TIPRA Amendments to Section 199, 8798-8815 [E8-2761]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 32 (Friday, February 15, 2008)]
[Rules and Regulations]
[Pages 8798-8815]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-2761]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9381]
RIN 1545-BF79


TIPRA Amendments to Section 199

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations concerning the 
amendments made by the Tax Increase Prevention and Reconciliation Act 
of 2005 to section 199 of the Internal Revenue Code. The final 
regulations also contain a rule concerning the use of losses incurred 
by members of an expanded affiliated group. Section 199 provides a 
deduction for income attributable to domestic production activities. 
The final regulations affect taxpayers engaged in certain domestic 
production activities.

DATES: Effective Date: These regulations are effective February 15, 
2008.
    Applicability Date: For dates of applicability, see Sec.  1.199-
8(i)(5) and (6).

FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec.  1.199-2(e)(2) 
and 1.199-8(i)(5), Paul Handleman or David McDonnell, (202) 622-3040; 
concerning Sec. Sec.  1.199-3(i)(7) and (8), and 1.199-5, William 
Kostak, (202) 622-3060; and concerning Sec. Sec.  1.199-7(b)(4) and 
1.199-8(i)(6), Ken Cohen, (202) 622-7790 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document provides rules relating to the deduction for income 
attributable to domestic production activities under section 199 of the 
Internal Revenue Code (Code). Section 199 was added to the Code by 
section 102 of the American Jobs Creation Act of 2004 (Pub. L. 108-357, 
118 Stat. 1418), and amended by section 403(a) of the Gulf Opportunity 
Zone Act of 2005 (Pub. L. 109-135, 119 Stat. 25), section 514 of the 
Tax Increase Prevention and Reconciliation Act of 2005 (Pub. L. 109-
222, 120 Stat. 345) (TIPRA), and section 401 of the Tax Relief and 
Health Care Act of 2006 (Pub. L. 109-432, 120 Stat. 2922). On June 1, 
2006, the IRS and Treasury Department published final regulations under 
section 199 (TD 9263, 71 FR 31268). On October 19, 2006, the IRS and 
Treasury Department published final and temporary regulations on the 
TIPRA amendments to section 199 (TD 9293, 71 FR 61662) and cross-
referencing proposed regulations (REG-127819-06, 71 FR 61692). No 
public hearing was requested or held on the proposed regulations. One 
comment responding to the proposed regulations was received. After 
consideration of the comment, the proposed regulations are adopted as 
amended by this Treasury decision and the corresponding temporary 
regulations are removed.

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

[[Page 8799]]

taxable year. For this purpose, section 199(b)(2)(A) defines the term 
W-2 wages to mean, with respect to any person for any taxable year of 
such person, the sum of the amounts described in section 6051(a)(3) and 
(8) paid by such person with respect to employment of employees by such 
person during the calendar year ending during such taxable year. 
Section 514(a) of TIPRA added new section 199(b)(2)(B), which provides 
that the term W-2 wages does not include any amount which is not 
properly allocable to domestic production gross receipts (DPGR) for 
purposes of section 199(c)(1). Section 199(b)(2)(C) provides that the 
term W-2 wages does not include any amount that is not properly 
included in a return filed with the Social Security Administration on 
or before the 60th day after the due date (including extensions) for 
the return.

Pass-thru Entities

    Section 199(d)(1)(A) provides that, in the case of a partnership or 
S corporation, (i) section 199 shall be applied at the partner or 
shareholder level, (ii) each partner or shareholder shall take into 
account such person's allocable share of each item described in section 
199(c)(1)(A) or (B) (determined without regard to whether the items 
described in section 199(c)(1)(A) exceed the items described in section 
199(c)(1)(B)), and (iii) each partner or shareholder shall be treated 
for purposes of section 199(b) as having W-2 wages for the taxable year 
in an amount equal to such person's allocable share of the W-2 wages of 
the partnership or S corporation for the taxable year (as determined 
under regulations prescribed by the Secretary).
    Section 199(d)(1)(B) provides that, in the case of a trust or 
estate, (i) the items referred to in section 199(d)(1)(A)(ii) (as 
determined therein) and the W-2 wages of the trust or estate for the 
taxable year shall be apportioned between the beneficiaries and the 
fiduciary (and among the beneficiaries) under regulations prescribed by 
the Secretary, and (ii) for purposes of section 199(d)(2), AGI of the 
trust or estate shall be determined as provided in section 67(e) with 
the adjustments described in such section.
    Section 199(d)(1)(C) provides that the Secretary may prescribe 
rules requiring or restricting the allocation of items and wages under 
section 199(d)(1) and may prescribe such reporting requirements as the 
Secretary determines appropriate.

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. Section 199(d)(4)(B) provides that an EAG is an 
affiliated group as defined in section 1504(a), determined by 
substituting ``more than 50 percent'' for ``at least 80 percent'' each 
place it appears and without regard to section 1504(b)(2) and (4).

Authority to Prescribe Regulations

    Section 199(d)(9) authorizes the Secretary to prescribe such 
regulations as are necessary to carry out the purposes of section 199, 
including regulations that prevent more than one taxpayer from being 
allowed a deduction under section 199 with respect to any activity 
described in section 199(c)(4)(A)(i).

