified production activities income
(QPAI) (as defined in § 1.199–1(c)), for
which the cooperative is allowed a
section 199 deduction. For this purpose,
patronage dividends and per-unit retain
allocations include any advances on
patronage and per-unit retains paid in
money during the taxable year.
(f) Specified agricultural or
horticultural cooperative. A specified
agricultural or horticultural cooperative
means a cooperative to which Part I of
subchapter T of the Code applies and
the cooperative has MPGE in whole or
significant part within the United States
any agricultural or horticultural
product, or has marketed agricultural or
horticultural products. For this purpose,
agricultural or horticultural products
also include fertilizer, diesel fuel, and
other supplies used in agricultural or
horticultural production.
(g) Written notice to patrons. In order
for a patron to qualify for the section
199 deduction, paragraph (a) of this
section requires that the cooperative
identify in a written notice the patron’s
portion of the section 199 deduction
that is attributable to the portion of the
cooperative’s QPAI for which the
cooperative is allowed a section 199
deduction. This written notice must be
mailed by the cooperative to its patrons
no later than the 15th day of the ninth
month following the close of the taxable
year. The cooperative may use the same
written notice, if any, that it uses to
notify patrons of their respective
allocations of patronage dividends, or
may use a separate timely written
notice(s) to comply with this section.
The cooperative must report the amount
of the patron’s section 199 deduction on
Form 1099–PATR, ‘‘Taxable
Distributions Received From
Cooperative,’’ issued to the patron.

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(h) Additional rules relating to
passthrough of section 199 deduction.
The cooperative may, at its discretion,
pass through all, some, or none of the
section 199 deduction to its patrons.
However, the cooperative may not apply
section 199(d)(3) and this section to any
portion of the section 199 deduction
that is not passed through to its patrons.
A cooperative member of a federated
cooperative may pass through the
section 199 deduction it receives from
the federated cooperative to its member
patrons. Patrons may claim the section
199 deduction for the taxable year in
which they receive the written notice
from the cooperative informing them of
the section 199 amount without regard
to the taxable income limitation under
§ 1.199–1(a) and (b).
(i) W–2 wages. The W–2 wage
limitation described in § 1.199–2 shall
be applied at the cooperative level
whether or not the cooperative chooses
to pass through some or all of the
section 199 deduction. Any section 199
deduction that has been passed through
by a cooperative to its patrons is not
subject to the W–2 wage limitation a
second time at the patron level.
(j) Recapture of section 199
deduction. If the amount of the section
199 deduction that was passed through
to patrons exceeds the amount
allowable as a section 199 deduction as
determined on audit or reported on an
amended return, then recapture of the
excess will occur at the cooperative
level in the taxable year the cooperative
took the excess section 199 deduction
amount into account.
(k) Section is exclusive. This section
is the exclusive method for cooperatives
and their patrons to compute the
amount of the section 199 deduction.
Thus, a patron may not deduct any
amount with respect to a patronage
dividend or a per-unit retain allocation
unless the requirements of this section
are satisfied.
(l) No double counting. To the extent
a cooperative passes through the section
199 deduction to a patron, a qualified
payment received by the patron of the
cooperative is not taken in account for
purposes of section 199.
(m) Examples. The following
examples illustrate the application of
this section:
Example 1. (i) Cooperative X markets corn
grown by its members within the United
States for sale to retail grocers. For its
calendar year ended December 31, 2007,
Cooperative X has gross receipts of
$1,500,000, all derived from the sale of corn
grown by its members within the United
States. Cooperative X pays $370,000 for its
members’ corn and its W–2 wages (as defined
in § 1.199–2(e)) for 2007 total $130,000.

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31313

Cooperative X has no other costs. Patron A
is a member of Cooperative X. Patron A is a
cash basis taxpayer and files Federal income
tax returns on a calendar year basis. All corn
grown by Patron A in 2007 is sold through
Cooperative X and Patron A is eligible to
share in patronage dividends paid by
Cooperative X for that year.
(ii) Cooperative X is a cooperative
described in paragraph (f) of this section.
Accordingly, this section applies to
Cooperative X and its patrons and all of
Cooperative X’s gross receipts from the sale
of its patrons’ corn qualify as domestic
production gross receipts (as defined § 1.199–
3(a)). Cooperative X’s QPAI is $1,000,000.
Cooperative X’s section 199 deduction for its
taxable year 2007 is $60,000 (.06 ×
$1,000,000). Because this amount is less than
50% of Cooperative X’s W–2 wages, the
entire amount is allowed as a section 199
deduction subject to the rules of section
199(d)(3) and this section.
Example 2. (i) The facts are the same as in
Example 1 except that Cooperative X decides
to pass its entire section 199 deduction
through to its members. Cooperative X
declares a patronage dividend for its 2007
taxable year of $1,000,000, which it pays on
March 15, 2008. Pursuant to paragraph (g) of
this section, Cooperative X notifies members
in written notices that accompany the
patronage dividend notification that it is
allocating to them the section 199 deduction
it is entitled to claim in the taxable year
2007. On March 15, 2008, Patron A receives
a $10,000 patronage dividend that is a
qualified payment under paragraph (e) of this
section from Cooperative X. In the notice that
accompanies the patronage dividend, Patron
A is designated a $600 section 199
deduction. Under paragraph (a) of this
section, Patron A must claim a $600 section
199 deduction for the taxable year ending
December 31, 2008, without regard to the
taxable income limitation under § 1.199–1(a)
and (b). Cooperative X must report the
amount of Patron A’s section 199 deduction
on Form 1099–PATR, ‘‘Taxable Distributions
Received From Cooperative,’’ issued to
Patron A for the calendar year 2008.
(ii) Under paragraph (b) of this section,
Cooperative X is required to reduce its
patronage dividend deduction of $1,000,000
by the $60,000 section 199 deduction passed
through to members (whether or not
Cooperative X pays patronage on book or
Federal income tax net earnings). As a
consequence, Cooperative X is entitled to a
patronage dividend deduction for the taxable
year ending December 31, 2007, in the
amount of $940,000 ($1,000,000 ¥ $60,000)
and to a section 199 deduction in the amount
of $60,000 ($1,000,000 × .06). Its taxable
income for 2007 is $0.
Example 3. (i) The facts are the same as in
Example 1 except that Cooperative X paid
out $500,000 to its patrons as advances on
expected patronage net earnings. In 2007,
Cooperative X pays its patrons a $500,000
($1,000,000¥$500,000 already paid)
patronage dividend in cash or a combination
of cash and qualified written notices of
allocation. Under paragraph (b) of this
section and section 1382, Cooperative X is
allowed a patronage dividend deduction of

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Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules and Regulations

$440,000 ($500,000¥$60,000 section 199
deduction), whether patronage net earnings
are distributed on book or Federal income tax
net earnings.
(ii) The patrons will have received a gross
amount of $1,000,000 in qualified payments
under paragraph (e) of this section from
Cooperative X ($500,000 paid during the
taxable year as advances and the additional
$500,000 paid as patronage dividends). If
Cooperative X passes through its entire
section 199 deduction to its members by
providing the notice required by paragraph
(g) of this section, then the patrons will be
allowed a $60,000 section 199 deduction,
resulting in a net $940,000 taxable
distribution from Cooperative X. Pursuant to
paragraph (l) of this section, the $1,000,000
received by the patrons from Cooperative X
is not taken into account for purposes of
section 199 in the hands of the patrons.

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§ 1.199–7

Expanded affiliated groups.

(a) In general. The provisions of this
section apply solely for purposes of
section 199 of the Internal Revenue
Code (Code). All members of an
expanded affiliated group (EAG) are
treated as a single corporation for
purposes of section 199.
Notwithstanding the preceding
sentence, except as otherwise provided
in the Code and regulations (see, for
example, sections 199(c)(7) and 267,
§ 1.199–3(b), paragraph (a)(3) of this
section, and the consolidated return
regulations), each member of an EAG is
a separate taxpayer that computes its
own taxable income or loss, qualified
production activities income (QPAI) (as
defined in § 1.199–1(c)), and W–2 wages
(as defined in § 1.199–2(e)). If members
of an EAG are also members of a
consolidated group, see paragraph (d) of
this section.
(1) Definition of expanded affiliated
group. An EAG is an affiliated group as
defined in section 1504(a), determined
by substituting more than 50 percent for
at least 80 percent each place it appears
and without regard to section 1504(b)(2)
and (4).
(2) Identification of members of an
expanded affiliated group—(i) In
general. A corporation must determine
if it is a member of an EAG on a daily
basis.
(ii) Becoming or ceasing to be a
member of an expanded affiliated
group. If a corporation becomes or
ceases to be a member of an EAG, the
corporation is treated as becoming or
ceasing to be a member of the EAG at
the end of the day on which its status
as a member changes.
(3) Attribution of activities—(i) In
general. If a member of an EAG (the
disposing member) derives gross
receipts (as defined in § 1.199–3(c))
from the lease, rental, license, sale,
exchange, or other disposition (as

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defined in § 1.199–3(i)) of qualifying
production property (QPP) (as defined
in § 1.199–3(j)) that was manufactured,
produced, grown or extracted (MPGE)
(as defined in § 1.199–3(e)), in whole or
in significant part (as defined in
§ 1.199–3(g)) in the United States (as
defined in § 1.199–3(h)), a qualified film
(as defined in § 1.199–3(k)), or
electricity, natural gas, or potable water
(as defined in § 1.199–3(l)) (collectively,
utilities) that was produced in the
United States, such property was MPGE
or produced by another corporation (or
corporations), and the disposing
member is a member of the same EAG
as the other corporation (or
corporations) at the time that the
disposing member disposes of the QPP,
qualified film, or utilities, then the
disposing member is treated as
conducting the previous activities
conducted by such other corporation (or
corporations) with respect to the QPP,
qualified film, or utilities in
determining whether its gross receipts
are domestic production gross receipts
(DPGR) (as defined in § 1.199–3(a)).
With respect to a lease, rental, or
license, the disposing member is treated
as having disposed of the QPP, qualified
film, or utilities on the date or dates on
which it takes into account the gross
receipts derived from the lease, rental,
or license under its methods of
accounting. With respect to a sale,
exchange, or other disposition, the
disposing member is treated as having
disposed of the QPP, qualified film, or
utilities on the date on which it ceases
to own the QPP, qualified film, or
utilities for Federal income tax
purposes, even if no gain or loss is taken
into account.
(ii) Special rule. Attribution of
activities does not apply for purposes of
the construction of real property under
§ 1.199–3(m) or the performance of
engineering and architectural services
under § 1.199–3(n). A member of an
EAG must engage in a construction
activity under § 1.199–3(m)(2), provide
engineering services under § 1.199–
3(n)(2), or provide architectural services
under § 1.199–3(n)(3) in order for the
member’s gross receipts to be derived
from construction, engineering, or
architectural services.
(4) Examples. The following examples
illustrate the application of paragraph
(a)(3) of this section. Assume that all
taxpayers are calendar year taxpayers.
The examples are as follows:
Example 1. Corporations M and N are
members of the same EAG. M is engaged
solely in the trade or business of
manufacturing furniture in the United States
that it sells to unrelated persons. N is
engaged solely in the trade or business of

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engraving companies’ names on pens and
pencils purchased from unrelated persons
and then selling the pens and pencils to such
companies. For purposes of this example,
assume that if N was not a member of an
EAG, its activities would not qualify as
MPGE. Accordingly, although M’s sales of
the furniture qualify as DPGR (assuming all
the other requirements of § 1.199–3 are met),
N’s sales of the engraved pens and pencils do
not qualify as DPGR because neither N nor
another member of the EAG MPGE the pens
and pencils.
Example 2. For the entire 2007 year,
Corporations A and B are members of the
same EAG. A is engaged solely in the trade
or business of MPGE machinery in the
United States. A and B each own 45% of
partnership C and unrelated persons own the
remaining 10%. C is engaged solely in the
trade or business of MPGE the same type of
machinery in the United States as A. In 2007,
B purchases and then resells the machinery
MPGE in 2007 by A and C. B also resells
machinery it purchases from unrelated
persons. If only B’s activities were
considered, B would not qualify for the
deduction under § 1.199–1(a) (section 199
deduction). However, because at the time B
disposes of the machinery B is a member of
the EAG that includes A, B is Treated as
conducting A’s previous MPGE activities in
determining whether B’s gross receipts from
the sale of the machinery MPGE by A are
DPGR. C is not a member of the EAG and
thus C’s MPGE activities are not attributed to
B in determining whether B’s gross receipts
from the sale of the machinery MPGE by C
are DPGR. Accordingly, B’s gross receipts
attributable to its sale of the machinery it
purchases from A are DPGR (assuming all the
other requirements of § 1.199–3 are met). B’s
gross receipts attributable to its sale of the
machinery it purchases from C and from the
unrelated persons are non-DPGR because no
member of the EAG MPGE the machinery
and because C does not qualify as an EAG
partnership.
Example 3. The facts are the same as in
Example 2 except that rather than reselling
the machinery, B rents the machinery it
acquired from A to unrelated persons and B
takes the gross receipts attributable to the
rental of the machinery into account under
its methods of accounting in 2007, 2008, and
2009. In addition, as of the close of business
on December 31, 2008, A and B cease to be
members of the same EAG. With respect to
the machinery acquired from C and the
unrelated persons, B’s gross receipts
attributable to the rental of the machinery in
2007, 2008, and 2009 are non-DPGR because
no member of the EAG MPGE the machinery
and because C does not qualify as an EAG
partnership. With respect to machinery
acquired from A, B’s gross receipts in 2007
and 2008 attributable to the rental of the
machinery are DPGR because at the time B
takes into account the gross receipts derived
from the rental of the machinery into account
under its methods of accounting, B is a
member of the same EAG as A and B is
treated as conducting A’s previous MPGE
activities. However, with respect to the rental
receipts in 2009, because A and B are not
members of the same EAG in 2009, B’s rental
receipts are non-DPGR.

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Example 4. For the entire 2007 year,
Corporation P owns over 50% of the stock of
Corporation S. In 2007, P MPGE QPP in the
United States and transfers the QPP to S. On
February 28, 2008, P disposes of stock of S,
reducing P’s ownership of S below 50% and
P and S cease to be members of the same
EAG. On June 30, 2008, S sells the QPP to
an unrelated person. Unless P’s transfer of
the QPP to S took place in a transaction to
which section 381(a) applies (see § 1.199–
8(e)(3)), because S is not a member of the
same EAG as P on June 30, 2008, S is not
treated as conducting the activities
conducted by P in determining if S’s receipts
are DPGR, notwithstanding that P and S were
members of the same EAG when P MPGE the
QPP and when P transferred the QPP to S.
Example 5. For the entire 2007 year,
Corporations X and Y are unrelated
corporations. In 2007, X MPGE QPP in the
United States and sells the QPP to Y. On
August 31, 2008, X acquires over 50% of the
stock of Y, thus making X and Y members of
the same EAG. On November 30, 2008, Y
sells the QPP to an unrelated person. Because
X and Y are members of the same EAG on
November 30, 2008, Y is treated as
conducting the activities conducted by X in
2007 in determining if Y’s receipts are DPGR,
notwithstanding that X and Y were not
members of the same EAG when X MPGE the
QPP nor when X sold the QPP to Y.

rwilkins on PROD1PC63 with RULES_2

(5) Anti-avoidance rule. If a
transaction between members of an EAG
is engaged in or structured with a
principal purpose of qualifying for, or
increasing the amount of, the section
199 deduction of the EAG or the portion
of the section 199 deduction allocated to
one or more members of the EAG,
adjustments must be made to eliminate
the effect of the transaction on the
computation of the section 199
deduction.
(b) Computation of expanded
affiliated group’s section 199
deduction—(1) In general. The section
199 deduction for an EAG is determined
by the EAG by aggregating each
member’s taxable income or loss, QPAI,
and W–2 wages, if any. For purposes of
this determination, a member’s QPAI
may be positive or negative. A member’s
taxable income or loss and QPAI shall
be determined by reference to the
member’s methods of accounting.
(2) Example. The following example
illustrates the application of paragraph
(b)(1) of this section:
Example. Corporations X, Y, and Z,
calendar year taxpayers, are the only
members of an EAG and are not members of
a consolidated group. X has taxable income
of $50,000, QPAI of $15,000, and W–2 wages
of $1,000. Y has taxable income of ($20,000),
QPAI of ($1,000), and W–2 wages of $750. Z
has $0 taxable income and $0 QPAI, but has
W–2 wages of $2,000. In determining the
EAG’s section 199 deduction, the EAG
aggregates each member’s taxable income or
loss, QPAI, and W–2 wages. Accordingly, the

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EAG has taxable income of $30,000 ($50,000
+ ($20,000) + $0), QPAI of $14,000 ($15,000
+ ($1,000) + $0), and W–2 wages of $3,750
($1,000 + $750 + $2,000).

