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


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9381]
RIN 1545-BF79


TIPRA Amendments to Section 199

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

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

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

SUPPLEMENTARY INFORMATION:

Background

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

General Overview

    Section 199(a)(1) allows a deduction equal to 9 percent (3 percent 
in the case of taxable years beginning in 2005 or 2006, and 6 percent 
in the case of taxable years beginning in 2007, 2008, or 2009) of the 
lesser of (A) the qualified production activities income (QPAI) of the 
taxpayer for the taxable year, or (B) taxable income (determined 
without regard to section 199) for the taxable year (or, in the case of 
an individual, adjusted gross income (AGI)).
    Section 199(b)(1) limits the deduction for a taxable year to 50 
percent of the W-2 wages paid by the taxpayer during the calendar year 
that ends in such

[[Page 8799]]

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

Pass-thru Entities

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

Expanded Affiliated Groups

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

Authority to Prescribe Regulations

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

Summary of Comments

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

[[Page 8800]]

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

Effective/Applicability Dates

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

Special Analyses

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

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

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

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


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


Sec.  1.199-0  Table of contents.

* * * * *

[[Page 8801]]

Sec.  1.199-2 Wage limitation.

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

* * * * *
    (i) * * *
    (7) Qualifying in-kind partnership for taxable years beginning 
after May 17, 2006, the enactment date of the Tax Increase 
Prevention and Reconciliation Act of 2005.
    (i) In general.
    (ii) Definition of qualifying in-kind partnership.
    (iii) Other rules.
    (iv) Example.
    (8) Partnerships owned by members of a single expanded 
affiliated group for taxable years beginning after May 17, 2006, the 
enactment date of the Tax Increase Prevention and Reconciliation Act 
of 2005.
    (i) In general.
    (ii) Attribution of activities.
    (A) In general.
    (B) Attribution between EAG partnerships.
    (C) Exceptions to attribution.
    (iii) Other rules.
    (iv) Examples.
* * * * *
Sec.  1.199-5 Application of section 199 to pass-thru entities for 
taxable years beginning after May 17, 2006, the enactment date of 
the Tax Increase Prevention and Reconciliation Act of 2005.

    (a) In general.
    (b) Partnerships.
    (1) In general.
    (i) Determination at partner level.
    (ii) Determination at entity level.
    (2) Disallowed losses or deductions.
    (3) Partner's share of paragraph (e)(1) wages.
    (4) Transition rule for definition of W-2 wages and for W-2 wage 
limitation.
    (5) Partnerships electing out of subchapter K.
    (6) Examples.
    (c) S corporations.
    (1) In general.
    (i) Determination at shareholder level.
    (ii) Determination at entity level.
    (2) Disallowed losses and deductions.
    (3) Shareholder's share of paragraph (e)(1) wages.
    (4) Transition rule for definition of W-2 wages and for W-2 wage 
limitation.
    (d) Grantor trusts.
    (e) Non-grantor trusts and estates.
    (1) Allocation of costs.
    (2) Allocation among trust or estate and beneficiaries.
    (i) In general.
    (ii) Treatment of items from a trust or estate reporting 
qualified production activities income.
    (3) Transition rule for definition of W-2 wages and for W-2 wage 
limitation.
    (4) Example.
    (f) Gain or loss from the disposition of an interest in a pass-
thru entity.
    (g) No attribution of qualified activities.
* * * * *
Sec.  1.199-7 Expanded affiliated groups.

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

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


Sec.  1.199-1  [Amended]

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

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


Sec.  1.199-2  Wage limitation.

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

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

[[Page 8802]]

production activities that generate DPGR are within Standard 
Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of 
X's production activities that generate non-DPGR are within SIC 
Industry Group BBB (SIC BBB). X is able to specifically identify CGS 
allocable to DPGR and to non-DPGR. X incurs $900 of research and 
experimentation expenses (R&E) that are deductible under section 
174, $300 of which are performed with respect to SIC AAA and $600 of 
which are performed with respect to SIC BBB. None of the R&E is 
legally mandated R&E as described in Sec.  1.861-17(a)(4) and none 
of the R&E is included in CGS. X incurs section 162 selling expenses 
that are not includible in CGS and are definitely related to all of 
X's gross income. For X's taxable year ending April 30, 2011, the 
adjusted basis of X's assets is $50,000, $40,000 of which generate 
gross income attributable to DPGR and $10,000 of which generate 
gross income attributable to non-DPGR. For X's taxable year ending 
April 30, 2011, the total square footage of X's headquarters is 
8,000 square feet, of which 2,000 square feet is set aside for 
domestic production activities. For its taxable year ending April 
30, 2011, X's taxable income is $1,380 based on the following 
Federal income tax items:

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

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

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

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

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

    (B) Step two. X determines that $1,042 of the $3,000 in 
paragraph (e)(1) wages are properly allocable to DPGR, and are 
therefore W-2 wages, as shown in the following calculation:
Step one wage expense/X's total wage expense for taxable year ending 
April 30, 2011 x X's paragraph (e)(1) wages
$625/$1,800 x $3,000 = $1,042
    (iv) Section 199 deduction determination. X's tentative 
deduction under Sec.  1.199-1(a) (section 199 deduction) is $124 
(.09 x (lesser of QPAI of $1,395 or taxable income of $1,380)) 
subject to the wage limitation under section 199(b)(1) (W-2 wage 
limitation) of $521 (50% x $1,042). Accordingly, X's section 199 
deduction for its taxable year ending April 30, 2011, is $124.
    Example 2. Section 861 method and EAG. (i) Facts. The facts are 
the same as in Example 1 except that X owns stock in Y, a United 
States corporation, equal to 75% of the total voting power of the 
stock of Y and 80% of the total value of the stock of Y. X and Y are 
not members of an affiliated group as defined in section 1504(a). 
Accordingly, the rules of Sec.  1.861-14T do not apply to X's and 
Y's selling expenses, R&E, and charitable contributions. X and Y 
are, however, members of an affiliated group for purposes of 
allocating and apportioning interest expense (see Sec.  1.861-
11T(d)(6)) and are also members of an EAG. Y's taxable year ends 
April 30, 2011. For Y's taxable year ending April 30, 2011, Y has 
$2,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. For Y's 
taxable year ending April 30, 2011, the adjusted basis of Y's assets 
is $50,000, $20,000 of which generate gross income attributable to 
DPGR and $30,000 of which generate gross income attributable to non-
DPGR. All of Y's activities that generate DPGR are within SIC 
Industry Group AAA (SIC AAA). All of Y's activities that generate 
non-DPGR are within SIC Industry Group BBB (SIC BBB). None of X's 
and Y's sales are to each other. Y is not able to specifically 
identify CGS allocable to DPGR and non-DPGR. In this case, because 
CGS is definitely related under the facts and circumstances to all 
of Y's gross receipts, apportionment of CGS between DPGR and non-
DPGR based on gross receipts is appropriate. For Y's taxable year 
ending April 30, 2011, the total square footage of Y's headquarters 
is 8,000 square feet, of which 2,000 square feet is set aside for 
domestic production activities. Y incurs section 162 selling 
expenses that are not includible in CGS and are definitely related 
to all of Y's gross income. For Y's taxable year ending April 30, 
2011, Y's taxable income is $1,710 based on the following Federal 
income tax items:

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

    (ii) QPAI. (A) X's QPAI. Determination of X's QPAI is the same 
as in Example 1 except that interest is apportioned to gross income 
attributable to DPGR based on the combined adjusted bases of X's and 
Y's assets. See Sec.  1.861-11T(c). Accordingly, X's QPAI for its 
taxable year ending April 30, 2011, is $1,455, as shown in the 
following table:

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

[[Page 8803]]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[[Page 8804]]

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


Sec.  1.199-2T  [Removed]

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


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


Sec.  1.199-3  Domestic production gross receipts.

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

[[Page 8805]]

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

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

    (8) Partnerships owned by members of a single expanded affiliated 
group for taxable years beginning after May 17, 2006, the enactment 
date of the Tax Increase Prevention and Reconciliation Act of 2005--(i) 
In general. For purposes of this section, if all of the interests in 
the capital and profits of a partnership are owned by members of a 
single EAG at all times during the taxable year of the partnership (EAG 
partnership), then the EAG partnership and all members of that EAG are 
treated as a single taxpayer for purposes of section 199(c)(4) during 
that taxable year.
    (ii) Attribution of activities--(A) In general. If a member of an 
EAG (disposing member) derives gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of property that was MPGE 
or produced by an EAG partnership, all the partners of which are 
members of the same EAG to which the disposing member belongs at the 
time that the disposing member disposes of such property, then the 
disposing member is treated as conducting the MPGE or production 
activities previously conducted by the EAG partnership with respect to 
that property. The previous sentence applies only for those taxable 
years in which the disposing member is a member of the EAG of which all 
the partners of the EAG partnership are members for the entire taxable 
year of the EAG partnership. With respect to a lease, rental, or 
license, the disposing member is treated as having disposed of the 
property on the date or dates on which it takes into account its gross 
receipts from the lease, rental, or license under its method of 
accounting. With respect to a sale, exchange, or other disposition, the 
disposing member is treated as having disposed of the property on the 
date it ceases to own the property for Federal income tax purposes, 
even if no gain or loss is taken into account. Likewise, if an EAG 
partnership derives gross receipts from the lease, rental, license, 
sale, exchange, or other disposition of property that was MPGE or 
produced by a member (or members) of the same EAG (the producing 
member) to which all the partners of the EAG partnership belong at the 
time that the EAG partnership disposes of such property, then the EAG 
partnership is treated as conducting the MPGE or production activities 
previously conducted by the producing member with respect to that 
property. The previous sentence applies only for those taxable years in 
which the producing member is a member of the EAG of which all the 
partners of the EAG partnership are members for the entire taxable year 
of the EAG partnership. With respect to a lease, rental, or license, 
the EAG partnership is treated as having disposed of the property on 
the date or dates on which it takes into account its gross receipts 
derived from the lease, rental, or license under its method of 
accounting. With respect to a sale, exchange, or other disposition, the 
EAG partnership is treated as having disposed of the property on the 
date it ceases to own the property for Federal income tax purposes, 
even if no gain or loss is taken into account. See paragraph (i)(8)(iv) 
Example 3 of this section.
    (B) Attribution between EAG partnerships. If an EAG partnership 
(disposing partnership) derives gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of property that was MPGE 
or produced by another EAG partnership (producing partnership), then 
the disposing partnership is treated as conducting the MPGE or 
production activities previously conducted by the producing partnership 
with respect to that property, provided that each of these partnerships 
(the producing partnership and the disposing partnership) is owned for 
its entire taxable year in which the disposing partnership disposes of 
such property by members of the same EAG. With respect to a lease, 
rental, or license, the disposing partnership is treated as having 
disposed of the property on the date or dates on which it takes into 
account its gross receipts from the lease, rental, or license under its 
method of accounting. With respect to a sale, exchange, or other 
disposition, the disposing partnership is treated as having disposed of 
the property on the date it ceases to own the property for Federal 
income tax purposes, even if no gain or loss is taken into account.
    (C) Exceptions to attribution. Attribution of activities does not 
apply for purposes of the construction of real property under paragraph 
(m)(1) of this section and the performance of engineering and 
architectural services under paragraphs (n)(2) and (3) of this section, 
respectively.
    (iii) Other rules. Except as provided in this paragraph (i)(8), an 
EAG partnership is treated the same as other partnerships for purposes 
of section 199. Accordingly, an EAG partnership is subject to the rules 
of this section regarding the application of section 199 to pass-thru 
entities, including the section 199(d)(1)(A)(iii) rule under Sec.  
1.199-5(b)(3). In determining whether a member of an EAG or an EAG 
partnership MPGE QPP in whole or in significant part within the United 
States or produced a qualified film or produced utilities within the 
United States, see paragraphs (g)(2) and (3) of this section and 
Example 5 of paragraph (i)(8)(iv) of this section.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (i)(8). Assume that PRS, X, Y, and Z all are calendar year 
taxpayers. The examples read as follows:


[[Page 8806]]


    Example 1. Contribution. X and Y are the only partners in PRS, a 
partnership, for PRS's entire 2007 taxable year. X and Y are both 
members of a single EAG for the entire 2007 year. In 2007, X MPGE 
QPP within the United States and contributes the QPP to PRS. In 
2007, PRS sells the QPP for $1,000. Under this paragraph (i)(8), PRS 
is treated as having MPGE the QPP within the United States, and 
PRS's $1,000 gross receipts constitute DPGR. PRS, X, and Y must 
apply the rules of this section regarding the application of section 
199 to pass-thru entities with respect to the activity of PRS, 
including the section 199(d)(1)(A)(iii) rule for determining a 
partner's share of the paragraph (e)(1) wages from the partnership 
under Sec.  1.199-5(b)(3).
    Example 2. Sale. X, Y, and Z are the only members of a single 
EAG for the entire 2007 year. X and Y each own 50% of the capital 
and profits interests in PRS, a partnership, for PRS's entire 2007 
taxable year. In 2007, PRS MPGE QPP within the United States and 
then sells the QPP to X for $6,000, its fair market value at the 
time of the sale. PRS's gross receipts of $6,000 qualify as DPGR. In 
2007, X sells the QPP to customers for $10,000, incurring selling 
expenses of $2,000. Under paragraph (i)(8)(ii)(A) of this section, X 
is treated as having MPGE the QPP within the United States, and X's 
$10,000 of gross receipts qualify as DPGR. PRS, X and Y must apply 
the rules of this section regarding the application of section 199 
to pass-thru entities with respect to the activity of PRS, including 
application of the section 199(d)(1)(A)(iii) rule for determining a 
partner's share of the paragraph (e)(1) wages from the partnership 
under Sec.  1.199-5(b)(3). The results would be the same if PRS sold 
the QPP to Z rather than to X. However, if PRS did sell the QPP to 
Z, and Z was not a member of the EAG for PRS's entire taxable year, 
the activities previously conducted by PRS with respect to the QPP 
would not be attributed to Z, and none of Z's $10,000 of gross 
receipts would qualify as DPGR.
    Example 3. Lease. X, Y, and Z are the only members of a single 
EAG for the entire 2007 year. X and Y each own 50% of the capital 
and profits interests in PRS, a partnership, for PRS's entire 2007 
taxable year. In 2007, PRS MPGE QPP within the United States and 
then sells the QPP to X for $6,000, its fair market value at the 
time of the sale. PRS's gross receipts of $6,000 qualify as DPGR. In 
2007, X rents the QPP it acquired from PRS to customers unrelated to 
X. X takes the gross receipts attributable to the rental of the QPP 
into account under its method of accounting in 2007 and 2008. On 
July 1, 2008, X ceases to be a member of the same EAG to which Y, 
the other partner in PRS, belongs. For 2007, X is treated as having 
MPGE the QPP within the United States under paragraph (i)(8)(ii)(A) 
of this section, and its gross receipts derived from the rental of 
the QPP qualify as DPGR. For 2008, however, because X and Y, 
partners in PRS, are no longer members of the same EAG for the 
entire year, the gross rental receipts X takes into account in 2008 
do not qualify as DPGR.
    Example 4. Distribution. X and Y are the only partners in PRS, a 
partnership, for PRS's entire 2007 taxable year. X and Y are both 
members of a single EAG for the entire 2007 year. In 2007, PRS MPGE 
QPP within the United States, incurring $600 of CGS, and then 
distributes the QPP to X. X's adjusted basis in the QPP is $600. X 
incurs $200 of CGS to further MPGE the QPP within the United States. 
In 2007, X sells the QPP for $1,500 to an unrelated customer. X is 
treated as having disposed of the QPP on the date it ceases to own 
the QPP for Federal income tax purposes. Under paragraph 
(i)(8)(ii)(A) of this section, X is treated as having MPGE the QPP 
within the United States, and X's $1,500 of gross receipts qualify 
as DPGR.
    Example 5. Multiple sales. (i) Facts. X and Y are the only 
partners in PRS, a partnership, 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 finished dosage form 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 finished dosage form drug within the 
United States are $12 and account for 10% of X's $120 CGS of the 
drug. In 2007, X sells the finished dosage form drug to Y and Y 
sells the finished dosage form drug to customers. Assume that Y's 
own MPGE activity with respect to the finished dosage form 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 finished dosage form 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 paragraph (g)(3) of this section 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 finished 
dosage form drug to Y are DPGR because X is considered to have MPGE 
the finished dosage form drug in significant part in the United 
States pursuant to the safe harbor described in paragraph (g)(3) of 
this section 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 finished dosage form drug at the time X disposes 
of the finished dosage form drug to Y. Similarly, Y's gross receipts 
from the sale of the finished dosage form drug to customers are DPGR 
because Y is considered to have MPGE the finished dosage form drug 
in significant part in the United States pursuant to the safe harbor 
described in paragraph (g)(3) of this section 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 finished dosage 
form drug at the time Y disposes of the finished dosage form drug to 
Y's customers.
* * * * *
    (p) * * * Thus, partners, including partners in partnerships 
described in paragraphs (i)(7) and (8) of this section and Sec.  1.199-
9(i) and (j), may not treat guaranteed payments as DPGR. See Sec. Sec.  
1.199-5(b)(6) Example 5 and 1.199-9(b)(6) Example 5.


