Reg-105847-05

Friday,
November 4, 2005

Part II

Department of the
Treasury
Internal Revenue Service
26 CFR Part 1
Income Attributable to Domestic
Production Activities; Proposed Rule

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Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules
building access list to attend the
hearing, LaNita Van Dyke, (202) 622–
7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG–105847–05]
RIN 1545–BE33

Income Attributable to Domestic
Production Activities
Internal Revenue Service (IRS),
Treasury.
ACTION: Notice of proposed rulemaking
and notice of public hearing.
AGENCY:

SUMMARY: This document contains
proposed regulations concerning the
deduction for income attributable to
domestic production activities under
section 199. Section 199 was enacted as
part of the American Jobs Creation Act
of 2004, (the Act). The regulations will
affect taxpayers engaged in certain
domestic production activities. This
document also provides a notice of a
public hearing on these proposed
regulations.

Written or electronic comments
must be received by January 3, 2006.
Outlines of topics to be discussed at the
public hearing scheduled for
Wednesday, January 11, 2006, must be
received by December 21, 2005.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR (REG–105847–05), room
5203, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand
delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m.
to: CC:PA:LPD:PR (REG–105847–05),
Courier’s Desk, Internal Revenue
Service, 1111 Constitution Avenue,
NW., Washington, DC, or sent
electronically, via the IRS Internet site
at http://www.irs.gov/regs or via the
Federal eRulemaking Portal at http://
www.regulations.gov (IRS–REG–
105847–05). The public hearing will be
held in the IRS Auditorium, Internal
Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC.
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, Scott Rabinowitz, (202) 622–
4970; concerning § 1.199–5, Martin
Schaffer, (202) 622–3080; concerning
§ 1.199–7, Ken Cohen, (202) 622–7790;
concerning submission of comments,
the hearing, and/or to be placed on the
DATES:

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Paperwork Reduction Act
The collections of information
contained in this notice of proposed
rulemaking have been submitted to the
Office of Management and Budget for
review in accordance with the
Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the
collections of information should be
sent 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, with copies to
the Internal Revenue Service, Attn: IRS
Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC
20224. Comments on the collection of
information should be received by
January 3, 2006.
Comments are specifically requested
concerning:
Whether the proposed collection of
information is necessary for the proper
performance of the functions of the IRS,
including whether the information will
have practical utility;
The accuracy of the estimated burden
associated with the proposed collection
of information;
How the quality, utility, and clarity of
the information to be collected may be
enhanced;
How the burden of complying with
the proposed collections of information
may be minimized, including through
the application of automated collection
techniques or other forms of information
technology; and
Estimates of capital or start-up costs
and costs of operation, maintenance,
and purchase of service to provide
information.
The collection of information in these
proposed regulations is in § 1.199–6(b)
involving patrons of agricultural and
horticultural cooperatives. This
information is required so that patrons
of agricultural and horticultural
cooperatives may claim the section 199
deduction. The collections of
information is mandatory. The likely
respondents are business or other forprofit institutions.
Estimated total annual reporting
burden: 9,000 hours.
Estimated average annual burden
hours per respondent: 3 hours.
Estimated number of respondents:
3,000.
Estimated annual frequency of
responses: annually.
An agency may not conduct or
sponsor, and a person is not required to

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respond to, a collection of information
unless it displays a valid control
number assigned by the Office of
Management and Budget.
Books or records relating to a
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 contains proposed
regulations 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 Act (Public Law 108–
357, 118 Stat. 1418). On January 19,
2005, the IRS and Treasury Department
issued Notice 2005–14 (2005–7 I.R.B.
498) providing interim guidance on
section 199 and inviting comments on
issues arising under section 199.
Written and electronic comments
responding to Notice 2005–14 were
received. The IRS and Treasury
Department have reviewed and
considered all the comments in the
process of preparing these proposed
regulations. This preamble to the
proposed regulations describes many of
the more 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.
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 the sum of the aggregate amounts
the taxpayer is required under section
6051(a)(3) and (8) to include on the
Forms W–2, ‘‘Wage and Tax Statement,’’
of the taxpayer’s employees during the
calendar year ending during the

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taxpayer’s taxable year. 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.
Qualified Production Activities Income
Under section 199(c)(1), QPAI is the
excess of domestic production gross
receipts (DPGR) over the sum of: (a) The
cost of goods sold (CGS) allocable to
such receipts; (b) other deductions,
expenses, or losses directly allocable to
such receipts; and (c) a ratable portion
of deductions, expenses, and losses not
directly allocable to such receipts or
another class of income.
Section 199(c)(2) provides that the
Secretary shall prescribe rules for the
proper allocation of items of income,
deduction, expense, and loss for
purposes of determining QPAI.
Section 199(c)(3) provides special
rules for determining costs in
computing QPAI. Under these special
rules, any item or service imported into
the United States without an arm’s
length transfer price shall be treated as
acquired by purchase, and its cost shall
be 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 imported 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)
construction performed in the United
States; or (iii) engineering or
architectural services performed in the
United States for construction projects
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; and (ii) the

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transmission or distribution of
electricity, natural gas, or potable water.
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.
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) provides that, in the
case of an S corporation, partnership,
estate or trust, or other pass-thru entity,
section 199 generally is applied at the
shareholder, partner, or similar level,
except as otherwise provided in rules
applicable to patrons of cooperatives.
Section 199(d)(1) further provides that
the Secretary shall prescribe rules for
the application of section 199, including
rules relating to: (a) Restrictions on the
allocation of the deduction to taxpayers
at the partner or similar level; and (b)
additional reporting requirements.
The general rule is that section 199 is
applied at the shareholder, partner, or
similar level. However, section
199(d)(1)(B) limits the amount of W–2
wages from a pass-thru entity that may
be used by each shareholder, partner, or
similar person to compute the section
199 deduction. Specifically, section
199(d)(1)(B) provides that such person
is treated as having been allocated W–
2 wages from such entity in an amount
equal to the lesser of: (i) Such person’s
allocable share of such wages (without
regard to this rule) from such entity as
determined under regulations
prescribed by the Secretary; or (ii) 2

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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 the QPAI of that entity allocated to
such person for the taxable year.
Individuals
In the case of an individual, section
199(d)(2) provides that the deduction is
equal to the applicable percentage 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.
Patrons of Certain Cooperatives
Section 199(d)(3) provides special
rules under which a taxpayer receiving
certain patronage dividends or certain
qualified per-unit retain allocations
from a cooperative (to which subchapter
T applies) engaged in the MPGE, in
whole or in significant part, or in the
marketing of any agricultural or
horticultural product is allowed a
section 199 deduction with respect to
the amount of the patronage dividends
or qualified per-unit retain allocations
that are: (a) Allocable to the portion of
the cooperative’s QPAI that would be
deductible by the cooperative; and (b)
designated as such by the cooperative in
a written notice mailed to its patrons
during the payment period described in
section 1382. Such an amount, however,
does not reduce the taxable income of
the cooperative under section 1382.
In determining the portion of the
cooperative’s QPAI that would be
deductible by the cooperative, 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-unit retain allocations,
and nonpatronage distributions) and, in
the case of a cooperative engaged in
marketing agricultural and horticultural
products, the cooperative is treated as
having MPGE, in whole or in significant
part, any agricultural and horticultural
products marketed by the cooperative
that its patrons have MPGE.
Expanded Affiliated Groups
Section 199(d)(4)(A) provides that all
members of an expanded affiliated
group (EAG) are treated as a single
corporation for purposes of section 199.
Taking into account the provisions of
the Congressional Letter, as described
elsewhere, 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

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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 rules to
coordinate the deduction allowed under
section 199 with the alternative
minimum tax (AMT) imposed by
section 55. Taking into account the
provisions of the Congressional Letter,
as described elsewhere, section
199(d)(6) provides that for purposes of
determining alternative minimum
taxable income (AMTI) under section
55, the section 199 deduction shall be
determined without regard to any
adjustments under sections 56 through
59, except that in the case of a
corporation (including a corporation
subject to tax under section 511), the
taxable income limitation is the
corporation’s AMTI.
Authority To Prescribe Regulations
Section 199(d)(7) authorizes the
Secretary to prescribe such regulations
as are necessary to carry out the
purposes of section 199.
Congressional Letter
On July 21, 2005, the Chairman and
Ranking Member of the Senate Finance
Committee and the Chairman of the
House Ways and Means Committee
introduced the Tax Technical
Corrections Act of 2005, H.R. 3376 and
S. 1447, 109th Cong. (2005). In a letter
on the same date to the Treasury
Department (the Congressional Letter),
they provided clarification for several
issues so that appropriate regulatory
guidance may be issued reflecting their
intention. These proposed regulations
reflect the intent expressed in the
Congressional Letter with respect to
section 199.
Summary of Comments
Qualified Production Activities Income
One commentator requested that the
proposed regulations clarify the
treatment of advance payments, and the
costs related to those payments, for
purposes of computing QPAI. Section
4.03(3) of Notice 2005–14 provides that,
in the case of advance payments (for

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goods, services, and use of property)
that are recognized under the taxpayer’s
method of accounting in a taxable year
earlier than that in which the property
or services are delivered, performed,
and provided, the taxpayer must
accurately identify, based on a
reasonable method, whether the receipts
(and the corresponding expenses)
qualify as DPGR. If a taxpayer
recognizes an advance payment in Year
1, and the CGS in Year 2, the
commentator asks whether CGS must be
applied to reduce DPGR in Year 2, even
though the DPGR and CGS are
recognized in different taxable years.
The proposed regulations clarify that,
in the example the commentator cites
involving advance payments, as well as
other circumstances (such as taxpayers
that use the cash receipts and
disbursements method) where gross
receipts and corresponding expenses are
recognized in different taxable years,
taxpayers must take the receipts and
expenses into account for purposes of
section 199 in the taxable year such
items are recognized under their
methods of accounting for Federal
income tax purposes. The IRS and
Treasury Department believe it would
be unduly burdensome and complicated
to create a separate set of timing rules
for purposes of section 199. Thus, gross
receipts and costs are taken into account
for purposes of computing QPAI in the
taxable year they are recognized for
Federal income tax purposes under the
taxpayer’s methods of accounting, even
if the related gross receipts or costs, as
applicable, are taken into account in
different taxable years. If the gross
receipts are recognized in an
intercompany transaction within the
meaning of § 1.1502–13, see also
§ 1.199–7(d).
A commentator requested clarification
of how the advance payment rules
would apply in the following scenario.
In Year 1, a taxpayer sells for $100 a
one-year software maintenance
agreement that provides for software
updates (that the taxpayer would MPGE
in whole or in significant part within
the United States) and customer support
services. At the end of Year 1, the
taxpayer uses a reasonable method to
allocate 60 percent of the gross receipts
($60) to the software updates and 40
percent ($40) to the customer support
services. The taxpayer treats the $60 as
DPGR in Year 1. In Year 2, no software
updates are provided. The commentator
asks whether the taxpayer in this
scenario would be required to amend its
Year 1 return and reduce its DPGR by
$60, reduce DPGR by $60 in Year 2, or
make no adjustment for Year 1 or Year
2.

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Consistent with the application of the
rules relating to advance payments,
which require that the taxpayer follow
its methods of accounting for Federal
income tax purposes, the taxpayer
should make no adjustment in Year 1
(by amended return) or in Year 2 for the
$60 that was appropriately treated as
DPGR in Year 1, even though no
software updates were provided in Year
2.
A commentator suggested that the
proposed regulations clarify how a
taxpayer that uses a long-term contract
method determines the portion of the
percentage of completion revenue
reported for each contract for the taxable
year that is allocated to DPGR. The
proposed regulations provide that
taxpayers using a long-term contract
method (for example, under section 460)
may use any reasonable method of
allocating gross receipts under such a
contract between DPGR and non-DPGR.
A number of comments were received
regarding the rule in section 4.03(1) of
Notice 2005–14 that requires that
section 199 be applied on an item-byitem basis. Some commentators stated
that applying section 199 on an item-byitem basis is unduly burdensome, and
that the proposed regulations should
permit taxpayers to determine QPAI on
a division or product-line basis instead.
The IRS and Treasury Department,
however, continue to believe that
applying section 199 on a basis other
than item-by-item would allow
taxpayers to receive the benefits of
section 199 with respect to gross
receipts that should not qualify as
DPGR. Accordingly, the proposed
regulations retain the requirement that
section 199 be applied on an item-byitem basis.
Many commentators requested
clarification of what constitutes an item.
Commentators asked whether an item is
a final product or whether one or more
component parts of the final product
may qualify as an item. For example, if
a final product does not meet the in
whole or in significant part requirement
(so that gross receipts from the sale of
the final product are non-DPGR),
commentators inquired whether they
could allocate gross receipts to a
component of the product that did meet
all of the requirements of section 199(c),
and thereby treat that portion of the
gross receipts as DPGR.
H.R. Conf. Rep. No. 755, 108th Cong.,
2d Sess. 272 n. 27 (2004) (the
Conference Report) indicates that a
component may be treated as qualifying
property in the case of food and
beverages. Footnote 27 of the
Conference Report explains that, in the
context of food and beverages prepared

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at a retail establishment, although a cup
of coffee prepared at a retail
establishment does not qualify under
section 199(c), a portion of the cup of
coffee, that is, the coffee beans (roasted
at a facility separate from the retail
establishment) that meet the
requirements under section 199(c), does
qualify under section 199. The Joint
Committee on Taxation Staff, General
Explanation of Tax Legislation Enacted
in the 108th Congress, 109th Cong., 1st
Sess. 172 (2005) (the Blue Book),
indicates Congressional intent that this
treatment is not limited to food and
beverages, but rather, is permitted with
respect to section 199 in general.
Accordingly, in the case of QPP,
qualified films, and utilities, the
proposed regulations define an item as
the property offered for sale to
customers that meets all of the
requirements under section 199(c). If the
property offered for sale does not meet
all of the requirements under section
199(c), a taxpayer must treat as the item
any portion of the property offered for
sale that meets all of these requirements.
However, in no case shall the portion of
the property offered for sale that is
treated as the item exclude any other
portion that meets all of the
requirements under section 199(c). For
example, assume that the taxpayer
MPGE software entirely within the
United States, attaches the software to a
router that it MPGE entirely outside the
United States, and then sells the
combined property. Assume further that
if the combined property is treated as
the item, the gross receipts from the sale
will not qualify as DPGR because the
combined property does not satisfy the
in whole or in significant part
requirement. The proposed regulations
require the taxpayer to treat the software
as an item; separate from the router,
because the software meets all of the
requirements of section 199(c) (that is,
it is computer software that is MPGE by
the taxpayer in whole or in significant
part within the United States). This is
the case even if the software is not
offered for sale to customers separately
from the router. Accordingly, the gross
receipts from the software qualify as
DPGR, but the gross receipts from the
router do not qualify as DPGR.
Alternatively, assume that the
taxpayer MPGE only software but that
some of the content is MPGE within the
United States and some content is
MPGE outside the United States.
Assuming that the software does not
meet the requirements of section 199(c),
that portion of the software that is
MPGE within the United States must be
treated as the item. Accordingly, gross

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receipts from the sale of the software
must be allocated (using any reasonable
method) between that portion that is
MPGE within the United States (which
is DPGR if all other requirements of
section 199(c) are met) and that portion
that is MPGE outside the United States
(which is non-DPGR).
In the case of construction and
architectural and engineering services,
commentators asked that the proposed
regulations clarify whether the item is
the construction project itself, or
whether the item can constitute a task
or sub-task that is performed as part of
the construction project. The IRS and
Treasury Department believe that the
determination of what constitutes the
item for purposes of construction and
architectural or engineering services
should be made on a case-by-case basis
taking into account all of the facts and
circumstances. Taxpayers may use any
reasonable method of determining the
item for this purpose.
A commentator requested that the
proposed regulations clarify how the
rules for determining DPGR apply in the
case of a taxpayer that repairs or
rebuilds property for a customer. The
commentator suggested the IRS and
Treasury Department distinguish
between ‘‘repair’’ activities and
‘‘rebuild’’ activities. In the case of a
repair contract where the customer
retains the benefits and burdens of the
property while it is being repaired, the
commentator suggests that the
contractor should be permitted to treat
as DPGR the gross receipts attributable
to parts that the contractor MPGE in
whole or in significant part within the
United States, as well as the gross
receipts attributable to the installation
of those parts. Gross receipts
attributable to the parts MPGE by the
taxpayer in whole or in significant part
within the United States are DPGR
(assuming all the other requirements of
section 199(c) are met). Consistent with
the general rule for installation
(discussed below), the installation
activity will be considered an MPGE
activity only if the contractor retains the
benefits and burdens of ownership with
respect to the parts while the parts are
being installed. In addition, the gross
receipts attributable to the installation
of parts that the contractor MPGE may
qualify as DPGR if the exception for
embedded installation described in
§ 1.199–3(h)(4)(ii)(D) of the proposed
regulations applies. The contractor is
not permitted to treat as DPGR gross
receipts attributable to purchased parts,
or the installation of purchased parts.
The commentator suggested that the
proposed regulations provide a special
rule for ‘‘rebuild’’ contracts, which the

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commentator suggested be defined as
any contract where the value of the
rebuild work performed exceeds 25
percent of the value of the preexisting
property immediately before the
rebuild. The commentator further
suggested that if more than 50 percent
of the contractor’s costs of performing
the rebuild is attributable to the cost of
parts that the contractor MPGE, the
contractor should not be required to
allocate its gross receipts between parts
that it MPGE and any parts that it
purchased. The commentator’s
suggested rule would effectively create
for rebuild contracts a separate de
minimis exception to the general
allocation requirement. The IRS and
Treasury Department believe that the de
minimis exceptions provided in the
proposed regulations (for example, the 5
percent de minimis exception discussed
later generally applicable to embedded
services and embedded nonqualifying
property) are appropriate. Accordingly,
the proposed regulations do not adopt
this suggestion.
Section 4.03(2) of Notice 2005–14
provides that, if the amount of the
taxpayer’s gross receipts that do not
qualify as DPGR equals or exceeds 5
percent of the total gross receipts, the
taxpayer is required to allocate all gross
receipts between DPGR and non-DPGR.
For purposes of this 5 percent de
minimis rule, the proposed regulations
in § 1.199–1(d)(2) provide that, in the
case of an S corporation, partnership,
estate, trust, 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 the
owner’s share of any of the pass-thru
entity’s gross receipts as well as all
other gross receipts of the owner. In
addition, the 5 percent de minimis
exception in § 1.199–3(h)(4)(ii)(E)
applies at the entity level to each item
that qualifies.
Commentators also observed that, in
determining whether the taxpayer’s
method of allocating gross receipts and
CGS between DPGR and non-DPGR is
reasonable, the list of factors cited in
section 4.03(2) of Notice 2005–14 with
respect to gross receipts is inconsistent
with the list of factors cited in section
4.05(2)(b) of the notice with respect to
CGS. The list of factors was intended to
be as consistent as possible for both
gross receipts and CGS, and appropriate
changes to the lists have been

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incorporated into the proposed
regulations as necessary.
Taxable Income
In the Congressional Letter, the
Treasury Department was advised that
unrelated business taxable income,
rather than taxable income, applies for
purposes of section 199(a)(1) in
computing the unrelated business
income tax under section 511.
Accordingly, the proposed regulations
in § 1.199–1(b) provide that, for
purposes of determining the tax
imposed by section 511, section
199(a)(1)(B) is applied using unrelated
business taxable income.
The Congressional Letter also
indicates that the section 199 deduction
is not taken into account for purposes of
computing taxable income under the
rules relating to the carryover of a net
operating loss (NOL). Accordingly, the
proposed regulations provide that for
purposes of computing the section 199
deduction, the definition of taxable
income under section 63 applies, but
without regard to section 199. The
proposed regulations also provide that
the section 199 deduction is not taken
into account in computing taxable
income when determining the amount
of the NOL carryback and carryover
under section 172(b)(2). Thus, except as
otherwise provided in § 1.199–7(c)(2) of
the proposed regulations (concerning
the portion of a section 199 deduction
allocated to a member of an EAG), the
section 199 deduction can neither create
an NOL carryback or carryover nor
increase the amount of an NOL
carryback or carryover.
Wage Limitation
A commentator requested that the IRS
and Treasury Department clarify
whether self-employment income of
self-employed individuals as reported
on the individuals’ Schedule SE, ‘‘SelfEmployment Income,’’ of Form 1040
and/or payments for nonemployee
compensation reported by the taxpayer
on Form 1099–MISC, ‘‘Miscellaneous
Income,’’ are included in determining
the amount of the W–2 wages of the
taxpayer. A commentator also requested
that the IRS clarify whether guaranteed
payments to partners are included in
W–2 wages for purposes of section 199.
The statutory language in section
199(b) refers to the amounts a taxpayer
is required to report as wages on Form
W–2 pursuant to section 6051 with
respect to the employment of employees
of the taxpayer. Neither selfemployment income nor guaranteed
payments to partners are required to be
reported under section 6051. In
addition, section 4.02(1)(a) of Notice

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2005–14 and § 1.199–2(a)(1) of the
proposed regulations define employees
as including only common law
employees of the taxpayer and officers
of a corporate taxpayer. Consistent with
the statutory intent, this definition does
not include independent contractors or
partners. Thus, payments to
independent contractors and selfemployment income, including
guaranteed payments made to partners,
are not included in determining W–2
wages.
The proposed regulations provide for
the same three methods of calculating
W–2 wages as contained in Notice
2005–14. It is anticipated that when
final regulations are issued, these three
methods will be published in a notice
rather than as part of the final
regulations. It is anticipated that this
notice will be published at the same
time as the final regulations. The
methods will be included in a notice
rather than the final regulations so that
if changes are made to the box numbers
on Form W–2, ‘‘Wage and Tax
Statement,’’ a new notice can be issued
reflecting those changes more promptly
than an amendment to final regulations.
The non-duplication rule in § 1.199–
2(e) continues to provide that amounts
that are treated as W–2 wages for any
taxable year under any method may not
be treated as W–2 wages for any other
taxable year. Additional language has
been added to the non-duplication rule
to clarify that the same W–2 wages
cannot be claimed by more than one
taxpayer for purposes of section 199.
Domestic Production Gross Receipts
DPGR includes the gross receipts of
the taxpayer that are derived from any
lease, rental, license, sale, exchange, or
other disposition of property described
in section 199(c)(4)(A)(i). Commentators
specifically asked whether fees such as
cotton or real estate broker’s fees are
DPGR. These fees are non-DPGR
because they are not derived from any
lease, rental, license, sale, exchange, or
other disposition of property under
section 199(c)(4)(A)(i).
Commentators asked for clarification
of whether DPGR includes gross receipts
derived by a taxpayer from the
subsequent sale or lease of QPP MPGE
within the United States by the
taxpayer, sold, and then reacquired by
the taxpayer. The proposed regulations
in § 1.199–3(h)(2) provide an example to
illustrate the rule that gross receipts
from the subsequent sale or lease of QPP
are DPGR to the taxpayer that originally
MPGE the QPP within the United States.
Any interest component of the lease
payment also qualifies as DPGR because
section 199(c)(4)(A)(i) provides that

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DPGR means gross receipts derived by
the taxpayer from any lease.
Commentators pointed out that the
rule for allocating gross receipts for
purposes of identifying DPGR under
section 3.04(1) of Notice 2005–14
appears to adopt a specific
identification standard, whereas section
4.03(2) appears to provide a reasonable
basis standard. The proposed
regulations provide in § 1.199–1(d)(1)
that the taxpayer must allocate its gross
receipts from all transactions based on
a 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. 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
purposes, then the taxpayer must use
that specific identification method to
determine DPGR. If a taxpayer does not
use a specific identification method for
other purposes and cannot, without
undue burden or expense, use a specific
identification method, the taxpayer is
not required to use a specific
identification method to determine
DPGR.
Related Persons
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.
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).
However, footnote 29 in the Conference
Report indicates that this provision is
not intended to apply to property leased
by the taxpayer to a related person if the
property is held for sublease or is
subleased to an unrelated person for the
ultimate use of such unrelated person,
or to a license to a related person for
reproduction and sale, exchange, lease,
rental or sublicense to an unrelated
person for the ultimate use of such
unrelated person. Accordingly, the
proposed regulations include these
exceptions from the general rule of
exclusion under section 199(c)(7).
One commentator stated that if a
television network licenses
programming to an affiliate station,
applying section 199(c)(7) to treat the
royalty payment received from the
affiliate as non-DPGR places these
vertically integrated companies at a
competitive disadvantage. The
commentator therefore suggested that
the proposed regulations provide an

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exception for networks and affiliate
stations. The proposed regulations do
not adopt this suggestion, which is not
consistent with section 199(c)(7).
Derived From a Lease, Rental, License,
Sale, Exchange, or Other Disposition
Commentators asked whether gains
and losses associated with hedging
transactions are included in DPGR. For
example, utilities may hedge to manage
the risk of changes in prices of ordinary
inputs into the production process. For
purposes of section 199 only, the
proposed regulations include a rule in
§ 1.199–3(h)(3) concerning hedges
(within the meaning of section
1221(b)(2) and § 1.1221–2(b)) of
inventory that is QPP and supplies
consumed in activities giving rise to
DPGR. The proposed regulations require
gain or loss on the hedging transaction
to be taken into account in determining
DPGR. The proposed rule applies to
hedges that manage the risk of currency
fluctuations but only to the extent that
the hedges are not integrated with an
underlying transaction under § 1.988–
5(b).
Commentators suggested that the
proposed regulations treat gross receipts
attributable to the distribution or
delivery of QPP as derived from the
lease, rental, license, sale, exchange, or
other disposition of that property. The
commentators stated that section
199(c)(4)(B)(ii), which specifically
provides that DPGR does not include
gross receipts derived from the
transmission and distribution of
utilities, indicates (by negative
implication) that gross receipts
attributable to the distribution or
delivery of QPP is intended to be
considered DPGR. Moreover, some
commentators interpreted language in
section 3.04(10)(c) of Notice 2005–14,
stating that bottled water is treated as
QPP and that DPGR may include gross
receipts attributable to distribution of
bottled water, as suggesting that gross
receipts attributable to distribution and
delivery of QPP are considered DPGR.
In general, the IRS and Treasury
Department believe that gross receipts
attributable to distribution and delivery
of QPP are not DPGR because
distribution and delivery are properly
regarded as services, regardless of
whether the taxpayer retains the
benefits and burdens of ownership of
the property at the time it is delivered.
No inference to the contrary in Notice
2005–14 was intended. Thus, the
proposed regulations clarify that
taxpayers generally must allocate gross
receipts between the lease, rental,
license, sale, exchange, or other
disposition of the property itself and the

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delivery component. The IRS and
Treasury Department, however, believe
that, because distribution and delivery
are service components common to
QPP, it is appropriate, as a matter of
administrative convenience, to treat
embedded distribution and delivery
services similar to the qualified
warranty exception in section 4.04(7)(b)
of Notice 2005–14. Thus, the taxpayer
must include in DPGR gross receipts
attributable to the distribution and
delivery of QPP if (1) in the normal
course of business, the charge for the
delivery or distribution service is
included in the price charged for the
sale of the QPP, and (2) the charge for
the delivery or distribution service is
neither separately offered nor separately
bargained for with the customer.
For similar reasons, the proposed
regulations also treat embedded
qualified operating manuals provided in
connection with the sale or disposition
of QPP, qualified films, and utilities
similar to embedded qualified
warranties.
The proposed regulations also provide
special rules for installation activities.
The IRS and Treasury Department
believe that, in some circumstances,
installation is appropriately viewed as
an MPGE activity, and in others it is
appropriately viewed as a service. For
example, installation is properly viewed
as an MPGE activity if the taxpayer
MPGE QPP within the United States and
installs the QPP while the taxpayer
retains the benefits and burdens of
ownership of the QPP. In that case,
gross receipts attributable to the
installation, whether or not embedded,
are derived from the lease, rental,
license, sale, exchange, or other
disposition of the QPP. If, however, the
benefits and burdens of ownership pass
to the customer prior to the installation
of the QPP, the taxpayer is performing
a service by installing the customer’s
property. In that case, gross receipts
attributable to installation are not
derived from the lease, rental, license,
sale, exchange, or other disposition of
the property, and the taxpayer generally
is required under the proposed
regulations to allocate gross receipts
between the proceeds of sale or
disposition of the property (DPGR) and
the installation service (non-DPGR).
However, the IRS and Treasury
Department believe that, because
installation is a service component
common to sales or dispositions of QPP,
if the benefits and burdens of ownership
pass to the customer prior to the
installation, it is appropriate to treat
embedded installation similar to an
embedded qualified warranty, qualified

