Internal Revenue Bulletin 2005-47 (PDF rendition): IRS Revenue Procedures

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.

Bulletin No. 200
5-47
November 21, 200
5
HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.
INCOME TAX
T.D. 9228, page 972.
Final regulations under section 42 of the Code eliminate the
requirement in regulations section 1.42–1(h) that a completed
Form 8609,Low-Income Housing Credit Allocation and Certifi-
cation, must be filed with an owner’s Federal income tax return
for each of the 15 taxable years of the compliance period when
theownerclaimsthelow-incomehousingcredit.
REG–1058
47–05, page 987.
Proposed r
egulations under section 199 of the Code relate to
the deduc
tion for income attributable to domestic production
activiti
es. Section 199 was enacted as part of the American
Jobs Crea
tion Act of 2004, and allows a deduction equal to
3percent
(for 2005 and 2006) of the lesser of the qualified
producti
on activities income of the taxpayer for the taxable
year, or
thetaxableincomeofthetaxpayerforthetaxable
year, su
bject to certain limits. The applicable percentage rises
to 6 perc
ent for 2007, 2008, and 2009, and 9 percent for
2010 and
subsequent years. A public hearing is scheduled for
Januar
y 11, 2006.
Rev. Proc. 2005–70, page 979.
Cost-of-living adjustments for 2006.This procedure sets
forth the cost-of-living adjustments to certain items for 2006
as required under various provisions of the Code.
Rev. Proc. 2005–71, page 985.
This procedure modifies Rev. Proc. 2004–59, 2004–2 C.B.
678, to extend the sunset date for participation in the Voluntary
Compliance Program from December 31, 2005, to March 31,
2006, and provides that no extensions will be granted beyond
June 30, 2006. Rev. Proc. 2004–59 modified.
EMPLOYEE PLANS
Notice 2005–72, page 976.
Weighted average interest rate update; corporate bond
indices; 30-year Treasury securities.The weighted aver-
age interest rate for November 2005 and the resulting permis-
sible range of interest rates used to calculate current liability
and to determine the required contribution are set forth.
ESTATE TAX
Rev. Proc. 2005–70, page 979.
Cost-of-living adjustments for 2006.This procedure sets
forth the cost-of-living adjustments to certain items for 2006
as required under various provisions of the Code.
GIFT TAX
Rev. Proc. 2005–70, page 979.
Cost-of-living adjustments for 2006.This procedure sets
forth the cost-of-living adjustments to certain items for 2006
as required under various provisions of the Code.
EXCISE TAX
Rev. Proc. 2005–70, page 979.
Cost-of-living adjustments for 2006.This procedure sets
forth the cost-of-living adjustments to certain items for 2006
as required under various provisions of the Code.
(Continued on the next page)
Fi
nding Lists begin on page ii.

ADMINISTRATIVE
Notice 2005–81, page 977.
This notice supplements Notice 2005–66, 2005–40 I.R.B.
620, which postponed until January 3, 2006, deadlines for
the IRS to perform certain acts under section 7508A of the
Code with respect to certain taxpayers affected by Hurricane
Katrina. This notice (1) expands the definition of “covered dis-
aster area” to include additional counties and parishes that the
Federal Emergency Management Agency (FEMA) determined
were eligible for federal assistance after the IRS issued Notice
2005–66; (2) extends the deadlines for the IRS to perform
certain acts to February 28, 2006, to match the deadlines
for affected taxpayers to file, pay, and perform certain acts;
(3) expands the definition of affected taxpayer to match the
definition of affected taxpayers in Notice 2005–73, 2005–42
I.R.B. 723; and (4) grants the IRS a postponement of time to
perform an act not previously identified in Notice 2005–66 –
issuing a Notice of Final Partnership Administrative Adjustment
(FPAA) under section 6223. Notice 2005–66 supplemented.
Notice 200
5–82, page 978.
In Notice 2
005–82, the IRS under section 7508A of the Code
extends th
e period for the government to take certain actions
until Febr
uary 28, 2005, with respect to certain taxpayers af-
fected by H
urricane Rita. In response to Hurricane Rita, in News
Release I
R-2005-110 of September 26, 2005, the IRS granted
relief fo
r taxpayers affected by Hurricane Rita. News Release
IR-2005-
110 provided that all counties and parishes in Texas
and Louis
iana constitute a “covered disaster area” within the
meaning o
f regulations section 301.7508A–1(d)(2). Further,
News Rel
ease IR-2005-110 provided that taxpayers affected
by the di
saster will have until February 28, 2006, to file tax
returns
and submit payments, including, but not limited to, the
October
17, 2005, deadline for individuals who received a sec-
ond ext
ension for filing their individual income tax returns. In
additi
on, News Release IR-2005-110 provided affected taxpay-
ers unt
il February 28, 2006, to perform the acts listed in sec-
tion 30
1.7508A–1(c)(1) and Rev. Proc. 2005–27, 2005–20
I.R.B.
1050.
Rev. Proc. 2005–70, page 979.
Cost-of-living adjustments for 2006.This procedure sets
forth the cost-of-living adjustments to certain items for 2006
as required under various provisions of the Code.
Rev. Proc. 2005–71, page 985.
This procedure modifies Rev. Proc. 2004–59, 2004–2 C.B.
678, to extend the sunset date for participation in the Voluntary
Compliance Program from December 31, 2005, to March 31,
2006, and provides that no extensions will be granted beyond
June 30, 2006. Rev. Proc. 2004–59 modified.
November 21, 20052005–47 I.R.B.

The IRS Mission
Provide America’s taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
Introduction
The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
Superintendent of Documents on a subscription basis. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis.
It is the policy of the Service to publish in the Bulletin all sub-
stantive rulings necessary to promote a uniform application of
the tax laws, including all rulings that supersede, revoke, mod-
ify, or amend any of those previously published in the Bulletin.
All published rulings apply retroactively unless otherwise indi-
cated. Procedures relating solely to matters of internal man-
agement are not published; however, statements of internal
practices and procedures that affect the rights and duties of
taxpayers are published.
Revenue rulings represent the conclusions of the Service on the
application of the law to the pivotal facts stated in the revenue
ruling. In those based on positions taken in rulings to taxpayers
or technical advice to Service field offices, identifying details
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be considered,
and Service personnel and others concerned are cautioned
against reaching the same conclusions in other cases unless
the facts and circumstances are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—19
86 Code.
This part i
ncludes rulings and decisions based on provisions of
the Intern
al Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows: Subpart A,
Tax Conventions and Other Related Items, and Subpart B, Leg-
islation and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the Department of the Treasury’s Office of the Assistant Sec-
retary (Enforcement).
Part IV
.—Items of General Interest.
This par
t includes notices of proposed rulemakings, disbar-
ment an
d suspension lists, and announcements.
The last Bulletin for each month includes a cumulative index
for the matters published during the preceding months. These
monthly indexes are cumulated on a semiannual basis, and are
published in the last Bulletin of each semiannual period.
The c
ontents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents, U.S.Government Printing Office, Washington, DC 20402.
2005–47 I.R.B.November 21, 2005

Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 1.—Tax Imposed
The Service provides inflation adjustments to the
tax rate tables for individuals, trusts, and estates for
taxable years beginning in 2006. In addition, the
amounts of certain reductions allowed against the
unearned income of minor children in computing
the “kiddie tax” are adjusted. Also adjusted are the
amounts used to determine whether a parent may
elect to report the “kiddie tax” on the parent’s return.
See Rev. Proc. 2005-70, page 979.
Section 23.—Adoption
Expenses
The Service provides inflation adjustments to the
adoption credit allowed for the adoption of a child for
taxable years beginning in 2006. The Service also
provides inflation adjustments to the value used in
calculating the modified adjusted gross income lim-
itations used to determine the amount of adoption
credit that is allowed in taxable years beginning in
2006. See Rev. Proc. 2005-70, page 979.
Section 24.—Child Tax
Credit
The Service provides inflation adjustments for the
value used in determining the amount of the credit
that may be refundable beginning in 2006. See Rev.
Proc. 2005-70, page 979.
Section 25A.—Hope and
Lifetime Learning Credits
The Service provides inflation adjustments for the
amount of qualified tuition and related expenses that
are taken into account in determining the amount of
the Hope Scholarship Credit for taxable years begin-
ning in 2006, and for the amount of a taxpayer’s mod-
ified adjusted gross income that is taken into account
in determining the reduction in the amount of the
Hope Scholarship and Lifetime Learning Credits oth-
erwise available. See Rev. Proc. 2005-70, page 979.
Section 32.—Earned
Income
The Service provides inflation adjustments to the
limitations on the earned income credit for taxable
years beginning in 2006. See Rev. Proc. 2005-70,
page 979.
Section 42.—Low-Income
Housing Credit
The Service provides inflation adjustments to the
amounts used to calculate the State housing credit
ceiling used in determining the low-income housing
credit for calendar year 2006. See Rev. Proc. 2005-
70, page 979.
26 CFR 1.42–1: Limitation on low-income housing
credit allowed with respect to qualified low-income
buildings receiving housing credit allocations from
State or local housing credit agency.
T.D. 9228
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1
Low-Income Housing Credit
Allocation and Certification;
Revisions
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains reg-
ulations that reduce the burden for taxpay-
ers filing Form 8609, “Low-Income Hous-
ing Credit Allocation and Certification.”
The regulations affect owners of low-in-
come housing projects who claim the low-
income housing credit.
DATES:Effective Date: These regulations
are effective November 7, 2005.
Date of Applicability: For date of appli-
cability, see §1.42–1(j).
FOR FURTHER INFORMATION
CONTACT: Paul F. Handleman, (202)
622–3040 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
On January 27, 2004, the Treasury
Department and IRS published Treasury
Decision 9112, 2004–1 C.B. 523, in the
Federal Register(69 FR 3826), which
removed impediments to the electronic
filing of Form 8609, “Low-Income Hous-
ing Credit Allocation and Certification,”
by revising former §1.42–1T(e)(1) and
(h)(2) and adding §1.42–1(h). Former
§1.42–1T(e)(1) and (h)(2) required an
owner to include a third-party signature
from an authorized State or local hous-
ing credit agency (Agency) official when
filing the form with the owner’s Fed-
eral income tax return for each year of
the 15-year compliance period. Section
1.42–1(h) contains the filing requirement
for Form 8609 and no longer requires the
third-party signature when filing the form
with the owner’s Federal income tax re-
turn.
Explanation of Provisions
Section 42 provides for a low-income
housing credit that may be claimed as part
of the general business credit under sec-
tion 38. In general, the credit is allowable
only if the owner of a qualified low-in-
come building receives a housing credit al-
location from an Agency of the jurisdiction
where the building is located.
Section 1.42–1(h) provides that a com-
pleted Form 8586, “Low-Income Housing
Credit,” must be filed with the owner’s
Federal income tax return for each taxable
year the owner of a qualified low-income
building is claiming the low-income hous-
ing credit under section 42(a). A com-
pleted Form 8609 must be filed with the
owner’s Federal income tax return for each
of the 15 taxable years of the compliance
period. Failure to comply with the require-
ment of the preceding sentence for any tax-
able year after the first taxable year in the
credit period will be treated as a mathemat-
ical or clerical error for purposes of section
6213(b)(1) and (g)(2).
The IRS plans to reduce taxpayer bur-
den by allowing taxpayers to file Form
8609 one time, instead of filing the form
with the same information for 15 consec-
utive years. Taxpayers currently file the
form as part of their return with the Inter-
nal Revenue Service center that processes
their return. Planned revisions to the form
should improve administration of the low-
income housing credit program by requir-
ing taxpayers to send completed forms to
the Philadelphia service center, where each
Agency currently sends Part I of the form.
The requirements for completing and fil-
ingForm8609willbeaddressedinthein-
structions to the form.
2005–47 I.R.B.972November 21, 2005

Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in Executive Order
12866. Therefore, a regulatory assessment
is not required. It also has been deter-
minedthatsection553(b)and(d)ofthe
Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regula-
tions. Because no notice of proposed rule-
making is required, the Regulatory Flex-
ibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f) of the
Internal Revenue Code, these regulations
were submitted to the Chief Counsel for
Advocacy of the Small Business Admin-
istration for comment on their impact on
small business.
Drafting Information
The principal author of these regula-
tions is Paul F. Handleman, Office of the
Associate Chief Counsel (Passthroughs
and Special Industries), IRS. However,
other personnel from the IRS and Treasury
Department participated in their develop-
ment.
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR part 1 is amended
as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.42–1 is amended by
revising paragraphs (h) and (j) to read as
follows:
§1.42–1 Limitation on low-income
housing credit allowed with respect to
qualified low-income buildings receiving
housing credit allocations from a State or
local housing credit agency.
*****
(h)Filing of forms. Unless otherwise
provided in forms or instructions, a com-
pleted Form 8586, “Low-Income Housing
Credit,” (or any successor form) must be
filed with the owner’s Federal income tax
return for each taxable year the owner of a
qualified low-income building is claiming
the low-income housing credit under sec-
tion 42(a). Unless otherwise provided in
forms or instructions, a completed Form
8609, “Low-Income Housing Credit Al-
location and Certification,” (or any suc-
cessor form) must be filed by the build-
ing owner with the IRS. The requirements
for completing and filing Forms 8586 and
8609 are addressed in the instructions to
the forms.
*****
(j)Effective dates.Section 1.42–1(h)
appliestoformsfiledonorafterNovem-
ber 7, 2005. The rules that apply for forms
filed before November 7, 2005 are con-
tained in §1.42–1T(h) and §1.42–1(h) (see
26 CFR part 1 revised as of April 1, 2003,
and April 1, 2005).
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved October 26, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary
of the Treasury.
(Filed by the Office of the Federal Register on November 4,
2005, 8:45 a.m., and published in the issue of the Federal
Register for November 7, 2005, 70 F.R. 67355)
Section 59.—Other
Definitions and Special
Rules
The Service provides an inflation adjustment to the
exemption amount used in computing the alternative
minimum tax for a minor child subject to the “kiddie
tax” for taxable years beginning in 2006. See Rev.
Proc. 2005-70, page 979.
Section 62.—Adjusted
Gross Income Defined
The Service provides inflation adjustments to the
amounts an eligible employer may pay in 2006 to cer-
tain welders and heavy equipment mechanics for rig-
related expenses that are deemed substantiated under
an accountable plan when paid in accordance with
Rev. Proc. 2002–41, 2002–1 C.B. 1098. See Rev.
Proc. 2005-70, page 979.
Section 63.—Taxable
Income Defined
The Service provides inflation adjustments to the
standard deduction amounts (including the limitation
in the case of certain dependents, and the additional
standard deduction for the aged or blind) for taxable
years beginning in 2006. See Rev. Proc. 2005-70,
page 979.
Section 68.—Overall
Limitation on Itemized
Deductions
The Service provides inflation adjustments to the
overall limitation on itemized deductions for taxable
years beginning in 2006. See Rev. Proc. 2005-70,
page 979.
Section 132.—Certain
Fringe Benefits
The Service provides inflation adjustments to the
limitations on the exclusion of income for a qualified
transportation fringe benefit for taxable years begin-
ning in 2006. See Rev. Proc. 2005-70, page 979.
Section 135.—Income
From United States Savings
Bonds Used to Pay Higher
Education Tuition and Fees
The Service provides inflation adjustments to the
limitation on the exclusion of income from United
States savings bonds for taxpayers who pay qualified
higher education expenses for taxable years begin-
ning in 2006. See Rev. Proc. 2005-70, page 979.
Section 137.—Adoption
Assistance Programs
The Service provides inflation adjustments to the
maximum amount that can be excluded from an em-
ployee’s gross income in connection with a qualified
adoption assistance programfor taxable years begin-
ning in 2006. The Service also provides inflation ad-
justments to the amount used to calculate the modi-
fied adjusted gross income limitations used to deter-
mine the amount that can be excluded from an em-
ployee’s gross income for taxable years beginning in
2006. See Rev. Proc. 2005-70, page 979.
Section 146.—Volume Cap
The Service provides inflation adjustments to the
amounts used to determine the State ceiling for the
volume cap of private activity bonds for calendar year
2006. See Rev. Proc. 2005-70, page 979.
Section 148.—Arbitrage
26 CFR 1.148–5: Yield and valuation of investments.
The Service provides inflation adjustments for de-
termining in the calendar year 2006 whether a bro-
ker’s commission or similar fee with respect to the
November 21, 20059732005–47 I.R.B.

acquisition of a guaranteed investment contract or in-
vestments purchased for a yield restricted defeasance
escrow is reasonable. See Rev. Proc. 2005-70, page
979.
Section 151.—Allowance
of Deductions for Personal
Exemptions
The Service provides inflation adjustments to the
personal exemption and to the threshold amounts of
adjusted gross income above which the exemption
amount phases out for taxable years beginning in
2006. See Rev. Proc. 2005-70, page 979.
Section 170.—Charitable,
etc., Contributions and Gifts
The Service provides inflation adjustments to the
“insubstantial benefit” guidelines for calendar year
2006. Under the guidelines, a charitable contribu-
tion is fully deductible even though the contributor re-
ceives “insubstantial benefits” from the charity. See
Rev. Proc. 2005-70, page 979.
Section 179.—Election
to Expense Certain
Depreciable Business
Assets
The Service provides inflation adjustments to the
aggregate cost of section 179 property that a taxpayer
may elect to treat as an expense for taxable years be-
ginning in 2006. See Rev. Proc. 2005-70, page 979.
Section 213.—Medical,
Dental, etc., Expenses
The Service provides inflation adjustments to the
limitation on the amount of eligible long-term care
premiums includible in the term “medical care” for
taxable years beginning in 2006. See Rev. Proc.
2005-70, page 979.
Section 220.—Archer MSAs
The Service provides inflation adjustments to the
amounts used to determine whether a health plan is
a “high deductible health plan” for purposes of de-
termining whether an individual is eligible for a de-
duction for cash paid to a medical savings account
for taxable years beginning in 2006. See Rev. Proc.
2005-70, page 979.
Section 221.—Interest on
Education Loans
The Service provides inflation adjustments to the
income limitations used to determine the allowable
deduction for interest on education loans for taxable
years beginning in 2006. See Rev. Proc. 2005-70,
page 979.
Section 223.—Health
Savings Accounts
The Service provides inflation adjustments for cal-
endar year 2006 to the monthly limitations on deduc-
tions under a high deductible plan and to the amounts
used in defining a high deductible plan. See Rev.
Proc. 2005-70, page 979.
Section 512.—Unrelated
Business Taxable Income
The Service provides an inflation adjustment to the
maximum amount of annual dues that can be paid
to certain agricultural or horticultural organizations
without any portion being treated as unrelated trade
or business income by reason of any benefits or priv-
ileges available to members for taxable years begin-
ning in 2006. See Rev. Proc. 2005-70, page 979.
Section 513.—Unrelated
Trade or Business
The Service provides an inflation adjustment to
the maximum cost of a “low cost article” for tax-
able years beginning in 2006. Funds raised through
a charity’s distribution of “low cost articles” will not
be treated as unrelated business income to the charity.
See Rev. Proc. 2005-70, page 979.
Section 685.—Treatment
of Funeral Trusts
The Service provides an inflation adjustment to the
maximum amount of contributions that may be made
to a qualified funeral trust for contracts entered in
calendar year 2006. See Rev. Proc. 2005-70, page
979.
Section 877.—Expatriation
to Avoid Tax
The Service provides an inflation adjustment to
the amount used for calendar year 2006 to determine
whether an individual’s loss of United States citizen-
ship had the avoidance of United States tax as one of
its principal purposes. See Rev. Proc. 2005-70, page
979.
Section 2032A.—Valuation
of Certain Farm, etc.,
Real Property
The Service provides an inflation adjustment to the
maximum amount by which the value of certain farm
and other qualified real property included in a dece-
dent’s gross estate may be deceased for purposes of
valuing the estate of a decedent dying in calendar year
2006. See Rev. Proc. 2005-70, page 979.
Section 2503.—Taxable
Gifts
The Service provides an inflation adjustment to the
amount of gifts that may be made to a person in a
calendar year without including the amount in taxable
gifts for calendar year 2006. See Rev. Proc. 2005-70,
page 979.
Section 2523.—Gift to
Spouse
The Service provides an inflation adjustment to the
amount of gifts that may be made in a calendar year
to a spouse who is not a citizen of the United States
without including the amount in taxable gifts for cal-
endar year 2006. See Rev. Proc. 2005-70, page 979.
Section 4161.—Imposition
of Tax
The Service provides an inflation adjustment to the
amount of excise tax imposed for calendar year 2006
on the first sale by a manufacturer, producer, or im-
porter of any shaft of a type used in the manufacture
of certain arrows. See Rev. Proc. 2005-70, page 979.
Section 4261.—Imposition
of Tax
The Service provides inflation adjustments to the
amounts of the excise taxes on passenger air trans-
portation beginning or ending in the United States and
for each domestic segment of air transportation for
calendar year 2006. See Rev. Proc. 2005-70, page
979.
Section 60
33.—Returns by
Exempt Organizations
The Service provides an inflation adjustment to
the amount of dues certain exempt organizations with
nondeductible lobbying expenditures can charge and
still be excepted from reporting requirements for tax-
able years beginning in 2006. See Rev. Proc. 2005-
70, page 979.
Section 6039F.—Notice of
Large Gifts Received From
Foreign Persons
The Service provides an inflation adjustment to the
amount of gifts received, in a taxable year from for-
eign persons, that triggers areporting requirement for
a United States person for taxable years beginning in
2006. See Rev. Proc. 2005-70, page 979.
2005–47 I.R.B.974November 21, 2005

Section 6323.—Validity
and Priority Against
Certain Persons
The Service provides inflation adjustments for cal-
endar year 2006 to (1) the maximum amount of a ca-
sual sale of personal property below which a federal
tax lien will not be valid against a purchaser of the
property and (2) the maximum amount of a contract
for the repair or improvement of certain residential
property at or below which a federal tax lien will not
be valid against a mechanic’s lienor. See Rev. Proc.
2005-70, page 979.
Section 6334.—Property
Exempt From Levy
The Service provides inflation adjustments to the
value of certain property exempt from levy (fuel, pro-
visions, furniture, household personal effects, arms
for personal use, livestock, poultry, and books and
tools of a trade, business, or profession) for calendar
year 2006. See Rev. Proc. 2005-70, page 979.
Section 6601.—Interest
on Underpayment,
Nonpayment, or Extensions
of Time for Payment, of Tax
The Service provides an inflation adjustment to
the amount used to determine the amount of interest
charged on a certain portion of the estate tax payable
in installments for the estate of a decedent dying in
calendar year 2006. See Rev. Proc. 2005-70, page
979.
Section 7430.—Awarding
of Costs and Certain Fees
The Service provides an inflation adjustment to the
hourly limit on attorney fees incurred in calendar year
2006 that may be awarded in a judgment or settlement
of an administrative or judicial proceeding concern-
ing the determination, collection, or refund of tax, in-
terest, or penalty. See Rev. Proc. 2005-70, page 979.
Section 7702B.—Treatment
of Qualified Long-Term
Care Insurance
The Service provides an inflation adjustment to the
stated dollar amount for calendar year 2006 of theper
diemlimitation regarding periodic payments received
under a qualified long-term care insurance contract
or periodic payments received under a life insurance
contract that are treated aspaid by reason of the death
of a chronically ill individual. See Rev. Proc. 2005-
70, page 979.
November 21, 20059752005–47 I.R.B.