Sec.  1.199-3T  [Removed]

0
Par. 7. Section 1.199-3T is removed.


0
Par. 8. Section 1.199-4 is amended by:
0
1. Revising paragraph (d)(5).
0
2. Removing the language ``Sec.  1.199-9(d)'' in paragraph (e)(1) and 
adding the language ``Sec.  1.199-5(d) or Sec.  1.199-9(d)'' in its 
place.
0
3. Revising paragraph (f)(5).
    The revisions read as follows:


Sec.  1.199-4  Costs allocable to domestic production gross receipts.

* * * * *
    (d) * * *
    (5) Treatment of items from a pass-thru entity reporting qualified 
production activities income. If, pursuant to Sec.  1.199-5(e)(2) or 
Sec.  1.199-9(e)(2), or to the authority granted in Sec.  1.199-
5(b)(1)(ii) or (c)(1)(ii), or Sec.  1.199-9(b)(1)(ii) or (c)(1)(ii), a 
taxpayer must combine QPAI and W-2 wages from a partnership, S 
corporation, trust (to the extent not described in Sec.  1.199-5(d) or 
Sec.  1.199-9(d)) or estate with the taxpayer's total QPAI and W-2 
wages from other sources, then for purposes of apportioning the 
taxpayer's interest expense under this paragraph (d), the taxpayer's 
interest in such partnership (and, where relevant in apportioning the 
taxpayer's interest expense, the partnership's assets), the taxpayer's 
shares in such S corporation, or the taxpayer's interest in such trust 
shall be disregarded.
* * * * *
    (f) * * *
    (5) Trusts and estates. Trusts and estates under Sec. Sec.  1.199-
5(e) and 1.199-9(e) may not use the small business simplified overall 
method.
* * * * *

0
Par. 9. Section 1.199-5 is added 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.

    (a) In general. The provisions of this section apply solely for 
purposes of

[[Page 8807]]