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67225

delivery, and a qualified operating
manual.
A number of commentators suggested
that the IRS and Treasury Department
expand the exception to the allocation
requirement for a qualified warranty to
include all services (including training,
technical and customer support, and
regular maintenance of the property), as
well as all nonqualifying property
(including purchased spare parts), the
charge for which is embedded in the
contract price of the lease, rental,
license, sale, exchange, or other
disposition of QPP, qualified films, and
utilities. Other commentators stated that
the proposed regulations should adopt
principles similar to § 1.482–2(b), so
that services that are ancillary and
incidental to the sale of QPP, qualified
films, and utilities would not be treated
as embedded services and no allocation
of gross receipts to those services would
be required. These commentators
believe that footnote 27 in the
Conference Report supports such a
position in stating that the conferees
intend that the Secretary provide
guidance regarding the allocation of
gross receipts that draws on the
principles of section 482. Other
commentators stated that, elsewhere in
the Code and regulations, transactions
are given a single characterization based
on their predominant nature and that
section 199 should be applied in the
same manner. For example, if the
predominant nature of a transaction is
the sale of property, all gross receipts
from the transaction should be treated
as proceeds from the sale. Finally, some
commentators stated that a taxpayer’s
treatment of a transaction for financial
reporting purposes should govern its
characterization for section 199
purposes.
The IRS and Treasury Department
infer that the commentators are referring
to § 1.482–2(b)(8), which provides that,
in general, no separate allocation will be
made in connection with ancillary and
subsidiary services provided with a
transfer of property. Services ancillary
and subsidiary to another transaction
may be referred to, outside the section
199 context, as embedded services. The
IRS and Treasury Department do not
intend that services defined as
embedded services under section 199
will be treated in the same manner
provided in § 1.482–2(b)(8) because
such treatment would be generally
inconsistent with the intent and
purpose of section 199.
The IRS and Treasury Department
further believe that the reference to
section 482 principles in footnote 27 of
the Conference Report reflects an intent
to apply section 482 principles

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consistently with the general intent and
purpose of section 199. The IRS and
Treasury Department continue to
believe that the statutory language and
legislative history require that
transactions be bifurcated into
qualifying and nonqualifying elements
and that gross receipts be allocated
accordingly for purposes of section 199.
The IRS and Treasury Department
further believe that the exceptions to
this general rule should be limited.
Expanding the special exceptions to
include all, or ancillary or incidental,
embedded services and embedded
nonqualifying property would result in
the inclusion in DPGR of gross receipts
that the IRS and Treasury Department
do not believe were intended to be
within the scope of section 199. The
legislative history also does not support
adopting principles applicable to other
Code sections under which a single
predominant nature character is
assigned to a transaction, or
characterizing transactions for purposes
of section 199 according to their
treatment for financial reporting
purposes. Accordingly, the proposed
regulations do not adopt these
suggestions.
One commentator requested that the
proposed regulations clarify whether the
embedded services rule is intended to
require taxpayers to treat certain
service-type activities that take place as
part of the MPGE process as embedded
services. The proposed regulations
clarify that embedded services do not
include service-type activities that take
place as part of the MPGE process (that
is, while the taxpayer is engaged in an
MPGE activity with respect to the
property and retains the benefits and
burdens of ownership of the property).
For example, with respect to QPP,
activities such as non-construction
engineering, materials analysis and
selection, subcontractor inspections and
approval, routine production
inspections, product testing and
documentation, and assistance with
certain regulatory approvals, if
undertaken in connection with a
qualifying MPGE activity, are
considered part of the MPGE of the QPP
and are not considered embedded
services. No separate allocation of gross
receipts to such activities is required.
Services and nonqualifying property
are not considered embedded if they are
either separately offered or separately
bargained for, or a charge for the service
or nonqualifying property is separately
stated. Thus, for example, if a charge for
freight or delivery is separately stated
on an invoice for the sale of an item of
QPP, the delivery service is not
embedded and gross receipts

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attributable to that service are nonDPGR, even if the purchaser does not
have the option of refusing the service.
Further, separately stated or bargained
for amounts will not be respected unless
they reflect the fair market value of the
service or nonqualifying property. For
example, if a taxpayer offers contracts to
customers that include a cellular phone
priced on the invoice at $595 and three
years of cellular telephone service
priced on the invoice at $5, the $5 stated
amount for the service will only be
respected if it represents an allocation of
gross receipts consistent with the
principles of section 482.
Gross receipts attributable to
embedded services, embedded
nonqualifying property, or any other
embedded element (other than a
qualified warranty, qualified delivery,
qualified installation, and a qualified
operating manual) may be considered
DPGR under the 5 percent de minimis
exception. The proposed regulations
clarify that, with respect to the de
minimis exception, taxpayers should
apply the 5 percent against the total
amount of the gross receipts derived
from the lease, rental, license, sale,
exchange, or other disposition of the
item of QPP, qualified films, or utilities.
The total amount of DPGR includes
gross receipts attributable to a qualified
warranty, qualified delivery, qualified
installation, and/or a qualified operating
manual that are treated as DPGR with
respect to that item. In the case of a
lease or an installment sale, the de
minimis exception is applied by taking
into account the total amount of gross
receipts under the lease or installment
sale that are attributable to the item of
QPP, qualified films, or utilities.
Under the proposed regulations, as
under Notice 2005–14, applicable
Federal income tax principles apply in
determining whether a transaction (or
any part of a transaction) is, in
substance, a lease, rental, license, sale,
exchange, or other disposition, or
whether it is a service. For this purpose,
section 3.04(7)(a) of Notice 2005–14
cites Rev. Rul. 88–65 (1988–2 C.B. 32),
and describes that revenue ruling as
treating a short-term rental as a service.
Many commentators asked that the
proposed regulations clarify that not all
short-term rentals will be regarded as
services for purposes of section 199.
They observed that Rev. Rul. 88–65
involves the lease of automobiles and
trucks on a daily basis (normally for not
more than one week), and that the
taxpayer performs significant services in
connection with the vehicle, including
maintenance and repairs, and pays all
taxes and insurance on the vehicle. The
IRS and Treasury Department

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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
transactions include both service and
property rental elements. Therefore, the
proposed regulations clarify that, in
such cases, taxpayers must allocate
gross receipts between the qualifying
rental of QPP or qualified films (DPGR)
and the non-qualifying services (nonDPGR). The allocation must be based on
the facts and circumstances of each
transaction. Generally, in the case of
short-term transactions, such as those
described in Rev. Rul. 88–65, in which
significant services are provided in
connection with the property, the
transaction will consist mostly of
services.
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. For
example, assume that a taxpayer
operates a video game arcade that
features video game machines that the
taxpayer MPGE. The machines remain
in the taxpayer’s possession during the
customers’ use. 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.
A number of commentators objected
to the position taken in section
4.04(7)(d) of Notice 2005–14 that gross
receipts from Internet access services,
online services, customer support,
telephone services, games played
through a website, provider-controlled
software online access services, and
other services are not derived from a
lease, rental, license, sale, exchange, or
other disposition of the software.
Consistent with the notice, the proposed
regulations reflect the position that the
use of online computer software does
not rise to the level of a lease, rental,
license, sale, exchange, or other
disposition as required under section
199 but is instead a service. This is the
case even if the customer must agree to
terms and conditions (which may be
termed a license by the software
provider) before using the software
online, or receive enabling software to
facilitate the customer’s use of the
primary software on the customer’s
hardware.
If gross receipts attributable to the use
of online software were permitted to
qualify as DPGR because the same or
similar software also is available to

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customers on disk or by download,
different items of software available
online would be subject to disparate
treatment under section 199. In
addition, if online software were
permitted to qualify as DPGR, it would
be difficult to distinguish this online
software from software that is used to
facilitate a service. The IRS and
Treasury Department are requesting
comments in the Request for Comments
section on this issue.
One commentator suggested that the
term lease, rental, license, sale,
exchange, or other disposition,
especially the term other disposition,
was intended to be interpreted broadly
to include gross receipts from any
means of commercialization of property,
whether or not an actual transfer of the
property occurs. Another commentator
noted that section 3.04(7)(d) of Notice
2005–14 states that gross receipts
derived by a taxpayer from software that
is merely offered for use to customers
online for a fee are non-DPGR, and
suggested that if the software is also
offered to customers on disk or by
download, then gross receipts for online
use of otherwise qualifying software
would be DPGR. The commentator also
noted that the same section provides
that a ‘‘service provided using computer
software that does not involve a transfer
of the computer software does not result
in [DPGR],’’ and suggested that this
language implies that if the software is
not used in providing a service, no
transfer is required for purposes of
section 199. The IRS and Treasury
Department did not intend the results
suggested by the commentators and the
proposed regulations have been clarified
as necessary.
A number of commentators requested
clarification and expansion of the rule
in Notice 2005–14 that treats advertising
receipts attributable to the sale or other
disposition of newspapers and
magazines as DPGR. Notice 2005–14
explains that advertising receipts in this
context are inextricably linked to the
gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition of the newspapers and
magazines. In response to comments,
the proposed regulations clarify that this
rule also applies, under the same
rationale, to advertising receipts relating
to telephone directories and periodicals,
whereby a taxpayer’s gross receipts
derived from the lease, rental, license,
sale, exchange, or other disposition of
the telephone directories or periodicals
that are MPGE in whole or in significant
part within the United States includes
advertising income from advertisements
placed in those media, but only to the
extent the gross receipts, if any, derived

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from the lease, rental, license, sale,
exchange, or other disposition of the
telephone directories or periodicals are
DPGR. The proposed regulations clarify
that advertising revenue for advertising
in online newspapers and periodicals is
non-DPGR, because any underlying
receipts from the property itself are nonDPGR, as there is no lease, rental,
license, sale, exchange, or other
disposition of such property. The
proposed regulations provide similar
treatment for gross receipts attributable
to product placements in a qualified
film. The gross receipts attributable to
product placements will be treated as
DPGR, but (as with newspapers) only if
the gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of the qualified film
are DPGR. Thus, for product placement
revenue to be derived from a qualified
film, there must be a lease, rental,
license, sale, exchange, or other
disposition of the qualified film.
Section 3.04(9)(a) of Notice 2005–14
provides that revenue from the licensing
of film characters is not derived from
the lease, rental, license, sale, exchange,
or other disposition of a qualified film.
One commentator stated that this
treatment is inconsistent with the
income forecast method, and that
revenue from licensing of film-related
intangibles is inextricably linked to (and
therefore should be treated as derived
from) the qualified film. The proposed
regulations do not adopt this comment.
Section 199(c)(4)(A)(i)(II) clearly
requires that receipts must be derived
from a lease, rental, license, sale,
exchange, or other disposition of a
qualified film to be DPGR. Receipts
derived from the licensing of related
intangibles, including film characters,
trademarks, and trade names, do not
meet this requirement. Further, the IRS
and Treasury Department do not agree
that receipts derived from licensing of
film-related intangibles are inextricably
linked to the gross receipts derived from
a qualified film.
Some commentators objected to the
rule in section 4.04(7)(a) of Notice
2005–14 that provides that if a taxpayer
exchanges QPP MPGE by the taxpayer
in whole or in significant part within
the United States for other property in
a taxable exchange, the value of the
property received by the taxpayer is
DPGR; whereas any gross receipts
derived from a subsequent sale by the
taxpayer of the acquired property are
non-DPGR because the taxpayer did not
MPGE the acquired property. The
commentators noted that in their
industry, fungible commodities held for
sale to customers are exchanged
routinely between producers as a

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practical means of avoiding logistical
problems in meeting customers’ needs
and reducing transportation and storage
costs. The commentators noted that
these exchanges typically are not treated
as taxable exchanges on the parties’
financial records. The commentators
requested that the proposed regulations
instead provide that if the property
relinquished in the exchange is QPP,
qualified films, or utilities, then the
property received in the exchange
should be treated as QPP, qualified
films, or utilities and gross receipts
derived from the subsequent sale of that
property should be treated as DPGR.
Another commentator suggested that
this treatment be applied only to
nontaxable exchanges.
The proposed regulations do not
adopt these suggestions. The IRS and
Treasury Department believe that the
character of property as having been
MPGE in whole or in significant part by
the taxpayer within the United States is
not an attribute of the property, like
basis and holding periods, that may be
substituted with the transfer of the
property. The IRS and Department
Treasury believe that the commentators’
interpretations are inconsistent with
section 199(c)(4)(A)(i)(I).
Commentators requested that the IRS
and Treasury Department clarify
whether gross receipts from mineral
royalties and net profits interests are
properly treated as DPGR. Mineral
royalties, including net profits interests,
are returns on passive interests in
mineral properties, the owner of which
makes no expenditure for operation or
development. The courts and the IRS
have long considered these types of
income to be in the nature of rent (see,
for example, Kirby Petroleum Co. v.
Comm’r, 326 U.S. 599 (1946)).
Accordingly, the proposed regulations
in § 1.199–3(h)(9) provide that gross
receipts from mineral interests and net
profits interests other than operating or
working interests are not treated as
DPGR.
Definition of Manufactured, Produced,
Grown, or Extracted
Section 4.04(3)(b) of Notice 2005–14
provides that a taxpayer that MPGE QPP
for the taxable year should treat itself as
a producer under section 263A with
respect to the QPP for the taxable year
unless the taxpayer is not subject to
section 263A. In response,
commentators questioned whether all
taxpayers that are subject to section
263A are considered to have MPGE QPP
for purposes of section 199. Taxpayers
who do not MPGE QPP may
nevertheless be subject to section 263A.
For example, a taxpayer that has

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property produced for it under a
contract is considered a producer of
property under section 263A, but may
not be considered as having MPGE
property for purposes of section 199 if
it does not have the benefits and
burdens of ownership of the property
while it is being produced.
Additionally, in some circumstances a
taxpayer that manufactures property for
a customer pursuant to a contract may
be considered the producer of the
property for purposes of section 263A
and not to have MPGE the property for
purposes of section 199. Accordingly,
not all taxpayers that are subject to
section 263A are considered to have
MPGE QPP for purposes of section 199.
Commentators also have questioned
whether a taxpayer that engages in
certain production activities that are
exempt from section 263A (for example,
developing computer software under
Rev. Proc. 2000–50 (2000–1 C.B. 601),
producing property pursuant to a longterm contract under section 460, or
farming exempt under section 263A(d))
must treat itself as a producer under
section 263A if the taxpayer wants to be
treated as MPGE QPP for purposes of
section 199. The proposed regulations
in § 1.199–3(d)(4) provide that a
taxpayer that has MPGE QPP for the
taxable year should treat itself as a
producer under section 263A with
respect to the QPP for the taxable year
unless the taxpayer is not subject to
section 263A. A taxpayer whose MPGE
activity is exempt from section 263A is
not required to change its method of
accounting under section 263A to treat
itself as engaged in the MPGE of QPP for
purposes of section 199.
Commentators requested clarification
as to whether a reseller that engages in
de minimis production activities or that
has property produced for it under
contract, which constitutes the MPGE of
QPP under section 199, is precluded
from using the simplified resale method
provided by § 1.263A–3(d). Section
1.263A–3(a)(4)(ii) provides that a
reseller with de minimis production
activities is permitted to use the
simplified resale method. Likewise,
§ 1.263A–3(a)(4)(iii) provides that a
reseller otherwise permitted to use the
simplified resale method is permitted to
use the method if it has personal
property produced for it under a
contract if the contract is entered into
incident to its resale activities and the
property is sold to its customers. The
section 263A consistency rule provided
in § 1.199–3(d)(4) of the proposed
regulations does not affect the rules
provided in § 1.263A–3. Accordingly, a
reseller with de minimis production or
that has property produced for it under

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a contract that is considered the MPGE
of QPP for purposes of section 199 is not
precluded from using the simplified
resale method if the taxpayer meets the
requirements of § 1.263A–3(a)(4)(ii) or
(iii).
Definition of By the Taxpayer
Section 1.199–3(e)(1) of the proposed
regulations provides that, with the
exception of rules that are applicable to
an EAG, certain oil and gas partnerships
described in § 1.199–3(h)(7), EAG
partnerships described in § 1.199–
3(h)(8), and certain government
contracts described in § 1.199–3(e)(2),
only one taxpayer may claim the section
199 deduction with respect to the MPGE
of QPP. If one taxpayer MPGE QPP
pursuant to a contract with another
person, then only the taxpayer that has
the benefits and burdens of ownership
of the property under Federal income
tax principles during the time the
property is MPGE will be considered to
have MPGE the QPP. In contrast,
§ 1.263A–2(a)(1)(ii)(B) provides that
property produced for the taxpayer
under a contract is considered as
produced by the taxpayer to the extent
the taxpayer makes payments or
otherwise incurs costs with respect to
the property, even if the taxpayer is not
the owner of the property while the
property is being produced.
Commentators questioned why a similar
rule does not apply in the context of
section 199. The rule provided by
§ 1.263A–2(a)(1)(ii)(B) is derived from
section 263A(g)(2). That section
specifically provides that a taxpayer is
treated as producing property produced
for it under a contract to the extent that
it has made payments or incurred costs
with respect to the contract. In contrast,
section 199(c)(4)(A)(i) provides that
DPGR only includes gross receipts of the
taxpayer that are derived from any lease,
rental, license, sale, exchange, or other
disposition of QPP MPGE by the
taxpayer in whole in significant part
within the United States. Accordingly,
the proposed regulations do not contain
a provision that is analogous to
§ 1.263A–2(a)(1)(ii)(B).
While sections 199, 263A, and 936 all
have benefits and burdens standards,
the standard under section 199 is not
the same as those under sections 263A
and 936. Commentators suggested that
the proposed regulations adopt the
broader standard under § 1.263A–
2(a)(1)(ii)(A) that provides that a
taxpayer is not considered to be
producing property unless the taxpayer
is considered the owner of the property
produced under Federal income tax
principles. The determination of
whether a taxpayer is considered an

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owner is based on all of the facts and
circumstances, including the various
benefits and burdens of ownership
vested with the taxpayer. Because the
standard under the section 263A
regulations is broad, it has been
interpreted to allow two taxpayers to be
considered the producer of the same
property. Compare, for example, Suzy’s
Zoo v. Comm’r, 114 T.C. 1 (2000), aff’d
273 F.3d 875 (9th Cir. 2001) and Golden
Gate Litho v. Comm’r, T.C. Memo
(1998–184).
The IRS and Treasury Department
continue to believe that the requirement
of section 199(c)(4)(A)(i) that property
be MPGE by the taxpayer means that
only one taxpayer may claim the section
199 deduction with respect to the same
function performed with respect to the
same property. Therefore, it would be
inappropriate to adopt the standard
under the section 263A regulations. In
addition, this interpretation is
supported by the Congressional Letter
that states the Treasury Department has
the authority to prescribe rules to
prevent the section 199 deduction from
being claimed by more than one
taxpayer with respect to the same
economic activity described in section
199(c)(4)(A)(i). Thus, consistent with
Notice 2005–14, the proposed
regulations in § 1.199–3(e)(1) provide
that only one taxpayer may claim the
section 199 deduction with respect to
any MPGE activity.
Commentators also proposed other
alternatives to the benefits and burdens
standard, such as looking to the person
that has the economic risks and benefits,
adopting the qualified research rules
under § 1.41–2(e)(2), providing safe
harbors based on contract terms, treating
the person that arranges for the
acquisition of the property as the owner,
and looking to the person that controls
the process by which the property is
MPGE. The proposed regulations do not
adopt any of these suggestions because
the IRS and Treasury Department
believe that there is considerable
variation in the types of contract
manufacturing situations. Therefore, the
proposed regulations contain the same
benefits and burdens standard used in
Notice 2005–14 because it is a standard
that the IRS and Treasury Department
believe covers all of the varied factual
situations.
Commentators requested that the
proposed regulations provide examples
of how to apply the benefits and
burdens standard. The proposed
regulations contain examples
illustrating contract manufacturing
situations in which the taxpayer with
the benefits and burdens of ownership

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under Federal income tax principles is
treated as manufacturing the QPP.
In the Congressional Letter, the
Treasury Department was advised that
gross receipts derived from certain
contracts to manufacture or produce
property for the Federal government are
derived from the sale of such property
and, therefore, are DPGR. The proposed
regulations in § 1.199–3(e)(2) provide
that a taxpayer will be treated as
meeting the by the taxpayer requirement
if the QPP, qualified films, or utilities
are MPGE or otherwise produced in the
United States by the taxpayer pursuant
to a contract with the Federal
government and the Federal Acquisition
Regulation requires that title or risk of
loss with respect to the QPP, qualified
films, or utilities be transferred to the
Federal government before the MPGE or
production of the QPP, qualified films,
or utilities is complete.
In Whole or In Significant Part
Under section 199(c)(4)(A)(i)(I), QPP
must be MPGE in whole or in significant
part by the taxpayer within the United
States. The proposed regulations in
§ 1.199–3(f)(1) clarify that the in whole
or in significant part requirement
applies to both the by the taxpayer
requirement and the within the United
States requirement.
Section 4.04(5)(b) of Notice 2005–14
provides that QPP will be treated as
having been MPGE in significant part by
the taxpayer within the United States if
the MPGE of the QPP performed within
the United States is substantial in
nature. Design and development costs
do not qualify as substantial in nature
for any QPP other than computer
software and sound recordings. The
proposed regulations in § 1.199–3(f)(2)
substitute research and experimental
expenditures under section 174 for
design and development costs.
Section 4.04(5)(c) of Notice 2005–14
provides that a taxpayer will be treated
as having MPGE property in whole or in
significant part within the United States
if, in connection with the property,
conversion costs (direct labor and
related factory burden) to MPGE the
property are incurred by the taxpayer
within the United States and the costs
account for 20 percent or more of the
total CGS of the property. The proposed
regulations in § 1.199–3(f)(3) provide
that, in the case of tangible personal
property, research and experimental
expenditures under section 174 and any
other costs of creating intangibles may
be excluded from total CGS for purposes
of the safe harbor.
A commentator suggested that a
taxpayer’s activity within the United
States that is critical to the functionality

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or nature of property should be
considered to meet the in significant
part requirement under section
199(c)(4)(A)(i)(I) even if the activity is
not substantial in nature. The proposed
regulations do not adopt this suggestion
because the IRS and Treasury
Department do not believe that this is an
accurate measurement of the degree of
activity required to satisfy the in whole
or in significant part requirement.
Qualifying Production Property
Commentators requested that the IRS
and Treasury Department reconsider the
rule under section 4.04(8)(c) and (d) of
Notice 2005–14 which provides that, if
the medium in which computer
software or sound recordings are
contained is tangible, then such
medium is considered tangible personal
property for purposes of section 199.
This rule has been removed and the
proposed regulations in § 1.199–3(i)(5)
provide that if a taxpayer MPGE
computer software or sound recordings
that the taxpayer fixed on, or added to,
tangible personal property (for example,
a computer diskette or an appliance),
then the tangible medium with the
computer software or sound recordings
may be treated by the taxpayer as
computer software or sound recordings,
as applicable. However, the proposed
regulations provide that, if a taxpayer
treats the tangible medium as computer
software or sound recordings, any costs
under section 174 attributable to the
tangible medium are not considered in
determining whether the taxpayer’s
activity is substantial in nature under
§ 1.199–3(f)(2) or conversion costs under
§ 1.199–3(f)(3). In addition, because a
taxpayer may MPGE tangible personal
property, but not computer software or
sound recordings that the taxpayers
fixes on, or adds to, the tangible
personal property MPGE by the
taxpayer, the proposed regulations
provide that the computer software or
sound recordings may be treated by the
taxpayer as tangible personal property.
Commentators requested that the
proposed regulations clarify whether the
exceptions from computer software
under section 168(i)(2)(B)(iv) apply to
computer software under section 199. In
response to this comment, the proposed
regulations provide in § 1.199–3(i)(3)(i)
that these exceptions do not apply for
purposes of section 199 and computer
software also includes the machinereadable 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

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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.
A commentator requested that the
proposed regulations provide that the
creation and licensing of copyrighted
business information reports constitutes
the MPGE of QPP. Formerly distributed
in hard copy, this information is now
generally distributed electronically.
Customers are required to use the
information only for their own use, and
no copyright is transferred to them. The
commentator contends that, while the
activity of creating the business
information reports provided to
customers is not a production activity in
the traditional sense, the definition of
MPGE is broad enough to encompass
this activity. The IRS and Treasury
Department do not agree with this
comment because creating a database of
business information is not MPGE, the
database is not QPP, and the business
information reports are not QPP MPGE
by the taxpayer.
Qualified Films
Similar to the rules for computer
software, section 4.04(9)(a) of Notice
2005–14 provides that if a medium on
which a qualified film is fixed is
tangible (such as a DVD), the property
consists of both a qualified film and
tangible personal property. The notice
contains examples in which taxpayers
that either produce a qualified film and
purchase the tangible medium, or MPGE
the tangible medium and license the
qualified film, must allocate gross
receipts between the tangible medium
and the qualified film. For the reasons
stated under the discussion of computer
software, the proposed regulations allow
certain taxpayers to treat such combined
property as either tangible personal
property or a qualified film, as
applicable.
One commentator requested that the
proposed regulations clarify the
requirement that 50 percent of the total
compensation relating to the production
of the film be compensation for services
performed in the United States by
actors, production personnel, directors,
and producers. Specifically, the
commentator requested that the phrase
‘‘total compensation relating to the
production of the film’’ be interpreted to
mean compensation for services
performed only by actors, production
personnel, directors, and producers. The
commentator further requested that the
term ‘‘compensation’’ be interpreted to

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include all compensation (not just W–2
wages) that is paid to these individuals
and that is required to be capitalized by
film producers under section 263A and
§ 1.263A–1(e)(2) and (3). These
suggestions have been adopted in the
proposed regulations.
Definition of Construction Performed in
the United States
Section 4.04(11)(a) of Notice 2005–14
defines the term ‘‘construction’’ to mean
the construction or erection of real
property by a taxpayer that is in a trade
or business that is considered
construction for purposes of the North
American Industry Classification
System (NAICS). Commentators asked
how a taxpayer in multiple trades or
businesses determines if it is in a
construction NAICS code. The proposed
regulations clarify that in order for a
taxpayer to be considered in a
construction NAICS code, it must be
engaged in a construction trade or
business (but not necessarily its primary
trade or business) on a regular and
ongoing basis. The determination of
whether an entity is in a NAICS code is
generally tested on an entity-by-entity
basis. Under this rule, a member of an
EAG must perform the construction
activity in order for its gross receipts to
qualify as DPGR from construction. See
§ 1.199–7(a)(3). In addition, the taxpayer
must actually perform the construction
activity. For example, if a taxpayer in a
construction NAICS code hired an
unrelated general contractor to construct
a building, the gross receipts derived by
the taxpayer from the sale of the
building would not be DPGR because
the taxpayer did not construct the
building. The proposed regulations
provide an example to illustrate this
rule.
Commentators also asked that the
proposed regulations clarify whether
eligible construction activities are
limited to a specific NAICS code.
Section 1.199–3(l)(1)(i) provides that a
trade or business that is considered
construction for purposes of the NAICS
codes means a construction activity
under the two-digit NAICS code of 23
and any other construction activity in
any other NAICS code relating to the
construction of real property. For
example, a construction activity relating
to the construction of real property that
is not under the two-digit NAICS code
of 23 but which qualifies as an eligible
construction activity would include the
construction of oil and gas wells for
NAICS code 213111 (drilling oil and gas
wells) and 213112 (support activities for
oil and gas operations). Commentators
also asked that the proposed regulations
include a listing of construction

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activities relating to oil and gas wells. In
response to this request, the proposed
regulations provide, as a matter of
administrative grace, that qualifying
construction activities also include
activities relating to drilling an oil well
and mining, and include any activities
treated by the taxpayer as 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.
Commentators contend that gross
receipts attributable to the leasing or
rental of constructed real property
qualify as DPGR because the right to use
constructed property represents one
right in the bundle of rights derived
from the construction of real property.
The proposed regulations do not adopt
this interpretation because gross
receipts derived from the rental of real
property that a taxpayer constructs are
not derived from construction, but are
instead compensation for the use or
forbearance of the property. Similarly,
gross receipts derived from renting or
leasing equipment such as bulldozers
and generators to contractors for use in
the construction of real property are
non-DPGR (assuming the rental
companies do not manufacture the
equipment).
Section 4.04(11)(a) of Notice 2005–14
contains a safe harbor rule for
determining when tangible personal
property that is sold as part of a
construction project may be considered
real property. If more than 95 percent of
the total gross receipts derived by a
taxpayer from a construction project are
derived from real property (as defined
in § 1.263A–8(c)), then the total gross
receipts derived by the taxpayer from
the project are DPGR from construction.
Commentators stated that it was unclear
what items of tangible personal property
are included in this rule (for example,
small or major appliances, home
theaters, and fixtures installed by a
builder) and whether it was intended
that land be included for purposes of
this safe harbor. Consequently, this rule
has been replaced in the proposed
regulations with a de minimis exception
in § 1.199–3(l)(1)(ii). Accordingly, if less
than 5 percent of the total gross receipts
derived by a taxpayer from a
construction project are derived from
activities other than the construction of
real property in the United States (for
example, from non-construction
activities, the sale of tangible personal
property, or land) then the total gross
receipts derived by the taxpayer from
the project are DPGR from construction.
Many commentators suggested that
the proposed regulations treat gross
receipts attributable to the sale or other

