[Federal Register Volume 71, Number 202 (Thursday, October 19, 2006)]
[Rules and Regulations]
[Pages 61662-61680]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-17402]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9293]
RIN 1545-BF88


TIPRA Amendments to Section 199

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations 
concerning the amendments made by the Tax Increase Prevention and 
Reconciliation Act of 2005 to section 199 of the Internal Revenue Code. 
The temporary 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 regulations will affect taxpayers engaged in certain 
domestic production activities. The text of the temporary regulations 
also serves as the text of the proposed regulations set forth in the 
notice of proposed rulemaking on this subject in the Proposed Rules 
section in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective October 19, 
2006.
    Applicability Date: For dates of applicability, see Sec.  1.199-
8T(i)(5) and (6).

FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec.  1.199-2T(e)(2) 
and 1.199-8T(i)(5), Paul Handleman or Lauren Ross Taylor, (202) 622-
3040; concerning Sec. Sec.  1.199-3T(i)(7) and (8), and 1.199-5T, 
Martin Schaffer, (202) 622-3080; and concerning Sec. Sec.  1.199-
7T(b)(4) and 1.199-8T(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) and section 514 of the 
Tax Increase Prevention and Reconciliation Act of 2005 (Pub. L. 109-
222, 120 Stat. 345) (TIPRA). On June 1, 2006, the IRS and Treasury 
Department published final regulations under section 199 (71 FR 31268). 
The preamble to the final regulations states that the IRS and Treasury 
Department plan on issuing regulations on the amendments made to 
section 199 by section 514 of TIPRA.

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)(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. 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.

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), as amended by section 514(b) of TIPRA, 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.

[[Page 61663]]

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

Explanation of Provisions

W-2 Wages Properly Allocable to Domestic Production Gross Receipts

    Section 514(a) of TIPRA amended section 199(b)(2) to provide that 
the term W-2 wages does not include any amount that is not properly 
allocable to DPGR for purposes of section 199(c)(1). The Secretary is 
authorized to provide rules for the proper allocation of items 
(including wages) in determining QPAI. See section 199(d)(8). The 
temporary regulations provide that for taxable years beginning after 
May 17, 2006, 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. The temporary regulations provide that 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.
    The temporary regulations provide safe harbors for determining the 
amount of paragraph (e)(1) wages that is properly allocable to DPGR. 
Under the wage expense safe harbor 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 in cost of goods sold (CGS) under this safe harbor, 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. For example, a reasonable method would include a 
taxpayer using direct labor included in CGS as wage expense included in 
CGS. Additionally, a reasonable method would include a taxpayer using 
the section 263A labor costs used by the taxpayer in its simplified 
service cost method with labor-based allocation ratio under Sec.  
1.263-1(h)(4)(ii) as wage expense included in CGS. Because CGS 
frequently includes goods manufactured in prior years, and thus would 
frequently include paragraph (e)(1) wages from prior years attributable 
to DPGR, the amount of paragraph (e)(1) wages in CGS that is properly 
allocable to DPGR may be difficult to determine. The IRS and Treasury 
Department request comments on appropriate safe harbors for determining 
the amount of paragraph (e)(1) wages in CGS that are properly allocable 
to DPGR.
    A taxpayer that uses the small business simplified overall method 
of cost allocation 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 that 
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.
    As a consequence of the amendment to section 199(b)(2) made by 
TIPRA and its interplay with the rules in Sec.  1.199-7(a) and (b) for 
the computation of an EAG's section 199 deduction, the section 199 
deduction for the members of an EAG may be reduced if one member of an 
EAG uses employees of another member of the EAG to perform activities 
attributable to DPGR and does not have paragraph (e)(1) wages. 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. 
Therefore, prior to the amendment to section 199(b)(2), in determining 
the wage limitation under section 199(b)(1) (the W-2 wage limitation), 
it was irrelevant which member of an EAG had the paragraph (e)(1) 
wages, because there was no requirement that paragraph (e)(1) wages be 
properly allocable to DPGR to qualify as W-2 wages, and the W-2 wages 
of all the members of an EAG are aggregated.
    For example, assume that X and Y are members of an EAG and do not 
join in the filing of a consolidated Federal income tax return. X has 
paragraph (e)(1) wages incurred in connection with Y's DPGR activities, 
but X has no DPGR itself. Further assume that Y has no paragraph (e)(1) 
wages. Prior to the amendment to section 199(b)(2), notwithstanding 
that X has no DPGR, X would have W-2 wages, because there was no 
requirement that paragraph (e)(1) wages be properly allocable to DPGR. 
Thus, the EAG would have W-2 wages, the same as if Y, rather than X, 
had the paragraph (e)(1) wages. Assuming the EAG had QPAI and taxable 
income, the EAG would receive a section 199 deduction.
    After the 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 to qualify as W-2 wages. 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. 
Thus, after the amendment to section 199(b)(2), X's paragraph (e)(1) 
wages do not qualify as W-2 wages, because X has no DPGR to which the 
paragraph (e)(1) wages would be properly allocable. Accordingly, as 
neither X nor Y has W-2 wages, the EAG has no W-2 wages and no section 
199 deduction. If Y had the paragraph (e)(1) wages rather than X, the 
EAG would have W-2 wages and a section 199 deduction.
    However, if X and Y join in the filing of a consolidated Federal 
income tax return, the results may differ. Section 1.1502-13(c)(1)(i) 
and (c)(4) requires that the separate entity attributes of X's and Y's 
intercompany items or corresponding items be redetermined to the extent 
necessary to produce the effect as if X and Y were divisions of a 
single corporation. Thus, Sec.  1.1502-13(c)(1)(i) and (c)(4) may apply 
to treat the paragraph (e)(1) wages incurred by X as W-2 wages. The 
temporary regulations provide examples to demonstrate the described 
scenarios.

Pass-Thru Entities

    Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) regarding 
a partner's or shareholder's share of W-2

[[Page 61664]]

wages from a partnership or S corporation for taxable years beginning 
after May 17, 2006. After TIPRA, the section 199(d)(1)(A)(iii) wage 
limitation for pass-thru entities no longer includes the second prong 
of a 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.
    Section 1.199-5T(b)(3) and (c)(3) provides guidance regarding a 
partner's or shareholder's share of W-2 wages of a partnership or an S 
corporation after the effective date of TIPRA. Except as provided by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b)), the partnership or S corporation must allocate 
its paragraph (e)(1) wages (including any such wages from a lower-tier 
partnership of which the partnership or S corporation is a partner) 
among its partners or shareholders in the same manner that wage expense 
is allocated among those partners or shareholders. The partner or 
shareholder must add its share of the paragraph (e)(1) wages from the 
partnership or S corporation to the partner's or shareholder's 
paragraph (e)(1) wages from other sources, if any. The partner (other 
than a partner that itself is a partnership or S corporation) or 
shareholder then must calculate its W-2 wages (as defined in Sec.  
1.199-2T(e)(2)) by determining the amount of its paragraph (e)(1) wages 
properly allocable to DPGR. See Sec.  1.199-2T(e)(2) for the 
computation of W-2 wages.
    Section 1.199-5T(e) requires a non-grantor trust or estate to 
calculate each beneficiary's share (as well as the trust's or estate's 
share, if any) of QPAI and W-2 wages from the trust or estate at the 
trust or estate level. The QPAI of a trust or estate 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.
    Because the second prong of the wage limitation of section 
199(d)(1)(A)(iii) was prospectively repealed by TIPRA, there is no 
longer any need for a special rule for tiered structures (where a pass-
thru entity owns an interest in another pass-thru entity). Accordingly, 
the rule in Sec.  1.199-9(g) of the final regulations regarding the 
section 199(d)(1)(A)(iii) wage limitation and tiered structures has not 
been included in these temporary regulations.
    The temporary regulations provide a transition rule for the 
situation in which a partner (or shareholder) and a partnership (or S 
corporation) have different taxable years, only one of which begins on 
or before the effective date of TIPRA. Under Sec.  1.199-5T(b)(4) and 
(c)(4), the beginning date of the taxable year of the partnership (or S 
corporation) determines which definition of W-2 wages and which W-2 
wage limitation for pass-thru entities apply.