Part III. Administrative, Procedural, and Miscellaneous
Weighted Average Interest
Rate Update
Notice 2005–72
This notice provides guidance as to the
corporate bond weighted average interest
rate and the permissible range of interest
rates specified under § 412(b)(5)(B)(ii)(II)
of the Internal Revenue Code. In ad-
dition, it provides guidance as to the
interest rate on 30-year Treasury securi-
ties under § 417(e)(3)(A)(ii)(II), and the
weighted average interest rate and permis-
sible ranges of interest rates based on the
30-year Treasury securities rate.
CORPORATE BOND WEIGHTED
AVERAGE INTEREST RATE
Sections412(b)(5)(B)(ii)and
412(l)(7)(C)(i), as amended by the Pen-
sion Funding Equity Act of 2004, provide
that the interest rates used to calculate cur-
rent liability and to determine the required
contribution under § 412(l) for plan years
beginning in 2004 or 2005 must be within
a permissible range based on the weighted
average of the rates of interest on amounts
invested conservatively in long term in-
vestment grade corporate bonds during the
4-year period ending on the last day before
the beginning of the plan year.
Notice 2004–34, 2004–1 C.B. 848, pro-
vides guidelines for determining the cor-
porate bond weighted average interest rate
and the resulting permissible range of in-
terest rates used to calculate current liabil-
ity. That notice establishes that the corpo-
rate bond weighted average is based on the
monthly composite corporate bond rate de-
rived from designated corporate bond in-
dices.
The composite corporate bond rate for
October 2005 is 5.68 percent. Pursuant
to Notice 2004–34, the Service has de-
termined this rate as the average of the
monthly yields for the included corporate
bond indices for that month.
The following corporate bond weighted
average interest rate was determined for
plan years beginning in the month shown
below.
For Plan Years
Corporate
Bond90% to 110%
Beginning in:WeightedPermissible
MonthYearAverageRange
November20055.795.21 to 5.79
30-YEAR TREASURY SECURITIES
WEIGHTED AVERAGE INTEREST
RATE
Section 417(e)(3)(A)(ii)(II) defines
the applicable interest rate, which must
be used for purposes of determining the
minimum present value of a participant’s
benefit under § 417(e)(1) and (2), as the
annual rate of interest on 30-year Treasury
securities for the month before the date
of distribution or such other time as the
Secretary may by regulations prescribe.
Section 1.417(e)–1(d)(3) of the Income
Tax Regulations provides that the applica-
bleinterestrateforamonthistheannual
interest rate on 30-year Treasury securi-
ties as specified by the Commissioner for
that month in revenue rulings, notices or
other guidance published in the Internal
Revenue Bulletin.
Section 404(a)(1) of the Code, as
amended by the Pension Funding Eq-
uity Act of 2004, permits an employer
to elect to disregard subclause (II) of
§ 412(b)(5)(B)(ii) to determine the max-
imum amount of the deduction allowed
under § 404(a)(1).
The rate of interest on 30-year Treasury
securities for October 2005 is 4.68 percent.
Pursuant to Notice 2002–26, 2002–1 C.B.
743, the Service has determined this rate
as the monthly average of the daily deter-
mination of yield on the 30-year Treasury
bond maturing in February 2031.
The following 30-year Treasury rates
were determined for the plan years begin-
ning in the month shown below.
For Plan Years
30-Year
Treasury90% to 105%90% to 110%
Beginning in:WeightedPermissiblePermissible
MonthYearAverageRangeRange
November20054.884.39 to 5.124.39 to 5.37
Drafting Information
The principal authors of this notice
are Paul Stern and Tony Montanaro of
the Employee Plans, Tax Exempt and
Government Entities Division. For fur-
ther information regarding this notice,
please contact the Employee Plans’ tax-
payer assistance telephone service at
1–877–829–5500 (a toll-free number),
between the hours of 8:00 a.m. and
6:30 p.m. Eastern time, Monday through
Friday. Mr. Stern may be reached at
1–202–283–9703. Mr. Montanaro may
be reached at 1–202–283–9714. The tele-
phone numbers in thepreceding sentences
are not toll-free.
2005–47 I.R.B.976November 21, 2005

Katrina — Supplemental
Government Acts Notice
Notice 2005–81
PURPOSE
This notice supplements Notice
2005–66, 2005–40 I.R.B. 620 (October
3, 2005), which postponed until January
3, 2006, deadlines for the Internal Rev-
enue Service (IRS) to perform certain
acts under section 7508A with respect to
certain taxpayers affected by Hurricane
Katrina. This Notice (1) expands the defi-
nition of “covered disaster area” to include
additional counties and parishes that the
Federal Emergency Management Agency
(FEMA) determined were eligible for fed-
eral assistance after the IRS issued Notice
2005–66; (2) extends the deadlines for the
IRS to perform certain acts to February
28, 2006, to match the deadlines for af-
fected taxpayers to file, pay, and perform
certain acts; (3) expands the definition of
affected taxpayer to match the definition
of affected taxpayers in Notice 2005–73,
2005–42 I.R.B. 723 (October 17, 2005);
and (4) grants the IRS a postponement
of time to perform an act not previously
identified in Notice 2005–66 — issuing a
Notice of Final Partnership Administrative
Adjustment (FPAA) under section 6223.
ADDENDA TO NOTICE 2005–66
Covered disaster area
Notice 2005–66 specifically identified
those counties and parishes FEMA had
designated at that time as eligible for Pub-
lic Assistance or Public Assistance and
Individual Assistance as constituting a
“covered disaster area” within the mean-
ing of Treas. Reg. § 301.7508A–1(d)(2).
After the IRS issued Notice 2005–66,
FEMA designated eight additional coun-
ties in Florida, 16 additional counties in
Alabama, and 30 additional counties in
Mississippi as eligible for Public Assis-
tance or Public Assistance and Individual
Assistance. All counties and parishes so
designated by FEMA constitute a “covered
disaster area” within the meaning of sec-
tion 301.7508A–1(d)(2).SeeAppendix
to Notice 2005–73 (complete list of coun-
ties and parishes designated by FEMA).
The postponement of time for the IRS to
perform the acts listed in Notice 2005–66,
otherwise due on or after September 6,
2005, and on or before February 28, 2006,
applies to all the counties and parishes
listed in the Appendix to Notice 2005–73,
and to counties and parishes that FEMA
later designates as eligible for Individual
Assistance and/or Public Assistance as a
result of the devastation caused by Hurri-
cane Katrina.
Extension of the postponement period
By news releases issued on August
30, 2005, September 2, 2005, Septem-
ber 8, 2005, and September 14, 2005,
the IRS granted affected taxpayers un-
til January 3, 2006, to file certain re-
turns, to pay certain taxes, and to per-
form certain time-sensitive acts listed
in section 301.7508A–1(c)(1) and Rev.
Proc. 2005–27, 2005–20 I.R.B. 1050.See
IR–2005–84; IR–2005–91; IR–2005–96;
IR–2005–103. Notice 2005–73 and News
Release IR–2005–109 summarize the re-
lief granted and the definitions of affected
taxpayers and covered disaster area.
On September 23, 2005, the President
signed the Katrina Emergency Tax Relief
Act of 2005, Pub. L. 109–73 (KETRA).
Section 403(b) of KETRA provides that in
the case of any taxpayer determined by the
Secretary of the Treasury to be affected by
the Presidentially declared disaster relat-
ing to Hurricane Katrina, any relief pro-
vided under section 7508A should be for
a period ending not earlier than February
28, 2006. By News Release IR–2005–112
of September 28, 2005, the IRS informed
affected taxpayers of the postponement of
time to February 28, 2006, to file returns,
pay taxes, and perform other time-sensi-
tive acts under the tax laws. In consid-
eration of the additional time Congress
granted affected taxpayers to file, pay, and
perform certain acts, this notice supple-
ments Notice 2005–66 by extending the
period for the IRS to perform certain acts
otherwise due on or after September 6,
2005, and on or before February 28, 2006,
to February 28, 2006.
Affected taxpayers
Under section 301.7508A–1(d)(1)(vii),
the IRS may determine that any other per-
son is affected by a Presidentially-declared
disaster and thereforeeligible for relief.
Accordingly, the IRS has determined that
the following persons are also affected by
Hurricane Katrina and its aftermath: (1)
all workers assisting in the relief activi-
ties in the covered disaster area, regardless
of whether they are affiliated with recog-
nized government or philanthropic organi-
zations; (2) any individual whose principal
residence, and any business entity whose
principal place of business, is not located
in the covered disaster area, but whose
tax professional/practitioner’s office is lo-
cated in the covered disaster area; and (3)
individuals, visiting the covered disaster
areas, who were killed or injured as a result
of Hurricane Katrina and its aftermath. For
purposes of (3) above, the estate of an in-
dividual visiting the covered disaster who
was killed as a result of the hurricane is
also considered to be an affected taxpayer.
SeeNotice 2005–73. Thus, this notice sup-
plements Notice 2005–66 by extending the
period for the IRS to perform certain acts
related to affected taxpayers as defined in
Notice 2005–73 otherwise due on or after
September 6, 2005, and on or before Feb-
ruary 28, 2006, to February 28, 2006.
Time for Issuing Notice of Final
Partnership Administrative Adjustment
In addition to the acts listed in Notice
2005–66, for affected taxpayers described
in Notice 2005–66 (including taxpayers
whose documents maintained by the IRS
within the covered disaster area may have
been lost or destroyed as a result of Hurri-
cane Katrina, or remain in buildings that
are inaccessible) and this notice, a post-
ponement until February 28, 2006, is pro-
vided under section 7508A for the IRS to
issueanFPAAtotheTaxMattersPart-
ner under section 6223 with respect to the
tax attributable to the partnership items of
partners of any partnership that is an af-
fected taxpayer if the last date for issuance
of the FPAA is on or after November 7,
2005, and on or before February 28, 2006.
DRAFTING INFORMATION
The principal author of this notice is
Dillon Taylor of the Office of Associate
Chief Counsel, Procedure and Administra-
tion (Administrative Provisions and Judi-
cial Practice Division). For further infor-
mation regarding thisnotice, you may call
(202) 622–4940 (not a toll-free call).
November 21, 20059772005–47 I.R.B.

Rita — Government Act Notice
Notice 2005–82
PURPOSE
This notice under section 7508A post-
pones the deadlines for certain acts per-
formed by the Internal Revenue Service
(IRS) with respect to certain taxpayers
affected by Hurricane Rita. In response
to Hurricane Rita, the President issued
disaster declarations on September 23,
2005, covering Texas and Louisiana. The
Presidential declarations authorized, un-
der the Robert T. Stafford Disaster Relief
and Emergency Assistance Act, 42 U.S.C.
§§ 5121–5206 (Stafford Act), the Fed-
eral Emergency Management Agency
(FEMA) to provide Individual Assistance,
Public Assistance, and assistance under
the Hazard Mitigation Grant Program to
counties and parishes in each state. Un-
der that authority, FEMA determined that
certain counties and parishes within those
states were eligible for both Individual
Assistance and Public Assistance, that
all counties in Texas and all parishes in
Louisiana were eligible for Public Assis-
tance, and that all counties and parishes
could apply for assistance under the Haz-
ard Mitigation Grant Program.
By News Release IR–2005–110 of
September 26, 2005, the IRS granted re-
lief for taxpayers affected by Hurricane
Rita. News Release IR–2005–110 pro-
vided that all counties and parishes in
Texas and Louisiana constitute a “cov-
ered disaster area” within the meaning of
§ 301.7508A–1(d)(2), of the Procedure
& Administration Regulations. Further,
News Release IR–2005–110 provided
that taxpayers affected by the disaster
will have until February 28, 2006, to
file tax returns and submit payments. In
addition, News Release IR–2005–110
provided affected taxpayers until Febru-
ary 28, 2006, to perform the acts listed in
section 301.7508A–1(c)(1) and Rev. Proc.
2005–27, 2005–20 I.R.B. 1050 (May 16,
2005).
BACKGROUND
Section 7508A provides the Secretary
with authority to postpone the time for
performing certain acts under the internal
revenue laws for a taxpayer affected by
a Presidentially declared disaster as de-
fined in section 1033(h)(3). Pursuant to
section 7508A(a), a period of up to one
year may be disregarded in determining
whether the performance of certain acts by
affected taxpayers is timely under the in-
ternal revenue laws. Section 7508A(a)(1)
includes the acts listed in section 7508(a)
as those that may be postponed.See also
§ 301.7508A–1(c)(1). Section 7508(a) and
§ 301.7508A–1(c)(1) include a number of
acts performed by taxpayers for which sec-
tion 7508A relief may apply. These in-
clude, but are not limited to: the filing of
certain tax returns; the payment of certain
taxes; the filing of a Tax Court petition; the
filing of a claim for credit or refund of tax;
and the bringing of a lawsuit upon a claim
for credit or refund of tax.
Section 301.7508A–1(d)(1) describes
several types of “affected taxpayers” el-
igible for certain postponements of up to
one year. These affected taxpayers include
any individual whose principal residence,
and any business entity whose principal
place of business, is located in the cov-
ered disaster area; any individual who is a
relief worker affiliated with a recognized
government or philanthropic organiza-
tion and who is assisting in the covered
disaster area; any individual whose prin-
cipal residence, and any business entity
whose principal place of business, is not
located in the covereddisaster area, but
whose records necessary to meet a filing
or payment deadline are maintained in the
covered disaster area; any estate or trust
that has tax records necessary to meet a
filing or payment deadline in the covered
disaster area; and any spouse of an af-
fected taxpayer, solely with regard to a
joint return of the husband and wife.
Additionally,undersection
301.7508A–1(d)(1)(vii), the IRS may
determine that any other person is affected
by a Presidentially declared disaster and is
therefore eligible for relief. Accordingly,
as stated in News Release IR–2005–110,
the IRS has determined that the following
persons are also affected by Hurricane
Rita and its aftermath: (1) all workers
assisting in the relief activities in the
covered disaster area, regardless of
whether they are affiliated with rec-
ognized government or philanthropic
organizations; (2) any individual whose
principal residence, and any business
entity whose principal place of business,
is not located in the covered disaster area,
but whose tax professional/practitioner’s
office is located in the covered disaster
area; and (3) individuals, visiting the
covered disaster area, who were killed or
injured as a result of Hurricane Rita and its
aftermath. For purposes of (3) above, the
estate of an individual visiting the covered
disaster area who was killed as a result of
the hurricane is also considered to be an
affected taxpayer.SeeIR–2005–110.
ACTSPERFORMEDBYTHE
GOVERNMENT
In News Release IR–2005–110, the IRS
granted affected taxpayers additional time
until February 28, 2006, to file tax re-
turns, to submit payments, and to perform
certain time-sensitive acts listed in sec-
tion 301.7508A–1(c)(1) and in Rev. Proc.
2005–27. In consideration of the addi-
tional time that affected taxpayers have
been granted to perform certain acts, this
notice extends the period for the govern-
ment to take certain actions. Under the au-
thority of section 7508A(a)(1) and section
301.7508A–1(c)(2), for affected taxpayers
covered by News Release IR–2005–110,
this notice provides a postponement until
February 28, 2006, under section 7508A
for the following government acts if the
last date for performance of the act is on
or after November 7, 2005, and on or be-
fore February 28, 2006: making an assess-
ment of any tax; issuing a statutory no-
tice of deficiency; allowing a credit or re-
fund of any tax; collecting by the Secre-
tary, by levy or otherwise, the amount of
any liability in respect of any tax; bring-
ing suit by the United States, or any officer
on its behalf, in respect of any tax liabil-
ity; returning property under section 6343;
discharging an executor from personal lia-
bility for a decedent’s taxes under section
6905; and issuing a notice of Final Partner-
ship Administrative Adjustment (FPAA)
to the Tax Matters Partner under section
6223 with respect to the tax attributable
to the partnership items of partners of any
partnership subject to TEFRA proceedings
that is an affected taxpayer.
Documents maintained by the IRS
within the covered disaster area may have
been lost or destroyed as a result of Hur-
ricane Rita, or remain in buildings that
are inaccessible. The destruction, loss or
inaccessibility of these documents will
2005–47 I.R.B.978November 21, 2005

materially interfere with the IRS’s ability
to timely administer the internal revenue
laws with respect to certain taxpayers. The
taxpayers to whom these records relate are
“affected taxpayers”for the limited pur-
poses set forth in this paragraph. In these
cases, a postponement until February 28,
2006, is provided under section 7508A for
the following government acts if the last
date for performance of the act is on or
after November 7, 2005, and on or before
February 28, 2006: making an assessment
of any tax; issuing a statutory notice of de-
ficiency; allowing a credit or refund of any
tax; collecting by theSecretary, by levy
or otherwise, the amount of any liability
in respect of any tax; bringing suit by the
United States, or any office on its behalf,
in respect of any tax liability; returning
property under section 6343; the discharge
of an executor from personal liability for a
decedent’s taxes under section 6905, and
issuing an FPAA under section 6223 as
described above. The disregarding of time
under section 7508A results in a deadline
of February 28, 2006, not in a suspension
of a period. The IRS will notify as soon
as practicable any affected taxpayers, as
defined under this paragraph, of the gov-
ernment act or acts that will be postponed.
DRAFTING INFORMATION
The principal author of this notice is
Dillon Taylor of the Office of Associate
Chief Counsel, Procedure and Administra-
tion (Administrative Provisions and Judi-
cial Practice Division). For further infor-
mation regarding thisnotice, you may call
(202) 622–4940 (not a toll-free call).
26 CFR 601.602: Tax forms and instructions.
(Also Part I, §§ 1, 23, 24, 25A, 32, 42, 59, 62, 63, 68, 132, 135, 137, 146, 148, 151, 170, 179, 213, 220, 221, 223, 512, 513, 685, 877, 2032A, 2503, 2523, 4161, 4261,
6033, 6039F, 6323, 6334, 6601, 7430, 7702B; 1.148–5.)
Rev. Proc. 2005–70
TABLE OF CONTENTS
SECTION 1. PURPOSE
SECTION 2. CHANGES
SECT
ION 3. 2006 ADJUSTED ITEMS
C
odeSection
.01TaxRateTables.......................................................................... 1(a)–(e)
.02
UnearnedIncomeofMinorChildrenTaxedasifParent’sIncome(“KiddieTax”)................
1(g
)
.03AdoptionCredit.......................................................................... 23
.04ChildTaxCredit......................................................................... 24
.05
HopeandLifetimeLearningCredits........................................................
25A
.06EarnedIncomeCredit..................................................................... 32
.07Low-IncomeHousingCredit .............................................................. 42(h)
.0
8AlternativeMinimumTaxExemptionforaChildSubjecttothe“KiddieTax”...................
59
(j)
.09 Transportation Mainline Pipeline ConstructionIndustry Optional Expense Substantiation Rules for
PaymentstoEmployeesunderAccountablePlans ............................................... 62(c)
.10StandardDeduction ...................................................................... 63
.
11OverallLimitationonItemizedDeductions..................................................
6
8
.12QualifiedTransportationFringe............................................................ 132(f)
.13 Income from United States Savings Bonds for Taxpayers Who Pay Qualified Higher Education
Expenses................................................................................... 135
.14AdoptionAssistancePrograms............................................................. 137
.15PrivateActivityBondsVolumeCap........................................................ 146(d)
.16 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments
PurchasedforaYieldRestrictedDefeasanceEscrow............................................. 148
.17PersonalExemption...................................................................... 151
.18ElectiontoExpenseCertainDepreciableAssets.............................................. 179
November 21, 20059792005–47 I.R.B.