Summary of Comments

    For taxable years beginning after May 17, 2006, Sec.  1.199-
2T(e)(2)(i) provides that the term W-2 wages includes only amounts 
described in Sec.  1.199-2(e)(1) (paragraph (e)(1) wages) that are 
properly allocable to DPGR (as defined in Sec.  1.199-3) for purposes 
of section 199(c)(1). A taxpayer may determine the amount of paragraph 
(e)(1) wages that is properly allocable to DPGR using any reasonable 
method that is satisfactory to the Secretary based on all of the facts 
and circumstances.
    Section 1.199-2T(e)(2)(ii) and (iii) provide safe harbors for 
determining the amount of paragraph (e)(1) wages that is properly 
allocable to DPGR. Under the wage expense safe harbor in Sec.  1.199-
2T(e)(2)(ii)(A) for taxpayers using either the section 861 method of 
cost allocation under Sec.  1.199-4(d) or the simplified deduction 
method under Sec.  1.199-4(e), a taxpayer may determine the amount of 
paragraph (e)(1) wages that is properly allocable to DPGR by 
multiplying the amount of paragraph (e)(1) wages by the ratio of the 
taxpayer's wage expense included in calculating QPAI for the taxable 
year to the taxpayer's total wage expense used in calculating the 
taxpayer's taxable income (or AGI, if applicable) for the taxable year. 
For purposes of determining the amount of wage expense included in cost 
of goods sold (CGS) for this safe harbor, Sec.  1.199-2T(e)(2)(ii)(B) 
provides that a taxpayer may determine its wage expense included in CGS 
using any reasonable method that is satisfactory to the Secretary based 
on all of the facts and circumstances.
    Under the wage expense safe harbor in Sec.  1.199-2T(e)(2)(ii)(A), 
a taxpayer uses its wage expense, not W-2 wages, to determine the 
amount of W-2 wages that are properly allocable to DPGR. Section 1.199-
2T(e)(2)(ii)(A) defines the term wage expense as wages (that is, 
compensation paid by the employer in the active conduct of a trade or 
business to its employees) that are properly taken into account under 
the taxpayer's method of accounting.
    The commentator suggested that, in certain circumstances, it should 
not be necessary for W-2 wages to be paid by a taxpayer in order for 
those wages to be properly allocable to DPGR. Specifically, the 
commentator suggested that W-2 wages should be treated as properly 
allocable to DPGR if the wages are paid to employees that are 
performing services in connection with an activity attributable to 
DPGR. Thus, in the case of partnership-shared services, if the 
employees of one partnership perform services that give rise to DPGR 
for another partnership and both partnerships have common ownership, 
then some or all of the W-2 wages should be treated as properly 
allocable to DPGR. The commentator further suggested that W-2 wages 
should be properly allocable to DPGR as long as the owner of the pass-
thru entity includes in its taxable income DPGR (as a distributive 
share of another pass-thru entity's DPGR) and deducts from its taxable 
income wages paid to employees (those employed by the pass-thru entity) 
whose services created that DPGR.
    As an alternative, the commentator suggested that owners of certain 
pass-thru entities be permitted to treat non-DPGR as DPGR for purposes 
of determining whether W-2 wages are properly allocable to DPGR. The 
commentator suggested that the activity attribution rules for 
qualifying in-kind partnerships in Sec.  1.199-3T(i)(7)(i), EAG 
partnerships in Sec.  1.199-3T(i)(8)(ii), and EAGs in Sec.  1.199-
7(a)(3) be extended to pass-thru entities with respect to gross 
receipts attributable to services performed by employees of a pass-thru 
entity if such gross receipts are taken into account as an item of 
income on a tax return in which the DPGR attributable to those services 
also is reported. The commentator believes the result of such a rule 
would be to recharacterize non-DPGR as DPGR if the activities giving 
rise to the employee wages contribute to generating DPGR that is 
reported on the same tax return as the wage deduction. Therefore, the 
pass-thru entity with the employees would be treated as engaged in a 
qualifying production activity to the extent of the W-2 wages and the 
W-2 wages would be treated as properly allocable to DPGR.
    The interplay between the TIPRA amendment to section 199(b)(2) and 
the

[[Page 8800]]

rules for qualifying in-kind partnerships under Sec.  1.199-3T(i)(7), 
EAG partnerships under Sec.  1.199-3T(i)(8), and EAGs under Sec.  
1.199-7 may reduce or eliminate the section 199 deduction for EAGs and 
partners in qualifying in-kind partnerships if one entity uses 
employees of another entity to perform activities giving rise to DPGR. 
In addition, even though Sec.  1.199-3(f) provides rules for contract 
manufacturing and certain government contracts, the TIPRA amendment to 
section 199(b)(2) may reduce or eliminate the section 199 deduction for 
taxpayers entering into such contracts because the contract 
manufacturer's W-2 wages are not attributed to the taxpayer.
    The commentator's suggestions would treat pass-thru entities more 
favorably than non-consolidated EAGs. In general, Sec.  1.199-7(a) and 
(b) provides that each member of an EAG calculates its own taxable 
income or loss, QPAI, and W-2 wages, which are then aggregated in 
determining the EAG's section 199 deduction. After the TIPRA amendment 
to section 199(b)(2), to qualify as W-2 wages within the meaning of 
Sec.  1.199-2T(e)(2), paragraph (e)(1) wages must be properly allocable 
to DPGR. Because each member of an EAG separately calculates its own 
items before they are aggregated by the EAG, the member having the 
paragraph (e)(1) wages must itself have DPGR to which the wages are 
properly allocable in order to qualify those wages as W-2 wages. 
Paragraph (e)(1) wages that are not properly allocable to DPGR of the 
member having the paragraph (e)(1) wages do not qualify as W-2 wages, 
even if the paragraph (e)(1) wages were paid in connection with another 
member's DPGR activities. Example 5 in Sec.  1.199-2T(e)(2)(iv) 
illustrates this point.
    Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) regarding 
a partner's or shareholder's share of W-2 wages from a partnership or S 
corporation for taxable years beginning after May 17, 2006. After 
TIPRA, the section 199(d)(1)(A)(iii) rule for determining a partner's 
or shareholder's share of W-2 wages from a pass-thru entity no longer 
includes the second prong of the former two-prong standard, by which a 
partner's or shareholder's share of W-2 wages from the partnership or S 
corporation was limited to the lesser of that person's allocable share 
of W-2 wages from the entity or a specified percentage of the person's 
QPAI, computed by taking into account only the items of the entity 
allocated to that person for the taxable year of the entity. Before 
TIPRA, if the employees of a partnership performed services that gave 
rise to DPGR for another entity, but the partnership had no DPGR, then 
under the section 199(d)(1)(A)(iii) wage limitation, a partner could 
not take into account any W-2 wages from the partnership. After TIPRA, 
if the partner uses the section 861 method of cost allocation under 
Sec.  1.199-4(d), the partner cannot take into account any W-2 wages 
from the partnership because the W-2 wages do not generate DPGR in the 
partnership. Thus, in the case of partnership-shared services where the 
partner uses the section 861 method, the TIPRA amendment to section 
199(b)(2) retains the result that the partner cannot take into account 
any W-2 wages from the partnership in applying the wage limitation 
under section 199(b)(1).
    Moreover, the TIPRA amendment modified the W-2 wage limitation to 
narrow the availability of the section 199 deduction. The commentator's 
suggestions would allow more taxpayers to claim the section 199 
deduction and increase the amount of the deduction for some taxpayers, 
which conflicts with the changes made by TIPRA. Accordingly, the final 
regulations do not adopt the commentator's suggestions.
    In finalizing Sec.  1.199-5, certain clarifying changes have been 
made and conforming clarifications have been made to Sec.  1.199-9.
    As described in the preamble to the final and temporary regulations 
on the TIPRA amendments to section 199, published on October 19, 2006 
(TD 9293, 71 FR 61662), the combination of the aggregation rules for 
determining the taxable income of an EAG in Sec.  1.199-7(b)(1) of the 
June 1, 2006 final regulations (TD 9263, 71 FR 31268) and the rules of 
section 172 for net operating loss deductions could cause the 
unintended result of the same loss being used twice in determining the 
taxable income limitation under section 199(a)(1)(B). To eliminate this 
unintended result, Sec.  1.199-7T(b)(4) was promulgated to prevent a 
loss that was used in the year it was sustained in determining any 
EAG's taxable income for purposes of the taxable income limitation 
under section 199(a)(1)(B) from being used again as either a carryover 
or carryback to any taxable year in determining the taxable income 
limitation under section 199(a)(1)(B). No comments were received on the 
provisions of Sec.  1.199-7T(b)(4) and those provisions are finalized 
without change.

