[Code of Federal Regulations] [Title 26, Volume 3] [Revised as of April 1, 2008] From the U.S. Government Printing Office via GPO Access [CITE: 26CFR1.199-5] [Page 392-403] TITLE 26--INTERNAL REVENUE CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY (CONTINUED) PART 1_INCOME TAXES--Table of Contents Sec. 1.199-5 Application of section 199 to pass-thru entities for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. (a) In general. The provisions of this section apply solely for purposes of section 199 of the Internal Revenue Code (Code). (b) Partnerships--(1) In general--(i) Determination at partner level. The deduction with respect to the qualified production activities of the partnership allowable under Sec. 1.199-1(a) (section 199 deduction) is determined at the partner level. As a result, each partner must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of the partner's interest in the partnership. Except as provided by publication pursuant to paragraph (b)(1)(ii) of this section, for purposes of this section, each partner is allocated, in accordance with sections 702 and 704, its share of partnership items (including items of income, gain, loss, and deduction), cost of goods sold (CGS) allocated to such items of income, and gross receipts that are included in such items of income, even if the partner's share of CGS and other deductions and losses exceeds domestic production gross receipts (DPGR) (as defined in Sec. 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. Guaranteed payments under section 707(c) are not considered allocations of partnership income for purposes of this section. Guaranteed payments under section 707(c) are deductions by the partnership that must be taken into account under the rules of Sec. 1.199-4. See Sec. 1.199-3(p) and paragraph (b)(6) Example 5 of this section. Except as provided in paragraph (b)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, a partner aggregates its distributive share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the partnership (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its qualified production activities income (QPAI) (as defined in Sec. 1.199-1(c)). (ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this chapter), permit a partnership to calculate a partner's share of QPAI and W-2 wages as defined in Sec. 1.199- 2(e)(2) (W-2 wages) at the entity level, instead of allocating to the partner, in accordance with sections 702 and 704, the partner's share of partnership items (including items of income, gain, loss, and deduction) and amounts described in Sec. 1.199-2(e)(1) [[Page 393]] (paragraph (e)(1) wages). If a partnership does calculate QPAI at the entity level-- (A) Each partner is allocated its share of QPAI (subject to the limitations of paragraph (b)(2) of this section) and W-2 wages from the partnership, which are combined with the partner's QPAI and W-2 wages from other sources, if any; (B) For purposes of computing the partner's QPAI under Sec. Sec. 1.199-1 through 1.199-8, a partner does not take into account the items from the partnership (for example, a partner does not take into account items from the partnership in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources; (C) A partner generally does not recompute its share of QPAI from the partnership using another method; however, the partner might have to adjust its share of QPAI from the partnership to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and (D) A partner's distributive share of QPAI from a partnership may be less than zero. (2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this chapter), losses or deductions of a partnership are taken into account in computing the partner's QPAI for a taxable year only if, and to the extent that, the partner's distributive share of those losses or deductions from all of the partnership's activities is not disallowed by section 465, 469, or 704(d), or any other provision of the Code. If only a portion of the partner's distributive share of the losses or deductions from a partnership is allowed for a taxable year, a proportionate share of those allowed losses or deductions that are allocated to the partnership's qualified production activities, determined in a manner consistent with sections 465, 469, and 704(d), and any other applicable provision of the Code, is taken into account in computing QPAI for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year under section 465, 469, or 704(d), or any other provision of the Code, the partner takes into account a proportionate share of those allowed losses or deductions that are allocated to the partnership's qualified production activities in computing the partner's QPAI for that later taxable year. Losses or deductions of the partnership that are disallowed for taxable years beginning on or before December 31, 2004, however, are not taken into account in a later taxable year for purposes of computing the partner's QPAI for that later taxable year, whether or not the losses or deductions are allowed for other purposes. (3) Partner's share of paragraph (e)(1) wages. Under section 199(d)(1)(A)(iii), a partner's share of paragraph (e)(1) wages of a partnership for purposes of determining the partner's wage limitation under section 199(b)(1) (W-2 wage limitation) equals the partner's allocable share of those wages. Except as provided by publication in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this chapter), the partnership must allocate the amount of paragraph (e)(1) wages among the partners in the same manner it allocates wage expense among those partners. The partner must add its share of the paragraph (e)(1) wages from the partnership to the partner's paragraph (e)(1) wages from other sources, if any. The partner (other than a partner that itself is a partnership or S corporation) then must calculate its W-2 wages by determining the amount of the partner's total paragraph (e)(1) wages properly allocable to DPGR. If the partner is a partnership or S corporation, the partner must allocate its paragraph (e)(1) wages (including the paragraph (e)(1) wages from a lower-tier partnership) among its partners or shareholders in the same manner it allocates wage expense among those partners or shareholders. See Sec. 1.199-2(e)(2) for the computation of W-2 wages and for the proper allocation of any such wages to DPGR. (4) Transition rule for definition of W-2 wages and for W-2 wage limitation. If a partnership and any partner in that partnership have different taxable years, only one of which begins after [[Page 394]] May 17, 2006, the definition of W-2 wages of the partnership and the section 