.19EligibleLong-TermCarePremiums........................................................ 213(d)(10)
.20MedicalSavingsAccounts ................................................................ 220
.21InterestonEducationLoans............................................................... 221
.22HealthSavingsAccounts.................................................................. 223
.23TreatmentofDuesPaidtoAgriculturalorHorticulturalOrganizations.......................... 512(d)
.24 Insubstantial Benefit Limitations for Contributions Associated with Charitable Fund-Raising
Campaigns ................................................................................. 513(h)
.25FuneralTrusts ........................................................................... 685
.26ExpatriationtoAvoidTax................................................................. 877
.27 Valuation of Qualified Real Property in Decedent’s Gross Estate............................... 2032A
.28AnnualExclusionforGifts................................................................ 2503&2523
.29TaxonArrowShafts...................................................................... 4161
.30PassengerAirTransportationExciseTax.................................................... 4261
.31 Reporting Exception for Certain Exempt Organizations with Nondeductible Lobbying
Expenditures ............................................................................... 6033(e)(3)
.32 Notice of Large Gifts Received from Foreign Persons........................................ 6039F
.33PersonsAgainstWhichaFederalTaxLienIsNotValid....................................... 6323
.34PropertyExemptfromLevy............................................................... 6334
.35InterestonaCertainPortionoftheEstateTaxPayableinInstallments.......................... 6601(j)
.36AttorneyFeeAwards..................................................................... 7430
.37 Periodic Payments Received under Qualified Long-Term Care Insurance Contracts or under Certain
LifeInsuranceContracts ..................................................................... 7702B(d)
SECTION 4. EFFECTIVE DATE
SECTION 5. DRAFTING INFORMATION
SECTION 1. PURPOSE
This revenue procedure sets forth infla-
tion adjusted items for 2006.
SECTION 2. CHANGES
.01 The amount of tax imposed by
§ 4161(b)(2)(A) on the first sale by the
manufacturer, producer, or importer of
any shaft of a type used in the manu-
facture of certain arrows is adjusted for
inflation. (Section 3.29).
SECTION3.2006ADJUSTEDITEMS
.01Tax Rate Tables. For taxable years
beginning in 2006, the tax rate tables under
§1areasfollows:
TABLE 1 — Section 1(a). — Married Individuals Filing Joint Returns and Surviving Spouses
If Taxable Income Is:The Tax Is:
Not Over $15,100
10% of the taxable income
Over $15,100 but not over $61,300$1,510 plus 15% of the excess over $15,100
Over $61,300 but not over $123,700$8,440 plus 25% of the excess over $61,300
Over $123,700 but not over $188,450$24,040 plus 28% of the excess over $123,700
Over $188,450 but not over $336,550$42,170 plus 33% of the excess over $188,450
Over $336,550$91,043 plus 35% of the excess over $336,550
2005–47 I.R.B.980November 21, 2005

TABLE 2 — Section 1(b). — Heads of Households
If Taxable Income Is:The Tax Is:
Not Over $10,750
10% of the taxable income
Over $10,750 but not over $41,050$1,075 plus 15% of the excess over $10,750
Over $41,050 but not over $106,000$5,620 plus 25% of the excess over $41,050
Over $106,000 but not over $171,650$21,857.50 plus 28% of the excess over $106,000
Over $171,650 but not over $336,550$40,239.50 plus 33% of the excess over $171,650
Over $336,550$94,656.50 plus 35% of the excess over $336,550
TABLE 3 — Section 1(c). — Unmarried Individuals (other than Surviving Spouse and Heads of Households).
If Taxable Income Is:The Tax Is:
Not Over $7,550
10% of the taxable income
Over $7,550 but not over $30,650$755 plus 15% of the excess over $7,550
Over $30,650 but not over $74,200$4,220 plus 25% of the excess over $30,650
Over $74,200 but not over $154,800$15,107.50 plus 28% of the excess over $74,200
Over $154,800 but not over $336,550$37,675.50 plus 33% of the excess over $154,800
Over $336,550$97,653 plus 35% of the excess over $336,550
TABLE 4 — Section 1(d). — Married Individuals Filing Separate Returns
If Taxable Income Is:The Tax Is:
Not Over $7,550
10% of the taxable income
Over $7,550 but not over $30,650$755 plus 15% of the excess over $7,550
Over $30,650 but not over $61,850$4,220 plus 25% of the excess over $30,650
Over $61,850 but not over $94,225$12,020 plus 28% of the excess over $61,850
Over $94,225 but not over $168,275$21,085 plus 33% of the excess over $94,225
Over $168,275$45,521.50 plus 35% of the excess over $168,275
TABLE 5 — Section 1(e). — Estates and Trusts
I
f Taxable Income Is:
T
he Tax Is:
Not Over $2,050
15% of the taxable income
Over $2,050 but not over $4,850$307.50 plus 25% of the excess over $2,050
Over $4,850 but not over $7,400$1,007.50 plus 28% of the excess over $4,850
Over $7,400 but not over $10,050$1,721.50 plus 33% of the excess over $7,400
Over $10,050$2,596 plus 35% of the excess over $10,050
.02Unearned Income of Minor Chil-
dren Taxed as if Parent’s Income (the
“Kiddie Tax”).For taxable years
beginning in 2006, the amount in
§ 1(g)(4)(A)(ii)(I), which is used to reduce
the net unearned income reported on the
child’s return that is subject to the “kiddie
tax,” is $850. (This amount is the same
as the $850 standard deduction amount
provided in section 3.10(2) of this revenue
procedure.) The same $850 amount is
used for purposes of § 1(g)(7) (that is, in
determining whether a parent may elect
to include a child’s gross income in the
parent’s gross income and for calculating
the “kiddie tax”). For example, one of the
requirements for the parental election is
that a child’s gross income is more than the
November 21, 20059812005–47 I.R.B.

amount referenced in § 1(g)(4)(A)(ii)(I)
but less than 10 times such amount; thus,
a child’s gross income for 2006 must be
more than $850 but less than $8,500 to
satisfy that requirement.
.03Adoption Credit. For taxable years
beginning in 2006, under § 23(a)(3) the
maximum credit allowed for an adoption
of a child with special needs is $10,960.
For taxable years beginning in 2006,
under § 23(b)(1) the maximum credit al-
lowed with regard to other adoptions is the
amount of qualified adoption expenses up
to $10,960. The available adoption credit
begins to phase out under § 23(b)(2)(A)
for taxpayers with modified adjusted
gross income in excess of $164,410 and
is completely phased out for taxpayers
with modified adjusted gross income of
$204,410. (See section 3.14 of this rev-
enue procedure for the adjusted items
relating to adoption assistance programs.)
.04Child Tax Credit. For taxable
years beginning in 2006, the value used
in § 24(d)(1)(B)(i) in determining the
amount of credit under § 24 that may be
refundable is $11,300.
.05Hope and Lifetime Learning Cred-
its.
(1) For taxable years beginning in 2006,
100 percent of qualified tuition and re-
lated expenses not in excess of $1,100 and
50 percent of such expenses in excess of
$1,100 are taken into account in determin-
ing the amount of the Hope Scholarship
Credit under § 25A(b)(1).
(2) For taxable years beginning in
2006, a taxpayer’s modified adjusted
gross income in excess of $45,000
($90,000 for a joint return) is taken into
account in determining the reduction un-
der § 25A(d)(2)(A)(ii) in the amount of
the Hope Scholarship and Lifetime Learn-
ing Credits otherwise allowable under
§25A(a).
.06Earned Income Credit.
(1)In general. For taxable years be-
ginning in 2006, the following amounts
are used to determine the earned income
credit under § 32(b). The “earned in-
come amount” is the amount of earned
income at or above which the maximum
amount of the earned income credit is al-
lowed. The “threshold phaseout amount”
is the amount of adjusted gross income
(or, if greater, earned income) above which
the maximum amount of the credit begins
to phase out. The “completed phaseout
amount” is the amount of adjusted gross
income (or if greater, earned income) at or
above which no credit is allowed.
Number of Qualifying Children
ItemOneTwo or MoreNone
Earned Income Amount
$ 8,080$11,340$ 5,380
Maximum Amount of Credit
$ 2,747$ 4,536$ 412
Threshold Phaseout Amount
(Single, Surviving Spouse, or
Head of Household)
$14,810$14,810$ 6,740
Completed Phaseout Amount
(Single, Surviving Spouse, or Head of
Household)
$32,001$36,348$12,120
Threshold Phaseout Amount
(Married Filing Jointly)
$16,810$16,810$ 8,740
Completed Phaseout Amount
(Married Filing Jointly)
$34,001$38,348$14,120
The instructions for the Form 1040 se-
ries provide tables showing the amount of
the earned income credit for each type of
taxpayer.
(2)Excessive investment income.For
taxable years beginning in 2006, the
earned income tax credit is denied under
§ 32(i) if the aggregate amount of certain
investment income exceeds $2,800.
.07Low-Income Housing Credit.For
calendar year 2006, the amounts used un-
der § 42(h)(3)(C)(ii) to calculate the State
housing credit ceiling for the low-income
housing credit is the greater of (i) $1.90
multiplied by the State population, or (ii)
$2,190,000.
.08Alternative Minimum Tax Exemp-
tion for a Child Subject to the “Kiddie
Tax.”For taxable years beginning in 2006,
for a child to whom the § 1(g) “kiddie tax”
applies, the exemption amount under §§ 55
and 59(j) for purposes of the alternative
minimum tax under § 55 may not exceed
the sum of (i) such child’s earned income
for the taxable year, plus (ii) $6,050.
.09Transportation Mainline Pipeline
Construction Industry Optional Expense
Substantiation Rules for Payments to Em-
ployees under Accountable Plans.For
calendar year 2006, an eligible employer
may pay certain welders and heavy equip-
mentmechanicsanamountofupto$14
per hour for rig-related expenses that is
deemed substantiated under an account-
able plan when paid in accordance with
Rev. Proc. 2002–41, 2002–1 C.B. 1098.
If the employer provides fuel or otherwise
reimburses fuel expenses, up to $8 per hour
is deemed substantiated when paid under
Rev. Proc. 2002–41.
.10Standard Deduction.
(1)In general. For taxable years be-
ginning in 2006, the standard deduction
amounts under § 63(c)(2) are as follows:
2005–47 I.R.B.982November 21, 2005

Filing StatusStandard Deduction
Married Individuals Filing Joint Returns and Surviving Spouses (§ 1(a))
$10,300
Heads of Households (§ 1(b))
$ 7,550
Unmarried Individuals (other than Surviving Spouses and Heads of
Households) (§ 1(c))
$ 5,150
Married Individuals Filing Separate Returns (§ 1(d))
$ 5,150
(2)Dependent. For taxable years be-
ginning in 2006, the standard deduction
amount under § 63(c)(5) for an individual
who may be claimed as a dependent by an-
other taxpayer may not exceed the greater
of (i) $850, or (ii) the sum of $300 and the
individual’s earned income.
(3)Aged and blind. For taxable years
beginning in 2006, the additional standard
deduction amounts under § 63(f) for the
aged and for the blindare $1,000 for each.
These amounts are increased to $1,250 if
the individual is also unmarried and not a
surviving spouse.
.11Overall Limitation on Itemized De-
ductions. For taxable years beginning in
2006, the “applicable amount” of adjusted
gross income under § 68(b), above which
the amount of otherwise allowable item-
ized deductions is reduced under § 68, is
$150,500 (or $75,250 for a separate return
filed by a married individual).
.12Qualified Transportation Fringe.
For taxable years beginning in 2006, the
monthly limitation under § 132(f)(2)(A)
(regarding the aggregate fringe benefit
exclusion amount for transportation in a
commuter highway vehicle and any tran-
sit pass) is $105. The monthly limitation
under § 132(f)(2)(B) (regarding the fringe
benefit exclusion amount for qualified
parking) is $205.
.13Income from United States Savings
Bonds for Taxpayers Who Pay Qualified
Higher Education Expenses. For taxable
years beginning in 2006, the exclusion un-
der § 135 (regarding income from United
States savings bonds for taxpayers who
pay qualified higher education expenses)
begins to phase out for modified adjusted
gross income above $94,700 for joint re-
turns and $63,100 for other returns. This
exclusion completely phases out for modi-
fied adjusted gross income of $124,700 or
more for joint returns and $78,100 or more
for other returns.
.14Adoption Assistance Programs.For
taxable years beginning in 2006, under
§ 137(a)(2) the maximum amount that can
be excluded from an employee’s gross
income in connection with the adoption
by the employee of a child with special
needs is $10,960. For taxable years be-
ginning in 2006, under § 137(b)(1) the
maximum amount that can be excluded
from an employee’s gross income for the
amounts paid or expenses incurred by the
employer for qualified adoption expenses
furnished pursuant to an adoption assis-
tance program in connection with other
adoptions by the employee is $10,960. The
amount excludable from an employee’s
gross income begins to phase out under
§ 137(b)(2)(A) for taxpayers with mod-
ified adjusted gross income in excess of
$164,410 and is completely phased out for
taxpayers with modified adjusted gross
income of $204,410. (See section 3.03
of this revenue procedure for the adjusted
items relating to the adoption credit.)
.15Private Activity Bonds Volume Cap.
For calendar year 2006, the amounts used
under § 146(d)(1) to calculate the State
ceiling for the volume cap for private
activity bonds is the greater of (i) $80
multiplied by the State population, or (ii)
$246,610,000.
.16Safe Harbor Rules for Broker
Commissions on Guaranteed Invest-
ment Contracts or Investments Purchased
for a Yield Restricted Defeasance Es-
crow. For calendar year 2006, under
§ 1.148–5(e)(2)(iii)(B)(1), a broker’s
commission or similar fee with respect
to the acquisition of a guaranteed invest-
ment contract or investments purchased
for a yield restricted defeasance escrow
is reasonable to the extent that (i) the
amount of the fee that the issuer treats as
a qualified administrative cost does not
exceed the lesser of (A) $32,000, or (B)
0.2 percent of the computational base (as
defined in § 1.148–5(e)(2)(iii)(B)(2)) or,
if more, $3,000; and (ii) the issuer does
not treat more than $90,000 in brokers’
commissions or similar fees as qualified
administrative costs with respect to all
guaranteed investment contracts and in-
vestments for yield restricted defeasance
escrows purchased with gross proceeds of
the issue.
.17Personal Exemption.
(1)Exemption amount. For taxable
years beginning in 2006, the personal ex-
emption amount under § 151(d) is $3,300.
(2)Phase out. For taxable years be-
ginning in 2006, the personal exemption
amount begins to phase out at, and is com-
pletely phased out after, the following ad-
justed gross income amounts:
Filing StatusAGI – Beginning
of Phaseout
AGI – Exemption
Fully Phased Out
Married Individuals Filing Joint Returns and Surviving Spouses (§ 1(a))
$225,750$348,250
Heads of Households (§ 1(b))
$188,150$310,650
Unmarried Individuals (other than Surviving Spouses and Heads of
Households) (§ 1(c))
$150,500$273,000
Married Individuals Filing Separate Returns (§ 1(d))
$112,875$174,125
November 21, 20059832005–47 I.R.B.

.18Election to Expense Certain Depre-
ciable Assets. For taxable years beginning
in 2006, under § 179(b)(1) the aggregate
cost of any § 179 property a taxpayer may
elect to treat as an expense shall not exceed
$108,000. Under § 179(b)(2) the $108,000
limitation shall be reduced (but not below
zero) by the amount by which the cost of
§ 179 property placed in service during the
2006 taxable year exceeds $430,000.
.19Eligible Long-Term Care Premi-
ums. For taxable years beginning in 2006,
the limitations under § 213(d)(10) (re-
garding eligible long-term care premiums
includible in the term “medical care”) are
as follows:
Attained Age Before the Close of the Taxable YearLimitation on Premiums
40 or less
$280
More than 40 but not more than 50
$530
More than 50 but not more than 60
$1,060
More than 60 but not more than 70
$2,830
More than 70
$3,530
.20Medical Savings Accounts.
(1)Self-only coverage. For taxable
years beginning in 2006, the term “high
deductible health plan” as defined in
§ 220(c)(2)(A) means,for self-only cov-
erage, a health plan that has an annual
deductible that is not less than $1,800 and
not more than $2,700, and under which the
annual out-of-pocket expenses required to
be paid (other than for premiums) for cov-
ered benefits does not exceed $3,650.
(2)Family coverage. For taxable years
beginning in 2006, the term “high de-
ductible health plan” means, for family
coverage, a health plan that has an annual
deductible that is not less than $3,650 and
not more than $5,450, and under which the
annual out-of-pocket expenses required to
be paid (other than for premiums) for cov-
ered benefits does not exceed $6,650.
.21Interest on Education Loans.For
taxable years beginning in 2006, the
$2,500 maximum deduction for interest
paid on qualified education loans under
§ 221 is reduced under § 221(b)(2)(B)
when modified adjusted gross income ex-
ceeds $50,000 ($105,000 for joint returns),
and is completely eliminated when mod-
ified adjusted gross income is $65,000
($135,000 for joint returns).
.22Health Savings Accounts.
(1)Monthly contribution limitation.
For calendar year 2006, the monthly limi-
tation on deductions under § 223(b)(2)(A)
for an individual with self-only coverage
under a high deductible plan as of the first
dayofsuchmonthis
1
/12ofthelesserof(i)
the annual deductible, or (ii) $2,700. For
calendar year 2006, the monthly limitation
on deductions under § 223(b)(2)(B) for an
individual with family coverage under a
high deductible plan as of the first day of
such month is
1
/12of the lesser of (i) the
annual deductible, or (ii) $5,450.
(2)High deductible health plan.For
calendar year 2006, a high deductible
health plan is defined under § 223(c)(2)(A)
as a health plan with an annual deductible
that is not less than $1,050 for self-only
coverage or $2,100 for family coverage,
and the annual out-of pocket expenses
(deductibles, co-payments, and other
amounts, but not premiums) do not ex-
ceed $5,250 for self-only coverage or
$10,500 for family coverage.
.23Treatment of Dues Paid to Agricul-
tural or Horticultural Organizations.For
taxable years beginning in 2006, the limi-
tation under § 512(d)(1) (regarding the ex-
emption of annual dues required to be paid
by a member to an agricultural or horticul-
tural organization) is $131.
.24Insubstantial Benefit Limitations
for Contributions Associated with Chari-
table Fund-Raising Campaigns.
(1)Low cost article. For taxable years
beginning in 2006, the unrelated business
income of certain exempt organizations
under § 513(h)(2) does not include a “low
cost article” of $8.60 or less.
(2)Other insubstantial benefits.For
taxable years beginning in 2006, the $5,
$25, and $50 guidelines in section 3 of
Rev. Proc. 90–12, 1990–1 C.B. 471 (as
amplified and modified), for disregarding
the value of insubstantial benefits received
by a donor in return for a fully deductible
charitable contribution under § 170, are
$8.60, $43, and $86, respectively.
.25Funeral Trusts. For a contract en-
tered into during calendar year 2006 for
a “qualified funeral trust,” as defined in
§ 685, the trust may not accept aggregate
contributions by or for the benefit of an in-
dividual in excess of $8,500.
.26Expatriation to Avoid Tax. For cal-
endar year 2006, an individual with “av-
erage annual net income tax” of more than
$131,000 for the 5 taxable years ending be-
fore the date of the loss of United States
citizenship under § 877(a)(2)(A) is subject
to tax under § 877(b).
.27Valuation of Qualified Real Prop-
erty in Decedent’s Gross Estate.Foran
estate of a decedent dying in calendar year
2006, if the executor elects to use the spe-
cial use valuation method under § 2032A
for qualified real property, the aggregate
decrease in the value of qualified real prop-
erty resulting from electing to use § 2032A
that is taken into account for purposes of
the estate tax may not exceed $900,000.
.28Annual Exclusion for Gifts.
(1) For calendar year 2006, the first
$12,000 of gifts to any person (other than
gifts of future interests in property) are
not included in the total amount of taxable
gifts under § 2503 made during that year.
(2) For calendar year 2006, the first
$120,000 of gifts to a spouse who is not
a citizen of the United States (other than
gifts of future interests in property) are
not included in the total amount of taxable
gifts under §§ 2503 and 2523(i)(2) made
during that year.
.29Tax on Arrow Shafts. For calen-
dar year 2006, the tax imposed under
§ 4161(b)(2)(A) on the first sale by the
manufacturer, producer, or importer of
any shaft of a type used in the manufac-
ture of certain arrows is $0.40 per shaft.
.30Passenger Air Transportation Ex-
cise Tax. For calendar year 2006, the tax
2005–47 I.R.B.984November 21, 2005

under § 4261(b) on the amount paid for
each domestic segment of taxable trans-
portation by air is $3.30. For calendar
year 2006, the tax under § 4261(c) on any
amount paid (whether within or without
the United States) for any transportation
ofanypersonbyair,ifsuchtransportation
begins or ends in the United States, gen-
erally is $14.50. However, for a domes-
tic segment beginning or ending in Alaska
or Hawaii as described in § 4261(c)(3), the
tax only applies to departures and is at the
rate of $7.30.
.31Reporting Exception for Certain
Exempt Organizations with Nondeductible
Lobbying Expenditures. For taxable years
beginning in 2006, the annual per per-
son, family, or entity dues limitation to
qualify for the reporting exception under
§ 6033(e)(3) (and section 5.05 of Rev.
Proc. 98–19, 1998–1 C.B. 547), regarding
certain exempt organizations with nonde-
ductible lobbying expenditures, is $91 or
less.
.32Notice of Large Gifts Received from
Foreign Persons. For taxable years begin-
ning in 2006, recipients of gifts from cer-
tain foreign persons may be required to re-
port these gifts under § 6039F if the ag-
gregate value of gifts received in a taxable
year exceeds $12,760.
.33Persons Against Which a Federal
Tax Lien Is Not Valid. For calendar year
2006, a federal tax lien is not valid against
(i) certain purchasers under § 6323(b)(4)
who purchased personal property in a
casual sale for less than $1,240, or (ii)
a mechanic’s lienor under § 6323(b)(7)
that repaired or improved certain residen-
tial property if the contract price with the
owner is not more than $6,210.
.34Property Exempt from Levy.For
calendar year 2006, the value of property
exempt from levy under § 6334(a)(2) (fuel,
provisions, furniture, and other household
personal effects, as well as arms for per-
sonal use, livestock, and poultry) may not
exceed $7,430. The value of property ex-
empt from levy under § 6334(a)(3) (books
and tools necessary for the trade, business,
or profession of the taxpayer) may not ex-
ceed $3,710.
.35InterestonaCertainPortionofthe
Estate Tax Payable in Installments.Foran
estate of a decedent dying in calendar year
2006, the dollar amount used to determine
the “2-percent portion” (for purposes of
calculating interest under § 6601(j)) of the
estate tax extended as provided in § 6166
is $1,200,000.
.36Attorney Fee Awards. For fees
incurred in calendar year 2006, the
attorney fee award limitation under
§ 7430(c)(1)(B)(iii) is $160 per hour.
.37Periodic Payments Received un-
der Qualified Long-Term Care Insurance
Contracts or under Certain Life Insur-
ance Contracts. For calendar year 2006,
the stated dollar amount of theper diem
limitation under § 7702B(d)(4) (regarding
periodic payments received under a qual-
ified long-term care insurance contract or
periodic payments received under a life
insurance contract that are treated as paid
by reason of the death of a chronically ill
individual) is $250.
SECTION 4. EFFECTIVE DATE
.01General Rule. Except as provided
in section 4.02, this revenue procedure ap-
plies to taxable years beginning in 2006.
.02Calendar Year Rule. This revenue
procedure applies to transactions or events
occurring in calendar year 2006 for pur-
poses of sections 3.07 (low-income hous-
ing credit), 3.09 (pipeline construction
industry optional expense substantiation
rules), 3.15 (private activity bond volume
cap), 3.16 (safe harbor rules for broker
commissions on guaranteed investment
contracts or investments purchased for a
yield restricted defeasance escrow), 3.22
(health savings accounts), 3.25 (funeral
trusts), 3.26 (expatriation to avoid tax),
3.27 (valuation of qualified real property
in decedent’s gross estate), 3.28 (annual
exclusion for gifts),3.29(taxonarrow
shafts), 3.30 (passenger air transportation
excise tax), 3.33 (persons against which a
federal tax lien is not valid), 3.34 (prop-
erty exempt from levy), 3.35 (interest on a
certain portion of the estate tax payable in
installments), 3.36 (attorney fee awards),
and 3.37 (periodic payments received un-
der qualified long-term care insurance
contracts or under certain life insurance
contracts).
SECTION 5. DRAFTING
INFORMATION
The principal author of this revenue
procedure is Marnette M. Myers of the Of-
fice of Associate Chief Counsel (Income
Tax & Accounting). For further infor-
mation regarding this revenue procedure,
contact Ms. Myers at (202) 622–4920 (not
a toll-free call).
26 CFR 1.1441–7: Extension of offer to resolve issues
arising from certain tax, withholding, and reporting
obligations of U.S. withholding agents with respect to
payments to foreign persons.
AmendmenttoSunsetDate
of Section 1441 Voluntary
Compliance Program Under
Rev. Proc. 2004–59
Rev. Proc. 2005–71
SECTION 1. PURPOSE
This revenue procedure modifies Rev.
Proc. 2004–59, 2004–2 C.B. 678, to ex-
tend the sunset date of the Section 1441
Voluntary Compliance Program (“Section
1441 VCP”) to March 31, 2006.
SECTION 2.
BACKGROUND
Rev. Proc. 2004–59 set forth the pro-
visions of the Section 1441 VCP, a pro-
gram that is available to certain withhold-
ing agents with respect to the withholding,
payment, and reporting of certain taxes due
on payments to foreign persons.
The IRS initiated the Section 1441 VCP
as a temporary program. Section 6 of Rev.
Proc. 2004–59 provided that the Section
1441 VCP became effective September 29,
2004, and would be available for submis-
sions made on or before December 31,
2005.
The volume of Section 1441 VCP sub-
missions has increased steadily since the
inception of the program. Many withhold-
ing agents that wish to participate in the
program will not be able to complete the
submission process before December 31,
2005, and will be excluded from participa-
tion in the VCP without an extension. To
enable such withholding agents to partic-
ipate in the VCP, this revenue procedure
amends Section 6 of Rev. Proc. 2004–59
to extend the sunset date of the program
for three months, to March 31, 2006. In
addition, this revenue procedure amends
Section 5.01, which allows taxpayers to re-
quest extensions to complete VCP submis-
sions under certain circumstances. This
revenue procedure provides that, for sec-
November 21, 20059852005–47 I.R.B.