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disposition of land as DPGR derived
from construction of real property.
Commentators also suggested that
construction begins as soon as
production activities begin, that is,
when land is acquired and the
entitlement process, such as obtaining
proper zoning and permits, commences
in connection with construction of real
property. The proposed regulations do
not adopt these suggestions. The IRS
and Treasury Department continue to
believe that Congress intended the
benefit under section 199 only for
construction services performed in the
United States. Taxpayers do not
construct land and thus any gain
attributable to the disposition of land
(including zoning, planning, entitlement
costs and other costs capitalized to the
land such as the demolition of
structures under section 280B) is not
eligible for the section 199 deduction.
Commentators also argue that the land
exclusion creates an administrative and
financial burden because a valuation
will be necessary for any sale of real
property that includes land. To address
the administrative burden in identifying
and valuing the gross receipts
attributable to land in connection with
qualifying construction activities, the
proposed regulations provide a safe
harbor in § 1.199–3(l)(5)(ii). Under this
safe harbor, a taxpayer may allocate
gross receipts between the proceeds
from the sale, exchange, or other
disposition of real property constructed
by the taxpayer and the gross receipts
attributable to the sale, exchange, or
other disposition of land by reducing its
costs related to DPGR in § 1.199–4 by
costs of the land and any other costs
capitalized to the land (collectively,
land costs) (including land costs in any
common improvements as defined in
section 2.01 of Rev. Proc. 92–29 (1992–
1 C.B. 748)), and by reducing its DPGR
from qualifying construction activities
by those land costs plus a specified
percentage. The percentage is based on
the number of years that elapse between
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. The percentage is
5 percent for years zero through 5; 10
percent for years 6 through 10; and 15
percent for years 11 through 15. Land
held by a taxpayer for 16 or more years
is not eligible for the safe harbor and the
taxpayer must allocate gross receipts
between the land and the qualifying real
property. For example, if a taxpayer
acquires land in 2001 and constructs
houses that it sells in 2005, 2008, and

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2012, the houses sold in 2005 are
subject to the 5 percent reduction; the
houses sold in 2008 are subject to the 10
percent reduction; and the houses sold
in 2012 are subject to the 15 percent
reduction.
Commentators suggested that
developers of raw land should be
entitled to a section 199 deduction for
improvements to land such as building
roads, sidewalks, and installing utilities.
In addition, they suggested that
entitlements such as zoning, permits,
and surveys that add value to the land
should be included in DPGR similar to
the treatment of design and
development costs for software and
sound recordings. The proposed
regulations provide that a taxpayer in a
construction NAICS code that sells
developed land will have DPGR to the
extent the receipts are attributable to
real property such as infrastructure but
not to the land and any entitlements
attributable to the land. The proposed
regulations provide examples in
§ 1.199–3(l)(5)(iii) to illustrate this rule.
Commentators suggested that the
proposed regulations extend the
embedded services exception for
qualified warranties in connection with
the sale of property to construction
warranties. The IRS and Treasury
Department agree with this suggestion.
Accordingly, § 1.199–3(l)(5)(i) provides
DPGR derived from the construction of
real property includes gross receipts
from any warranty that is provided in
connection with the construction of the
real property if, in the normal course of
the taxpayer’s business, the charge for
the construction warranty is included in
the price for the construction project
and the construction warranty is neither
separately offered by the taxpayer nor
separately bargained for with the
customer (that is, the customer cannot
purchase the constructed real property
without the construction warranty).
Engineering and Architectural Services
Section 4.04(12)(a) of Notice 2005–14
provides that DPGR includes gross
receipts derived from engineering or
architectural services performed in the
United States for real property
construction projects in the United
States. Commentators stated that the
definition of engineering and
architectural services should not be
limited to real property because this
limitation is inconsistent with the rules
for engineering and architectural
services under the domestic
international sales corporation, foreign
sales corporation, and extraterritorial
income exclusion provisions. The IRS
and Treasury Department continue to
believe that the statutory language in

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section 199(c)(4)(A)(iii) requires that
only engineering and architectural
services relating to real property qualify
for the section 199 deduction and that
the same rules relating to construction
of real property apply for engineering or
architectural services. In addition, the
Blue Book at page 172 n. 292, states that
DPGR includes gross receipts derived
from the engineering or architectural
services performed with respect to real
property only. Thus, DPGR only
includes gross receipts derived from
engineering or architectural services
performed in the United States for the
construction of real property in the
United States. In addition, the IRS and
Treasury Department believe that,
consistent with the rules for
construction activities, a taxpayer
performing engineering and
architectural services must be in a trade
or business described in an engineering
or architectural NAICS code.
Accordingly, the proposed regulations
require that, at the time the taxpayer
performs the engineering or
architectural services, the taxpayer must
be in a trade or business on a regular
and ongoing basis (but not necessarily
its primary trade or business) that is
considered engineering or architectural
services for purposes of the NAICS
codes, for example NAICS codes 541330
(engineering services) or 541310
(architectural services).
A commentator also requested
clarification of whether a structure
enclosing an electric generation station
as described in Rev. Rul. 69–412 (1969–
2 C.B. 2) would be considered real
property for purposes of section
199(c)(4)(A)(iii). In that revenue ruling,
the structure qualified as section 38
property for investment credit purposes.
The revenue ruling does not determine
whether the property was real or
personal property. Under section
4.04(11)(a) of Notice 2005–14, real
property includes residential and
commercial buildings including items
that are structural components of such
buildings and inherently permanent
structures other than tangible personal
property in the nature of machinery.
The proposed regulations in § 1.199–
3(l)(1)(i) retain this language. Thus, a
structure enclosing an electric
generation station as described in Rev.
Rul. 69–412 is treated as real property
for purposes of section 199(c)(4)(A)(iii).
In addition, similar to the rules for
construction, the determination of
whether an entity is in an engineering
or architectural NAICS code is made on
an entity-by-entity basis. Under this
rule, a member of an EAG must perform
the engineering or architectural services
in order for its gross receipts to qualify

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as DPGR from engineering or
architectural services. See § 1.199–
7(a)(3). In addition, the taxpayer must
actually perform the engineering or
architectural services.
One commentator pointed out that the
requirement in section 4.04(12)(a) of
Notice 2005–14 that a taxpayer must
substantiate that the engineering or
architectural services relate to a
construction project in the United States
is unnecessary because taxpayers are
already required to identify and allocate
gross receipts attributable to DPGR
based upon a reasonable method
satisfactory to the Secretary for purposes
of determining QPAI. Because there was
no intention on the part of the IRS and
Treasury Department to create an
additional substantiation requirement
for engineering and architectural
services, this additional substantiation
requirement is not required under the
proposed regulations.
Commentators requested clarification
of whether gross receipts attributable to
feasibility studies, for example,
planning possible road or building
configurations for a potential real
property development project, is a
qualifying activity. The commentators
state that engineering and architectural
firms are often hired for these studies to
determine a project’s practicability.
Accordingly, the proposed regulations
provide in § 1.199–3(m)(1) that DPGR
includes 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.
Food and Beverages
Section 199(c)(4)(B)(i) provides that
DPGR does not include gross receipts of
the taxpayer that are derived from the
sale of food and beverages prepared by
the taxpayer at a retail establishment.
Section 4.04(13) of Notice 2005–14
defines a ‘‘retail establishment’’ as real
property 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. One commentator stated that food
carts and portable food stands should
not be considered retail establishments
because they do not constitute real
property. The IRS and Treasury
Department believe that the term ‘‘retail
establishment’’ is intended to be
interpreted broadly to include any
facility at which the taxpayer prepares
food or beverages and makes retail sales
of the food or beverages to the public.
See Conference Report at page 272
(footnote 27) (retail establishment not

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limited to establishments at which
customers dine on premises or to those
engaged primarily in the dining trade).
Accordingly, the proposed regulations
do not adopt this suggestion, and the
term ‘‘retail establishment’’ is clarified
to include both real and personal
property. In addition, a facility at which
food and beverages are prepared solely
for take out service or delivery is a retail
establishment (for example, a caterer).
Consistent with Notice 2005–14, the
proposed regulations provide that if a
taxpayer’s facility is a retail
establishment, then, as a matter of
administrative grace, a taxpayer is
permitted to allocate its gross receipts
between gross receipts derived from the
wholesale sale of the food and beverages
prepared at the retail establishment
(which are DPGR, assuming all the other
requirements of section 199(c) are met)
and the gross receipts derived from the
retail sale of the food and beverages
prepared and sold at the retail
establishment (which are non-DPGR).
For this purpose, wholesale sales are
defined as sales of food and beverages
to be resold by the purchaser.
One commentator requested
clarification how the retail
establishment exception applies in the
case of wineries. While producers of
distilled spirits, wines, and beer may
conduct retail sales of their products on
their premises, such sales do not
transform the entire premises of the
distilled spirits plant, bonded wine
cellar (or bonded winery), or brewery
into a retail establishment. Chapter 51 of
Title 26 of the United States Code, and
the implementing regulations found in
27 CFR parts 19, 24, and 25, create clear
distinctions between that portion of a
distilled spirits plant, winery, or
brewery devoted to production activities
and the portion devoted to other
activities, such as retail sales. Consistent
with the treatment of such facilities for
purposes of Chapter 51 of Title 26 of the
United States Code and the regulations
thereunder, the proposed regulations
provide that the portion of a distilled
spirits plant, bonded winery, or brewery
that is restricted to production
activities, including the processing and
blending of distilled spirits, wine, and
beer products, will not be treated as a
retail establishment for purposes of
section 199(c)(4)(B)(i). Thus, for
example, for purposes of section 199,
taxpaid wine sold from the taxpaid
premises of a bonded winery is not
considered to have been produced at a
retail establishment because it is
considered to have been produced on
the bonded premises of the winery.
Accordingly, the sales of such wine will
be treated as DPGR for purposes of

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section 199 (assuming all the other
requirements of section 199(c) are met).
A similar result applies to the sale of
taxpaid distilled spirits from the general
(taxpaid) premises of a distilled spirits
plant, and to the sale of taxpaid beer
from the tavern portion of a brewery.
A commentator suggested that the
proposed regulations interpret the term
food and beverages to mean only items
prepared by the taxpayer in a single
serving size for immediate consumption
by the purchaser. The commentator
believes that the Conference Report in
footnote 27 supports this interpretation
because these characteristics are
common to the examples that the
footnote provides (that is, brewed coffee
and venison sausage prepared at a
restaurant). The commentator further
contends that this interpretation
eliminates the distinction between food
and beverages prepared off-site (gross
receipts from the retail sale of which
may be DPGR) and those prepared onsite (gross receipts from the retail sale of
which are non-DPGR), a distinction that
the commentator believes Congress did
not intend.
The IRS and Treasury Department do
not believe that the statute or
Conference Report supports the
commentator’s interpretation. If the
commentator’s interpretation was
correct, then gross receipts from the
retail sale of the roasted coffee beans in
footnote 27 would have qualified as
DPGR even if the taxpayer had roasted
the beans at its retail establishment
because the beans are not sold in single
servings for immediate consumption.
However, footnote 27 makes clear that
the gross receipts attributable to the
beans only qualify because the beans
were roasted at a facility separate from
the retail establishment. Thus, the
statute and legislative history clearly
provide different treatment for gross
receipts attributable to the retail sale of
food and beverages prepared at a retail
establishment and food and beverages
prepared elsewhere.
The same commentator requested
clarification of how the food and
beverages exception applies to in-store
bakeries. Footnote 27 of the Conference
Report provides an example of a
taxpayer that operates a supermarket
that includes an in-store bakery, and
provides that the taxpayer may allocate
its gross receipts between DPGR and
non-DPGR. The commentator believes
that the example could be interpreted to
mean that all gross receipts allocable to
sales (both retail and wholesale) of
items prepared in the bakery are nonDPGR. Section 4.04(13) of Notice 2005–
14 however, as a matter of
administrative grace, permits gross

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receipts from wholesale sales of food
and beverages produced at a retail
establishment to qualify as DPGR (if all
other requirements of section 199(c) are
met), and the proposed regulations
retain this rule. Thus, gross receipts
from wholesale sales of items produced
at the in-store bakery (for example,
items sold to restaurants) may qualify as
DPGR (if all other requirements of
section 199(c) are met). The
commentator further stated, consistent
with the first comment, that gross
receipts from retail sales of bakery
products that require further processing
by the consumer to be suitable for
individual consumption (such as
unsliced cakes and unsliced loaves of
bread) should not be excluded from
DPGR under section 199(c)(4)(B)(i). For
the reasons stated above, the IRS and
Treasury Department believe that retail
sales of these items are subject to that
exclusion. Receipts allocable to
wholesale sales of these items, however,
may qualify as DPGR under the
administrative exception, assuming all
the other requirements of section 199(c)
are met.
Determining Costs
To determine its QPAI for the taxable
year, a taxpayer must subtract from its
DPGR the amount of CGS allocable to
DPGR, the other deductions, expenses,
and losses (deductions) directly
allocable to DPGR, and a ratable portion
of other deductions that are not directly
allocable to DPGR or another class of
income. A taxpayer’s costs must be
determined using the taxpayer’s
methods of accounting for Federal
income tax purposes.
Allocation of Cost of Goods Sold
Notice 2005–14 provides that if a
taxpayer can identify from its books and
records CGS allocable to DPGR, CGS
allocable to DPGR is that amount. The
Notice also provides that if a taxpayer’s
books and records do not allow it to
identify CGS allocable to DPGR, the
taxpayer may use a reasonable
allocation method to allocate CGS
between DPGR and non-DPGR. The
Notice further provides that, if a
taxpayer uses a method to allocate gross
receipts between DPGR and non-DPGR,
then the taxpayer may not use a
different method for purposes of
allocating CGS.
Commentators suggested that a
taxpayer should be permitted to allocate
CGS using a reasonable method separate
from the method used to allocate gross
receipts because using the same
allocation method for gross receipts and
CGS may not be possible or may distort
income. For example, a taxpayer that

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can identify from its books and records
gross receipts allocable to DPGR may
not be able to specifically identify CGS
allocable to DPGR. Commentators also
questioned whether a taxpayer that can
identify from its books and records CGS
allocable to DPGR must allocate CGS on
such basis when it allocates gross
receipts using a different method. The
proposed regulations clarify that if a
taxpayer does, or can without undue
burden or expense, specifically identify
from its books and records CGS
allocable to DPGR, CGS allocable to
DPGR is that amount irrespective of
whether the taxpayer uses another
allocation method to allocate gross
receipts between DPGR and other gross
receipts. The proposed regulations also
clarify that if a taxpayer cannot, without
undue burden or expense, use a specific
identification method to determine CGS
allocable to DPGR, the taxpayer is not
required to use a specific identification
method to determine CGS allocable to
DPGR, but may use some other
reasonable method. A taxpayer’s use of
a method for purposes of allocating CGS
between DPGR and non-DPGR that is
different from its method for allocating
gross receipts between DPGR and nonDPGR will ordinarily not be considered
reasonable unless the method for
allocating CGS is demonstrably more
accurate than the method used to
allocate gross receipts.
Commentators also suggested that
CGS allocable to DPGR may not be
readily ascertainable when a taxpayer
uses the last-in, first-out (LIFO) method
to account for its inventory. Therefore,
commentators requested that a
simplified method be provided to
allocate CGS between DPGR and nonDPGR when a taxpayer uses the LIFO
method to account for its inventory. The
proposed regulations provide that a
taxpayer that uses the LIFO method to
account for its inventory may use any
reasonable method to allocate CGS
between DPGR and non-DPGR. In
addition, the regulations provide
simplified methods that a taxpayer may
use to allocate CGS when a taxpayer
uses the LIFO method to account for its
inventories.
The IRS and Treasury Department
also received comments requesting
clarification of the types of costs that are
required to be allocated as CGS
allocable to DPGR. In particular,
commentators stated that section 263A
only requires taxpayers to capitalize
costs with respect to inventory on hand
at the end of the taxable year and that
as a result taxpayers generally do not
include indirect costs in CGS, but
instead deduct the amount not allocated
to ending inventory. Section 263A

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requires a taxpayer that produces
inventory to include in inventory costs
the direct costs of producing the
property and the property’s properly
allocable share of indirect costs for
purposes of determining both ending
inventory and CGS. Consistent with
Notice 2005–14, the proposed
regulations provide that, for purposes of
determining CGS allocable to DPGR,
CGS includes the costs that would have
been included in ending inventory
under the principles of sections 263A,
471, and 472 if the goods sold during
the taxable year were on hand at the end
of the taxable year. However, a taxpayer
is permitted to use any reasonable
method to allocate indirect costs
properly included in CGS between
DPGR and non-DPGR if the taxpayer’s
books and records do not, or cannot
without undue burden or expense,
specifically identify CGS allocable to
DPGR.
Comments also were received
concerning whether a taxpayer is
permitted to use a reasonable allocation
method to allocate CGS if it uses the
simplified production method or
simplified resale method for additional
section 263A costs. The proposed
regulations clarify that a taxpayer that
uses either the simplified production
method or the simplified resale method
for additional section 263A costs may
use a reasonable allocation method to
allocate both section 471 costs and
additional section 263A costs included
in CGS. The proposed regulations
further provide that if a taxpayer uses
the simplified production method or the
simplified resale method to allocate
additional section 263A costs to ending
inventory, additional section 263A costs
ordinarily should be allocated in the
same proportion as section 471 costs are
allocated.
Allocation and Apportionment of
Deductions
Consistent with Notice 2005–14, the
proposed regulations provide three
methods for allocating and apportioning
deductions. However, as described
below, modifications have been made in
these proposed regulations to the
qualification requirements of the
simplified deduction method and the
small business simplified overall
method.
The first method, the ‘‘section 861
method,’’ is required to be used by a
taxpayer, unless the taxpayer is eligible
and chooses to use either the simplified
deduction method or the small business
simplified overall method. Under the
section 861 method, section 199 is
treated as an operative section described
in § 1.861–8(f). Accordingly, a taxpayer

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determines the deductions allocated and
apportioned to DPGR by applying the
allocation and apportionment rules
provided by §§ 1.861–8 through 1.861–
17 and §§ 1.861–8T through 1.861–14T
(the section 861 regulations), subject to
certain special rules. The IRS and
Treasury Department recognize that the
allocation and apportionment rules of
the section 861 method may be
burdensome to certain taxpayers,
particularly smaller taxpayers, that
otherwise would not be required to use
these rules. Accordingly, the proposed
regulations provide two alternative
methods, the simplified deduction
method and the small business
simplified overall method, with a goal
of minimizing the need for smaller
taxpayers to devote additional resources
to compliance.
Under the ‘‘simplified deduction
method,’’ a taxpayer’s deductions are
apportioned between DPGR and other
receipts based on relative gross receipts.
The simplified deduction method does
not apply to the allocation of CGS.
Notice 2005–14 permits only taxpayers
with average annual gross receipts of
$25,000,000 or less to use the simplified
deduction method. Several
commentators requested that the
simplified deduction method also be
made available to taxpayers with gross
receipts in excess of $25,000,000. Many
of these comments were from taxpayers
that have not in the past been required
to allocate and apportion deductions
under the section 861 regulations. Some
commentators suggested that the
simplified deduction method be used
for all costs, except for limited
identified costs such as interest, for
which the section 861 method would
continue to apply. Still other
commentators suggested that taxpayers
be allowed to use other existing cost
allocation methods, such as those under
section 263A or under other government
regulatory procedures.
In response to these comments, the
IRS and Treasury Department have
modified the eligibility requirements for
the simplified deduction method. Under
the proposed regulations, a taxpayer
may 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. However, the IRS
and Treasury Department still believe
that for taxpayers above this threshold
the section 861 method is the
appropriate method of allocating and
apportioning deductions for purposes of
determining QPAI. Furthermore, the
alternative allocation methods suggested
by commentators would each require
additional rules and guidance to address

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the interaction of the suggested methods
with other Federal income tax rules and
would result in administrative
complexity and inefficiency. The IRS
and Treasury Department believe that
use of the section 861 method will
result in an appropriate cost allocation
and apportionment for purposes of
section 199 and will be easier
administratively for both taxpayers and
the IRS than any new, equally
comprehensive cost allocation and
apportionment rules that might be
created.
Section 1.199–4(f) of the proposed
regulations provides that a qualifying
small taxpayer may use the ‘‘small
business simplified overall method’’ to
apportion CGS and deductions to DPGR.
Under Notice 2005–14, a qualifying
small taxpayer is a taxpayer that has
average annual gross receipts of
$5,000,000 or less or a taxpayer that is
eligible to use the cash method as
provided in Rev. Proc. 2002–28 (2002–
1 C.B. 815). The IRS and Treasury
Department are concerned that the
$5,000,000 average annual gross receipts
threshold without further modification
could be used by large taxpayers to
circumvent the requirements to allocate
and apportion deductions using the
section 861 method. As a result, a
deduction limitation has been added to
this method. In addition, commentators
requested that the definition of
qualifying small taxpayer for purposes
of the small business simplified overall
method be expanded to include farmers
that are not required to use the accrual
method under section 447. The
proposed regulations incorporate this
suggestion. Accordingly, the proposed
regulations provide that a qualifying
small taxpayer is a taxpayer that; (1) has
both average annual gross receipts of
$5,000,000 or less, and CGS and
deductions (excluding NOL deductions
and deductions not attributable to the
conduct of a trade or business) for the
current taxable year of $5,000,000 or
less; (2) is engaged in the trade or
business of farming that is not required
to use the accrual method under section
447; or (3) is eligible to use the cash
method as provided in Rev. Proc. 2002–
28.
Notice 2005–14 specifically requested
comments on whether taxpayers should
be able to change between the three cost
allocation methods of section 199 on
amended returns and whether there
should be restrictions on a taxpayer’s
ability to change from one method to
another. Several commentators
suggested that a taxpayer should be
allowed to change its cost allocation
method on an amended return and that
a taxpayer should be able to annually

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choose to use any of the three methods.
The IRS and Treasury Department agree
that a taxpayer that qualifies to use a
particular allocation and apportionment
method should be able to change to that
method at any time. Accordingly, the
proposed regulations generally provide
that a taxpayer eligible to use the
simplified deduction method may
choose at any time to use the simplified
deduction method or the section 861
method for a taxable year. A taxpayer
eligible to use the small business
simplified overall method may choose
at any time to use the small business
simplified overall method, the
simplified deduction method, or the
section 861 method for a taxable year.
This rule does not affect, however, any
restrictions or limitations that apply
within the section 861 method.
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. In response to a commentator’s
inquiry, the proposed regulations make
it clear that the owner of a pass-thru
entity need not be engaged directly in
the entity’s trade or business in order to
claim a section 199 deduction on the
basis of that owner’s share of the passthru entity’s items.
Some commentators recommended
that section 199 be applied to
partnerships by using an aggregate
approach in situations where the
qualified production activities are
conducted by the partnership, which
distributes or sells the QPP, qualified
films, or utilities to a partner who then
leases, rents, licenses, sells, exchanges,
or otherwise disposes of the property, or
where the qualified production
activities are conducted by a partner
which contributes or sells the QPP,
qualified films, or utilities to the
partnership, which then leases, rents,
licenses, sells, exchanges, or otherwise
disposes of the property. The
commentators maintained that the
income derived by the partners and the
partnerships from the lease, rental,
license, sale, exchange, or other
disposition of the property in these
situations should be treated as QPAI
and qualify for the section 199
deduction. The proposed regulations do

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not follow the commentators’
recommendation because section
199(c)(4)(A) requires that the gross
receipts must be derived from the
taxpayer’s own qualified production
activities to qualify as DPGR.
Accordingly, except for; (i) certain
qualifying oil and gas partnerships; and
(ii) EAG partnerships, discussed below,
the proposed regulations provide that
the owner of a pass-thru entity is not
treated as directly conducting the
qualified production activities of the
pass-thru entity, and vice versa, with
respect to the property transferred
between the pass-thru entity and the
owner. This rule applies to all
partnerships, including partnerships
that have elected out of subchapter K
under section 761(a). In addition,
attribution of activities does not apply
for purposes of the construction of real
property and the performance of
engineering and architectural services.
The proposed regulations, pursuant to
the Congressional Letter, provide a
limited exception for certain
partnerships in which all of the capital
and profits interests are owned by
members of a single EAG at all times
during the taxable year of the
partnership (EAG partnership). For
purposes of determining the DPGR of a
partnership and its partners, an EAG
partnership and all members of the EAG
in which the partners of the EAG
partnership are members are treated as
a single taxpayer during the taxable year
for purposes of section 199(c)(4). Thus,
if an EAG partnership MPGE or
produces property and distributes,
leases, rents, licenses, sells, exchanges,
or otherwise disposes of that property to
a member of an EAG in 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 members of the
EAG. Similarly, if one or more members
of an EAG in 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.
Except as otherwise provided, an EAG
partnership is generally treated the same
as other partnerships for purposes of
section 199. Accordingly, the proposed
regulations provide that an EAG
partnership is subject to the rules of
§ 1.199–5 regarding the application of
section 199 to pass-thru entities, and the
application of the section 199(d)(1)(B)

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wage limitation under § 1.199–5(a)(3).
Under the proposed regulations, if an
EAG partnership distributes property to
a partner, then, solely for purposes of
section 199(d)(1)(B)(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 the partner
derives gross receipts from the
distributed property during the taxable
year of the partner with or within which
the partnership’s taxable year (in which
the distribution occurs) ends. Costs
included in the adjusted basis of the
distributed property and any other
relevant deductions are taken into
account in computing the partner’s
QPAI. The proposed regulations provide
that the small business simplified
overall method is not available to EAG
partnerships.
Another commentator asked whether
the owner of a pass-thru entity might
have to perform multiple QPAI
calculations, distinguishing between
pass-thru and non-pass-thru production
activities. The proposed regulations
make it clear that, when determining its
section 199 deduction, an owner of a
pass-thru entity aggregates items of
income and expense from the entity
(including W–2 wages) with its own
items of income and expense (including
W–2 wages) for purposes of allocating
and apportioning deductions to DPGR.
As noted above, the amount of W–2
wages of a pass-thru entity taken into
account by an owner in applying the
wage limitation of section 199(b) is
determined under section 199(d)(1)(B).
The proposed regulations provide that
in determining an owner’s allocable
share of wages under section
199(d)(1)(B)(i), W–2 wages are deemed
to be allocated in the same way as wage
expense is allocated. In the case of a
non-grantor trust or estate, the W–2
wages are deemed to be allocated among
the trust or estate and the various
beneficiaries in the same manner as
QPAI, as described below. Although a
pass-thru entity’s QPAI is computed by
deducting wages paid by the entity
during its entire taxable year, generally
it is the pass-thru entity’s W–2 wages (as
shown on the Forms W–2 for the
calendar year ending within that taxable
year) that are used to compute the wage
limitation under section 199(b) and an
owner’s allocable share of wages under
section 199(d)(1)(B)(i). If QPAI,
computed by taking into account only
the items of the pass-thru entity
allocated to the owner, is not greater

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than zero, the owner may not take into
account the W–2 wages of the entity in
computing the section 199(b) wage
limitation.
A commentator requested that the
proposed regulations clarify and
illustrate by example how the section
199(d)(1)(B) wage limitation applies in a
tiered partnership structure. In
particular, the commentator suggested
that the W–2 wages of a lower-tier
partnership with positive QPAI are
properly allocable to the partner of the
upper-tier partnership even if the QPAI
allocated to the partner from the uppertier partnership is less than zero. The
proposed regulations do not adopt this
suggestion. The proposed regulations
provide that the section 199(d)(1)(B)
wage limitation must be applied at each
level in a tiered structure. Thus, in a
tiered structure, the owner of a passthru entity (including an owner that
itself is a pass-thru entity) calculates the
amounts described in section
199(d)(1)(B)(i) (allocable share) and
(d)(1)(B)(ii) (twice the applicable
percentage of the QPAI from the entity)
separately with regard to its interest in
that pass-thru entity. The proposed
regulations provide rules regarding the
treatment of W–2 wages when a passthru entity (upper-tier entity) owns an
interest in one or more other pass-thru
entities (lower-tier entities). An example
in the proposed regulations illustrates
the application of these rules.
The proposed regulations contain
special rules for trusts and estates. To
the extent that a grantor or another
person is treated as owning all or part
of a trust under sections 671 through
679 (grantor trust), the owner will
compute 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. In the
case of a non-grantor trust or estate, the
DPGR and expenses needed to compute
the QPAI, as well as the W–2 wages
relevant to the computation of the wage
limitation, must be allocated among the
trust or estate and its various
beneficiaries. Each beneficiary’s share of
the trust’s or estate’s QPAI (which will
be less than zero if the CGS and the
deductions allocated and apportioned to
DPGR exceed the trust’s or estate’s
DPGR) and W–2 wages will be
determined based on the proportion of
the trust’s or estate’s distributable net
income (DNI), as defined by section
643(a), that is deemed to be distributed
to that beneficiary for that taxable year.
Similarly, the proportion of the entity’s
DNI that is not deemed distributed by
the trust or estate will determine the
entity’s share of the QPAI and W–2
wages. In addition, if the trust or estate