(3) Net operating loss carrybacks and
carryovers. In determining the taxable
income of an EAG, if a member of an
EAG has a net operating loss (NOL)
carryback or carryover to the taxable
year, then the amount of the NOL used
to offset taxable income cannot exceed
the taxable income of that member.
(c) Allocation of an expanded
affiliated group’s section 199 deduction
among members of the expanded
affiliated group—(1) In general. An
EAG’s section 199 deduction as
determined in paragraph (b)(1) of this
section is allocated among the members
of the EAG in proportion to each
member’s QPAI, regardless of whether
the EAG member has taxable income or
loss or W–2 wages for the taxable year.
For this purpose, if a member has
negative QPAI, the QPAI of the member
shall be treated as zero.
(2) Use of section 199 deduction to
create or increase a net operating loss.
Notwithstanding § 1.199–1(b), if a
member of an EAG has some or all of
the EAG’s section 199 deduction
allocated to it under paragraph (c)(1) of
this section and the amount allocated
exceeds the member’s taxable income
(determined prior to allocation of the
section 199 deduction), the section 199
deduction will create an NOL for the
member. Similarly, if a member of an
EAG, prior to the allocation of some or
all of the EAG’s section 199 deduction
to the member, has an NOL for the
taxable year, the portion of the EAG’s
section 199 deduction allocated to the
member will increase the member’s
NOL.
(d) Special rules for members of the
same consolidated group—(1)
Intercompany transactions. In the case
of an intercompany transaction between
consolidated group members S and B (as
the terms intercompany transaction, S,
and B are defined in § 1.1502–13(b)(1)),
S takes the intercompany transaction
into account in computing the section
199 deduction at the same time and in
the same proportion as S takes into
account the income, gain, deduction, or
loss from the intercompany transaction
under § 1.1502–13.
(2) Attribution of activities in the
construction of real property and the
performance of engineering and
architectural services. Notwithstanding
paragraph (a)(3)(ii) of this section, a
disposing member (as described in
paragraph (a)(3)(i) of this section) is
treated as conducting the previous
activities conducted by each other
member of its consolidated group with

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31315

respect to the construction of real
property under § 1.199–3(m) and the
performance of engineering and
architectural services under § 1.199–
3(n), but only with respect to activities
performed during the period of
consolidation.
(3) Application of the simplified
deduction method and the small
business simplified overall method. For
purposes of applying the simplified
deduction method under § 1.199–4(e)
and the small business simplified
overall method under § 1.199–4(f), a
consolidated group determines its QPAI
using its members’ DPGR, non-DPGR,
cost of goods sold (CGS), and all other
deductions, expenses, or losses
(deductions), determined after
application of § 1.1502–13.
(4) Determining the section 199
deduction—(i) Expanded affiliated
group consists of consolidated group
and non-consolidated group members.
In determining the section 199
deduction, if an EAG includes
corporations that are members of the
same consolidated group and
corporations that are not members of the
same consolidated group, the
consolidated taxable income or loss,
QPAI, and W–2 wages, if any, of the
consolidated group (and not the
separate taxable income or loss, QPAI,
and W–2 wages of the members of the
consolidated group), are aggregated with
the taxable income or loss, QPAI, and
W–2 wages, if any, of the nonconsolidated group members. For
example, if A, B, C, S1, and S2 are
members of the same EAG, and A, S1,
and S2 are members of the same
consolidated group (the A consolidated
group), then the A consolidated group is
treated as one member of the EAG.
Accordingly, the EAG is considered to
have three members, the A consolidated
group, B, and C. The consolidated
taxable income or loss, QPAI, and W–
2 wages, if any, of the A consolidated
group are aggregated with the taxable
income or loss, QPAI, and W–2 wages,
if any, of B and C in determining the
EAG’s section 199 deduction.
(ii) Expanded affiliated group consists
only of members of a single
consolidated group. If all the members
of an EAG are members of the same
consolidated group, the consolidated
group’s section 199 deduction is
determined using the consolidated
group’s consolidated taxable income or
loss, QPAI, and W–2 wages, rather than
the separate taxable income or loss,
QPAI, and W–2 wages of its members.
(5) Allocation of the section 199
deduction of a consolidated group
among its members. The section 199
deduction of a consolidated group (or

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the section 199 deduction allocated to a
consolidated group that is a member of
an EAG) is allocated to the members of
the consolidated group in proportion to
each consolidated group member’s
QPAI, regardless of whether the
consolidated group member has
separate taxable income or loss or W–2
wages for the taxable year. In allocating
the section 199 deduction of a
consolidated group among its members,
any redetermination of a corporation’s
receipts, CGS, or other deductions from
an intercompany transaction under
§ 1.1502–13(c)(1)(i) or (c)(4) for
purposes of section 199 is not taken into
account. Also, for purposes of this
allocation, if a consolidated group
member has negative QPAI, the QPAI of
the member shall be treated as zero.
(e) Examples. The following examples
illustrate the application of paragraphs
(a) through (d) of this section:
Example 1. Corporations X and Y are
members of the same EAG but are not
members of a consolidated group. All the
activities described in this example take
place during the same taxable year. X and Y
each use the section 861 method described in
§ 1.199–4(d) for allocating and apportioning
their deductions. X incurs $5,000 in costs in
manufacturing a machine, all of which are
capitalized. X is entitled to a $1,000
depreciation deduction for the machine in
the current taxable year. X rents the machine
to Y for $1,500. Y uses the machine in
manufacturing QPP within the United States.
Y incurs $1,400 of CGS in manufacturing the
QPP. Y sells the QPP to unrelated persons for
$7,500. Pursuant to section 199(c)(7) and
§ 1.199–3(b), X’s rental income is non-DPGR
(and its related costs are not attributable to
DPGR). Accordingly, Y has $4,600 of QPAI
(Y’s $7,500 DPGR received from unrelated
persons¥Y’s $1,400 CGS allocable to such
receipts¥Y’s $1,500 of rental expense), X has
$0 of QPAI, and the EAG has $4,600 of QPAI.
Example 2. The facts are the same as in
Example 1 except that X and Y are members
of the same consolidated group. Pursuant to
section 199(c)(7) and § 1.199–3(b), X’s rental
income ordinarily would not be DPGR (and
its related costs would not be allocable to
DPGR). However, because X and Y are
members of the same consolidated group,
§ 1.1502–13(c)(1)(i) provides that the separate
entity attributes of X’s intercompany items or
Y’s corresponding items, or both, may be
redetermined in order to produce the same
effect as if X and Y were divisions of a single
corporation. If X and Y were divisions of a
single corporation, X and Y would have
QPAI of $5,100 ($7,500 DPGR received from
unrelated persons¥$1,400 CGS allocable to
such receipts¥$1,000 depreciation
deduction). To obtain this same result for the
consolidated group, X’s rental income is
redetermined as DPGR, which results in the
consolidated group having $9,000 of DPGR
(the sum of Y’s DPGR of $7,500 + X’s DPGR
of $1,500) and $3,900 of costs allocable to
DPGR (the sum of Y’s $1,400 CGS + Y’s
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depreciation expense). For purposes of
determining how much of the consolidated
group’s section 199 deduction is allocated to
X and Y, pursuant to paragraph (d)(5) of this
section, the redetermination of X’s rental
income as DPGR under § 1.1502–13(c)(1)(i) is
not taken into account (X’s costs are
considered to be allocable to DPGR because
they are allocable to the consolidated group
deriving DPGR). Accordingly, for this
purpose, X is deemed to have ($1,000) of
QPAI (X’s $0 DPGR¥X’s $1,000 depreciation
deduction). Because X is deemed to have
negative QPAI, also pursuant to paragraph
(d)(5) of this section, X’s QPAI is treated as
zero. Y has $4,600 of QPAI (Y’s $7,500
DPGR¥Y’s $1,400 CGS allocable to such
receipts¥Y’s $1,500 of rental expense).
Accordingly, X is allocated $0/($0 + $4,600)
of the consolidated group’s section 199
deduction and Y is allocated $4,600/($0 +
$4,600) of the consolidated group’s section
199 deduction.
Example 3. Corporations P and S are
members of the same EAG but are not
members of a consolidated group. P and S
each use the section 861 method for
allocating and apportioning their deductions
and are both calendar year taxpayers. In
2007, P incurs $1,000 in research and
development expenses in creating an
intangible asset and deducts these expenses
in 2007. P anticipates that it will license the
intangible asset to S. On January 1, 2008, P
licenses the intangible asset to S for $2,500.
S uses the intangible asset in manufacturing
QPP within the United States. S incurs
$2,000 of additional costs in manufacturing
the QPP. On December 31, 2008, S sells the
QPP to unrelated persons for $10,000.
Because on December 31, 2007, P anticipates
that it will license the intangible asset to S,
a related person, and also because the
intangible asset is not QPP, P’s license
receipts from S will be non-DPGR.
Accordingly, P’s research and development
expenses in 2007 are not attributable to
DPGR. In 2008, S has $5,500 of QPAI (S’s
$10,000 DPGR received from unrelated
persons¥S’s $2,000 additional costs in
manufacturing the QPP¥S’s $2,500 of
license expense), P has $0 of QPAI, and the
EAG has $5,500 of QPAI.
Example 4. (i) Determination of
consolidated group’s QPAI. The facts are the
same as in Example 3 except that P and S are
members of the same consolidated group.
Pursuant to section 199(c)(7) and § 1.199–
3(b), and also because the intangible asset is
not QPP, P’s license income ordinarily would
not be DPGR (and its related costs would not
be allocable to DPGR). However, because P
and S are members of the same consolidated
group, § 1.1502–13(c)(1)(i) provides that the
separate entity attributes of P’s intercompany
items or S’s corresponding items, or both,
may be redetermined in order to produce the
same effect as if P and S were divisions of
a single corporation. If P and S were
divisions of a single corporation, in 2007 the
single corporation would have $1,000 of
expenses allocable to the anticipated DPGR
from the sale of the QPP to unrelated
persons, resulting in a negative QPAI (from
this individual item) of $1,000. In 2008, the
single corporation would have QPAI of

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$8,000 ($10,000 DPGR received from
unrelated persons¥$2,000 additional costs
in manufacturing the QPP). To obtain this
same result for the consolidated group, P’s
license income from S is redetermined as
DPGR. P’s research and development
expenses are allocable to DPGR. This results
in the consolidated group having negative
QPAI in 2007 (from the research and
development expense) of $1,000. In 2008, the
consolidated group has $12,500 of DPGR (the
sum of S’s DPGR of $10,000 + P’s DPGR of
$2,500) and $4,500 of costs allocable to DPGR
(the sum of S’s $2,000 additional costs + S’s
$2,500 license expense), resulting in $8,000
of QPAI in 2008.
(ii) Allocation of deduction. Since the
consolidated group has no QPAI in 2007,
there is no section 199 deduction to be
allocated between P and S in 2007. In 2008,
the consolidated group has $8,000 of QPAI
and, assuming that the group has positive
taxable income and W–2 wages, the
consolidated group will have a section 199
deduction. For purposes of determining how
much of the consolidated group’s section 199
deduction is allocated to P and S, pursuant
to paragraph (d)(5) of this section, the
redetermination of P’s license income as
DPGR under § 1.1502–13(c)(1)(i) is not taken
into account. Accordingly, for purposes of
allocating the consolidated group’s section
199 deduction between P and S, P is deemed
to have $0 DPGR and $0 QPAI in 2008. S has
$5,500 of QPAI (S’s $10,000 DPGR ¥ S’s
$2,000 in additional costs allocable to such
receipts ¥ S’s $2,500 of license expense).
Accordingly, P is allocated $0/($0 + $5,500)
of the consolidated group’s section 199
deduction in 2008 and S is allocated $5,500/
($0 + $5,500) of the consolidated group’s
section 199 deduction.
Example 5. (i) Facts. Corporations A and B
are the only two members of an EAG but are
not members of a consolidated group. A and
B each file Federal income tax returns on a
calendar year basis. The average annual gross
receipts of the EAG are less than or equal to
$100,000,000 and A and B each use the
simplified deduction method under § 1.199–
4(e). In 2007, A MPGE televisions within the
United States. A has $10,000,000 of DPGR
from sales of televisions to unrelated persons
and $2,000,000 of DPGR from sales of
televisions to B. In addition, A has gross
receipts from computer consulting services
with unrelated persons of $3,000,000. A has
CGS of $6,000,000. A is able to determine
from its books and records that $4,500,000 of
its CGS are attributable to televisions sold to
unrelated persons and $1,500,000 are
attributable to televisions sold to B (see
§ 1.199–4(b)(2)). A has other deductions of
$4,000,000. A has no other items of income,
gain, or deductions. In 2007, B sells the
televisions it purchased from A to unrelated
persons for $4,100,000. B also pays $100,000
for administrative services performed in
2007. B has no other items of income, gain,
or deductions.
(ii) QPAI. (A) A’s QPAI. In order to
determine A’s QPAI, A subtracts its
$6,000,000 CGS from its $12,000,000 DPGR.
Under the simplified deduction method, A
then apportions its remaining $4,000,000 of
deductions to DPGR in proportion to the ratio

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of its DPGR to total gross receipts. Thus, of
A’s $4,000,000 of deductions, $3,200,000 is
apportioned to DPGR ($4,000,000 ×
$12,000,000/$15,000,000). Accordingly, A’s
QPAI is $2,800,000 ($12,000,000
DPGR¥$6,000,000 CGS¥$3,200,000
deductions apportioned to its DPGR).
(B) B’s QPAI. Although B did not MPGE
the televisions it sold, pursuant to paragraph
(a)(3) of this section, B is treated as
conducting A’s MPGE of the televisions in
determining whether B’s gross receipts are
DPGR. Thus, B has $4,100,000 of DPGR. In
order to determine B’s QPAI, B subtracts its
$2,000,000 CGS from its $4,100,000 DPGR.
Under the simplified deduction method, B
then apportions its remaining $100,000 of
deductions to DPGR in proportion to the ratio
of its DPGR to total gross receipts. Thus,
because B has no other gross receipts, all of
B’s $100,000 of deductions is apportioned to
DPGR ($100,000 × $4,100,000/$4,100,000).
Accordingly, B’s QPAI is $2,000,000
($4,100,000 DPGR¥$2,000,000
CGS¥$100,000 deductions apportioned to its
DPGR).
Example 6. (i) Facts. The facts are the same
as in Example 5 except that A and B are
members of the same consolidated group, B
does not sell the televisions purchased from
A until 2008, and B’s $100,000 paid for
administrative services are paid in 2008 for
services performed in 2008. In addition, in
2008, A has $3,000,000 in gross receipts from
computer consulting services with unrelated
persons and $1,000,000 in related
deductions.
(ii) Consolidated group’s 2007 QPAI. The
consolidated group’s DPGR and total gross
receipts in 2007 are $10,000,000 and
$13,000,000, respectively, because, pursuant
to paragraph (d)(1) of this section and
§ 1.1502–13, the sale of the televisions from
A to B is not taken into account in 2007. In
order to determine the consolidated group’s
QPAI, the consolidated group subtracts its
$4,500,000 CGS from the televisions sold to
unrelated persons from its $10,000,000
DPGR. Under the simplified deduction
method, the consolidated group apportions
its remaining $4,000,000 of deductions to
DPGR in proportion to the ratio of its DPGR
to total gross receipts. Thus, $3,076,923
($4,000,000 × $10,000,000/$13,000,000) is
allocated to DPGR. Accordingly, the
consolidated group’s QPAI for 2007 is
$2,423,077 ($10,000,000 DPGR¥$4,500,000
CGS¥$3,076,923 deductions apportioned to
its DPGR).
(iii) Allocation of consolidated group’s
2007 section 199 deduction to its members.
Because B’s only activity during 2007 is the
purchase of televisions from A, B has no
DPGR or deductions and thus, no QPAI, in
2007. Accordingly, the entire section 199
deduction in 2007 for the consolidated group
will be allocated to A.
(iv) Consolidated group’s 2008 QPAI.
Pursuant to paragraph (d)(1) of this section
and § 1.1502–13(c), A’s sale of televisions to
B in 2007 is taken into account in 2008 when
B sells the televisions to unrelated persons.
However, because A and B are members of
a consolidated group, § 1.1502–13(c)(1)(i)
provides that the separate entity attributes of
A’s intercompany items or B’s corresponding

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items, or both, may be redetermined in order
to produce the same effect as if A and B were
divisions of a single corporation.
Accordingly, A’s $2,000,000 of gross receipts
are redetermined to be non-DPGR and as not
being gross receipts for purposes of allocating
costs between DPGR and non-DPGR, and B’s
$2,000,000 CGS are redetermined to be not
allocable to DPGR. Notwithstanding that A’s
receipts are redetermined to be non-DPGR
and as not being gross receipts for purposes
of allocating costs between DPGR and nonDPGR, A’s CGS are still considered to be
allocable to DPGR because they are allocable
to the consolidated group deriving DPGR.
Accordingly, the consolidated group’s DPGR
in 2008 is $4,100,000 from B’s sales of
televisions, and its total receipts are
$7,100,000 ($4,100,000 DPGR plus
$3,000,000 non-DPGR from A’s computer
consulting services). To determine the
consolidated group’s QPAI, the consolidated
group subtracts A’s $1,500,000 CGS from the
televisions sold to B from its $4,100,000
DPGR. Under the simplified deduction
method, the consolidated group apportions
its remaining $1,100,000 of deductions
($1,000,000 from A and $100,000 from B) to
DPGR in proportion to the consolidated
group’s ratio of its DPGR to total gross
receipts. Thus, $635,211 ($1,100,000 ×
$4,100,000/$7,100,000) is allocated to DPGR.
Accordingly, the consolidated group’s QPAI
for 2008 is $1,964,789 ($4,100,000
DPGR¥$1,500,000 CGS¥$635,211
deductions apportioned to its DPGR), the
same QPAI that would result if A and B were
divisions of a single corporation.
(v) Allocation of consolidated group’s 2008
section 199 deduction to its members. (A) A’s
QPAI. For purposes of allocating the
consolidated group’s section 199 deduction
to its members, pursuant to paragraph (d)(5)
of this section, the redetermination of A’s
$2,000,000 in receipts is disregarded.
Accordingly, for this purpose, A’s DPGR are
$2,000,000 (receipts from the sale of
televisions to B taken into account in 2008)
and its total receipts are $5,000,000
($2,000,000 DPGR + $3,000,000 non-DPGR
from its computer consulting services). In
determining A’s QPAI, A subtracts its
$1,500,000 CGS from the televisions sold to
B from its $2,000,000 DPGR. Under the
simplified deduction method, A apportions
its remaining $1,000,000 of deductions in
proportion to the ratio of its DPGR to total
receipts. Thus, $400,000 ($1,000,000 ×
$2,000,000/$5,000,000) is allocated to DPGR.
Thus, A’s QPAI is $100,000 ($2,000,000
DPGR¥$1,500,000 CGS¥$400,000
deductions allocated to its DPGR).
(B) B’s QPAI. B’s DPGR and its total gross
receipts are each $4,100,000. For purposes of
allocating the consolidated group’s section
199 deduction to its members, pursuant to
paragraph (d)(5) of this section, the
redetermination of B’s $2,000,000 CGS as not
allocable to DPGR is disregarded. In
determining B’s QPAI, B subtracts its
$2,000,000 CGS from the televisions
purchased from A from its $4,100,000 DPGR.
Under the simplified deduction method, B
apportions its remaining $100,000
deductions in proportion to the ratio of its
DPGR to total receipts. Thus, all $100,000