Effective/Applicability Dates

    Section 199 applies to taxable years beginning after December 31, 
2004. Sections 1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 are 
applicable for taxable years beginning on or after October 19, 2006 
(the effective date of the temporary regulations). A taxpayer may apply 
Sec. Sec.  1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 to taxable 
years beginning after May 17, 2006, and before October 19, 2006, 
regardless of whether the taxpayer otherwise relied upon Notice 2005-14 
(2005-1 CB 498) (see Sec.  601.601(d)(2)(ii)(b)), the provisions of 
REG-105847-05 (2005-2 CB 987), or Sec. Sec.  1.199-1 through 1.199-8. 
Section 1.199-7(b)(4) is applicable for taxable years beginning on or 
after February 15, 2008.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to this regulation, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding this regulation has been submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal authors of these regulations are Paul Handleman and 
Lauren Ross Taylor, Office of the Associate Chief Counsel (Passthroughs 
and Special Industries), IRS. However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 2. Section 1.199-0 is amended by adding new entries for Sec. Sec.  
1.199-2(e)(2), 1.199-3(i)(7), 1.199-3(i)(8), 1.199-5, and 1.199-7(b)(4) 
to read as follows:


Sec.  1.199-0  Table of contents.

* * * * *

[[Page 8801]]

Sec.  1.199-2 Wage limitation.

* * * * *
    (e) * * *
    (2) Limitation on W-2 wages for taxable years beginning after 
May 17, 2006, the enactment date of the Tax Increase Prevention and 
Reconciliation Act of 2005.
    (i) In general.
    (ii) Wage expense safe harbor.
    (A) In general.
    (B) Wage expense included in cost of goods sold.
    (iii) Small business simplified overall method safe harbor.
    (iv) Examples.
* * * * *
Sec.  1.199-3 Domestic production gross receipts.

* * * * *
    (i) * * *
    (7) Qualifying in-kind partnership for taxable years beginning 
after May 17, 2006, the enactment date of the Tax Increase 
Prevention and Reconciliation Act of 2005.
    (i) In general.
    (ii) Definition of qualifying in-kind partnership.
    (iii) Other rules.
    (iv) Example.
    (8) Partnerships owned by members of a single expanded 
affiliated group for taxable years beginning after May 17, 2006, the 
enactment date of the Tax Increase Prevention and Reconciliation Act 
of 2005.
    (i) In general.
    (ii) Attribution of activities.
    (A) In general.
    (B) Attribution between EAG partnerships.
    (C) Exceptions to attribution.
    (iii) Other rules.
    (iv) Examples.
* * * * *
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.
    (b) Partnerships.
    (1) In general.
    (i) Determination at partner level.
    (ii) Determination at entity level.
    (2) Disallowed losses or deductions.
    (3) Partner's share of paragraph (e)(1) wages.
    (4) Transition rule for definition of W-2 wages and for W-2 wage 
limitation.
    (5) Partnerships electing out of subchapter K.
    (6) Examples.
    (c) S corporations.
    (1) In general.
    (i) Determination at shareholder level.
    (ii) Determination at entity level.
    (2) Disallowed losses and deductions.
    (3) Shareholder's share of paragraph (e)(1) wages.
    (4) Transition rule for definition of W-2 wages and for W-2 wage 
limitation.
    (d) Grantor trusts.
    (e) Non-grantor trusts and estates.
    (1) Allocation of costs.
    (2) Allocation among trust or estate and beneficiaries.
    (i) In general.
    (ii) Treatment of items from a trust or estate reporting 
qualified production activities income.
    (3) Transition rule for definition of W-2 wages and for W-2 wage 
limitation.
    (4) Example.
    (f) Gain or loss from the disposition of an interest in a pass-
thru entity.
    (g) No attribution of qualified activities.
* * * * *
Sec.  1.199-7 Expanded affiliated groups.

* * * * *
    (b) * * *
    (4) Losses used to reduce taxable income of expanded affiliated 
group.
    (i) In general.
    (ii) Examples.
* * * * *
Sec.  1.199-8 Other rules.

* * * * *
    (i) * * *
    (5) Tax Increase Prevention and Reconciliation Act of 2005.
    (6) Losses used to reduce taxable income of expanded affiliated 
group.
* * * * *


Sec.  1.199-1  [Amended]

0
Par. 3. Section 1.199-1 is amended by removing the language ``Sec.  
1.199-9(d)'' in paragraphs (d)(3)(i) and (ii) and adding the language 
``Sec.  1.199-5(d) or Sec.  1.199-9(d)'' in its place.

0
Par. 4. Section 1.199-2 is amended by revising paragraph (e)(2) to read 
as follows:


Sec.  1.199-2  Wage limitation.

* * * * *
    (e) * * *
    (2) Limitation on W-2 wages for taxable years beginning after May 
17, 2006, the enactment date of the Tax Increase Prevention and 
Reconciliation Act of 2005--(i) In general. The term W-2 wages includes 
only amounts described in paragraph (e)(1) of this section (paragraph 
(e)(1) wages) that are properly allocable to domestic production gross 
receipts (DPGR) (as defined in Sec.  1.199-3) for purposes of section 
199(c)(1). A taxpayer may determine the amount of paragraph (e)(1) 
wages that is properly allocable to DPGR using any reasonable method 
that is satisfactory to the Secretary based on all of the facts and 
circumstances.
    (ii) Wage expense safe harbor--(A) In general. A taxpayer using 
either the section 861 method of cost allocation under Sec.  1.199-4(d) 
or the simplified deduction method under Sec.  1.199-4(e) may determine 
the amount of paragraph (e)(1) wages that is properly allocable to DPGR 
for a taxable year by multiplying the amount of paragraph (e)(1) wages 
for the taxable year by the ratio of the taxpayer's wage expense 
included in calculating qualified production activities income (QPAI) 
(as defined in Sec.  1.199-1(c)) for the taxable year to the taxpayer's 
total wage expense used in calculating the taxpayer's taxable income 
(or adjusted gross income, if applicable) for the taxable year, without 
regard to any wage expense disallowed by section 465, 469, 704(d), or 
1366(d). A taxpayer that uses the section 861 method of cost allocation 
under Sec.  1.199-4(d) or the simplified deduction method under Sec.  
1.199-4(e) to determine QPAI must use the same expense allocation and 
apportionment methods that it uses to determine QPAI to allocate and 
apportion wage expense for purposes of this safe harbor. For purposes 
of this paragraph (e)(2)(ii), the term wage expense means wages (that 
is, compensation paid by the employer in the active conduct of a trade 
or business to its employees) that are properly taken into account 
under the taxpayer's method of accounting.
    (B) Wage expense included in cost of goods sold. For purposes of 
paragraph (e)(2)(ii)(A) of this section, a taxpayer may determine its 
wage expense included in cost of goods sold (CGS) using any reasonable 
method that is satisfactory to the Secretary based on all of the facts 
and circumstances, such as using the amount of direct labor included in 
CGS or using section 263A labor costs (as defined in Sec.  1.263A-
1(h)(4)(ii)) included in CGS.
    (iii) Small business simplified overall method safe harbor. A 
taxpayer that uses the small business simplified overall method under 
Sec.  1.199-4(f) may use the small business simplified overall method 
safe harbor for determining the amount of paragraph (e)(1) wages that 
is properly allocable to DPGR. Under this safe harbor, the amount of 
paragraph (e)(1) wages that is properly allocable to DPGR is equal to 
the same proportion of paragraph (e)(1) wages that the amount of DPGR 
bears to the taxpayer's total gross receipts.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (e)(2). See Sec.  1.199-5(e)(4) for an example of the 
application of paragraph (e)(2)(ii) of this section to a trust or 
estate. The examples read as follows:

    Example 1. Section 861 method and no EAG. (i) Facts. X, a United 
States corporation that is not a member of an expanded affiliated 
group (EAG) (as defined in Sec.  1.199-7) or an affiliated group as 
defined in the regulations under section 861, engages in activities 
that generate both DPGR and non-DPGR. X's taxable year ends on April 
30, 2011. For X's taxable year ending April 30, 2011, X has $3,000 
of paragraph (e)(1) wages reported on 2010 Forms W-2. All of X's

[[Page 8802]]

production activities that generate DPGR are within Standard 
Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of 
X's production activities that generate non-DPGR are within SIC 
Industry Group BBB (SIC BBB). X is able to specifically identify 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 Sec.  1.861-17(a)(4) and none 
of the R&E is included in CGS. X incurs section 162 selling expenses 
that are not includible in CGS and are definitely related to all of 
X's gross income. For X's taxable year ending April 30, 2011, the 
adjusted basis of X's assets is $50,000, $40,000 of which generate 
gross income attributable to DPGR and $10,000 of which generate 
gross income attributable to non-DPGR. For X's taxable year ending 
April 30, 2011, the total square footage of X's headquarters is 
8,000 square feet, of which 2,000 square feet is set aside for 
domestic production activities. For its taxable year ending April 
30, 2011, X's taxable income is $1,380 based on the following 
Federal income tax items:

DPGR (all from sales of products within SIC AAA).............     $3,000
Non-DPGR (all from sales of products within SIC BBB).........      3,000
CGS allocable to DPGR (includes $200 of wage expense)........      (600)
CGS allocable to non-DPGR (includes $600 of wage expense)....    (1,800)
Section 162 selling expenses (includes $600 of wage expense).      (840)
Section 174 R&E-SIC AAA (includes $100 of wage expense)......      (300)
Section 174 R&E-SIC BBB (includes $200 of wage expense)......      (600)
Interest expense (not included in CGS).......................      (300)
Headquarters overhead expense (includes $100 of wage expense)      (180)
                                                              ----------
    X's taxable income.......................................      1,380
 

    (ii) X's QPAI. X allocates and apportions its deductions to 
gross income attributable to DPGR under the section 861 method in 
Sec.  1.199-4(d). In this case, the section 162 selling expenses and 
overhead expense are definitely related to all of X's gross income. 
Based on the facts and circumstances of this specific case, 
apportionment of the section 162 selling expenses between DPGR and 
non-DPGR on the basis of X's gross receipts is appropriate. In 
addition, based on the facts and circumstances of this specific 
case, apportionment of the headquarters overhead expense between 
DPGR and non-DPGR on the basis of the square footage of X's 
headquarters is appropriate. For purposes of apportioning R&E, X 
elects to use the sales method as described in Sec.  1.861-17(c). X 
elects to apportion interest expense under the tax book value method 
of Sec.  1.861-9T(g). X has $2,400 of gross income attributable to 
DPGR (DPGR of $3,000 - CGS of $600 allocated based on X's books and 
records). X's QPAI for its taxable year ending April 30, 2011, is 
$1,395, as shown in the following table:

DPGR (all from sales of products within SIC AAA)............     $3,000
CGS allocable to DPGR.......................................       (600)
Section 162 selling expenses ($840 x ($3,000 DPGR/$6,000           (420)
 total gross receipts)).....................................
Section 174 R&E-SIC AAA.....................................       (300)
Interest expense (not included in CGS) ($300 x ($40,000 (X's       (240)
 DPGR assets)/$50,000 (X's total assets)))..................
Headquarters overhead expense ($180 x (2,000 square feet            (45)
 attributable to DPGR activity/total 8,000 square feet))....
                                                             -----------
    X's QPAI................................................      1,395
 

    (iii) W-2 wages. X chooses to use the wage expense safe harbor 
under paragraph (e)(2)(ii) of this section to determine its W-2 
wages, as shown in the following steps:
    (A) Step one. X determines that $625 of wage expense were taken 
into account in determining its QPAI in paragraph (ii) of this 
Example 1, as shown in the following table:

CGS wage expense............................................       $200
Section 162 selling expenses wage expense ($600 x ($3,000           300
 DPGR/$6,000 total gross receipts)).........................
Section 174 R&E-SIC AAA wage expense........................        100
Headquarters overhead wage expense ($100 x (2,000 square             25
 feet attributable to DPGR activity/8,000 total square
 feet)).....................................................
                                                             -----------
    Total wage expense taken into account...................        625
 

    (B) Step two. X determines that $1,042 of the $3,000 in 
paragraph (e)(1) wages are properly allocable to DPGR, and are 
therefore W-2 wages, as shown in the following calculation:
Step one wage expense/X's total wage expense for taxable year ending 
April 30, 2011 x X's paragraph (e)(1) wages
$625/$1,800 x $3,000 = $1,042
    (iv) Section 199 deduction determination. X's tentative 
deduction under Sec.  1.199-1(a) (section 199 deduction) is $124 
(.09 x (lesser of QPAI of $1,395 or taxable income of $1,380)) 
subject to the wage limitation under section 199(b)(1) (W-2 wage 
limitation) of $521 (50% x $1,042). Accordingly, X's section 199 
deduction for its taxable year ending April 30, 2011, is $124.
    Example 2. Section 861 method and EAG. (i) Facts. The facts are 
the same as in Example 1 except that X owns stock in Y, a United 
States corporation, equal to 75% of the total voting power of the 
stock of Y and 80% of the total value of the stock of Y. X and Y are 
not members of an affiliated group as defined in section 1504(a). 
Accordingly, the rules of Sec.  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 Sec.  1.861-
11T(d)(6)) and are also members of an EAG. Y's taxable year ends 
April 30, 2011. For Y's taxable year ending April 30, 2011, Y has 
$2,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. For Y's 
taxable year ending April 30, 2011, the adjusted basis of Y's assets 
is $50,000, $20,000 of which generate gross income attributable to 
DPGR and $30,000 of which generate gross income attributable to non-
DPGR. 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 specifically 
identify 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 Y's taxable year 
ending April 30, 2011, the total square footage of Y's headquarters 
is 8,000 square feet, of which 2,000 square feet is set aside for 
domestic production activities. Y incurs section 162 selling 
expenses that are not includible in CGS and are definitely related 
to all of Y's gross income. For Y's taxable year ending April 30, 
2011, Y's taxable income is $1,710 based on the following Federal 
income tax items:

DPGR (all from sales of products within SIC AAA)............     $3,000
Non-DPGR (all from sales of products within SIC BBB)........      3,000
CGS allocated to DPGR (includes $300 of wage expense).......     (1,200)
CGS allocated to non-DPGR (includes $300 of wage expense)...     (1,200)
Section 162 selling expenses (includes $300 of wage expense)       (840)
Section 174 R&E-SIC AAA (includes $20 of wage expense)......       (100)
Section 174 R&E-SIC BBB (includes $60 of wage expense)......       (200)
Interest expense (not included in CGS and not subject to           (500)
 Sec.   1.861-10T)..........................................
Charitable contributions....................................        (50)
Headquarters overhead expense (includes $40 of wage expense)       (200)
                                                             -----------
    Y's taxable income......................................      1,710
 

    (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 Sec.  1.861-11T(c). Accordingly, X's QPAI for its 
taxable year ending April 30, 2011, is $1,455, as shown in the 
following table:

DPGR (all from sales of products within SIC AAA)............     $3,000
CGS allocated to DPGR.......................................       (600)
Section 162 selling expenses ($840 x ($3,000 DPGR/$6,000           (420)
 total gross receipts)).....................................
Section 174 R&E-SIC AAA.....................................       (300)
Interest expense (not included in CGS and not subject to           (180)
 Sec.   1.861-10T) ($300 x ($60,000 (tax book value of X's
 and Y's DPGR assets)/$100,000 (tax book value of X's and
 Y's total assets)))........................................

[[Page 8803]]

 
Headquarters overhead expense ($180 x (2,000 square feet            (45)
 attributable to DPGR activity/total 8,000 square feet))....
                                                             -----------
    X's QPAI................................................      1,455
 

    (B) Y's QPAI. Y makes the same elections under the section 861 
method as does X. Y has $1,800 of gross income attributable to DPGR 
(DPGR of $3,000-CGS of $1,200 allocated based on Y's gross 
receipts). Y's QPAI for its taxable year ending April 30, 2011, is 
$905, as shown in the following table:

DPGR (all from sales of products within SIC AAA)............     $3,000
CGS allocated to DPGR.......................................     (1,200)
Section 162 selling expenses ($840 x ($3,000 DPGR/$6,000           (420)
 total gross receipts)).....................................
Section 174 R&E-SIC AAA.....................................       (100)
Interest expense (not included in CGS and not subject to           (300)
 Sec.   1.861-10T) ($500 x ($60,000 (tax book value of X's
 and Y's DPGR assets)/$100,000 (tax book value of X's and
 Y's total assets)))........................................
Charitable contributions (not included in CGS) ($50 x               (25)
 ($1,800 gross income attributable to DPGR/$3,600 total
 gross income)).............................................
Headquarters overhead expense ($200 x (2,000 square feet            (50)
 attributable to DPGR activity/total 8,000 square feet))....
                                                             -----------
    Y's QPAI................................................        905
 

    (iii) W-2 wages. (A) X's W-2 wages. X's W-2 wages are $1,042, 
the same as in Example 1.
    (B) Y's W-2 wages. Y chooses to use the wage expense safe harbor 
under paragraph (e)(2)(ii) of this section to determine its W-2 
wages, as shown in the following steps:
    (1) Step one. Y determines that $480 of wage expense were taken 
into account in determining its QPAI in paragraph (ii)(B) of this 
Example 2, as shown in the following table:

CGS wage expense............................................       $300
Section 162 selling expenses wage expense ($300 x ($3,000           150
 DPGR/$6,000 total gross receipts)).........................
Section 174 R&E-SIC AAA wage expense........................         20
Headquarters overhead wage expense ($40 x (2,000 square feet         10
 attributable to DPGR activity/8,000 total square feet))....
                                                             -----------
    Total wage expense taken into account...................        480
 

    (2) Step two. Y determines that $941 of the $2,000 paragraph 
(e)(1) wages are properly allocable to DPGR, and are therefore W-2 
wages, as shown in the following calculation:
Step one wage expense/Y's total wage expense for taxable year ending 
April 30, 2011 x Y's paragraph (e)(1) wages
$480/$1,020 x $2,000 = $941
    (iv) Section 199 deduction determination. The section 199 
deduction of the X and Y EAG is determined by aggregating the 
separately determined taxable income, QPAI, and W-2 wages of X and 
Y. See Sec.  1.199-7(b). Accordingly, the X and Y EAG's tentative 
section 199 deduction is $212 (.09 x (lesser of combined QPAI of X 
and Y of $2,360 (X's QPAI of $1,455 plus Y's QPAI of $905) or 
combined taxable incomes of X and Y of $3,090 (X's taxable income of 
$1,380 plus Y's taxable income of $1,710)) subject to the combined 
W-2 wage limitation of X and Y of $992 (50% x ($1,042 (X's W-2 
wages) + $941 (Y's W-2 wages)))). Accordingly, the X and Y EAG's 
section 199 deduction is $212. The $212 is allocated to X and Y in 
proportion to their QPAI. See Sec.  1.199-7(c).
    Example 3. Simplified deduction method. (i) Facts. Z, a 
corporation that is not a member of an EAG, engages in activities 
that generate both DPGR and non-DPGR. Z is able to specifically 
identify CGS allocable to DPGR and to non-DPGR. Z's taxable year 
ends on April 30, 2011. For Z's taxable year ending April 30, 2011, 
Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, 
and Z's taxable income is $1,380 based on the following Federal 
income tax items:

DPGR.........................................................     $3,000
Non-DPGR.....................................................      3,000
CGS allocable to DPGR (includes $200 of wage expense)........      (600)
CGS allocable to non-DPGR (includes $600 of wage expense)....    (1,800)
Expenses, losses, or deductions (deductions) (includes $1,000    (2,220)
 of wage expense)............................................
                                                              ----------
    Z's taxable income.......................................      1,380
 

    (ii) Z's QPAI. Z uses the simplified deduction method under 
Sec.  1.199-4(e) to apportion deductions between DPGR and non-DPGR. 
Z's QPAI for its taxable year ending April 30, 2011, is $1,290, as 
shown in the following table:

DPGR.........................................................     $3,000
CGS allocable to DPGR........................................      (600)
Deductions apportioned to DPGR ($2,220 x ($3,000 DPGR/$6,000     (1,110)
 total gross receipts))......................................
                                                              ----------
    Z's QPAI.................................................      1,290
 

    (iii) W-2 wages. Z chooses to use the wage expense safe harbor 
under paragraph (e)(2)(ii) of this section to determine its W-2 
wages, as shown in the following steps:
    (A) Step one. Z determines that $700 of wage expense were taken 
into account in determining its QPAI in paragraph (ii) of this 
Example 3, as shown in the following table:

Wage expense included in CGS allocable to DPGR...............       $200
Wage expense included in deductions ($1,000 in wage expense x        500
 ($3,000 DPGR/$6,000 total gross receipts))..................
                                                              ----------
Wage expense allocable to DPGR...............................        700
 