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has no DNI in a particular taxable year,
any QPAI and W–2 wages are allocated
to the trust or estate, and not to any
beneficiary.
Section 199(d)(1)(A)(i) provides that,
in the case of an estate or trust (or other
pass-thru entity), section 199 shall
apply at the beneficiary (or similar)
level. Pursuant to this provision, as
clarified by the Congressional Letter, the
proposed regulations provide that a
trust or estate may claim the section 199
deduction to the extent that QPAI is
allocated to it.
Solely for purposes of determining the
section 199 deduction for the taxable
year, the QPAI of a trust or estate must
be computed by allocating the expenses
described in section 199(d)(5) under
§ 1.652(b)–3 with respect to directly
attributable expenses. With respect to
other expenses described in section
199(d)(5), a trust or estate that qualifies
for the simplified deduction method
described in § 1.199–4(e) must use that
method, and any other trust or estate
must use the section 861 method
described in § 1.199–4(d). The small
business simplified overall method is
not available to a trust or estate.
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, 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.
Section 199 applies to taxable years
beginning after December 31, 2004.
Accordingly, these proposed regulations
apply to taxable years of pass-thru
entities that begin on or after January 1,
2005. The IRS and Treasury Department
recognize that a pass-thru entity will
need to provide certain information to
its owners to allow those persons to
compute the section 199 deduction. No
special provision with regard to
information reporting is made for
electing large partnerships (ELPs) as
defined by section 775, which are
subject to the same methods for
allocating and apportioning deductions
as are other partnerships. Thus, ELPs
are required to provide the same
information to their partners as other
partnerships for purposes of computing
the section 199 deduction. The IRS and
the Treasury Department intend to
provide information reporting rules for

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pass-thru entities in the relevant forms
and instructions.
Agricultural and Horticultural
Cooperatives
A commentator suggested that the
proposed regulations provide that
patrons cannot include patronage
dividends and per-unit retain
certificates in the computation of the
QPAI from the patron’s other farming
operations to the extent that those
amounts were taken into account by a
cooperative in determining the
cooperative’s section 199 deduction.
The commentator stated that in many
cases, both the cooperative and its
patrons will be engaged in qualifying
activities. For example, gross receipts
from crops raised by a farmer in the
United States may be eligible for the
section 199 deduction as well as the
receipts the cooperative derives from
the marketing of the crop. To avoid
duplication of section 199 benefits, the
proposed regulations clarify that under
§ 1.199–6(h) patronage dividends and
per-unit allocations a patron receives
from a cooperative that are taken into
account as part of the cooperative’s
computation of QPAI may not be taken
into account in computing the patron’s
QPAI from its own qualifying activities.
In addition, patronage dividends and
per-unit retain allocations include any
advances on patronage or per-unit
retains paid in money made during the
taxable year. Examples are provided to
illustrate this rule.
A commentator suggested that the
proposed regulations clarify the amount
of the section 199 deduction a
cooperative is required to pass through
to its patrons. Accordingly, the
proposed regulations clarify in § 1.199–
6(d) that the cooperative may, at its
discretion, pass through all, some, or
none of the allowable section 199
deduction to its patrons.
A commentator suggested that it
would be useful if the proposed
regulations address whether a
cooperative member of a federated
cooperative may pass through to its
patrons the section 199 deduction it
receives as a patron cooperative.
Accordingly, the proposed regulations
in § 1.199–6(d) provide that a
cooperative patron of a federated
cooperative may pass through the
section 199 deduction it receives to its
member patrons.
A commentator requested that the
proposed regulations address the form,
content, and timing of the patron
notification requirements. The
commentator stated that the notice
should not have to accompany the
patronage distribution. For instance, a

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cooperative should be permitted to send
out a notice passing through an
estimated amount of the section 199
deduction at the time patronage
dividends are paid and a second notice
(when the Federal income tax return is
completed and the section 199
deduction is actually determined)
covering anything that was not passed
through by the first notice, provided the
notice is sent during the payment period
in section 1382(d). The proposed
regulations provide in § 1.199–6(b) that,
in order for a patron to qualify for the
section 199 deduction, the cooperative
must designate the patron’s portion of
the section 199 deduction in a written
notice mailed by the cooperative to its
patrons no later than the 15th day of the
ninth month following the close of the
cooperative’s 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.
A commentator suggested that the
proposed regulations clarify that patrons
(whether they use the cash or accrual
method of accounting) are entitled to
claim the section 199 deduction passed
through from the cooperative on the
return for the taxable year in which they
receive written notification from the
cooperative. The proposed regulations
provide in § 1.199–6(d) that patrons may
claim the section 199 deduction for the
taxable year they receive the written
notice informing them of the section 199
deduction amount.
A commentator suggested that the
proposed regulations clarify that the
section 199 deduction of a cooperative
is subject to the W–2 wage limitation
under section 199(b) at the cooperative
level and that it is not subject to a
second W–2 wage limitation at the
patron level to the extent the section
199 deduction is passed through to its
patrons. The proposed regulations
provide in § 1.199–6(e) that the W–2
wage limitation shall be applied only at
the cooperative level whether or not the
cooperative chooses to pass through
some or all of the section 199 deduction.
In addition, the proposed regulations in
§ 1.199–6(d) provide that patrons may
claim the section 199 deduction without
regard to the taxable income limitation.
A commentator suggested that the
proposed regulations address what
happens when an audit determination
results in a decrease in the amount of a

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cooperative’s section 199 deduction
passed through to its patrons. The
proposed regulations provide in
§ 1.199–6(f) that, if an audit determines
or an amended return reports that the
amount of the section 199 deduction
that was passed through to patrons
exceeded the amount determined to be
allowable by the audit or on the
amended return, recapture of the audit
adjustment amount or excess amended
return amount will occur at the
cooperative level.
Expanded Affiliated Groups
Section 199(d)(4)(A) provides that all
members of an EAG are treated as a
single corporation for purposes of
section 199.
The single corporation language in
section 199(d)(4)(A) has created
confusion among commentators and the
proposed regulations clarify the
meaning of this language. The proposed
regulations provide that except as
otherwise provided in the Code and
regulations (see, for example, sections
199(c)(7) and 267, §§ 1.199–3(b) and
1.199–7(a)(3), and the consolidated
return regulations), each member of an
EAG is a separate taxpayer that
computes its own taxable income or
loss, QPAI, and W–2 wages, which are
then aggregated at the EAG level. For
example, if corporations X and Y are
members of the same EAG, but are not
members of the same consolidated
group, and X sells QPP it MPGE within
the United States to Y, the transaction
is taken into account in determining the
EAG’s section 199 deduction. If X and
Y are members of the same consolidated
group, see the section entitled
Consolidated Groups, below.
The IRS and Treasury Department
believe that Congress intended that an
EAG should be eligible for the section
199 deduction if the activities to
produce QPP, qualified films, and
utilities are done by one or more
members of the EAG other than the
member who leases, rents, licenses,
sells, exchanges, or otherwise disposes
of the QPP, qualified films, and utilities.
Accordingly, 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, qualified films, and
utilities MPGE or otherwise 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
films, and utilities in determining
whether its gross receipts are DPGR.
However, in general, attribution of

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activities does not apply for purposes of
the construction of real property under
§ 1.199–3(l)(1) or the performance of
engineering and architectural services
under § 1.199–3(m)(1). A member of an
EAG must engage in a construction
activity under § 1.199–3(l)(2), provide
engineering services under § 1.199–
3(m)(2), or provide architectural
services under § 1.199–3(m)(3) in order
for the member’s gross receipts to be
derived from construction, engineering,
or architectural services.
Notwithstanding the above, attribution
of activities in the construction of real
property and the performance of
engineering and architectural services
does apply for members of the same
consolidated group. For example, if X
and Y are members of the same EAG,
but are not members of the same
consolidated group, and X constructs a
commercial building and sells the
building to Y, and Y, who performs no
construction activities with respect to
the building, sells the building to an
unrelated person, Y is not attributed the
construction activities of X and Y’s
receipts from the sale of the building
will not be DPGR. However, if X and Y
are members of the same consolidated
group, Y is attributed the construction
activities of X and, assuming all the
requirements of section 199(c) are met,
Y’s receipts will be DPGR.
Some commentators suggested that
the proposed regulations provide a
special rule excluding finance
companies from an EAG. Section
199(d)(4)(A) specifically states that all
members of an EAG shall be treated as
a single corporation. Neither the statute
nor the legislative history provide any
exceptions that would allow taxpayers
to exclude certain types of companies,
including finance companies, from the
EAG. Accordingly, the commentators’
suggestion has not been adopted.
Notwithstanding that a transaction
between members of the same EAG (an
intragroup transaction) generally is
taken into account in determining the
section 199 deduction, the IRS and
Treasury Department recognize that
taxpayers may engage in an intragroup
transaction in an attempt to obtain a
section 199 deduction when none
should be available. Accordingly, the
proposed regulations retain the antiavoidance rule contained in Notice
2005–14. Thus, if a transaction between
members of the same 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

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transaction on the computation of the
section 199 deduction.
Some commentators asked whether
the $25,000,000 and $5,000,000 average
annual gross receipts thresholds for
using the simplified deduction method
and the small business simplified
overall method, respectively, are
applied at the EAG level, the
consolidated group level, or at the
member level. If the EAG was a single
corporation, the $25,000,000 and
$5,000,000 average annual gross receipts
thresholds would take into account the
activities of all the members of the EAG.
Accordingly, the $25,000,000 and
$5,000,000 average annual gross receipts
thresholds are applied at the EAG level.
Similarly, the new $10,000,000 total
assets threshold for using the simplified
deduction method and the new
$5,000,000 current year CGS and
deductions threshold for using the small
business simplified overall method also
are applied at the EAG level. The
determination of whether a taxpayer is
engaged in the trade or business of
farming that is not required to use the
accrual method of accounting under
section 447 is determined by taking into
account the activities of all the members
of the EAG. Similarly, the determination
of whether a taxpayer is eligible to use
the cash method as provided in Rev.
Proc. 2002–28, and is thus eligible to
use the small business simplified
overall method, is determined by taking
into account the activities of all the
members of the EAG.
Commentators requested that the rule
in Notice 2005–14 that requires all
members of the same EAG to use the
same cost allocation method be changed
to allow members to use different cost
allocation methods. In response to the
comments received, the IRS and
Treasury Department agree that if an
EAG is eligible to use the simplified
deduction method, each member of the
EAG may individually determine
whether it wants to use the section 861
method or the simplified deduction
method, notwithstanding that another
member of the EAG uses a different
method. Similarly, if the EAG is eligible
to use the small business simplified
overall method, each member of the
EAG may individually determine
whether it wants to use the section 861
method, the simplified deduction
method, or the small business
simplified overall method,
notwithstanding that another member of
the EAG uses a different method.
However, if the EAG is not eligible to
use either the simplified deduction
method or the small business simplified
overall method, then all members of the
EAG must use the section 861 method.

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Notwithstanding that the members of an
EAG generally are not required to use
the same cost allocation method, each
member of a consolidated group must
use the same cost allocation method.
Examples are provided to illustrate
these provisions.
A commentator also asked at what
level the de minimis rule described in
§ 1.199–1(d)(2) is tested. Section 1.199–
1(d)(2) treats all of a taxpayer’s gross
receipts as DPGR if less than 5 percent
of the taxpayer’s total gross receipts are
non-DPGR. 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. When
considering the purpose of the de
minimis rule, the IRS and Treasury
Department believe that it is appropriate
that the 5 percent threshold be
determined at the corporation level,
rather than at the EAG or consolidated
group level.
Consolidated Groups
The section 199 deduction of a
consolidated group (or 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. Further, if
two or more members of a consolidated
group engage in an intercompany
transaction, as defined in § 1.1502–
13(b)(1), the proposed regulations
clarify that if an item of income, gain,
deduction, or loss is not yet taken into
account under § 1.1502–13, the
intercompany transaction that gave rise
to the item is not taken into account in
computing the section 199 deduction
until the time and in the same
proportion that the item is taken into
account under § 1.1502–13. For
example, if corporations X and Y file a
consolidated Federal income tax return
and X sells QPP it MPGE within the
United States to Y, the transaction is not
taken into account until the time (and
in the same proportion) provided in the
matching rule of § 1.1502–13(c) or the
acceleration rule of § 1.1502–13(d). The
proposed regulations provide examples
to illustrate these principles.
Some commentators suggested that if
X’s receipts from an intercompany
transaction with consolidated group
member Y are non-DPGR (for example,
X licenses non-QPP to Y) and Y’s CGS
and other deductions from the
intercompany transaction are taken into

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account in determining the consolidated
group’s QPAI, the consolidated group’s
QPAI could be different than if X and
Y were divisions of a single corporation,
contrary to the general intent of
§ 1.1502–13. The consolidated return
regulations already prevent this result.
Under § 1.1502–13(c)(1)(i) and (c)(4),
X’s, Y’s, or both X’s and Y’s separate
entity attributes must be redetermined
to the extent necessary to treat X and Y
as if they were divisions of a single
corporation. Thus, X’s income may be
redetermined to be DPGR
(notwithstanding section 199(c)(7) or
that the item licensed by X in the
intercompany transaction does not
otherwise meet the requirements of
section 199(c)) or Y’s CGS and other
deductions from the intercompany
transaction may be redetermined to be
not allocable to DPGR, whichever
produces the effect as though X and Y
were divisions of a single corporation.
Similarly, if X MPGE QPP within the
United States and sells the QPP to Y,
but Y does not use the QPP in creating
DPGR, in order to produce the effect as
though X and Y were divisions of a
single corporation, X’s gross receipts
from the sale of the QPP may be
redetermined to be non-DPGR or Y’s
CGS and other deductions may be
redetermined to be allocable to DPGR.
In addition, if X MPGE QPP within the
United States and sells the QPP to Y,
and Y sells the QPP to an unrelated
person, X’s gross receipts may be
redetermined to be non-DPGR (and nonreceipts) and Y’s CGS and other
deductions may be redetermined to be
not allocable to DPGR, to the extent
necessary to produce the effect as
though X and Y were divisions of a
single corporation. The proposed
regulations provide examples to
illustrate the situations described above.
Some commentators asked whether
the section 199 deduction results in a
downward basis adjustment under
§ 1.1502–32 if the deduction is allocated
to a subsidiary member (S) of a
consolidated group. Section 1.1502–
32(b)(3)(ii)(B) already addresses this
situation. Although the section 199
deduction is taken into account under
the general operating rules of § 1.1502–
32(b)(3)(i), paragraph (b)(3)(ii)(B) of that
section provides that not only is S’s
income taken into account under the
general operating rules of § 1.1502–
32(b)(3)(i), but an amount of S’s income
equivalent to the section 199 deduction
is also treated as being tax-exempt
income under § 1.1502–32(b)(3)(ii)(A).
The net result is that the basis that P (S’s
parent) has in its S stock is not reduced
on account of the section 199 deduction.

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For example, if S earns $100 and is
entitled to a $9 section 199 deduction,
P’s basis in S increases by $100 because
the $100 income and the $9 deduction
are taken into account under § 1.1502–
32(b)(3)(i) (resulting in $91 of the
increase) and $9 of the income also is
taken into account under § 1.1502–
32(b)(3)(ii)(A) as tax-exempt income
(resulting in $9 of the increase).
The proposed regulations treat a
consolidated group as a single member
of the EAG. 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. Thus, the EAG is
considered to have three members, the
A consolidated group, B, and C.
Alternative Minimum Tax
Section 199(d)(6), as clarified by the
Congressional Letter, provides that for
purposes of determining AMTI under
section 55, the section 199 deduction
must be computed in the same manner
as for regular tax, except that in the case
of a corporation, the taxable income
limitation is the corporation’s AMTI.
Accordingly, the proposed regulations
provide that for purposes of determining
AMTI under section 55, a taxpayer that
is not a corporation 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 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). In the case
of a corporation (including a
corporation subject to tax under section
511(a)), 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 QPAI for the taxable year, or
the taxpayer’s AMTI (as defined in
section 55(b)(2)) 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 59. In the
case of an individual or a trust, AGI and
taxable income are also determined
without regard to any adjustments
under sections 56 through 59. The
amount of the deduction allowable for
purposes of computing AMTI for any
taxable year cannot exceed 50 percent of
the W–2 wages of the employer for the

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taxable year (as determined under
§ 1.199–2).
Revocation of Election Under Section
631(a)
Section 102(c) of the Act allows a
taxpayer to revoke an election under
section 631(a) to treat the cutting of
timber as a sale or exchange. Any
section 631(a) election for a taxable year
ending on or before October 22, 2004,
may be revoked under section 102(c) of
the Act for any taxable year ending after
that date. In addition, any election
under section 631(a) for a taxable year
ending on or before October 22, 2004
(and any revocation of the election
under section 102(c) of the Act), is
disregarded for purposes of determining
whether the taxpayer is eligible to make
a subsequent election under section
631(a). A revocation under section
102(c) of the Act will remain in effect
until the first taxable year for which the
taxpayer makes a new election under
section 631(a).
Commentators suggested that, if a
taxpayer makes an election under
section 631(a), section 199 should apply
to any resulting section 1231 gain. A
taxpayer that makes an election under
section 631(a) reports the difference
between the fair market value of the
timber cut and its actual cost as section
1231 gain. The proposed regulations do
not adopt the suggestion because timber
is real property, not tangible personal
property, and the cutting of timber does
not qualify under section
199(c)(4)(A)(i)(I). In the case of a
taxpayer who does not make an election
under section 631(a), or a taxpayer who
revokes an election under section 631(a)
pursuant to section 102(c) of the Act,
the cutting and sawing of timber
produces lumber which qualifies as
tangible personal property. The gross
receipts derived by a taxpayer from the
sale of lumber it produces qualify as
DPGR (assuming all the other
requirements of section 199(c) are met).
Proposed Effective Date
The regulations are proposed to be
applicable to taxable years beginning
after December 31, 2004. Section 199
applies to taxable years of pass-thru
entities beginning after December 31,
2004. Accordingly, section 199 does not
apply to taxable years of pass-thru
entities beginning before January 1,
2005. For example, assume a pass-thru
entity has a taxable year beginning July
1, 2004, and ending June 30, 2005, and
the owners of the pass-thru entity have
calendar taxable years. Because section
199 first applies to the pass-thru entity
for its taxable year beginning July 1,
2005, the first taxable year in which an

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owner of the pass-thru entity will be
eligible to claim a section 199 deduction
for the owner’s allocable or pro rata
share of items allocated or apportioned
to the qualified production activities of
the pass-thru entity will be the calendar
year 2006. Conversely, assume that a
pass-thru entity has a calendar taxable
year beginning January 1, 2005, and has
a short taxable year ending on June 30,
2005, due to the termination of the
entity. Assume the owners of that passthru entity have taxable years beginning
July 1, 2004, and ending June 30, 2005.
Because section 199 first applies to the
owners for their taxable years beginning
July 1, 2005, under § 1.199–8(g), the
owners of the pass-thru entity will be
ineligible to claim a section 199
deduction for the owners’ allocable or
pro rata share of items allocated or
apportioned to the qualified production
activities of the pass-thru entity for their
taxable years ending June 30, 2005.
Until the date final regulations are
published in the Federal Register, the
proposed regulations provide that
taxpayers may rely on the rules set forth
in the interim guidance on section 199
as set forth in Notice 2005–14 (Notice)
as well as the proposed regulations
under §§ 1.199–1 through 1.199–8
(proposed regulations). For this
purpose, if the proposed regulations and
the Notice include different rules for the
same particular issue, then the taxpayer
may rely on either the rule set forth in
the proposed regulations or the rule set
forth in the Notice. For example, the
Notice and the proposed regulations
both include the small business
simplified overall method, however the
eligibility requirements for the method
under the Notice have been modified in
the proposed regulations. Accordingly, a
taxpayer may rely on the eligibility
requirements for the method set forth in
either the Notice or the proposed
regulations. However, if the proposed
regulations include a rule that was not
included in the Notice, taxpayers are
not permitted to rely on the absence of
a rule to apply a rule contrary to the
proposed regulations. For example,
Notice 2005–14 does not include any
rules regarding the treatment of hedging
transactions whereas the proposed
regulations include such rules.
Accordingly, taxpayers are not
permitted to treat hedging transactions
contrary to the treatment provided in
the proposed regulations.
Request for Comments
The IRS and Treasury Department
invite taxpayers to submit comments on
issues relating to section 199. The IRS
and Treasury Department intend to
finalize the proposed regulations as

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soon as possible so taxpayers will have
the final regulations as they begin to
prepare their 2005 Federal income tax
returns. Accordingly, the IRS and
Treasury Department encourage
taxpayers to submit their comments by
January 3, 2006 so they can be given
proper consideration. In particular, the
IRS and Treasury Department encourage
taxpayers to submit comments on the
following issues:
1. Questions have arisen as to the
applicability under section 199 of a
Large and Mid-Size Business (LMSB)
directive dated March 14, 2002, ‘‘Field
Directive on the Use of Estimates from
Probability Samples,’’ that authorizes in
appropriate circumstances the use of
statistical sampling by taxpayers. LMSB
taxpayers are not precluded from
applying the concepts of the LMSB
directive for purposes of section 199.
The proposed regulations do not
provide specific rules on the use of
statistical sampling for 199 purposes,
however comments are requested on
how 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.
2. Taxpayers are eligible to make
certain elections under the section 861
regulations. For example, § 1.861–
9T(g)(1)(ii) permits a taxpayer to elect to
determine the value of its assets on the
basis of either their tax book value or
fair market value. Some of the elections
under the section 861 regulations
require the consent of the Commissioner
to revoke or to change to another
method. See §§ 1.861–8T(c)(2), 1.861–
9T(i)(2), and 1.861–17(e). Because the
section 861 method requires certain
taxpayers to use the rules of the section
861 regulations in a new context, these
taxpayers may want to reconsider
previously made elections under those
regulations. The IRS and Treasury
Department intend to issue a revenue
procedure granting taxpayers automatic
consent to change certain elections
under the section 861 regulations.
Comments are requested concerning
such an automatic consent procedure,
including which elections should be
included and the appropriate time
period during which the automatic
consent should apply.
3. The IRS and Treasury Department
note that there are special rules
regarding the application of the section
861 method in the case of affiliated
groups. See section 864(e)(5) and (6); see
also §§ 1.861–11(d)(7), 1.861–11T(d)(6),
1.861–14(d) and 1.861–14T. Comments
are requested regarding whether

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additional guidance is needed to clarify
how the rules under §§ 1.861–11T(c)
and (g) and 1.861–14T(c) apply under
the section 861 method to allocate and
apportion interest and other expenses
such as research and experimentation
expenses in computing QPAI of the
members of such affiliated groups in
which otherwise includible
corporations are owned indirectly
through foreign corporations and
partnerships.
4. Comments are requested
concerning whether gross receipts
derived from the provision of certain
types of online software should qualify
under section 199 as being derived from
a lease, rental, license, sale, exchange,
or other disposition of the software and,
if so, how to distinguish between such
types of online software.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a
significant regulatory action as defined
in Executive Order 12866. Therefore, a
regulatory assessment is not required. It
has also been determined that section
553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply.
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, as previously discussed, 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, this notice of proposed
rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment
on their impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations,
consideration will be given to any
written comments (a signed original and
eight (8) copies) or electronic comments
that are submitted timely to the IRS.
Comments are requested on all aspects
of the proposed regulations. In addition,
the IRS and Treasury Department
specifically request comments on the
clarity of the proposed rules and how
they can be made easier to understand.
All comments will be available for
public inspection and copying.
A public hearing has been scheduled
for Wednesday, January 11, 2006, at 10
a.m. in the IRS Auditorium, Internal
Revenue Building, 1111 Constitution
Avenue, NW., Washington DC. Due to
building security procedures, visitors

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must enter at the Constitution Avenue
entrance. In addition, all visitors must
present photo identification to enter the
building. Because of access restrictions,
visitors will not be admitted beyond the
immediate entrance area more than 30
minutes before the hearing starts. For
information about having your name
placed on the building access list to
attend the hearing, see the FOR FURTHER
INFORMATION CONTACT section of this
preamble.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons who wish to present oral
comments at the hearing must submit
electronic or written comments and an
outline of the topics to be discussed and
the time to be devoted to each topic (a
signed original and eight (8) copies) by
December 21, 2005. A period of 10
minutes will be allotted to each person
for making comments. An agenda
showing the scheduling of the speakers
will be prepared after the deadline for
receiving outlines has passed. Copies of
the agenda will be available free of
charge at the hearing.
Drafting Information
The principal authors of these
regulations are Paul Handleman and
Lauren Ross Taylor, Office of Associate
Chief Counsel (Passthroughs and
Special Industries), IRS. However, other
personnel from the IRS and Treasury
Department participated in their
development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is
proposed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by adding entries
in numerical order 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).
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). * * *

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Par. 2. Sections 1.199–0 through
1.199–8 are added to read as follows:
§ 1.199–0

Table of contents.

This section lists the headings that
appear in §§ 1.199–1 through 1.199–8.
§ 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.
(1) In general.
(2) Definition of item.
(i) In general.
(ii) Examples.
(d) Allocation of gross receipts.
(1) In general.
(2) De minimis rule.
(3) Examples.
(e) Timing rules for determining QPAI.
(1) Gross receipts and costs recognized in
different taxable years.
(2) Percentage of completion method.
(3) Example.
§ 1.199–2 Wage limitation.
(a) Rules of application.
(1) In general.
(2) Wages paid by entity other than
common law employer.
(b) No application in determining whether
amounts are wages for employment tax
purposes.
(c) Application in case of taxpayer with
short taxable year.
(d) Acquisition or disposition of a trade or
business (or major portion).
(e) Non-duplication rule.
(f) Definition of W–2 wages.
(1) In general.
(2) Methods for calculating W–2 wages.
(i) Unmodified box method.
(ii) Modified Box 1 method.
(iii) Tracking wages method.
§ 1.199–3 Domestic production gross
receipts.
(a) In general.
(b) Related persons.
(1) In general.
(2) Exceptions.
(c) Definition of gross receipts.
(d) 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.
(e) Definition of by the taxpayer.
(1) In general.
(2) Special rule for certain government
contracts.
(3) Examples.
(f) Definition of in whole or in significant
part.
(1) In general.
(2) Substantial in nature.
(3) Safe harbor.
(4) Examples.

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(g) Definition of United States.
(h) Definition of derived from the lease,
rental, license, sale, exchange, or other
disposition.
(1) In general.
(2) Examples.
(3) Hedging transactions.
(i) In general.
(ii) Currency fluctuations.
(iii) Other rules.
(4) Allocation of gross receipts—embedded
services and non-qualified property.
(i) In general.
(ii) Exceptions.
(iii) Examples.
(5) Advertising income.
(i) Tangible personal property.
(ii) Qualified films.
(iii) Examples.
(6) Computer software.
(i) In general.
(ii) Examples.
(7) Exception for certain oil and gas
partnerships.
(i) In general.
(ii) Example.
(8) Partnerships owned by members of a
single expanded affiliated group.
(i) In general.
(ii) Special rules for distributions from
EAG partnerships.
(iii) Examples.
(9) Non-operating mineral interests.
(i) Definition of qualifying production
property.
(1) In general.
(2) Tangible personal property.
(i) In general.
(ii) Local law.
(iii) Machinery.
(iv) 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.
(j) Definition of qualified film.
(1) In general.
(2) Tangible personal property with a film.
(i) Film licensed by a taxpayer.
(ii) Film produced by a taxpayer.
(A) Qualified films.
(B) Nonqualified films.
(3) Derived from a qualified film.
(4) Examples.
(5) Compensation for services.
(6) Determination of 50 percent.
(7) Exception.
(k) 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.
(5) Example.

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(l) Definition of construction performed in
the United States.
(1) Construction of real property.
(i) In general.
(ii) De minimis exception.
(2) Activities constituting construction.
(3) Definition of infrastructure.
(4) Definition of substantial renovation.
(5) Derived from construction.
(i) In general.
(ii) Land safe harbor.
(iii) Examples.
(m) Definition of engineering and
architectural services.
(1) In general.
(2) Engineering services.
(3) Architectural services.
(4) De minimis exception for performance
of services in the United States.
(n) Exception for sales of certain food and
beverages.
(1) In general.
(2) Examples.
§ 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.
(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 allocable or
apportioned to domestic production gross
receipts or gross income attributable to
domestic production gross receipts.
(1) In general.
(2) Treatment of certain deductions.
(i) In general.
(ii) Net operating losses.
(iii) Deductions not attributable to the
conduct of a trade or business.
(d) Section 861 method.
(1) In general.
(2) Deductions for charitable contributions.
(3) Research and experimental
expenditures.
(4) Deductions related to gross receipts
deemed to be domestic production gross
receipts.
(5) Examples.
(e) Simplified deduction method.
(1) In general.
(2) 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.