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($100,000 × $4,100,000/$4,100,000) is
allocated to DPGR. Thus, B’s QPAI is
$2,000,000 ($4,100,000 DPGR¥$2,000,000
CGS¥$100,000 deductions allocated to its
DPGR).
(C) Allocation to A and B. Pursuant to
paragraph (d)(5) of this section, the
consolidated group’s section 199 deduction
for 2008 is allocated $100,000/($100,000 +
$2,000,000) to A and $2,000,000/($100,000 +
$2,000,000) to B.
Example 7. Corporations S and B are
members of the same consolidated group that
files its Federal income tax returns on a
calendar year basis. In 2007, S manufactures
office furniture for B to use in B’s corporate
headquarters and S sells the office furniture
to B. S and B have no other activities in the
taxable year. If S and B were not members
of a consolidated group, S’s gross receipts
from the sale of the office furniture to B
would be DPGR (assuming all the other
requirements of § 1.199–3 are met) and S’s
CGS or other deductions, expenses, or losses
from the sale to B would be allocable to S’s
DPGR. However, because S and B are
members of a consolidated group, the
separate entity attributes of S’s intercompany
items or B’s corresponding items, or both,
may be redetermined under § 1.1502–
13(c)(1)(i) or (c)(4) in order to produce the
same effect as if S and B were divisions of
a single corporation. If S and B were
divisions of a single corporation, there would
be no DPGR with respect to the office
furniture because there would be no lease,
rental, license, sale, exchange, or other
disposition of the furniture by the single
corporation (and no CGS or other deductions
allocable to DPGR). Thus, in order to produce
the same effect as if S and B were divisions
of a single corporation, S’s gross receipts are
redetermined as non-DPGR. Accordingly, the
consolidated group has no DPGR (and no
CGS or other deductions allocated or
apportioned to DPGR) and receives no
section 199 deduction in 2007.
Example 8. (i) Facts. A and B are members
of the same consolidated group that files its
Federal income tax returns on a calendar year
basis. On January 1, 2007, A MPGE QPP
which is 10-year recovery property for $100
and depreciates it under the straight-line
method. On January 1, 2009, A sells the
property to B for $130. Under section
168(i)(7), B is treated as A for purposes of
section 168 to the extent B’s $130 basis does
not exceed A’s adjusted basis at the time of
the sale. B’s additional basis is treated as new
10-year recovery property for which B elects
the straight-line method of recovery. (To
simplify the example, the half-year
convention is disregarded.)
(ii) Depreciation; intercompany gain. A
claims $10 of depreciation for each taxable
year 2007 and 2008 and has an $80 basis at
the time of the sale to B. Thus, A has a $50
intercompany gain from its sale to B. For
each taxable year 2009 through 2016, B has
$10 of depreciation with respect to $80 of its
basis (the portion of its $130 basis not
exceeding A’s adjusted basis) and $5 of
depreciation with respect to the $50 of its
additional basis that exceeds A’s adjusted
basis. For each taxable year 2017 and 2018,
B has $5 of depreciation with respect to the

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$50 of its additional basis that exceeds A’s
adjusted basis.
(iii) Timing. A’s $50 gain is taken into
account to reflect the difference for each
consolidated return year between B’s
depreciation taken into account with respect
to the property and the depreciation that
would have been taken into account if A and
B were divisions of a single corporation. For
each taxable year 2009 through 2016, B takes
into account $15 of depreciation rather than
the $10 of depreciation that would have been
taken into account if A and B were divisions
of a single corporation. For each taxable year
2017 and 2018, B takes into account $5 of
depreciation rather than the $0 of
depreciation that would have been taken into
account if A and B were divisions of a single
corporation (the QPP would have been fully
depreciated after the 2016 taxable year if A
and B were divisions of a single corporation).
Thus, A takes $5 of gain into account in each
of the 2009 through 2018 taxable years (10%
of its $50 gain). Pursuant to § 1.199–7(d)(1),
A takes its sale to B into account in
computing the section 199 deduction at the
same time and in the same proportion as A
takes into account the income, gain,
deduction, or loss from the intercompany
transaction under § 1.1502–13. Thus, in each
taxable year 2009 through 2018, A takes into
account $13 of gross receipts (10% of its $130
gross receipts) from the sale to B. The group’s
income in each taxable year 2009 through
2016 is a $10 loss ($5 gain¥$15
depreciation), the same net amount it would
have been if A and B were divisions of a
single corporation. The group’s income in
each taxable year 2017 and 2018 is $0 ($5
gain¥$5 depreciation), the same net amount
it would have been if A and B were divisions
of a single corporation.
(iv) Attributes. If A and B were not
members of a consolidated group, A’s gross
receipts on the sale of the QPP to B would
be DPGR (assuming all the other
requirements of § 1.199–3 are met). However,
because A and B are members of a
consolidated group, the separate entity
attributes of A’s DPGR may be redetermined
under § 1.1502–13(c)(1)(i) or (c)(4) in order to
produce the same effect as if A and B were
divisions of a single corporation. If A and B
were divisions of a single corporation, there
would be no DPGR with respect to the QPP
because there would be no lease, rental,
license, sale, exchange, or other disposition
of the QPP by the single corporation (and no
CGS or other deductions allocable to DPGR).
Thus, in order to produce the same effect as
if A and B were divisions of a single
corporation, A’s $13 of gross receipts taken
into account in each year is redetermined as
non-DPGR. Accordingly, the consolidated
group has no DPGR (and no CGS or other
deductions allocable or apportioned to
DPGR) and receives no section 199
deduction.
Example 9. Corporations X, Y, and Z are
members of the same EAG but are not
members of a consolidated group. X, Y, and
Z each files Federal income tax returns on a
calendar year basis. Assume that the EAG has
W–2 wages in excess of the section 199(b)
wage limitation. Prior to 2007, X had no
taxable income or loss. In 2007, X has $0 of

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taxable income and $2,000 of QPAI, Y has
$4,000 of taxable income and $3,000 of QPAI,
and Z has $4,000 of taxable income and
$5,000 of QPAI. Accordingly, the EAG has
taxable income of $8,000, the sum of X’s
taxable income of $0, Y’s taxable income of
$4,000, and Z’s taxable income of $4,000.
The EAG has QPAI of $10,000, the sum of X’s
QPAI of $2,000, Y’s QPAI of $3,000, and Z’s
QPAI of $5,000. Because X’s, Y’s, and Z’s
taxable years all began in 2007, the transition
percentage under section 199(a)(2) is 6%.
Thus, the EAG’s section 199 deduction for
2007 is $480 (6% of the lesser of the EAG’s
taxable income of $8,000 or the EAG’s QPAI
of $10,000). Pursuant to paragraph (c)(1) of
this section, the $480 section 199 deduction
is allocated to X, Y, and Z in proportion to
their respective amounts of QPAI, that is $96
to X ($480 × $2,000/$10,000), $144 to Y ($480
× $3,000/$10,000), and $240 to Z ($480 ×
$5,000/$10,000). Although X’s taxable
income for 2007 determined prior to
allocation of a portion of the EAG’s section
199 deduction to it was $0, pursuant to
paragraph (c)(2) of this section X will have
an NOL for 2007 equal to $96. Because X’s
NOL for 2007 cannot be carried back to a
previous taxable year, X’s NOL carryover to
2008 will be $96.
Example 10. (i) Facts. Corporation P owns
all of the stock of Corporations S and T and
P, S, and T file a consolidated Federal
income tax return on a calendar year basis.
In 2007, P MPGE QPP in the United States
at a cost of $1,000. On November 30, 2007,
P sells the QPP to S for $2,500. On February
28, 2008, P disposes of 60% of the stock of
S. On June 30, 2008, S sells the QPP to an
unrelated person for $3,000.
(ii) Analysis. Because P and S are members
of a consolidated group in 2007, pursuant to
§ 1.199–7(d)(1) and § 1.1502–13, neither P’s
$1,500 of gain on the sale of QPP to S nor
P’s $2,500 gross receipts from the sale are
taken into account in 2007. Under § 1.1502–
13(d), P takes the intercompany transaction
into account immediately before S becomes
a non-member of the consolidated group. In
order to produce the same effect as if P and
S were divisions of a single corporation, P’s
gross receipts from the sale of the QPP to S
are redetermined under § 1.1502–13(c)(1)(i)
as non-DPGR. Further, because P and S are
not members of the same EAG when S sells
the QPP to the unrelated person, and because
P’s transfer of the QPP to S did not take place
in a transaction to which section 381(a)
applies, S is not treated as conducting the
activities conducted by P in determining if
S’s receipts are DPGR, notwithstanding that
P and S were members of the same EAG
when P MPGE the QPP and when P sold the
QPP to S. Accordingly, neither the P
consolidated group nor S will have DPGR
with respect to the QPP.
Example 11. Corporation X is the common
parent of a consolidated group, consisting of
X and Y, which has filed a consolidated
Federal income tax return for many years.
Corporation P is the common parent of a
consolidated group, consisting of P and S,
which has filed a consolidated Federal
income tax return for many years. The X and
P consolidated groups each file their
consolidated Federal income tax returns on

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a calendar year basis. X, Y, P and S are
members of the same EAG in 2008. In 2007,
the X consolidated group incurred a
consolidated net operating loss (CNOL) of
$25,000, none of which was carried back and
used to offset taxable income of prior taxable
years. Neither P nor S (nor the P consolidated
group) has ever incurred an NOL. In 2008,
the X consolidated group has (prior to the
deduction under section 172) taxable income
of $8,000 and the P consolidated group has
taxable income of $20,000. The X
consolidated group uses $8,000 of its CNOL
from 2007 to offset the X consolidated
group’s taxable income in 2008. None of the
X consolidated group’s remaining CNOL may
be used to offset taxable income of the P
consolidated group under paragraph (b)(3) of
this section. Accordingly, for purposes of
determining the EAG’s section 199
deduction, the EAG has taxable income of
$20,000 (the X consolidated group’s taxable
income (after the deduction under section
172) of $0 plus the P consolidated group’s
taxable income of $20,000).

(f) Allocation of income and loss by a
corporation that is a member of the
expanded affiliated group for only a
portion of the year—(1) In general. A
corporation that becomes or ceases to be
a member of an EAG during its taxable
year must allocate its taxable income or
loss, QPAI, and W–2 wages between the
portion of the taxable year that it is a
member of the EAG and the portion of
the taxable year that it is not a member
of the EAG. In general, this allocation of
items is made by using the pro rata
allocation method described in
paragraph (f)(1)(i) of this section.
However, a corporation may elect to use
the section 199 closing of the books
method described in paragraph (f)(1)(ii)
of this section. Neither the pro rata
allocation method nor the section 199
closing of the books method is a method
of accounting.
(i) Pro rata allocation method. Under
the pro rata allocation method, an equal
portion of a corporation’s taxable
income or loss, QPAI, and W–2 wages
for the taxable year is assigned to each
day of the corporation’s taxable year.
Those items assigned to those days that
the corporation was a member of the
EAG are then aggregated.
(ii) Section 199 closing of the books
method. Under the section 199 closing
of the books method, a corporation’s
taxable income or loss, QPAI, and W–
2 wages for the period during which the
corporation was a member of an EAG
are computed by treating the
corporation’s taxable year as two
separate taxable years, the first of which
ends at the close of the day on which
the corporation’s status as a member of
the EAG changes and the second of
which begins at the beginning of the day
after the corporation’s status as a
member of the EAG changes.

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(iii) Making the section 199 closing of
the books election. A corporation makes
the section 199 closing of the books
election by making the following
statement: ‘‘The section 199 closing of
the books election is hereby made with
respect to [insert name of corporation
and its employer identification number]
with respect to the following periods
[insert dates of the two periods between
which items are allocated pursuant to
the closing of the books method].’’ The
statement must be filed with the
corporation’s timely filed (including
extensions) Federal income tax return
for the taxable year that includes the
periods that are subject to the election.
Once made, a section 199 closing of the
books election is irrevocable.
(2) Coordination with rules relating to
the allocation of income under
§ 1.1502–76(b). If § 1.1502–76(b)
(relating to items included in a
consolidated return) applies to a
corporation that is a member of an EAG,
then any allocation of items required
under this paragraph (f) is made only
after the allocation of the corporation’s
items pursuant to § 1.1502–76(b).
(g) Total section 199 deduction for a
corporation that is a member of an
expanded affiliated group for some or
all of its taxable year—(1) Member of
the same expanded affiliated group for
the entire taxable year. If a corporation
is a member of the same EAG for its
entire taxable year, the corporation’s
section 199 deduction for the taxable
year is the amount of the section 199
deduction allocated to the corporation
by the EAG under paragraph (c)(1) of
this section.
(2) Member of the expanded affiliated
group for a portion of the taxable year.
If a corporation is a member of an EAG
only for a portion of its taxable year and
is either not a member of any EAG or
is a member of another EAG, or both, for
another portion of the taxable year, the
corporation’s section 199 deduction for
the taxable year is the sum of its section
199 deductions for each portion of the
taxable year.
(3) Example. The following example
illustrates the application of paragraphs
(f) and (g) of this section:
Example. Corporations X and Y, calendar
year corporations, are members of the same
EAG for the entire 2007 taxable year.
Corporation Z, also a calendar year
corporation, is a member of the EAG of
which X and Y are members for the first half
of 2007 and not a member of any EAG for the
second half of 2007. During the 2007 taxable
year, Z does not join in the filing of a
consolidated return. Z makes a section 199
closing of the books election. As a result, Z
has $80 of taxable income and $100 of QPAI
that is allocated to the first half of 2007 and
a $150 taxable loss and ($200) of QPAI that

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is allocated to the second half of 2007.
Taking into account Z’s taxable income,
QPAI, and W–2 wages allocated to the first
half of 2007 pursuant to the section 199
closing of the books election, the EAG has
positive taxable income and QPAI for 2007
and W–2 wages in excess of the section
199(b) wage limitation. Because the EAG has
both positive taxable income and QPAI and
sufficient W–2 wages, and because Z has
positive QPAI for the first half of 2007, a
portion of the EAG’s section 199 deduction
is allocated to Z. Because Z has negative
QPAI for the second half of 2007, Z is
allowed no section 199 deduction for the
second half of 2007. Thus, despite the fact
that Z has a $70 taxable loss and ($100) of
QPAI for the entire 2007 taxable year, Z is
entitled to a section 199 deduction for 2007
equal to the section 199 deduction allocated
to Z as a member of the EAG.

(h) Computation of section 199
deduction for members of an expanded
affiliated group with different taxable
years—(1) In general. If members of an
EAG have different taxable years, in
determining the section 199 deduction
of a member (the computing member),
the computing member is required to
take into account the taxable income or
loss, determined without regard to the
section 199 deduction, QPAI, and W–2
wages of each other group member that
are both—
(i) Attributable to the period that each
other member of the EAG and the
computing member are members of the
EAG; and
(ii) Taken into account in a taxable
year that begins after the effective date
of section 199 and such taxable year
ends with or within the taxable year of
the computing member with respect to
which the section 199 deduction is
computed.
(2) Example. The following example
illustrates the application of this
paragraph (h):
Example. (i) Corporations X, Y, and Z are
members of the same EAG. Neither X, Y, nor
Z is a member of a consolidated group. X and
Y are calendar year taxpayers and Z is a June
30 fiscal year taxpayer. Z came into existence
on July 1, 2007. Each corporation has taxable
income that exceeds its QPAI and has
sufficient W–2 wages to avoid the limitation
under section 199(b). For the taxable year
ending December 31, 2007, X’s QPAI is
$8,000 and Y’s QPAI is ($6,000). For its
taxable year ending June 30, 2008, Z’s QPAI
is $2,000.
(ii) In computing X’s and Y’s respective
section 199 deductions for their taxable years
ending December 31, 2007, X’s and Y’s
taxable income, QPAI, and W–2 wages from
their respective taxable years ending
December 31, 2007, are aggregated. The
EAG’s QPAI for this purpose is $2,000 (X’s
QPAI of $8,000 + Y’s QPAI of ($6,000)).
Because the taxable years of the computing
members, X and Y, began in 2007, the
transition percentage under section 199(a)(2)

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31319

is 6%. Accordingly, the EAG’s section 199
deduction is $120 ($2,000 × .06). The $120
deduction is allocated to each of X and Y in
proportion to their respective QPAI as a
percentage of the QPAI of each member of
the EAG that was taken into account in
computing the EAG’s section 199 deduction.
Pursuant to paragraph (c)(1) of this section,
in allocating the section 199 deduction
between X and Y, because Y’s QPAI is
negative, Y’s QPAI is treated as being $0.
Accordingly, X’s section 199 deduction for
its taxable year ending December 31, 2007, is
$120 ($120 × $8,000/($8,000 + $0)). Y’s
section 199 deduction for its taxable year
ending December 31, 2007, is $0 ($120 × $0/
($8,000 + $0)).
(iii) In computing Z’s section 199
deduction for its taxable year ending June 30,
2008, X’s and Y’s items from their respective
taxable years ending December 31, 2007, are
taken into account. Therefore, X’s and Y’s
taxable income or loss, determined without
regard to the section 199 deduction, QPAI,
and W–2 wages from their taxable years
ending December 31, 2007, are aggregated
with Z’s taxable income or loss, QPAI, and
W–2 wages from its taxable year ending June
30, 2008. The EAG’s QPAI is $4,000 (X’s
QPAI of $8,000 + Y’s QPAI of ($6,000) + Z’s
QPAI of $2,000). Because the taxable year of
the computing member, Z, began in 2007, the
transition percentage under section 199(a)(2)
is 6%. Accordingly, the EAG’s section 199
deduction is $240 ($4,000 × .06). A portion
of the $240 deduction is allocated to Z in
proportion to its QPAI as a percentage of the
QPAI of each member of the EAG that was
taken into account in computing the EAG’s
section 199 deduction. Pursuant to paragraph
(c)(1) of this section, in allocating a portion
of the $240 deduction to Z, because Y’s QPAI
is negative, Y’s QPAI is treated as being $0.
Z’s section 199 deduction for its taxable year
ending June 30, 2008, is $48 ($240 × $2,000/
($8,000 + $0 + $2,000)).
§ 1.199–8

Other rules.