199(d)(1)(A)(iii) rule for determining a partner's share of wages from that partnership is determined under the law applicable to partnerships based on the beginning date of the partnership's taxable year. Thus, for example, for the taxable year of a partnership beginning on or before May 17, 2006, a partner's share of W-2 wages from the partnership is determined under section 199(d)(1)(A)(iii) as in effect for taxable years beginning on or before May 17, 2006, even if the taxable year of that partner in which those wages are taken into account begins after May 17, 2006. (5) Partnerships electing out of subchapter K. For purposes of Sec. Sec. 1.199-1 through 1.199-8, the rules of this paragraph (b) apply to all partnerships, including those partnerships electing under section 761(a) to be excluded, in whole or in part, from the application of subchapter K of chapter 1 of the Code. (6) Examples. The following examples illustrate the application of this paragraph (b). Assume that each partner has sufficient adjusted gross income or taxable income so that the section 199 deduction is not limited under section 199(a)(1)(B). Assume also that the partnership and each of its partners (whether individual or corporate) are calendar year taxpayers. 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 equally. Both X and Y are engaged in a trade or business. PRS is not able to identify from its books and records CGS allocable to DPGR and non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of PRS's gross receipts, apportionment of CGS between DPGR and non- DPGR based on gross receipts is appropriate. For 2010, the adjusted basis of PRS's business assets is $5,000, $4,000 of which generate gross income attributable to DPGR and $1,000 of which generate gross income attributable to non-DPGR. For 2010, PRS has the following Federal income tax items: DPGR......................................................... $3,000 Non-DPGR..................................................... 3,000 CGS.......................................................... 3,240 Section 162 selling expenses................................. 1,200 Interest expense (not included in CGS)....................... 300 (ii) Allocation of PRS's Federal income tax items. X and Y each receive the following distributive share of PRS's Federal income tax items, as determined under the principles of Sec. 1.704-1(b)(1)(vii): Gross income attributable to DPGR ($1,500 (DPGR) - $810 $690 (allocable CGS))............................................ Gross income attributable to non-DPGR ($1,500 (non-DPGR) - 690 $810 (allocable CGS))....................................... Section 162 selling expenses................................. 600 Interest expense (not included in CGS)....................... 150 (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 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 Sec. 1.199-4(d). In this case, the section 162 selling expenses are not included in CGS and 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. X elects to apportion its distributive share of interest expense under the tax book value method of Sec. 1.861-9T(g). X's QPAI for 2010 is $366, as shown in the following table: DPGR........................................................ $1,500 CGS allocable to DPGR....................................... (810) Section 162 selling expenses ($600 x ($1,500 DPGR/$3,000 (300) total gross receipts))..................................... Interest expense (not included in CGS) ($150 x ($2,000 (X's (24) share of PRS's DPGR assets)/$12,500 (X's non-PRS assets ($10,000) + X's share of PRS assets ($2,500))))............ ----------- X's QPAI................................................ 366 (B) Y's QPAI. (1) For 2010, in addition to the activities of PRS, Y engages in production activities that generate both DPGR and non-DPGR. 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 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 $600 (allocable CGS))............................................ [[Page 395]] Gross income attributable to non-DPGR ($3,000 (other gross 1,380 receipts) -$1,620 (allocable CGS)).......................... Section 162 selling expenses................................. 540 Interest expense (not included in CGS)....................... 90 (2) Y determines its QPAI in the same general manner as X. However, because Y has other trade or business activities outside of PRS, Y must aggregate its distributive share of PRS's Federal income tax items with its own such items. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of Sec. 1.199-4(d). In this case, Y's distributive share of PRS's section 162 selling expenses, 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 (including Y's share of PRS's gross receipts) is appropriate. Y elects to apportion its distributive share of interest expense under the tax book value method of Sec. 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 in the following table: DPGR ($1,500 from PRS and $1,500 from non-PRS activities).... $3,000 CGS allocable to DPGR ($810 from PRS and $900 from non-PRS (1,710) activities)................................................. Section 162 selling expenses ($1,140 ($600 from PRS and $540 (456) from non-PRS activities) x $3,000 ($1,500 PRS DPGR + $1,500 non-PRS DPGR)/$7,500 ($3,000 PRS total gross receipts + $4,500 non-PRS total gross receipts))....................... Interest expense (not included in CGS) ($240 ($150 from PRS (192) and $90 from non-PRS activities) x $10,000 (Y's non-PRS DPGR assets ($8,000) + Y's share of PRS DPGR assets ($2,000))/ $12,500 (Y's non-PRS assets ($10,000) + Y's share of PRS assets ($2,500)))........................................... ---------- Y's QPAI................................................. 642 (iv) Determination of section 199 deduction. X's tentative section 199 deduction is $33 (.09 x $366, that is, QPAI determined at the partner level) subject to the W-2 wage limitation (50% of W-2 wages). Y's tentative section 199 deduction is $58 (.09 x $642) subject to the W-2 wage limitation. Example 2. Section 861 method with R&E expense. (i) Partnership Federal income tax items. X and Y, unrelated United States corporations each of which is engaged in a trade or business, are partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. Neither X nor Y is a member of an affiliated group. X and Y share all items of income, gain, loss, deduction, and credit equally. 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 non-DPGR are within SIC Industry Group BBB (SIC BBB). PRS 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 PRS's gross receipts, a