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(3) Members of an expanded affiliated
group.
(i) In general.
(ii) Exception.
(iii) Examples.
(4) Ineligible pass-thru entities.
(g) Average annual gross receipts.
(1) In general.
(2) Members of an EAG.
(h) Total assets.
(1) In general.
(2) Members of an EAG.
(i) Total costs for the current taxable year.
(1) In general.
(2) Members of an EAG.
§ 1.199–5 Application of section 199 to
pass-thru entities.
(a) Partnerships.
(1) Determination at partner level.
(2) Disallowed deductions.
(3) Partner’s share of W–2 wages.
(4) Examples.
(b) S corporations.
(1) Determination at shareholder level.
(2) Disallowed deductions.
(3) Shareholder’s share of W–2 wages.
(c) Grantor trusts.
(d) Non-grantor trusts and estates.
(1) Computation of section 199 deduction.
(2) Example.
(e) Gain or loss from the disposition of an
interest in a pass-thru entity.
(f) Section 199(d)(1)(B) wage limitation and
tiered structures.
(1) In general.
(2) Share of W–2 wages.
(3) Example.
(g) No attribution of qualified activities.
§ 1.199–6 Agricultural and horticultural
cooperatives.
(a) In general.
(b) Written notice to patrons.
(c) Determining cooperative’s qualified
production activities income.
(d) Additional rules relating to passthrough of section 199 deduction.
(e) W–2 wages.
(f) Recapture of section 199 deduction.
(g) Section is exclusive.
(h) No double counting.
(i) 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.
(4) Examples.
(5) Anti-avoidance rule.
(b) Computation of expanded affiliated
group’s section 199 deduction.
(1) In general.
(2) Net operating loss 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.

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(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.
(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) Individuals.
(b) Trade or business requirement.
(c) Coordination with alternative minimum
tax.
(d) Nonrecognition transactions.
(1) In general.
(2) Section 1031 exchanges.
(3) Section 381 transactions.
(e) Taxpayers with a 52–53 week taxable
year.
(f) Section 481(a) adjustments.
(g) Effective date.
§ 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

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percent of the W–2 wages of the
employer for the taxable year (as
determined under § 1.199–2).
(b) Taxable income and adjusted
gross income—(1) In general. For
purposes of paragraph (a) of this section,
the definition of taxable income under
section 63 applies and taxable income is
determined without regard to section
199. 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. For
purposes of determining the tax
imposed by section 511, paragraph (a) of
this section is applied using unrelated
business taxable income. For purposes
of determining the amount of a net
operating loss (NOL) carryback or
carryover under section 172(b)(2),
taxable income is determined without
regard to the deduction allowed under
section 199.
(2) Examples. The following examples
illustrate the application of this
paragraph (b):
Example 1. (i) Facts. X, a United States
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) of $600 in 2010. During 2010, ×
incurs W–2 wages of $300. × 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)
subject to the wage limitation of $150 (50%
× $300)).
Example 2. (i) Facts. X, a United States
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. 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—(1) In general. QPAI for any
taxable year is an amount equal to the
excess (if any) of the taxpayer’s
domestic production gross receipts
(DPGR) over the sum of the cost of
goods sold (CGS) that is allocable to
such receipts, other deductions,
expenses, or losses (collectively,
deductions) directly allocable to such
receipts, and a ratable portion of
deductions that are not directly
allocable to such receipts or another
class of income. See §§ 1.199–3 and
1.199–4. For purposes of this paragraph
(c), QPAI is determined on an item-by-

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item basis (and not, for example, on a
division-by-division, product line-byproduct line, or transaction-bytransaction basis) and is the sum of
QPAI derived by the taxpayer from each
item (as defined in paragraph (c)(2) of
this section). For purposes of this
determination, QPAI from each item
may be positive or negative. DPGR and
its related CGS and deductions must be
included in the QPAI computation
regardless of whether, when viewed in
isolation, the DPGR exceeds the CGS
and deductions allocated and
apportioned thereto. For example, if a
taxpayer has $3 of QPAI from the sale
of a shirt and derives ($1) of QPAI from
the sale of a hat, the taxpayer’s QPAI is
$2.
(2) Definition of item—(i) In general.
Except as otherwise provided in this
paragraph, the term item means, for
purposes of §§ 1.199–1 through 1.199–8,
the property offered for sale to
customers that meets all of the
requirements under this section and
§ 1.199–3. If the property offered for sale
does not meet these requirements, a
taxpayer must treat as the item any
portion of the property offered for sale
that meets these requirements. However,
in no case shall the portion of the
property offered for sale that is treated
as the item exclude any other portion
that meets these requirements. In no
event may an item consist of two or
more properties offered for sale that are
not packaged and sold together as one
item. In addition, 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). In the case of
construction (as defined in § 1.199–
3(l)(1)) or engineering and architectural
services (as defined in § 1.199–3(m)(1)),
a taxpayer may use any reasonable
method, taking into account all of the
facts and circumstances, to determine
what construction activities and
engineering or architectural services
constitute an item.
(ii) Examples. The following
examples illustrate the application of
paragraph (c)(2)(i) of this section:
Example 1. X manufactures leather and
rubber shoe soles in the United States. X
imports shoe uppers, which are the parts of
the shoe above the sole. X manufactures
shoes for sale by sewing or otherwise
attaching the soles to the imported uppers. If
the shoes do not meet the requirements
under this section and § 1.199–3, then under
paragraph (c)(2)(i) of this section, X must
treat the sole as the item if the sole meets the
requirements under this section and § 1.199–
3.
Example 2. The facts are the same as in
Example 1 except that X also buys some
finished shoes from unrelated parties and

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resells them to retail shoe stores. X sells
shoes in individual pairs. X ships the shoes
in boxes, each box containing 50 pairs of
shoes, some of which X manufactured, and
some of which X purchased. X cannot treat
a box of 50 pairs of shoes as an item, because
the box of shoes is not sold at retail.
Example 3. Y manufactures toy cars in the
United States. Y also purchases cars that
were manufactured by unrelated parties. In
addition to packaging some cars individually,
Y also packages some cars in sets of three.
Some of the cars in the sets may have been
manufactured by Y and some may have been
purchased. The three-car packages are sold
by toy stores at retail. Y must treat each
three-car package as the item. However, if the
three-car package does not meet the
requirements under this section and § 1.199–
3, Y must treat a toy car in the three-car
package as the item, provided the toy car
meets the requirements under this section
and § 1.199–3.
Example 4. The facts are the same as
Example 3 except that the toy store follows
Y’s recommended pricing arrangement for
the individual toy cars for sale to customers
at three for $10. Frequently, this results in
retail customers purchasing three individual
cars in one transaction. Y must treat each toy
car as an item and cannot treat three
individual toy cars as one item, because the
individual toy cars are not packaged together
for retail sale.
Example 5. Z produces in bulk form in the
United States the active ingredient for a
pharmaceutical product. Z 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 and § 1.199–3 are met. FX uses the
active ingredient to produce the finished
dosage form drug. FX sells the drug in
finished dosage to Z, which sells the drug to
customers. Under paragraph (c)(2)(i) of this
section, if the finished dosage does not meet
the requirements under this section and
§ 1.199–3, Z must treat the active ingredient
portion as the item if the ingredient meets the
requirements under this section and § 1.199–
3.

(d) Allocation of gross receipts—(1) In
general. A taxpayer must determine the
portion of its gross receipts that is DPGR
and the portion of its gross receipts that
is non-DPGR. Applicable Federal
income tax principles apply to
determine whether a transaction is, in
substance, a lease, rental, license, sale,
exchange or other disposition, or
whether it is a service (or some
combination thereof). For example, if a
taxpayer leases, rents, licenses, sells,
exchanges, or otherwise disposes of
qualifying production property (QPP)
(as defined in § 1.199–3(i)(1)), the gross
receipts of which constitute DPGR, and
engages in transactions with respect to
similar property, the gross receipts of
which do not constitute DPGR, the
taxpayer must allocate its gross receipts
from all the transactions based on a
reasonable method that is satisfactory to
the Secretary based on all of the facts

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Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules
and circumstances and that accurately
identifies the gross receipts that
constitute DPGR. 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 gross receipts
and the method 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 various methods; and whether the
taxpayer applies the method
consistently from year to year. Thus, 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 purposes, then the
taxpayer must use that specific
identification method to determine
DPGR. If a taxpayer does not use a
specific identification method for other
purposes and cannot, without undue
burden or expense, use a specific
identification method, then the taxpayer
is not required to use a specific
identification method to determine
DPGR.
(2) De minimis rule. 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 nonDPGR (after application of exceptions
provided in § 1.199–3(h)(4), (k)(4)(iv),
(l)(1)(ii), (m)(4), and (n)(1) that result in
gross receipts being treated as DPGR). If
the amount of the taxpayer’s gross
receipts that do not qualify as DPGR
equals or exceeds 5 percent of the
taxpayer’s total gross receipts, 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 or a consolidated
group, the determination of whether less
than 5 percent of the taxpayer’s total
gross receipts are non-DPGR is made at
the corporation level rather than at the
EAG or consolidated group level, as
applicable. In the case of an S
corporation, partnership, estate or trust,
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

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gross receipts earned by the owner from
its activities as well as the owner’s share
of any pass-thru entity’s gross receipts.
(3) Examples. The following examples
illustrate the application of this
paragraph (d):
Example 1. 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 (either by purchase
or in a taxable exchange for gasoline refined
by X in the United States) from an unrelated
party. X does not commingle the gasoline. X
must allocate its gross receipts between the
gross receipts attributable to the gasoline
refined by X in the United States (that qualify
as DPGR if all the other requirements of
§ 1.199–3 are met) and X’s gross receipts
derived from the resale of the acquired
gasoline (that do not qualify as DPGR) if 5
percent or more of X’s total gross receipts are
not from the sale of gasoline refined by X
within the United States.
Example 2. X manufactures the same type
of QPP at facilities within the United States
and outside the United States which are sold
separately. X must allocate its gross receipts
between the receipts from the QPP
manufactured within the United States and
receipts from the QPP not manufactured
within the United States if 5 percent or more
of X’s total gross receipts are not from the
sale of QPP manufactured by X within the
United States.

(e) Timing rules for determining
QPAI—(1) Gross receipts and costs
recognized in different taxable years. If
a taxpayer recognizes and reports on a
Federal income tax return gross receipts
that the taxpayer identifies as DPGR,
then the taxpayer must treat the CGS
and deductions related to such receipts
as relating to DPGR, regardless of
whether such receipts ultimately qualify
as DPGR. Similarly, if a taxpayer pays
or incurs and reports on a Federal
income tax return CGS or deductions
and identifies such CGS or deductions
as relating to DPGR, then the taxpayer
must treat the gross receipts related to
such CGS or deductions as DPGR,
regardless of whether such receipts
ultimately qualify as DPGR. Similar
rules apply if the taxpayer recognizes
and reports on a Federal income tax
return gross receipts that the taxpayer
identifies as non-DPGR, or pays or
incurs and reports on a Federal income
tax return CGS or deductions that the
taxpayer identifies as relating to nonDPGR. The determination of whether
gross receipts qualify as DPGR or nonDPGR, and whether CGS or deductions
relate to DPGR or non-DPGR, must be
made in accordance with the rules
provided in §§ 1.199–1 through 1.199–8,
as applicable. If the gross receipts are
recognized in an intercompany
transaction within the meaning of
§ 1.1502–13, see also § 1.199–7(d). See

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§ 1.199–4 for allocation and
apportionment of CGS and deductions.
(2) Percentage of completion method.
A taxpayer using the percentage of
completion method under section 460
must determine the ratio of DPGR and
non-DPGR using a reasonable method
that accurately identifies the gross
receipts that constitute DPGR. See
paragraph (d)(1) of this section for the
factors taken into consideration in
determining whether the taxpayer’s
method is reasonable.
(3) Example. The following example
illustrates the application of paragraph
(e)(1) of this section:
Example. X, a calendar year accrual
method taxpayer, enters into a contract with
Y, an unrelated person, in 2005 for the sale
of QPP. In 2005, X receives an advance
payment from Y for the QPP. In 2006, X
manufactures the QPP within the United
States and delivers the QPP to Y. X’s method
of accounting requires X to include the entire
advance payment in its gross income for
Federal income tax purposes in 2005.
Assuming X can determine, using any
reasonable method, that all the requirements
of this section and § 1.199–3 will be met, the
advance payment qualifies as DPGR in 2005.
The CGS and deductions relating to the QPP
under the contract are taken into account
under § 1.199–4 in determining X’s QPAI in
2006, the taxable year the CGS and
deductions are otherwise deductible for
Federal income tax purposes and must be
treated as relating to DPGR in that taxable
year.
§ 1.199–2

Wage limitation.

(a) Rules of application—(1) In
general. 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 of the taxpayer. For
this purpose, except as provided in
paragraph (c) 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). For purposes of
section 199(b)(2) and this section, the
term taxpayer means employer.
(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

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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
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.
(b) No application in determining
whether amounts are wages for
employment tax purposes. The
discussion of wages in this section is for
purposes of section 199 only and has no
application in determining whether
amounts are wages under section
3121(a) for purposes of the Federal
Insurance Contributions Act (FICA),
under section 3306(b) for purposes of
the Federal Unemployment Tax Act
(FUTA), under section 3401(a) for
purposes of the Collection of Income
Tax at Source on Wages (Federal income
tax withholding), or any other wage
related determination.
(c) Application in case of taxpayer
with 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 those wages paid during the
short taxable year to employees of the
taxpayer as determined under the
tracking wages method described in
paragraph (f)(2)(iii) of this section. In
applying the tracking wages method in
the case of a short taxable year, the
taxpayer must apply the method as
follows—
(1) In paragraph (f)(2)(iii)(A) of this
section, the total amount of wages
subject to Federal income tax
withholding and reported on Form W–
2 must include only those wages subject
to Federal income tax withholding that
are actually paid to employees during
the short taxable year and reported on
Form W–2 for the calendar year ending
within that short taxable year;
(2) In paragraph (f)(2)(iii)(B) of this
section, only the supplemental
unemployment benefits paid during the
short taxable year that were included in
the total in paragraph (f)(2)(iii)(A) of this
section as modified by paragraph (c)(1)
of this section are required to be
deducted; and
(3) In paragraph (f)(2)(iii)(C) of this
section, only the portion of the amounts
reported in Box 12, Codes D, E, F, G,

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and S, on Forms W–2, that are actually
deferred or contributed during the short
taxable year may be included in W–2
wages.
(d) 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
permissible method for Form W–2
reporting is used.
(e) Non-duplication rule. Amounts
that are treated as W–2 wages for a
taxable year under any method may not
be treated as W–2 wages of any other
taxable year. Also, an amount may not
be treated as W–2 wages by more than
one taxpayer.
(f) Definition of W–2 wages—(1) In
general. Section 199(b)(2) defines W–2
wages for purposes of section 199(b)(1)
as the sum of the amounts required to
be included on statements under section
6051(a)(3) and (8) with respect to
employment of employees of the
taxpayer for the calendar 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). Under the 2004 and 2005 Form
W–2, the elective deferrals under
section 402(g)(3) and the amounts
deferred under section 457 directly
correlate to coded items reported in Box
12 on Form W–2. Box 12, Code D, is for
elective deferrals to a section 401(k)
cash or deferred arrangement; Box 12,
Code E, is for elective deferrals under a
section 403(b) salary reduction
agreement; Box 12, Code F, is for
elective deferrals under a section
408(k)(6) salary reduction Simplified
Employee Pension (SEP); Box 12, Code
G, is for elective deferrals under a
section 457(b) plan; and Box 12, Code

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S, is for employee salary reduction
contributions under a section 408(p)
SIMPLE (simple retirement account).
(2) Methods for calculating W–2
wages. For any taxable year, taxpayers
may use one of three methods in
calculating W–2 wages. These three
methods are subject to the nonduplication rule provided in paragraph
(e) of this section, and the tracking
wages method is subject to the rule
provided in paragraph (c) of this
section, if applicable.
(i) Unmodified box method. Under the
Unmodified box method, W–2 wages are
calculated by taking, without
modification, the lesser of—
(A) The total entries in Box 1 of all
Forms W–2 filed with the Social
Security Administration (SSA) by the
taxpayer with respect to employees of
the taxpayer for employment by the
taxpayer; or
(B) The total entries in Box 5 of all
Forms W–2 filed with the SSA by the
taxpayer with respect to employees of
the taxpayer for employment by the
taxpayer.
(ii) Modified Box 1 method. Under the
Modified Box 1 method, the taxpayer
makes modifications to the total entries
in Box 1 of Forms W–2 filed with
respect to employees of the taxpayer.
W–2 wages under this method are
calculated as follows—
(A) Total the amounts in Box 1 of all
Forms W–2 filed with the SSA by the
taxpayer with respect to employees of
the taxpayer for employment by the
taxpayer;
(B) Subtract from the total in
paragraph (f)(2)(ii)(A) of this section
amounts included in Box 1 of Forms W–
2 that are not wages for Federal income
tax withholding purposes and amounts
included in Box 1 of Forms W–2 that are
treated as wages under section 3402(o)
(for example, supplemental
unemployment benefits); and
(C) Add to the amount obtained after
paragraph (f)(2)(ii)(B) of this section
amounts that are reported in Box 12 of
Forms W–2 with respect to employees
of the taxpayer for employment by the
taxpayer and that are properly coded D,
E, F, G, or S.
(iii) Tracking wages method. Under
the Tracking wages method, the
taxpayer actually tracks total wages
subject to Federal income tax
withholding and makes appropriate
modifications. W–2 wages under this
method are calculated as follows—
(A) Total the amounts of wages
subject to Federal income tax
withholding that are paid to employees
of the taxpayer for employment by the
taxpayer and that are reported on Forms

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W–2 filed with the SSA by the taxpayer
for the calendar year;
(B) Subtract from the total in
paragraph (f)(2)(iii)(A) of this section the
supplemental unemployment
compensation benefits (as defined in
section 3402(o)(2)(A)) that were
included in the total in paragraph
(f)(2)(iii)(A) of this section; and
(C) Add to the amount obtained after
paragraph (f)(2)(iii)(B) of this section
amounts that are reported in Box 12 of
Forms W–2 with respect to employees
of the taxpayer for employment by the
taxpayer and that are properly coded D,
E, F, G, or S.
§ 1.199–3
receipts.

Domestic production gross

(a) In general. Domestic production
gross receipts (DPGR) are the gross
receipts (as defined in paragraph (c) of
this section) of the taxpayer that are
derived from (as defined in paragraph
(h) of this section)—
(1) Any lease, rental, license, sale,
exchange, or other disposition of—
(i) Qualifying production property
(QPP) (as defined in paragraph (i)(1) of
this section) that is manufactured,
produced, grown, or extracted (MPGE)
(as defined in paragraph (d) of this
section) by the taxpayer (as defined in
paragraph (e) of this section) in whole
or in significant part (as defined in
paragraph (f) of this section) within the
United States (as defined in paragraph
(g) of this section);
(ii) Any qualified film (as defined in
paragraph (j) of this section) produced
by the taxpayer (in accordance with
paragraph (j) of this section); or
(iii) Electricity, natural gas, or potable
water (as defined in paragraph (k) of this
section) (collectively, utilities) produced
by the taxpayer in the United States (in
accordance with paragraph (k) of this
section);
(2) Construction (as defined in
paragraph (l) of this section) performed
in the United States (in accordance with
paragraph (l) of this section); or
(3) Engineering or architectural
services (as defined in paragraph (m) of
this section) performed in the United
States for construction projects in the
United States (in accordance with
paragraph (m) of this section).
(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).

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(2) Exceptions. Paragraph (b)(1) of this
section does not apply to any QPP or
qualified films leased or rented by the
taxpayer to a related person if the QPP
or qualified films are held for sublease
or rent, or are subleased or rented, by
the related person to an unrelated
person for the ultimate use of the
unrelated person. Similarly, paragraph
(b)(1) of this section does not apply to
the license of QPP or qualified films 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.
(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
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) Definition of manufactured,
produced, grown, or extracted—(1) In
general. Except as provided in
paragraphs (d)(2) and (3) of this section,

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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.
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,
pursuant to paragraph (e)(1) of this
section, in order for gross 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 do not
qualify as MPGE.
(3) Installing. If a taxpayer installs an
item of QPP and engages in no other
MPGE with respect to the QPP, the
taxpayer’s installing activity does not
qualify as MPGE. However, if the
taxpayer installs an item of QPP MPGE
by the taxpayer, and the taxpayer has
the benefits and burdens of ownership
of the item of QPP under Federal
income tax principles during the period
the installing activity occurs, the
portion of the installing activity that
relates to the item of QPP is MPGE.
(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 for the taxable year
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.

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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 (d):
Example 1. A, B, and C are unrelated
taxpayers and are not cooperatives to which
Part I of subchapter T of the Internal Revenue
Code applies. A owns grain storage bins in
the United States in which it stores for a fee
B’s agricultural products that were grown in
the United States. B sells its agricultural
products to C. C processes B’s agricultural
products 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
States and C processes B’s agricultural
products into refined agricultural products
outside the United States. Pursuant to
paragraph (d)(1) of this section, the gross
receipts derived by A are DPGR from the
MPGE of QPP within the United States. B’s
and C’s respective 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 in the
customers’ property. Y’s installation of
purchased replacement parts does not qualify
as MPGE pursuant to paragraph (d)(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 of the
replacement parts during the reconstruction
and refurbishment activity and while
installing the parts. Y’s gross receipts from
the MPGE of the replacement parts and Y’s
gross receipts from the installation of the
replacement parts, which is an MPGE activity
pursuant to paragraph (d)(3) of this section,
are DPGR.
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 parties 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

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accessories. X’s activity is minor assembly
under paragraph (d)(2) of this section which
is not an MPGE activity.
Example 7. The facts are the same as in
Example 6 except that X manufactures some
of the accessories it adds to the automobiles.
Pursuant to § 1.199–1(c)(2), if an automobile
with accessories does not meet the
requirements for being an item, X must treat
each accessory that it manufactures as an
item for purposes of determining whether X
MPGE the item in whole or in significant part
within the United States under paragraph
(f)(1) of this section and whether the
installation of the item is MPGE under
paragraph (d)(3) of this section.
Example 8. 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’s sales
of the engraved pens and pencils do not
qualify as DPGR because Y does not MPGE
the pens and pencils.

(e) 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,
certain oil and gas partnerships under
paragraph (h)(7) of this section, EAG
partnerships under paragraph (h)(8) of
this section, and government contracts
in paragraph (e)(2) of this section, only
one taxpayer may claim the deduction
under § 1.199–1(a) with respect to any
qualifying activity under paragraph
(d)(1) of this section performed in
connection with the same QPP, or the
production of qualified films or utilities.
If one taxpayer performs a qualifying
activity under paragraph (d)(1), (j)(1), or
(k)(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 property
under Federal income tax principles
during the period the qualifying activity
occurs is treated as engaging in the
qualifying activity.
(2) Special rule for certain
government contracts. QPP, qualified
films, or utilities will be treated as
MPGE or otherwise produced by the
taxpayer notwithstanding the
requirements of paragraph (e)(1) of this
section if—
(i) The QPP, qualified films, or
utilities are MPGE or otherwise
produced by the taxpayer pursuant to a
contract with the Federal government;
and
(ii) The Federal Acquisition
Regulation (48 CFR) requires that title or
risk of loss with respect to the QPP,
qualified films, or utilities be transferred
to the Federal government before the
MPGE of the QPP, or the production of

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the qualified films or utilities, is
complete.
(3) Examples. The following examples
illustrate the application of this
paragraph (e):
Example 1. X designs machines that it
uses in its trade or business. X contracts with
Y, an unrelated taxpayer, 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 (e)(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 taxpayer, for
the manufacture of the machines. The
contract between X and Y is a costreimbursable type contract. 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 (e)(1) of this section.

(f) 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 pursuant to paragraph
(e)(1) of this section with an unrelated
party for the unrelated party 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 the taxpayer is considered to
MPGE the QPP under this section. The
unrelated party 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 (f)(1).

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(2) Substantial in nature. QPP will be
treated as MPGE in significant part by
the taxpayer within the United States
for purposes of paragraph (f)(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 property, and the
nature of the MPGE activity that the
taxpayer performs within the United
States. Research and experimental
activities under section 174 and the
creation of intangibles do not qualify as
substantial in nature for any QPP other
than computer software (as defined in
paragraph (i)(3) of this section) and
sound recordings (as defined in
paragraph (i)(4) of this section). In the
case of an EAG member, an EAG
partnership (as defined in paragraph
(h)(8) of this section), or members of an
EAG in which the partners of the EAG
partnership are members, in
determining whether the substantial in
nature requirement is met with respect
to an item of QPP, all of the previous
activities of the members of the EAG,
the EAG partnership, and all members
of the EAG in which the partners of the
EAG partnership are members, as
applicable, are taken into account.
(3) Safe harbor. A taxpayer will be
treated as having MPGE QPP in whole
or in significant part within the United
States for purposes of paragraph (f)(1) of
this section if, in connection with the
QPP, conversion costs (direct labor and
related factory burden) 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. For
purposes of the safe harbor under this
paragraph (f)(3), research and
experimental expenditures under
section 174 and the costs of creating
intangibles do not qualify as conversion
costs for any QPP other than computer
software and sound recordings. In the
case of tangible personal property (as
defined in paragraph (i)(2) of this
section), research and experimental
expenditures under section 174 and any
other costs incurred in the creation of
intangibles may be excluded from CGS
for purposes of determining whether the
taxpayer meets the safe harbor under
this paragraph (f)(3). For purposes of
this safe harbor, research and
experimental expenditures under
section 174 and any other costs of
creating intangibles for computer
software and sound recordings must be
allocated to the computer software and
sound recordings to which the

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expenditures and costs relate under
§ 1.199–4(b). In the case of an EAG
member, an EAG partnership, or
members of an EAG in which the
partners of the EAG partnership are
members, in determining whether the
requirements of the safe harbor under
this paragraph (f)(3) are met with
respect to an item of QPP, all of the
previous conversion costs of the
members of the EAG, the EAG
partnership, and all members of the
EAG in which the partners of the EAG
partnership are members, as applicable,
to MPGE the QPP are taken into
account. If a taxpayer enters into a
contract with an unrelated party for the
unrelated party to MPGE QPP for the
taxpayer, and the taxpayer is considered
pursuant to paragraph (e)(1) of this
section to MPGE the QPP, then for
purposes of this safe harbor the
taxpayer’s conversion costs shall
include both the taxpayer’s conversion
costs as well as the conversion costs of
the unrelated party to MPGE the QPP
under the contract.
(4) Examples. The following examples
illustrate the application of this
paragraph (f):
Example 1. X purchases from Y unrefined
oil extracted outside the United States and 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 activity is substantial
in nature under paragraph (f)(2) of this
section. Therefore, X has MPGE the jewelry
in significant part within the United States.
Example 3. (i) 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 taxpayer, 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
Conversion costs (direct labor and
factory burden): $325
Total cost of goods sold: $1,800
Gross profit: $700
Administrative and selling expenses:
$300
Taxable income: $400
(ii) Although X’s conversion costs are
less than 20 percent of total CGS ($325/

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$1,800, or 18 percent), the operations
conducted by X in connection with the
property purchased and sold are
substantial in nature under paragraph
(f)(2) of this section because of 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 (f)(1) of
this section.
Example 4. X produces a qualified film (as
defined in paragraph (j)(1) of this section)
and licenses the film to Y, an unrelated
taxpayer, for duplication of the film onto
DVDs. Y purchases the DVDs from an
unrelated person. Unless Y satisfies the safe
harbor under paragraph (f)(3) of this section,
Y’s income for duplicating X’s qualified film
onto the DVDs is non-DPGR because the
duplication is not substantial in nature
relative to the DVD with the film.
Example 5. X imports into the United
States QPP that is partially manufactured. 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 in whole or in significant
part requirement under paragraph (f)(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 6. X manufactures QPP in
significant part within the United States and
exports the QPP for further manufacture
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 7. X is a retailer 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 non-DPGR
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 occurs in whole or in significant
part within the United States.

(g) 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

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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.
(h) Definition of derived from the
lease, rental, license, sale, exchange, or
other disposition—(1) In general. The
term derived from the lease, rental,
license, sale, exchange, or other
disposition is defined as, and limited to,
the gross receipts directly derived from
the lease, rental, license, sale, exchange,
or other disposition, even if the taxpayer
has already recognized gross receipts
from a previous lease, rental, license,
sale, exchange, or other disposition of
the same property. Applicable Federal
income tax principles apply to
determine whether a transaction is, in
substance, a lease, rental, license, sale,
exchange or other disposition, or
whether it is a service (or some
combination thereof). For example,
gross receipts derived from the sale of
QPP includes gross receipts derived
from the sale of QPP MPGE in whole or
in significant part within the United
States by a taxpayer for sale, as well as
gross receipts derived from the sale of
QPP MPGE in whole or in significant
part within the United States by a
taxpayer and used in the taxpayer’s
trade or business before being sold. The
entire amount of lease income including
any interest that is not separately stated
is considered derived from the lease of
QPP or a qualified film. In addition, 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.
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, qualified
films, or utilities for an unrelated
person’s property is DPGR for the
taxpayer (assuming all the other
requirements of this section are met).
However, unless the taxpayer further
MPGE the QPP or further produces the
qualified films or utilities received in
the exchange, any gross receipts from
the subsequent sale by the taxpayer of
the property received in the exchange
are non-DPGR because the taxpayer did
not MPGE or otherwise produce such
property, even if the property was QPP,
qualified films, or utilities in the hands
of the other person.
(2) Examples. The following examples
illustrate the application of paragraph
(h)(1) of this section:

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Example 1. 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 thereafter, 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, and from the
sale of the QPP to Z all qualify as 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 taxpayer, 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 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 3. Cable company X charges
subscribers $15 a month for its basic cable
television. Y, an unrelated taxpayer,
produces in the United States all of the
programs on its cable channel which it
licenses to X for $.10 per subscriber per
month. The programs are qualified films
within the meaning of paragraph (j)(1) of this
section. The gross receipts derived by Y are
derived from a license of a qualified film
produced by Y and are DPGR (assuming all
the other requirements of this section are
met).