Expanded Affiliated Groups

    After issuance of the final regulations, it was brought to the 
attention of the IRS and Treasury Department that the combination of 
the aggregation rules for determining the taxable income of an EAG in 
Sec.  1.199-7(b)(1) and the rules of section 172 for net operating loss 
(NOL) deductions can result in the same loss being used twice in 
determining the taxable income limitation under section 199(a)(1)(B). 
That is, in determining the taxable income limitation under section 
199(a)(1)(B), a loss sustained by a member of an EAG could be used in 
the year the loss is sustained to offset the taxable income of another 
member of the EAG in determining the EAG's taxable income limitation. 
However, because the EAG is not a separate taxpaying entity that files 
its own tax return, the member that sustained the loss would still have 
an NOL carryover or carryback. Thus, the loss could be used again as an 
NOL deduction of the member that sustained the loss in a previous or 
subsequent year to offset its own income, either as a member of the 
same EAG, a different EAG, or on a stand-alone basis. Because the 
section 199 deduction is a percentage of the lesser of QPAI or taxable 
income (subject to the W-2 wage limitation), the use of the same loss 
twice could potentially reduce the section 199 deduction that should be 
allowable.
    For example, assume that corporations X and Y are the only two 
members of an EAG and that X and Y do not file a consolidated Federal 
income tax return. In 2010, X and Y each have $100 of QPAI which, under 
Sec.  1.199-7(b), are aggregated in determining the EAG's QPAI. X has 
$100 of taxable income and Y has a $100 NOL, which are also aggregated 
in determining the EAG's taxable income for purposes of the taxable 
income limitation of section 199(a)(1)(B). Further assume that the EAG 
has sufficient W-2 wages so that the section 199 deduction is not 
limited under section 199(b)(1). Thus, although in 2010 the EAG has 
$200 of QPAI and sufficient W-2 wages so that the section 199 deduction 
is not limited under section 199(b)(1), as a result of the use of Y's 
NOL, the EAG has $0 of taxable income and no section 199 deduction. 
However, because the EAG is not a separate taxpaying entity, Y has an 
NOL of $100 which is available for carryover or carryback. In 2011, X 
has $100 of taxable income and Y, before the deduction allowed under 
section 172, has $300 of taxable income. Under section 172, Y reduces 
its 2011 taxable income of $300 by its 2010 NOL of $100, thus reducing 
Y's taxable income to $200. Y's loss was effectively used twice, first 
in 2010 to reduce the EAG's taxable income for purposes of the taxable 
income limitation of section 199(a)(1)(B) and then in 2011 to reduce 
Y's own taxable income, which reduces the EAG's aggregate taxable 
income for purposes of the taxable income limitation.
    This result was not intended. Accordingly, Sec.  1.199-7T(b)(4) has 
been added to provide that, to the extent that an NOL was used in the 
year it was sustained in determining any EAG's taxable income for 
purposes of the taxable income limitation of section 199(a)(1)(B), such 
NOL is not treated as an NOL carryover or NOL carryback to any taxable 
year in determining the taxable income limitation under section 
199(a)(1)(B). Thus, in the previous example, solely for purposes of 
determining the EAG's 2011 taxable income limitation under section 
199(a)(1)(B), Y would not have an NOL carryover from 2010, because the 
entire $100 NOL was used in 2010 to reduce the EAG's taxable income. 
Therefore, for purposes of determining the EAG's taxable income 
limitation in 2011, Y would have taxable income of $300 and the EAG 
would have aggregate taxable income of $400. The temporary regulations 
provide examples to illustrate this provision.

Effective Date

    Section 199 applies to taxable years beginning after December 31, 
2004. These temporary regulations are applicable for taxable years 
beginning on or after October 19, 2006. A taxpayer may apply Sec. Sec.  
1.199-2T(e)(2), 1.199-3T(i)(7) and (8), and 1.199-5T 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)), the provisions of REG-105847-05 (2005-
47 IRB 987) (see Sec.  601.601(d)(2)), or Sec. Sec.  1.199-1 through

[[Page 61665]]

1.199-8. A taxpayer may apply Sec.  1.199-7T(b)(4) to taxable years 
beginning after December 31, 2004, and before October 19, 2006 
regardless of whether the taxpayer otherwise relied upon Notice 2005-
14, the provisions of REG-105847-05, or Sec. Sec.  1.199-1 through 
1.199-9. The applicability of these temporary regulations expires on 
October 19, 2009.

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 these regulations. For 
applicability of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.), 
refer to the cross-reference notice of proposed rulemaking published 
elsewhere in this issue of the Federal Register. Pursuant to section 
7805(f) of the Code, these temporary regulations will be submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on their 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 is amended by adding 
entries in numerical order to read in part as follows:

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


0
Par. 2. Section 1.199-0 is amended by adding the following entries for 
Sec. Sec.  1.199-7(b)(4) and 1.199-8(i)(5) and (6):


Sec.  1.199-0  Table of contents.

* * * * *


Sec.  1.199-7  Expanded affiliated groups.

* * * * *
    (b) * * *
    (4) Losses used to reduce taxable income of expanded affiliated 
group. [Reserved].


Sec.  1.199-8  Other rules.

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

0
Par. 3. Section 1.199-2 is amended by adding a sentence at the end of 
paragraph (e)(2) to read as follows:


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. * * * For further guidance, see Sec.  
1.199-2T(e)(2).
* * * * *

0
Par. 4. Section 1.199-2T is added to read as follows:


1.199-2T  Wage limitation (temporary).

    (a) through (d) [Reserved]. For further guidance, see Sec.  1.199-
2(a) through (d).
    (e) Definition of W-2 wages--(1) In general. [Reserved]. For 
further guidance, see Sec.  1.199-2(e)(1).
    (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 Sec.  1.199-2(e)(1) (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.  1.199-5T for an example of the 
application of paragraph (e)(2)(ii) of this section to a trust or 
estate.

    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 
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

[[Page 61666]]

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                 (1,800)
 expense).............................................
Section 162 selling expenses (includes $600 of wage                (840)
 expense).............................................
Section 174 R&E-SIC AAA (includes $100 of wage                     (300)
 expense).............................................
Section 174 R&E-SIC BBB (includes $200 of wage                     (600)
 expense).............................................
Interest expense (not included in CGS)................             (300)
Headquarters overhead expense (includes $100 of wage               (180)
 expense).............................................
                                                       -----------------
    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/                 (420)
 $6,000 total gross receipts))........................
Section 174 R&E-SIC AAA...............................             (300)
Interest expense (not included in CGS) ($300 x                     (240)
 ($40,000 (X's DPGR assets)/$50,000 (X's total
 assets)))............................................
Headquarters overhead expense ($180 x (2,000 square                 (45)
 feet 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                    300
 ($3,000 DPGR/$6,000 total gross receipts))............
Section 174 R&E-SIC AAA wage expense...................              100
Headquarters overhead wage expense ($100 x (2,000                     25
 square 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:
[GRAPHIC] [TIFF OMITTED] TR19OC06.000

    a(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 stock 
of Y and 80% of the total value of stock of Y. X and Y are not 
members of an affiliated group as defined in section 1504(a). 
Accordingly, the rules of 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.