(a) In general. The provisions of this
section apply solely for purposes of
section 199 of the Internal Revenue
Code (Code). When calculating the
deduction under § 1.199–1(a) (section
199 deduction), taxpayers are required
to make numerous allocations under
§§ 1.199–1 through 1.199–9. In making
these allocations, taxpayers may use any
reasonable method that is satisfactory to
the Secretary based on all of the facts
and circumstances, unless the
regulations under §§ 1.199–1 through
1.199–9 specify a method. A change in
a taxpayer’s method of allocating or
apportioning gross receipts, cost of
goods sold (CGS), expenses, losses, or
deductions (deductions) does not
constitute a change in method of
accounting to which the provisions of
sections 446 and 481 and the
regulations thereunder apply.
(b) Individuals. In the case of an
individual, the section 199 deduction is
equal to the applicable percentage of the

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lesser of the taxpayer’s qualified
production activities income (QPAI) (as
defined in § 1.199–1(c)) for the taxable
year, or adjusted gross income (AGI) for
the taxable year determined after
applying sections 86, 135, 137, 219, 221,
222, and 469, and without regard to
section 199.
(c) Trade or business requirement—(1)
In general. Sections 1.199–1 through
1.199–9 are applied by taking into
account only items that are attributable
to the actual conduct of a trade or
business.
(2) Individuals. An individual
engaged in the actual conduct of a trade
or business must apply §§ 1.199–1
through 1.199–9 by taking into account
in computing QPAI only items that are
attributable to that trade or business (or
trades or businesses) and any items
allocated from a pass-thru entity
engaged in a trade or business.
Compensation received by an individual
employee for services performed as an
employee is not considered gross
receipts for purposes of computing
QPAI under §§ 1.199–1 through 1.199–
9. Similarly, any costs or expenses paid
or incurred by an individual employee
with respect to those services performed
as an employee are not considered CGS
or deductions of that employee for
purposes of computing QPAI under
§§ 1.199–1 through 1.199–9.
(3) Trusts and estates. For purposes of
this paragraph (c), a trust or estate is
treated as an individual.
(d) Coordination with alternative
minimum tax. For purposes of
determining alternative minimum
taxable income (AMTI) under section
55, a taxpayer that is not a corporation
must deduct an amount equal to 9
percent (3 percent in the case of taxable
years beginning in 2005 or 2006, and 6
percent in the case of taxable years
beginning in 2007, 2008, or 2009) of the
lesser of the taxpayer’s QPAI for the
taxable year, or the taxpayer’s taxable
income for the taxable year, determined
without regard to the section 199
deduction (or in the case of an
individual, AGI). For purposes of
determining AMTI in the case of a
corporation (including a corporation
subject to tax under section 511(a)), a
taxpayer must deduct an amount equal
to 9 percent (3 percent in the case of
taxable years beginning in 2005 or 2006,
and 6 percent in the case of taxable
years beginning in 2007, 2008, or 2009)
of the lesser of the taxpayer’s QPAI for
the taxable year, or the taxpayer’s AMTI
for the taxable year, determined without
regard to the section 199 deduction. For
purposes of computing AMTI, QPAI is
determined without regard to any
adjustments under sections 56 through

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59. In the case of an individual or a nongrantor trust or estate, AGI and taxable
income are also determined without
regard to any adjustments under
sections 56 through 59. The amount of
the deduction allowable under this
paragraph (d) for any taxable year
cannot exceed 50 percent of the W–2
wages of the employer for the taxable
year (as determined under § 1.199–2).
The section 199 deduction is not taken
into account in determining the amount
of the alternative tax net operating loss
deduction (ATNOL) allowed under
section 56(a)(4). For example, assume
that for the calendar year 2007, a
corporation has both AMTI (before the
NOL deduction and before the section
199 deduction) and QPAI of $1,000,000,
and has an ATNOL carryover to 2007 of
$5,000,000. Assume that the taxpayer
has W–2 wages in excess of the section
199(b) wage limitation. Under section
56(d), the ATNOL deduction for 2007 is
$900,000 (90 percent of $1,000,000),
reducing AMTI to $100,000. The
taxpayer must then further reduce the
AMTI by the section 199 deduction of
$6,000 (six percent of the lesser of
$1,000,000 or $100,000) to $94,000. The
ATNOL carryover to 2008 is $4,100,000.
(e) Nonrecognition transactions—(1)
In general—(i) Sections 351, 721, and
731. Except as provided for an EAG
partnership (as defined in § 1.199–9(j))
and an expanded affiliated group (EAG)
(as defined in § 1.199–7), if property is
transferred by the taxpayer to an entity
in a transaction to which section 351 or
721 applies, then whether the gross
receipts derived by the entity are
domestic production gross receipts
(DPGR) (as defined in § 1.199–3) shall
be determined based solely on the
activities performed by the entity
without regard to the activities
performed by the taxpayer prior to the
contribution of the property to the
entity. Except as provided for a
qualifying in-kind partnership (as
defined in § 1.199–9(i)) and an EAG
partnership, if property is transferred by
a partnership to a partner in a
transaction to which section 731
applies, then whether gross receipts
derived by the partner are DPGR shall
be determined based on the activities
performed by the partner without regard
to the activities performed by the
partnership before the distribution of
the property to the partner.
(ii) Exceptions—(A) Section
708(b)(1)(B). If property is deemed to be
contributed by a partnership (transferor
partnership) to another partnership
(transferee partnership) as a result of a
termination under section 708(b)(1)(B),
then the transferee partnership shall be
treated as performing those activities

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performed by the transferor partnership
with respect to the transferred property
of the transferor partnership.
(B) Transfers by reason of death. If
property is transferred upon or by
reason of the death of an individual
(decedent), then the decedent’s
successor(s) in interest shall be treated
as having performed those activities
performed by or deemed to have been
performed (pursuant to § 1.199–9(i)) by
the decedent with respect to the
transferred property. For this purpose, a
transfer shall include without limitation
the passing of the property by bequest,
contractual provision, beneficiary
designation, or operation of law, and
successor in interest shall include
without limitation the decedent’s heirs
or legatees, the decedent’s estate or
trust, or the beneficiary or beneficiaries
of the decedent’s estate or trust.
(2) Section 1031 exchanges. If a
taxpayer exchanges property for
replacement property in a transaction to
which section 1031 applies, then
whether the gross receipts derived from
the lease, rental, license, sale, exchange,
or other disposition of the replacement
property are DPGR shall be determined
based solely on the activities performed
by the taxpayer with respect to the
replacement property.
(3) Section 381 transactions. If a
corporation (the acquiring corporation)
acquires the assets of another
corporation (the target corporation) in a
transaction to which section 381(a)
applies, then the acquiring corporation
shall be treated as performing those
activities of the target corporation with
respect to the acquired assets of the
target corporation. Therefore, to the
extent that the acquired assets of the
target corporation would have given rise
to DPGR if leased, rented, licensed, sold,
exchanged, or otherwise disposed of by
the target corporation, such assets will
give rise to DPGR if leased, rented,
licensed, sold, exchanged, or otherwise
disposed of by the acquiring corporation
(assuming all the other requirements of
§ 1.199–3 are met).
(f) Taxpayers with a 52–53 week
taxable year. For purposes of applying
§ 1.441–2(c)(1) in the case of a taxpayer
using a 52–53 week taxable year, any
reference in section 199(a)(2) (the phasein rule), §§ 1.199–1 through 1.199–9 to
a taxable year beginning after a
particular calendar year means a taxable
year beginning after December 31st of
that year. Similarly, any reference to a
taxable year beginning in a particular
calendar year means a taxable year
beginning after December 31st of the
preceding calendar year. For example, a
52–53 week taxable year that begins on
December 26, 2006, is deemed to begin

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on January 1, 2007, and the transition
percentage for that taxable year is 6
percent.
(g) Section 481(a) adjustments. For
purposes of determining QPAI, a section
481(a) adjustment, whether positive or
negative, taken into account by a
taxpayer during the taxable year that is
solely attributable to either the
taxpayer’s gross receipts, CGS, or
deductions must be allocated or
apportioned between DPGR and nonDPGR using the methods used by a
taxpayer to allocate or apportion gross
receipts, CGS, and deductions between
DPGR and non-DPGR for the current
taxable year. See §§ 1.199–1 and 1.199–
4 for rules related to the allocation and
apportionment of gross receipts, CGS,
and deductions, respectively. For
example, if a taxpayer changes its
method of accounting for inventories
from the last-in, first-out (LIFO) method
to the first-in, first-out (FIFO) method
and the taxpayer uses the small business
simplified overall method to apportion
CGS between DPGR and non-DPGR, the
taxpayer is required to apportion the
resulting section 481(a) adjustment,
whether positive or negative, between
DPGR and non-DPGR using the small
business simplified overall method. If a
section 481(a) adjustment is not solely
attributable to either gross receipts,
CGS, or deductions (for example, the
taxpayer changes its overall method of
accounting from an accrual method to
the cash method) and the section 481(a)
adjustment cannot be specifically
identified with either gross receipts,
CGS, or deductions, then the section
481(a) adjustment, whether positive or
negative, must be attributed to, or
among, gross receipts, CGS, or
deductions using any reasonable
method that is satisfactory to the
Secretary based on all of the facts and
circumstances, and then allocated or
apportioned between DPGR and nonDPGR using the same methods the
taxpayer uses to allocate or apportion
gross receipts, CGS, or deductions
between DPGR and non-DPGR for the
taxable year or taxable years that the
section 481(a) adjustment is taken into
account. Factors taken into
consideration in determining whether
the method is reasonable include
whether the taxpayer uses the most
accurate information available; the
relationship between the section 481(a)
adjustment and the apportionment base
chosen; the accuracy of the method
chosen as compared with other possible
methods; and the time, burden, and cost
of using alternative methods. If a section
481(a) adjustment is spread over more
than one taxable year, then a taxpayer

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must attribute the section 481(a)
adjustment among gross receipts, CGS,
or deductions, as applicable, in the
same amount for each taxable year
within the spread period. For example,
if a taxpayer, using a reasonable method
that is satisfactory to the Secretary based
on all of the facts and circumstances,
determines that a section 481(a)
adjustment that is required to be spread
over four taxable years should be
attributed half to gross receipts and half
to deductions, then the taxpayer must
attribute the section 481(a) adjustment
half to gross receipts and half to
deductions in each of the four taxable
years of the spread period. Further, if
such taxpayer uses the simplified
deduction method to apportion
deductions between DPGR and nonDPGR in the first taxable year of the
spread period, then the taxpayer must
use the simplified deduction method to
apportion half the section 481(a)
adjustment for that taxable year between
DPGR and non-DPGR for that taxable
year. Similarly, if in the second taxable
year of the spread period the taxpayer
uses the section 861 method to
apportion and allocate costs between
DPGR and non-DPGR, then the taxpayer
must use the section 861 method to
allocate and apportion half the section
481(a) adjustment for that taxable year
between DPGR and non-DPGR for that
taxable year.
(h) Disallowed losses or deductions.
Except as provided by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter),
losses or deductions of a taxpayer that
otherwise would be taken into account
in computing the taxpayer’s section 199
deduction are taken into account only if
and to the extent the deductions are not
disallowed by section 465 or 469, or any
other provision of the Code. If only a
portion of the taxpayer’s share of the
losses or deductions is allowed for a
taxable year, the proportionate share of
those allowable losses or deductions
that are allocated to the taxpayer’s
qualified production activities,
determined in a manner consistent with
section 465 and 469, and any other
applicable provision of the Code, is
taken into account in computing QPAI
for purposes of the section 199
deduction for that taxable year. To the
extent that any of the disallowed losses
or deductions are allowed in a later
taxable year, the taxpayer takes into
account a proportionate share of those
losses or deductions in computing its
QPAI for that later taxable year. Losses
or deductions of the taxpayer that are
disallowed for taxable years beginning
on or before December 31, 2004, are not

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taken into account in a later taxable year
for purposes of computing the
taxpayer’s QPAI and the wage limitation
of section 199(d)(1)(A)(iii) under
§ 1.199–9 for that taxable year,
regardless of whether the losses or
deductions are allowed for other
purposes. For taxpayers that are
partners in partnerships, see § 1.199–
9(b)(2). For taxpayers that are
shareholders in S corporations, see
§ 1.199–9(c)(2).
(i) Effective dates—(1) In general.
Section 199 applies to taxable years
beginning after December 31, 2004.
Sections 1.199–1 through 1.199–8 are
applicable for taxable years beginning
on or after June 1, 2006. For a taxable
year beginning on or before May 17,
2006, the enactment date of the Tax
Increase Prevention and Reconciliation
Act of 2005 (Pub. L. 109–222, 120 Stat.
345), a taxpayer may apply §§ 1.199–1
through 1.199–9 provided that the
taxpayer applies all provisions in
§§ 1.199–1 through 1.199–9 to the
taxable year. For a taxable year
beginning after May 17, 2006, and
before June 1, 2006, a taxpayer may
apply §§ 1.199–1 through 1.199–8
provided that the taxpayer applies all
provisions in §§ 1.199–1 through 1.199–
8 to the taxable year. For a taxpayer who
chooses not to rely on these final
regulations for a taxable year beginning
before June 1, 2006, the guidance under
section 199 that applies to such taxable
year is contained in Notice 2005–14
(2005–1 C.B. 498) (see § 601.601(d)(2) of
this chapter). In addition, a taxpayer
also may rely on the provisions of REG–
105847–05 (2005–47 I.R.B. 987) (see
§ 601.601(d)(2) of this chapter) for a
taxable year beginning before June 1,
2006. If Notice 2005–14 and REG105847–05 include different rules for
the same particular issue, then a
taxpayer may rely on either the rule set
forth in Notice 2005–14 or the rule set
forth in REG–105847–05. However, if
REG–105847–05 includes a rule that
was not included in Notice 2005–14,
then a taxpayer is not permitted to rely
on the absence of a rule in Notice 2005–
14 to apply a rule contrary to REG–
105847–05. For taxable years beginning
after May 17, 2006, and before June 1,
2006, a taxpayer may not apply Notice
2005–14, REG–105847–05, or any other
guidance under section 199 in a manner
inconsistent with amendments made to
section 199 by section 514 of the Tax
Increase Prevention and Reconciliation
Act of 2005.
(2) Pass-thru entities. In determining
the deduction under section 199, items
arising from a taxable year of a
partnership, S corporation, estate, or
trust beginning before January 1, 2005,

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shall not be taken into account for
purposes of section 199(d)(1).
(3) Non-consolidated EAG members.
A member of an EAG that is not a
member of a consolidated group may
apply paragraph (i)(1) of this section
without regard to how other members of
the EAG apply paragraph (i)(1) of this
section.
(4) Computer software provided to
customers over the Internet. [Reserved].
For further guidance, see § 1.199–
8T(i)(4).

rwilkins on PROD1PC63 with RULES_2

§ 1.199–9 Application of section 199 to
pass-thru entities for taxable years
beginning on or before May 17, 2006, the
enactment date of the Tax Increase
Prevention and Reconciliation Act of 2005.

(a) In general. The provisions of this
section apply solely for purposes of
section 199 of the Internal Revenue
Code (Code).
(b) Partnerships—(1) In general—(i)
Determination at partner level. The
deduction with respect to the qualified
production activities of the partnership
allowable under § 1.199–1(a) (section
199 deduction) is determined at the
partner level. As a result, each partner
must compute its deduction separately.
The section 199 deduction has no effect
on the adjusted basis of the partner’s
interest in the partnership. Except as
provided by publication pursuant to
paragraph (b)(1)(ii) of this section, for
purposes of this section, each partner is
allocated, in accordance with sections
702 and 704, its share of partnership
items (including items of income, gain,
loss, and deduction), cost of goods sold
(CGS) allocated to such items of income,
and gross receipts that are included in
such items of income, even if the
partner’s share of CGS and other
deductions and losses exceeds domestic
production gross receipts (DPGR) (as
defined in § 1.199–3(a)) and regardless
of the amount of the partner’s share of
W–2 wages (as defined in § 1.199–2(e))
of the partnership for the taxable year.
A partnership may specially allocate
items of income, gain, loss, or deduction
to its partners, subject to the rules of
section 704(b) and the supporting
regulations. Guaranteed payments under
section 707(c) are not considered
allocations of partnership income for
purposes of this section. Guaranteed
payments under section 707(c) are
deductions by the partnership that must
be taken into account under the rules of
§ 1.199–4. See § 1.199–3(p) and
paragraph (b)(6) Example 5 of this
section. Except as provided in
paragraph (b)(1)(ii) of this section, to
determine its section 199 deduction for
the taxable year, a partner aggregates its
distributive share of such items, to the

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extent they are not otherwise disallowed
by the Code, with those items it incurs
outside the partnership (whether
directly or indirectly) for purposes of
allocating and apportioning deductions
to DPGR and computing its qualified
production activities income (QPAI) (as
defined in § 1.199–1(c)).
(ii) Determination at entity level. The
Secretary may, by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter),
permit a partnership to calculate a
partner’s share of QPAI at the entity
level, instead of allocating, in
accordance with sections 702 and 704,
the partner’s share of partnership items
(including items of income, gain, loss,
and deduction). If a partnership does
calculate QPAI at the entity level—
(A) The partner is allocated its share
of QPAI and W–2 wages (as defined in
§ 1.199–2(e)), which (subject to the
limitations of paragraph (b)(2) of this
section and section 199(d)(1)(A)(iii),
respectively) are combined with the
partner’s QPAI and W–2 wages from
other sources;
(B) For purposes of computing QPAI
under §§ 1.199–1 through 1.199–9, a
partner does not take into account the
items from such a partnership (for
example, a partner does not take into
account items from such a partnership
in determining whether a threshold or
de minimis rule applies or when the
partner allocates and apportions
deductions in calculating its QPAI from
other sources);
(C) A partner generally does not
recompute its share of QPAI from the
partnership using another method;
however, the partner might have to
adjust its share of QPAI from the
partnership to take into account certain
disallowed losses or deductions, or the
allowance of suspended losses or
deductions; and
(D) A partner’s distributive share of
QPAI from a partnership may be less
than zero.
(2) Disallowed losses or deductions.
Except as provided by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter),
losses or deductions of a partnership
that otherwise would be taken into
account in computing the partner’s
section 199 deduction for a taxable year
are taken into account in that year only
if and to the extent the partner’s
distributive share of those losses or
deductions from all of the partnership’s
activities is not disallowed by section
465, 469, or 704(d), or any other
provision of the Code. If only a portion
of the partner’s distributive share of the
losses or deductions is allowed for a
taxable year, a proportionate share of

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those allowable losses or deductions
that are allocated to the partnership’s
qualified production activities,
determined in a manner consistent with
sections 465, 469, and 704(d), and any
other applicable provision of the Code,
is taken into account in computing
QPAI and the wage limitation of section
199(d)(1)(A)(iii) for that taxable year. To
the extent that any of the disallowed
losses or deductions are allowed in a
later taxable year, the partner takes into
account a proportionate share of those
losses or deductions in computing its
QPAI for that later taxable year. Losses
or deductions of the partnership that are
disallowed for taxable years beginning
on or before December 31, 2004, are not
taken into account in a later taxable year
for purposes of computing the partner’s
QPAI or the wage limitation of section
199(d)(1)(A)(iii) for that taxable year,
regardless of whether the losses or
deductions are allowed for other
purposes.
(3) Partner’s share of W–2 wages.
Under section 199(d)(1)(A)(iii), a
partner’s share of W–2 wages of a
partnership for purposes of determining
the partner’s section 199(b) wage
limitation is the lesser of the partner’s
allocable share of those wages (without
regard to section 199(d)(1)(A)(iii)), or 2
times 3 percent of the QPAI computed
by taking into account only the items of
the partnership allocated to the partner
for the taxable year of the partnership.
Except as provided by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter),
this QPAI calculation is performed by
the partner using the same cost
allocation method that the partner uses
in calculating the partner’s section 199
deduction. The partnership must
allocate W–2 wages (prior to the
application of the wage limitation)
among the partners in the same manner
as wage expense. The partner must add
the partner’s share of the W–2 wages
from the partnership, as limited by
section 199(d)(1)(A)(iii), to the partner’s
W–2 wages from other sources, if any.
If QPAI, computed by taking into
account only the items of the
partnership allocated to the partner for
the taxable year (as required by the wage
limitation of section 199(d)(1)(A)(iii)) is
not greater than zero, then the partner
may not take into account any W–2
wages of the partnership in applying the
wage limitation of § 1.199–2 (but the
partner will, nevertheless, aggregate its
distributive share of partnership items
including wage expense with those
items not from the partnership in
computing its QPAI when determining
its section 199 deduction). See § 1.199–

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Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules and Regulations
2 for the computation of W–2 wages,
and paragraph (g) of this section for
rules regarding pass-thru entities in a
tiered structure.
(4) Transition percentage rule for W–
2 wages. With regard to partnerships, for
purposes of section 199(d)(1)(A)(iii)(II)
the transition percentages determined
under section 199(a)(2) shall be
determined by reference to the
partnership’s taxable year. Thus, if a
partner uses a calendar year taxable
year, and owns an interest in a
partnership that has a taxable year
ending on April 30, the partner’s section
199(d)(1)(A)(iii) wage limitation for the
partnership’s taxable year beginning on
May 1, 2006, would be calculated using
3 percent, even though the partner
includes the partner’s distributive share
of partnership items from that taxable
year on the partner’s 2007 Federal
income tax return.