(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 property described in
section 1221(a)(8) consumed in the
activity giving rise to DPGR, and
provided that the transaction is a
hedging transaction within the meaning
of section 1221(b)(2) and § 1.1221–2(b),
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

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preceding sentence applies only to the
extent that § 1.988–5(b) does not apply.
(iii) 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, gain, or loss with respect to
hedging transactions.
(4) Allocation of gross receipts—
embedded services and non-qualified
property—(i) In general. Except as
otherwise provided in paragraph
(h)(4)(ii), paragraph (l) (relating to
construction), and paragraph (m)
(relating to architectural and
engineering 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 is not separately stated from the
amount charged for the lease, rental,
license, sale, exchange, or other
disposition of QPP, qualified films, or
utilities, DPGR includes only the
receipts from the lease, rental, license,
sale, exchange, or other disposition of
the item (if all the other requirements of
this section are met) and not any
receipts attributable to the embedded
service by the taxpayer. 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 (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.
(ii) Exceptions. There are five
exceptions to the rules under paragraph
(h)(4)(i) 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 property to which
the embedded services or non-qualified
property relate, gross receipts derived
from—
(A) A qualified warranty, that is, a
warranty that is provided in connection
with the lease, rental, license, sale,
exchange, or other disposition of QPP,
qualified films or utilities if—
(1) In the normal course of the
taxpayer’s business, 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 property; and
(2) The warranty is neither separately
offered by the taxpayer nor separately
bargained for with the customer (that is,
a customer cannot purchase the
property without the warranty);

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(B) 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—
(1) In the normal course of the
taxpayer’s business, 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 property; and
(2) The delivery or distribution
service is neither separately offered by
the taxpayer nor separately bargained
for with the customer (that is, a
customer cannot purchase the property
without delivery or distribution
service);
(C) 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, qualified films or
utilities if—
(1) In the normal course of the
taxpayer’s business, 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 property;
(2) The manual is neither separately
offered by the taxpayer nor separately
bargained for with the customer (that is,
a customer cannot purchase the
property without the manual); and
(3) The manual is not provided in
connection with a training course for
the customer;
(D) A qualified installation, that is, an
installation service (including minor
assembly) for QPP that is provided in
connection with the lease, rental,
license, sale, exchange, or other
disposition of the QPP if—
(1) In the normal course of the
taxpayer’s business, 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 property; and
(2) The installation is neither
separately offered by the taxpayer nor
separately bargained for with the
customer (that is, a customer cannot
purchase the property without the
installation service); and
(E) 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
total gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of each item of QPP,

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qualified films, or utilities (including
the gross receipts for the embedded
services and property described in
paragraphs (h)(4)(ii)(A), (B), (C), (D) and
(k)(4)(iv) of this section). The allocation
of the gross receipts attributable to the
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 property. In the case of gross
receipts derived from the lease, rental,
license, sale, exchange, or other
disposition of QPP, qualified films, and
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 derived
from the lease, rental, license, sale,
exchange, or other disposition of the
item of QPP, qualified films, or utilities.
For purposes of applying this de
minimis exception, the gross receipts
described in paragraphs (h)(4)(ii)(A),
(B), (C), (D) and (k)(4)(iv) of this section
are treated as DPGR. This de minimis
exception does not apply if the prices of
the services or non-qualified property
are separately stated by the taxpayer, or
if the services or non-qualified property
are separately offered or separately
bargained for with the customer (that is,
the customer can purchase the property
without the services or non-qualified
property).
(iii) Examples. The following
examples illustrate the application of
this paragraph (h)(4):
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. The QPP and
training services are separately stated in the
sales contract. Because the training services
are separately stated, the training services are
not treated as embedded services under the
de minimis exception in paragraph
(h)(4)(ii)(E) of this section.
Example 2. The facts are the same as in
Example 1 except that 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 percent of the gross receipts
derived from the sale of X’s QPP to Z,
including the gross receipts for the training
services, then the gross receipts may be
included in DPGR under the de minimis
exception in paragraph (h)(4)(ii)(E) 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. The price of the QPP and the delivery
fee are separately stated in the sales contract.
The retailer’s customers cannot purchase the
QPP without paying for the delivery fee.

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Because the delivery fee is separately stated,
the delivery fee does not qualify as DPGR
under the qualified delivery exception in
paragraph (h)(4)(ii)(B) of this section or the
de minimis exception under paragraph
(h)(4)(ii)(E) of this section.
Example 4. X enters into a single, lumpsum priced contract with Y, an unrelated
taxpayer, and the contract has the following
terms: X will produce QPP within the United
States for Y; X will deliver the QPP to Y; X
will provide a one-year warranty on the QPP;
X will provide operating and maintenance
manuals with the QPP; X will provide 100
hours of training and training manuals to Y’s
employees on the use and maintenance of the
QPP; X will provide purchased spare parts
for the QPP; and X will provide a 3-year
service agreement for the QPP. None of the
services or property was separately offered or
separately bargained for. The receipts for the
production of the QPP are DPGR under
paragraphs (d)(1) and (f) of this section
(assuming all the other requirements of this
section are met). X may include in DPGR the
gross receipts for delivering the QPP, which
is a qualified delivery under paragraph
(h)(4)(ii)(B) of this section; the gross receipts
for the one-year warranty, which is a
qualified warranty under paragraph
(h)(4)(ii)(A) of this section; and the gross
receipts for the operating and maintenance
manuals, each of which is a qualified
operating manual under paragraph
(h)(4)(ii)(C) of this section. If the gross
receipts for the embedded services consisting
of the employee training and 3-year service
agreement, and for the non-qualified property
consisting of the purchased spare parts and
the employee training manuals, which are
not qualified operating manuals, are in total
less than 5 percent of the gross receipts
derived from the sale of X’s QPP to Y
(including the gross receipts for the
embedded services and non-qualified
property), those gross receipts may be
included in DPGR (assuming there are no
other embedded services or non-qualified
property under the contract) under the de
minimis exception in paragraph (h)(4)(ii)(E)
of this section. If, however, the gross receipts
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 5 percent of the gross receipts
derived from the sale of X’s QPP to Y
(including the gross receipts for the
embedded services and non-qualified
property), those gross receipts do not qualify
as DPGR under the de minimis exception in
paragraph (h)(4)(ii)(E) of this section.

(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, or periodicals that
are MPGE in whole or in significant part
within the United States include
advertising income from advertisements
placed in those media, but only to the
extent the gross receipts, if any, derived
from the lease, rental, license, sale,

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exchange, or other disposition of the
newspapers, magazines, telephone
directories, or periodicals are DPGR
(without regard to this paragraph
(h)(5)(i)).
(ii) Qualified films. A taxpayer’s gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other
disposition of a qualified film include
product-placement income with respect
to that qualified film, that is,
compensation for placing or integrating
a product into the qualified film, but
only to the extent the gross receipts
derived from the qualified film (if any)
are DPGR (without regard to this
paragraph (h)(5)(ii)).
(iii) Examples. The following
examples illustrate the application of
this paragraph (h)(5):
Example 1. X MPGE and sells newspapers
within the United States. X’s gross receipts
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 also distributes with
its newspapers advertising flyers that are
MPGE by the advertiser. The fees X receives
for distributing the advertising flyers are not
derived from the sale of X’s newspapers
because X did not MPGE the advertising
flyers that it distributes. As a result, the
distribution fee is for the provision of a
distribution service and is non-DPGR under
paragraph (h)(5)(i) of this section.
Example 3. X produces two television
programs that are qualified films (as defined
in paragraph (j)(1) of this section). X licenses
the first television program to Y’s television
station and X licenses the second television
program to Z’s television station. Both
television programs contain product
placements for which X received
compensation. Z, but not Y, is a related
person to X within the meaning of paragraph
(b)(1) of this section. The gross receipts
derived by X from licensing the qualified
film to Y are DPGR. As a result, pursuant to
paragraph (h)(5)(ii) of this section, all of X’s
product placement 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 qualified film to Z are
non-DPGR under paragraph (b)(1) of this
section. As a result, pursuant to paragraph
(h)(5)(ii) of this section, none of X’s product
placement income for the second television
program is treated as gross receipts derived
from the qualified film under paragraph
(h)(5)(ii) of this section.

(6) Computer software—(i) In general.
Gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition of computer software (as
defined in paragraph (i)(3) of this
section) do not include gross receipts

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derived from Internet access services,
online services, customer and technical
support, telephone services, online
electronic books and journals, games
played through a Web site, providercontrolled software online access
services, and other similar services that
do not constitute the lease, rental,
license, sale, exchange, or other
disposition of computer software that
was developed by the taxpayer.
(ii) Examples. The following
examples illustrate the application of
this paragraph (h)(6):
Example 1. X produces and prints a
newspaper in the United States which it sells
to customers. X also has an online version of
the newspaper which is available only to
subscribers. The gross receipts derived from
the sale of the newspaper X produces and
prints qualify as DPGR. However, because X’s
gross receipts from the online newspaper
subscription are not derived from the lease,
rental, license, sale, exchange, or disposition
of computer software under paragraph
(h)(6)(i) of this section, the gross receipts
attributable to the online newspaper
subscription fees are non-DPGR under
paragraph (h)(6)(i) of this section.
Example 2. The facts are the same as in
Example 1 except that X’s gross receipts
attributable to the online version of its
newspaper are derived from fees from
customers to view the newspaper online and
payments from advertisers to display
advertising online. X’s gross receipts derived
from allowing customers online access to X’s
newspaper are non-DPGR because, pursuant
to paragraph (h)(6)(i) of this section, the gross
receipts relating to online newspapers are not
derived from the lease, rental, license, sale,
exchange, or other disposition of QPP, but
rather is the provision of an online access
service. As a result, because X’s gross
receipts from the online access services are
non-DPGR, the related online advertising
receipts are similarly non-DPGR under
paragraph (h)(5)(i) of this section.

(7) Exception for certain oil and gas
partnerships—(i) In general. If a
partnership is engaged solely in the
extraction, refining, or processing of oil
or natural gas, and distributes the oil or
natural gas or products derived from the
oil or natural gas (products) to one or
more partners, then each partner is
treated as extracting, refining, or
processing any oil or natural gas or
products extracted, refined, or
processed by the partnership and
distributed to that partner. Thus, to the
extent that the extracting, refining, or
processing of the distributed oil or
natural gas or products occurs in whole
or in significant part within the United
States, gross receipts derived by each
partner from the sale, exchange, or other
disposition of the distributed oil or
natural gas or products are treated as
DPGR (provided all requirements of this
section are met). Solely for purposes of

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section 199(d)(1)(B)(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
oil or natural gas or products at the time
of distribution to the partner and the
deemed gross receipts are allocated to
that partner, provided the partner
derives gross receipts from the
distributed property during the taxable
year of the partner with or within which
the partnership’s taxable year (in which
the distribution occurs) ends. Costs
included in the adjusted basis of the
distributed oil or natural gas or products
and any other relevant deductions are
taken into account in computing the
partner’s QPAI. See § 1.199–5 for the
application of section 199 to pass-thru
entities.
(ii) Example. The following example
illustrates the application of this
paragraph (h)(7). Assume that PRS and
X are calendar year taxpayers. The
example reads as follows:
Example. X is a partner in PRS, a
partnership which engages solely in the
extraction of oil within the United States. In
2010, 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(f)), 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 2010, X sells the oil for
$1,500 to a customer. Under paragraph
(h)(7)(i) of this section, X is treated as having
extracted the oil. The extraction and refining
of the oil qualify as an MPGE activity under
paragraph (d)(1) of this section. 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 2010. In addition, PRS is treated
as having $1,000 of DPGR solely for purposes
of applying the wage limitation of section
199(d)(1)(B)(ii). Accordingly, X’s share of
PRS’s W–2 wages determined under section
199(d)(1)(B) is $72, the lesser of $500 (X’s
allocable share of PRS’s W–2 wages included
in CGS) and $72 (2 × ($400 ($1,000 deemed
DPGR less $600 of CGS) × .09)). X adds the
$72 of PRS W–2 wages to its $100 of W–2
wages incurred in refining the oil for
purposes of section 199(b).

(8) Partnerships owned by members of
a single expanded affiliated group—(i)
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. Thus, if an EAG

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partnership MPGE or produces property
and distributes, leases, rents, licenses,
sells, exchanges, or otherwise disposes
of that property to a member of an EAG
in 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
members of the EAG. Similarly, if one
or more members of an EAG in 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.
Attribution of activities does not apply
for purposes of the construction of real
property under § 1.199–3(l)(1) and the
performance of engineering and
architectural services under § 1.199–
3(m)(2) and (3), respectively. An EAG
partnership may not use the small
business simplified overall method
described in § 1.199–4(f). Except as
provided in this paragraph (h)(8), 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
§ 1.199–5 regarding the application of
section 199 to pass-thru entities,
including application of the section
199(d)(1)(B) wage limitation under
§ 1.199–5(a)(3). See paragraphs (f)(2)
and (3) of this section for the
aggregation of activities and conversion
costs among EAG partnerships and all
members of the EAG in which the
partners of the EAG partnership are
members.
(ii) Special rules for distributions from
EAG partnerships. If an EAG
partnership distributes property to a
partner, then, solely for purposes of
section 199(d)(1)(B)(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 the partner
derives gross receipts from the
distributed property during the taxable
year of the partner with or within which
the partnership’s taxable year (in which
the distribution occurs) ends. Costs
included in the adjusted basis of the
distributed property and any other
relevant deductions are taken into
account in computing the partner’s
QPAI.
(iii) Examples. The following
examples illustrate the rules of this

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paragraph (h)(8). Assume that PRS, X, Y,
and Z all are calendar year taxpayers.
The examples read as follows:
Example 1. Contribution. X and Y, both
members of a single EAG, are the only
partners in PRS, a partnership, for PRS’s
entire 2010 taxable year. In 2010, X MPGE
QPP within the United States and contributes
the property to PRS. In 2010, PRS sells the
QPP for $1,000. PRS’s $1,000 gross receipts
constitute DPGR. PRS, X, and Y must apply
the rules of § 1.199–5 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)(B) wage limitation under § 1.199–
5(a)(3).
Example 2. Sale. X, Y, and Z are the only
members of a single EAG. X and Y each own
50% of the capital and profits interests in
PRS, a partnership, for PRS’s entire 2010
taxable year. In 2010, 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 2010, X sells the
QPP to customers for $10,000, incurring
selling expenses of $2,000. Under this
paragraph (h)(8), X is treated as having MPGE
the QPP within the United States, and X’s
$10,000 of gross receipts qualify as DPGR
($6,000 of CGS and $2,000 of other selling
expenses are subtracted from DPGR in
determining X’s QPAI). The results would be
the same if PRS sold the property to Z rather
than to X.
Example 3. Distribution. X and Y, both
members of a single EAG, are the only
partners in PRS, a partnership, for PRS’s
entire 2010 taxable year. In 2010, PRS MPGE
QPP within the United States, incurring $600
of CGS, including $500 of W–2 wages (as
defined in § 1.199–2(f)), 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
2010, X sells the QPP for $1,500 to a
customer. Under paragraph (h)(8)(i) 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. X subtracts
from the $1,500 of DPGR the $600 of CGS
incurred by PRS and the $200 of direct costs
incurred by X. Thus, X’s QPAI is $700 for
2010. In addition, PRS is treated as having
DPGR of $1,000 solely for purposes of
applying the wage limitation of section
199(d)(1)(B)(ii). Accordingly, X’s share of
PRS’S W–2 wages determined under section
199(d)(1)(B) is $72, the lesser of $500 (X’s
allocable share of PRS’S W–2 wages included
in CGS) and $72 (2 x ($400 ($1,000 deemed
DPGR less $600 of CGS) x .09)). X adds the
$72 of PRS W–2 wages to its $100 of W–2
wages incurred in MPGE the QPP for
purposes of section 199(b).
Example 4. Multiple sales. X and Y, both
non-consolidated members of a single EAG,
are the only partners in PRS, a partnership,
for PRS’s entire 2010 taxable year. PRS
produces in bulk form in the United States
the active ingredient for a pharmaceutical

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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 conversion costs to MPGE the
active ingredient within the United States are
$15 and account for 15 percent of PRS’s $100
CGS of the active ingredient. 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
conversion costs to MPGE the drug within
the United States are $12 and account for 10
percent of X’s $120 CGS of the drug. X sells
the drug in finished dosage to Y and Y sells
the drug to customers. Y incurs $2 of
conversion costs and Y’s CGS in selling the
drug to customers is $130. PRS’s gross
receipts from the sale of the active ingredient
to X are non-DPGR because PRS’s MPGE
activity is not substantial in nature and PRS
does not satisfy the safe harbor described in
paragraph (f)(3) of this section because PRS’s
conversion costs account for less than 20
percent 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 paragraph (f)(3) of this section
because the $27 ($15 + $12) of conversion
costs incurred by PRS and X equals or
exceeds 20 percent of X’s total CGS ($120) of
the drug at the time the drug is sold 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 paragraph
(f)(3) of this section because the $29 ($15 +
$12 + $2) of conversion costs incurred by
PRS, X, and Y equals or exceeds 20 percent
of Y’s total CGS ($130) of the drug at the time
the drug is sold to customers.

(9) Non-operating mineral interests.
DPGR does not include gross receipts
derived from mineral interests other
than operating mineral interests within
the meaning of § 1.614–2(b).
(i) Definition of qualifying production
property—(1) In general. QPP means—
(i) Tangible personal property (as
defined in paragraph (i)(2) of this
section);
(ii) Computer software (as defined in
paragraph (i)(3) of this section); and
(iii) Sound recordings (as defined in
paragraph (i)(4) of this section).
(2) Tangible personal property—(i) In
general. The term tangible personal
property is any tangible property other
than land, buildings (including items
that are structural components of such
buildings), and any property described
in paragraph (i)(3), (i)(4), (j)(1), or (k) of
this section. Property such as
production machinery, printing presses,
transportation and office equipment,
refrigerators, grocery counters, testing
equipment, display racks and shelves,

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Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules

and neon and other signs that are
contained in or attached to a building
constitutes tangible personal property
for purposes of this paragraph (i)(2)(i).
Except as provided in paragraphs
(i)(5)(ii) and (j)(2)(i) of this section,
computer software, sound recordings,
and qualified films are not treated as
tangible personal property regardless of
whether they are fixed on a tangible
medium. However, the tangible medium
on which such property may be fixed
(for example, a videocassette, a
computer diskette, or other similar
tangible item) is tangible personal
property.
(ii) Local law. In determining whether
property is tangible personal property,
local law is not controlling.
(iii) Machinery. Property that is in the
nature of machinery (other than
structural components of a building) is
tangible personal property even if such
property is located outside a building.
Thus, for example, a gasoline pump,
hydraulic car lift, or automatic vending
machine, although annexed to the
ground, is considered tangible personal
property. A structure that is property in
the nature of machinery or is essentially
an item of machinery or equipment is
not an inherently permanent structure
and is tangible personal property. In the
case, however, of a building or
inherently permanent structure that
includes property in the nature of
machinery as a structural component,
the property in the nature of machinery
is real property.
(iv) 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.
For purposes of this paragraph (i)(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,

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executive systems, monitors, compilers
and translators, assembly routines, and
utility programs, as well as application
programs, are included. Except as
provided in paragraph (i)(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
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, 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
(i)(5) of this section, if the medium
(such as compact discs, tapes, or other
phonorecordings) in which the sounds
may be embodied is tangible, the
medium is considered tangible personal
property for purposes of paragraph (i)(2)
of this section.

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(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
computer software or sound recordings
that is fixed on, or added to, tangible
personal property by the taxpayer (for
example, a computer diskette, or an
appliance), 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
tangible personal property as computer
software under this paragraph
(i)(5)(i)(A), any costs under section 174
attributable to the tangible personal
property are not considered in
determining whether the taxpayer’s
activity is substantial in nature under
paragraph (f)(2) of this section and are
not conversion costs under paragraph
(f)(3) 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 tangible personal
property as sound recordings under this
paragraph (i)(5)(i)(B), any costs under
section 174 attributable to the tangible
personal property are not considered in
determining whether the taxpayer’s
activity is substantial in nature under
paragraph (f)(2) of this section and are
not conversion costs under paragraph
(f)(3) of this section.
(ii) Tangible personal property. If a
taxpayer MPGE tangible personal
property but not the computer software
or sound recordings that the taxpayer
fixes on, or adds to, the tangible
personal property MPGE by the taxpayer
(for example, a computer diskette or an
appliance), then for purposes of this
section the tangible personal property
with the computer software or sound
recordings may be treated by the
taxpayer as tangible personal property
under paragraph (i)(2) of this section.
For purposes of paragraph (f)(3) of this
section, the taxpayer’s CGS for each
item includes the taxpayer’s cost of
licensing the computer software or
sound recordings.
(j) 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 all actors,
production personnel, directors, and

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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.
The term production personnel includes
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. The term
production personnel does not include,
however, individuals whose activities
are ancillary to the production, such as
advertisers and promoters, distributors,
studio administrators and managers,
studio security personnel, and personal
assistants to actors. The term production
personnel also does not include
individuals whose activities relate to
fixing the film on tangible personal
property. The definition of qualified
film is limited to the master copy of the
film (or other copy from which the
holder is licensed to make and produce
copies), and, except as provided in
paragraph (j)(2) of this section, does not
include tangible personal property
embodying the qualified film, such as
DVDs or videocassettes.
(2) Tangible personal property with a
film—(i) Film licensed to a taxpayer. If
a taxpayer MPGE tangible personal
property (such as a DVD) in whole or in
significant part in the United States and
fixes to the tangible personal property a
film that the taxpayer licenses from the
producer of the film, then the taxpayer
may treat the tangible personal property
with the affixed film as QPP, regardless
of whether the film is a qualified film.
The determination of whether gross
receipts of such a taxpayer from the
lease, rental, license, sale, exchange, or
other disposition of the tangible
personal property with the affixed film
are DPGR is made under the rules of
paragraphs (d), (e), and (f) of this
section. For purposes of paragraph (f)(3)
of this section, the taxpayer’s CGS for
each item includes the taxpayer’s cost of
licensing the film from the producer of
the film.
(ii) Film produced by a taxpayer. If a
taxpayer produces a film and also fixes
the film on tangible personal property
(for example, a DVD), then for purposes
of this section—
(A) Qualified films. If the film is a
qualified film, the taxpayer may treat
the tangible personal property on which
the qualified film is fixed as part of the
qualified film, in which case the gross
receipts derived from the lease, rental,
license, sale, exchange, or other
disposition of the tangible personal
property with the affixed qualified film

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will be DPGR (assuming all the other
requirements of this section are met),
regardless of whether the taxpayer
MPGE the tangible personal property in
whole or in significant part within the
United States; and
(B) Nonqualified films. If the film is
not a qualified film (nonqualified film),
any gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of the tangible
personal property with the nonqualified
film that are allocable to the
nonqualified film are non-DPGR. The
taxpayer, however, may treat the
tangible personal property (without the
nonqualified film) as an item of QPP.
Thus, the determination of whether
gross receipts of such a taxpayer derived
from the lease, rental, license, sale,
exchange, or other disposition of the
tangible personal property with the
affixed nonqualified film, that are
allocable to the tangible personal
property, are DPGR is made under the
rules of paragraphs (d), (e), and (f) of
this section.
(3) Derived from a qualified film.
DPGR includes the gross receipts of the
taxpayer which are derived from any
lease, rental, license, sale, exchange, or
other disposition of any qualified film
produced by the taxpayer. Showing a
qualified film on a television station is
not a lease, rental, license, sale,
exchange, or other disposition of the
qualified film. Ticket sales for viewing
qualified films 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 (j)(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 the film characters are
not gross receipts derived from a
qualified film.
(4) Examples. The following examples
illustrate the application of paragraphs
(j)(2) and (3) of this section:
Example 1. X produces a qualified film in
the United States and duplicates the film
onto purchased DVDs. X sells the DVDs with
the qualified film to customers. Under
paragraph (j)(2)(ii)(A) of this section, X may
treat the DVD with the qualified film as a
qualified film. Accordingly, X’s gross receipts

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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 50 percent requirement under
(j)(1) of this section and X manufactures the
DVDs in the United States. Under paragraph
(j)(2)(ii)(B) of this section, X may treat the
DVD without the nonqualified film as
tangible personal property. 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 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
qualified films on a television station is not
a lease, rental, license, sale, exchange, or
other disposition, pursuant to paragraph (j)(3)
of this section, the advertising income X
receives from advertisers is not derived from
the lease, rental, license, sale, exchange, or
other disposition of qualified films.
Example 4. X produces a qualified film and
contracts with Y, an unrelated taxpayer, 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 (f)(3) of this section. Y’s gross
receipts from manufacturing the DVDs and
duplicating the film onto the DVDs are
DPGR. X’s gross receipts from the sale of the
DVDs to customers are DPGR.

(5) Compensation for services. The
term compensation for services means
all payments for services performed by
actors, 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

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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.
(6) Determination of 50 percent. A
taxpayer may use any reasonable
method of determining the
compensation for services performed in
the United States by actors, production
personnel, directors, and producers, and
the total compensation paid to those
individuals for services relating to the
production of the property. 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.
(7) 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.
(k) Electricity, natural gas, or potable
water—(1) In general. DPGR includes
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 (k)(4) of this section that
describes certain gross receipts that do
not qualify as DPGR, therefore requiring
a taxpayer to allocate its gross receipts
between DPGR and non-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

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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 final 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.
Notwithstanding paragraphs (k)(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, then the gross receipts derived
from that lease, rental, license, sale,
exchange, or other disposition that are
attributable to the transmission and
distribution of the utilities must be
treated for purposes of section 199 as
being DPGR if all other requirements of
this section are met.
(5) Example. The following example
illustrates the application of this
paragraph (k):
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 for the sale of
electricity produced at the wind turbine are
DPGR. The gross receipts of Y from
transporting X’s electricity to Z are nonDPGR under paragraph (k)(4)(i) of this
section. Likewise, the gross receipts of Z from

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distributing the electricity are non-DPGR
under paragraph (k)(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 (k)(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 to
production activities, transmission activities,
and distribution activities.