    (B) Step two. Z determines that $1,167 of the $3,000 paragraph 
(e)(1) wages are properly allocable to DPGR, and are therefore W-2 
wages, as shown in the following calculation:
Step one wage expense / Z's total wage expense for taxable year 
ending April 30, 2011 x Z's paragraph (e)(1) wages
$700 / $1,800 x $3,000 = $1,167
    (iv) Section 199 deduction determination. Z's tentative section 
199 deduction is $116 (.09 x (lesser of QPAI of $1,290 or taxable 
income of $1,380)) subject to the W-2 wage limitation of $584 (50% x 
$1,167). Accordingly, Z's section 199 deduction for its taxable year 
ending April 30, 2011, is $116.
    Example 4. Small business simplified overall method. (i) Facts. 
Z, a corporation that is not a member of an EAG, engages in 
activities that generate both DPGR and non-DPGR. Z's taxable year 
ends on April 30, 2011. For Z's taxable year ending April 30, 2011, 
Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, 
and Z's taxable income is $1,380 based on the following Federal 
income tax items:

DPGR.........................................................     $3,000
Non-DPGR.....................................................      3,000
CGS and deductions...........................................    (4,620)
                                                              ----------
    Z's taxable income.......................................      1,380
 

    (ii) Z's QPAI. Z uses the small business simplified overall 
method under Sec.  1.199-4(f) to apportion CGS and deductions 
between DPGR and non-DPGR. Z's QPAI for its taxable year ending 
April 30, 2011, is $690, as shown in the following table:

DPGR.........................................................     $3,000
CGS and deductions apportioned to DPGR ($4,620 x ($3,000 DPGR/   (2,310)
 $6,000 total gross receipts))...............................
                                                              ----------
    Z's QPAI.................................................        690
 

    (iii) W-2 wages. Z's W-2 wages under paragraph (e)(2)(iii) of 
this section are $1,500, as shown in the following calculation:

$3,000 in paragraph (e)(1) wages x ($3,000 DPGR/$6,000 total      $1,500
 gross receipts).............................................
 

    (iv) Section 199 deduction determination. Z's tentative section 
199 deduction is $62 (.09 x (lesser of QPAI of $690 or taxable 
income of $1,380)) subject to the W-2 wage limitation of $750 (50% x 
$1,500). Accordingly, Z's section 199 deduction for its taxable year 
ending April 30, 2011, is $62.
    Example 5. Corporation uses employees of non-consolidated EAG 
member. (i) Facts. Corporations S and B are the only members of a 
single EAG but are not members of a consolidated group. S and B are 
both calendar year taxpayers. All the activities described in this 
Example 5 take place during the same taxable year and they are the 
only activities of S and B. S and B each use the section 861 method 
described in Sec.  1.199-4(d) for allocating and apportioning their 
deductions. B is a manufacturer but has only three employees of its 
own. S employs the remainder of the personnel who perform the 
manufacturing activities for B. S's only receipts are from supplying 
employees to B. In 2010, B manufactures qualifying production 
property (QPP) (as defined in Sec.  1.199-3(j)(1)), using its three 
employees and S's employees, and sells the QPP for $10,000,000. B's 
total CGS and other deductions are $6,000,000, including

[[Page 8804]]

$1,000,000 paid to S for the use of S's employees and $100,000 paid 
to its own employees. B reports the $100,000 paid to its employees 
on the 2010 Forms W-2 issued to its employees. S pays its employees 
$800,000 that is reported on the 2010 Forms W-2 issued to the 
employees.
    (ii) B's W-2 wages. In determining its W-2 wages, B utilizes the 
wage expense safe harbor described in paragraph (e)(2)(ii) of this 
section. The entire $100,000 paid by B to its employees is included 
in B's wage expense included in calculating its QPAI and is the only 
wage expense used in calculating B's taxable income. Thus, under the 
wage expense safe harbor described in paragraph (e)(2)(ii) of this 
section, B's W-2 wages are $100,000 ($100,000 (paragraph (e)(1) 
wages) x ($100,000 (wage expense used in calculating B's QPAI)/
$100,000 (wage expense used in calculating B's taxable income))).
    (iii) S's W-2 wages. In determining its W-2 wages, S utilizes 
the wage expense safe harbor described in paragraph (e)(2)(ii) of 
this section. Because S's $1,000,000 in receipts from B do not 
qualify as DPGR and are S's only gross receipts, none of the 
$800,000 paid by S to its employees is included in S's wage expense 
included in calculating its QPAI. However, the entire $800,000 is 
included in calculating S's taxable income. Thus, under the wage 
expense safe harbor described in paragraph (e)(2)(ii)(A) of this 
section, S's W-2 wages are $0 ($800,000 (paragraph (e)(1) wages) x 
($0 (wage expense used in calculating S's QPAI)/$800,000 (wage 
expense used in calculating S's taxable income))).
    (iv) Determination of EAG's section 199 deduction. The section 
199 deduction of the S and B EAG is determined by aggregating the 
separately determined taxable income or loss, QPAI, and W-2 wages of 
S and B. See Sec.  1.199-7(b). B's taxable income and QPAI are each 
$4,000,000 ($10,000,000 DPGR - $6,000,000 CGS and other deductions). 
S's taxable income is $200,000 ($1,000,000 gross receipts - $800,000 
total deductions). S's QPAI is $0 ($0 DPGR - $0 CGS and other 
deductions). B's W-2 wages (as calculated in paragraph (ii) of this 
Example 5) are $100,000 and S's W-2 wages (as calculated in 
paragraph (iii) of this Example 5) are $0. The EAG's tentative 
section 199 deduction is $360,000 (.09 x (lesser of combined QPAI of 
$4,000,000 (B's QPAI of $4,000,000 + S's QPAI of $0) or combined 
taxable income of $4,200,000 (B's taxable income of $4,000,000 + S's 
taxable income of $200,000))) subject to the W-2 wage limitation of 
$50,000 (50% x ($100,000 (B's W-2 wages) + $0 (S's W-2 wages))). 
Accordingly, the S and B EAG's section 199 deduction for 2010 is 
$50,000. The $50,000 is allocated to S and B in proportion to their 
QPAI. See Sec.  1.199-7(c). Because S has no QPAI, the entire 
$50,000 is allocated to B.
    Example 6. Corporation using employees of consolidated EAG 
member. The facts are the same as in Example 5 except that B and S 
are members of the same consolidated group. Ordinarily, as 
demonstrated in Example 5, S's $1,000,000 of receipts would not be 
DPGR and its $800,000 paid to its employees would not be W-2 wages 
(because the $800,000 would not be properly allocable to DPGR). 
However, because S and B are members of the same consolidated group, 
Sec.  1.1502-13(c)(1)(i) provides that the separate entity 
attributes of S's intercompany items or B's corresponding items, or 
both, may be redetermined 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, S and B would have QPAI and 
taxable income of $4,200,000 ($10,000,000 DPGR received from the 
sale of the QPP - $5,800,000 CGS and other deductions) and, under 
the wage expense safe harbor described in paragraph (e)(2)(ii) of 
this section, would have $900,000 of W-2 wages ($900,000 (combined 
paragraph (e)(1) wages of S and B) x ($900,000 (wage expense used in 
calculating QPAI)/$900,000 (wage expense used in calculating taxable 
income))). The single corporation would have a tentative section 199 
deduction equal to 9% of $4,200,000, or $378,000, subject to the W-2 
wage limitation of 50% of $900,000, or $450,000. Thus, the single 
corporation would have a section 199 deduction of $378,000. To 
obtain this same result for the consolidated group, S's $1,000,000 
of receipts from the intercompany transaction are redetermined as 
DPGR. Thus, S's $800,000 paid to its employees are costs properly 
allocable to DPGR and S's W-2 wages are $800,000. Accordingly, the 
consolidated group has QPAI and taxable income of $4,200,000 
($11,000,000 DPGR (from the sale of the QPP and the redetermined 
intercompany transaction) - $6,800,000 CGS and other deductions) and 
W-2 wages of $900,000. The consolidated group's section 199 
deduction is $378,000, the same as the single corporation. However, 
for purposes of allocating the section 199 deduction between S and 
B, the redetermination of S's income as DPGR under Sec.  1.1502-
13(c)(1)(i) is not taken into account. See Sec.  1.199-7(d)(5). 
Accordingly, the consolidated group's entire section 199 deduction 
of $378,000 is allocated to B.
* * * * *