(5) Partnerships electing out of
subchapter K. For purposes of §§ 1.199–
1 through 1.199–9, the rules of
paragraph (b) of this section shall apply
to all partnerships, including those
partnerships electing under section
761(a) to be excluded, in whole or in
part, from the application of subchapter
K of chapter 1 of the Code.
(6) Examples. The following examples
illustrate the application of this
paragraph (b). Assume that each partner
has sufficient adjusted gross income or
taxable income so that the section 199
deduction is not limited under section
199(a)(1)(B); that the partnership and
each of its partners (whether individual
or corporate) are calendar year
taxpayers; and that the amount of the
partnership’s W–2 wages equals wage
expense for each taxable year. The
examples are as follows:

Example 1. Section 861 method with
interest expense. (i) Partnership Federal
income tax items. X and Y, unrelated United
States corporations, are each 50% partners in
PRS, a partnership that engages in
production activities that generate both
DPGR and non-DPGR. X and Y share all
items of income, gain, loss, deduction, and
credit 50% each. Both X and Y are engaged
in a trade or business. PRS is not able to
identify from its books and records CGS
allocable to DPGR and non-DPGR. In this
case, because CGS is definitely related under
the facts and circumstances to all of PRS’s
gross income, apportionment of CGS between
DPGR and non-DPGR based on gross receipts
is appropriate. For 2006, the adjusted basis
of PRS’s business assets is $5,000, $4,000 of
which generate gross income attributable to
DPGR and $1,000 of which generate gross
income attributable to non-DPGR. For 2006,
PRS has the following Federal income tax
items:

DPGR ...................................................................................................................................................................................................
Non-DPGR ...........................................................................................................................................................................................
CGS (includes $200 of W–2 wages) ...................................................................................................................................................
Section 162 selling expenses (includes $300 of W–2 wages) ...........................................................................................................
Interest expense (not included in CGS) ..............................................................................................................................................

(ii) Allocation of PRS’s items of income,
gain, loss, deduction, or credit. X and Y each

receive the following distributive share of
PRS’s items of income, gain, loss, deduction

of X’s non-PRS assets, all of which are
investment assets, is $10,000. X’s only gross
receipts for 2006 are those attributable to the
allocation of gross income from PRS. X
allocates and apportions its deductible items
to gross income attributable to DPGR under
the section 861 method of § 1.199–4(d). In
this case, the section 162 selling expenses
(including W–2 wages) are definitely related

X’s QPAI ............................................................................................................................................................................................

rwilkins on PROD1PC63 with RULES_2

and records CGS allocable to DPGR and to
non-DPGR. For 2006, the adjusted basis of
Y’s non-PRS assets attributable to its
production activities that generate DPGR is

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$1,500
(810)
(300)
(24)
366

$8,000 and to other production activities that
generate non-DPGR is $2,000. Y has no other
assets. Y has the following Federal income
tax items relating to its non-PRS activities:

Gross income attributable to DPGR ($1,500 (DPGR) ¥ $900 (allocable CGS, includes $70 of W–2 wages)) ...............................
Gross income attributable to non-DPGR ($3,000 (other gross receipts) ¥ $1,620 (allocable CGS, includes $150 of W–2
wages)) .............................................................................................................................................................................................
Section 162 selling expenses (includes $30 of W–2 wages) .............................................................................................................
Interest expense (not included in CGS) ..............................................................................................................................................

VerDate Aug<31>2005

$690
690
600
150

to all of PRS’s gross receipts. Based on the
facts and circumstances of this specific case,
apportionment of those expenses between
DPGR and non-DPGR on the basis of PRS’s
gross receipts is appropriate. X elects to
apportion its distributive share of interest
expense under the tax book value method of
§ 1.861–9T(g). X’s QPAI for 2006 is $366, as
shown below:

DPGR .................................................................................................................................................................................................
CGS allocable to DPGR (includes $50 of W–2 wages) ....................................................................................................................
Section 162 selling expenses (includes $75 of W–2 wages) ($600 × $1,500/$3,000) ....................................................................
Interest expense (not included in CGS) ($150 × $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))) .......................................................................................................................

(B) Y’s QPAI. (1) For 2006, in addition to
the activities of PRS, Y engages in production
activities that generate both DPGR and nonDPGR. Y is able to identify from its books

$3,000
3,000
3,240
1,200
300

or credit, as determined 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)) ...............................
Gross income attributable to non-DPGR ($1,500 (non-DPGR) ¥ $810 (allocable CGS, includes $50 of W–2 wages)) .................
Section 162 selling expenses (includes $150 of W–2 wages) ...........................................................................................................
Interest expense (not included in CGS) ..............................................................................................................................................

(iii) Determination of QPAI. (A) X’s QPAI.
Because the section 199 deduction is
determined at the partner level, X determines
its QPAI by aggregating, to the extent
necessary, its distributive share of PRS’s
Federal income tax items with all other such
items from all other, non-PRS-related
activities. For 2006, X does not have any
other such items. For 2006, the adjusted basis

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$600
1,380
540
90

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(2) Y determines its QPAI in the same
general manner as X. However, because Y has
other trade or business activities outside of
PRS, Y must aggregate its distributive share
of PRS’s Federal income tax items with its
own such items. Y allocates and apportions
its deductible items to gross income
attributable to DPGR under the section 861
method of § 1.199–4(d). In this case, Y’s

distributive share of PRS’s section 162 selling
expenses (including W–2 wages), as well as
those selling expenses from Y’s non-PRS
activities, are definitely related to all of its
gross income. Based on the facts and
circumstances of this specific case,
apportionment of those expenses between
DPGR and non-DPGR on the basis of Y’s
gross receipts is appropriate. Y elects to

apportion its distributive share of interest
expense under the tax book value method of
§ 1.861–9T(g). Y has $1,290 of gross income
attributable to DPGR ($3,000 DPGR ($1,500
from PRS and $1,500 from non-PRS
activities) ¥ $1,710 CGS ($810 from PRS and
$900 from non-PRS activities). Y’s QPAI for
2006 is $642, as shown below:

DPGR ($1,500 from PRS and $1,500 from non-PRS activities) ......................................................................................................
CGS allocable to DPGR ($810 from PRS and $900 from non-PRS activities) (includes $120 of W–2 wages) .............................
Section 162 selling expenses (includes $180 of W–2 wages) ($1,140 ($600 from PRS and $540 from non-PRS activities) ×
($1,500 PRS DPGR + $1,500 non-PRS DPGR)/($3,000 PRS total gross receipts + $4,500 non-PRS total gross receipts)) ....
Interest expense (not included in CGS) ($240 ($150 from PRS and $90 from non-PRS activities) × $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))) ...............................................................................................................................................................
Y’s QPAI ............................................................................................................................................................................................

(iv) PRS W–2 wages allocated to X and Y
under section 199(d)(1)(A)(iii). Solely for
purposes of calculating the PRS W–2 wages
that are allocated to them under section
199(d)(1)(A)(iii) for purposes of the wage
limitation of section 199(b), X and Y must
separately determine QPAI taking into
account only the items of PRS allocated to
them. X and Y must use the same methods

of allocation and apportionment that they use
to determine their QPAI in paragraphs (iii)(A)
and (B) of this Example 1, respectively.
Accordingly, X and Y must apportion
deductible section 162 selling expenses that
include W–2 wage expense on the basis of
gross receipts, and must apportion interest
expense according to the tax book value
method of § 1.861–9T(g).

QPAI ..................................................................................................................................................................................................

$250 from non-PRS activities)). Accordingly,
Y’s section 199 deduction for 2006 is $19.
Example 2. Section 861 method with R&E
expense. (i) Partnership items of income,
gain, loss, deduction or credit. X and Y,
unrelated United States corporations each of
which is engaged in a trade or business, are
partners in PRS, a partnership that engages
in production activities that generate both
DPGR and non-DPGR. Neither X nor Y is a
member of an affiliated group. X and Y share
all items of income, gain, loss, deduction,
and credit 50% each. All of PRS’s domestic
production activities that generate DPGR are
within Standard Industrial Classification
(SIC) Industry Group AAA (SIC AAA). All of
PRS’s production activities that generate nonDPGR are within SIC Industry Group BBB

rwilkins on PROD1PC63 with RULES_2

receive the following distributive share of
PRS’s items of income, gain, loss, deduction,

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642

$1,500
(810)
(300)
(120)
270

$3,000
3,000
2,400
840
300
600

or credit, as determined 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)) .................................................
Gross income attributable to non-DPGR ($1,500 (other gross receipts)¥$600 (CGS, includes $50 of W–2 wages)) ....................
Section 162 selling expenses (includes $50 of W–2 wages) .............................................................................................................
Section 174 R&E–SIC AAA .................................................................................................................................................................

VerDate Aug<31>2005

(192)

(SIC BBB). PRS is not able to identify from
its books and records CGS allocable to DPGR
and to non-DPGR and, therefore, apportions
CGS to DPGR and non-DPGR based on its
gross receipts. PRS incurs $900 of research
and experimentation expenses (R&E) that are
deductible under section 174, $300 of which
are performed with respect to SIC AAA and
$600 of which are performed with respect to
SIC BBB. None of the R&E is legally
mandated R&E as described in § 1.861–
17(a)(4) and none is included in CGS. PRS
incurs section 162 selling expenses (that
include W–2 wage expense) that are not
includible in CGS and not directly allocable
to any gross income. For 2006, PRS has the
following Federal income tax items:

DPGR (all from sales of products within SIC AAA) ............................................................................................................................
Non-DPGR (all from sales of products within SIC BBB) ....................................................................................................................
CGS (includes $200 of W–2 wages) ...................................................................................................................................................
Section 162 selling expenses (includes $100 of W–2 wages) ...........................................................................................................
Section 174 R&E–SIC AAA .................................................................................................................................................................
Section 174 R&E–SIC BBB .................................................................................................................................................................

(ii) Allocation of PRS’s items of income,
gain, loss, deduction, or credit. X and Y each

(456)

(A) QPAI of X and Y, solely for this
purpose, is determined by allocating and
apportioning each partner’s share of PRS
expenses to each partner’s share of PRS gross
income of $690 attributable to DPGR ($1,500
DPGR¥$810 CGS, apportioned based on
gross receipts). Thus, QPAI of X and Y solely
for this purpose is $270, as shown below:

DPGR .................................................................................................................................................................................................
CGS allocable to DPGR ....................................................................................................................................................................
Section 162 selling expenses (including W–2 wages) ($600 × ($1,500/$3,000)) ............................................................................
Interest expense (not included in CGS) ($150 × $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)) ...............................................................................................................

(B) X’s and Y’s shares of PRS’s W–2 wages
determined under section 199(d)(1)(A)(iii) for
purposes of the wage limitation of section
199(b) are$16, the lesser of $250 (partner’s
allocable share of PRS’s W–2 wages ($100
included in total CGS, and $150 included in
selling expenses) and $16 (2 × ($270 × .03)).
(v) Section 199 deduction determination.
(A) X’s tentative section 199 deduction is $11
(.03 × $366 (that is, QPAI determined at
partner level)) subject to the wage limitation
of $8 (50% × $16). Accordingly, X’s section
199 deduction for 2006 is $8.
(B) Y’s tentative section 199 deduction is
$19 (.03 × $642 (that is, QPAI determined at
the partner level) subject to the wage
limitation of $133 (50% × ($16 from PRS and

$3,000
(1,710)

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900
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150

Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules and Regulations
Section 174 R&E–SIC BBB .................................................................................................................................................................

(iii) Determination of QPAI. (A) X’s QPAI.
Because the section 199 deduction is
determined at the partner level, X determines
its QPAI by aggregating, to the extent
necessary, its distributive shares of PRS’s
Federal income tax items with all other such
items from all other, non-PRS-related
activities. For 2006, X does not have any
other such tax items. X’s only gross receipts
for 2006 are those attributable to the
allocation of gross income from PRS. As
stated, all of PRS’s domestic production

activities that generate DPGR are within SIC
AAA. X allocates and apportions its
deductible items to gross income attributable
to DPGR under the section 861 method of
§ 1.199–4(d). In this case, the section 162
selling expenses (including W–2 wages) are
definitely related to all of PRS’s gross
income. Based on the facts and
circumstances of this specific case,
apportionment of those expenses between
DPGR and non-DPGR on the basis of PRS’s
gross receipts is appropriate. For purposes of

X’s QPAI ............................................................................................................................................................................................

from its books and records CGS allocable to
DPGR and to non-DPGR. In this case, because
CGS is definitely related under the facts and
circumstances to all of Y’s non-PRS gross
receipts, apportionment of CGS between

rwilkins on PROD1PC63 with RULES_2

apportionment of such expenses between
DPGR and non-DPGR on the basis of Y’s
gross receipts is appropriate. For purposes of
apportioning R&E, Y elects to use the sales
method as described in § 1.861–17(c).
(3) With respect to sales that generate
DPGR, Y has gross income of $2,400 ($4,500
DPGR ($1,500 from PRS and $3,000 from
non-PRS activities) ¥$2,100 CGS ($600 from
sales of products by PRS and $1,500 from
non-PRS activities)). Because all of the sales
in SIC AAA generate DPGR, all of Y’s share

$1,500
(600)
(210)
(150)
540

DPGR and non-DPGR based on Y’s non-PRS
gross receipts is appropriate. For 2006, Y has
the following non-PRS Federal income tax
items:

DPGR (from sales of products within SIC AAA) .................................................................................................................................
DPGR (from sales of products within SIC BBB) .................................................................................................................................
Non-DPGR (from sales of products within SIC BBB) .........................................................................................................................
CGS (allocated to DPGR within SIC AAA) (includes $56 of W–2 wages) .........................................................................................
CGS (allocated to DPGR within SIC BBB) (includes $56 of W–2 wages) .........................................................................................
CGS (allocated to non-DPGR within SIC BBB) (includes $113 of W–2 wages) ................................................................................
Section 162 selling expenses (includes $30 of W–2 wages) .............................................................................................................
Section 174 R&E–SIC AAA .................................................................................................................................................................
Section 174 R&E–SIC BBB .................................................................................................................................................................

(2) Because Y has DPGR as a result of
activities outside PRS, Y must aggregate its
distributive share of PRS’s Federal income
tax items with such items from all its other,
non-PRS-related activities. Y allocates and
apportions its deductible items to gross
income attributable to DPGR under the
section 861 method of § 1.199–4(d). In this
case, the section 162 selling expenses
(including W–2 wages) are definitely related
to all of Y’s gross income. Based on the facts
and circumstances of the specific case,

300

apportioning R&E, X elects to use the sales
method as described in § 1.861–17(c).
Because X has no direct sales of products,
and because all of PRS’s SIC AAA sales
attributable to X’s share of PRS’s gross
income generate DPGR, all of X’s share of
PRS’s section 174 R&E attributable to SIC
AAA is taken into account for purposes of
determining X’s QPAI. Thus, X’s total QPAI
for 2006 is $540, as shown below:

DPGR (all from sales of products within SIC AAA) ..........................................................................................................................
CGS (includes $50 of W–2 wages) ...................................................................................................................................................
Section 162 selling expenses (including W–2 wages) ($420 × ($1,500 DPGR/$3,000 total gross receipts)) .................................
Section 174 R&E–SIC AAA ...............................................................................................................................................................

(B) Y’s QPAI. (1) For 2006, in addition to
the activities of PRS, Y engages in domestic
production activities that generate both
DPGR and non-DPGR. With respect to those
non-PRS activities, Y is not able to identify

31325

$1,500
1,500
3,000
750
750
1,500
540
300
450

of PRS’s section 174 R&E attributable to SIC
AAA and the section 174 R&E attributable to
SIC AAA that Y incurs in its non-PRS
activities are taken into account for purposes
of determining Y’s QPAI. Because only a
portion of the sales within SIC BBB generate
DPGR, only a portion of the section 174 R&E
attributable to SIC BBB is taken into account
in determining Y’s QPAI. Thus, Y’s QPAI for
2006 is $1,282, as shown below:

DPGR ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities) .............................................................................
CGS ($600 from sales of products by PRS and $1,500 from non-PRS activities) ..........................................................................
Section 162 selling expenses (including W–2 wages) ($420 from PRS + $540 from non-PRS activities) × ($4,500 DPGR/
$9,000 total gross receipts)) ..........................................................................................................................................................
Section 174 R&E–SIC AAA ($150 from PRS and $300 from non-PRS activities) ...........................................................................
Section 174 R&E–SIC BBB ($300 from PRS + $450 from non-PRS activities) × ($1,500 DPGR/$6,000 total gross receipts allocated to SIC BBB ($1,500 from PRS and $4,500 from non-PRS activities)) ...............................................................................

$4,500
(2,100)

Y’s QPAI ............................................................................................................................................................................................