section 199 of the Internal Revenue Code (Code).
    (b) Partnerships--(1) In general--(i) Determination at partner 
level. The deduction with respect to the qualified production 
activities of the partnership allowable under Sec.  1.199-1(a) (section 
199 deduction) is determined at the partner level. As a result, each 
partner must compute its deduction separately. The section 199 
deduction has no effect on the adjusted basis of the partner's interest 
in the partnership. Except as provided by publication pursuant to 
paragraph (b)(1)(ii) of this section, for purposes of this section, 
each partner is allocated, in accordance with sections 702 and 704, its 
share of partnership items (including items of income, gain, loss, and 
deduction), cost of goods sold (CGS) allocated to such items of income, 
and gross receipts that are included in such items of income, even if 
the partner's share of CGS and other deductions and losses exceeds 
domestic production gross receipts (DPGR) (as defined in Sec.  1.199-
3(a)). A partnership may specially allocate items of income, gain, 
loss, or deduction to its partners, subject to the rules of section 
704(b) and the supporting regulations. Guaranteed payments under 
section 707(c) are not considered allocations of partnership income for 
purposes of this section. Guaranteed payments under section 707(c) are 
deductions by the partnership that must be taken into account under the 
rules of Sec.  1.199-4. See Sec.  1.199-3(p) and paragraph (b)(6) 
Example 5 of this section. Except as provided in paragraph (b)(1)(ii) 
of this section, to determine its section 199 deduction for the taxable 
year, a partner aggregates its distributive share of such items, to the 
extent they are not otherwise disallowed by the Code, with those items 
it incurs outside the partnership (whether directly or indirectly) for 
purposes of allocating and apportioning deductions to DPGR and 
computing its qualified production activities income (QPAI) (as defined 
in Sec.  1.199-1(c)).
    (ii) Determination at entity level. The Secretary may, by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), permit a partnership to 
calculate a partner's share of QPAI and W-2 wages as defined in Sec.  
1.199-2(e)(2) (W-2 wages) at the entity level, instead of allocating to 
the partner, in accordance with sections 702 and 704, the partner's 
share of partnership items (including items of income, gain, loss, and 
deduction) and amounts described in Sec.  1.199-2(e)(1) (paragraph 
(e)(1) wages). If a partnership does calculate QPAI at the entity 
level--
    (A) Each partner is allocated its share of QPAI (subject to the 
limitations of paragraph (b)(2) of this section) and W-2 wages from the 
partnership, which are combined with the partner's QPAI and W-2 wages 
from other sources, if any;
    (B) For purposes of computing the partner's QPAI under Sec. Sec.  
1.199-1 through 1.199-8, a partner does not take into account the items 
from the partnership (for example, a partner does not take into account 
items from the partnership in determining whether a threshold or de 
minimis rule applies or in allocating and apportioning deductions) in 
calculating its QPAI from other sources;
    (C) A partner generally does not recompute its share of QPAI from 
the partnership using another method; however, the partner might have 
to adjust its share of QPAI from the partnership to take into account 
certain disallowed losses or deductions, or the allowance of suspended 
losses or deductions; and
    (D) A partner's distributive share of QPAI from a partnership may 
be less than zero.
    (2) Disallowed losses or deductions. Except as provided by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), losses or deductions of a 
partnership are taken into account in computing the partner's QPAI for 
a taxable year only if, and to the extent that, the partner's 
distributive share of those losses or deductions from all of the 
partnership's activities is not disallowed by section 465, 469, or 
704(d), or any other provision of the Code. If only a portion of the 
partner's distributive share of the losses or deductions from a 
partnership is allowed for a taxable year, a proportionate share of 
those allowed losses or deductions that are allocated to the 
partnership's qualified production activities, determined in a manner 
consistent with sections 465, 469, and 704(d), and any other applicable 
provision of the Code, is taken into account in computing QPAI for that 
taxable year. To the extent that any of the disallowed losses or 
deductions are allowed in a later taxable year under section 465, 469, 
or 704(d), or any other provision of the Code, the partner takes into 
account a proportionate share of those allowed losses or deductions 
that are allocated to the partnership's qualified production activities 
in computing the partner's QPAI for that later taxable year. Losses or 
deductions of the partnership that are disallowed for taxable years 
beginning on or before December 31, 2004, however, are not taken into 
account in a later taxable year for purposes of computing the partner's 
QPAI for that later taxable year, whether or not the losses or 
deductions are allowed for other purposes.
    (3) Partner's share of paragraph (e)(1) wages. Under section 
199(d)(1)(A)(iii), a partner's share of paragraph (e)(1) wages of a 
partnership for purposes of determining the partner's wage limitation 
under section 199(b)(1) (W-2 wage limitation) equals the partner's 
allocable share of those wages. Except as provided by publication in 
the Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter), the partnership must allocate the amount of paragraph (e)(1) 
wages among the partners in the same manner it allocates wage expense 
among those partners. The partner must add its share of the paragraph 
(e)(1) wages from the partnership to the partner's paragraph (e)(1) 
wages from other sources, if any. The partner (other than a partner 
that itself is a partnership or S corporation) then must calculate its 
W-2 wages by determining the amount of the partner's total paragraph 
(e)(1) wages properly allocable to DPGR. If the partner is a 
partnership or S corporation, the partner must allocate its paragraph 
(e)(1) wages (including the paragraph (e)(1) wages from a lower-tier 
partnership) among its partners or shareholders in the same manner it 
allocates wage expense among those partners or shareholders. See Sec.  
1.199-2(e)(2) for the computation of W-2 wages and for the proper 
allocation of any such wages to DPGR.
    (4) Transition rule for definition of W-2 wages and for W-2 wage 
limitation. If a partnership and any partner in that partnership have 
different taxable years, only one of which begins after May 17, 2006, 
the definition of W-2 wages of the partnership and the section 
199(d)(1)(A)(iii) rule for determining a partner's share of wages from 
that partnership is determined under the law applicable to partnerships 
based on the beginning date of the partnership's taxable year. Thus, 
for example, for the taxable year of a partnership beginning on or 
before May 17, 2006, a partner's share of W-2 wages from the 
partnership is determined under section 199(d)(1)(A)(iii) as in effect 
for taxable years beginning on or before May 17, 2006, even if the 
taxable year of that partner in which those wages are taken into 
account begins after May 17, 2006.
    (5) Partnerships electing out of subchapter K. For purposes of 
Sec. Sec.  1.199-1 through 1.199-8, the rules of this paragraph (b) 
apply to all partnerships, including those partnerships electing under 
section 761(a) to be excluded, in whole or in part, from the 
application of subchapter K of chapter 1 of the Code.