Sec.  1.199-2T  [Removed]

0
Par. 5. Section 1.199-2T is removed.


0
Par. 6. Section 1.199-3 is amended by:
0
1. Revising the first sentence of paragraph (f)(1).
0
2. Adding the language ``paragraph (i)(8) of this section and'' before 
the language ``Sec.  1.199-9(j)'' in paragraph (g)(4)(ii)(B).
0
3. Adding the language ``paragraph (i)(7) of this section and'' before 
the language ``Sec.  1.199-9(i)'' in paragraph (g)(4)(ii)(D).
0
4. Revising paragraphs (i)(7) and (8).
0
5. Removing the language ``Sec.  1.199-9(e)'' in the last sentence of 
paragraph (m)(6)(iv)(B) and adding the language ``Sec. Sec.  1.199-5(e) 
and 1.199-9(e)'' in its place.
0
6. Revising the second and third sentences in paragraph (p).
    The revisions read as follows:


Sec.  1.199-3  Domestic production gross receipts.

* * * * *
    (f) * * * (1) In general. With the exception of the rules 
applicable to an expanded affiliated group (EAG) under Sec.  1.199-7, 
qualifying in-kind partnerships under paragraph (i)(7) of this section 
and Sec.  1.199-9(i), EAG partnerships under paragraph (i)(8) of this 
section and Sec.  1.199-9(j), and government contracts under paragraph 
(f)(2) of this section, only one taxpayer may claim the deduction under 
Sec.  1.199-1(a) with respect to any qualifying activity under 
paragraphs (e)(1), (k)(1), and (l)(1) of this section performed in 
connection with the same QPP, or the production of a qualified film or 
utilities. * * *
* * * * *
    (i) * * *
    (7) Qualifying in-kind partnership for taxable years beginning 
after May 17, 2006, the enactment date of the Tax Increase Prevention 
and Reconciliation Act of 2005--(i) In general. If a partnership is a 
qualifying in-kind partnership described in paragraph (i)(7)(ii) of 
this section, then each partner is treated as having MPGE or produced 
the property MPGE or produced by the partnership that is distributed to 
that partner. If a partner of a qualifying in-kind partnership derives 
gross receipts from the lease, rental, license, sale, exchange, or 
other disposition of the property that was MPGE or produced by the 
qualifying in-kind partnership and distributed to that partner, then, 
provided such partner is a partner of the qualifying in-kind 
partnership at the time the partner disposes of the property, the 
partner is treated as conducting the MPGE or production activities 
previously conducted by the qualifying in-kind partnership with respect 
to that property. With respect to a lease, rental, or license, the 
partner is treated as having disposed of the property on the date or 
dates on which it takes into account its gross receipts derived from 
the lease, rental, or license under its method of accounting. With 
respect to a sale, exchange, or other disposition, the partner is 
treated as having disposed of the property on the date it ceases to own 
the property for Federal income tax purposes, even if no gain or loss 
is taken into account.
    (ii) Definition of qualifying in-kind partnership. For purposes of 
this paragraph (i)(7), a qualifying in-kind partnership is a 
partnership engaged solely in--
    (A) The extraction, refining, or processing of oil, natural gas (as

[[Page 8805]]

described in paragraph (l)(2) of this section), petrochemicals, or 
products derived from oil, natural gas, or petrochemicals in whole or 
in significant part within the United States;
    (B) The production or generation of electricity in the United 
States; or
    (C) An activity or industry designated by the Secretary by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (iii) Other rules. Except as provided in this paragraph (i)(7), a 
qualifying in-kind partnership is treated the same as other 
partnerships for purposes of section 199. Accordingly, a qualifying in-
kind partnership is subject to the rules of this section regarding the 
application of section 199 to pass-thru entities, including application 
of the section 199(d)(1)(A)(iii) rule for determining a partner's share 
of the amounts described in Sec.  1.199-2(e)(1) (paragraph (e)(1) 
wages) from the partnership under Sec.  1.199-5(b)(3). In determining 
whether a qualifying in-kind partnership or its partners MPGE QPP in 
whole or in significant part within the United States, see paragraphs 
(g)(2) and (3) of this section.
    (iv) Example. The following example illustrates the application of 
this paragraph (i)(7). Assume that PRS and X are calendar year 
taxpayers. The example reads as follows:

    Example. X, Y, and Z are partners in PRS, a qualifying in-kind 
partnership described in paragraph (i)(7)(ii) of this section. X, Y, 
and Z are corporations. In 2007, PRS distributes oil to X that PRS 
derived from its oil extraction. PRS incurred $600 of CGS extracting 
the oil distributed to X, and X's adjusted basis in the distributed 
oil is $600. X incurs $200 of CGS in refining the oil within the 
United States. In 2007, X, while it is a partner in PRS, sells the 
oil to a customer for $1,500. X is treated as having disposed of the 
property on the date it ceases to own the property for Federal 
income tax purposes. Under paragraph (i)(7)(i) of this section, X is 
treated as having extracted the oil. The extraction and refining of 
the oil each qualify as an MPGE activity under paragraph (e)(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 it incurred. Thus, X's QPAI is 
$700 for 2007.