(l) Definition of construction
performed in the United States—(1)
Construction of real property—(i) In
general. The term construction means
the construction or erection of real
property (that is, residential and
commercial buildings (including items
that are structural components of such
buildings), inherently permanent
structures other than tangible personal
property in the nature of machinery (see
paragraph (i)(2)(iii) of this section),
inherently permanent land
improvements, oil and gas wells, and
infrastructure) 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). 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 (l)(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 (l)(1)(i) even though under
local law the property is considered
tangible personal property.
(ii) De minimis exception. For
purposes of paragraph (l)(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 (l)(1)(i) of this
section) are derived from activities other
than the construction of real property in
the United States (for example, from
non-construction activities or the sale of

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tangible personal property or land) then
the total gross receipts derived by the
taxpayer from the project are DPGR from
construction.
(2) Activities constituting
construction. Activities constituting
construction include activities
performed in connection with a project
to erect or substantially renovate real
property, but 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, the gross receipts
derived from the tangential services are
DPGR. 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 (l)(1) of
this section. The taxpayer engaged in
these activities must make a reasonable
inquiry to determine whether the
activity relates to the erection or
substantial renovation of real property
in the United States. Construction
activities also include activities relating
to drilling an oil well and mining and
include any activities 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
lease, license, or rental of equipment,
for example, bulldozers, generators, or
computers, to contractors for use by the
contractors in the construction of real
property is not a construction activity
under this paragraph (l)(2). The term
construction does not include any
activity that is within the definition of
engineering and architectural services
under paragraph (m) of this section.
(3) Definition of infrastructure. The
term infrastructure includes roads,
power lines, water systems, railroad
spurs, communications facilities,
sewers, sidewalks, cable, and wiring.
The term also includes inherently
permanent oil and gas platforms.
(4) 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

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property, substantially prolongs the
useful life of the property, or adapts the
property to a new or different use.
(5) 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
complete). DPGR derived from the
construction of real property includes
compensation for the performance of
construction services by the taxpayer in
the United States. However, 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 (l)(5)(ii) of this
section, gross receipts attributable to the
sale or other disposition of land
(including zoning, planning, entitlement
costs, and other costs capitalized to the
land such as the demolition of
structures under section 280B). In
addition, 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—
(A) In the normal course of the
taxpayer’s business, 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 the customer (that is, the customer
cannot purchase the constructed real
property without the construction
warranty).
(ii) Land safe harbor. For purposes of
paragraph (l)(5)(i) of this section, a
taxpayer may allocate gross receipts
between the proceeds from the sale,
exchange, or other disposition of real
property constructed by the taxpayer
and the gross receipts attributable to the
sale, exchange, or other disposition of
land by reducing its costs related to
DPGR under § 1.199–4 by 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 such as the demolition of
structures under section 280B 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

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DPGR by those land costs plus a
percentage. The percentage is based on
the number of years that elapse between
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. The percentage is
5 percent for years zero through 5; 10
percent for years 6 through 10; and 15
percent for years 11 through 15. Land
held by a taxpayer for 16 or more years
is not eligible for the safe harbor under
this paragraph (l)(5)(ii) and the taxpayer
must allocate gross receipts between
land and qualifying real property.
(iii) Examples. The following
examples illustrate the application of
this paragraph (l)(5):
Example 1. X, 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 Y,
an unrelated taxpayer (a general contractor),
to oversee a substantial renovation of the
building (within the meaning of paragraph
(l)(4) of this section). Y retains Z (a
subcontractor) to install a new electrical
system in the building as part of that
substantial renovation. The amounts that Y
receives from X for construction services, and
amounts that Z receives from Y for
construction services, qualify as DPGR under
paragraph (l)(5)(i) of this section provided Y
and Z meet all of the requirements of
paragraph (l)(1) of this section. The gross
receipts that X receives from the subsequent
sale of the building do not qualify as DPGR
because X did not engage in any activity
constituting construction under paragraph
(l)(2) of this section even though X is in the
trade or business of construction. The results
would be the same if X and Y were members
of the same EAG under § 1.199–7(a).
However, if X and Y 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 (l)(1) of this
section. However, X’s gross receipts derived
from the purchased materials do not qualify
as DPGR.
Example 3. X is in a trade or business that
is considered construction under the twodigit NAICS code of 23. X buys unimproved
land. X gets the land zoned for residential
housing through an entitlement process. X
grades the land and sells the land to home
builders. The gross receipts that X receives
from the sale of the land do not qualify as
DPGR under paragraph (l)(5)(i) of this section
because the gross receipts are not derived
from the construction of real property.

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Example 4. The facts are the same as in
Example 3 except that X builds roads,
sewers, sidewalks, and installs power and
water lines on the land. The gross receipts
that X receives that are attributable to the sale
of the roads, sewers, sidewalks, and power
and water lines, which qualify as
infrastructure under paragraph (l)(3) of this
section, are DPGR. X’s gross receipts from the
land including capitalized costs of
entitlements do not qualify as DPGR under
paragraph (l)(5)(i) of this section because the
gross receipts are not derived from the
construction of real property.
Example 5. (i) X is engaged in the business
activities of constructing housing within the
meaning of paragraph (l)(1) of this section.
On June 1, 2005, X pays $50,000,000 for
1,000 acres of land that X will develop as a
new housing development. In 2008, 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 halfacre lots over 5 years. On January 31, 2010,
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
include $30,000 in land costs underlying the
common improvements.

(ii) Pursuant to the land safe harbor
under paragraph (l)(5)(ii) of this section,
X calculates the total costs under
§ 1.199–4 for each house sold in 2010 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 May 31, 2010, 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, 2005, and sold the
houses on the land between January 31,
2010, and May 31, 2010, the percentage
reduction for X is 5 percent because X
has held the land for not more than 5
years from the anniversary of the date of
acquisition. Thus, the DPGR for each
house is $237,000
($300,000¥$60,000¥$3,000) with costs
for each house of $195,000 for a
calculation of QPAI for each house of
$42,000.
Example 6. The facts are the same as in
Example 5 except some of the houses are
sold between June 1, 2010, and December 31,
2010. X calculates the DPGR for each house
sold between June 1, 2010, and December 31,
2010, 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, 2005, and sold
the houses on the land between June 1, 2010,

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and December 31, 2010, the percentage
reduction for X is 10 percent because X has
held the land for more than 5 years but not
more than 10 years from the anniversary of
the date of acquisition. Thus, the DPGR for
each house is $234,000
($300,000¥$60,000¥$6,000) with costs for
each house of $195,000 for a calculation of
QPAI for each house of $39,000.

(m) Definition of engineering and
architectural services—(1) In general.
DPGR includes gross receipts derived
from engineering or architectural
services performed in the United States
for a construction project described in
paragraph (l) 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. DPGR includes 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.
(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) De minimis exception for
performance of services in the United
States. 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 (l) of this section) are derived
from services not relating to a

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construction project described in
paragraph (l) of this section (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 are
DPGR from engineering or architectural
services performed in the United States
for a construction project.
(n) Exception for 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) 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 solely for
take out service or delivery is a retail
establishment (for example, a caterer). A
facility at which food or beverages are
prepared will not be treated as a retail
establishment if less than 5 percent of
the gross receipts from the sale of food
or beverages at that facility during the
taxable year are attributable to retail
sales. If a taxpayer’s facility is a retail
establishment in the United States, then,
for purposes of this section, the taxpayer
may allocate its gross receipts between
gross receipts derived from the retail
sale of the food and beverages prepared
and sold at the retail establishment
(which are non-DPGR) and gross
receipts derived from the wholesale sale
of the food and beverages prepared at
the retail establishment (which are
DPGR). Wholesale sales are sales of food
and beverages to be resold 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) Examples. The following examples
illustrate the application of this
paragraph (n):
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 roasted 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

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establishments represent receipts from the
sale of coffee beans roasted at the facility, the
receipts are DPGR. To the extent the gross
receipts of X’s retail establishments represent
receipts 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(c)(2), 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
in California. Bottles of wine produced by Y
at the bonded winery are sold to consumers
at the taxpaid premises. Pursuant to
paragraph (n)(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 (n)(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 sales of the wine are DPGR (assuming all
the other requirements of this section are
met).
§ 1.199–4 Costs allocable to domestic
production gross receipts.

(a) In general. 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, the amount of
expenses or losses (deductions) directly
allocable to DPGR, and a ratable portion
of other deductions not directly
allocable to DPGR or to another class of
income. Paragraph (b) of this section
provides rules for determining CGS
allocable to DPGR. Paragraph (c) of this
section provides rules for determining
the deductions allocated and
apportioned to DPGR and a ratable
portion of deductions that are not
directly allocable to DPGR or to another
class of income. Paragraph (d) of this
section provides that a taxpayer
generally must determine deductions
allocated and apportioned to DPGR or to
gross income attributable to DPGR using
the rules of the regulations at §§ 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.

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(b) Cost of goods sold allocable to
domestic production gross receipts—(1)
In general. When determining its QPAI,
a taxpayer must reduce DPGR by 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. Additional section
263A costs, as defined in § 1.263A–
1(d)(3), must be included in
determining CGS. 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(i)(1)), a
qualified film (as defined in § 1.199–
3(j)(1)), or electricity, natural gas, and
potable water (as defined in § 1.199–
3(k)) (collectively, utilities) that will, or
have, generated DPGR notwithstanding
that the gross receipts attributable to the
sale of the QPP, qualified films, or
utilities will, or have been, included in
the computation of gross income for a
different taxable year. For example,
advance payments related to 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. CGS allocable to DPGR
includes inventory valuation
adjustments such as writedowns under
the lower of cost or market method. If
non-DPGR is treated as DPGR pursuant
to §§ 1.199–1(d)(2) and 1.199–3(h)(4),
(k)(4)(iv), (l)(1)(ii), (m)(4), or (n)(1), CGS
related to such gross receipts that are
treated as DPGR must be allocated or
apportioned to DPGR.
(2) Allocating cost of goods sold. A
taxpayer must use a reasonable method
that is satisfactory to the Secretary to
allocate CGS between DPGR and nonDPGR. 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

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taxpayer for internal management and
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 various methods; and
whether the taxpayer applies the
method consistently from year to year.
If a taxpayer does, or can, without
undue burden or expense, specifically
identify from its books and records CGS
allocable to DPGR, the 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 cannot, without undue
burden or expense, use a specific
identification method to determine CGS
allocable to DPGR is not required to use
a specific identification method to
determine CGS allocable to DPGR.
Ordinarily, if a taxpayer uses a method
to allocate gross receipts between DPGR
and non-DPGR, 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.
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.
(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(g)) 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. 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, CGS allocable to
DPGR includes inventory adjustments to
QPP that is MPGE in whole or in
significant part within the United
States, qualified films produced in the
United States, or utilities produced 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)

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(subnormal goods at bona 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 various methods; and whether the
taxpayer applies the method
consistently from year to year. If a
taxpayer does, or can, without undue
burden or expense, specifically identify
from its books and records the proper
amount of inventory valuation
adjustments allocable to DPGR, then the
taxpayer must allocate that amount to
DPGR. A taxpayer that cannot, without
undue burden or expense, use a specific
identification method to determine the
proper amount of inventory valuation
adjustments allocable to DPGR is not
required to use a specific identification
method to allocate 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.
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, 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

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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, qualified films, and
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, qualifying
films, and 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.

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Ordinarily, if a taxpayer uses the
simplified production method or the
simplified resale method, then
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):
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 in gross income when the
payments are received. In December 2005, 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
2006, T produces and ships the furniture to
X. In 2006, 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 contract price from
X in 2006. T must include the $5,000
advance payment in income and DPGR in
2005. The remaining $15,000 of the contract
price must be included in income and DPGR
when received by T in 2006. T must include
the $14,000 it incurred to produce the
furniture in CGS and CGS allocable to DPGR
in 2006. See § 1.199–1(e)(1) 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 in
significant part 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 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 2005 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 sale of item A is $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 2005, 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
in significant part within the United States
and the sales of item A generate DPGR. Y
does not produce item B in significant part
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, 2005, is as follows:

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Item

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 2005, Y incurs $52,500 of section 471
costs and 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.
(iii) The closing inventory of the pools at
December 31, 2005, contains 3,000 units of

Item

item A and 2,500 units of item B. The closing
inventory of the pool at December 31, 2005,
shown at base-year and current-year cost is
as follows:

Base-year
cost

Quantity

Amount

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, 2005, 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 currentyear 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 percent). 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 ........................................................................................................................................................................

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

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

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

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 2006, Y experiences an inventory
decrement. During 2006, 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, 2006, contains 2,000 units of

Item

......................
......................
(6,000)
46,500

item A and 2,500 units of item B. The closing
inventory of the pool at December 31, 2006,
shown at base-year and current-year cost is
as follows:

Base-year
cost

Quantity

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

$52,500

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, 2006, amounts to
$20,000, and is less than the $25,000 base-

year cost of the opening inventory for that
year by $5,000 (the decrement stated at baseyear cost). This liquidation is reflected by

reducing the most recent layer of increment.
The LIFO value of the inventory at December
31, 2006 is:
Base cost

Index

LIFO value

January 1, 2005, base cost .....................................................................................................................
December 31, 2005, 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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inventory is $5,000 ($25,000 ¥ $20,000). The
ratio of the change in base-year cost of item

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A to the change in base-year cost of the total
inventory is 100% ($5,000/$5,000).

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(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

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 allocable or
apportioned 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 directly allocable to
DPGR, and a ratable portion of
deductions that are not directly
allocable to DPGR or to another class of
income. 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

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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 qualified
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 to use
the small business simplified overall
method, the simplified deduction
method, or the section 861 method for
a taxable year. A taxpayer eligible to use
the simplified deduction method may
choose at any time to use the simplified
deduction method or the section 861
method for a taxable year.
(2) Treatment of certain deductions—
(i) In general. The rules provided in this
paragraph (c)(2) apply to net operating
losses and certain other deductions for
purposes of allocating and apportioning
deductions to DPGR or gross income
attributable to DPGR for all of the
methods provided by this section.
(ii) 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.
(iii) Deductions not attributable to the
conduct of a trade or business.
Deductions not attributable to the
conduct of a trade or business are not
allocated or apportioned to DPGR or
gross income attributable to DPGR. For
example, the standard deduction
provided by section 63(c) and the
deduction for personal exemptions
provided by section 151 are not
allocated or apportioned to DPGR or
gross income attributable to DPGR.
(d) Section 861 method—(1) In
general. A taxpayer must allocate and
apportion its deductions using the
allocation and apportionment rules
provided by the section 861 method
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 its distributive share of

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deductions from pass-thru entities) to
gross income attributable to DPGR. If the
taxpayer applies the allocation and
apportionment rules of the section 861
regulations for an operative section
other than section 199, 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 sections
170, 873(b)(2), and 882(c)(1)(B)) must be
ratably apportioned between gross
income attributable to DPGR and other
gross income based on the relative
amounts of gross income. For
individuals, this provision applies
solely to deductions for charitable
contributions that are attributable to the
actual conduct of a trade or business.
(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 related to gross
receipts deemed to be domestic
production gross receipts. If non-DPGR
is treated as DPGR pursuant to §§ 1.199–
1(d)(2) and 1.199–3(h)(4), (k)(4)(iv),
(l)(1)(ii), (m)(4), or (n)(1), deductions
related to such gross receipts that are
treated as DPGR must be allocated or
apportioned to gross income attributable
to DPGR.
(5) Examples. The following examples
illustrate the operation of the section
861 method. Assume that with respect
to the allocation and apportionment of
interest expense, § 1.861–10T does not
apply in the following examples. The
examples read as follows:
Example 1. General section 861 method. (i)
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 nonDPGR. 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

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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 non-DPGR. 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 include W–2 wages as
defined in § 1.199–2(f)) that are not

67261

includible in CGS and not directly allocable
to any gross income. For 2010, the adjusted
basis of X’s assets that generate gross income
attributable to DPGR and to non-DPGR is,
respectively, $4,000 and $1,000. 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 (includes $100 of W–2 wages) ......................................................................................................................
CGS allocable to non-DPGR (includes $100 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 ...................................................................................................................................................................
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 chooses to allocate and
apportion 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 (including W–2
wages) 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
(includes $100 of W–2 wages) 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 (includes $100 of W–2 wages) ......................................................................................................................
Section 162 selling expenses (includes $100 of W–2 wages) ($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 ...................................................................................................................................................................

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

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

1,320

(iii) Section 199 deduction determination.
X’s tentative deduction under § 1.199–1(a)
(section 199 deduction) is $119 (.09 × (lesser
of QPAI of $1,320 and taxable income of
$1,380)) subject to the wage limitation of
$150 (50% × $300). Accordingly, 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
percent of the total voting power of stock of
Y and 80 percent 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 that generate
gross income attributable to DPGR and to
non-DPGR is, respectively, $21,000 and
$24,000. All of Y’s 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 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 (includes $300 of W–2 wages) .....................................................................................................................
CGS allocated to non-DPGR (includes $300 of W–2 wages) ..............................................................................................................
Section 162 selling expenses (includes $300 of W–2 wages) .............................................................................................................
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 .........................................................................................................................................................................

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

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

1,910

(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

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

§ 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 (includes $300 of W–2 wages) .....................................................................................................................
Section 162 selling expenses (includes $100 of W–2 wages) ($840 × ($3,000 DPGR/$6,000 total gross receipts)) .........................

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(600)
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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)) ...
Section 174 R&E–SIC AAA ...................................................................................................................................................................
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

(150)
(120)
(300)
1,410

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 (includes $300 of W–2 wages) .....................................................................................................................
Section 162 selling expenses (includes $300 of W–2 wages) ($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 ...................................................................................................................................................................

$3,000
(1,200)
(420)

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

1,005

(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)) subject to the wage
limitation of $600 (50% × ($300 (X’s W–2
wages) + $900 (Y’s W–2 wages))).
Accordingly, the 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. A taxpayer with average
annual gross receipts (as defined in
paragraph (g) of this section) of
$25,000,000 or less, or total assets at the
end of the taxable year (as defined in
paragraph (h) of this section) of
$10,000,000 or less, may use the
simplified deduction method to
apportion deductions between DPGR
and non-DPGR. This paragraph 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)(ii) of this section and deductions
not attributable to the actual conduct of
a trade or business as provided in
paragraph (c)(2)(iii) of this section) are
ratably apportioned between DPGR and
non-DPGR based on relative gross
receipts. Accordingly, the amount of
deductions apportioned to DPGR is
equal to the same proportion of the total
deductions that the amount of DPGR
bears to total gross receipts. Whether an
owner of a pass-thru entity may use the
simplified deduction method is
determined at the level of the owner of
the pass-thru entity. Whether a trust or
an estate may use the simplified

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deduction method is determined at the
trust or estate level. In the case of a trust
or estate, the simplified deduction
method is 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 those
items of any lower-tier entity, prior to
any charitable or distribution deduction.
In the case of an owner of any other
pass-thru entity, 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) Members of an expanded affiliated
group—(i) In general. Whether the
members of an EAG may use the
simplified deduction method is
determined by reference to the average
annual gross receipts and total assets of
the EAG. If the average annual gross
receipts of the EAG are less than or
equal to $25,000,000 or the total assets
of the EAG at the end of its taxable year
are less than or equal to $10,000,000,
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)(2)(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)(2) 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 $2,000,000, $7,000,000, and

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(250)
(25)
(100)

$13,000,000, 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 $25,000,000, 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 $17,000,000. Because the
average annual gross receipts of the EAG are
greater than $25,000,000 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
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 (i)
of this section) are apportioned between
DPGR and other receipts 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. In the case of a pass-thru
entity, whether the small business
simplified overall method may be used
by such entity is determined at the passthru entity level and, if such entity is
eligible, the small business simplified
overall method is applied at the passthru entity level.

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(2) Qualifying small taxpayer. For
purposes of this paragraph (f), a
qualifying small taxpayer is—
(i) A taxpayer that has both average
annual gross receipts (as defined in
paragraph (g) of this section) of
$5,000,000 or less and total costs for the
current taxable year 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) Members of an expanded affiliated
group—(i) In general. Whether the
members of an EAG may use the small
business simplified overall method is
determined by reference to all the
members of the EAG. If both the average
annual gross receipts and the total costs
for the current taxable year 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)(3)(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)(3) 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 and total costs for the current taxable
year of $1,000,000, $1,500,000, and
$2,000,000, respectively. Because both the
average annual gross receipts and total costs
for the current taxable year 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

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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.

(4) Ineligible pass-thru entities.
Qualifying oil and gas partnerships
under § 1.199–3(h)(7), EAG partnerships
under § 1.199–3(h)(8), and trusts and
estates under § 1.199–5(d) 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 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 EAG. 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
(as described in § 1.199–7(h)) are
aggregated.
(h) Total assets—(1) In general. For
purposes of the simplified deduction
method provided by paragraph (e) of
this section, total assets means the total
assets the taxpayer has at the end of the
taxable year that are attributable to the
taxpayer’s trade or business. 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 the Form 1120, ‘‘United
States Corporation Income Tax Return,’’
in accordance with the Form 1120
instructions.
(2) Members of an EAG. To compute
the total assets at the end of the taxable
year of an EAG, the total assets, at the

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end of its 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.
(i) Total costs for the current taxable
year—(1) 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)(ii) of this section and deductions
not attributable to the conduct of a trade
or business as provided in paragraph
(c)(2)(iii) of this section) for the current
taxable year.
(2) Members of an EAG. To compute
the total costs for the current taxable
year of an EAG, the total costs for the
entire 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 are aggregated.
§ 1.199–5 Application of section 199 to
pass-thru entities.

(a) Partnerships—(1) Determination at
partner level. The deduction 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. 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)). 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. To
determine its section 199 deduction for
the taxable year, a partner generally
aggregates its distributive share of such
items, to the extent they are not
otherwise disallowed by the Internal
Revenue 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)). However, if a
partnership uses the small business
simplified overall method described in
§ 1.199–4(f), then each partner is
allocated its share of QPAI and W–2
wages (as defined in § 1.199–2(f)),
which (subject to the limitation under
section 199(d)(1)(B)) are combined with

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the partner’s QPAI and W–2 wages from
other sources. Under this method, a
partner’s distributive share of QPAI
from a partnership may be less than
zero.
(2) Disallowed deductions.
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,
704(d), or any other provision of the
Internal Revenue 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 partnership’s
qualified production activities,
determined in a manner consistent with
sections 465, 469, 704(d), and any other
applicable provision of the Internal
Revenue Code, is taken into account in
computing 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
partner takes into account a
proportionate share of those losses or
deductions in computing its QPAI for
that later taxable year.
(3) Partner’s share of W–2 wages.
Under section 199(d)(1)(B), a partner’s
share of W–2 wages of a partnership for
purposes of determining the partner’s

section 199(b) limitation is the lesser of
the partner’s allocable share of those
wages (without regard to section
199(d)(1)(B)), or 2 times 9 percent (3
percent for taxable years beginning in
2005 or 2006, and 6 percent for taxable
years beginning in 2007, 2008, or 2009)
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. In
general, 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. However, if a
partnership uses the small business
simplified overall method described in
§ 1.199–4(f), the QPAI used by each
partner to determine the wage limitation
under section 199(d)(1)(B) is the same as
the share of QPAI allocated to the
partner. Each partner must compute its
share of W–2 wages from the
partnership in accordance with section
199(d)(1)(B) (with W–2 wages being
allocated to the partner in the same
manner as is wage expense), and then
add that share to its W–2 wages from
other sources, if any. The application of
section 199(d)(1)(B) therefore means
that if QPAI, computed by taking into
account only the items of the
partnership allocated to the partner for
the taxable year, is not greater than zero,
the partner may not take into account
any W–2 wages of the partnership in
computing the partner’s section 199

deduction. See § 1.199–2 for the
computation of W–2 wages, and
paragraph (f) of this section for rules
regarding pass-thru entities in a tiered
structure.
(4) Examples. The following examples
illustrate the application of this
paragraph (a). 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 read 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. 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 2010, the adjusted basis of
PRS 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 2010,
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
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 (nonDPGR) – $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) .................................

$690

690
600
150

(iii) Determination of QPAI. (A) X’s QPAI.
Because the section 199 deduction is

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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 2010, X does not have any
other such items. For 2010, the adjusted basis
of X’s non-PRS assets, all of which are
investment assets, is $10,000. X’s only gross
receipts for 2010 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
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 2010 is $366, as
shown below:

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

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 and X’s share of PRS
assets)) .................................

$1,500

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

366

(810)
(300)

(24)

(B) Y’s QPAI. (1) For 2010, 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
and records CGS allocable to DPGR and to
non-DPGR. For 2010, the adjusted basis of
Y’s non-PRS assets attributable to its
production activities that generate DPGR is
$8,000 and to other production activities that

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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) .................................

$600

1,380
540
90

(2) Y determines its QPAI in the same
general manner as X. However, because Y has
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
2010 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 nonPRS activities) × ($1,500
PRS DPGR + $1,500 nonPRS 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 and
Y’s share of PRS DPGR assets)/$12,500 (Y’s non-PRS
assets and Y’s share of PRS
assets)) .................................

$3,000

(1,710)

(456)

(192)

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

642

(iv) PRS W–2 wages allocated to X and Y
under section 199(d)(1)(B). Solely for

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purposes of calculating the PRS W–2 wages
that are allocated to them under section
199(d)(1)(B) 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
which includes W–2 wage expense on the
basis of gross receipts, and apportion interest
expense according to the tax book value
method of § 1.861–9T(g).
(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)) .........................

$1,500
(810)

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

270

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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 2010, 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 ......

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

(300)

(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,
or credit, as determined under the principles
of § 1.704–1(b)(1)(vii):

(120)

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

(B) X’s and Y’s shares of PRS’s W–2 wages
determined under section 199(d)(1)(B) for
purposes of the wage limitation of section
199(b) are $49, the lesser of $250 (partner’s
allocable share of PRS’s W–2 wages ($100
included in CGS, and $150 included in
selling expenses) and $49 (2 × ($270 × .09)).
(v) Section 199 deduction determination.
(A) X’s tentative section 199 deduction is $33
(.09 × $366 (that is, QPAI determined at
partner level)) subject to the wage limitation
of $25 (50% × $49). Accordingly, X’s section
199 deduction for 2010 is $25.
(B) Y’s tentative section 199 deduction is
$58 (.09 × $642 (that is, QPAI determined at
the partner level) subject to the wage
limitation of $150 (50% × ($49 (from PRS))
and $250 (from non-PRS activities)).
Accordingly, Y’s section 199 deduction for
2010 is $58.
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, 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
(SIC BBB). PRS is not able to identify from

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$900

900
420
150
300

(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 2010, X does not have any
other such tax items. X’s only gross receipts
for 2010 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
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,

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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 2010 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 ......

$1,500
(600)

(210)
(150)

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

540

(B) Y’s QPAI. (1) For 2010, 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
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
DPGR and non-DPGR based on Y’s non-PRS
gross receipts is appropriate. For 2010, 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 ......

22:35 Nov 03, 2005

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 nonPRS 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)
Y’s QPAI ...................................

$4,500
(2,100)

(480)
(450)

(188)
1,282

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

(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,
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

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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
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
2010 is $1,282, as shown below:

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(iv) PRS W–2 wages allocated to X and Y
under section 199(d)(1)(B). Solely for
purposes of calculating the PRS W–2 wages
that are allocated to X and Y under section
199(d)(1)(B) 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 2, respectively.
Accordingly, X and Y must apportion section
162 selling expense which includes W–2
wage expense on the basis of gross receipts,
and 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
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 ....................................

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$1,500
(600)

Section 162 selling expenses
(including W–2 wages) ($420
× $1,500/$3,000) ...................
Section 174 R&E–SIC AAA ......

(210)
(150)

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

540

(B) X’s and Y’s shares of PRS’s W–2 wages
determined under section 199(d)(1)(B) for
purposes of the wage limitation of section
199(b) are $97, 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 $97 (2 × ($540 × .09)).
(v) Section 199 deduction determination.
(A) X’s tentative section 199 deduction is $49
(.09 × $540 (QPAI determined at partner
level)) subject to the wage limitation of $49
(50% × $97). Accordingly, X’s section 199
deduction for 2010 is $49.
(B) Y’s tentative section 199 deduction is
$115 (.09 × $1,282 (QPAI determined at
partner level) subject to the wage limitation
of $176 (50% × $352 ($97 from PRS + $255
from non-PRS activities)). Accordingly, Y’s
section 199 deduction for 2010 is $115.
Example 3. Simplified deduction method
with special allocations. (i) In general. X and
Y are unrelated corporate partners in PRS.
PRS 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
2010 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 2010
taxable year, X has gross receipts attributable
to non-partnership 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 the
partnership 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 nonDPGR¥$250 allocable CGS), and $1,800 of
deductions (comprised of X’s special
allocations of $1,600 of wage expense for
marketing and $200 of other expenses).
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/$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)(B) wage limitation, QPAI is
computed taking into account only the items
of the partnership allocated to the partner for
the taxable year of the partnership. Thus, X

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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)(B) 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) or $0 (2 × ($0 QPAI
x .09)). X’s tentative deduction is $5 ($50
QPAI × .09), 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 total section
199 deduction for the 2010 taxable year is $5.
Example 4. Small business simplified
overall method. A, an individual, and X, a
corporation, are partners in PRS. PRS engages
in manufacturing activities that generate both
DPGR and non-DPGR. A and X share all
items of income, gain, loss, deduction, and
credit equally. In the 2010 taxable year, PRS
has total gross receipts of $2,000 ($1,000 of
which is DPGR), CGS of $800 (including
$400 of W–2 wages), and deductions of $800.
A and PRS use the small business simplified
overall method under § 1.199–4(f). X uses the
section 861 method. Under the small
business simplified overall method, PRS’s
CGS and deductions apportioned to DPGR
equal $800 (($800 CGS plus $800 of other
deductions) × ($1,000 DPGR/$2,000 total
gross receipts)). Accordingly, PRS’s QPAI is
$200 ($1,000 DPGR¥$800 CGS and other
deductions). Under the partnership
agreement, PRS’s QPAI is allocated $100 to
A and $100 to X. A’s share of partnership W–
2 wages for purposes of the section
199(d)(1)(B) limitation is $18, the lesser of
$200 (A’s 50% allocable share of PRS’s $400
of W–2 wages) or $18 (2 × ($100 QPAI × .09)).
A’s tentative deduction is $9 ($100 QPAI ×
.09), subject to the section 199(b)(1) wage
limitation of $9 (50% × $18). Assuming that
A engages in no other activities generating
DPGR, A’s total section 199 deduction for the
2010 taxable year is $9. X must use $100 of
QPAI and $18 of W–2 wages to determine its
section 199 deduction using the section 861
method.