[[Page 61667]]

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                 (1,200)
 expense).............................................
Section 162 selling expenses (includes $300 of wage                (840)
 expense).............................................
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              (500)
 to Sec.   1.861-10T).................................
Charitable contributions..............................              (50)
Headquarters overhead expense (includes $40 of wage                (200)
 expense).............................................
                                                       -----------------
    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/                 (420)
 $6,000 total gross receipts))........................
Section 174 R&E-SIC AAA...............................             (300)
Interest expense (not included in CGS and not subject              (180)
 to 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))).......................
Headquarters overhead expense ($180 x (2,000 square                 (45)
 feet 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/                 (420)
 $6,000 total gross receipts))........................
Section 174 R&E-SIC AAA...............................             (100)
Interest expense (not included in CGS and not subject              (300)
 to 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                 (50)
 feet 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                    150
 ($3,000 DPGR/$6,000 total gross receipts))............
Section 174 R&E-SIC AAA wage expense...................               20
Headquarters overhead wage expense ($40 x (2,000 square               10
 feet 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:

[[Page 61668]]

[GRAPHIC] [TIFF OMITTED] TR19OC06.001

    a(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                 (1,800)
 expense).............................................
Expenses, losses, or deductions (deductions) (includes           (2,220)
 $1,000 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/           (1,110)
 $6,000 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                  500
 expense x ($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:
[GRAPHIC] [TIFF OMITTED] TR19OC06.002

    a(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
------------------------------------------------------------------------


[[Page 61669]]

    (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                 (2,310)
 ($3,000 DPGR/$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 gross 
receipts)--$1,500

    (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 members of the same EAG 
but are not members of a consolidated group. S and B are both 
calendar year taxpayers. All the activities described in this 
example 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 $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.

0
Par. 5. Section 1.199-3 is amended by adding a sentence at the end of 
each of paragraphs (i)(7) and (8) to read as follows:


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. * * * For further guidance, see Sec.  
1.199-3T(i)(7).
    (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. * * 
* For further guidance, see Sec.  1.199-3T(i)(8).
* * * * *

0
Par. 6. Section 1.199-3T is amended by adding paragraphs (i)(7) and (8) 
to read as follows:


Sec.  1.199-3T  Domestic production gross receipts (temporary).

* * * * *
    (i) * * *
    (7) Qualifying in-kind partnership for taxable years beginning 
after May 17,

[[Page 61670]]

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 manufactured, 
produced, grown, or extracted (MPGE) (as defined in Sec.  1.199-3(e)) 
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 
described in Sec.  1.199-3(l)(2)), 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) wage limitation under Sec.  1.199-
5T(b)(3). In determining whether a qualifying in-kind partnership or 
its partners MPGE qualifying production property (QPP) (as defined in 
Sec.  1.199-3(j)) in whole or in significant part within the United 
States (as defined in Sec.  1.199-3(h)), see Sec.  1.199-3(g)(2) and 
(3).
    (iv) Example. The following example illustrates the application of 
this paragraph (i)(7). Assume that PRS and X are calendar year 
taxpayers.

    Example. X, Y and Z are partners in PRS, a qualifying in-kind 
partnership described in paragraph (i)(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 qualify as an MPGE activity under Sec.  1.199-3(e)(1). 
Therefore, X's $1,500 of gross receipts qualify as DPGR. X subtracts 
from the $1,500 of DPGR the $600 of CGS incurred by PRS and the $200 
of refining costs 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 expanded affiliated group (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

[[Page 61671]]

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 Sec.  
1.199-3(m)(1) and the performance of engineering and architectural 
services under Sec.  1.199-3(n)(2) and (3), 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) wage limitation under 
Sec.  1.199-5T(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 Sec.  1.199-3(g)(2) and (3) 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.

    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) wage limitation under Sec.  
1.199-5T(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) wage limitation under 
Sec.  1.199-5T(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 directly allocable costs 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, for PRS's entire 2007 taxable year. 
X and Y are both non-consolidated members of a single EAG for the 
entire 2007 year. PRS produces in bulk form in the United States the 
active ingredient for a drug. Assume that PRS's own MPGE activity 
with respect to the active ingredient is not substantial in nature, 
taking into account all of the facts and circumstances, and PRS's 
direct labor and overhead to MPGE the active ingredient within the 
United States are $15 and account for 15% of PRS's $100 CGS of the 
active ingredient. In 2007, PRS sells the active ingredient in bulk 
form to X. X uses the active ingredient to produce the finished 
dosage form drug. Assume that X's own MPGE activity with respect to 
the drug is not substantial in nature, taking into account all of 
the facts and circumstances, and X's direct labor and overhead to 
MPGE the drug within the United States are $12 and account for 10% 
of X's $120 CGS of the drug. In 2007, X sells the drug in finished 
dosage to Y and Y sells the drug to customers. Assume that Y's own 
MPGE activity with respect to the drug is not substantial in nature, 
taking into account all of the facts and circumstances, and Y incurs 
$2 of direct labor and overhead and Y's CGS in selling the drug to 
customers is $130.
    (ii) Analysis. PRS's gross receipts from the sale of the active 
ingredient to X are non-DPGR because PRS's MPGE activity is not 
substantial in nature and PRS does not satisfy the safe harbor 
described in Sec.  1.199-3(g)(3) because PRS's direct labor and 
overhead account for less than 20% of PRS's CGS of the active 
ingredient. X's gross receipts from the sale of the drug to Y are 
DPGR because X is considered to have MPGE the drug in significant 
part in the United States pursuant to the safe harbor described in 
Sec.  1.199-3(g)(3) because the $27 ($15 + $12) of direct labor and 
overhead incurred by PRS and X equals or exceeds 20% of X's total 
CGS ($120) of the drug at the time X disposes of the drug to Y. 
Similarly, Y's gross receipts from the sale of the drug to customers 
are DPGR because Y is considered to have MPGE the drug in 
significant part in the United States pursuant to the safe harbor 
described in Sec.  1.199-3(g)(3) because the $29 ($15 + $12 + $2) of 
direct labor and overhead incurred by PRS, X, and Y equals or 
exceeds 20% of Y's total CGS ($130) of the drug at the time Y 
disposes of the drug to Y's customers.


0
Par. 7. Section 1.199-5 is amended by adding a sentence at the end to 
read as follows:


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.

    * * * For further guidance, see Sec.  1.199-5T.

0
Par. 8. Section 1.199-5T is added to read as follows:


Sec.  1.199-5T  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 (temporary).

    (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

[[Page 61672]]

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.  
1.199-2T(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) (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 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 section 
199 deduction 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 allowable losses or deductions that are allocated to the 
partnership's qualified production activities, determined in a manner 
consistent with sections 465, 469, and 704(d), and any other applicable 
provision of the Code, is taken into account in computing QPAI 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, 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.  
1.199-2T(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 on or before May 17, 
2006, the definition of W-2 wages of the partnership and the section 
199(d)(1)(A)(iii) limitation on W-2 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 paragraph (b) of this 
section 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.

    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

[[Page 61673]]

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-                  690
 DPGR)--$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/                 (300)
 $3,000 total gross receipts)).........................
Interest expense (not included in CGS) ($150 x ($2,000              (24)
 (X's 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
 (allocableCGS)).......................................
Gross income attributable to non-DPGR ($3,000 (other               1,380
 gross 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                     $3,000
 activities)...........................................
CGS allocable to DPGR ($810 from PRS and $900 from non-          (1,710)
 PRS activities).......................................

[[Page 61674]]

 
Section 162 selling expenses ($1,140 ($600 from PRS and            (456)
 $540 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            (192)
 PRS 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, apportionment of CGS between DPGR and non-
DPGR based on gross receipts is appropriate. 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 Sec.  1.861-17(a)(4) 
and none is included in CGS. For 2010, PRS has 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....................................................            2,400
Section 162 selling expenses...........................              840
Section 174 R&E-SIC AAA................................              300
Section 174 R&E-SIC BBB................................              600
------------------------------------------------------------------------

    (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)--$600              $900
 (CGS))................................................
Gross income attributable to non-DPGR ($1,500 (other                 900
 gross receipts)--$600 (CGS))..........................
Section 162 selling expenses...........................              420
Section 174 R&E-SIC AAA................................              150
Section 174 R&E-SIC BBB................................              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 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 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 Sec.  1.199-
4(d). In this case, the section 162 selling expenses 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 Sec.  1.861-17(c). Because X has no 
direct sales of products, and because all of PRS's SIC AAA sales 
attributable to X's share of PRS's gross income generate DPGR, all 
of X's share of PRS's section 174 R&E attributable to SIC AAA is 
taken into account for purposes of determining X's QPAI. Thus, X's 
total QPAI for 2010 is $540, as shown in the following table:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......           $1,500
CGS....................................................            (600)
Section 162 selling expenses ($420 x ($1,500 DPGR/                 (210)
 $3,000 total gross receipts)).........................
Section 174 R&E-SIC AAA................................            (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 non-PRS CGS is 
definitely related under the facts and circumstances to all of Y's 
non-PRS gross receipts, apportionment of non-PRS 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)...........           $1,500
DPGR (from sales of products within SIC BBB)...........            1,500
Non-DPGR (from sales of products within SIC BBB).......            3,000
CGS (allocated to DPGR within SIC AAA).................              750