1,282

(iv) PRS W–2 wages allocated to X and Y
under section 199(d)(1)(A)(iii). Solely for
purposes of calculating the PRS W–2 wages
that are allocated to X and Y under section
199(d)(1)(A)(iii) for purposes of the wage
limitation of section 199(b), X and Y must
separately determine QPAI taking into
account only the items of PRS allocated to

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them. X and Y must use the same methods
of allocation and apportionment that they use
to determine their QPAI in paragraphs (iii)(A)
and (B) of this Example 2, respectively.
Accordingly, X and Y must apportion section
162 selling expenses that include W–2 wage
expense on the basis of gross receipts, and

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(480)
(450)
(188)

apportion section 174 R&E expense under the
sales method as described in § 1.861–17(c).
(A) QPAI of X and Y, solely for this
purpose, is determined by allocating and
apportioning each partner’s share of PRS
expenses to each partner’s share of PRS gross
income of $900 attributable to DPGR ($1,500
DPGR—$600 CGS, allocated based on PRS’s

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gross receipts). Because all of PRS’s SIC AAA
sales generate DPGR, all of X’s and Y’s shares
of PRS’s section 174 R&E attributable to SIC
AAA is taken into account for purposes of

determining X’s and Y’s QPAI. None of PRS’s
section 174 R&E attributable to SIC BBB is
taken into account because PRS has no DPGR
within SIC BBB. Thus, X and Y each has

QPAI, solely for this purpose, of $540, as
shown below:

DPGR (all from sales of products within SIC AAA) ..........................................................................................................................
CGS (includes $50 of W–2 wages) ...................................................................................................................................................
Section 162 selling expenses (including W–2 wages) ($420 × $1,500/$3,000) ...............................................................................
Section 174 R&E–SIC AAA ...............................................................................................................................................................

rwilkins on PROD1PC63 with RULES_2

QPAI ..................................................................................................................................................................................................

(B) X’s and Y’s shares of PRS’s W–2 wages
determined under section 199(d)(1)(A)(iii) for
purposes of the wage limitation of section
199(b) are $32, the lesser of $150 (partner’s
allocable share of PRS’s W–2 wages ($100
included in CGS, and $50 included in selling
expenses)) and $32 (2 × ($540 × .03)).
(v) Section 199 deduction determination.
(A) X’s tentative section 199 deduction is $16
(.03 × $540 (QPAI determined at partner
level)) subject to the wage limitation of $16
(50% × $32). Accordingly, X’s section 199
deduction for 2006 is $16.
(B) Y’s tentative section 199 deduction is
$38 (.03 x $1,282 (QPAI determined at
partner level) subject to the wage limitation
of $144 (50% x $287 ($32 from PRS + $255
from non-PRS activities)). Accordingly, Y’s
section 199 deduction for 2006 is $38.
Example 3. Partnership with special
allocations. (i) In general. X and Y are
unrelated corporate partners in PRS and each
is engaged in a trade or business. PRS is a
partnership that engages in a domestic
production activity and other activities. In
general, X and Y share all partnership items
of income, gain, loss, deduction, and credit
equally, except that 80% of the wage expense
of PRS and 20% of PRS’s other expenses are
specially allocated to X (substantial
economic effect under section 704(b) is
presumed). In the 2006 taxable year, PRS’s
only wage expense is $2,000 for marketing,
which is not included in CGS. PRS has
$8,000 of gross receipts ($6,000 of which is
DPGR), $4,000 of CGS ($3,500 of which is
allocable to DPGR), and $3,000 of deductions
(comprised of $2,000 of wages for marketing
and $1,000 of other expenses). X qualifies for
and uses the simplified deduction method
under § 1.199–4(e). Y does not qualify to use
that method and, therefore, must use the
section 861 method under § 1.199–4(d). In
the 2006 taxable year, X has gross receipts
attributable to non-partnership trade or
business activities of $1,000 and wages of
$200. None of X’s non-PRS gross receipts is
DPGR.
(ii) Allocation and apportionment of costs.
Under the partnership agreement, X’s
distributive share of the items of PRS is
$1,250 of gross income attributable to DPGR
($3,000 DPGR × $1,750 allocable CGS), $750
of gross income attributable to non-DPGR
($1,000 non-DPGR × $250 allocable CGS),
and $1,800 of deductions (comprised of X’s
special allocations of $1,600 of wage expense
($2,000 × 80%) for marketing and $200 of
other expenses ($1,000 × 20%)). Under the
simplified deduction method, X apportions
$1,200 of other deductions to DPGR ($2,000
($1,800 from the partnership and $200 from
non-partnership activities) × ($3,000 DPGR/

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$5,000 total gross receipts)). Accordingly, X’s
QPAI is $50 ($3,000 DPGR × $1,750 CGS ×
$1,200 of deductions). However, in
determining the section 199(d)(1)(A)(iii)
wage limitation, QPAI is computed taking
into account only the items of PRS allocated
to X for the taxable year of PRS. Thus, X
apportions $1,350 of deductions to DPGR
($1,800 × ($3,000 DPGR/$4,000 total gross
receipts from PRS)). Accordingly, X’s QPAI
for purposes of the section 199(d)(1)(A)(iii)
wage limitation is $0 ($3,000 DPGR × $1,750
CGS × $1,350 of deductions). X’s share of
PRS’s W–2 wages is $0, the lesser of $1,600
(X’s 80% allocable share of $2,000 of wage
expense for marketing) and $0 (2 × ($0 QPAI
× .03)). X’s tentative deduction is $2 ($50
QPAI × .03), subject to the section 199(b)(1)
wage limitation of $100 (50% × $200 ($0 of
PRS-related W–2 wages + $200 of non-PRS
W–2 wages)). Accordingly, X’s section 199
deduction for the 2006 taxable year is $2.
Example 4. Partnership with no W–2
wages. (i) Facts. A, an individual, and B, an
individual, are partners in PRS. PRS is a
partnership that engages in manufacturing
activities that generate both DPGR and nonDPGR. A and B share all items of income,
gain, loss, deduction, and credit equally. In
the 2006 taxable year, PRS has total gross
receipts of $2,000 ($1,000 of which is DPGR),
CGS of $400 and deductions of $800. PRS has
no W–2 wages. A and B each use the small
business simplified overall method under
§ 1.199–4(f). A has trade or business activities
outside of PRS. With respect to those
activities, A has total gross receipts of $1,000
($500 of which is DPGR), CGS of $400
(including $50 of W–2 wages) and
deductions of $200 for the 2006 taxable year.
B has no trade or business activities outside
of PRS and pays $0 of W–2 wages directly
for the 2006 taxable year. A’s distributive
share of the items of the partnership is $500
DPGR, $500 non-DPGR, $200 CGS, and $400
of deductions.
(ii) Section 199(d)(1)(A)(iii) wage
limitation. A’s CGS and deductions
apportioned to DPGR from PRS equal $300
(($200 CGS + $400 of other deductions) ×
($500 DPGR/$1,000 total gross receipts)).
Accordingly, for purposes of the wage
limitation of section 199(d)(1)(A)(iii), A’s
QPAI is $200 ($500 DPGR × $300 CGS and
other deductions). A’s share of partnership
W–2 wages after application of the section
199(d)(1)(A)(iii) limitation is $0, the lesser of
$0 (A’s 50% allocable share of PRS’s $0 of
W–2 wages) or $12 (2 × ($200 QPAI × .03)).
B’s share of PRS’s W–2 wages also is $0.
(iii) Section 199 deduction computation.
A’s total CGS and deductions apportioned to
DPGR equal $600 (($200 PRS CGS + $400

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$1,500
(600)
(210)
(150)
540

outside trade or business CGS + $400 PRS
deductions + $200 outside trade or business
deductions) × ($1,000 total DPGR ($500 from
PRS + $500 from outside trade or business)/
$2,000 total gross receipts ($1,000 from PRS
+ $1,000 from outside trade or business)).
Accordingly, A’s QPAI is $400 ($1,000 DPGR
× $600 CGS and deductions). A’s tentative
deduction is $12 ($400 QPAI × .03), subject
to the section 199(b)(1) wage limitation of
$25 (50% × $50 total W–2 wages). A’s section
199 deduction for the 2006 taxable year is
$12. B’s total section 199 deduction for the
2006 taxable year is $0 because B has no W–
2 wages for the 2006 taxable year.
Example 5. Guaranteed payment. (i) Facts.
The facts are the same as Example 4 except
that in 2006 PRS also makes a guaranteed
payment of $200 to A for services, and PRS
pays $200 of W–2 wages to PRS employees,
which is included within the $400 of CGS.
See section 707(c). This guaranteed payment
is taxable to A as ordinary income and is
properly deducted by PRS under section 162.
Pursuant to § 1.199–3(p), A may not treat any
part of this payment as DPGR. Accordingly,
PRS has total gross receipts of $2,000 ($1,000
of which is DPGR), CGS of $400 (including
$200 of W–2 wages) and deductions of
$1,000 (including the $200 guaranteed
payment) for the 2006 taxable year. A’s
distributive share of the items of the
partnership is $500 DPGR, $500 non-DPGR,
$200 CGS, and $500 of deductions.
(ii) Section 199(d)(1)(A)(iii) wage
limitation. A’s CGS and deductions
apportioned to DPGR from PRS equal $350
(($200 CGS + $500 of other deductions) ×
($500 DPGR/$1,000 total gross receipts)).
Accordingly, for purposes of the wage
limitation of section 199(d)(1)(A)(iii), A’s
QPAI is $150 ($500 DPGR × $350 CGS and
other deductions). A’s share of partnership
W–2 wages after application of the section
199(d)(1)(A)(iii) limitation is $9, the lesser of
$100 (A’s 50% allocable share of PRS’s $200
of W–2 wages) or $9 (2 × ($150 QPAI × .03)).
B’s share of PRS’s W–2 wages after
application of section 199(d)(1)(A)(iii) also is
$9.
(iii) A’s section 199 deduction
computation. A’s total CGS and deductions
apportioned to DPGR equal $591 (($200 PRS
CGS + $400 outside trade or business CGS +
$500 PRS deductions + $200 outside trade or
business deductions) × ($1,000 total DPGR
($500 from PRS + $500 from outside trade or
business)/$2,200 total gross receipts ($1,000
from PRS + $200 guaranteed payment +
$1,000 from outside trade or business)).
Accordingly, A’s QPAI is $409 ($1,000 DPGR
× $591 CGS and other deductions). A’s
tentative deduction is $12 ($409 QPAI × .03),

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subject to the section 199(b)(1) wage
limitation of $30 (50% × $59 ($9 PRS W–2
wages $50 + W–2 wages from A’s trade or
business activities outside of PRS)). A’s
section 199 deduction for the 2006 taxable
year is $12.
(iv) B’s section 199 deduction
computation. B’s QPAI is $150 ($500 DPGR
× $350 CGS and other deductions). B’s
tentative deduction is $5 ($150 QPAI × .03),
subject to the section 199(b)(1) wage
limitation of $5 (50% × $9). Assuming that
B engages in no other activities generating
DPGR, B’s section 199 deduction for the 2006
taxable year is $5.

(c) S corporations—(1) In general—(i)
Determination at shareholder level. The
section 199 deduction with respect to
the qualified production activities of an
S corporation is determined at the
shareholder level. As a result, each
shareholder must compute its deduction
separately. The section 199 deduction
will have no effect on the basis of a
shareholder’s stock in an S corporation.
Except as provided by publication
pursuant to paragraph (c)(1)(ii) of this
section, for purposes of this section,
each shareholder is allocated, in
accordance with section 1366, its pro
rata share of S corporation items
(including items of income, gain, loss,
and deduction), CGS allocated to such
items of income, and gross receipts
included in such items of income, even
if the shareholder’s share of CGS and
other deductions and losses exceeds
DPGR, and regardless of the amount of
the shareholder’s share of the W–2
wages of the S corporation for the
taxable year. Except as provided by
publication under paragraph (c)(1)(ii) of
this section, to determine its section 199
deduction for the taxable year, the
shareholder aggregates its pro rata share
of such items, to the extent they are not
otherwise disallowed by the Code, with
those items it incurs outside the S
corporation (whether directly or
indirectly) for purposes of allocating
and apportioning deductions to DPGR
and computing its QPAI.
(ii) Determination at entity level. The
Secretary may, by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter),
permit an S corporation to calculate a
shareholder’s share of QPAI at the entity
level, instead of allocating, in
accordance with section 1366, the
shareholder’s pro rata share of S
corporation items (including items of
income, gain, loss, and deduction). If an
S corporation does calculate QPAI at the
entity level—
(A) Each shareholder is allocated its
share of QPAI and W–2 wages, which
(subject to the limitations under
paragraph (c)(2) of this section and
section 199(d)(1)(A)(iii), respectively)

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are combined with the shareholder’s
QPAI and W–2 wages from other
sources;
(B) For purposes of computing QPAI
under §§ 1.199–1 through 1.199–9, a
shareholder does not take into account
the items from such an S corporation
(for example, a shareholder does not
take into account items from such an S
corporation in determining whether a
threshold or de minimis rule applies or
when the shareholder allocates and
apportions deductions in calculating its
QPAI from other sources);
(C) A shareholder generally does not
recompute its share of QPAI from the S
corporation using another method;
however, the shareholder might have to
adjust its share of QPAI from the S
corporation to take into account certain
disallowed losses or deductions, or the
allowance of suspended losses or
deductions; and
(D) A shareholder’s share of QPAI
from an S corporation may be less than
zero.
(2) Disallowed losses or deductions.
Except as provided by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter),
losses or deductions of the S
corporation that otherwise would be
taken into account in computing the
shareholder’s section 199 deduction for
a taxable year are taken into account in
that year only if and to the extent the
shareholder’s pro rata share of the losses
or deductions from all of the S
corporation’s activities is not disallowed
by section 465, 469, or 1366(d), or any
other provision of the Code. If only a
portion of the shareholder’s share of the
losses or deductions is allowed for a
taxable year, a proportionate share of
those allowable losses or deductions
that are allocated to the S corporation’s
qualified production activities,
determined in a manner consistent with
sections 465, 469, and 1366(d), and any
other applicable provision of the Code,
is taken into account in computing the
QPAI and the wage limitation of section
199(d)(1)(A)(iii) for that taxable year. To
the extent that any of the disallowed
losses or deductions are allowed in a
later taxable year, the shareholder takes
into account a proportionate share of
those losses or deductions in computing
its QPAI for that later taxable year.
Losses or deductions of the S
corporation that are disallowed for
taxable years beginning on or before
December 31, 2004, are not taken into
account in a later taxable year for
purposes of computing the
shareholder’s QPAI or the wage
limitation of section 199(d)(1)(A)(iii) for
that taxable year, regardless of whether

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31327

the losses or deductions are allowed for
other purposes.
(3) Shareholder’s share of W–2 wages.
Under section 199(d)(1)(A)(iii), an S
corporation shareholder’s share of the
W–2 wages of the S corporation for
purposes of determining the
shareholder’s section 199(b) limitation
is the lesser of the shareholder’s
allocable share of those wages (without
regard to section 199(d)(1)(A)(iii)), or 2
times 3 percent of the QPAI computed
by taking into account only the items of
the S corporation allocated to the
shareholder for the taxable year of the
S corporation. Except as provided by
publication in the Internal Revenue
Bulletin (see § 601.601(d)(2)(ii)(b) of this
chapter), this QPAI calculation is
performed by the shareholder using the
same cost allocation method that the
shareholder uses in calculating the
shareholder’s section 199 deduction.
The S corporation must allocate W–2
wages (prior to the application of the
wage limitation) among the
shareholders in the same manner as
wage expense. The shareholder must
add the shareholder’s share of W–2
wages from the S corporation, as limited
by section 199(d)(1)(A)(iii), to the
shareholder’s W–2 wages from other
sources, if any. If QPAI, computed by
taking into account only the items of the
S corporation allocated to the
shareholder for the taxable year (as
required by the wage limitation of
section 199(d)(1)(A)(iii)), is not greater
than zero, then the shareholder may not
take into account any W–2 wages of the
S corporation in applying the wage
limitation of § 1.199–2 (but the
shareholder will, nevertheless, aggregate
its distributive share of S corporation
items including wage expense with
those items not from the S corporation
in computing its QPAI when
determining its section 199 deduction).
See § 1.199–2 for the computation of W–
2 wages, and paragraph (g) of this
section for rules regarding pass-thru
entities in a tiered structure.
(4) Transition percentage rule for W–
2 wages. With regard to S corporations,
for purposes of section
199(d)(1)(A)(iii)(II) the transition
percentages determined under section
199(a)(2) shall be determined by
reference to the S corporation’s taxable
year. Thus, if an S corporation
shareholder uses a calendar year taxable
year, and owns stock in an S
corporation that has a taxable year
ending on April 30, the shareholder’s
section 199(d)(1)(A)(iii) wage limitation
for the S corporation’s taxable year
beginning on May 1, 2006, would be
calculated using 3 percent, even though
the shareholder includes the