tion 1441 VCP submissions made after
December 31, 2005, no extensions will be
granted beyond June 30, 2006.
SECTION 3. EXTENSION OF SUNSET
DATE
Sections 5 and 6 of Rev. Proc. 2004–59
are amended as follows.
In Section 5.01, the following sentence
is added after the existing text. “For sec-
tion 1441 VCP submissions made after
December 31, 2005, no extensions will be
granted beyond June 30, 2006.”
In Section 6, the second sentence
is amended by deleting “December 31,
2005” and inserting in its place, “March
31, 2006.” A third, fourth, and fifth sen-
tence are added as follows: “A Section
1441 VCP submission may not be made
for calendar year 2005 Forms 1042 and
1042-S. A Section 1441 VCP submission
made after December 31, 2005, must in-
clude an executed Form 872,Consent to
Extend the Time to Assess Tax, consenting
to extend for one additional year the time
to assess tax with respect to amounts re-
portable on Form 1042 for the 2002 year.
If the withholding agent has filed a Form
945 for the 2002 year, it should further
include an executed Form SS–10,Consent
to Extend the Time to Assess Employment
Taxes, to extend the assessment period for
income tax withholding for an additional
year.”
SECTION 4. INQUIRIES
For further information regarding the
Section 1441 VCP contact the Section
1441 VCP Coordinator at (212) 298–2698
(not a toll-free number).
SECTION 5. EFFECT ON OTHER
DOCUMENTS
Rev. Proc. 2004–59 is modified.
SECTION 6. EFFECTIVE DATE
This revenue procedure is effective
September 29, 2004, the effective date of
Rev. Proc. 2004–59.
SECTION 7. DRAFTING
INFORMATION
The principal author of this revenue
procedure is Kathryn Holman of the
Office of Associate Chief Counsel (In-
ternational). For further information re-
garding this revenue procedure, contact
Kathryn Holman at (202) 622–3840 (not a
toll-free call).
2005–47 I.R.B.986November 21, 2005

Part IV. Items of General Interest
Notice of Proposed
Rulemaking and Notice of
Public Hearing
Income Attributable to
Domestic Production Activities
REG–105847–05
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemak
ing
and notice of public hearing.
SUMMARY: This document contains pro-
posed regulations concerning the deduc-
tion for income attributable to domestic
production activities under section 199.
Section 199 was enacted as part of the
American Jobs Creation Act of 2004, (the
Act). The regulations will affect taxpayers
engaged in certain domestic production
activities. This document also provides a
notice of a public hearing on these pro-
posed regulations.
DATES: Written or electronic comments
must be received by January 3, 2006. Out-
lines of topics to be discussed at the public
hearing scheduled for Wednesday, January
11, 2006, must be received by December
21, 2005.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR(REG–105847–05),
room 5203, Internal Revenue Ser-
vice, POB 7604, Ben Franklin Sta-
tion, Washington, DC 20044. Submis-
sions may be hand delivered Monday
through Friday between the hours of 8
a.m.and4p.m.to:CC:PA:LPD:PR
(REG–105847–05), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitution
Avenue, NW, Washington, DC, or sent
electronically, via the IRS Internet site at
www.irs.gov/regsor via the Federal eRule-
making Portal atwww.regulations.gov
(IRS-REG–105847–05). The public hear-
ingwillbeheldintheIRSAuditorium,
Internal Revenue Building, 1111 Constitu-
tion Avenue, NW, Washington, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning §§1.199–1,
1.199–3, 1.199–6, and 1.199–8, Paul
Handleman or Lauren Ross Taylor,
(202) 622–3040; concerning §1.199–2,
Alfred Kelley, (202) 622–6040; con-
cerning §1.199–4(c) and (d), Richard
Chewning, (202) 622–3850; concerning
all other provisions of §1.199–4, Scott
Rabinowitz, (202) 622–4970; concern-
ing §1.199–5, Martin Schaffer, (202)
622–3080; concerning §1.199–7, Ken
Cohen, (202) 622–7790; concerning sub-
mission of comments, the hearing, and/or
to be placed on the building access list
to attend the hearing, LaNita Van Dyke,
(202) 622–7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information con-
tained in this notice of proposed rulemak-
ing have been submitted to the Office of
Management and Budget for review in
accordance with the Paperwork Reduc-
tion Act of 1995 (44 U.S.C. 3507(d)).
Comments on the collections of infor-
mation should be sent to theOffice of
Management and Budget,Attn: Desk
Officer for the Department of the Trea-
sury, Office of Information and Regula-
tory Affairs, Washington, DC 20503, with
copies to theInternal Revenue Service,
Attn: IRS Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC
20224. Comments on the collection of
information should be received by January
3, 2006.
Comments are specifically requested
concerning:
Whether the proposed collection of in-
formation is necessary for the proper per-
formance of the functions of the IRS, in-
cluding whether the information will have
practical utility;
The accuracy of the estimated burden
associated with the proposed collection of
information;
How the quality, utility, and clarity of
the information to be collected may be en-
hanced;
How the burden of complying with the
proposed collections of information may
be minimized, including through the appli-
cation of automated collection techniques
or other forms of information technology;
and
Estimates of capital or start-up costs
and costs of operation, maintenance, and
purchase of service to provide information.
The collection of information in these
proposed regulations is in §1.199–6(b) in-
volving patrons of agricultural and horti-
cultural cooperatives. This information is
required so that patrons of agricultural and
horticultural cooperatives may claim the
section 199 deduction. The collections of
information is mandatory. The likely re-
spondents are business or other for-profit
institutions.
Estimated total annual reporting bur-
den: 9,000 hours.
Estimated average annual burden hours
per respondent: 3 hours.
Estimated number of respondents:
3,000.
Estimated annual frequency of re-
sponses: annually.
An agency may not conduct or sponsor,
and a person is not required to respond to, a
collection of information unless it displays
a valid control number assigned by the Of-
fice of Management and Budget.
Books or records relating to a collection
of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return
information are confidential, as required
by 26 U.S.C. 6103.
Background
This document contains proposed reg-
ulations relating to the deduction for in-
come attributable to domestic production
activities under section 199 of the Inter-
nal Revenue Code (Code). Section 199
was added to the Code by section 102 of
the Act (Public Law 108 357, 118 Stat.
1418). On January 19, 2005, the IRS
and Treasury Department issued Notice
2005–14, 2005–7 I.R.B. 498, providing in-
terim guidance on section 199 and invit-
ing comments on issues arising under sec-
tion 199. Written and electronic comments
responding to Notice 2005–14 were re-
ceived. The IRS and Treasury Department
have reviewed and considered all the com-
ments in the process of preparing these
proposed regulations. This preamble to
the proposed regulations describes many
of the more significant comments received
November 21, 20059872005–47 I.R.B.

by the IRS and Treasury Department. Be-
cause of the large volume of comments re-
ceived, however, the IRS and Treasury De-
partment are not able to address all of the
comments in this preamble.
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 ac-
tivities income (QPAI) of the taxpayer for
the taxable year; or (b) taxable income (de-
termined without regard to section 199) for
the taxable year (or, in the case of an indi-
vidual, 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 cal-
endar year that ends in such taxable year.
For this purpose, section 199(b)(2) defines
the termW–2 wagesto mean the sum of
the aggregate amounts the taxpayer is re-
quired under section 6051(a)(3) and (8) to
include on the Forms W–2, “Wage and Tax
Statement,” of the taxpayer’s employees
during the calendar year ending during the
taxpayer’s taxable year. Section 199(b)(3)
provides that the Secretary shall prescribe
rules for the application of section 199(b)
in the case of an acquisition or disposition
of a major portion of either a trade or busi-
ness or a separate unit of a trade or business
during the taxable year.
Qualified Production Activities Income
Under section 199(c)(1), QPAI is the
excess of domestic production gross re-
ceipts (DPGR) over the sum of: (a) the cost
of goods sold (CGS) allocable to such re-
ceipts; (b) other deductions, expenses, or
losses directly allocable to such receipts;
and (c) a ratable portion of deductions, ex-
penses, and losses not directly allocable to
such receipts or another class of income.
Section 199(c)(2) provides that the Sec-
retary shall prescribe rules for the proper
allocation of items of income, deduction,
expense, and loss for purposes of deter-
mining QPAI.
Section 199(c)(3) provides special rules
for determining costs in computing QPAI.
Under these special rules, any item or ser-
vice imported into the United States with-
out an arm’s length transfer price shall
be treated as acquired by purchase, and
its cost shall be treated as not less than
its value immediately after it enters the
United States. A similar rule applies in de-
termining the adjusted basis of leased or
rented property when the lease or rental
gives rise to DPGR. If the property has
been exported by the taxpayer for further
manufacture, the increase in cost or ad-
justed basis must not exceed the difference
between the value of the property when ex-
ported and its value when imported back
into the United States after further manu-
facture.
Section 199(c)(4)(A) definesDPGRto
mean the taxpayer’s gross receipts that are
derived from: (i) any lease, rental, license,
sale, exchange, or other disposition of
(I) qualifying production property (QPP)
that was manufactured, produced, grown,
or extracted (MPGE) by the taxpayer in
whole or in significant part within the
United States; (II) any qualified film pro-
duced by the taxpayer; or(III) electricity,
natural gas, or potable water (collectively,
utilities) produced by the taxpayer in the
United States; (ii) construction performed
in the United States; or (iii) engineering
or architectural servicesperformedinthe
United States for construction projects in
the United States.
Section 199(c)(4)(B) excepts from
DPGR gross receipts of the taxpayer that
are derived from: (i) the sale of food and
beverages prepared by the taxpayer at a
retail establishment; and (ii) the transmis-
sion or distribution of electricity, natural
gas, or potable water.
Section 199(c)(5) definesQPPto mean:
(A) tangible personal property; (B) any
computer software; and (C) any property
described in section 168(f)(4) (certain
sound recordings).
Section 199(c)(6) defines aqualified
filmto mean any property described in sec-
tion 168(f)(3) if not less than 50 percent
of the total compensation relating to pro-
duction of the property is compensation
for services performed in the United States
by actors, production personnel, directors,
and producers. The term does not include
property with respect to which records are
required to be maintained under 18 U.S.C.
2257 (generally, films, videotapes, or other
matter that depict actual sexually explicit
conduct and are produced in whole or in
part with materials that have been mailed
or shipped in interstate or foreign com-
merce, or are shipped or transported or are
intended for shipment or transportation in
interstate or foreign commerce).
Section 199(c)(7) provides that DPGR
does not include any gross receipts of the
taxpayer derived from property leased, li-
censed, or rented by the taxpayer for use
by any related person. A person is treated
as related to another person if both persons
are treated as a single employer under ei-
ther section 52(a) or (b) (without regard to
section 1563(b)), or section 414(m) or (o).
Pass-thru Entities
Section 199(d)(1) provides that, in the
case of an S corporation, partnership, es-
tate or trust, or other pass-thru entity, sec-
tion 199 generally is applied at the share-
holder, partner, or similar level, except as
otherwise provided in rules applicable to
patrons of cooperatives. Section 199(d)(1)
further provides that the Secretary shall
prescribe rules for the application of sec-
tion 199, including rules relating to: (a) re-
strictions on the allocation of the deduction
to taxpayers at the partner or similar level;
and (b) additional reporting requirements.
The general rule is that section 199 is
applied at the shareholder, partner, or sim-
ilar level. However, section 199(d)(1)(B)
limits the amount of W–2 wages from a
pass-thru entity that may be used by each
shareholder, partner, or similar person
to compute the section 199 deduction.
Specifically, section 199(d)(1)(B) pro-
vides that such person is treated as having
been allocated W–2 wages from such en-
tity in an amount equal to the lesser of:
(i) such person’s allocable share of such
wages (without regard to this rule) from
such entity as determined under regula-
tions prescribed by the Secretary; or (ii) 2
times 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
QPAI of that entity allocated to such per-
son for the taxable year.
Individuals
In the case of an individual, section
199(d)(2) provides that the deduction is
equal to the applicable percentage of the
lesser of the taxpayer’s: (a) QPAI for the
taxable year; or (b) AGI for the taxable
year determined after applying sections 86,
2005–47 I.R.B.988November 21, 2005

135, 137, 219, 221, 222, and 469, and
without regard to section 199.
Patrons of Certain Cooperatives
Section 199(d)(3) provides special rules
under which a taxpayer receiving certain
patronage dividends or certain qualified
per-unit retain allocations from a cooper-
ative (to which subchapter T applies) en-
gaged in the MPGE, in whole or in sig-
nificant part, or in the marketing of any
agricultural or horticultural product is al-
lowed a section 199 deduction with respect
to the amount of the patronage dividends
or qualified per-unit retain allocations that
are: (a) allocable to the portion of the co-
operative’s QPAI that would be deductible
by the cooperative; and (b) designated as
such by the cooperative in a written notice
mailed to its patrons during the payment
period described in section 1382. Such an
amount, however, does not reduce the tax-
able income of the cooperative under sec-
tion 1382.
In determining the portion of the coop-
erative’s QPAI that would be deductible
by the cooperative, the cooperative’s tax-
able income is computed without taking
into account any deduction allowable un-
der section 1382(b) or (c) (relating to
patronage dividends, per-unit retain allo-
cations, and nonpatronage distributions)
and, in the case of a cooperative engaged
in marketing agricultural and horticultural
products, the cooperative is treated as hav-
ing MPGE, in whole or in significant part,
any agricultural and horticultural products
marketed by the cooperative that its pa-
trons have MPGE.
Expanded Affiliated Groups
Section 199(d)(4)(A) provides that all
members of an expanded affiliated group
(EAG) are treated as a single corpora-
tion for purposes of section 199. Taking
into account the provisions of the Con-
gressional Letter, as described elsewhere,
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).
Section 199(d)(4)(C) provides that, ex-
cept as provided in regulations, the sec-
tion 199 deduction is allocated among the
members of the EAG in proportion to each
member’s respective amount (if any) of
QPAI.
Trade or Business Requirement
Section 199(d)(5) provides that section
199 is applied by taking into account only
items that are attributable to the actual con-
duct of a trade or business.
Alternative Minimum Tax
Section 199(d)(6) provides rules to co-
ordinate the deduction allowed under sec-
tion 199 with the alternative minimum tax
(AMT) imposed by section 55. Taking
into account the provisions of the Congres-
sional Letter, as described elsewhere, sec-
tion 199(d)(6) provides that for purposes
of determining alternative minimum tax-
able income (AMTI) under section 55, the
section 199 deduction shall be determined
without regard to any adjustments under
sections 56 through 59, except that in the
case of a corporation (including a corpora-
tion subject to tax under section 511), the
taxable income limitation is the corpora-
tion’s AMTI.
Authority to Prescribe Regulations
Section 199(d)(7) authorizes the Secre-
tary to prescribe such regulations as are
necessary to carry out the purposes of sec-
tion 199.
Congressional Letter
On July 21, 2005, the Chairman and
Ranking Member of the Senate Finance
Committee and the Chairman of the House
Ways and Means Committee introduced
the Tax Technical Corrections Act of
2005, H.R. 3376 and S. 1447, 109th Cong.
(2005). In a letter on the same date to the
Treasury Department (the Congressional
Letter), they provided clarification for sev-
eral issues so that appropriate regulatory
guidance may be issued reflecting their
intention. These proposed regulations
reflect the intent expressed in the Con-
gressional Letter with respect to section
199.
Summary of Comments
Qualified Production Activities Income
One commentator requested that the
proposed regulations clarify the treatment
of advance payments, and the costs related
to those payments, for purposes of com-
puting QPAI. Section 4.03(3) of Notice
2005–14 provides that, in the case of ad-
vance payments (for goods, services, and
use of property) thatare recognized under
the taxpayer’s method of accounting in
a taxable year earlier than that in which
the property or servicesare delivered, per-
formed, and provided, the taxpayer must
accurately identify, based on a reasonable
method, whether the receipts (and the cor-
responding expenses) qualify as DPGR.
If a taxpayer recognizes an advance pay-
ment in Year 1, and the CGS in Year 2, the
commentator asks whether CGS must be
applied to reduce DPGR in Year 2, even
though the DPGR and CGS are recognized
in different taxable years.
The proposed regulations clarify that,
in the example the commentator cites
involving advance payments, as well as
other circumstances (such as taxpayers
that use the cash receipts and disburse-
ments method) where gross receipts and
corresponding expenses are recognized
in different taxable years, taxpayers must
take the receipts and expenses into account
for purposes of section 199 in the taxable
year such items are recognized under their
methods of accounting for Federal in-
come tax purposes. The IRS and Treasury
Department believe it would be unduly
burdensome and complicated to create a
separate set of timing rules for purposes of
section 199. Thus, gross receipts and costs
are taken into account for purposes of
computing QPAI in the taxable year they
are recognized for Federal income tax
purposes under the taxpayer’s methods of
accounting, even if the related gross re-
ceipts or costs, as applicable, are taken into
account in different taxable years. If the
gross receipts are recognized in an inter-
company transaction within the meaning
of §1.1502–13, see also §1.199–7(d).
A commentator requested clarification
of how the advance payment rules would
apply in the following scenario. In Year
1, a taxpayer sells for $100 a one-year
software maintenance agreement that pro-
vides for software updates (that the tax-
payer would MPGE in whole or in sig-
nificant part within the United States) and
customer support services. At the end
of Year 1, the taxpayer uses a reasonable
method to allocate 60 percent of the gross
receipts ($60) to the software updates and
November 21, 20059892005–47 I.R.B.