[[Page 61675]]

 
CGS (allocated to DPGR within SIC BBB).................              750
CGS (allocated to non-DPGR within SIC BBB).............            1,500
Section 162 selling expenses...........................              540
Section 174 R&E-SIC AAA................................              300
Section 174 R&E-SIC BBB................................              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 Sec.  
1.199-4(d). In this case, the section 162 selling expenses 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 (including Y's share of PRS's gross receipts) is 
appropriate. For purposes of apportioning R&E, Y elects to use the 
sales method as described in Sec.  1.861-17(c).
    (3) With respect to sales that generate DPGR, Y has gross income 
of $2,400 ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS 
activities) - $2,100 CGS ($600 from sales of products by PRS and 
$1,500 from non-PRS activities)). Because all of the sales in SIC 
AAA generate DPGR, all of Y's share 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 in the 
following table:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR ($4,500 DPGR ($1,500 from PRS and $3,000 from non-           $4,500
 PRS activities))......................................
CGS ($600 from sales of products by PRS and $1,500 from          (2,100)
 non-PRS activities)...................................
Section 162 selling expenses ($960 ($420 from PRS +                (480)
 $540 from non-PRS activities) x ($4,500 DPGR/$9,000
 total gross receipts))................................
Section 174 R&E SIC AAA ($150 from PRS and $300 from               (450)
 non-PRS activities)...................................
Section 174 R&E-SIC BBB ($750 ($300 from PRS + $450                (188)
 from non-PRS activities) x ($1,500 DPGR/$6,000 total
 gross receipts allocated to SIC BBB ($1,500 from PRS +
 $4,500 from non-PRS activities))).....................
                                                        ----------------
    Y's QPAI...........................................            1,282
------------------------------------------------------------------------

    (iv) Determination of section 199 deduction. X's tentative 
section 199 deduction is $49 (.09 x $540, 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 $115 (.09 x $1,282) 
subject to the W-2 wage limitation.

    Example 3. Partnership with special allocations. (i) In general. 
X and Y are unrelated corporate partners in PRS and each is engaged 
in a trade or business. PRS is a partnership that engages in a 
domestic production activity and other activities. In general, X and 
Y share all partnership items of income, gain, loss, deduction, and 
credit equally, except that 80% of the wage expense of PRS and 20% 
of PRS's other expenses are specially allocated to X. Under all the 
facts and circumstances, these special allocations have substantial 
economic effect under section 704(b). 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 wage expense for 
marketing and $1,000 of other expenses). X qualifies for and uses 
the simplified deduction method under Sec.  1.199-4(e). Y does not 
qualify to use that method and, therefore, must use the section 861 
method under Sec.  1.199-4(d). In the 2010 taxable year, X has gross 
receipts attributable to non-partnership trade or business 
activities of $1,000 and wage expense of $200. None of X's non-PRS 
gross receipts is DPGR. For purposes of this example, with regard to 
both X and PRS, paragraph (e)(1) wages equal wage expense for the 
2010 taxable year.
    (ii) Allocation and apportionment of costs. Under the 
partnership agreement, X's distributive share of the Federal income 
tax items of PRS is $1,250 of gross income attributable to DPGR 
($3,000 DPGR - $1,750 allocable CGS), $750 of gross income 
attributable to non-DPGR ($1,000 non-DPGR - $250 allocable CGS), and 
$1,800 of deductions (comprised of X's special allocations of $1,600 
of wage expense ($2,000 x 80%) for marketing and $200 of other 
expenses ($1,000 x 20%)). Under the simplified deduction method, X 
apportions $1,200 of other deductions to DPGR ($2,000 ($1,800 from 
the partnership and $200 from non-partnership activities) x ($3,000 
DPGR/$5,000 total gross receipts)). Accordingly, X's QPAI is $50 
($3,000 DPGR - $1,750 CGS - $1,200 of deductions). X has $1,800 of 
paragraph (e)(1) wages ($1,600 (X's 80% share) from PRS + $200 (X's 
own non-PRS paragraph (e)(1) wages)). To calculate its W-2 wages, X 
must determine how much of this $1,800 is properly allocable under 
Sec.  1.199-2T(e)(2) to X's total DPGR (including X's share of DPGR 
from PRS). Thus, X's tentative section 199 deduction for the 2010 
taxable year is $5 (.09 x $50), subject to the W-2 wage limitation 
(50% of X's W-2 wages).

    Example 4. Partnership with no paragraph (e)(1) wages. (i) 
Facts. A and B, both individuals, are partners in PRS. PRS is a 
partnership that engages in manufacturing activities that generate 
both DPGR and non-DPGR. A and B share all items of income, gain, 
loss, deduction, and credit equally. For the 2010 taxable year, PRS 
has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of 
$400 and deductions of $800. PRS has no paragraph (e)(1) wages. Each 
partner's distributive share of PRS's Federal income tax items is 
$500 DPGR, $500 non-DPGR, $200 CGS, and $400 of deductions. A has 
trade or business activities outside of PRS (non-PRS activities). 
With respect to those activities, A has total gross receipts of 
$1,000 ($500 of which is DPGR), CGS of $400 (including $50 of 
paragraph (e)(1) wages), and deductions of $200 for the 2010 taxable 
year. B has no trade or business activities outside of PRS. A and B 
each use the small business simplified overall method under Sec.  
1.199-4(f).
    (ii) A's QPAI. A's total CGS and deductions apportioned to DPGR 
equal $600 (($1,200 ($200 PRS CGS + $400 non-PRS CGS + $400 PRS 
deductions + $200 non-PRS trade or business deductions)) x ($1,000 
total DPGR ($500 from PRS + $500 from non-PRS activities)/$2,000 
total gross receipts ($1,000 from PRS + $1,000 from non-PRS 
activities))). Accordingly, A's QPAI is $400 ($1,000 DPGR ($500 from 
PRS + $500 from non-PRS activities) - $600 CGS and deductions).
    (iii) A's W-2 wages and section 199 deduction. A has $50 of 
paragraph (e)(1) wages ($0 from PRS + $50 from A's non-PRS 
activities). To calculate A's W-2 wages, A determines, under a 
reasonable method satisfactory to the Secretary, that $40 of this 
$50 is properly allocable under Sec.  1.199-2T(e)(2) to A's DPGR 
from PRS and non-PRS activities. A's tentative section 199 deduction 
is $36 (.09 x $400), subject to the W-2 wage limitation of $20 (50% 
of W-2 wages of $40). Thus, A's section 199 deduction is $20.
    (iv) B's QPAI and section 199 deduction. B's CGS and deductions 
apportioned to DPGR equal $300 (($200 PRS CGS + $400 PRS deductions) 
x ($500 DPGR from PRS /$1,000 total gross receipts from PRS)). 
Accordingly, B's QPAI is $200 ($500 DPGR - $300 CGS and deductions). 
B's tentative section 199 deduction is $18 (.09 x $200), subject to 
the W-2 wage limitation. In this case, however, the limitation is 
$0, because B has no paragraph (e)(1) wages. Thus, B's section 199 
deduction is $0.