[[Page 8808]]

    (6) Examples. The following examples illustrate the application of 
this paragraph (b). Assume that each partner has sufficient adjusted 
gross income or taxable income so that the section 199 deduction is not 
limited under section 199(a)(1)(B). Assume also that the partnership 
and each of its partners (whether individual or corporate) are calendar 
year taxpayers. The examples read as follows:

    Example 1. Section 861 method with interest expense. (i) 
Partnership Federal income tax items. X and Y, unrelated United 
States corporations, are each 50% partners in PRS, a partnership 
that engages in production activities that generate both DPGR and 
non-DPGR. X and Y share all items of income, gain, loss, deduction, 
and credit equally. Both X and Y are engaged in a trade or business. 
PRS is not able to identify from its books and records CGS allocable 
to DPGR and non-DPGR. In this case, because CGS is definitely 
related under the facts and circumstances to all of PRS's gross 
receipts, apportionment of CGS between DPGR and non-DPGR based on 
gross receipts is appropriate. For 2010, the adjusted basis of PRS's 
business assets is $5,000, $4,000 of which generate gross income 
attributable to DPGR and $1,000 of which generate gross income 
attributable to non-DPGR. For 2010, PRS has the following Federal 
income tax items:

DPGR.........................................................     $3,000
Non-DPGR.....................................................      3,000
CGS..........................................................      3,240
Section 162 selling expenses.................................      1,200
Interest expense (not included in CGS).......................        300
 

    (ii) Allocation of PRS's Federal income tax items. X and Y each 
receive the following distributive share of PRS's Federal income tax 
items, as determined under the principles of Sec.  1.704-
1(b)(1)(vii):

Gross income attributable to DPGR ($1,500 (DPGR) - $810             $690
 (allocable CGS))............................................
Gross income attributable to non-DPGR ($1,500 (non-DPGR) -           690
 $810 (allocable CGS)).......................................
Section 162 selling expenses.................................        600
Interest expense (not included in CGS).......................        150
 

    (iii) Determination of QPAI. (A) X's QPAI. Because the section 
199 deduction is determined at the partner level, X determines its 
QPAI by aggregating its distributive share of PRS's Federal income 
tax items with all other such items from all other, non-PRS-related 
activities. For 2010, X does not have any other such items. For 
2010, the adjusted basis of X's non-PRS assets, all of which are 
investment assets, is $10,000. X's only gross receipts for 2010 are 
those attributable to the allocation of gross income from PRS. X 
allocates and apportions its deductible items to gross income 
attributable to DPGR under the section 861 method of Sec.  1.199-
4(d). In this case, the section 162 selling expenses are not 
included in CGS and are definitely related to all of PRS's gross 
income. Based on the facts and circumstances of this specific case, 
apportionment of those expenses between DPGR and non-DPGR on the 
basis of PRS's gross receipts is appropriate. X elects to apportion 
its distributive share of interest expense under the tax book value 
method of Sec.  1.861-9T(g). X's QPAI for 2010 is $366, as shown in 
the following table:

DPGR........................................................     $1,500
CGS allocable to DPGR.......................................       (810)
Section 162 selling expenses ($600 x ($1,500 DPGR/$3,000           (300)
 total gross receipts)).....................................
Interest expense (not included in CGS) ($150 x ($2,000 (X's         (24)
 share of PRS's DPGR assets)/$12,500 (X's non-PRS assets
 ($10,000) + X's share of PRS assets ($2,500))))............
                                                             -----------
    X's QPAI................................................        366
 

    (B) Y's QPAI. (1) For 2010, in addition to the activities of 
PRS, Y engages in production activities that generate both DPGR and 
non-DPGR. Y is able to identify from its books and records CGS 
allocable to DPGR and to non-DPGR. For 2010, the adjusted basis of 
Y's non-PRS assets attributable to its production activities that 
generate DPGR is $8,000 and to other production activities that 
generate non-DPGR is $2,000. Y has no other assets. Y has the 
following Federal income tax items relating to its non-PRS 
activities:

Gross income attributable to DPGR ($1,500 (DPGR) - $900             $600
 (allocable CGS))............................................
Gross income attributable to non-DPGR ($3,000 (other gross         1,380
 receipts) -$1,620 (allocable CGS))..........................
Section 162 selling expenses.................................        540
Interest expense (not included in CGS).......................         90
 

    (2) Y determines its QPAI in the same general manner as X. 
However, because Y has other trade or business activities outside of 
PRS, Y must aggregate its distributive share of PRS's Federal income 
tax items with its own such items. Y allocates and apportions its 
deductible items to gross income attributable to DPGR under the 
section 861 method of Sec.  1.199-4(d). In this case, Y's 
distributive share of PRS's section 162 selling expenses, as well as 
those selling expenses from Y's non-PRS activities, are definitely 
related to all of its gross income. Based on the facts and 
circumstances of this specific case, apportionment of those expenses 
between DPGR and non-DPGR on the basis of Y's gross receipts 
(including Y's share of PRS's gross receipts) is appropriate. Y 
elects to apportion its distributive share of interest expense under 
the tax book value method of Sec.  1.861-9T(g). Y has $1,290 of 
gross income attributable to DPGR ($3,000 DPGR ($1,500 from PRS and 
$1,500 from non-PRS activities)--$1,710 CGS ($810 from PRS and $900 
from non-PRS activities)). Y's QPAI for 2010 is $642, as shown in 
the following table:

DPGR ($1,500 from PRS and $1,500 from non-PRS activities)....     $3,000
CGS allocable to DPGR ($810 from PRS and $900 from non-PRS       (1,710)
 activities).................................................
Section 162 selling expenses ($1,140 ($600 from PRS and $540       (456)
 from non-PRS activities) x $3,000 ($1,500 PRS DPGR + $1,500
 non-PRS DPGR)/$7,500 ($3,000 PRS total gross receipts +
 $4,500 non-PRS total gross receipts)).......................
Interest expense (not included in CGS) ($240 ($150 from PRS        (192)
 and $90 from non-PRS activities) x $10,000 (Y's non-PRS DPGR
 assets ($8,000) + Y's share of PRS DPGR assets ($2,000))/
 $12,500 (Y's non-PRS assets ($10,000) + Y's share of PRS
 assets ($2,500)))...........................................
                                                              ----------
    Y's QPAI.................................................        642
 

    (iv) Determination of section 199 deduction. X's tentative 
section 199 deduction is $33 (.09 x $366, that is, QPAI determined 
at the partner level) subject to the W-2 wage limitation (50% of W-2 
wages). Y's tentative section 199 deduction is $58 (.09 x $642) 
subject to the W-2 wage limitation.
    Example 2. Section 861 method with R&E expense. (i) Partnership 
Federal income tax items. X and Y, unrelated United States 
corporations each of which is engaged in a trade or business, are 
partners in PRS, a partnership that engages in production activities 
that generate both DPGR and non-DPGR. Neither X nor Y is a member of 
an affiliated group. X and Y share all items of income, gain, loss, 
deduction, and credit equally. All of PRS's domestic production 
activities that generate DPGR are within Standard Industrial 
Classification (SIC) Industry Group AAA (SIC AAA). All of PRS's 
production activities that generate non-DPGR are within SIC Industry 
Group BBB (SIC BBB). PRS is not able to identify from its books and 
records CGS allocable to DPGR and to non-DPGR. In this case, because 
CGS is definitely related under the facts and circumstances to all 
of PRS's gross receipts, 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):

[[Page 8809]]



Gross income attributable to DPGR ($1,500 (DPGR) - $600             $900
 (CGS))......................................................
Gross income attributable to non-DPGR ($1,500 (other gross           900
 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/$3,000          (210)
 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
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-PRS       $4,500
 activities))...............................................
CGS ($600 from sales of products by PRS and $1,500 from non-     (2,100)
 PRS activities)............................................
Section 162 selling expenses ($960 ($420 from PRS + $540           (480)
 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 non-PRS       (450)
 activities)................................................
Section 174 R&E-SIC BBB ($750 ($300 from PRS + $450 from non-      (188)
 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 3, 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.  1.199-2(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

[[Page 8810]]

(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.  1.199-2(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, 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.  1.199-2(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.  1.199-2(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 the shareholder's 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 QPAI 
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 allowed 
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 1366(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

[[Page 8811]]

December 31, 2004, however, 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.  1.199-2(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 after May 17, 2006, 
the definition of W-2 wages of the S corporation and the section 
199(d)(1)(A)(iii) rule for determining a shareholder's share of wages 
from that S corporation is determined under the law applicable to 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. For this purpose, the trust or 
estate's DNI is determined with regard to the separate share rule of 
section 663(c), but without regard to section 199. 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) rule for determining the respective shares of 
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. The example reads as 
follows:

    Example. (i) Computation of DNI and inclusion and deduction 
amounts. (A) Trust's

[[Page 8812]]

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 CGS       $10,000
 (including wage expense of $1,000)).........................
Gross income attributable to non-DPGR ($5,000 other gross          5,000
 receipts-$0 CGS)............................................
Selling expenses attributable to DPGR (includes wage expense       3,000
 of $2,000)..................................................
Other expenses (includes wage expense of $1,000).............      2,000
 

    (B) Trust's direct activities. In addition to its cash 
distribution in 2010 from PRS, Trust 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 as a        10,000
 business....................................................
Real estate taxes............................................      1,000
Trustee commissions..........................................      3,000
State income and personal property taxes.....................      5,000
Wage expense for rental business (direct paragraph (e)(1)          2,000
 wages)......................................................
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) is 
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 is not a trade or business expense and, thus, is 
not taken into account in computing QPAI. The portion of the state 
income and personal property taxes that is treated as an other trade 
or business expense 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 ($15,000 DPGR-$5,000 CGS-
$3,000 selling expenses)-$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.  1.199-2(e)(2)(ii) to 
determine its W-2 wages. For its taxable year ending December 31, 
2010, Trust has $5,000 ($3,000 from PRS + $2,000 of Trust) 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 DPGR...     $1,000
Wage expense included in selling expense directly                  2,000
 attributable to DPGR........................................
Wage expense included in non-directly attributable deductions        500
 ($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 trade or business activities outside of Trust and 
attributable to DPGR (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

[[Page 8813]]

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 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 1.199-3(i)(7).
    (g) No attribution of qualified activities. Except as provided in 
Sec.  1.199-3(i)(7) regarding qualifying in-kind partnerships and Sec.  
1.199-3(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. This rule applies to all 
partnerships, including partnerships that have elected out of 
subchapter K under section 761(a). Accordingly, 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.