40 percent ($40) to the customer support
services. The taxpayer treats the $60 as
DPGR in Year 1. In Year 2, no software
updates are provided. The commentator
asks whether the taxpayer in this scenario
would be required to amend its Year 1 re-
turn and reduce its DPGR by $60, reduce
DPGR by $60 in Year 2, or make no ad-
justment for Year 1 or Year 2.
Consistent with the application of the
rules relating to advance payments, which
require that the taxpayer follow its meth-
ods of accounting for Federal income tax
purposes, the taxpayer should make no ad-
justment in Year 1 (by amended return) or
in Year 2 for the $60 that was appropriately
treated as DPGR in Year 1, even though no
software updates were provided in Year 2.
A commentator suggested that the pro-
posed regulations clarify how a taxpayer
that uses a long-term contract method de-
termines the portion of the percentage of
completion revenue reported for each con-
tract for the taxable year that is allocated to
DPGR. The proposed regulations provide
that taxpayers using a long-term contract
method (for example, under section 460)
may use any reasonable method of allocat-
ing gross receipts under such a contract be-
tween DPGR and non-DPGR.
A number of comments were received
regarding the rule in section 4.03(1) of No-
tice 2005–14 that requires that section 199
be applied on an item-by-item basis. Some
commentators stated that applying section
199 on an item-by-item basis is unduly
burdensome, and that the proposed regula-
tions should permit taxpayers to determine
QPAI on a division or product-line basis
instead. The IRS and Treasury Depart-
ment, however, continue to believe that ap-
plying section 199 on a basis other than
item-by-item would allow taxpayers to re-
ceive the benefits of section 199 with re-
spect to gross receipts that should not qual-
ify as DPGR. Accordingly, the proposed
regulations retain the requirement that sec-
tion 199 be applied on an item-by-item ba-
sis.
Many commentators requested clarifi-
cation of what constitutes an item. Com-
mentators asked whether an item is a final
product or whether one or more compo-
nent parts of the final product may qualify
as an item. For example, if a final product
does not meet the in whole or in significant
part requirement (so that gross receipts
from the sale of the final product are non-
DPGR), commentators inquired whether
they could allocate gross receipts to a com-
ponent of the product that did meet all
of the requirements of section 199(c), and
thereby treat that portion of the gross re-
ceipts as DPGR.
H.R. Conf. Rep. No. 755, 108th
Cong., 2d Sess. 272 n. 27 (2004) (the
Conference Report) indicates that a com-
ponent may be treated as qualifying prop-
erty in the case of food and beverages.
Footnote 27 of the Conference Report ex-
plains that, in the context of food and bev-
erages prepared at a retail establishment,
although a cup of coffee prepared at a re-
tail establishment does not qualify under
section 199(c), a portion of the cup of cof-
fee, that is, the coffee beans (roasted at
a facility separate from the retail estab-
lishment) that meet the requirements un-
der section 199(c), does qualify under sec-
tion 199. The Joint Committee on Taxation
Staff,General Explanation of Tax Legisla-
tion Enacted in the 108th Congress, 109th
Cong., 1st Sess. 172 (2005) (the Blue
Book), indicates Congressional intent that
this treatment is not limited to food and
beverages, but rather, is permitted with re-
spect to section 199 in general. Accord-
ingly, in the case of QPP, qualified films,
and utilities, the proposed regulations de-
fine anitemas the property offered for sale
to customers that meets all of the require-
ments under section 199(c). If the prop-
erty offered for sale does not meet all of
the requirements under section 199(c), a
taxpayer must treat as the item any portion
of the property offered for sale that meets
all of these requirements. However, in no
case shall the portion of the property of-
fered for sale that is treated as the item ex-
clude any other portion that meets all of
the requirements under section 199(c). For
example, assume that the taxpayer MPGE
software entirely within the United States,
attaches the software to a router that it
MPGE entirely outside the United States,
and then sells the combined property. As-
sume further that if the combined property
is treated as the item, the gross receipts
from the sale will not qualify as DPGR be-
cause the combined property does not sat-
isfy the in whole or in significant part re-
quirement. The proposed regulations re-
quire the taxpayer to treat the software as
an item; separate from the router, because
the software meets allof the requirements
of section 199(c) (that is, it is computer
software that is MPGE by the taxpayer
in whole or in significant part within the
United States). This is the case even if
the software is not offered for sale to cus-
tomers separately from the router. Accord-
ingly, the gross receipts from the software
qualify as DPGR, but the gross receipts
from the router do not qualify as DPGR.
Alternatively, assume that the taxpayer
MPGE only software but that some of the
content is MPGE within the United States
and some content is MPGE outside the
United States. Assuming that the software
does not meet the requirements of section
199(c), that portion of the software that is
MPGE within the United States must be
treated as the item. Accordingly, gross re-
ceipts from the sale of the software must be
allocated (using any reasonable method)
between that portion that is MPGE within
the United States (which is DPGR if all
other requirements of section 199(c) are
met) and that portion that is MPGE outside
the United States (which is non-DPGR).
In the case of construction and architec-
tural and engineering services, commen-
tators asked that the proposed regulations
clarify whether the item is the construction
project itself, or whether the item can con-
stitute a task or sub-task that is performed
as part of the construction project. The
IRS and Treasury Department believe that
the determination of what constitutes the
item for purposes of construction and ar-
chitectural or engineering services should
be made on a case-by-case basis taking
into account all of the facts and circum-
stances. Taxpayers may use any reason-
able method of determining the item for
this purpose.
A commentator requested that the pro-
posed regulations clarify how the rules for
determining DPGR apply in the case of a
taxpayer that repairs or rebuilds property
for a customer. The commentator sug-
gested the IRS and Treasury Department
distinguish between “repair” activities and
“rebuild” activities. In the case of a re-
pair contract where the customer retains
the benefits and burdens of the property
while it is being repaired, the commen-
tator suggests that the contractor should
be permitted to treat as DPGR the gross
receipts attributable to parts that the con-
tractor MPGE in whole or in significant
part within the United States, as well as
the gross receipts attributable to the in-
stallation of those parts. Gross receipts
2005–47 I.R.B.990November 21, 2005

attributable to the parts MPGE by the tax-
payer in whole or in significant part within
the United States are DPGR (assuming all
the other requirements of section 199(c)
are met). Consistent with the general
rule for installation (discussed below),
the installation activity will be considered
an MPGE activity only if the contractor
retains the benefits and burdens of own-
ership with respect to the parts while the
parts are being installed. In addition, the
gross receipts attributable to the instal-
lation of parts that the contractor MPGE
may qualify as DPGR if the exception
for embedded installation described in
§1.199–3(h)(4)(ii)(D) of the proposed reg-
ulations applies. The contractor is not
permitted to treat as DPGR gross receipts
attributable to purchased parts, or the in-
stallation of purchased parts.
The commentator suggested that the
proposed regulations provide a special
rule for “rebuild” contracts, which the
commentator suggested be defined as any
contract where the value of the rebuild
work performed exceeds 25 percent of the
value of the preexisting property immedi-
ately before the rebuild. The commentator
further suggested that if more than 50
percent of the contractor’s costs of per-
forming the rebuild is attributable to the
cost of parts that the contractor MPGE,
the contractor should not be required to
allocate its gross receipts between parts
that it MPGE and any parts that it pur-
chased. The commentator’s suggested
rule would effectively create for rebuild
contracts a separatede minimisexception
to the general allocation requirement. The
IRS and Treasury Department believe that
thede minimisexceptions provided in the
proposed regulations (for example, the 5
percentde minimisexception discussed
later generally applicable to embedded
services and embedded nonqualifying
property) are appropriate. Accordingly,
the proposed regulations do not adopt this
suggestion.
Section 4.03(2) of Notice 2005–14 pro-
vides that, if the amount of the taxpayer’s
gross receipts that do not qualify as DPGR
equals or exceeds 5 percent of the total
gross receipts, the taxpayer is required to
allocate all gross receipts between DPGR
and non-DPGR. For purposes of this 5
percentde minimisrule, the proposed reg-
ulations in §1.199–1(d)(2) provide that,
in the case of an S corporation, partner-
ship, estate, trust, or other pass-thru entity,
the determination of whether less than
5 percent of the pass-thru entity’s total
gross receipts are non-DPGR is made at
the pass-thru entity level. In the case of
an owner of a pass-thru entity, the deter-
mination of whether less than 5 percent
of the owner’s total gross receipts are
non-DPGR is made at the owner level,
taking into account the owner’s share of
any of the pass-thru entity’s gross receipts
as well as all other gross receipts of the
owner. In addition, the 5 percentde min-
imisexception in §1.199–3(h)(4)(ii)(E)
applies at the entity level to each item that
qualifies.
Commentators also observed that,
in determining whether the taxpayer’s
method of allocating gross receipts and
CGS between DPGR and non-DPGR is
reasonable, the list of factors cited in
section 4.03(2) of Notice 2005–14 with
respect to gross receipts is inconsistent
with the list of factors cited in section
4.05(2)(b) of the notice with respect to
CGS. The list of factors was intended to
be as consistent as possible for both gross
receipts and CGS, and appropriate changes
to the lists have been incorporated into the
proposed regulations as necessary.
Taxable Income
In the Congressional Letter, the Trea-
sury Department was advised that unre-
lated business taxable income, rather than
taxable income, applies for purposes of
section 199(a)(1) in computing the unre-
lated business income tax under section
511. Accordingly, the proposed regula-
tions in §1.199–1(b) provide that, for pur-
poses of determining the tax imposed by
section 511, section 199(a)(1)(B) is ap-
plied using unrelated business taxable in-
come.
The Congressional Letter also indicates
that the section 199 deduction is not taken
into account for purposes of computing
taxable income under the rules relating
to the carryover of a net operating loss
(NOL). Accordingly, the proposed regu-
lations provide that for purposes of com-
puting the section 199 deduction, the def-
inition of taxable income under section
63 applies, but without regard to section
199. The proposed regulations also pro-
vide that the section 199 deduction is not
taken into account in computing taxable
income when determining the amount of
the NOL carryback and carryover under
section 172(b)(2). Thus, except as oth-
erwise provided in §1.199–7(c)(2) of the
proposed regulations (concerning the por-
tion of a section 199 deduction allocated to
a member of an EAG), the section 199 de-
duction can neither create an NOL carry-
back or carryover nor increase the amount
of an NOL carryback or carryover.
Wage Limitation
A commentator requested that the IRS
and Treasury Department clarify whether
self-employment income of self-employed
individuals as reported on the individuals’
Schedule SE, “Self-Employment Tax,” of
Form 1040 and/or payments for nonem-
ployee compensation reported by the
taxpayer on Form 1099-MISC, “Miscella-
neous Income,” are included in determin-
ing the amount of the W–2 wages of the
taxpayer. A commentator also requested
that the IRS clarify whether guaranteed
payments to partners are included in W–2
wages for purposes of section 199.
The statutory language in section
199(b) refers to the amounts a taxpayer
is required to report as wages on Form
W–2 pursuant to section 6051 with respect
to the employment of employees of the
taxpayer. Neither self-employment in-
come nor guaranteed payments to partners
are required to be reported under section
6051. In addition, section 4.02(1)(a) of
Notice 2005–14 and §1.199–2(a)(1) of the
proposed regulations define employees as
including only common law employees of
the taxpayer and officers of a corporate
taxpayer. Consistent with the statutory
intent, this definition does not include in-
dependent contractors or partners. Thus,
payments to independent contractors and
self-employment income, including guar-
anteed payments made to partners, are not
included in determining W–2 wages.
The proposed regulations provide for
the same three methods of calculating W–2
wages as contained in Notice 2005–14.
It is anticipated that when final regula-
tions are issued, these three methods will
be published in a notice rather than as
part of the final regulations. It is antic-
ipated that this notice will be published
at the same time as the final regulations.
The methods will be included in a notice
rather than the final regulations so that if
November 21, 20059912005–47 I.R.B.

changes are made to the box numbers on
Form W–2, “Wage and Tax Statement,” a
new notice can be issued reflecting those
changes more promptly than an amend-
ment to final regulations.
The non-duplication rule in
§1.199–2(e) continues to provide that
amounts that are treated as W–2 wages
for any taxable year under any method
may not be treated as W–2 wages for any
other taxable year. Additional language
has been added to the non-duplication rule
to clarify that the same W–2 wages cannot
be claimed by more than one taxpayer for
purposes of section 199.
Domestic Production Gross Receipts
DPGR includes the gross receipts of the
taxpayer that are derived from any lease,
rental, license, sale, exchange, or other dis-
position of property described in section
199(c)(4)(A)(i). Commentators specifi-
cally asked whether fees such as cotton or
real estate broker’s fees are DPGR. These
fees are non-DPGR because they are not
derived from any lease, rental, license,
sale, exchange, or other disposition of
property under section 199(c)(4)(A)(i).
Commentators asked for clarification of
whether DPGR includes gross receipts de-
rived by a taxpayer from the subsequent
sale or lease of QPP MPGE within the
United States by the taxpayer, sold, and
then reacquired by the taxpayer. The pro-
posed regulations in §1.199–3(h)(2) pro-
vide an example to illustrate the rule that
gross receipts from the subsequent sale or
lease of QPP are DPGR to the taxpayer
that originally MPGE the QPP within the
United States. Any interest component of
the lease payment also qualifies as DPGR
because section 199(c)(4)(A)(i) provides
that DPGR means gross receipts derived
by the taxpayer from any lease.
Commentators pointed out that the rule
for allocating gross receipts for purposes
of identifying DPGRunder section 3.04(1)
of Notice 2005–14 appears to adopt a spe-
cific identification standard, whereas sec-
tion 4.03(2) appears to provide a reason-
able basis standard. The proposed regu-
lations provide in §1.199–1(d)(1) that the
taxpayer must allocate its gross receipts
from all transactions based on a reason-
able method that is satisfactory to the Sec-
retary based on all of the facts and cir-
cumstances and that accurately identifies
the gross receipts that constitute DPGR.
If a taxpayer can, without undue burden
or expense, specifically identify where an
item was manufactured, or if the taxpayer
uses a specific identification method for
other purposes, then the taxpayer must use
that specific identification method to de-
termine DPGR. If a taxpayer does not use
a specific identification method for other
purposes and cannot, without undue bur-
den or expense, use a specific identifica-
tion method, the taxpayer is not required
to use a specific identification method to
determine DPGR.
Related Persons
Section 199(c)(7) provides that DPGR
does not include any gross receipts of the
taxpayer derived fromproperty leased, li-
censed, or rented by the taxpayer for use
by any related person. A person is treated
as related to another person if both persons
are treated as a single employer under ei-
ther section 52(a) or (b) (without regard
to section 1563(b)), or section 414(m) or
(o). However, footnote 29 in the Confer-
ence Report indicates that this provision is
not intended to apply to property leased by
the taxpayer to a related person if the prop-
erty is held for sublease or is subleased to
an unrelated person for the ultimate use
of such unrelated person, or to a license
to a related person for reproduction and
sale, exchange, lease, rental or sublicense
to an unrelated person for the ultimate use
of such unrelated person. Accordingly, the
proposed regulations include these excep-
tions from the general rule of exclusion un-
der section 199(c)(7).
One commentator stated that if a televi-
sion network licenses programming to an
affiliate station, applying section 199(c)(7)
to treat the royalty payment received from
the affiliate as non-DPGR places these
vertically integrated companies at a com-
petitive disadvantage. The commentator
therefore suggested that the proposed reg-
ulations provide an exception for networks
and affiliate stations. The proposed regu-
lations do not adopt this suggestion, which
is not consistent with section 199(c)(7).
Derived from a Lease, Rental, License,
Sale, Exchange, or Other Disposition
Commentators asked whether gains
and losses associated with hedging trans-
actions are included in DPGR. For exam-
ple, utilities may hedge to manage the risk
of changes in prices of ordinary inputs
into the production process. For purposes
of section 199 only, the proposed regu-
lations include a rule in §1.199–3(h)(3)
concerning hedges (within the meaning of
section 1221(b)(2) and §1.1221–2(b)) of
inventory that is QPP and supplies con-
sumed in activities giving rise to DPGR.
The proposed regulations require gain or
loss on the hedging transaction to be taken
into account in determining DPGR. The
proposed rule applies to hedges that man-
age the risk of currency fluctuations but
only to the extent that the hedges are not
integrated with an underlying transaction
under §1.988–5(b).
Commentators suggested that the pro-
posed regulations treat gross receipts
attributable to the distribution or delivery
of QPP as derived from the lease, rental,
license, sale, exchange, or other disposi-
tion of that property. The commentators
stated that section 199(c)(4)(B)(ii), which
specifically provides that DPGR does not
include gross receipts derived from the
transmission and distribution of utilities,
indicates (by negative implication) that
gross receipts attributable to the distribu-
tion or delivery of QPP is intended to be
considered DPGR. Moreover, some com-
mentators interpreted language in section
3.04(10)(c) of Notice 2005–14, stating
that bottled water is treated as QPP and
that DPGR may include gross receipts at-
tributable to distribution of bottled water,
as suggesting that gross receipts attribut-
able to distribution and delivery of QPP
are considered DPGR.
In general, the IRS and Treasury De-
partment believe that gross receipts at-
tributable to distribution and delivery of
QPP are not DPGR because distribution
and delivery are properly regarded as
services, regardless of whether the tax-
payer retains the benefits and burdens of
ownership of the property at the time it
is delivered. No inference to the con-
trary in Notice 2005–14 was intended.
Thus, the proposed regulations clarify that
taxpayers generally must allocate gross
receipts between the lease, rental, license,
sale, exchange, or other disposition of the
property itself and the delivery compo-
nent. The IRS and Treasury Department,
however, believe that, because distribu-
tion and delivery are service components
commontoQPP,itisappropriate,asa
2005–47 I.R.B.992November 21, 2005

matter of administrative convenience, to
treat embedded distribution and delivery
services similar to the qualified warranty
exception in section 4.04(7)(b) of Notice
2005–14. Thus, the taxpayer must include
in DPGR gross receipts attributable to the
distribution and delivery of QPP if (1) in
the normal course of business, the charge
for the delivery or distribution service is
included in the price charged for the sale of
the QPP, and (2) the charge for the delivery
or distribution service is neither separately
offered nor separately bargained for with
the customer.
For similar reasons, the proposed regu-
lations also treat embedded qualified oper-
ating manuals provided in connection with
the sale or disposition of QPP, qualified
films, and utilities similar to embedded
qualified warranties.
The proposed regulations also provide
special rules for installation activities. The
IRS and Treasury Department believe that,
in some circumstances, installation is ap-
propriately viewed as an MPGE activity,
and in others it is appropriately viewed as a
service. For example, installation is prop-
erly viewed as an MPGE activity if the tax-
payer MPGE QPP within the United States
and installs the QPP while the taxpayer re-
tains the benefits and burdens of owner-
ship of the QPP. In that case, gross receipts
attributable to the installation, whether or
not embedded, are derived from the lease,
rental, license, sale, exchange, or other dis-
position of the QPP. If, however, the bene-
fits and burdens of ownership pass to the
customer prior to the installation of the
QPP, the taxpayer is performing a service
by installing the customer’s property. In
that case, gross receipts attributable to in-
stallation are not derived from the lease,
rental, license, sale, exchange, or other dis-
position of the property, and the taxpayer
generally is required under the proposed
regulations to allocate gross receipts be-
tween the proceeds of sale or disposition
of the property (DPGR) and the installa-
tion service (non-DPGR). However, the
IRS and Treasury Department believe that,
because installation is a service component
common to sales or dispositions of QPP,
if the benefits and burdens of ownership
pass to the customer prior to the installa-
tion, it is appropriate to treat embedded in-
stallation similar to an embedded qualified
warranty, qualified delivery, and a quali-
fied operating manual.
A number of commentators suggested
that the IRS and Treasury Department ex-
pand the exception to the allocation re-
quirement for a qualified warranty to in-
clude all services (including training, tech-
nical and customer support, and regular
maintenance of the property), as well as
all nonqualifying property (including pur-
chased spare parts), the charge for which
is embedded in the contract price of the
lease, rental, license, sale, exchange, or
other disposition ofQPP, qualified films,
and utilities. Other commentators stated
that the proposed regulations should adopt
principles similar to §1.482–2(b), so that
services that are ancillary and incidental
to the sale of QPP, qualified films, and
utilities would not be treated as embed-
ded services and no allocation of gross re-
ceipts to those services would be required.
These commentators believe that footnote
27 in the Conference Report supports such
a position in stating that the conferees in-
tend that the Secretary provide guidance
regarding the allocation of gross receipts
that draws on the principles of section 482.
Other commentators stated that, elsewhere
in the Code and regulations, transactions
are given a single characterization based
on their predominant nature and that sec-
tion 199 should be applied in the same
manner. For example, if the predominant
nature of a transaction is the sale of prop-
erty, all gross receipts from the transaction
should be treated as proceeds from the sale.
Finally, some commentators stated that a
taxpayer’s treatment of a transaction for
financial reporting purposes should gov-
ern its characterization for section 199 pur-
poses.
The IRS and Treasury Department in-
fer that the commentators are referring
to §1.482–2(b)(8), which provides that,
in general, no separate allocation will be
made in connection with ancillary and
subsidiary services provided with a trans-
fer of property. Services ancillary and
subsidiary to another transaction may be
referred to, outside the section 199 con-
text, as embedded services. The IRS and
Treasury Department do not intend that
services defined as embedded services un-
der section 199 will be treated in the same
manner provided in §1.482–2(b)(8) be-
cause such treatmentwould be generally
inconsistent with the intent and purpose of
section 199.
The IRS and Treasury Department fur-
ther believe that the reference to section
482 principles in footnote 27 of the Con-
ference Report reflects an intent to apply
section 482 principles consistently with
the general intent and purpose of section
199. The IRS and Treasury Department
continue to believe that the statutory lan-
guage and legislative history require that
transactions be bifurcated into qualify-
ing and nonqualifying elements and that
gross receipts be allocated accordingly
for purposes of section 199. The IRS
and Treasury Department further believe
that the exceptions to this general rule
should be limited. Expanding the special
exceptions to include all, or ancillary or
incidental, embedded services and embed-
ded nonqualifying property would result
in the inclusion in DPGR of gross receipts
that the IRS and Treasury Department do
not believe were intended to be within
the scope of section 199. The legislative
history also does not support adopting
principles applicable to other Code sec-
tions under which a single predominant
nature character is assigned to a trans-
action, or characterizing transactions for
purposes of section 199 according to their
treatment for financialreporting purposes.
Accordingly, the proposed regulations do
not adopt these suggestions.
One commentator requested that the
proposed regulations clarify whether the
embedded services rule is intended to
require taxpayers to treat certain ser-
vice-type activities that take place as part
of the MPGE process as embedded ser-
vices. The proposed regulations clarify
that embedded services do not include
service-type activities that take place as
part of the MPGE process (that is, while
the taxpayer is engaged in an MPGE ac-
tivity with respect to the property and
retains the benefits and burdens of owner-
ship of the property). For example, with
respect to QPP, activities such as non-con-
struction engineering, materials analysis
and selection, subcontractor inspections
and approval, routine production inspec-
tions, product testing and documentation,
and assistance with certain regulatory ap-
provals, if undertaken in connection with a
qualifying MPGE activity, are considered
part of the MPGE of the QPP and are not
considered embedded services. No sep-
arate allocation of gross receipts to such
activities is required.
November 21, 20059932005–47 I.R.B.