    Example 5. Guaranteed payment. (i) Facts. The facts are the same 
as in Example 4,

[[Page 61676]]

except that in 2010 PRS also makes a guaranteed payment of $200 to A 
for services rendered by A (see section 707(c)), and PRS incurs $200 
of wage expense for employees' salary, which is included within the 
$400 of CGS (in this case the wage expense of $200 equals PRS's 
paragraph (e)(1) wages). The guaranteed payment is taxable to A as 
ordinary income and is properly deducted by PRS under section 162. 
Pursuant to Sec.  1.199-3(p), A may not treat any part of this 
payment as DPGR. Accordingly, PRS has total gross receipts of $2,000 
($1,000 of which is DPGR), CGS of $400 (including $200 of wage 
expense) and deductions of $1,000 (including the $200 guaranteed 
payment) for the 2010 taxable year. Each partner's distributive 
share of the items of the partnership is $500 DPGR, $500 non-DPGR, 
$200 CGS (including $100 of wage expense), and $500 of deductions.
    (ii) A's QPAI and W-2 wages. A's total CGS and deductions 
apportioned to DPGR equal $591 ($1,300 ($200 PRS CGS + $400 non-PRS 
CGS + $500 PRS deductions + $200 non-PRS trade or business 
deductions) x ($1,000 total DPGR ($500 from PRS + $500 from non-PRS 
activities)/$2,200 total gross receipts ($1,000 from PRS + $200 
guaranteed payment + $1,000 from non-PRS activities))). Accordingly, 
A's QPAI is $409 ($1,000 DPGR - $591 CGS and other deductions). A's 
total paragraph (e)(1) wages are $150 ($100 from PRS + $50 from non-
PRS activities). To calculate its W-2 wages, A must determine how 
much of this $150 is properly allocable under Sec.  1.199-2T(e)(2) 
to A's total DPGR from PRS and non-PRS activities. A's tentative 
section 199 deduction is $37 (.09 x $409), subject to the W-2 wage 
limitation (50% of W-2 wages).
    (iii) B's QPAI and W-2 wages. B's QPAI is $150 ($500 DPGR - $350 
CGS and other deductions). B has $100 of paragraph (e)(1) wages (all 
from PRS). To calculate its W-2 wages, B must determine how much of 
this $100 is properly allocable under Sec.  1.199-2T(e)(2) to B's 
total DPGR. B's tentative section 199 deduction is $14 (.09 x $150), 
subject to the W-2 wage limitation (50% of B's W-2 wages).

    (c) S corporations--(1) In general--(i) Determination at 
shareholder level. The section 199 deduction with respect to the 
qualified production activities of an S corporation is determined at 
the shareholder level. As a result, each shareholder must compute its 
deduction separately. The section 199 deduction has no effect on the 
adjusted basis of a shareholder's stock in an S corporation. Except as 
provided by publication pursuant to paragraph (c)(1)(ii) of this 
section, for purposes of this section, each shareholder is allocated, 
in accordance with section 1366, its pro rata share of S corporation 
items (including items of income, gain, loss, and deduction), CGS 
allocated to such items of income, and gross receipts included in such 
items of income, even if the shareholder's share of CGS and other 
deductions and losses exceeds DPGR. Except as provided by publication 
under paragraph (c)(1)(ii) of this section, to determine its section 
199 deduction for the taxable year, the shareholder aggregates its pro 
rata share of such items, to the extent they are not otherwise 
disallowed by the Code, with those items it incurs outside the S 
corporation (whether directly or indirectly) for purposes of allocating 
and apportioning deductions to DPGR and computing its QPAI.
    (ii) Determination at entity level. The Secretary may, by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), permit an S corporation to 
calculate a shareholder's share of QPAI and W-2 wages at the entity 
level, instead of allocating to the shareholder, in accordance with 
section 1366, the shareholder's pro rata share of S corporation items 
(including items of income, gain, loss, and deduction) and paragraph 
(e)(1) wages. If an S corporation does calculate QPAI at the entity 
level--
    (A) Each shareholder is allocated its share of QPAI (subject to the 
limitations of paragraph (c)(2) of this section) and W-2 wages from the 
S corporation, which are combined with the shareholder's QPAI and W-2 
wages from other sources, if any;
    (B) For purposes of computing QPAI under Sec. Sec.  1.199-1 through 
1.199-8, a shareholder does not take into account the items from the S 
corporation (for example, a shareholder does not take into account 
items from the S corporation 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 shareholder generally does not recompute its share of QPAI 
from the S corporation using another method; however, the shareholder 
might have to adjust its share of QPAI from the S corporation to take 
into account certain disallowed losses or deductions, or the allowance 
of suspended losses or deductions; and
    (D) A shareholder's share of QPAI from an S corporation may be less 
than zero.
    (2) Disallowed losses or deductions. Except as provided by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), losses or deductions of the S 
corporation are taken into account in computing the shareholder's 
section 199 deduction for a taxable year only if, and to the extent 
that, the shareholder's pro rata share of the losses or deductions from 
all of the S corporation's activities is not disallowed by section 465, 
469, or 1366(d), or any other provision of the Code. If only a portion 
of the shareholder's share of the losses or deductions from an S 
corporation is allowed for a taxable year, a proportionate share of 
those allowable losses or deductions that are allocated to the S 
corporation's qualified production activities, determined in a manner 
consistent with sections 465, 469, and 1366(d), and any other 
applicable provision of the Code, is taken into account in computing 
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 
shareholder takes into account a proportionate share of those allowed 
losses or deductions that are allocated to the S corporation's 
qualified production activities in computing the shareholder's QPAI for 
that later taxable year. Losses or deductions of the S corporation that 
are disallowed for taxable years beginning on or before December 31, 
2004, are not taken into account in a later taxable year for purposes 
of computing the shareholder's QPAI for that later taxable year, 
whether or not the losses or deductions are allowed for other purposes.
    (3) Shareholder's share of paragraph (e)(1) wages. Under section 
199(d)(1)(A)(iii), an S corporation shareholder's share of the 
paragraph (e)(1) wages of the S corporation for purposes of determining 
the shareholder's W-2 wage limitation equals the shareholder'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 S corporation must allocate the paragraph (e)(1) wages 
among the shareholders in the same manner it allocates wage expense 
among those shareholders. The shareholder then must add its share of 
the paragraph (e)(1) wages from the S corporation to the shareholder's 
paragraph (e)(1) wages from other sources, if any, and then must 
determine the portion of those total paragraph (e)(1) wages allocable 
to DPGR to compute the shareholder's W-2 wages. See Sec.  1.199-
2T(e)(2) for the computation of W-2 wages and for the proper allocation 
of such wages to DPGR.
    (4) Transition rule for definition of W-2 wages and for W-2 wage 
limitation. If an S corporation and any of its shareholders have 
different taxable years, only one of which begins on or before May 17, 
2006, the definition of W-2 wages of the S corporation and the section 
199(d)(1)(A)(iii) limitation on W-2 wages from that S corporation is 
determined under the law applicable to

[[Page 61677]]