Sec.  1.199-5T  [Removed]

0
Par. 10. Section 1.199-5T is removed.


0
Par. 11. Section 1.199-7 is amended by revising 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--(i) In general. The amount of an NOL sustained by any member of 
an EAG 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 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). The examples read as 
follows:

    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 QPAI 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 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.

[[Page 8814]]

    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.
* * * * *


Sec.  1.199-7T  [Removed]

0
Par. 12. Section 1.199-7T is removed.


0
Par. 13. Section 1.199-8 is amended by:
0
1. Removing the language ``Sec.  1.199-9(j)'' in paragraph (e)(1)(i) 
and adding the language ``Sec. Sec.  1.199-3(i)(8) and 1.199-9(j)'' in 
its place.
0
2. Removing the language ``Sec.  1.199-9(i)'' in paragraph (e)(1)(i) 
and adding the language ``Sec. Sec.  1.199-3(i)(7) and 1.199-9(i)'' in 
its place.
0
3. Removing the language ``Sec.  1.199-9(i)'' in paragraph 
(e)(1)(ii)(B) and adding the language ``Sec.  1.199-3(i)(7) or Sec.  
1.199-9(i)'' in its place.
0
4. Revising the last two sentences in paragraph (h).
0
5. Revising paragraphs (i)(5) and (i)(6).
    The revisions read as follows:


Sec.  1.199-8  Other rules.

* * * * *
    (h) Disallowed losses or deductions. * * * For taxpayers that are 
partners in partnerships, see Sec. Sec.  1.199-5(b)(2) and 1.199-
9(b)(2). For taxpayers that are shareholders in S corporations, see 
Sec. Sec.  1.199-5(c)(2) and 1.199(c)(2).
    (i) * * *
    (5) Tax Increase Prevention and Reconciliation Act of 2005. 
Sections 1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 are 
applicable for taxable years beginning on or after October 19, 2006. A 
taxpayer may apply Sec. Sec.  1.199-2(e)(2), 1.199-3(i)(7) and (8), and 
1.199-5 to taxable years beginning after May 17, 2006, and October 19, 
2006, regardless of whether the taxpayer otherwise relied upon Notice 
2005-14 (2005-1 CB 498) (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter), the provisions of REG-105847-05 (2005-2 CB 987), or 
Sec. Sec.  1.199-1 through 1.199-8.
    (6) Losses used to reduce taxable income of expanded affiliated 
group. Section 1.199-7(b)(4) is applicable for taxable years beginning 
on or after February 15, 2008. For taxable years beginning on or after 
October 19, 2006, and before February 15, 2008, see Sec.  1.199-
7T(b)(4) (see 26 CFR part 1 revised as of April 1, 2007).
* * * * *


Sec.  1.199-8T  [Removed]

0
Par. 14. Section 1.199-8T is removed.


0
Par. 15. Section 1.199-9 is amended by:
0
1. Revising paragraph (b)(1)(ii)(B).
0
2. Removing the language ``paragraph (b) of this section shall'' from 
paragraph (b)(5) and adding the language ``this paragraph (b)'' in its 
place.
0
3. Revising paragraph (c)(1)(ii)(B).
0
4. Revising paragraph (e)(2)(i).
0
5. Removing the language ``directly allocable costs'' in the sixth 
sentence of Example 4 in paragraph (j)(5) and adding the language 
``CGS'' in its place.
0
6. Adding the language ``finished dosage form'' before the word 
``drug'' each time it appears in the seventh, eighth, and ninth 
sentences in paragraph (j)(5) Example 5 (i) and in the second and third 
sentences in paragraph (j)(5) Example 5 (ii).
    The revisions read as follows:


Sec.  1.199-9  Application of section 199 to pass-thru entities for 
taxable years beginning on or before May 17, 2006, the enactment date 
of the Tax Increase Prevention and Reconciliation Act of 2006.

* * * * *
    (b) * * *
    (1) * * *
    (ii) * * *
    (B) For purposes of computing the partner's QPAI under Sec. Sec.  
1.199-1 through 1.199-9, 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) * * *
    (1) * * *
    (ii) * * *
    (B) For purposes of computing the shareholder's QPAI under 
Sec. Sec.  1.199-1 through 1.199-9, 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;
* * * * *
    (e) * * *
    (2) * * * (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. For this purpose, 
the trust or estate's DNI is determined with regard to the separate 
share rule of section 663(c), but without regard to section 199. 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 (subject to 
the wage limitation as described in paragraph (e)(3) of this section) 
are aggregated with the

[[Page 8815]]

beneficiary's QPAI and W-2 wages from other sources, if any.
* * * * *

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
    Approved: February 1, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
 [FR Doc. E8-2761 Filed 2-14-08; 8:45 am]
BILLING CODE 4830-01-P