Services and nonqualifying property
are not considered embedded if they are
either separately offered or separately
bargained for, or a charge for the service
or nonqualifying property is separately
stated. Thus, for example, if a charge for
freight or delivery is separately stated on
an invoice for the sale of an item of QPP,
the delivery service is not embedded and
gross receipts attributable to that service
are non-DPGR, even if the purchaser does
not have the option of refusing the service.
Further, separately stated or bargained for
amounts will not be respected unless they
reflect the fair market value of the service
or nonqualifying property. For example,
if a taxpayer offers contracts to customers
that include a cellular phone priced on the
invoice at $595 and three years of cellular
telephone service priced on the invoice at
$5, the $5 stated amount for the service
will only be respected if it represents an
allocation of gross receipts consistent with
the principles of section 482.
Gross receipts attributable to embedded
services, embedded nonqualifying prop-
erty, or any other embedded element (other
than a qualified warranty, qualified de-
livery, qualified installation, and a quali-
fied operating manual) may be considered
DPGR under the 5 percentde minimisex-
ception. The proposed regulations clarify
that, with respect to thede minimisex-
ception, taxpayers should apply the 5 per-
cent against the total amount of the gross
receipts derived from the lease, rental, li-
cense, sale, exchange, or other disposi-
tion of the item of QPP, qualified films,
or utilities. The total amount of DPGR in-
cludes gross receipts attributable to a qual-
ified warranty, qualified delivery, qualified
installation, and/or a qualified operating
manual that are treated as DPGR with re-
spect to that item. In the case of a lease
or an installment sale, thede minimisex-
ception is applied by taking into account
the total amount of gross receipts under the
lease or installment sale that are attribut-
able to the item of QPP, qualified films, or
utilities.
Under the proposed regulations, as un-
der Notice 2005–14, applicable Federal
income tax principles apply in determin-
ing whether a transaction (or any part of
a transaction) is, in substance, a lease,
rental, license, sale, exchange, or other dis-
position, or whether it is a service. For
this purpose, section 3.04(7)(a) of Notice
2005–14 cites Rev. Rul. 88–65, 1988–2
C.B. 32, and describes that revenue rul-
ing as treating a short-term rental as a ser-
vice. Many commentators asked that the
proposed regulations clarify that not all
short-term rentals will be regarded as ser-
vices for purposes of section 199. They
observed that Rev. Rul. 88–65 involves
the lease of automobiles and trucks on a
daily basis (normally for not more than one
week), and that the taxpayer performs sig-
nificant services in connection with the ve-
hicle, including maintenance and repairs,
and pays all taxes and insurance on the ve-
hicle. The IRS and Treasury Department
acknowledge that the short-term nature of
a transaction does not, by itself, render the
transaction a service for purposes of sec-
tion 199 and that many transactions in-
clude both service and property rental el-
ements. Therefore, the proposed regula-
tions clarify that, in such cases, taxpay-
ers must allocate gross receipts between
the qualifying rental of QPP or qualified
films (DPGR) and the non-qualifying ser-
vices (non-DPGR). The allocation must be
based on the facts and circumstances of
each transaction. Generally, in the case of
short-term transactions, such as those de-
scribed in Rev. Rul. 88–65, in which sig-
nificant services are provided in connec-
tion with the property, the transaction will
consist mostly of services.
Not every transaction in which prop-
erty is used in connection with provid-
ing a service to customers, however, con-
stitutes a mixture of services and rental
for which allocation of gross receipts is
appropriate. For example, assume that
a taxpayer operates a video game arcade
that features video game machines that the
taxpayer MPGE. The machines remain in
the taxpayer’s possession during the cus-
tomers’ use. Gross receipts derived from
customers’ use of the machines at the tax-
payer’s arcade are not derived from the
lease, rental, license, sale, exchange, or
other disposition of the machines. Rather,
the machines are used to provide a ser-
vice and, thus, the gross receipts are non-
DPGR.
A number of commentators objected
to the position taken in section 4.04(7)(d)
of Notice 2005–14 that gross receipts
from Internet access services, online ser-
vices, customer support, telephone ser-
vices, games played through a website,
provider-controlled software online ac-
cess services, and other services are not
derived from a lease, rental, license, sale,
exchange, or other disposition of the soft-
ware. Consistent with the notice, the
proposed regulations reflect the position
that the use of online computer software
does not rise to the level of a lease, rental,
license, sale, exchange, or other disposi-
tion as required under section 199 but is
instead a service. This is the case even
if the customer must agree to terms and
conditions (which may be termed alicense
by the software provider) before using
the software online,or receive enabling
software to facilitate the customer’s use
of the primary software on the customer’s
hardware.
If gross receipts attributable to the use
of online software were permitted to qual-
ify as DPGR because the same or simi-
lar software also is available to customers
on disk or by download, different items of
software available online would be subject
to disparate treatment under section 199.
In addition, if online software were per-
mitted to qualify as DPGR, it would be
difficult to distinguish this online software
from software that is used to facilitate a
service. The IRS and Treasury Department
are requesting comments in the Request
for Comments section on this issue.
One commentator suggested that the
term lease, rental, license, sale, exchange,
or other disposition, especially the term
other disposition, was intended to be in-
terpreted broadly to include gross receipts
from any means of commercialization of
property, whether or not an actual transfer
of the property occurs. Another com-
mentator noted that section 3.04(7)(d) of
Notice 2005–14 states that gross receipts
derived by a taxpayer from software that
is merely offered for use to customers
online for a fee are non-DPGR, and sug-
gested that if the software is also offered
to customers on disk or by download, then
gross receipts for online use of otherwise
qualifying software would be DPGR. The
commentator also noted that the same
section provides that a “service provided
using computer software that does not in-
volve a transfer of the computer software
does not result in [DPGR],” and suggested
that this language implies that if the soft-
ware is not used in providing a service, no
transfer is required for purposes of section
199. The IRS and Treasury Department
did not intend the results suggested by the
2005–47 I.R.B.994November 21, 2005

commentators and the proposed regula-
tions have been clarified as necessary.
A number of commentators requested
clarification and expansion of the rule
in Notice 2005–14 that treats advertising
receipts attributableto the sale or other
disposition of newspapers and magazines
as DPGR. Notice 2005–14 explains that
advertising receipts in this context are
inextricably linked to the gross receipts
derived from the lease, rental, license,
sale, exchange, or other disposition of the
newspapers and magazines. In response
to comments, the proposed regulations
clarify that this rule also applies, under
the same rationale, to advertising receipts
relating to telephone directories and pe-
riodicals, whereby ataxpayer’s gross
receipts derived from the lease, rental, li-
cense, sale, exchange, or other disposition
of the telephone directories or periodicals
that are MPGE in whole or in significant
part within the United States includes
advertising income from advertisements
placed in those media, but only to the ex-
tent the gross receipts, if any, derived from
the lease, rental, license, sale, exchange,
or other disposition of the telephone di-
rectories or periodicals are DPGR. The
proposed regulations clarify that adver-
tising revenue for advertising in online
newspapers and periodicals is non-DPGR,
because any underlying receipts from the
property itself are non-DPGR, as there is
no lease, rental, license, sale, exchange,
or other disposition of such property.
The proposed regulations provide similar
treatment for gross receipts attributable
to product placements in a qualified film.
The gross receipts attributable to product
placements will be treated as DPGR, but
(as with newspapers) only if the gross
receipts derived from the lease, rental, li-
cense, sale, exchange, or other disposition
of the qualified film are DPGR. Thus, for
product placement revenue to be derived
from a qualified film, there must be a
lease, rental, license, sale, exchange, or
other disposition of the qualified film.
Section 3.04(9)(a) of Notice 2005–14
provides that revenue from the licensing
of film characters is not derived from the
lease, rental, license, sale, exchange, or
other disposition of a qualified film. One
commentator stated that this treatment
is inconsistent with the income forecast
method, and that revenue from licensing
of film-related intangibles is inextricably
linked to (and therefore should be treated
as derived from) the qualified film. The
proposed regulations do not adopt this
comment. Section 199(c)(4)(A)(i)(II)
clearly requires that receipts must be de-
rived from a lease, rental, license, sale,
exchange, or other disposition of a qual-
ified film to be DPGR. Receipts derived
from the licensing of related intangibles,
including film characters, trademarks, and
trade names, do not meet this requirement.
Further, the IRS and Treasury Department
do not agree that receipts derived from
licensing of film-related intangibles are
inextricably linked to the gross receipts
derived from a qualified film.
Some commentators objected to the
rule in section 4.04(7)(a) of Notice
2005–14 that provides that if a taxpayer
exchanges QPP MPGE by the taxpayer
in whole or in significant part within
the United States for other property in a
taxable exchange, the value of the prop-
erty received by the taxpayer is DPGR;
whereas any gross receipts derived from
a subsequent sale by the taxpayer of the
acquired property are non-DPGR because
the taxpayer did not MPGE the acquired
property. The commentators noted that
in their industry, fungible commodities
held for sale to customers are exchanged
routinely between producers as a practi-
cal means of avoiding logistical problems
in meeting customers’ needs and reduc-
ing transportation and storage costs. The
commentators noted that these exchanges
typically are not treated as taxable ex-
changes on the parties’ financial records.
The commentators requested that the pro-
posed regulations instead provide that if
the property relinquished in the exchange
is QPP, qualified films, or utilities, then the
property received in the exchange should
be treated as QPP, qualified films, or util-
ities and gross receipts derived from the
subsequent sale of that property should be
treated as DPGR. Another commentator
suggested that this treatment be applied
only to nontaxable exchanges.
The proposed regulations do not adopt
these suggestions. The IRS and Treasury
Department believe that the character of
property as having been MPGE in whole
or in significant part by the taxpayer within
the United States is not an attribute of the
property, like basis and holding periods,
that may be substituted with the transfer
of the property. The IRS and Department
Treasury believe that the commentators’
interpretations are inconsistent with sec-
tion 199(c)(4)(A)(i)(I).
Commentators requested that the IRS
and Treasury Department clarify whether
gross receipts from mineral royalties and
net profits interests are properly treated as
DPGR. Mineral royalties, including net
profits interests, are returns on passive
interests in mineral properties, the owner
of which makes no expenditure for oper-
ation or development. The courts and the
IRS have long considered these types of
income to be in the nature of rent (see, for
example,Kirby Petroleum Co. v. Comm’r,
326 U.S. 599 (1946)). Accordingly, the
proposed regulations in §1.199–3(h)(9)
provide that gross receipts from mineral
interests and net profits interests other
than operating or working interests are not
treated as DPGR.
Definition of Manufactured, Produced,
Grown, or Extracted
Section 4.04(3)(b) of Notice 2005–14
provides that a taxpayer that MPGE QPP
for the taxable year should treat itself as
a producer under section 263A with re-
spect to the QPP for the taxable year un-
less the taxpayer is not subject to section
263A. In response, commentators ques-
tioned whether all taxpayers that are sub-
ject to section 263A are considered to have
MPGE QPP for purposes of section 199.
Taxpayers who do not MPGE QPP may
nevertheless be subject to section 263A.
For example, a taxpayer that has property
produced for it under a contract is con-
sidered a producer of property under sec-
tion 263A, but may not be considered as
having MPGE property for purposes of
section 199 if it does not have the bene-
fits and burdens of ownership of the prop-
erty while it is being produced. Addition-
ally, in some circumstances a taxpayer that
manufactures propertyfor a customer pur-
suant to a contract may be considered the
producer of the property for purposes of
section 263A and not to have MPGE the
property for purposes of section 199. Ac-
cordingly, not all taxpayers that are sub-
ject to section 263A are considered to have
MPGE QPP for purposes of section 199.
Commentators also have questioned
whether a taxpayer that engages in cer-
tain production activities that are exempt
from section 263A (for example, develop-
November 21, 20059952005–47 I.R.B.

ing computer software under Rev. Proc.
2000–50, 2000–2 C.B. 601, producing
property pursuant to a long-term contract
under section 460, or farming exempt un-
der section 263A(d)) must treat itself as
a producer under section 263A if the tax-
payer wants to be treated as MPGE QPP
for purposes of section 199. The proposed
regulations in §1.199–3(d)(4) provide that
a taxpayer that has MPGE QPP for the
taxable year should treat itself as a pro-
ducer under section263A with respect to
the QPP for the taxable year unless the
taxpayer is not subject to section 263A.
A taxpayer whose MPGE activity is ex-
empt from section 263A is not required
to change its method of accounting under
section 263A to treat itself as engaged in
theMPGEofQPPforpurposesofsection
199.
Commentators requested clarification
as to whether a reseller that engages inde
minimisproduction activities or that has
property produced for it under contract,
which constitutes the MPGE of QPP un-
der section 199, is precluded from using
the simplified resale method provided by
§1.263A–3(d). Section 1.263A–3(a)(4)(ii)
provides that a reseller withde minimis
production activities is permitted to use
the simplified resale method. Likewise,
§1.263A–3(a)(4)(iii) provides that a re-
seller otherwise permitted to use the sim-
plified resale method is permitted to use
the method if it has personal property
produced for it under a contract if the con-
tract is entered into incident to its resale
activities and the property is sold to its
customers. The section 263A consistency
rule provided in §1.199–3(d)(4) of the pro-
posed regulations does not affect the rules
provided in §1.263A–3. Accordingly, a
reseller withde minimisproduction or
that has property produced for it under a
contract that is considered the MPGE of
QPP for purposes of section 199 is not
precluded from using the simplified resale
method if the taxpayer meets the require-
ments of §1.263A–3(a)(4)(ii) or (iii).
Definition of By the Taxpayer
Section 1.199–3(e)(1) of the proposed
regulations provides that, with the ex-
ception of rules that are applicable to an
EAG, certain oil and gas partnerships
described in §1.199–3(h)(7), EAG part-
nerships described in §1.199–3(h)(8), and
certain government contracts described in
§1.199–3(e)(2), only one taxpayer may
claim the section 199 deduction with
respecttotheMPGEofQPP.Ifonetax-
payer MPGE QPP pursuant to a contract
with another person, then only the tax-
payer that has the benefits and burdens
of ownership of the property under Fed-
eral income tax principles during the time
the property is MPGE will be consid-
ered to have MPGE the QPP. In con-
trast, §1.263A–2(a)(1)(ii)(B) provides that
property produced for the taxpayer under
a contract is considered as produced by the
taxpayer to the extent the taxpayer makes
payments or otherwise incurs costs with
respect to the property, even if the taxpayer
is not the owner of the property while the
property is being produced. Commenta-
tors questioned why a similar rule does not
apply in the context of section 199. The
rule provided by §1.263A–2(a)(1)(ii)(B)
is derived from section 263A(g)(2). That
section specifically provides that a tax-
payer is treated as producing property
produced for it under a contract to the ex-
tent that it has made payments or incurred
costs with respect to the contract. In con-
trast, section 199(c)(4)(A)(i) provides that
DPGR only includes gross receipts of the
taxpayer that are derived from any lease,
rental, license, sale, exchange, or other
disposition of QPP MPGE by the taxpayer
in whole in significant part within the
United States. Accordingly, the proposed
regulations do not contain a provision that
is analogous to §1.263A–2(a)(1)(ii)(B).
While sections 199, 263A, and 936
all have benefits and burdens standards,
the standard under section 199 is not the
same as those under sections 263A and
936. Commentators suggested that the
proposed regulations adopt the broader
standard under §1.263A–2(a)(1)(ii)(A)
that provides that a taxpayer is not con-
sidered to be producing property unless
the taxpayer is considered the owner of
the property produced under Federal in-
come tax principles. The determination
of whether a taxpayer is considered an
owner is based on all of the facts and cir-
cumstances, including the various benefits
and burdens of ownership vested with
the taxpayer. Because the standard under
the section 263A regulations is broad, it
has been interpreted to allow two tax-
payers to be considered the producer of
the same property. Compare, for exam-
ple,Suzy’s Zoo v. Comm’r,114T.C.1
(2000),aff’d273 F.3d 875 (9th Cir. 2001)
andGolden Gate Litho v. Comm’r,T.C.
Memo (1998–184).
The IRS and Treasury Department
continue to believe that the requirement
of section 199(c)(4)(A)(i) that property
be MPGE by the taxpayer means that
only one taxpayer may claim the section
199 deduction with respect to the same
function performed with respect to the
same property. Therefore, it would be
inappropriate to adopt the standard under
the section 263A regulations. In addi-
tion, this interpretation is supported by
the Congressional Letter that states the
Treasury Department has the authority to
prescribe rules to prevent the section 199
deduction from being claimed by more
than one taxpayer with respect to the same
economic activity described in section
199(c)(4)(A)(i). Thus, consistent with
Notice 2005–14, the proposed regulations
in §1.199–3(e)(1) provide that only one
taxpayer may claim the section 199 deduc-
tion with respect to any MPGE activity.
Commentators also proposed other
alternatives to the benefits and burdens
standard, such as looking to the person
that has the economic risks and benefits,
adopting the qualified research rules un-
der §1.41–2(e)(2), providing safe harbors
based on contract terms, treating the per-
son that arranges for the acquisition of
the property as the owner, and looking
to the person that controls the process by
which the property is MPGE. The pro-
posed regulations do not adopt any of
these suggestions because the IRS and
Treasury Department believe that there is
considerable variation in the types of con-
tract manufacturing situations. Therefore,
the proposed regulations contain the same
benefits and burdens standard used in No-
tice 2005–14 because it is a standard that
the IRS and Treasury Department believe
covers all of the varied factual situations.
Commentators requested that the pro-
posed regulations provide examples of
how to apply the benefits and burdens
standard. The proposed regulations con-
tain examples illustrating contract manu-
facturing situations in which the taxpayer
with the benefits and burdens of owner-
ship under Federal income tax principles
is treated as manufacturing the QPP.
In the Congressional Letter, the Trea-
sury Department was advised that gross
2005–47 I.R.B.996November 21, 2005

receipts derived from certain contracts
to manufacture or produce property for
the Federal government are derived from
the sale of such property and, therefore,
are DPGR. The proposed regulations in
§1.199–3(e)(2) provide that a taxpayer
will be treated as meeting the by the tax-
payer requirement if the QPP, qualified
films, or utilities are MPGE or other-
wise produced in the United States by the
taxpayer pursuant to acontract with the
Federal government and the Federal Ac-
quisition Regulation requires that title or
risk of loss with respect to the QPP, quali-
fied films, or utilities be transferred to the
Federal government before the MPGE or
production of the QPP, qualified films, or
utilities is complete.
In Whole or In Significant Part
Under section 199(c)(4)(A)(i)(I), QPP
must be MPGE in whole or in signif-
icant part by the taxpayer within the
United States. The proposed regulations
in §1.199–3(f)(1) clarify that the in whole
or in significant part requirement applies
to both the by the taxpayer requirement
and the within the United States require-
ment.
Section 4.04(5)(b) of Notice 2005–14
provides that QPP will be treated as hav-
ing been MPGE in significant part by the
taxpayer within the United States if the
MPGE of the QPP performed within the
United States is substantial in nature. De-
sign and development costs do not qual-
ify as substantial in nature for any QPP
other than computer software and sound
recordings. The proposed regulations in
§1.199–3(f)(2) substitute research and ex-
perimental expenditures under section 174
for design and development costs.
Section 4.04(5)(c) of Notice 2005–14
provides that a taxpayer will be treated as
having MPGE property in whole or in sig-
nificant part within the United States if, in
connection with the property, conversion
costs (direct labor and related factory bur-
den) to MPGE the property are incurred by
the taxpayer within the United States and
the costs account for 20 percent or more
of the total CGS of the property. The pro-
posed regulations in §1.199–3(f)(3) pro-
vide that, in the case of tangible personal
property, research and experimental ex-
penditures under section 174 and any other
costs of creating intangibles may be ex-
cluded from total CGS for purposes of the
safe harbor.
A commentator suggested that a tax-
payer’s activity within the United States
that is critical to the functionality or nature
of property should be considered to meet
the in significant part requirement under
section 199(c)(4)(A)(i)(I) even if the activ-
ity is not substantial in nature. The pro-
posed regulations do not adopt this sugges-
tion because the IRS and Treasury Depart-
ment do not believe that this is an accurate
measurement of the degree of activity re-
quired to satisfy the in whole or in signifi-
cant part requirement.
Qualifying Production Property
Commentators requested that the IRS
and Treasury Department reconsider the
rule under section 4.04(8)(c) and (d) of
Notice 2005–14 which provides that, if the
medium in which computer software or
sound recordings are contained is tangible,
then such medium is considered tangible
personal property for purposes of section
199. This rule has been removed and the
proposed regulations in §1.199–3(i)(5)
provide that if a taxpayer MPGE com-
puter software or sound recordings that
the taxpayer fixed on, or added to, tan-
gible personal property (for example, a
computer diskette oran appliance), then
the tangible medium with the computer
software or sound recordings may be
treated by the taxpayer as computer soft-
ware or sound recordings, as applicable.
However, the proposed regulations pro-
vide that, if a taxpayer treats the tangible
medium as computer software or sound
recordings, any costs under section 174
attributable to the tangible medium are
not considered in determining whether the
taxpayer’s activity is substantial in nature
under §1.199–3(f)(2) or conversion costs
under §1.199–3(f)(3). In addition, because
a taxpayer may MPGE tangible personal
property, but not computer software or
sound recordings that the taxpayers fixes
on, or adds to, the tangible personal prop-
erty MPGE by the taxpayer, the proposed
regulations provide that the computer soft-
ware or sound recordings may be treated
by the taxpayer as tangible personal prop-
erty.
Commentators requested that the pro-
posed regulations clarify whether the
exceptions from computer software under
section 168(i)(2)(B)(iv) apply to computer
software under section 199. In response
to this comment, the proposed regulations
provide in §1.199–3(i)(3)(i) that these
exceptions do not apply for purposes of
section 199 and computer software also
includes the machine-readable code for
video games and similar programs, for
equipment that is an integral part of other
property, and for typewriters, calculators,
adding and accounting machines, copiers,
duplicating equipment, and similar equip-
ment, regardless of whether the code is
designed to operate on a computer (as de-
fined in section 168(i)(2)(B)). Computer
programs of all classes, for example, op-
erating systems, executive systems, mon-
itors, compilers and translators, assembly
routines, and utility programs as well as
application programs, are included.
A commentator requested that the pro-
posed regulations provide that the creation
and licensing of copyrighted business in-
formation reports constitutes the MPGE
of QPP. Formerly distributed in hard copy,
this information is now generally dis-
tributed electronically. Customers are re-
quired to use the information only for their
own use, and no copyright is transferred
to them. The commentator contends that,
while the activity of creating the business
information reports provided to customers
is not a production activity in the tradi-
tional sense, the definition of MPGE is
broad enough to encompass this activity.
The IRS and Treasury Department do not
agree with this comment because creating
a database of business information is not
MPGE, the database is not QPP, and the
business information reports are not QPP
MPGE by the taxpayer.
Qualified Films
Similar to the rules for computer
software, section 4.04(9)(a) of Notice
2005–14 provides that if a medium on
which a qualified film is fixed is tangible
(such as a DVD), the property consists of
both a qualified film and tangible personal
property. The notice contains examples
in which taxpayers that either produce a
qualified film and purchase the tangible
medium, or MPGE the tangible medium
and license the qualified film, must allo-
cate gross receipts between the tangible
medium and the qualified film. For the
reasons stated under the discussion of
November 21, 20059972005–47 I.R.B.