S corporations based on the beginning date of the S corporation's 
taxable year. Thus, for example, for the short taxable year of an S 
corporation beginning after May 17, 2006, and ending in 2006, a 
shareholder's share of W-2 wages from the S corporation is determined 
under section 199(d)(1)(A)(iii) for taxable years beginning after May 
17, 2006, even if that shareholder's taxable year began on or before 
May 17, 2006.
    (d) Grantor trusts. To the extent that the grantor or another 
person is treated as owning all or part (the owned portion) of a trust 
under sections 671 through 679, such person (owner) computes its QPAI 
with respect to the owned portion of the trust as if that QPAI had been 
generated by activities performed directly by the owner. Similarly, for 
purposes of the W-2 wage limitation, the owner of the trust takes into 
account the owner's share of the paragraph (e)(1) wages of the trust 
that are attributable to the owned portion of the trust. The provisions 
of paragraph (e) of this section do not apply to the owned portion of a 
trust.
    (e) Non-grantor trusts and estates--(1) Allocation of costs. The 
trust or estate calculates each beneficiary's share (as well as the 
trust's or estate's own share, if any) of QPAI and W-2 wages from the 
trust or estate at the trust or estate level. The beneficiary of a 
trust or estate may not recompute its share of QPAI or W-2 wages from 
the trust or estate by using another method to reallocate the trust's 
or estate's qualified production costs or paragraph (e)(1) wages, or 
otherwise. Except as provided in paragraph (d) of this section, the 
QPAI of a trust or estate must be computed by allocating expenses 
described in section 199(d)(5) in one of two ways, depending on the 
classification of those expenses under Sec.  1.652(b)-3. Specifically, 
directly attributable expenses within the meaning of Sec.  1.652(b)-3 
are allocated pursuant to Sec.  1.652(b)-3, and expenses not directly 
attributable within the meaning of Sec.  1.652(b)-3 (other expenses) 
are allocated under the simplified deduction method of Sec.  1.199-4(e) 
(unless the trust or estate does not qualify to use the simplified 
deduction method, in which case it must use the section 861 method of 
Sec.  1.199-4(d) with respect to such other expenses). For this 
purpose, depletion and depreciation deductions described in section 
642(e) and amortization deductions described in section 642(f) are 
treated as other expenses described in section 199(d)(5). Also for this 
purpose, the trust's or estate's share of other expenses from a lower-
tier pass-thru entity is not directly attributable to any class of 
income (whether or not those other expenses are directly attributable 
to the aggregate pass-thru gross income as a class for purposes other 
than section 199). A trust or estate may not use the small business 
simplified overall method for computing its QPAI. See Sec.  1.199-
4(f)(5).
    (2) Allocation among trust or estate and beneficiaries--(i) In 
general. The QPAI of a trust or estate (which will be less than zero if 
the CGS and deductions allocated and apportioned to DPGR exceed the 
trust's or estate's DPGR) and W-2 wages of a trust or estate are 
allocated to each beneficiary and to the trust or estate based on the 
relative proportion of the trust's or estate's distributable net income 
(DNI), as defined by section 643(a), for the taxable year that is 
distributed or required to be distributed to the beneficiary or is 
retained by the trust or estate. To the extent that the trust or estate 
has no DNI for the taxable year, any QPAI and W-2 wages are allocated 
entirely to the trust or estate. A trust or estate is allowed the 
section 199 deduction in computing its taxable income to the extent 
that QPAI and W-2 wages are allocated to the trust or estate. A 
beneficiary of a trust or estate is allowed the section 199 deduction 
in computing its taxable income based on its share of QPAI and W-2 
wages from the trust or estate, which are aggregated with the 
beneficiary's QPAI and W-2 wages from other sources, if any.
    (ii) Treatment of items from a trust or estate reporting qualified 
production activities income. When, pursuant to this paragraph (e), a 
taxpayer must combine QPAI and W-2 wages from a trust or estate with 
the taxpayer's total QPAI and W-2 wages from other sources, the 
taxpayer, when applying Sec. Sec.  1.199-1 through 1.199-8 to determine 
the taxpayer's total QPAI and W-2 wages from such other sources, does 
not take into account the items from such trust or estate. Thus, for 
example, a beneficiary of an estate that receives QPAI from the estate 
does not take into account the beneficiary's distributive share of the 
estate's gross receipts, gross income, or deductions when the 
beneficiary determines whether a threshold or de minimis rule applies 
or when the beneficiary allocates and apportions deductions in 
calculating its QPAI from other sources. Similarly, in determining the 
portion of the beneficiary's paragraph (e)(1) wages from other sources 
that is attributable to DPGR (thus, the W-2 wages from other sources), 
the beneficiary does not take into account DPGR and non-DPGR from the 
trust or estate.
    (3) Transition rule for definition of W-2 wages and for W-2 wage 
limitation. The definition of W-2 wages of a trust or estate and the 
section 199(d)(1)(A)(iii) limitation on W-2 wages from that trust or 
estate, and thus the beneficiary's share of W-2 wages from that trust 
or estate, is determined under the law applicable to pass-thru entities 
based on the beginning date of the taxable year of the trust or estate, 
regardless of the beginning date of the taxable year of the 
beneficiary.
    (4) Example. The following example illustrates the application of 
this paragraph (e). Assume that the partnership, trust, and trust 
beneficiary all are calendar year taxpayers.

    Example. (i) Computation of DNI and inclusion and deduction 
amounts. (A) Trust's distributive share of partnership items. Trust, 
a complex trust, is a partner in PRS, a partnership that engages in 
activities that generate DPGR and non-DPGR. In 2010, PRS distributes 
$10,000 cash to Trust. PRS properly allocates (in the same manner as 
wage expense) paragraph (e)(1) wages of $3,000 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          $10,000
 CGS (including wage expense of $1,000))...............
Gross income attributable to non-DPGR ($5,000 other                5,000
 gross receipts--$0 CGS)...............................
Selling expenses attributable to DPGR (includes wage               3,000
 expense of $2,000)....................................
Other expenses (includes wage expense of $1,000).......            2,000
------------------------------------------------------------------------

    (B) Trust's direct activities. Trust has direct paragraph (e)(1) 
wages of $2,000 for the 2010 taxable year. In addition to its cash 
distribution in 2010 from PRS, Trust also directly has the following 
items which are properly included in Trust's DNI:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Dividends..............................................          $10,000
Tax-exempt interest....................................           10,000
Rents from commercial real property operated by Trust             10,000
 as a business.........................................
Real estate taxes......................................            1,000

[[Page 61678]]

 
Trustee commissions....................................            3,000
State income and personal property taxes...............            5,000
Wage expense for rental business.......................            2,000
Other business expenses................................            1,000
------------------------------------------------------------------------