(b) S corporations—(1) Determination
at shareholder level. The section 199
deduction is determined at the
shareholder level. As a result, each
shareholder must compute its deduction
separately. 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. To determine its section 199
deduction for the taxable year, the
shareholder generally aggregates its pro
rata share of such items, to the extent
they are not otherwise disallowed by the
Internal Revenue Code, with those items
it incurs outside the S corporation
(whether directly or indirectly) for

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22:35 Nov 03, 2005

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purposes of allocating and apportioning
deductions to DPGR and computing its
QPAI. However, if an S corporation uses
the small business simplified overall
method described in § 1.199–4(f), then
each shareholder is allocated its share of
QPAI and W–2 wages, which (subject to
the limitation under section
199(d)(1)(B)) are combined with the
shareholder’s QPAI and W–2 wages
from other sources. Under this method,
a shareholder’s share of QPAI from an
S corporation may be less than zero.
(2) Disallowed deductions.
Deductions of the S corporation that
otherwise would be taken into account
in computing the shareholder’s section
199 deduction are taken into account
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 are not
disallowed by section 465, 469, 1366(d),
or any other provision of the Internal
Revenue Code. If only a portion of the
shareholder’s pro rata share of the losses
or deductions is allowed for a taxable
year, a proportionate share of the losses
or deductions allocated to the S
corporation’s qualified production
activities, determined in a manner
consistent with sections 465, 469,
1366(d), and any other applicable
provision of the Internal Revenue Code,
is taken into account in computing the
section 199 deduction for that taxable
year. To the extent that any of the
disallowed losses or deductions is
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.
(3) Shareholder’s share of W–2 wages.
Under section 199(d)(1)(B), 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)(B)), or 2
times 9 percent (3 percent for taxable
years beginning in 2005 or 2006, and 6
percent for taxable years beginning in
2007, 2008, or 2009) of the QPAI
computed by taking into account only
the items of the S corporation allocated
to the shareholder for the taxable year.
In general, 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.
However, if an S corporation uses the
small business simplified overall
method described in § 1.199–4(f), the
QPAI used by each shareholder to
determine the wage limitation under

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67267

section 199(d)(1)(B) is the same as the
share of QPAI allocated to the
shareholder. Each shareholder must
compute its share of W–2 wages from an
S corporation in accordance with
section 199(d)(1)(B) (with W–2 wages
being allocated to the shareholder in the
same manner as is wage expense), and
then add that share to the shareholder’s
W–2 wages from other sources, if any.
The application of section 199(d)(1)(B)
therefore means that if QPAI, computed
by taking into account only the items of
the S corporation allocated to the
shareholder for the taxable year, is not
greater than zero, the shareholder may
not take into account any W–2 wages of
the S corporation in computing the
shareholder’s section 199 deduction.
See § 1.199–2 for the computation of W–
2 wages, and paragraph (f) of this
section for rules regarding pass-thru
entities in a tiered structure.
(c) 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, the 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)(B) wage
limitation is not applicable to the
owned portion of the trust.
(d) Non-grantor trusts and estates—(1)
Computation of section 199 deduction.
Except as provided in paragraph (c) of
this section, solely for purposes of
determining the section 199 deduction
for the taxable year, the QPAI of a trust
or estate must be computed by
allocating expenses described in section
199(d)(5) under § 1.652(b)–3 with
respect to directly attributable expenses,
and under the simplified deduction
method of § 1.199–4(e) with respect to
other expenses described in section
199(d)(5) (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, 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

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§ 1.199–4(f)(4). The QPAI (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 may
claim 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 of section 199(d)(1)(B)) are
aggregated with the beneficiary’s QPAI
and W–2 wages from other sources.
Each beneficiary must compute its share
of W–2 wages from a trust or estate in
accordance with section 199(d)(1)(B).
The application of section 199(d)(1)(B)
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, the beneficiary may
not take into account any W–2 wages of
the trust or estate in computing the

beneficiary’s section 199 deduction. See
paragraph (f) of this section for rules
applicable to pass-thru entities in a
tiered structure.
(2) Example. The following example
illustrates the application of this
paragraph (d). Assume that the
partnership, trust, and trust beneficiary
all are calendar year taxpayers. The
example is as follows:
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 2010, PRS
distributes $10,000 to Trust. Trust’s
distributive share of PRS items, which are
properly included in Trust’s DNI, is as
follows:

Gross income attributable to DPGR ($15,000 DPGR¥$5,000 CGS (including W–2 wages of 1,000)) ................................................
Gross income attributable to other gross receipts ($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
receiving in 2010 the distribution from PRS,

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

Dividends .................................................................................................................................................................................................
Tax-exempt interest .................................................................................................................................................................................
Rents from commercial real property that is subject to a section 6166 election ....................................................................................
Real estate taxes .....................................................................................................................................................................................
Trustee commissions ...............................................................................................................................................................................
State income and personal property taxes .............................................................................................................................................
W–2 wages ..............................................................................................................................................................................................
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 $20,000
of gross receipts from PRS is reduced by
$5,000 of CGS, $3,000 of selling expenses,
and $2,000 of other expenses, 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

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

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 2010, 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
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 tax-exempt
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). Determining Trust’s QPAI under the
simplified deduction method requires a

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

multi-step approach to allocating costs. In
step 1, the Trust’s DPGR is first reduced by
the Trust’s expenses directly attributable to
DPGR under § 1.652(b)–3(a). In this step, the
$15,000 of DPGR from PRS is reduced by the
directly attributable $5,000 of CGS and
selling expenses of $3,000. In step 2, Trust
allocates its other business expenses on the
basis of its total gross receipts. In this
example, the portion of the trustee
commissions not directly attributable to the
rental operation, 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 combines its nondirectly attributable (other) expenses ($2,000
from PRS + $4,000 ($1,000 + $3,000) from its
own activities) and then apportions this total
between DPGR and other receipts on the
basis of Trust’s total gross receipts ($6,000 ×
$15,000 DPGR/$50,000 total gross receipts =
$1,800). Thus, for purposes of computing
Trust’s and B’s section 199 deduction, Trust’s
QPAI is $5,200 ($7,000 ¥$1,800). Because
the distribution of Trust’s DNI to B equals

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one-half of Trust’s DNI, Trust and B each has
QPAI from PRS for purposes of the section
199 deduction of $2,600.
(B) Section 199(d)(1)(B) wage limitation.
The wage limitation under section
199(d)(1)(B) 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 $990 of W–2
wages from PRS (the lesser of Trust’s
allocable share of PRS’s W–2 wages ($4,000)
or 2 × 9% of PRS’s QPAI ($5,500)). PRS’s
QPAI for purposes of the section 199(d)(1)(B)
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 $990 of W–2 wages to Trust’s
own $2,000 of W–2 wages (thus, $2,990).
Because the $14,000 distribution to B equals
one-half of Trust’s DNI, Trust and B each has
W–2 wages of $1,495. After applying the
section 199(d)(1)(B) wage limitation to B’s
share of the W–2 wages allocated from Trust,
B has W–2 wages of $468 from Trust (lesser
of $1,495 (allocable share of W–2 wages) or
2 × .09 × $2,600 (Trust’s QPAI)). B has W–
2 wages of $100 from non-Trust activities for
a total of $568 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 which is
added to the $2,600 QPAI from Trust for a
total of $3,600 of QPAI. B’s tentative
deduction is $324 (.09 × $3,600) which is
limited under section 199(b) to $284 (50% ×
$568 W–2 wages). Accordingly, B’s section
199 deduction for 2010 is $284.
(2) Trust’s computation. Trust has
sufficient taxable income so that the section
199 deduction is not limited under section
199(a)(1)(B). Trust’s tentative deduction is
$234 (.09 × $2,600 QPAI) which is limited
under section 199(b) to $748 (50% × $1,495
W–2 wages). Accordingly, Trust’s section 199
deduction for 2010 is $234.

(e) 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 partnerships, if section 751(a) or (b)
applies, 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 money 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

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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 or exchanged
or otherwise disposed of by the
partnership, the money or property
received 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 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 or exchanged 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. See § 1.751–
1(b).
(f) Section 199(d)(1)(B) 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, the wage
limitation of section 199(d)(1)(B) must
be applied at each tier (that is,
separately for each entity). Thus, at each
tier, the owner of a pass-thru entity
calculates the amounts described in
sections 199(d)(1)(B)(i) (allocable share)
and 199(d)(1)(B)(ii) (twice the
applicable percentage of 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)(B)(i) 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)(B),
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)(B),
and the upper-tier entity’s own W–2
wages. The W–2 wages of each lowertier entity in a tiered structure, in turn,
is computed as described in the
preceding sentence. Although all wages
paid during that taxable year are taken
into account in computing QPAI, only
the W–2 wages as described in § 1.199–
2 are taken into account in computing
the W–2 wage limitation.
(3) Example. The following example
illustrates the application of this
paragraph (f). Assume that each
partnership and each partner (whether
or not an individual) is a calendar year
taxpayer. The example is as follows:

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67269

Example. (i) In 2010, 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. Both partnerships are eligible
for and use the small business simplified
overall method under § 1.199–4(f). LTP has
QPAI of $400 ($900 DPGR—$450 CGS (which
includes W–2 wages of $100)—$50 other
deductions). Before taking into account its
distributive share from LTP, UTP has QPAI
of ($500) ($500 DPGR—$500 CGS (which
includes W–2 wages of $200)—$500 other
deductions). UTP’s distributive share of
LTP’s QPAI is $200.
(ii) UTP’s share of LTP’s W–2 wages for
purposes of the section 199(d)(1)(B)
limitation is $36, the lesser of $50 (UTP’s
allocable share of LTP’s W–2 wages paid) or
$36 (2 × ($200 QPAI × .09)). After taking into
account its distributive share from LTP, UTP
has QPAI of ($300) and W–2 wages of $236.
A’s distributive share of UTP’s QPAI is
($150). A’s limitation under section
199(d)(1)(B) with respect to A’s interest in
UTP is $0, the lesser of $118 (A’s allocable
share of UTP’s W–2 wages paid) or $0
(because A’s share of QPAI, ($150), is less
than zero).

(g) No attribution of qualified
activities. Except as provided in
§ 1.199–3(h)(7) regarding certain
qualifying oil and gas partnerships and
§ 1.199–3(h)(8) regarding EAG
partnerships, for purposes of section
199, an owner of a pass-thru entity is
not treated as conducting the qualified
production activities of the pass-thru
entity, and vice versa. This rule applies
to all partnerships, including
partnerships that have elected out of
subchapter K under section 761(a).
Accordingly, if a partnership MPGE
QPP within the United States, or
otherwise produces a qualified film or
utilities in the United States, and
distributes or leases, rents, licenses,
sells, exchanges, or otherwise disposes
of the property to a partner who then
leases, rents, licenses, sells, exchanges,
or otherwise disposes of the property,
the partner’s gross receipts from this
latter lease, rental, license, sale,
exchange, or other disposition are not
treated as DPGR under § 1.199–3. In
addition, if a partner MPGE QPP within
the United States, or otherwise produces
a qualified film or utilities in the United
States, and contributes or leases, rents,
licenses, sells, exchanges, or otherwise
disposes of the property to a partnership
which then leases, rents, licenses, sells,
exchanges, or otherwise disposes of the
property, the partnership’s gross
receipts from this latter disposition are
not treated as DPGR under § 1.199–3.
§ 1.199–6 Agricultural and horticultural
cooperatives.

(a) In general. This section applies to
a cooperative to which Part I of

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Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules

subchapter T of the Internal Revenue
Code applies and its patrons if the
cooperative has manufactured,
produced, grown, or extracted (MPGE)
(as defined in § 1.199–3(d)) in whole or
significant part (as defined in § 1.199–
3(f)) within the United States (as
defined in § 1.199–3(g)) 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. If any amount of a
patronage dividend or per-unit retain
allocation received by a patron is
allocable to the qualified production
activities income (QPAI) (as defined in
§ 1.199–1(c)) of the cooperative, would
be allowable as a deduction under
§ 1.199–1(a) (section 199 deduction) by
the cooperative, and is designated as
such in a written notice to the patron
during the payment period defined
under section 1382(d), then such
amount is deductible by the patron as a
section 199 deduction. For this purpose,
patronage dividends and per-unit retain
allocations include any advances on
patronage or per-unit retains paid in
money during the taxable year.
(b) 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
designate in a written notice the amount
of the patron’s patronage dividend or
per-unit retain allocation that is
allocable to QPAI and deductible by the
cooperative. This written notice
designating the patron’s portion of the
section 199 deduction 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.
(c) Determining cooperative’s
qualified production activities income.
In determining the portion of the
cooperative’s QPAI that would be
allowable as a section 199 deduction by
the cooperative, the cooperative’s
taxable income is computed without
taking into account any deduction
allowable under section 1382(b) or (c)
(relating to patronage dividends, perunit retain allocations, and
nonpatronage distributions) and, in the

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case of a cooperative engaged in the
marketing of agricultural and/or
horticultural products, the cooperative
is treated as having MPGE in whole or
in significant part within the United
States any agricultural or horticultural
products marketed by the cooperative
that its patrons have MPGE.
(d) 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. 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).
(e) 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.
(f) 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 the
amended return, recapture of the excess
will occur at the cooperative level.
(g) 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.
(h) No double counting. A patronage
dividend or per-unit retain allocation
received by a patron of a cooperative is
not QPAI in the hands of the patron.
(i) 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, 2005,
Cooperative X has gross receipts of
$1,500,000, all derived from the sale of corn
grown by its members. Cooperative X’s W–
2 wages for 2005 total $500,000. 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

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Patron A in 2005 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 an agricultural
cooperative described in paragraph (a) 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 under paragraph
(c) of this section is $1,000,000. Cooperative
X’s section 199 deduction for its taxable year
2005 is $30,000 (.03 × $1,000,000). Since this
amount is less than 50% of Cooperative X’s
W–2 wages, the entire amount is deductible.
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 2005
taxable year of $1,000,000, which it pays on
March 15, 2006. Pursuant to paragraph (b) of
this section, Cooperative X notifies members
in written notices which accompany the
patronage dividend notification that it is
allocating to them the section 199 deduction
it is entitled to claim in the taxable year
2005. On March 15, 2006, Patron A receives
a $10,000 patronage dividend from
Cooperative X. In the notice that
accompanies the patronage dividend, Patron
A is designated a $300 section 199
deduction. Under paragraph (d) of this
section, Patron A may claim a $300 section
199 deduction for the taxable year ending
December 31, 2006, 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 the
Patron A for the calendar year 2006.
(ii) Under section 199(d)(3)(A), Cooperative
X is required to reduce its patronage
dividend deduction of $1,000,000 by the
$30,000 section 199 deduction passed
through to members (whether or not
Cooperative X pays patronage on book or tax
net earnings). As a consequence, Cooperative
X is entitled to a patronage dividend
deduction for the taxable year ending
December 31, 2005, in the amount of
$970,000 ($1,000,000¥$30,000) and to a
section 199 deduction in the amount of
$30,000 ($1,000,000 × .03). Its taxable income
for 2005 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 2005,
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 sections 199(d)(3)(A) and
1382, Cooperative X is allowed a patronage
dividend deduction of $470,000
($500,000¥$30,000 section 199 deduction),
whether patronage net earnings are
distributed on book or tax net earnings.
(ii) The patrons will have received a gross
amount of $1,000,000 from Cooperative X
($500,000 paid during the taxable year as
advances and the additional $500,000 paid as

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Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules
qualified patronage dividends). If
Cooperative X passes through its entire
section 199 deduction to its members by
providing the notice required by paragraph
(b) of this section, the patrons will be
allowed a $30,000 section 199 deduction,
resulting in a net $970,000 taxable
distribution from Cooperative X. Pursuant to
paragraph (h) of this section, the $1,000,000
received by the patrons from Cooperative X
is not QPAI in the hands of the patrons.
§ 1.199–7

Expanded affiliated groups.

(a) In general. 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 Internal Revenue 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
activites income (QPAI) (as defined in
§ 1.199–1(c)), and W–2 wages (as
defined in § 1.199–2(f)). 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. 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 defined in § 1.199–3(h))
of qualifying production property (QPP)
(as defined in § 1.199–3(i)) that was
manufactured, produced, grown or
extracted (MPGE) (as defined in § 1.199–
3(d)), in whole or in significant part (as
defined in § 1.199–3(f)), in the United
States (as defined in § 1.199–3(g)), a
qualifed film (as defined in § 1.199–3(j))
that was produced in the United States,
or electricity, natural gas, or potable
water (as defined in § 1.199–3(k))

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(collectively, utilities) that was
produced in the United States 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 domestic production
gross receipts (DPGR) (as defined in
§ 1.199–3(a)). However, attribution of
activities does not apply for purposes of
the construction of real property under
§ 1.199–3(l) or the performance of
engineering and architectural services
under § 1.199–3(m). A member of an
EAG must engage in a construction
activity under § 1.199–3(l)(2), provide
engineering services under § 1.199–
3(m)(2), or provide architectural
services under § 1.199–3(m)(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:
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
engraving companies’ names on pens and
pencils purchased from unrelated persons
and then selling the pens and pencils to such
companies. 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 2006 taxable
year, Corporations A and B are members of
the same EAG. A is engaged solely in the
trade or business of manufacturing QPP in
the United States. A and B each own 45
percent of partnership C and unrelated
persons own the remaining 10 percent. C is
engaged solely in the trade or business of
manufacturing the same type of QPP in the
United States as A. In 2006, B purchases and
then resells the QPP manufactured in 2006
by A and C. B also resells QPP 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 B is a member
of the EAG that includes A, B is treated as
conducting A’s manufacturing activities in
determining whether B’s gross receipts 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
are DPGR. Accordingly, B’s gross receipts
attributable to its sale of the QPP 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 QPP it
purchases from C and from the unrelated

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persons are non-DPGR because no member of
the EAG MPGE the QPP. If rather than
reselling the QPP, B rented the QPP it
acquired from A to unrelated persons, B’s
gross receipts attributable to the rental of the
QPP would also be DPGR (assuming all the
other requirements of § 1.199–3 are met).

(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 aggregating each member’s taxable
income or loss, QPAI, and W–2 wages.
For this purpose, a member’s QPAI is
determined under § 1.199–1. 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) Net operating loss carryovers. In
determing 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 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), which
generally prevents the section 199
deduction from creating or increasing an
NOL, 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

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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
(intercompany transaction, S, and B as
defined in § 1.1502–13(b)(1)), S takes an
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) of this section, a
disposing member (as described in such
paragraph) is treated as conducting the
activities conducted by each other
member of the consolidated group with
respect to the construction of real
property under § 1.199–3(l) and the
performance of engineering and
architectural services under § 1.199–
3(m).
(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
by reference to its members’ DPGR, nonDPGR, cost of goods sold (CGS), and all
other deductions, expenses, or losses
(deductions), determined on a
consolidated basis.
(4) Determining the section 199
deduction—(i) Expanded affiliated
group consists of consolidated group
and non-consolidated group members. If
an EAG includes corporations that are
members of the same consolidated
group and corporations that are not
members of the same consolidated
group, in computing the taxable income
of the EAG, the consolidated taxable
income or loss, QPAI, and W–2 wages
of the consolidated group, 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 of the non-consolidated
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), the A consolidated

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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 of the A
consolidated group are aggregated with
the taxable income or loss, QPAI, and
W–2 wages 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 by reference to the
consolidated group’s consolidated
taxable income or loss, QPAI, and W–
2 wages, not 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
the section 199 deduction allocated to a
consolidated group that is a member of
an EAG) must be 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. For purposes
of allocating the section 199 deduction
of a consolidated group among its
members, any redetermination of a
corporation’s receipts from an
intercompany transaction as DPGR or
non-DPGR or as non-receipts, and any
redetermination of a corporation’s CGS
or other deductions from an
intercompany transaction as either
allocable to or not allocable to DPGR
under § 1.1502–13(c)(1)(i) or (c)(4) 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
(b), (c), and (d) of this section:
Example 1. Corporations X and Y are
members of the same EAG but are not
members of a consolidated group. 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

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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 income or Y’s
expenses, or both X’s income and Y’s
expenses, 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 recharacterized 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 $1,500 rental expense + X’s
$1,000 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. (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
$25,000,000 and A and B each use the
simplified deduction method under § 1.199–
4(e). In 2006, 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

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$4,000,000. A has no other items of income,
gain, or deductions. In 2006, B sells the
televisions it purchased from A to unrelated
persons for $4,100,000 and pays $100,000 for
administrative services performed in 2006. 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
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 4. (i) Facts. The facts are the same
as in Example 3 except that A and B are
members of the same consolidated group, B
does not sell the televisions purchased from
A until 2007, and B’s $100,000 paid for
administrative services are paid in 2007 for
services performed in 2007. In addition, in
2007, 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 2006 QPAI. The
consolidated group’s DPGR and total gross
receipts in 2006 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 2006. 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 2006 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
2006 section 199 deduction to its members.
Because B’s only activity during 2006 is the
purchase of televisions from A, B has no

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DPGR or deductions and thus, no QPAI, in
2006. Accordingly, the entire section 199
deduction in 2006 for the consolidated group
will be allocated to A.
(iv) Consolidated group’s 2007 QPAI.
Pursuant to paragraph (d)(1) of this section
and § 1.1502–13(c), A’s sale of televisions to
B in 2006 is taken into account in 2007 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 income or B’s expenses, or both A’s
income and B’s expenses, 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 nonDPGR and non-receipts 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 nonreceipts, 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 2007 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 2007 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 2007
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 as non-DPGR and nonreceipts is disregarded. Accordingly, for this
purpose, A’s DPGR is $2,000,000 (receipts
from the sale of televisions to B taken into
account in 2007) 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

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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
($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 2007 is allocated $100,000/($100,000 +
$2,000,000) to A and $2,000,000/($100,000 +
$2,000,000) to B.
Example 5. Corporations S and B are
members of the same consolidated group. In
2006, 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 income or
B’s expenses, or both S’s income and B’s
expenses, 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 2006.
Example 6. 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 2006, X had no
taxable income or loss. In 2006, X has $0 of
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 2006, the transition
percentage under section 199(a)(2) is 3

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percent. Thus, the EAG’s section 199
deduction for 2006 is $240 (3% 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 $240
section 199 deduction is allocated to X, Y,
and Z in proportion to their respective
amounts of QPAI, that is $48 to X ($240 ×
$2,000/$10,000), $72 to Y ($240 × $3,000/
$10,000), and $120 to Z ($240 × $5,000/
$10,000). Although X’s taxable income for
2006 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 2006
equal to $48. Because X’s NOL for 2006
cannot be carried back to a previous taxable
year, X’s NOL carryover to 2007 will be $48.

(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 must be 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.
(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

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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,
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 2005 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 2005 and not a member of any EAG for the
second half of 2005. During the 2005 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 the taxable
year and a $150 taxable loss and ($200) of
QPAI that is allocated to the second half of
the taxable year. Taking into account Z’s
taxable income, QPAI, and W–2 wages
allocated to the first half of the taxable year
pursuant to the section 199 closing of the
books election, the EAG has positive taxable

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income and QPAI for the taxable year 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 the year,
a portion of the EAG’s section 199 deduction
is allocated to Z. Because Z has negative
QPAI for the second half of the year, Z is
allowed no section 199 deduction for the
second half of the taxable year. Thus, despite
the fact that Z has a $70 taxable loss and
($100) of QPAI for the entire 2005 taxable
year, Z is entitled to a section 199 deduction
for the taxable year 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, QPAI, and W–2 wages of each
group member that are both—
(i) Attributable to the period that the
member of the EAG and the computing
member are both members of the EAG;
and
(ii) Taken into account in a taxable
year that begins after the effective date
of section 199 and 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. Each corporation has
taxable income that exceeds its QPAI and has
sufficient W–2 wages to avoid the limitation
under section 199(b). For its taxable year
ending June 30, 2005, Z’s QPAI is $4,000. For
the taxable year ending December 31, 2005,
X’s QPAI is $8,000 and Y’s QPAI is ($6,000).
For its taxable year ending June 30, 2006, Z’s
QPAI is $2,000.
(ii) Because Z’s taxable year ending June
30, 2005, began on July 1, 2004, prior to the
effective date of section 199, Z is not allowed
a section 199 deduction for its taxable year
ending June 30, 2005.
(iii) In computing X’s and Y’s respective
section 199 deductions for their taxable years
ending December 31, 2005, Z’s items from its
taxable year ending June 30, 2005, are not
taken into account because Z’s taxable year
began before the effective date of section 199.
Instead, only X’s and Y’s taxable income,
QPAI, and W–2 wages from their respective
taxable years ending December 31, 2005, 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 2005,
the transition percentage under section

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199(a)(2) is 3 percent. Accordingly, the EAG’s
section 199 deduction is $60 ($2,000 × .03).
The $60 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, 2005, is
$60 ($60 × $8,000/($8,000 + $0)). Y’s section
199 deduction for its taxable year ending
December 31, 2005, is $0 ($60 × $0/($8,000
+ $0)).
(iv) In computing Z’s section 199
deduction for its taxable year ending June 30,
2006, X’s and Y’s items from their respective
taxable years ending December 31, 2005, are
taken into account. Therefore, X’s and Y’s
taxable income or loss, QPAI, and W–2 wages
from their taxable years ending December 31,
2005, are aggregated with Z’s taxable income
or loss, QPAI, and W–2 wages from its
taxable year ending June 30, 2006. 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 2005, the transition
percentage under section 199(a)(2) is 3
percent. Accordingly, the EAG’s section 199
deduction is $120 ($4,000 × .03). A portion
of the $120 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 $120 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, 2006, is $24 ($120 × $2,000/
($8,000 + $0 + $2,000)).
§ 1.199–8

Other rules.

(a) Individuals. In the case of an
individual, the deduction under
§ 1.199–1(a) (section 199 deduction) is
equal to the applicable percentage of the
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.
(b) Trade or business requirement.
Section 1.199–3 is applied by taking
into account only items that are
attributable to the actual conduct of a
trade or business.
(c) Coordination with alternative
minimum tax. For purposes of
determining alternative minimum
taxable income (AMTI) under section
55, a taxpayer that is not a corporation
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

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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 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 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
59. In the case of an individual or a
trust, 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 (c) 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).
(d) Nonrecognition transactions—(1)
In general. Except as provided for an
expanded affiliated group (EAG) (as
defined in § 1.199–7) and EAG
partnerships (as defined in § 1.199–
3(h)(8)), 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 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 in § 1.199–
3(h)(7) and (8) (exceptions for certain oil
and gas partnerships and EAG
partnerships), 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.
(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

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67275

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, 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, then the assets
will give rise to DPGR if leased, rented,
licensed, sold, exchanged, or otherwise
disposed of by the acquiring
corporation.
(e) 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 1.199–7,
and this section 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, 2004, is deemed to begin
on January 1, 2005, and the transition
percentage for that taxable year is 3
percent.
(f) Section 481(a) adjustments. For
purposes of determining QPAI, a section
481(a) adjustment, whether positive or
negative, taken into account during the
taxable year that is solely attributable to
either gross receipts, cost of goods sold
(CGS), or deductions, expenses, or
losses (deductions) must be allocated or
apportioned in the same manner as the
gross receipts, CGS, or deductions to
which it is attributable. See §§ 1.199–
1(d), 1.199–4(b), and 1.199–4(c) for rules
related to the allocation and
apportionment of gross receipts, CGS,
and deductions. For example, if a
taxpayer changes its method of
accounting for inventories from the lastin, first-out (LIFO) method to the firstin, first-out (FIFO) method, the taxpayer
is required to allocate the resulting
section 481(a) adjustment, whether
positive or negative, in the same manner
as the CGS computed for the taxable
year with respect to those inventories. If
a section 481(a) adjustment is not solely
attributable to either gross receipts,
CGS, or deductions (for example, the

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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), 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 and allocated or apportioned
in the same manner as the gross
receipts, CGS, or deductions to which it
is attributable. 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 various methods. If a section

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481(a) adjustment is spread over more
than one taxable year, a taxpayer must
attribute the section 481(a) adjustment
among gross receipts, CGS, or
deductions, as applicable, in the same
manner for each taxable year within the
spread period. For example, if a
taxpayer, using a reasonable method,
determines that a section 481(a)
adjustment that is required to be spread
over four taxable years should be
attributed entirely to gross receipts, then
the taxpayer must attribute the section
481(a) adjustment entirely to gross
receipts in each of the four taxable years
of the spread period.
(g) Effective date. The final
regulations will be applicable to taxable
years beginning after December 31,
2004. In the case of pass-thru entities
described in § 1.199–5, the final
regulations will be applicable to taxable
years of pass-thru entities beginning
after December 31, 2004. Until the date
final regulations are published in the

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Federal Register, taxpayers may rely on
the interim guidance on section 199 as
set forth in Notice 2005–14 (2005–7
I.R.B. 498) (see § 601.601(d)(2) of this
chapter), as well as the proposed
regulations under §§ 1.199–1 through
1.199–7, and this section. For this
purpose, if the proposed regulations and
Notice 2005–14 include different rules
for the same particular issue, then the
taxpayer may rely on either the rule set
forth in the proposed regulations or the
rule set forth in Notice 2005–14.
However, if the proposed regulations
include a rule that was not included in
Notice 2005–14, taxpayers are not
permitted to rely on the absence of a
rule to apply a rule contrary to the
proposed regulations.
Kevin M. Brown,
Acting Deputy Commissioner for Services and
Enforcement.
[FR Doc. 05–21484 Filed 11–3–05; 8:45 am]
BILLING CODE 4830–01–P

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