computer software, the proposed regu-
lations allow certain taxpayers to treat
such combined property as either tangible
personal property or a qualified film, as
applicable.
One commentator requested that the
proposed regulations clarify the require-
ment that 50 percent of the total compen-
sation relating to the production of the
film be compensation for services per-
formed in the United States by actors,
production personnel, directors, and pro-
ducers. Specifically, the commentator
requested that the phrase “total compensa-
tion relating to the production of the film”
be interpreted to mean compensation for
services performed only by actors, produc-
tion personnel, directors, and producers.
The commentator further requested that
the term “compensation” be interpreted to
include all compensation (not just W–2
wages) that is paid to these individuals
and that is required to be capitalized by
film producers under section 263A and
§1.263A–1(e)(2) and (3). These sugges-
tions have been adopted in the proposed
regulations.
Definition of Construction Performed in
the United States
Section 4.04(11)(a) of Notice 2005–14
defines the term “construction” to mean
the construction or erection of real prop-
erty by a taxpayer that is in a trade or
business that is considered construction for
purposes of the North American Industry
Classification System (NAICS). Commen-
tators asked how a taxpayer in multiple
trades or businesses determines if it is in a
construction NAICS code. The proposed
regulations clarify that in order for a tax-
payer to be considered in a construction
NAICS code, it must be engaged in a con-
struction trade or business (but not neces-
sarily its primary trade or business) on a
regular and ongoing basis. The determi-
nation of whether an entity is in a NAICS
code is generally tested on an entity-by-en-
tity basis. Under this rule, a member of
an EAG must perform the construction
activity in order for its gross receipts to
qualify as DPGR from construction. See
§1.199–7(a)(3). In addition, the taxpayer
must actually perform the construction ac-
tivity. For example, if a taxpayer in a con-
struction NAICS code hired an unrelated
general contractor to construct a building,
the gross receipts derived by the taxpayer
from the sale of the building would not be
DPGR because the taxpayer did not con-
struct the building. The proposed regula-
tions provide an example to illustrate this
rule.
Commentators also asked that the
proposed regulations clarify whether
eligible construction activities are lim-
ited to a specific NAICS code. Section
1.199–3(l)(1)(i) provides that a trade or
business that is considered construction
for purposes of the NAICS codes means
a construction activity under the two-digit
NAICS code of 23 and any other construc-
tion activity in any other NAICS code
relating to the construction of real prop-
erty. For example, a construction activity
relating to the construction of real prop-
erty that is not under the two-digit NAICS
code of 23 but which qualifies as an eli-
gible construction activity would include
the construction of oil and gas wells for
NAICS code 213111 (drilling oil and gas
wells) and 213112 (support activities for
oil and gas operations). Commentators
also asked that the proposed regulations
include a listing of construction activities
relating to oil and gas wells. In response to
this request, the proposed regulations pro-
vide, as a matter of administrative grace,
that qualifying construction activities also
include activities relating to drilling an oil
well and mining, and include any activi-
ties treated by the taxpayer as intangible
drilling and development costs under sec-
tion 263(c) and §1.612–4 and development
expenditures for a mine or natural deposit
under section 616.
Commentators contend that gross re-
ceipts attributable to the leasing or rental
of constructed real property qualify as
DPGR because the right to use constructed
property represents one right in the bundle
of rights derived from the construction of
real property. The proposed regulations do
not adopt this interpretation because gross
receipts derived from the rental of real
property that a taxpayer constructs are not
derived from construction, but are instead
compensation for the use or forbearance
of the property. Similarly, gross receipts
derived from renting or leasing equipment
such as bulldozers and generators to con-
tractors for use in the construction of real
property are non-DPGR (assuming the
rental companies do not manufacture the
equipment).
Section 4.04(11)(a) of Notice 2005–14
contains a safe harbor rule for determin-
ing when tangible personal property that
is sold as part of a construction project
may be considered real property. If more
than 95 percent of the total gross receipts
derived by a taxpayer from a construc-
tion project are derived from real property
(as defined in §1.263A–8(c)), then the to-
tal gross receipts derived by the taxpayer
from the project are DPGR from construc-
tion. Commentators stated that it was un-
clear what items of tangible personal prop-
erty are included in this rule (for exam-
ple, small or major appliances, home the-
aters, and fixtures installed by a builder)
and whether it was intended that land be
included for purposes of this safe harbor.
Consequently, this rule has been replaced
in the proposed regulations with ade min-
imisexception in §1.199–3(l)(1)(ii). Ac-
cordingly, if less than 5 percent of the total
gross receipts derived by a taxpayer from
a construction project are derived from ac-
tivities other than the construction of real
property in the United States (for exam-
ple, from non-construction activities, the
sale of tangible personal property, or land)
then the total gross receipts derived by the
taxpayer from the project are DPGR from
construction.
Many commentators suggested that the
proposed regulations treat gross receipts
attributable to the sale or other disposition
of land as DPGR derived from construc-
tion of real property. Commentators also
suggested that construction begins as soon
as production activities begin, that is,
when land is acquired and the entitlement
process, such as obtaining proper zoning
and permits, commences in connection
with construction of real property. The
proposed regulations do not adopt these
suggestions. The IRS and Treasury De-
partment continue to believe that Congress
intended the benefitunder section 199 only
for construction services performed in the
United States. Taxpayers do not construct
land and thus any gain attributable to
the disposition of land (including zoning,
planning, entitlement costs and other costs
capitalized to the land such as the demo-
lition of structures under section 280B) is
not eligible for the section 199 deduction.
Commentators also argue that the land
exclusion creates an administrative and
financial burden because a valuation will
be necessary for any sale of real property
2005–47 I.R.B.998November 21, 2005

that includes land. To address the admin-
istrative burden in identifying and valuing
the gross receipts attributable to land in
connection with qualifying construction
activities, the proposed regulations pro-
vide a safe harbor in §1.199–3(l)(5)(ii).
Under this safe harbor, a taxpayer may al-
locate gross receipts between the proceeds
from the sale, exchange, or other dispo-
sition of real property constructed by the
taxpayer and the gross receipts attributable
to the sale, exchange, or other disposition
of land by reducing its costs related to
DPGR in §1.199–4 by costs of the land
and any other costs capitalized to the land
(collectively, land costs) (including land
costs in any common improvements as de-
fined in section 2.01 of Rev. Proc. 92–29,
1992–1 C.B. 748), and by reducing its
DPGR from qualifying construction activ-
ities by those land costs plus a specified
percentage. The percentage is based on
the number of years that elapse between
the date the taxpayer acquires the land,
including the date the taxpayer enters into
the first option to acquire all or a portion
of the land, and ends on the date the tax-
payer sells each itemof real property on
the land. The percentage is 5 percent for
years zero through 5; 10 percent for years
6 through 10; and 15 percent for years 11
through 15. Land held by a taxpayer for
16 or more years is not eligible for the
safe harbor and the taxpayer must allocate
gross receipts between the land and the
qualifying real property. For example, if
a taxpayer acquires land in 2001 and con-
structs houses that it sells in 2005, 2008,
and 2012, the houses sold in 2005 are sub-
ject to the 5 percent reduction; the houses
sold in 2008 are subject to the 10 percent
reduction; and the houses sold in 2012 are
subject to the 15 percent reduction.
Commentators suggested that develop-
ers of raw land should be entitled to a sec-
tion 199 deduction for improvements to
land such as building roads, sidewalks, and
installing utilities. In addition, they sug-
gested that entitlements such as zoning,
permits, and surveys that add value to the
land should be included in DPGR similar
to the treatment of design and development
costs for software and sound recordings.
The proposed regulations provide that a
taxpayer in a construction NAICS code
that sells developed land will have DPGR
to the extent the receipts are attributable to
real property such as infrastructure but not
to the land and any entitlements attribut-
able to the land. The proposed regulations
provide examples in §1.199–3(l)(5)(iii) to
illustrate this rule.
Commentators suggested that the pro-
posed regulations extend the embedded
services exception for qualified warranties
in connection with the sale of property
to construction warranties. The IRS and
Treasury Department agree with this sug-
gestion. Accordingly, §1.199–3(l)(5)(i)
provides DPGR derived from the con-
struction of real property includes gross
receipts from any warranty that is provided
in connection with the construction of the
real property if, in the normal course of
the taxpayer’s business, the charge for the
construction warranty is included in the
price for the construction project and the
construction warrantyis neither separately
offered by the taxpayer nor separately bar-
gained for with the customer (that is, the
customer cannot purchase the constructed
real property without the construction
warranty).
Engineering and Architectural Services
Section 4.04(12)(a) of Notice 2005–14
provides that DPGR includes gross re-
ceipts derived from engineering or ar-
chitectural services performed in the
United States for realproperty construc-
tion projects in the United States. Com-
mentators stated that the definition of en-
gineering and architectural services should
not be limited to real property because this
limitation is inconsistent with the rules
for engineering and architectural services
under the domestic international sales cor-
poration, foreign sales corporation, and
extraterritorial income exclusion provi-
sions. The IRS and Treasury Department
continue to believe that the statutory lan-
guage in section 199(c)(4)(A)(iii) requires
that only engineering and architectural
services relating to real property qualify
for the section 199 deduction and that the
same rules relating to construction of real
property apply for engineering or architec-
tural services. In addition, the Blue Book
at page 172 n. 292, states that DPGR
includes gross receipts derived from the
engineering or architectural services per-
formed with respect to real property only.
Thus, DPGR only includes gross receipts
derived from engineering or architectural
services performed in the United States
for the construction of real property in
the United States. In addition, the IRS
and Treasury Department believe that,
consistent with the rules for construction
activities, a taxpayer performing engi-
neering and architectural services must
be in a trade or business described in
an engineering or architectural NAICS
code. Accordingly, the proposed regula-
tions require that, at the time the taxpayer
performs the engineering or architectural
services, the taxpayer must be in a trade
or business on a regular and ongoing basis
(but not necessarily its primary trade or
business) that is considered engineering or
architectural services for purposes of the
NAICS codes, for example NAICS codes
541330 (engineering services) or 541310
(architectural services).
A commentator also requested clari-
fication of whether a structure enclosing
an electric generation station as described
in Rev. Rul. 69–412, 1969–2 C.B. 2,
would be considered real property for
purposes of section 199(c)(4)(A)(iii). In
that revenue ruling, the structure quali-
fied as section 38 property for investment
credit purposes. The revenue ruling does
not determine whether the property was
real or personal property. Under section
4.04(11)(a) of Notice 2005–14, real prop-
erty includes residential and commercial
buildings including items that are struc-
tural components of such buildings and
inherently permanent structures other than
tangible personal property in the nature
of machinery. The proposed regulations
in §1.199–3(l)(1)(i) retain this language.
Thus, a structure enclosing an electric
generation station as described in Rev.
Rul. 69–412 is treated as real property for
purposes of section 199(c)(4)(A)(iii).
In addition, similar to the rules for con-
struction, the determination of whether an
entity is in an engineering or architectural
NAICS code is made on an entity-by-en-
tity basis. Under this rule, a member of
an EAG must perform the engineering
or architectural services in order for its
gross receipts to qualify as DPGR from
engineering or architectural services. See
§1.199–7(a)(3). In addition, the taxpayer
must actually perform the engineering or
architectural services.
One commentator pointed out that the
requirement in section 4.04(12)(a) of No-
tice 2005–14 that a taxpayer must substan-
tiate that the engineering or architectural
November 21, 20059992005–47 I.R.B.

services relate to a construction project in
the United States is unnecessary because
taxpayers are already required to identify
and allocate gross receipts attributable to
DPGR based upon a reasonable method
satisfactory to the Secretary for purposes
of determining QPAI. Because there was
no intention on the part of the IRS and
Treasury Department to create an addi-
tional substantiation requirement for engi-
neering and architectural services, this ad-
ditional substantiation requirement is not
required under the proposed regulations.
Commentators requested clarification
of whether gross receipts attributable to
feasibility studies, for example, planning
possible road or building configurations
for a potential real property develop-
ment project, is a qualifying activity.
The commentators state that engineering
and architectural firms are often hired
for these studies to determine a project’s
practicability. Accordingly, the proposed
regulations provide in §1.199–3(m)(1)
that DPGR includes gross receipts derived
from engineering or architectural services,
including feasibility studies for a con-
struction project in the United States, even
if the planned construction project is not
undertaken or is not completed.
Food and Beverages
Section 199(c)(4)(B)(i) provides that
DPGR does not include gross receipts of
the taxpayer that are derived from the sale
of food and beverages prepared by the
taxpayer at a retail establishment. Sec-
tion 4.04(13) of Notice 2005–14 defines
a “retail establishment” as real property
leased, occupied, or otherwise used by the
taxpayer in its trade or business of selling
food or beverages to the public at which
retail sales are made. One commentator
stated that food carts and portable food
stands should not be considered retail
establishments because they do not consti-
tute real property. The IRS and Treasury
Department believe that the term “retail
establishment” is intended to be inter-
preted broadly to include any facility at
which the taxpayer prepares food or bev-
erages and makes retail sales of the food or
beverages to the public. See Conference
Report at page 272 (footnote 27) (retail es-
tablishment not limited to establishments
at which customers dine on premises or
to those engaged primarily in the dining
trade). Accordingly, the proposed regula-
tions do not adopt this suggestion, and the
term “retail establishment” is clarified to
include both real and personal property.
In addition, a facility at which food and
beverages are prepared solely for take out
service or delivery is a retail establishment
(for example, a caterer).
Consistent with Notice 2005–14, the
proposed regulations provide that if a tax-
payer’s facility is a retail establishment,
then, as a matter of administrative grace, a
taxpayer is permitted to allocate its gross
receipts between gross receipts derived
from the wholesale sale of the food and
beverages prepared at the retail establish-
ment (which are DPGR, assuming all the
other requirements of section 199(c) are
met) and the gross receipts derived from
the retail sale of the food and beverages
prepared and sold at the retail establish-
ment (which are non-DPGR). For this
purpose, wholesale sales are defined as
sales of food and beverages to be resold
by the purchaser.
One commentator requested clarifica-
tion how the retail establishment excep-
tion applies in the case of wineries. While
producers of distilled spirits, wines, and
beer may conduct retail sales of their prod-
ucts on their premises, such sales do not
transform the entire premises of the dis-
tilled spirits plant, bonded wine cellar (or
bonded winery), or brewery into a retail es-
tablishment. Chapter 51 of Title 26 of the
United States Code, and the implementing
regulations found in 27 CFR Parts 19, 24,
and 25, create clear distinctions between
that portion of a distilled spirits plant, win-
ery, or brewery devoted to production ac-
tivities and the portion devoted to other
activities, such as retail sales. Consis-
tent with the treatment of such facilities
for purposes of Chapter 51 of Title 26 of
the United States Code and the regulations
thereunder, the proposed regulations pro-
vide that the portion of a distilled spirits
plant, bonded winery, or brewery that is
restricted to production activities, includ-
ing the processing and blending of distilled
spirits, wine, and beer products, will not
be treated as a retail establishment for pur-
poses of section 199(c)(4)(B)(i). Thus, for
example, for purposes of section 199, tax-
paid wine sold from the taxpaid premises
of a bonded winery is not considered to
have been produced at a retail establish-
ment because it is considered to have been
produced on the bonded premises of the
winery. Accordingly, the sales of such
wine will be treated as DPGR for purposes
of section 199 (assuming all the other re-
quirements of section 199(c) are met). A
similar result applies to the sale of taxpaid
distilled spirits from the general (taxpaid)
premises of a distilled spirits plant, and to
the sale of taxpaid beer from the tavern
portion of a brewery.
A commentator suggested that the pro-
posed regulations interpret the termfood
and beveragesto mean only items pre-
pared by the taxpayer in a single serving
size for immediate consumption by the
purchaser. The commentator believes
that the Conference Report in footnote 27
supports this interpretation because these
characteristics are common to the exam-
ples that the footnote provides (that is,
brewed coffee and venison sausage pre-
pared at a restaurant). The commentator
further contends that this interpretation
eliminates the distinction between food
and beverages prepared off-site (gross re-
ceipts from the retail sale of which may be
DPGR) and those prepared on-site (gross
receipts from the retail sale of which are
non-DPGR), a distinction that the com-
mentator believes Congress did not intend.
The IRS and Treasury Department do
not believe that the statute or Conference
Report supports the commentator’s inter-
pretation. If the commentator’s interpreta-
tion was correct, then gross receipts from
the retail sale of the roasted coffee beans
in footnote 27 would have qualified as
DPGR even if the taxpayer had roasted
the beans at its retail establishment be-
cause the beans are not sold in single serv-
ings for immediate consumption. How-
ever, footnote 27 makes clear that the gross
receipts attributableto the beans only qual-
ify because the beans were roasted at a
facility separate from the retail establish-
ment. Thus, the statute and legislative his-
tory clearly provide different treatment for
gross receipts attributable to the retail sale
of food and beverages prepared at a retail
establishment and food and beverages pre-
pared elsewhere.
The same commentator requested clar-
ification of how the food and beverages
exception applies to in-store bakeries.
Footnote 27 of the Conference Report
provides an example of a taxpayer that
operates a supermarket that includes an
in-store bakery, and provides that the
2005–47 I.R.B.1000November 21, 2005

taxpayer may allocate its gross receipts
between DPGR and non-DPGR. The com-
mentator believes that the example could
be interpreted to mean that all gross re-
ceipts allocable to sales (both retail and
wholesale) of items prepared in the bakery
are non-DPGR. Section 4.04(13) of Notice
2005–14 however, as a matter of adminis-
trative grace, permits gross receipts from
wholesale sales of food and beverages
produced at a retail establishment to qual-
ify as DPGR (if all other requirements of
section 199(c) are met), and the proposed
regulations retain this rule. Thus, gross
receipts from wholesale sales of items pro-
duced at the in-store bakery (for example,
items sold to restaurants) may qualify as
DPGR (if all other requirements of section
199(c) are met). The commentator further
stated, consistent with the first comment,
that gross receipts from retail sales of
bakery products that require further pro-
cessing by the consumer to be suitable for
individual consumption (such as unsliced
cakes and unsliced loaves of bread) should
not be excluded from DPGR under section
199(c)(4)(B)(i). For the reasons stated
above, the IRS and Treasury Department
believe that retail sales of these items are
subject to that exclusion. Receipts allo-
cable to wholesale sales of these items,
however, may qualify as DPGR under the
administrative exception, assuming all the
other requirements of section 199(c) are
met.
Determining Costs
To determine its QPAI for the taxable
year, a taxpayer must subtract from its
DPGR the amount of CGS allocable to
DPGR, the other deductions, expenses,
and losses (deductions) directly allocable
to DPGR, and a ratable portion of other
deductions that are not directly allocable
to DPGR or another class of income. A
taxpayer’s costs must be determined using
the taxpayer’s methods of accounting for
Federal income tax purposes.
Allocation of Cost of Goods Sold
Notice 2005–14 provides that if a tax-
payer can identify from its books and
records CGS allocable to DPGR, CGS al-
locable to DPGR is that amount. The No-
tice also provides that if a taxpayer’s books
and records do not allow it to identify CGS
allocable to DPGR, the taxpayer may use
a reasonable allocation method to allocate
CGS between DPGR and non-DPGR. The
Notice further provides that, if a taxpayer
uses a method to allocate gross receipts
between DPGR and non-DPGR, then the
taxpayer may not use a different method
for purposes of allocating CGS.
Commentators suggested that a tax-
payer should be permitted to allocate CGS
using a reasonable method separate from
the method used to allocate gross receipts
because using the sameallocation method
for gross receipts and CGS may not be
possible or may distort income. For exam-
ple, a taxpayer that can identify from its
books and records gross receipts allocable
to DPGR may not be able to specifically
identify CGS allocable to DPGR. Com-
mentators also questioned whether a tax-
payer that can identify from its books and
records CGS allocable to DPGR must al-
locate CGS on such basis when it allocates
gross receipts using a different method.
The proposed regulations clarify that if
a taxpayer does, or can without undue
burden or expense, specifically identify
from its books and records CGS alloca-
ble to DPGR, CGS allocable to DPGR is
that amount irrespective of whether the
taxpayer uses another allocation method
to allocate gross receipts between DPGR
and other gross receipts. The proposed
regulations also clarify that if a taxpayer
cannot, without undue burden or expense,
use a specific identification method to
determine CGS allocable to DPGR, the
taxpayer is not required to use a specific
identification method to determine CGS
allocable to DPGR, but may use some
other reasonable method. A taxpayer’s
use of a method for purposes of allocat-
ing CGS between DPGR and non-DPGR
that is different from its method for allo-
cating gross receipts between DPGR and
non-DPGR will ordinarily not be con-
sidered reasonable unless the method for
allocating CGS is demonstrably more ac-
curate than the method used to allocate
gross receipts.
Commentators also suggested that
CGS allocable to DPGR may not be read-
ily ascertainable when a taxpayer uses the
last-in, first-out (LIFO) method to account
for its inventory. Therefore, commenta-
tors requested that a simplified method be
provided to allocate CGS between DPGR
and non-DPGR when a taxpayer uses the
LIFO method to account for its inventory.
The proposed regulations provide that a
taxpayer that uses the LIFO method to
account for its inventory may use any rea-
sonable method to allocate CGS between
DPGR and non-DPGR. In addition, the
regulations provide simplified methods
that a taxpayer may use to allocate CGS
when a taxpayer uses the LIFO method to
account for its inventories.
The IRS and Treasury Department also
received comments requesting clarifica-
tion of the types of costs that are required
to be allocated as CGS allocable to DPGR.
In particular, commentators stated that
section 263A only requires taxpayers to
capitalize costs with respect to inventory
on hand at the end of the taxable year
and that as a result taxpayers generally
do not include indirect costs in CGS, but
instead deduct the amount not allocated to
ending inventory. Section 263A requires
a taxpayer that produces inventory to in-
clude in inventory costs the direct costs of
producing the property and the property’s
properly allocable share of indirect costs
for purposes of determining both ending
inventory and CGS. Consistent with No-
tice 2005–14, the proposed regulations
provide that, for purposes of determining
CGS allocable to DPGR, CGS includes
the costs that would have been included
in ending inventory under the principles
of sections 263A, 471, and 472 if the
goods sold during the taxable year were
on hand at the end of the taxable year.
However, a taxpayer is permitted to use
any reasonable method to allocate indirect
costs properly included in CGS between
DPGR and non-DPGR if the taxpayer’s
books and records do not, or cannot with-
out undue burden or expense, specifically
identify CGS allocable to DPGR.
Comments also were received concern-
ing whether a taxpayer is permitted to use
a reasonable allocation method to allocate
CGS if it uses the simplified production
method or simplified resale method for
additional section 263A costs. The pro-
posed regulations clarify that a taxpayer
that uses either the simplified production
method or the simplified resale method for
additional section 263A costs may use a
reasonable allocation method to allocate
both section 471 costs and additional sec-
tion 263A costs included in CGS. The pro-
posed regulations further provide that if
a taxpayer uses the simplified production
method or the simplified resale method to
November 21, 200510012005–47 I.R.B.