    (C) Allocation of deductions under Sec.  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 Sec.  1.652(b)-3(a) to the distributive share of 
income of PRS. Accordingly, the $5,000 of CGS, $3,000 of selling 
expenses, and $2,000 of other expenses are subtracted from the gross 
receipts from PRS ($20,000), resulting in net income from PRS of 
$10,000. With respect to the Trust's direct expenses, $1,000 of the 
trustee commissions, the $1,000 of real estate taxes, and the $2,000 
of wage expense are directly attributable under Sec.  1.652(b)-3(a) 
to the rental income.
    (2) Non-directly attributable expenses. Under Sec.  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 x ($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 Sec.  1.652(b)-3(b), the trustee 
allocates the entire amount of the remaining $5,778 of trustee 
commissions, state income and personal property taxes, and other 
business expenses to the $6,000 of net rental income, resulting in 
$222 ($6,000--$5,778) of net rental income.
    (D) Amounts included in taxable income. For 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 receives from Trust, B properly includes in 
B's gross income $5,000 of income from PRS, $111 of rents, and 
$5,000 of dividends, and properly excludes from B's gross income 
$3,889 of 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 Sec.  1.199-4(e). The determination of Trust's QPAI under the 
simplified deduction method requires multiple steps to allocate 
costs. First, the Trust's expenses directly attributable to DPGR 
under Sec.  1.652(b)-3(a) are subtracted from the Trust's DPGR. In 
this step, the directly attributable $5,000 of CGS and selling 
expenses of $3,000 are subtracted from the $15,000 of DPGR from PRS. 
Second, the Trust's expenses directly attributable under Sec.  
1.652(b)-3(a) to non-DPGR from a trade or business are subtracted 
from the Trust's trade or business non-DPGR. In this step, $4,000 of 
Trust expenses directly allocable to the real property rental 
activity ($1,000 of real estate taxes, $1,000 of Trustee 
commissions, and $2,000 of wages) are subtracted from the $10,000 of 
rental income. Third, Trust must identify the portion of its other 
expenses that is attributable to Trust's trade or business 
activities, if any, because expenses not attributable to trade or 
business activities are not taken into account in computing QPAI. In 
this step, in this example, the portion of the trustee commissions 
not directly attributable to the rental operation ($2,000) are 
directly attributable to non-trade or business activities. In 
addition, the state income and personal property taxes are not 
directly attributable under Sec.  1.652(b)-3(a) to either trade or 
business or non-trade or business activities, so the portion of 
those taxes not attributable to either the PRS interests or the 
rental operation are not trade or business expenses and, thus, are 
not taken into account 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 x $30,000 total trade or 
business gross receipts/$50,000 total gross receipts). Fourth, Trust 
then allocates its other trade or business expenses (not directly 
attributable under Sec.  1.652(b)-3(a)) between DPGR and non-DPGR on 
the basis of its total gross receipts from the conduct of a trade or 
business ($20,000 from PRS + $10,000 rental income). Thus, Trust 
combines its non-directly attributable (other) business expenses 
($2,000 from PRS + $4,000 ($1,000 of other business expenses + 
$3,000 of income and property taxes allocated to a trade or 
business) from its own activities) and then apportions this total 
($6,000) between DPGR and other receipts on the basis of Trust's 
total trade or business gross receipts ($6,000 of such expenses x 
$15,000 DPGR/$30,000 total trade or business gross receipts = 
$3,000). Thus, for purposes of computing Trust's and B's section 199 
deduction, Trust's QPAI is $4,000 ($7,000--$3,000). Because the 
distribution of Trust's DNI to B equals one-half of Trust's DNI, 
Trust and B each has QPAI from PRS for purposes of the section 199 
deduction of $2,000. B has $1,000 of QPAI from non-Trust activities 
that is added to the $2,000 QPAI from Trust for a total of $3,000 of 
QPAI.
    (B) W-2 wages. For the 2010 taxable year, Trust chooses to use 
the wage expense safe harbor under Sec.  1.199-2T(e)(2)(ii) to 
determine its W-2 wages. For its taxable year ending December 31, 
2010, Trust has $5,000 of paragraph (e)(1) wages reported on 2010 
Forms W-2. Trust's W-2 wages are $2,917, as shown in the following 
table:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Wage expense included in CGS directly attributable to             $1,000
 DPGR..................................................
Wage expense included in selling expense directly                  2,000
 attributable to DPGR..................................
Wage expense included in non-directly attributable                   500
 deductions ($1,000 in wage expense x ($15,000 DPGR/
 $30,000 total trade or business gross receipts))......
                                                        ----------------
Wage expense allocable to DPGR.........................            3,500
W-2 wages (($3,500 of wage expense allocable to DPGR/             $2,917
 $6,000 of total wage expense) x $5,000 in paragraph
 (e)(1) 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). Because the 
$14,000 Trust distribution to B equals one-half of Trust's DNI, B 
has W-2 wages from Trust of $1,459 (50% x $2,917). B has W-2 wages 
of $100 from non-Trust trade or business activities (computed 
without regard to B's interest in Trust pursuant to Sec.  1.199-
2(e)) for a total of $1,559 of W-2 wages. B has $1,000 of QPAI from 
non-Trust activities that is added to the $2,000 QPAI from Trust for 
a total of $3,000 of QPAI. B's tentative deduction is $270 (.09 x 
$3,000), limited under the W-2 wage limitation to $780 (50% x $1,559 
W-2 wages). Accordingly, B's section 199 deduction for 2010 is $270.
    (2) Trust's computation. Trust has sufficient adjusted gross 
income so that the section 199 deduction is not limited under 
section 199(a)(1)(B). Because the $14,000 Trust distribution to B 
equals one-half of Trust's DNI, Trust has W-2 wages of $1,459 (50% x 
$2,917). Trust's tentative deduction is $180 (.09 x $2,000 QPAI), 
limited under the W-2 wage limitation to $730 (50% x $1,459 W-2 
wages). Accordingly, Trust's section 199 deduction for 2010 is $180.

    (f) Gain or loss from the disposition of an interest in a pass-thru 
entity. DPGR generally does not include gain or loss recognized on the 
sale, exchange, or

[[Page 61679]]

other disposition of an interest in a pass-thru entity. However, with 
respect to a partnership, if section 751(a) or (b) applies, then gain 
or loss attributable to assets of the partnership giving rise to 
ordinary income under section 751(a) or (b), the sale, exchange, or 
other disposition of which would give rise to DPGR, is taken into 
account in computing the partner's section 199 deduction. Accordingly, 
to the extent that cash or property received by a partner in a sale or 
exchange of all or part of its partnership interest is attributable to 
unrealized receivables or inventory items within the meaning of section 
751(c) or (d), respectively, and the sale or exchange of the unrealized 
receivable or inventory items would give rise to DPGR if sold, 
exchanged, or otherwise disposed of by the partnership, the cash or 
property received by the partner is taken into account by the partner 
in determining its DPGR for the taxable year. Likewise, to the extent 
that a distribution of property to a partner is treated under section 
751(b) as a sale or exchange of property between the partnership and 
the distributee partner, and any property deemed sold or exchanged 
would give rise to DPGR if sold, exchanged, or otherwise disposed of by 
the partnership, the deemed sale or exchange of the property must be 
taken into account in determining the partnership's and distributee 
partner's DPGR to the extent not taken into account under the 
qualifying in-kind partnership rules. See Sec. Sec.  1.751-1(b) and 
1.199-3T(i)(7).
    (g) No attribution of qualified activities. Except as provided in 
Sec.  1.199-3T(i)(7) regarding qualifying in-kind partnerships and 
Sec.  1.199-3T(i)(8) regarding EAG partnerships, an owner of a pass-
thru entity is not treated as conducting the qualified production 
activities of the pass-thru entity, and vice versa. For example, if a 
partnership manufactures QPP within the United States, or produces a 
qualified film or produces utilities in the United States, and 
distributes or leases, rents, licenses, sells, exchanges, or otherwise 
disposes of such property to a partner who then, without performing its 
own qualifying activity, leases, rents, licenses, sells, exchanges, or 
otherwise disposes of such property, then the partner's gross receipts 
from this latter lease, rental, license, sale, exchange, or other 
disposition are treated as non-DPGR. In addition, if a partner 
manufactures QPP within the United States, or produces a qualified film 
or produces utilities in the United States, and contributes or leases, 
rents, licenses, sells, exchanges, or otherwise disposes of such 
property to a partnership which then, without performing its own 
qualifying activity, leases, rents, licenses, sells, exchanges, or 
otherwise disposes of such property, then the partnership's gross 
receipts from this latter disposition are treated as non-DPGR.

0
Par. 9. Section 1.199-7 is amended by adding new paragraph (b)(4) to 
read as follows:


Sec.  1.199-7  Expanded affiliated groups.

* * * * *
    (b) * * *
    (4) Losses used to reduce taxable income of expanded affiliated 
group. [Reserved]. For further guidance, see Sec.  1.199-7T(b)(4).
* * * * *

0
Par. 10. Section 1.199-7T is added to read as follows:


Sec.  1.199-7T  Expanded affiliated groups (temporary).