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shareholder’s pro rata share of S
corporation items from that taxable year
on the shareholder’s 2007 Federal
income tax return.
(d) Grantor trusts. To the extent that
the grantor or another person is treated
as owning all or part (the owned
portion) of a trust under sections 671
through 679, such person (owner)
computes its QPAI with respect to the
owned portion of the trust as if that
QPAI had been generated by activities
performed directly by the owner.
Similarly, for purposes of the section
199(b) wage limitation, the owner of the
trust takes into account the owner’s
share of the W–2 wages of the trust that
are attributable to the owned portion of
the trust. The section 199(d)(1)(A)(iii)
wage limitation is not applicable to the
owned portion of the trust. The
provisions of paragraph (e) of this
section do not apply to the owned
portion of a trust.
(e) Non-grantor trusts and estates—(1)
Allocation of costs. The trust or estate
calculates each beneficiary’s share (as
well as the trust’s or estate’s own share,
if any) of QPAI and W–2 wages from the
trust or estate at the trust or estate level.
The beneficiary of a trust or estate is not
permitted to use another cost allocation
method to recompute its share of QPAI
from the trust or estate or to reallocate
the costs of the trust or estate. Except as
provided in paragraph (d) of this
section, the QPAI of a trust or estate
must be computed by allocating
expenses described in section 199(d)(5)
in one of two ways, depending on the
classification of those expenses under
§ 1.652(b)–3. Specifically, directly
attributable expenses within the
meaning of § 1.652(b)–3 are allocated
pursuant to § 1.652(b)–3, and expenses
not directly attributable within the
meaning of § 1.652(b)–3 (other
expenses) are allocated under the
simplified deduction method of § 1.199–
4(e) (unless the trust or estate does not
qualify to use the simplified deduction
method, in which case it must use the
section 861 method of § 1.199–4(d) with
respect to such other expenses). For this
purpose, depletion and depreciation
deductions described in section 642(e)
and amortization deductions described
in section 642(f) are treated as other

expenses described in section 199(d)(5).
Also for this purpose, the trust’s or
estate’s share of other expenses from a
lower-tier pass-thru entity is not directly
attributable to any class of income
(whether or not those other expenses are
directly attributable to the aggregate
pass-thru gross income as a class for
purposes other than section 199). A
trust or estate may not use the small
business simplified overall method for
computing its QPAI. See § 1.199–4(f)(5).
(2) Allocation among trust or estate
and beneficiaries—(i) In general. The
QPAI of a trust or estate (which will be
less than zero if the CGS and deductions
allocated and apportioned to DPGR
exceed the trust’s or estate’s DPGR) and
W–2 wages of the trust or estate are
allocated to each beneficiary and to the
trust or estate based on the relative
proportion of the trust’s or estate’s
distributable net income (DNI), as
defined by section 643(a), for the taxable
year that is distributed or required to be
distributed to the beneficiary or is
retained by the trust or estate. To the
extent that the trust or estate has no DNI
for the taxable year, any QPAI and W–
2 wages are allocated entirely to the
trust or estate. A trust or estate is
allowed the section 199 deduction in
computing its taxable income to the
extent that QPAI and W–2 wages are
allocated to the trust or estate. A
beneficiary of a trust or estate is allowed
the section 199 deduction in computing
its taxable income based on its share of
QPAI and W–2 wages from the trust or
estate, which (subject to the wage
limitation as described in paragraph
(e)(3) of this section) are aggregated with
the beneficiary’s QPAI and W–2 wages
from other sources.
(ii) Treatment of items from a trust or
estate reporting qualified production
activities income. When, pursuant to
this paragraph (e), a taxpayer must
combine QPAI and W–2 wages from a
trust or estate with the taxpayer’s total
QPAI and W–2 wages from other
sources, the taxpayer, when applying
§§ 1.199–1 through 1.199–9 to
determine the taxpayer’s total QPAI and
W–2 wages from such other sources,
does not take into account the items
from such trust or estate. Thus, for
example, a beneficiary of an estate that

receives QPAI from the estate does not
take into account the beneficiary’s
distributive share of the estate’s gross
receipts, gross income, or deductions
when the beneficiary determines
whether a threshold or de minimis rule
applies or when the beneficiary
allocates and apportions deductions in
calculating its QPAI from other sources.
(3) Beneficiary’s share of W–2 wages.
The trust or estate must compute each
beneficiary’s share of W–2 wages from
the trust or estate in accordance with
section 199(d)(1)(A)(iii), as if the
beneficiary were a partner in a
partnership. The application of section
199(d)(1)(A)(iii) to each trust and estate
therefore means that if QPAI, computed
by taking into account only the items of
the trust or estate allocated to the
beneficiary for the taxable year, is not
greater than zero, then the beneficiary
may not take into account any W–2
wages of the trust or estate in applying
the wage limitation of § 1.199–2 (but the
beneficiary will, nevertheless, aggregate
its QPAI from the trust or estate with its
QPAI from other sources when
determining the beneficiary’s section
199 deduction). See paragraph (g) of this
section for rules applicable to pass-thru
entities in a tiered structure.
(4) Transition percentage rule for W–
2 wages. With regard to trusts and
estates, for purposes of section
199(d)(1)(A)(iii)(II), the transition
percentages determined under section
199(a)(2) shall be determined by
reference to the taxable year of the trust
or estate.
(5) Example. The following example
illustrates the application of this
paragraph (e) and paragraph (g) of this
section. Assume that the partnership,
trust, and trust beneficiary all are
calendar year taxpayers.
Example. (i) Computation of DNI and
inclusion and deduction amounts. (A) Trust’s
distributive share of partnership items. Trust,
a complex trust, is a partner in PRS, a
partnership that engages in activities that
generate DPGR and non-DPGR. In 2006, PRS
distributes $10,000 cash to Trust. Trust’s
distributive share of PRS items, which are
properly included in Trust’s DNI, is as
follows:

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Gross income attributable to DPGR ($15,000 DPGR ¥ $5,000 CGS (including W–2 wages of $1,000)) .......................................
Gross income attributable to non-DPGR ($5,000 other gross receipts ¥ $0 CGS) ..........................................................................
Selling expenses (includes W–2 wages of $2,000) ............................................................................................................................
Other expenses (includes W–2 wages of $1,000) ..............................................................................................................................

(B) Trust’s direct activities. In addition to
its cash distribution in 2006 from PRS, Trust

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also directly has the following items which
are properly included in Trust’s DNI:

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$10,000
5,000
3,000
2,000

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Dividends .............................................................................................................................................................................................
Tax-exempt interest .............................................................................................................................................................................
Rents from commercial real property operated by Trust as a business .............................................................................................
Real estate taxes .................................................................................................................................................................................
Trustee commissions ...........................................................................................................................................................................
State income and personal property taxes .........................................................................................................................................
W–2 wages for rental business ...........................................................................................................................................................
Other business expenses ....................................................................................................................................................................

(C) Allocation of deductions under
§ 1.652(b)–3—(1) Directly attributable
expenses. In computing Trust’s DNI for the
taxable year, the distributive share of
expenses of PRS are directly attributable
under § 1.652(b)–3(a) to the distributive share
of income of PRS. Accordingly, the $5,000 of
CGS, $3,000 of selling expenses, and $2,000
of other expenses are subtracted from the
gross receipts from PRS ($20,000), resulting
in net income from PRS of $10,000. With
respect to the Trust’s direct expenses, $1,000
of the trustee commissions, the $1,000 of real
estate taxes, and the $2,000 of W–2 wages are
directly attributable under § 1.652(b)–3(a) to
the rental income.
(2) Non-directly attributable expenses.
Under § 1.652(b)–3(b), the trustee must
allocate a portion of the sum of the balance
of the trustee commissions ($2,000), state
income and personal property taxes ($5,000),
and the other business expenses ($1,000) to
the $10,000 of tax-exempt interest. The
portion to be attributed to tax-exempt interest
is $2,222 ($8,000 × ($10,000 tax exempt
interest/$36,000 gross receipts net of direct
expenses)), resulting in $7,778 ($10,000 ¥
$2,222) of net tax-exempt interest. Pursuant
to its authority recognized under § 1.652(b)–
3(b), the trustee allocates the entire amount
of the remaining $5,778 of trustee
commissions, state income and personal
property taxes, and other business expenses
to the $6,000 of net rental income, resulting
in $222 ($6,000 ¥ $5,778) of net rental
income.
(D) Amounts included in taxable income.
For 2006, Trust has DNI of $28,000 (net
dividend income of $10,000 + net PRS
income of $10,000 + net rental income of
$222 + net tax-exempt income of $7,778).
Pursuant to Trust’s governing instrument,
Trustee distributes 50%, or $14,000, of that
DNI to B, an individual who is a
discretionary beneficiary of Trust. Assume
that there are no separate shares under Trust,
and no distributions are made to any other
beneficiary that year. Consequently, with
respect to the $14,000 distribution B receives
from Trust, B properly includes in B’s gross
income $5,000 of income from PRS, $111 of
rents, and $5,000 of dividends, and properly
excludes from B’s gross income $3,889 of taxexempt interest. Trust includes $20,222 in its
adjusted total income and deducts $10,111
under section 661(a) in computing its taxable
income.
(ii) Section 199 deduction. (A) Simplified
deduction method. For purposes of
computing the section 199 deduction for the
taxable year, assume Trust qualifies for the
simplified deduction method under § 1.199–
4(e). The determination of Trust’s QPAI
under the simplified deduction method
requires multiple steps to allocate costs.

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First, the Trust’s expenses directly
attributable to DPGR under § 1.652(b)–3(a)
are subtracted from the Trust’s DPGR. In this
step, the directly attributable $5,000 of CGS
and selling expenses of $3,000 are subtracted
from the $15,000 of DPGR from PRS. Next,
Trust must identify its other trade or business
expenses directly related to non-DPGR trade
or business income. In this example, the
portion of the trustee commissions not
directly attributable to the rental operation
($2,000), as well as the portion of the state
income and personal property taxes not
directly attributable to either the PRS
interests or the rental operation, are not trade
or business expenses and, thus, are ignored
in computing QPAI. The portion of the state
income and personal property taxes that is
treated as other trade or business expenses is
$3,000 ($5,000 × $30,000 total trade or
business gross receipts/$50,000 total gross
receipts). Trust then allocates its other trade
or business expenses on the basis of its total
gross receipts from the conduct of a trade or
business ($20,000 from PRS + $10,000 rental
income). Trust then combines its nondirectly attributable (other) business
expenses ($2,000 from PRS + $4,000 ($1,000
of other expenses + $3,000 of income and
property taxes) from its own activities) and
then apportions this total between DPGR and
other receipts on the basis of Trust’s total
trade or business gross receipts ($6,000 ×
$15,000 DPGR/$30,000 total trade or business
gross receipts = $3,000). Thus, for purposes
of computing Trust’s and B’s section 199
deduction, Trust’s QPAI is $4,000 ($7,000 ¥
$3,000). Because the distribution of Trust’s
DNI to B equals one-half of Trust’s DNI, Trust
and B each has QPAI from PRS for purposes
of the section 199 deduction of $2,000.
(B) Section 199(d)(1)(A)(iii) wage
limitation. The wage limitation under section
199(d)(1)(A)(iii) must be applied both at the
Trust level and at B’s level. After applying
this limitation to the Trust’s share of PRS’s
W–2 wages, Trust is allocated $330 of W–2
wages from PRS (the lesser of Trust’s
allocable share of PRS’s W–2 wages ($4,000)
or 2 × 3% of Trust’s QPAI from PRS
($5,500)). Trust’s QPAI from PRS for
purposes of the section 199(d)(1)(A)(iii)
limitation is determined by taking into
account only the items of PRS allocated to
Trust ($15,000 DPGR ¥ ($5,000 of CGS +
$3,000 selling expenses + $1,500 of other
expenses)). For this purpose, the $1,500 of
other expenses is determined by multiplying
$2,000 of other expenses from PRS by
$15,000 of DPGR from PRS, divided by
$20,000 of total gross receipts from PRS.
Trust adds this $330 of W–2 wages to Trust’s
own $2,000 of W–2 wages (thus, $2,330).
Because the $14,000 Trust distribution to B
equals one-half of Trust’s DNI, Trust and B

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31329
$10,000
10,000
10,000
1,000
3,000
5,000
2,000
1,000

each has W–2 wages of $1,165. After
applying the section 199(d)(1)(A)(iii) wage
limitation to B’s share of the W–2 wages
allocated from Trust, B has W–2 wages of
$120 from Trust (lesser of $1,165 (allocable
share of W–2 wages) or 2 × .03 × $2,000 (B’s
share of Trust’s QPAI)). B has W–2 wages of
$100 from non-Trust activities for a total of
$220 of W–2 wages.
(C) Section 199 deduction computation. (1)
B’s computation. B is eligible to use the small
business simplified overall method. Assume
that B has sufficient adjusted gross income so
that the section 199 deduction is not limited
under section 199(a)(1)(B). B has $1,000 of
QPAI from non-Trust activities that is added
to the $2,000 QPAI from Trust for a total of
$3,000 of QPAI. B’s tentative deduction is
$90 (.03 × $3,000), but it is limited under
section 199(b) to $110 (50% × $220 W–2
wages). Accordingly, B’s section 199
deduction for 2006 is $90.
(2) Trust’s computation. Trust has
sufficient adjusted gross income so that the
section 199 deduction is not limited under
section 199(a)(1)(B). Trust’s tentative
deduction is $60 (.03 × $2,000 QPAI), but it
is limited under section 199(b) to $583 (50%
× $1,165 W–2 wages). Accordingly, Trust’s
section 199 deduction for 2006 is $60.

(f) Gain or loss from the disposition of
an interest in a pass-thru entity. DPGR
generally does not include gain or loss
recognized on the sale, exchange, or
other disposition of an interest in a
pass-thru entity. However, with respect
to a partnership, if section 751(a) or (b)
applies, then gain or loss attributable to
assets of the partnership giving rise to
ordinary income under section 751(a) or
(b), the sale, exchange, or other
disposition of which would give rise to
DPGR, is taken into account in
computing the partner’s section 199
deduction. Accordingly, to the extent
that cash or property received by a
partner in a sale or exchange for all or
part of its partnership interest is
attributable to unrealized receivables or
inventory items within the meaning of
section 751(c) or (d), respectively, and
the sale or exchange of the unrealized
receivable or inventory items would
give rise to DPGR if sold, exchanged, or
otherwise disposed of by the
partnership, the cash or property
received by the partner is taken into
account by the partner in determining
its DPGR for the taxable year. Likewise,
to the extent that a distribution of
property to a partner is treated under

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Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules and Regulations

section 751(b) as a sale or exchange of
property between the partnership and
the distributee partner, and any
property deemed sold or exchanged
would give rise to DPGR if sold,
exchanged, or otherwise disposed of by
the partnership, the deemed sale or
exchange of the property must be taken
into account in determining the
partnership’s and distributee partner’s
DPGR to the extent not taken into
account under the qualifying in-kind
partnership rules. See § 1.751–1(b) and
paragraph (i) of this section.
(g) Section 199(d)(1)(A)(iii) wage
limitation and tiered structures—(1) In
general. If a pass-thru entity owns an
interest, directly or indirectly, in one or
more pass-thru entities, then the wage
limitation of section 199(d)(1)(A)(iii)
must be applied at each tier (that is,
separately for each entity). For purposes
of this wage limitation, references to
pass-thru entities includes partnerships,
S corporations, trusts (to the extent not
described in paragraph (d) of this
section) and estates. Thus, at each tier,
the owner of a pass-thru entity (or the
entity on behalf of the owner) calculates
the amounts described in sections
199(d)(1)(A)(iii)(I) (owner’s allocable
share) and 199(d)(1)(A)(iii)(II) (twice the
applicable percentage of the owner’s
QPAI from that entity) separately with
regard to its interest in that pass-thru
entity.
(2) Share of W–2 wages. For purposes
of section 199(d)(1)(A)(iii) and section
199(b), the W–2 wages of the owner of
an interest in a pass-thru entity (uppertier entity) that owns an interest in one
or more pass-thru entities (lower-tier
entities) are equal to the sum of the
owner’s allocable share of W–2 wages of
the upper-tier entity, as limited in
accordance with section
199(d)(1)(A)(iii), and the owner’s own
W–2 wages. The upper-tier entity’s W–
2 wages are equal to the sum of the
upper-tier entity’s allocable share of W–
2 wages of the next lower-tier entity, as
limited in accordance with section
199(d)(1)(A)(iii), and the upper-tier
entity’s own W–2 wages. The W–2
wages of each lower-tier entity in a
tiered structure, in turn, is computed as
described in the preceding sentence.
Except as provided by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter)—
(i) An upper-tier entity may compute
its share of QPAI attributable to items
from a lower-tier entity solely for
purposes of section 199(d)(1)(A)(iii)(II)
by applying either the section 861
method described in § 1.199–4(d) or the
simplified deduction method described
in § 1.199–4(e), provided the upper tier

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entity would otherwise qualify to use
such method.
(ii) Alternatively, the upper-tier entity
(other than a trust or estate described in
paragraph (e) of this section) may
compute its share of QPAI attributable
to items from a lower-tier entity solely
for purposes of section
199(d)(1)(A)(iii)(II) by applying the
small business simplified overall
method described in § 1.199–4(f),
regardless of whether such upper-tier
entity would otherwise qualify to use
the small business simplified overall
method.
(3) Example. The following example
illustrates the application of this
paragraph (g). Assume that each
partnership and each partner (whether
or not an individual) is a calendar year
taxpayer.
Example. (i) In 2006, A, an individual,
owns a 50% interest in a partnership, UTP,
which in turn owns a 50% interest in another
partnership, LTP. All partnership items are
allocated in proportion to these ownership
percentages. LTP has $900 DPGR, $450 CGS
(which includes W–2 wages of $100), and
$50 other deductions. Before taking into
account its share of items from LTP, UTP has
$500 DPGR, $500 CGS (which includes W–
2 wages of $200), and $500 other deductions.
UTP chooses to compute its share of QPAI
attributable to items from LTP for purposes
of section 199(d)(1)(A)(iii)(II) by applying the
small business simplified overall method
described in § 1.199–4(f). For purposes of the
wage limitation of section 199(d)(1)(A)(iii),
UTP’s distributive share of LTP’s QPAI is
$200 ($450 DPGR ¥ $250 CGS and other
deductions).
(ii) UTP’s share of LTP’s W–2 wages for
purposes of the section 199(d)(1)(A)(iii)
limitation is $12, the lesser of $50 (UTP’s
50% allocable share of LTP’s $100 of W–2
wages) or $12 (2 × ($200 QPAI × .03)). After
taking into account its share of items from
LTP, UTP has $950 DPGR, $725 CGS, and
$525 other deductions. A is eligible for and
uses the simplified deduction method
described in § 1.199–4(e). For purposes of the
wage limitation of section 199(d)(1)(A)(iii),
A’s distributive share of UTP’s QPAI is
($151) ($475 DPGR ¥ $363 CGS ¥ $263
other deductions). A’s wage limitation under
section 199(d)(1)(A)(iii) with respect to A’s
interest in UTP is $0, the lesser of $106 (A’s
50% allocable share of UTP’s $212 of W–2
wages) or $0 (because A’s share of UTP’s
QPAI ($151), is less than zero).

