Lawyer Article

Originally published in the CCH Federal Tax Weekly, Issue No 22, June 1, 2006. Republished with permission.

Tax experts from Washington, D.C., and around the nation expressed differing views on new regulations (T.D. 9262 and T.D. 9263; TAXDAY, 2006/05/25, I.1) issued on the domestic production activities deduction. Some said the regulations address many concerns and provide needed simplification. Others indicated that the regulations are still too complex and fail to address important issues.

Regulations Praised
Todd Reinstein of Pepper, Hamilton told CCH that "the government made the regulations a lot easier for taxpayers." Reinstein pointed to changes to the 5 percent de minimis rules, the treatment of construction activities and the requirements for expense allocation.

Beth Benko of Ernst & Young echoed this view, commenting that "the government has done a great job of providing simplifying regulations in a complex area. The regulations ease the administrative and compliance [burden], which was a concern." Benko noted that the government has simplified the necessary calculations and will do so further when it issues guidance allowing the use of statistical sampling.

Benko said the final regulations demonstrate Treasury's willingness to consider changes. Other helpful changes were the expansion of the in-kind distribution rules to other industries besides oil and gas, and expanded rules for qualified advertising receipts.

Zion Levi, tax partner in the Washington, D.C., office of Womble Carlyle Sandridge & Rice, PLLC, said that the final regulations eliminate many of the burdens and uncertainties that were identified in the proposed regulations, and provide various "pro-taxpayer" rules that potentially allow for a greater deduction under Code Sec. 199. For example, the final regulations clarify that the special government contracts rules also apply to gross receipts derived from certain subcontracts, that Code Sec. 174 costs are included for purposes of determining whether, in the case of computer software and sound recordings, the taxpayer produced in whole or in significant part such computer software or sound recordings, that all financing and interest components of a lease of qualifying property are considered to be derived from the lease of such qualifying property, and that the rule for advertising income also applies to qualified films.

Practitioner Concerns
Vincent J. O'Brien, a New York CPA, told CCH that "if there is beauty in simplification, then Code Sec. 199 does not have much beauty; however, the final regulations do simplify some things." O'Brien saw beneficial changes in the treatment of purchased materials in a construction project and the lack of basis adjustments to ownership interests in a passthrough entity.

James Kehl, a CPA with Meehan & Roby and author of the Practical Guide to the Sec. 199 Deduction (CCH), said that while the regulations "clarified the meaning of certain terms," they failed to answer questions "concerning agriculture and farming."

Howard Solodky, Chair of the tax group at Womble Carlyle, said that the Treasury and the IRS should be commended for the depth of the guidance provided in the final regulations; many of the changes made to Code Sec. 199 under the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) need to be addressed. For example, specific guidance regarding how Code Sec. 199 would apply to pass-through entities and their owners for taxable years beginning after May 17, 2006, needs to be issued.

Relief For Computer Software
The regulations package did address the concerns of the computer software industry about the treatment of income from online software products. Mark Nebergall, general counsel for SOFTEC (Software Finance & Tax Executives Council), a computer software coalition, told CCH that "we're pleased with the temporary regulations" that treat online software the same as software that is on a diskette or downloaded by the taxpayer. Nebergall said he "doesn't see any change in final regulations" that would withdraw the favorable treatment. Benko noted that "the regulations moved away from the factors for determining whether it's a service or a license." Carol Conjura of KPMG indicated that the rules reflect the industry's moving toward increased use of online software.

S Corporation Allocations
Michael Schlesinger, an attorney who authored the Practical Guide to S Corporations (CCH), said that "tax planning will have to occur if there are two or more shareholders in [an] S corporation and the shareholders are not being paid equal wages. ... an S corporate shareholder is not allocated his actual wages earned in the S corporation, only an allocable share. As a result, the shareholder who is pulling down the most salary will not obtain the full benefit from his or her work assuming equal share ownership; rather, the goldbricker who barely works comes out ahead."

Construction and Manufacturing Issues
The regulations maintained the benefits and burdens test for determining who has ownership of qualifying property and can therefore claim the deduction. Benko noted that this is a factual test that is not easy to apply. Reinstein expressed disappointment that the regulations declined to provide election for parties to decide who gets the deduction. This "would have been a major simplifying convention" and would encourage U.S. investment, he indicated.

Conjura and Benko said that the treatment of materials purchased by real estate developers was a major simplification. Builders will be able to claim the entire building as qualified receipts and will no longer have to back out the cost of purchased materials.

Treatment of Employees
Zion Levi cautioned taxpayers to not consider the benefits of Code Sec. 199 in a vacuum. For example, the final regulations define the term "employees" for purposes of the Code Sec. 199(b) W-2 wages limitation as including only common law employees of the taxpayer and officers of corporate taxpayers. To increase their otherwise available deduction under Code Sec. 199, many taxpayers may be tempted to take the position that some workers are in fact the taxpayer's employees, even though such workers receive their Forms W-2 from professional employer organizations or employee leasing firms. Such taxpayers, however, should weigh the Code Sec. 199 benefits that may be afforded by such a position with the potential overall costs to the taxpayer in advancing such a position, including for example the risk that such workers may now be able to claim that they are entitled to many fringe and retirement benefits otherwise available only to the taxpayer's employees.