    (a) [Reserved]. For further guidance, see Sec.  1.199-7(a).
    (b) Computation of expanded affiliated group's section 199 
deduction.
    (1) through (3) [Reserved]. For further guidance, see Sec.  1.199-
7(b)(1) through (3).
    (4) Losses used to reduce taxable income of expanded affiliated 
group--(i) In general. The amount of a net operating loss (NOL) 
sustained by any member of an expanded affiliated group (EAG) (as 
defined in Sec.  1.199-7) that is used in the year sustained in 
determining an EAG's taxable income limitation under section 
199(a)(1)(B) is not treated as an NOL carryover or NOL carryback to any 
taxable year in determining the taxable income limitation under section 
199(a)(1)(B). For purposes of this paragraph (b)(4), an NOL is 
considered to be used if it reduces an EAG's aggregate taxable income, 
regardless of whether the use of the NOL actually reduces the amount of 
the deduction under Sec.  1.199-1(a) (section 199 deduction) that the 
EAG would otherwise derive. An NOL is not considered to be used to the 
extent that it reduces an EAG's aggregate taxable income to an amount 
less than zero. If more than one member of an EAG has an NOL used in 
the same taxable year to reduce the EAG's taxable income, the members' 
respective NOLs are deemed used in proportion to the amount of their 
NOLs.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (b)(4). For purposes of these examples, assume that all 
relevant parties have sufficient W-2 wages so that the section 199 
deduction is not limited under section 199(b)(1).
    Example 1. (i) Facts. Corporations A and B are the only two 
members of an EAG. A and B are both calendar year taxpayers and they 
do not join in the filing of a consolidated Federal income tax 
return. Neither A nor B had taxable income or loss prior to 2010. In 
2010, A has qualified production activities income (QPAI) (as 
defined in Sec.  1.199-1(c)) and taxable income of $1,000 and B has 
QPAI of $1,000 and an NOL of $1,500. In 2011, A has QPAI of $2,000 
and taxable income of $1,000 and B has QPAI of $2,000 and taxable 
income prior to the NOL deduction allowed under section 172 of 
$2,000.
    (ii) Section 199 deduction for 2010. In determining the EAG's 
section 199 deduction for 2010, A's $1,000 of QPAI and B's $1,000 of 
QPAI are aggregated, as are A's $1,000 of taxable income and B's 
$1,500 NOL. Thus, for 2010, the EAG has QPAI of $2,000 and taxable 
income of ($500). The EAG's section 199 deduction for 2010 is 9% of 
the lesser of its QPAI or its taxable income. Because the EAG has a 
taxable loss in 2010, the EAG's section 199 deduction is $0.
    (iii) Section 199 deduction for 2011. In determining the EAG's 
section 199 deduction for 2011, A's $2,000 of QPAI and B's $2,000 of 
QPAI are aggregated, giving the EAG QPAI of $4,000. Also, $1,000 of 
B's NOL from 2010 was used in 2010 to reduce the EAG's taxable 
income to $0. The remaining $500 of B's 2010 NOL is not considered 
to have been used in 2010 because it reduced the EAG's taxable 
income below $0. Accordingly, for purposes of determining the EAG's 
taxable income limitation under section 199(a)(1)(B) in 2011, B is 
deemed to have only a $500 NOL carryover from 2010 to offset a 
portion of its 2011 taxable income. Thus, B's taxable income in 2011 
is $1,500 which is aggregated with A's $1,000 of taxable income. The 
EAG's taxable income limitation in 2011 is $2,500. The EAG's section 
199 deduction is 9% of the lesser of its QPAI of $4,000 or its 
taxable income of $2,500. Thus, the EAG's section 199 deduction in 
2011 is 9% of $2,500, or $225. The results would be the same if 
neither A nor B had QPAI in 2010.

    Example 2. The facts are the same as in Example 1 except that in 
2010 B was not a member of the same EAG as A, but instead was a 
member of an EAG with Corporation X, which had QPAI and taxable 
income of $1,000 in 2010, and had neither taxable income nor loss in 
any other year. There were no other members of the EAG in 2010 
besides B and X, and B and X did not file a consolidated Federal 
income tax return. As $1,000 of B's NOL was used in 2010 to reduce 
the B and X EAG's taxable income to $0, B is considered to have only 
a $500 NOL carryover from 2010 to offset a portion of its 2011 
taxable income for purposes of the taxable income limitation under 
section 199(a)(1)(B), just as in Example 1. Accordingly, the results 
for the A and B EAG in 2011 are the same as in Example 1.

    Example 3. The facts are the same as in Example 1 except that B 
is not a member of any EAG in 2011. Because $1,000 of B's NOL was 
used in 2010 to reduce the EAG's taxable income to $0, B is 
considered to have only a $500 NOL carryover from 2010 to offset a 
portion of its 2011 taxable income for

[[Page 61680]]

purposes of the taxable income limitation under section 
199(a)(1)(B), just as in Example 1. Thus, for purposes of 
determining B's taxable income limitation in 2011, B is considered 
to have taxable income of $1,500, and B has a section 199 deduction 
of 9% of $1,500, or $135.

    Example 4. Corporations A, B, and C are the only members of an 
EAG. A, B, and C are all calendar year taxpayers and they do not 
join in the filing of a consolidated Federal income tax return. None 
of the EAG members (A, B, or C) had taxable income or loss prior to 
2010. In 2010, A has QPAI of $2,000 and taxable income of $1,000, B 
has QPAI of $1,000 and an NOL of $1,000, and C has QPAI of $1,000 
and an NOL of $3,000. In 2011, prior to the NOL deduction allowed 
under section 172, A and B each has taxable income of $200 and C has 
taxable income of $5,000. In determining the EAG's section 199 
deduction for 2010, A's QPAI of $2,000, B's QPAI of $1,000, and C's 
QPAI of $1,000 are aggregated, as are A's taxable income of $1,000, 
B's NOL of $1,000, and C's NOL of $3,000. Thus, for 2010, the EAG 
has QPAI of $4,000 and taxable income of ($3,000). In determining 
the EAG's taxable income limitation under section 199(a)(1)(B) in 
2011, $1,000 of B's and C's aggregate NOLs in 2010 of $4,000 are 
considered to have been used in 2010 to reduce the EAG's taxable 
income to $0, in proportion to their NOLs. Thus, $250 of B's NOL 
from 2010 ($1,000 x $1,000/$4,000) and $750 of C's NOL from 2010 
($1,000 x $3,000/$4,000) are deemed to have been used in 2010. The 
remaining $750 of B's NOL and the remaining $2,250 of C's NOL are 
not deemed to have been used because so doing would have reduced the 
EAG's taxable income in 2010 below $0. Accordingly, for purposes of 
determining the EAG's taxable income limitation in 2011, B is deemed 
to have a $750 NOL carryover from 2010 and C is deemed to have a 
$2,250 NOL carryover from 2010. Thus, for purposes of determining 
the EAG's taxable income limitation, B's taxable income in 2011 is 
$0 and C's taxable income in 2011 is $2,750, which are aggregated 
with A's $200 taxable income. B's unused NOL carryover from 2010 
cannot be used to reduce either A's or C's 2011 taxable income. 
Thus, the EAG's taxable income limitation in 2011 is $2,950, A's 
taxable income of $200 plus B's taxable income of $0 plus C's 
taxable income of $2,750.


0
Par. 11. Section 1.199-8 is amended by adding new paragraphs (i)(5) and 
(6) to read as follows:


Sec.  1.199-8  Other rules.

* * * * *
    (i) * * *
    (5) Tax Increase Prevention and Reconciliation Act of 2005. 
[Reserved]. For further guidance, see Sec.  1.199-8T(i)(5).
    (6) Losses used to reduce taxable income of expanded affiliated 
group. [Reserved]. For further guidance, see Sec.  1.199-8T(i)(6).

0
Par. 12. Section 1.199-8T is amended by adding new paragraphs (i)(5) 
and (6) to read as follows:


Sec.  1.199-8T  Other rules (temporary).

* * * * *
    (i) * * *
    (5) Tax Increase Prevention and Reconciliation Act of 2005. 
Sections 1.199-2T(e)(2), 1.199-3T(i)(7) and (8), and 1.199-5T are 
applicable for taxable years beginning on or after October 19, 2006. A 
taxpayer may apply Sec. Sec.  1.199-2T(e)(2), 1.199-3T(i)(7) and (8), 
and 1.199-5T 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) of this 
chapter), the provisions of REG-105847-05 (2005-47 IRB 987) (see Sec.  
601.601(d)(2) of this chapter), or Sec. Sec.  1.199-1 through 1.199-8. 
The applicability of Sec. Sec.  1.199-2T(e)(2), 1.199-3T(i)(7) and (8), 
and 1.199-5T expires on October 19, 2009.
    (6) Losses used to reduce taxable income of expanded affiliated 
group. Section 1.199-7T(b)(4) is applicable for taxable years beginning 
on or after October 19, 2006. A taxpayer may apply Sec.  1.199-7T(b)(4) 
to taxable years beginning after December 31, 2004, 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) of this 
chapter), the provisions of REG-105847-05 (2005-47 IRB 987) (see Sec.  
601.601(d)(2) of this chapter), or Sec. Sec.  1.199-1 through 1.199-9. 
The applicability of Sec.  1.199-7T(b)(4) expires on October 19, 2009.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: October 12, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. E6-17402 Filed 10-18-06; 8:45 am]
BILLING CODE 4830-01-P