(h) No attribution of qualified
activities. Except as provided in
paragraph (i) of this section regarding
qualifying in-kind partnerships and
paragraph (j) of this section regarding
EAG partnerships, an owner of a passthru entity is not treated as conducting
the qualified production activities of the
pass-thru entity, and vice versa. For
example, if a partnership MPGE QPP
within the United States, or produces a
qualified film or produces utilities in

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the United States, and distributes or
leases, rents, licenses, sells, exchanges,
or otherwise disposes of such property
to a partner who then, without
performing its own qualifying MPGE or
other production, leases, rents, licenses,
sells, exchanges, or otherwise disposes
of such property, then the partner’s
gross receipts from this latter lease,
rental, license, sale, exchange, or other
disposition are treated as non-DPGR. In
addition, if a partner MPGE QPP within
the United States, or produces a
qualified film or produces utilities in
the United States, and contributes or
leases, rents, licenses, sells, exchanges,
or otherwise disposes of such property
to a partnership which then, without
performing its own qualifying MPGE or
other production, leases, rents, licenses,
sells, exchanges, or otherwise disposes
of such property, then the partnership’s
gross receipts from this latter
disposition are treated as non-DPGR.
(i) Qualifying in-kind partnership—(1)
In general. If a partnership is a
qualifying in-kind partnership described
in paragraph (i)(2) of this section, then
each partner is treated as MPGE or
producing the property MPGE or
produced by the partnership that is
distributed to that partner. If a partner
of a qualifying in-kind partnership
derives gross receipts from the lease,
rental, license, sale, exchange, or other
disposition of the property that was
MPGE or produced by the qualifying inkind partnership, then, provided such
partner is a partner of the qualifying inkind partnership at the time the partner
disposes of the property, the partner is
treated as conducting the MPGE or
production activities previously
conducted by the qualifying in-kind
partnership with respect to that
property. With respect to a lease, rental,
or license, the partner is treated as
having disposed of the property on the
date or dates on which it takes into
account its gross receipts derived from
the lease, rental, or license under its
methods of accounting. With respect to
a sale, exchange, or other disposition,
the partner is treated as having disposed
of the property on the date on which it
ceases to own the property for Federal
income tax purposes, even if no gain or
loss is taken into account.
(2) Definition of qualifying in-kind
partnership. For purposes of this
paragraph (i), a qualifying in-kind
partnership is a partnership engaged
solely in—
(i) The extraction, refining, or
processing of oil, natural gas (as
described in § 1.199–3(l)(2)),
petrochemicals, or products derived
from oil, natural gas, or petrochemicals

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in whole or in significant part within
the United States;
(ii) The production or generation of
electricity in the United States; or
(iii) An activity or industry designated
by the Secretary by publication in the
Internal Revenue Bulletin (see
§ 601.601(d)(2)(ii)(b) of this chapter).
(3) Special rules for distributions. If a
qualifying in-kind partnership
distributes property to a partner, then,
solely for purposes of section
199(d)(1)(A)(iii)(II), the partnership is
treated as having gross receipts in the
taxable year of the distribution equal to
the fair market value of the distributed
property at the time of distribution to
the partner and the deemed gross
receipts are allocated to that partner,
provided that the partner derives gross
receipts from the distributed property
(and takes into account such receipts
under its method of accounting) during
the taxable year of the partner with or
within which the partnership’s taxable
year (in which the distribution occurs)
ends. For rules for taking costs into
account (such as costs included in the
adjusted basis of the distributed
property), see § 1.199–4.
(4) Other rules. Except as provided in
this paragraph (i), a qualifying in-kind
partnership is treated the same as other
partnerships for purposes of section
199. Accordingly, a qualifying in-kind
partnership is subject to the rules of this
section regarding the application of
section 199 to pass-thru entities,
including application of the section
199(d)(1)(A)(iii) wage limitation under
paragraph (b)(3) of this section. In
determining whether a qualifying inkind partnership or its partners MPGE
QPP in whole or in significant part
within the United States, see § 1.199–
3(g)(2) and (3).
(5) Example. The following example
illustrates the application of this
paragraph (i). Assume that PRS and X
are calendar year taxpayers.
Example. X, Y and Z are partners in PRS,
a qualifying in-kind partnership described in
paragraph (i)(2) of this section. X, Y, and Z
are corporations. In 2006, PRS distributes oil
to X that PRS derived from its oil extraction.
PRS incurred $600 of CGS, including $500 of
W–2 wages (as defined in § 1.199–2(e)),
extracting the oil distributed to X, and X’s
adjusted basis in the distributed oil is $600.
The fair market value of the oil at the time
of the distribution to X is $1,000. X incurs
$200 of CGS, including $100 of W–2 wages,
in refining the oil within the United States.
In 2006, X, while it is a partner in PRS, sells
the oil to a customer for $1,500, taking the
gross receipts into account under its method
of accounting in the same taxable year. Under
paragraph (i)(1) of this section, X is treated
as having extracted the oil. The extraction
and refining of the oil qualify as an MPGE

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activity under § 1.199–3(e)(1). Therefore, X’s
$1,500 of gross receipts qualify as DPGR. X
subtracts from the $1,500 of DPGR the $600
of CGS incurred by PRS and the $200 of
refining costs incurred by X. Thus, X’s QPAI
is $700 for 2006. In addition, PRS is treated
as having $1,000 of DPGR solely for purposes
of applying the wage limitation in section
199(d)(1)(A)(iii) based on the applicable
percentage of QPAI. Accordingly, X’s share of
PRS’s W–2 wages determined under section
199(d)(1)(A)(iii) is $24, the lesser of $500 (X’s
allocable share of PRS’s W–2 wages included
in CGS) and $24 (2 × ($400 ($1,000 deemed
DPGR less $600 of CGS) × .03)). X adds the
$24 of PRS W–2 wages to its $100 of W–2
wages incurred in refining the oil for
purposes of section 199(b).

(j) Partnerships owned by members of
a single expanded affiliated group—(1)
In general. For purposes of this section,
if all of the interests in the capital and
profits of a partnership are owned by
members of a single EAG at all times
during the taxable year of the
partnership (EAG partnership), then the
EAG partnership and all members of
that EAG are treated as a single taxpayer
for purposes of section 199(c)(4) during
that taxable year.
(2) Attribution of activities—(i) In
general. If a member of an EAG
(disposing member) derives gross
receipts from the lease, rental, license,
sale, exchange, or other disposition of
property that was MPGE or produced by
an EAG partnership, all the partners of
which are members of the same EAG to
which the disposing member belongs at
the time that the disposing member
disposes of such property, then the
disposing member is treated as
conducting the MPGE or production
activities previously conducted by the
EAG partnership with respect to that
property. The previous sentence applies
only for those taxable years in which the
disposing member is a member of the
EAG of which all the partners of the
EAG partnership are members for the
entire taxable year of the EAG
partnership. With respect to a lease,
rental, or license, the disposing member
is treated as having disposed of the
property on the date or dates on which
it takes into account its gross receipts
from the lease, rental, or license under
its methods of accounting. With respect
to a sale, exchange, or other disposition,
the disposing member is treated as
having disposed of the property on the
date on which it ceases to own the
property for Federal income tax
purposes, even if no gain or loss is taken
into account. Likewise, if an EAG
partnership derives gross receipts from
the lease, rental, license, sale, exchange,
or other disposition of property that was
MPGE or produced by a member (or
members) of the same EAG (the

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producing member) to which all the
partners of the EAG partnership belong
at the time that the EAG partnership
disposes of such property, then the EAG
partnership is treated as conducting the
MPGE or production activities
previously conducted by the producing
member with respect to that property.
The previous sentence applies only for
those taxable years in which the
producing member is a member of the
EAG of which all the partners of the
EAG partnership are members for the
entire taxable year of the EAG
partnership. With respect to a lease,
rental, or license, the EAG partnership
is treated as having disposed of the
property on the date or dates on which
it takes into account its gross receipts
derived from the lease, rental, or license
under its methods of accounting. With
respect to a sale, exchange, or other
disposition, the EAG partnership is
treated as having disposed of the
property on the date on which it ceases
to own the property for Federal income
tax purposes, even if no gain or loss is
taken into account. See paragraph (j)(5)
Example 3 of this section.
(ii) Attribution between EAG
partnerships. If an EAG partnership
(disposing partnership) derives gross
receipts from the lease, rental, license,
sale, exchange, or other disposition of
property that was MPGE or produced by
another EAG partnership (producing
partnership), then the disposing
partnership is treated as conducting the
MPGE or production activities
previously conducted by the producing
partnership with respect to that
property, provided that the producing
partnership and the disposing
partnership are owned by members of
the same EAG for the entire taxable year
of the respective partnership in which
the disposing partnership disposes of
such property. With respect to a lease,
rental, or license, the disposing
partnership is treated as having
disposed of the property on the date or
dates on which it takes into account its
gross receipts from the lease, rental, or
license under its methods of accounting.
With respect to a sale, exchange, or
other disposition, the disposing
partnership is treated as having
disposed of the property on the date on
which it ceases to own the property for
Federal income tax purposes, even if no
gain or loss is taken into account.
(iii) Exceptions to attribution.
Attribution of activities does not apply
for purposes of the construction of real
property under § 1.199–3(m)(1) and the
performance of engineering and
architectural services under § 1.199–
3(n)(2) and (3), respectively.

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(3) Special rules for distributions. If
an EAG partnership distributes property
to a partner, then, solely for purposes of
section 199(d)(1)(A)(iii)(II), the EAG
partnership is treated as having gross
receipts in the taxable year of the
distribution equal to the fair market
value of the property at the time of
distribution to the partner and the
deemed gross receipts are allocated to
that partner, provided that the partner
derives gross receipts from the
distributed property (and takes such
receipts into account under its methods
of accounting) during the taxable year of
the partner with or within which the
partnership’s taxable year (in which the
distribution occurs) ends. For rules for
taking costs into account (such as costs
included in the adjusted basis of the
distributed property), see § 1.199–4.
(4) Other rules. Except as provided in
this paragraph (j), an EAG partnership is
treated the same as other partnerships
for purposes of section 199.
Accordingly, an EAG partnership is
subject to the rules of this section
regarding the application of section 199
to pass-thru entities, including
application of the section
199(d)(1)(A)(iii) wage limitation under
paragraph (b)(3) of this section. In
determining whether a member of an
EAG or an EAG partnership MPGE QPP
in whole or in significant part within
the United States or produced a
qualified film or produced utilities
within the United States, see § 1.199–
3(g)(2) and (3) and Example 5 of
paragraph (j)(5) of this section.
(5) Examples. The following examples
illustrate the rules of this paragraph (j).
Assume that PRS, X, Y, and Z all are
calendar year taxpayers.
Example 1. Contribution. X and Y are the
only partners in PRS, a partnership, for PRS’s
entire 2006 taxable year. X and Y are both
members of a single EAG for the entire 2006
year. In 2006, X MPGE QPP within the
United States and contributes the property to
PRS. In 2006, PRS sells the QPP for $1,000.
Under this paragraph (j), PRS is treated as
having MPGE the QPP within the United
States, and PRS’s $1,000 gross receipts
constitute DPGR. PRS, X, and Y must apply
the rules of this section regarding the
application of section 199 to pass-thru
entities with respect to the activity of PRS,
including application of the section
199(d)(1)(A)(iii) wage limitation under
paragraph (b)(3) of this section.
Example 2. Sale. X, Y, and Z are the only
members of a single EAG for the entire 2006
year. X and Y each own 50% of the capital
and profits interests in PRS, a partnership,
for PRS’s entire 2006 taxable year. In 2006,
PRS MPGE QPP within the United States and
then sells the property to X for $6,000, its fair
market value at the time of the sale. PRS’s
gross receipts of $6,000 qualify as DPGR. In
2006, X sells the QPP to customers for

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$10,000, incurring selling expenses of $2,000.
Under this paragraph (j), X is treated as
having MPGE the QPP within the United
States, and X’s $10,000 of gross receipts
qualify as DPGR. PRS, X and Y must apply
the rules of this section regarding the
application of section 199 to pass-thru
entities with respect to the activity of PRS,
including application of the section
199(d)(1)(A)(iii) wage limitation under
paragraph (b)(3) of this section. The results
would be the same if PRS sold the property
to Z rather than to X.
Example 3. Lease. X, Y, and Z are the only
members of a single EAG for the entire 2005
year. X and Y each own 50% of the capital
and profits interests in PRS, a partnership,
for PRS’s entire 2005 taxable year. In 2005,
PRS MPGE QPP within the United States and
then sells the property to X for $6,000, its fair
market value at the time of the sale. PRS’s
gross receipts of $6,000 qualify as DPGR. In
2005, X rents the QPP it acquired from PRS
to customers unrelated to X. X takes the gross
receipts attributable to the rental of the QPP
into account under its methods of accounting
in 2005 and 2006. On July 1, 2006, X ceases
to be a member of the same EAG to which
Y, the other partner in PRS, belongs. For
2005, X is treated as having MPGE the QPP
in the United States, and its gross receipts
derived from the rental of the QPP qualify as
DPGR. For 2006, however, because X and Y,
partners in PRS, are no longer members of
the same EAG for the entire year, the gross
rental receipts X takes into account in 2006
do not qualify as DPGR.
Example 4. Distribution. X and Y are the
only partners in PRS, a partnership, for PRS’s
entire 2006 taxable year. X and Y are both
members of a single EAG for the entire 2006
year. In 2006, PRS MPGE QPP within the
United States, incurring $600 of CGS,
including $500 of W–2 wages (as defined in
§ 1.199–2(e)), and then distributes the QPP to
X. X’s adjusted basis in the QPP is $600. At
the time of the distribution, the fair market
value of the QPP is $1,000. X incurs $200 of
directly allocable costs, including $100 of W–
2 wages, to further MPGE the QPP within the
United States. In 2006, X sells the QPP for
$1,500 to an unrelated customer and takes
the gross receipts into account under its
method of accounting in the same taxable
year. Under paragraph (j)(1) of this section,
X is treated as having MPGE the QPP within
the United States, and X’s $1,500 of gross
receipts qualify as DPGR. In addition, PRS is
treated as having DPGR of $1,000 solely for
purposes of applying the wage limitation in
section 199(d)(1)(A)(iii) based on the
applicable percentage of QPAI.
Example 5. Multiple sales. (i) Facts. X and
Y are the only partners in PRS, a partnership,
for PRS’s entire 2006 taxable year. X and Y
are both non-consolidated members of a
single EAG for the entire 2006 year. PRS
produces in bulk form in the United States
the active ingredient for a pharmaceutical
product. Assume that PRS’s own MPGE
activity with respect to the active ingredient
is not substantial in nature, taking into
account all of the facts and circumstances,
and PRS’s direct labor and overhead to MPGE
the active ingredient within the United States
are $15 and account for 15% of PRS’s $100

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CGS of the active ingredient. In 2006, PRS
sells the active ingredient in bulk form to X.
X uses the active ingredient to produce the
finished dosage form drug. Assume that X’s
own MPGE activity with respect to the drug
is not substantial in nature, taking into
account all of the facts and circumstances,
and X’s direct labor and overhead to MPGE
the drug within the United States are $12 and
account for 10% of X’s $120 CGS of the drug.
In 2006, X sells the drug in finished dosage
to Y and Y sells the drug to customers.
Assume that Y’s own MPGE activity with
respect to the drug is not substantial in
nature, taking into account all of the facts
and circumstances, and Y incurs $2 of direct
labor and overhead and Y’s CGS in selling
the drug to customers is $130.
(ii) Analysis. PRS’s gross receipts from the
sale of the active ingredient to X are nonDPGR because PRS’s MPGE activity is not
substantial in nature and PRS does not satisfy
the safe harbor described in § 1.199–3(g)(3)
because PRS’s direct labor and overhead
account for less than 20% of PRS’s CGS of
the active ingredient. X’s gross receipts from
the sale of the drug to Y are DPGR because
X is considered to have MPGE the drug in
significant part in the United States pursuant
to the safe harbor described in § 1.199–3(g)(3)
because the $27 ($15 + $12) of direct labor
and overhead incurred by PRS and X equals
or exceeds 20% of X’s total CGS ($120) of the
drug at the time X disposes of the drug to Y.
Similarly, Y’s gross receipts from the sale of
the drug to customers are DPGR because Y
is considered to have MPGE the drug in
significant part in the United States pursuant
to the safe harbor described in § 1.199–3(g)(3)
because the $29 ($15 + $12 + $2) of direct
labor and overhead incurred by PRS, X, and
Y equals or exceeds 20% of Y’s total CGS
($130) of the drug at the time Y disposes of
the drug to Y’s customers.

(k) Effective dates. Section 199
applies to taxable years beginning after
December 31, 2004. In determining the
deduction under section 199, items
arising from a taxable year of a
partnership, S corporation, estate, or
trust beginning before January 1, 2005,
shall not be taken into account for
purposes of section 199(d)(1). Section
1.199–9 does not apply to taxable years
beginning after May 17, 2006, the
enactment date of the Tax Increase
Prevention and Reconciliation Act of
2005 (Public Law 109–222, 120 Stat.
345). For taxable years beginning on or
before May 17, 2006, a taxpayer must
apply § 1.199–9 if the taxpayer applies
§§ 1.199–1 through 1.199–8 to that
taxable year. Notwithstanding the
preceding sentence, a partnership or S
corporation that is a qualifying small
taxpayer under § 1.199–4(f) of REG–
105847–05 (2005–47 I.R.B. 987) (see
§ 601.601(d)(2) of this chapter) may use
the small business simplified overall
method to apportion CGS and
deductions between DPGR and nonDPGR at the entity level under § 1.199–
4(f) of REG–105847–05 for taxable years

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beginning on or before May 17, 2006. If
a taxpayer chooses not to rely on
§§ 1.199–1 through 1.199–9 (as provided
in § 1.199–8(i)) for a taxable year
beginning before June 1, 2006, the
guidance under section 199 that applies
to taxable years beginning before June 1,
2006, is contained in Notice 2005–14
(2005–1 C.B. 498) (see § 601.601(d)(2) of
this chapter). In addition, a taxpayer
also may rely on the provisions of REG105847–05 for taxable years beginning
before June 1, 2006. If Notice 2005–14
and REG–105847–05 include different
rules for the same particular issue, then
a taxpayer may rely on either the rule
set forth in Notice 2005–14 or the rule
set forth in REG–105847–05. However,
if REG–105847–05 includes a rule that
was not included in Notice 2005–14,
then a taxpayer is not permitted to rely
on the absence of a rule in Notice 2005–

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14 to apply a rule contrary to REG–
105847–05. For taxable years beginning
after May 17, 2006, and before June 1,
2006, a taxpayer may not apply Notice
2005–14, REG–105847–05, or any other
guidance under section 199 in a manner
inconsistent with amendments made to
section 199 by section 514 of the Tax
Increase Prevention and Reconciliation
Act of 2005.
PART 602—OMB CONTROL NUMBERS
UNDER THE PAPERWORK
REDUCTION ACT
■ Par. 3. The authority citation for part
602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 4. In § 602.101, paragraph (b) is
amended by adding an entry to the table
in numerical order to read, in part, as
follows:

■

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§ 602.101

*

OMB Control numbers.

*
*
(b) * * *

*

*

CFR part or section where
identified and described
*
*
*
1.199–6 .................................
*

*

*

Current OMB
control No.
*
*

*
1545–1966
*

Mark E. Matthews,
Deputy Commissioner for Services and
Enforcement.
Approved: May 2, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary of the
Treasury.
[FR Doc. 06–4829 Filed 5–24–06; 11:47 am]
BILLING CODE 4830–01–P

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