    (8) Partnerships owned by members of a single expanded affiliated 
group for taxable years beginning after May 17, 2006, the enactment 
date of the Tax Increase Prevention and Reconciliation Act of 2005--(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.
    (ii) Attribution of activities--(A) In general. If a member of an 
EAG (disposing member) derives gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of property that was MPGE 
or produced by an EAG partnership, all the partners of which are 
members of the same EAG to which the disposing member belongs at the 
time that the disposing member disposes of such property, then the 
disposing member is treated as conducting the MPGE or production 
activities previously conducted by the EAG partnership with respect to 
that property. The previous sentence applies only for those taxable 
years in which the disposing member is a member of the EAG of which all 
the partners of the EAG partnership are members for the entire taxable 
year of the EAG partnership. With respect to a lease, rental, or 
license, the disposing member is treated as having disposed of the 
property on the date or dates on which it takes into account its gross 
receipts from the lease, rental, or license under its method of 
accounting. With respect to a sale, exchange, or other disposition, the 
disposing member is treated as having disposed of the property on the 
date it ceases to own the property for Federal income tax purposes, 
even if no gain or loss is taken into account. Likewise, if an EAG 
partnership derives gross receipts from the lease, rental, license, 
sale, exchange, or other disposition of property that was MPGE or 
produced by a member (or members) of the same EAG (the producing 
member) to which all the partners of the EAG partnership belong at the 
time that the EAG partnership disposes of such property, then the EAG 
partnership is treated as conducting the MPGE or production activities 
previously conducted by the producing member with respect to that 
property. The previous sentence applies only for those taxable years in 
which the producing member is a member of the EAG of which all the 
partners of the EAG partnership are members for the entire taxable year 
of the EAG partnership. With respect to a lease, rental, or license, 
the EAG partnership is treated as having disposed of the property on 
the date or dates on which it takes into account its gross receipts 
derived from the lease, rental, or license under its method of 
accounting. With respect to a sale, exchange, or other disposition, the 
EAG partnership is treated as having disposed of the property on the 
date it ceases to own the property for Federal income tax purposes, 
even if no gain or loss is taken into account. See paragraph (i)(8)(iv) 
Example 3 of this section.
    (B) Attribution between EAG partnerships. If an EAG partnership 
(disposing partnership) derives gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of property that was MPGE 
or produced by another EAG partnership (producing partnership), then 
the disposing partnership is treated as conducting the MPGE or 
production activities previously conducted by the producing partnership 
with respect to that property, provided that each of these partnerships 
(the producing partnership and the disposing partnership) is owned for 
its entire taxable year in which the disposing partnership disposes of 
such property by members of the same EAG. With respect to a lease, 
rental, or license, the disposing partnership is treated as having 
disposed of the property on the date or dates on which it takes into 
account its gross receipts from the lease, rental, or license under its 
method of accounting. With respect to a sale, exchange, or other 
disposition, the disposing partnership is treated as having disposed of 
the property on the date it ceases to own the property for Federal 
income tax purposes, even if no gain or loss is taken into account.
    (C) Exceptions to attribution. Attribution of activities does not 
apply for purposes of the construction of real property under paragraph 
(m)(1) of this section and the performance of engineering and 
architectural services under paragraphs (n)(2) and (3) of this section, 
respectively.
    (iii) Other rules. Except as provided in this paragraph (i)(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 this section regarding the application of section 199 to pass-thru 
entities, including the section 199(d)(1)(A)(iii) rule under Sec.  
1.199-5(b)(3). In determining whether a member of an EAG or an EAG 
partnership MPGE QPP in whole or in significant part within the United 
States or produced a qualified film or produced utilities within the 
United States, see paragraphs (g)(2) and (3) of this section and 
Example 5 of paragraph (i)(8)(iv) of this section.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (i)(8). Assume that PRS, X, Y, and Z all are calendar year 
taxpayers. The examples read as follows:


[[Page 8806]]


    Example 1. Contribution. X and Y are the only partners in PRS, a 
partnership, for PRS's entire 2007 taxable year. X and Y are both 
members of a single EAG for the entire 2007 year. In 2007, X MPGE 
QPP within the United States and contributes the QPP to PRS. In 
2007, PRS sells the QPP for $1,000. Under this paragraph (i)(8), PRS 
is treated as having MPGE the QPP within the United States, and 
PRS's $1,000 gross receipts constitute DPGR. PRS, X, and Y must 
apply the rules of this section regarding the application of section 
199 to pass-thru entities with respect to the activity of PRS, 
including the section 199(d)(1)(A)(iii) rule for determining a 
partner's share of the paragraph (e)(1) wages from the partnership 
under Sec.  1.199-5(b)(3).
    Example 2. Sale. X, Y, and Z are the only members of a single 
EAG for the entire 2007 year. X and Y each own 50% of the capital 
and profits interests in PRS, a partnership, for PRS's entire 2007 
taxable year. In 2007, PRS MPGE QPP within the United States and 
then sells the QPP 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 
2007, X sells the QPP to customers for $10,000, incurring selling 
expenses of $2,000. Under paragraph (i)(8)(ii)(A) of this section, X 
is treated as having MPGE the QPP within the United States, and X's 
$10,000 of gross receipts qualify as DPGR. PRS, X and Y must apply 
the rules of this section regarding the application of section 199 
to pass-thru entities with respect to the activity of PRS, including 
application of the section 199(d)(1)(A)(iii) rule for determining a 
partner's share of the paragraph (e)(1) wages from the partnership 
under Sec.  1.199-5(b)(3). The results would be the same if PRS sold 
the QPP to Z rather than to X. However, if PRS did sell the QPP to 
Z, and Z was not a member of the EAG for PRS's entire taxable year, 
the activities previously conducted by PRS with respect to the QPP 
would not be attributed to Z, and none of Z's $10,000 of gross 
receipts would qualify as DPGR.
    Example 3. Lease. X, Y, and Z are the only members of a single 
EAG for the entire 2007 year. X and Y each own 50% of the capital 
and profits interests in PRS, a partnership, for PRS's entire 2007 
taxable year. In 2007, PRS MPGE QPP within the United States and 
then sells the QPP 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 
2007, X rents the QPP it acquired from PRS to customers unrelated to 
X. X takes the gross receipts attributable to the rental of the QPP 
into account under its method of accounting in 2007 and 2008. On 
July 1, 2008, X ceases to be a member of the same EAG to which Y, 
the other partner in PRS, belongs. For 2007, X is treated as having 
MPGE the QPP within the United States under paragraph (i)(8)(ii)(A) 
of this section, and its gross receipts derived from the rental of 
the QPP qualify as DPGR. For 2008, however, because X and Y, 
partners in PRS, are no longer members of the same EAG for the 
entire year, the gross rental receipts X takes into account in 2008 
do not qualify as DPGR.
    Example 4. Distribution. X and Y are the only partners in PRS, a 
partnership, for PRS's entire 2007 taxable year. X and Y are both 
members of a single EAG for the entire 2007 year. In 2007, PRS MPGE 
QPP within the United States, incurring $600 of CGS, and then 
distributes the QPP to X. X's adjusted basis in the QPP is $600. X 
incurs $200 of CGS to further MPGE the QPP within the United States. 
In 2007, X sells the QPP for $1,500 to an unrelated customer. X is 
treated as having disposed of the QPP on the date it ceases to own 
the QPP for Federal income tax purposes. Under paragraph 
(i)(8)(ii)(A) 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.
    Example 5. Multiple sales. (i) Facts. X and Y are the only 
partners in PRS, a partnership