allocate additional section 263A costs to
ending inventory, additional section 263A
costs ordinarily should be allocated in the
same proportion as section 471 costs are
allocated.
Allocation and Apportionment of
Deductions
Consistent with Notice 2005–14, the
proposed regulations provide three meth-
ods for allocating and apportioning de-
ductions. However, as described below,
modifications have been made in these
proposed regulations to the qualification
requirements of the simplified deduction
method and the small business simplified
overall method.
The first method, the “section 861
method,”isrequiredtobeusedbya
taxpayer, unless the taxpayer is eligible
and chooses to use either the simpli-
fied deduction method or the small busi-
ness simplified overall method. Under
the section 861 method, section 199 is
treated as an operative section described
in §1.861–8(f). Accordingly, a taxpayer
determines the deductions allocated and
apportioned to DPGR by applying the
allocation and apportionment rules pro-
vided by §§1.861–8 through 1.861–17
and §§1.861–8T through 1.861–14T (the
section 861 regulations), subject to cer-
tain special rules. The IRS and Treasury
Department recognize that the allocation
and apportionment rules of the section
861 method may be burdensome to certain
taxpayers, particularly smaller taxpayers,
that otherwise would not be required to
use these rules. Accordingly, the pro-
posed regulations provide two alternative
methods, the simplified deduction method
and the small business simplified overall
method, with a goal of minimizing the
need for smaller taxpayers to devote addi-
tional resources to compliance.
Under the “simplified deduction
method,” a taxpayer’s deductions are
apportioned between DPGR and other
receipts based on relative gross receipts.
The simplified deduction method does
not apply to the allocation of CGS. Notice
2005–14 permits only taxpayers with aver-
age annual gross receipts of $25,000,000
or less to use the simplified deduction
method. Several commentators requested
that the simplified deduction method also
be made available to taxpayers with gross
receipts in excess of $25,000,000. Many
of these comments were from taxpayers
that have not in the past been required to
allocate and apportion deductions under
the section 861 regulations. Some com-
mentators suggested that the simplified
deduction method be used for all costs,
except for limited identified costs such as
interest, for which the section 861 method
would continue to apply. Still other com-
mentators suggested that taxpayers be
allowedtouseotherexistingcostalloca-
tion methods, such as those under section
263A or under other government regula-
tory procedures.
In response to these comments, the IRS
and Treasury Department have modified
the eligibility requirements for the simpli-
fied deduction method. Under the pro-
posed regulations, a taxpayer may use the
simplified deduction method if it has aver-
age annual gross receipts of $25,000,000
or less, or total assets at the end of the tax-
able year of $10,000,000 or less. However,
the IRS and Treasury Department still be-
lieve that for taxpayers above this thresh-
old the section 861 method is the appro-
priate method of allocating and apportion-
ing deductions for purposes of determining
QPAI. Furthermore, the alternative alloca-
tion methods suggested by commentators
would each require additional rules and
guidance to address the interaction of the
suggested methods with other Federal in-
come tax rules and would result in admin-
istrative complexity and inefficiency. The
IRS and Treasury Department believe that
use of the section 861 method will result in
an appropriate cost allocation and appor-
tionment for purposes of section 199 and
will be easier administratively for both tax-
payers and the IRS than any new, equally
comprehensive cost allocation and appor-
tionment rules that might be created.
Section 1.199–4(f) of the proposed reg-
ulations provides that a qualifying small
taxpayer may use the “small business sim-
plified overall method” to apportion CGS
and deductions to DPGR. Under Notice
2005–14, a qualifying small taxpayer is a
taxpayer that has average annual gross re-
ceipts of $5,000,000 or less or a taxpayer
that is eligible to use the cash method as
provided in Rev. Proc. 2002–28, 2002–1
C.B. 815. The IRS and Treasury Depart-
ment are concerned that the $5,000,000 av-
erage annual gross receipts threshold with-
out further modification could be used by
large taxpayers to circumvent the require-
ments to allocate and apportion deductions
usingthesection861method. Asare-
sult, a deduction limitation has been added
to this method. In addition, commentators
requested that the definition of qualifying
small taxpayer for purposes of the small
business simplified overall method be ex-
panded to include farmers that are not re-
quired to use the accrual method under sec-
tion 447. The proposed regulations incor-
porate this suggestion. Accordingly, the
proposed regulations provide that a quali-
fying small taxpayer is a taxpayer that; (1)
has both average annual gross receipts of
$5,000,000 or less, and CGS and deduc-
tions (excluding NOL deductions and de-
ductions not attributable to the conduct of
a trade or business) for the current taxable
year of $5,000,000 or less; (2) is engaged
in the trade or business of farming that is
not required to use the accrual method un-
der section 447; or (3) is eligible to use
the cash method as provided in Rev. Proc.
2002–28.
Notice 2005–14 specifically requested
comments on whether taxpayers should be
able to change between the three cost allo-
cation methods of section 199 on amended
returns and whether there should be re-
strictions on a taxpayer’s ability to change
from one method to another. Several com-
mentators suggested that a taxpayer should
be allowed to change its cost allocation
method on an amended return and that a
taxpayer should be able to annually choose
to use any of the three methods. The
IRS and Treasury Department agree that
a taxpayer that qualifies to use a particu-
lar allocation and apportionment method
should be able to change to that method
at any time. Accordingly, the proposed
regulations generally provide that a tax-
payer eligible to use the simplified deduc-
tion method may choose at any time to
use the simplified deduction method or the
section 861 method for a taxable year. A
taxpayer eligible to use the small business
simplified overall method may choose at
any time to use the small business sim-
plified overall method, the simplified de-
duction method, or the section 861 method
for a taxable year. This rule does not
affect, however, any restrictions or limi-
tations that apply within the section 861
method.
2005–47 I.R.B.1002November 21, 2005

Pass-thru Entities
Section 199 applies at the owner level
in a manner consistent with the economic
arrangement of the owners of the pass-thru
entity. Under the proposed regulations,
each owner computes its section 199 de-
duction by taking into account its distribu-
tive or proportionate share of the pass-thru
entity’s items (including items of income
and gain, as well as items of loss and de-
duction not otherwise disallowed by the
Code), CGS allocated to such items of in-
come, and gross receipts included in such
items of income. In response to a commen-
tator’s inquiry, the proposed regulations
make it clear that the owner of a pass-thru
entity need not be engaged directly in the
entity’s trade or business in order to claim
asection199deductiononthebasisof
that owner’s share of the pass-thru entity’s
items.
Some commentators recommended that
section 199 be applied to partnerships by
using an aggregate approach in situations
where the qualified production activities
are conducted by the partnership, which
distributes or sells the QPP, qualified films,
or utilities to a partner who then leases,
rents, licenses, sells, exchanges, or oth-
erwise disposes of the property, or where
the qualified production activities are con-
ducted by a partner which contributes or
sells the QPP, qualified films, or utilities to
the partnership, which then leases, rents,
licenses, sells, exchanges, or otherwise
disposes of the property. The commenta-
tors maintained that the income derived
by the partners and the partnerships from
the lease, rental, license, sale, exchange,
or other disposition of the property in
these situations should be treated as QPAI
and qualify for the section 199 deduction.
The proposed regulations do not follow
the commentators’ recommendation be-
cause section 199(c)(4)(A) requires that
the gross receipts must be derived from
the taxpayer’s own qualified production
activities to qualify as DPGR. Accord-
ingly, except for; (i) certain qualifying oil
and gas partnerships; and (ii) EAG part-
nerships, discussed below, the proposed
regulations provide that the owner of a
pass-thru entity is not treated as directly
conducting the qualified production activ-
ities of the pass-thru entity, and vice versa,
with respect to the property transferred be-
tween the pass-thru entity and the owner.
This rule applies to all partnerships, in-
cluding partnerships that have elected out
of subchapter K under section 761(a). In
addition, attribution of activities does not
apply for purposes of the construction of
real property and the performance of engi-
neering and architectural services.
The proposed regulations, pursuant to
the Congressional Letter, provide a lim-
ited exception for certain partnerships in
which all of the capital and profits inter-
ests are owned by members of a single
EAG at all times during the taxable year
of the partnership (EAG partnership). For
purposes of determining the DPGR of a
partnership and its partners, an EAG part-
nership and all members of the EAG in
which the partners of the EAG partner-
ship are members are treated as a single
taxpayer during the taxable year for pur-
poses of section 199(c)(4). Thus, if an
EAG partnership MPGE or produces prop-
erty and distributes, leases, rents, licenses,
sells, exchanges, or otherwise disposes of
that property to a member of an EAG in
which the partners of the EAG partnership
are members, then the MPGE or produc-
tion activity conducted by the EAG part-
nership will be treated as having been con-
ducted by the members of the EAG. Sim-
ilarly, if one or more members of an EAG
in which the partners of an EAG part-
nership are members MPGE or produces
property, and contributes, leases, rents, li-
censes, sells, exchanges, or otherwise dis-
poses of that property to the EAG partner-
ship, then the MPGE or production activity
conducted by the EAG member (or mem-
bers) will be treated as having been con-
ducted by the EAG partnership.
Except as otherwise provided, an EAG
partnership is generally treated the same
as other partnerships for purposes of sec-
tion 199. Accordingly, the proposed regu-
lations provide that an EAG partnership is
subject to the rules of §1.199–5 regarding
the application of section 199 to pass-thru
entities, and the application of the sec-
tion 199(d)(1)(B) wage limitation under
§1.199–5(a)(3). Under the proposed reg-
ulations, if an EAG partnership distributes
property to a partner, then, solely for pur-
poses of section 199(d)(1)(B)(ii), the EAG
partnership is treated as having gross re-
ceipts in the taxable year of the distribution
equal to the fair market value of the prop-
erty at the time of distribution to the part-
ner and the deemed gross receipts are allo-
cated to that partner, provided the partner
derives gross receipts from the distributed
property during the taxable year of the
partner with or within which the partner-
ship’s taxable year (in which the distribu-
tion occurs) ends. Costs included in the ad-
justed basis of the distributed property and
any other relevant deductions are taken
into account in computing the partner’s
QPAI. The proposed regulations provide
that the small business simplified overall
method is not available to EAG partner-
ships.
Another commentator asked whether
the owner of a pass-thru entity might
have to perform multiple QPAI calcula-
tions, distinguishing between pass-thru
and non-pass-thru production activities.
The proposed regulations make it clear
that, when determining its section 199
deduction, an owner of a pass-thru entity
aggregates items of income and expense
from the entity (including W–2 wages)
with its own items of income and expense
(including W–2 wages) for purposes of
allocating and apportioning deductions to
DPGR. As noted above, the amount of
W–2 wages of a pass-thru entity taken into
account by an owner in applying the wage
limitation of section 199(b) is determined
under section 199(d)(1)(B). The proposed
regulations provide that in determining an
owner’s allocable share of wages under
section 199(d)(1)(B)(i), W–2 wages are
deemed to be allocated in the same way
as wage expense is allocated. In the case
of a non-grantor trust or estate, the W–2
wages are deemed to be allocated among
the trust or estate and the various bene-
ficiaries in the same manner as QPAI, as
described below. Although a pass-thru
entity’s QPAI is computed by deducting
wages paid by the entity during its entire
taxable year, generally it is the pass-thru
entity’s W–2 wages (as shown on the
Forms W–2 for the calendar year ending
within that taxable year) that are used to
compute the wage limitation under section
199(b) and an owner’s allocable share of
wages under section 199(d)(1)(B)(i). If
QPAI,computedbytakingintoaccount
only the items of the pass-thru entity al-
located to the owner, is not greater than
zero, the owner may not take into account
the W–2 wages of the entity in computing
the section 199(b) wage limitation.
A commentator requested that the pro-
posed regulations clarify and illustrate
November 21, 200510032005–47 I.R.B.

by example how the section 199(d)(1)(B)
wage limitation applies in a tiered partner-
ship structure. In particular, the commen-
tator suggested that the W–2 wages of a
lower-tier partnership with positive QPAI
are properly allocable to the partner of the
upper-tier partnership even if the QPAI
allocated to the partner from the upper-tier
partnership is less than zero. The proposed
regulations do not adopt this suggestion.
The proposed regulations provide that
the section 199(d)(1)(B) wage limitation
must be applied at each level in a tiered
structure. Thus, in a tiered structure, the
owner of a pass-thru entity (including
an owner that itself is a pass-thru en-
tity) calculates the amounts described in
section 199(d)(1)(B)(i) (allocable share)
and (d)(1)(B)(ii) (twice the applicable
percentage of the QPAI from the entity)
separately with regard to its interest in that
pass-thru entity. The proposed regulations
provide rules regarding the treatment of
W–2 wages when a pass-thru entity (up-
per-tier entity) owns an interest in one or
more other pass-thru entities (lower-tier
entities). An example in the proposed reg-
ulations illustrates the application of these
rules.
The proposed regulations contain spe-
cial rules for trusts and estates. To the
extent that a grantor or another person is
treated as owning all or part of a trust under
sections 671 through 679 (grantor trust),
the owner will compute its QPAI with re-
spect to the owned portion of the trust as
if that QPAI had been generated by activ-
ities performed directly by the owner. In
the case of a non-grantor trust or estate, the
DPGR and expenses needed to compute
the QPAI, as well as the W–2 wages rele-
vant to the computation of the wage limita-
tion, must be allocated among the trust or
estate and its various beneficiaries. Each
beneficiary’s share of the trust’s or estate’s
QPAI (which will be less than zero if the
CGS and the deductions allocated and ap-
portioned to DPGR exceed the trust’s or
estate’s DPGR) and W–2 wages will be
determined based on the proportion of the
trust’s or estate’s distributable net income
(DNI), as defined by section 643(a), that
is deemed to be distributed to that ben-
eficiary for that taxable year. Similarly,
the proportion of the entity’s DNI that is
not deemed distributed by the trust or es-
tate will determine the entity’s share of the
QPAI and W–2 wages. In addition, if the
trust or estate has no DNI in a particular
taxable year, any QPAI and W–2 wages are
allocated to the trust or estate, and not to
any beneficiary.
Section 199(d)(1)(A)(i) provides that,
in the case of an estate or trust (or other
pass-thru entity), section 199 shall apply
at the beneficiary (or similar) level. Pur-
suant to this provision, as clarified by the
Congressional Letter, the proposed regu-
lations provide that a trust or estate may
claim the section 199 deduction to the ex-
tent that QPAI is allocated to it.
Solely for purposes of determining the
section 199 deduction for the taxable year,
theQPAIofatrustorestatemustbecom-
puted by allocating the expenses described
in section 199(d)(5) under §1.652(b)–3
with respect to directly attributable ex-
penses. With respect to other expenses
described in section 199(d)(5), a trust or
estate that qualifies for the simplified de-
duction method described in §1.199–4(e)
must use that method, and any other trust
or estate must use the section 861 method
described in §1.199–4(d). The small
business simplifiedoverall method is not
available to a trust or estate.
Because the sale of an interest in a pass-
thru entity does not reflect the realization
of DPGR by that entity, DPGR generally
does not include gain or loss recognized on
the sale, exchange or other disposition of
an interest in the entity. However, consis-
tent with Notice 2005–14, if section 751(a)
or (b) applies, then gain or loss attribut-
able to partnership assets giving rise to or-
dinary income under section 751(a) or (b),
the sale, exchange, or other disposition of
which would give rise to an item of DPGR,
is taken into account in computing the part-
ner’s section 199 deduction.
Section 199 applies to taxable years be-
ginning after December 31, 2004. Ac-
cordingly, these proposed regulations ap-
ply to taxable years of pass-thru entities
that begin on or after January 1, 2005. The
IRS and Treasury Department recognize
that a pass-thru entity will need to provide
certain information to its owners to allow
those persons to compute the section 199
deduction. No special provision with re-
gard to information reporting is made for
electing large partnerships (ELPs) as de-
finedbysection775,whicharesubjectto
the same methods for allocating and ap-
portioning deductions as are other partner-
ships. Thus, ELPs are required to pro-
vide the same information to their part-
ners as other partnerships for purposes of
computing the section 199 deduction. The
IRS and the Treasury Department intend
to provide information reporting rules for
pass-thru entities in the relevant forms and
instructions.
Agricultural and Horticultural
Cooperatives
A commentator suggested that the pro-
posed regulations provide that patrons
cannot include patronage dividends and
per-unit retain certificates in the computa-
tion of the QPAI from the patron’s other
farming operations to the extent that those
amounts were taken into account by a co-
operative in determining the cooperative’s
section 199 deduction. The commentator
stated that in many cases, both the coop-
erative and its patrons will be engaged in
qualifying activities. For example, gross
receipts from crops raised by a farmer
in the United States may be eligible for
the section 199 deduction as well as the
receipts the cooperative derives from the
marketing of the crop. To avoid duplica-
tion of section 199 benefits, the proposed
regulations clarify that under §1.199–6(h)
patronage dividends and per-unit alloca-
tions a patron receives from a cooperative
that are taken into account as part of the
cooperative’s computation of QPAI may
not be taken into account in computing the
patron’s QPAI from its own qualifying ac-
tivities. In addition, patronage dividends
and per-unit retain allocations include any
advances on patronage or per-unit retains
paid in money made during the taxable
year. Examples are provided to illustrate
this rule.
A commentator suggested that the pro-
posed regulations clarify the amount of the
section 199 deduction a cooperative is re-
quired to pass through to its patrons. Ac-
cordingly, the proposed regulations clarify
in §1.199–6(d) that the cooperative may,
at its discretion, pass through all, some, or
none of the allowable section 199 deduc-
tion to its patrons.
A commentator suggested that it would
be useful if the proposed regulations ad-
dress whether a cooperative member of a
federated cooperative may pass through
to its patrons the section 199 deduction
it receives as a patron cooperative. Ac-
cordingly, the proposed regulations in
2005–47 I.R.B.1004November 21, 2005

§1.199–6(d) provide that a cooperative
patron of a federated cooperative may
pass through the section 199 deduction it
receives to its member patrons.
A commentator requested that the
proposed regulations address the form,
content, and timing of the patron notifi-
cation requirements. The commentator
stated that the notice should not have to
accompany the patronage distribution. For
instance, a cooperative should be permit-
ted to send out a notice passing through
an estimated amount of the section 199
deduction at the time patronage dividends
are paid and a second notice (when the
Federal income tax return is completed
and the section 199 deduction is actually
determined) covering anything that was
not passed through by the first notice, pro-
vided the notice is sent during the payment
period in section 1382(d). The proposed
regulations provide in §1.199–6(b) that,
in order for a patron to qualify for the
section 199 deduction, the cooperative
must designate the patron’s portion of the
section 199 deduction in a written notice
mailed by the cooperative to its patrons no
later than the 15
th
day of the ninth month
following the close of the cooperative’s
taxable year. The cooperative may use
the same written notice, if any, that it uses
to notify patrons of their respective allo-
cations of patronage dividends, or may
use a separate timely written notice(s) to
comply with this section. The cooperative
must report the amount of the patron’s sec-
tion 199 deduction on Form 1099-PATR,
“Taxable Distributions Received From
Cooperatives,” issued to the patron.
A commentator suggested that the
proposed regulations clarify that patrons
(whether they use the cash or accrual
method of accounting) are entitled to
claim the section 199 deduction passed
through from the cooperative on the re-
turn for the taxable year in which they
receive written notification from the coop-
erative. The proposed regulations provide
in §1.199–6(d) that patrons may claim the
section 199 deduction for the taxable year
they receive the written notice informing
them of the section 199 deduction amount.
A commentator suggested that the pro-
posed regulations clarify that the section
199 deduction of a cooperative is subject
to the W–2 wage limitation under section
199(b) at the cooperative level and that it
is not subject to a second W–2 wage lim-
itation at the patron level to the extent the
section 199 deduction is passed through
to its patrons. The proposed regulations
provide in §1.199–6(e) that the W–2 wage
limitation shall be applied only at the co-
operative level whether or not the cooper-
ative chooses to pass through some or all of
the section 199 deduction. In addition, the
proposed regulations in §1.199–6(d) pro-
vide that patrons may claim the section 199
deduction without regard to the taxable in-
come limitation.
A commentator suggested that the pro-
posed regulations address what happens
when an audit determination results in a
decrease in the amount of a cooperative’s
section 199 deduction passed through to
its patrons. The proposed regulations pro-
vide in §1.199–6(f) that, if an audit deter-
mines or an amended return reports that the
amount of the section 199 deduction that
was passed through to patrons exceeded
the amount determined to be allowable by
the audit or on the amended return, recap-
ture of the audit adjustment amount or ex-
cess amended return amount will occur at
the cooperative level.
Expanded Affiliated Groups
Section 199(d)(4)(A) provides that all
members of an EAG are treated as a single
corporation for purposes of section 199.
Thesinglecorporationlanguageinsec-
tion 199(d)(4)(A) has created confusion
among commentators and the proposed
regulations clarify themeaning of this lan-
guage. The proposed regulations provide
that except as otherwise provided in the
Code and regulations (see, for example,
sections 199(c)(7) and 267, §§1.199–3(b)
and 1.199–7(a)(3), and the consolidated
return regulations), each member of an
EAG is a separate taxpayer that computes
its own taxable income or loss, QPAI, and
W–2 wages, which are then aggregated at
the EAG level. For example, if corpora-
tions X and Y are members of the same
EAG, but are not members of the same
consolidated group, and X sells QPP it
MPGE within the United States to Y, the
transaction is taken into account in deter-
mining the EAG’s section 199 deduction.
If X and Y are members of the same con-
solidated group, see the section entitled
Consolidated Groups, below.
The IRS and Treasury Department be-
lieve that Congress intended that an EAG
should be eligible for the section 199 de-
duction if the activities to produce QPP,
qualified films, and utilities are done by
one or more members of the EAG other
than the member who leases, rents, li-
censes, sells, exchanges, or otherwise
disposes of the QPP, qualified films, and
utilities. Accordingly, the proposed regu-
lations provide generally that if a member
of an EAG (the disposing member) de-
rives gross receipts from the lease, rental,
license, sale, exchange, or other disposi-
tion of QPP, qualified films, and utilities
MPGE or otherwise produced by another
member or members of the same EAG,
the disposing member is treated as con-
ducting the activities conducted by each
other member of the EAG with respect to
the QPP, qualified films, and utilities in
determining whether its gross receipts are
DPGR. However, in general, attribution
of activities does not apply for purposes
of the construction of real property un-
der §1.199–3(l)(1) or the performance
of engineering and architectural services
under §1.199–3(m)(1). A member of
an EAG must engage in a construction
activity under §1.199–3(l)(2), provide en-
gineering services under §1.199–3(m)(2),
or provide architectural services under
§1.199–3(m)(3) in order for the mem-
ber’s gross receipts to be derived from
construction, engineering, or architectural
services. Notwithstanding the above, attri-
bution of activities in the construction of
real property and the performance of en-
gineering and architectural services does
apply for members of the same consoli-
dated group. For example, if X and Y are
members of the same EAG, but are not
members of the same consolidated group,
and X constructs a commercial building
and sells the building to Y, and Y, who
performs no construction activities with
respect to the building, sells the building
to an unrelated person, Y is not attributed
the construction activities of X and Y’s
receipts from the sale of the building will
not be DPGR. However, if X and Y are
members of the same consolidated group,
Y is attributed the construction activities
of X and, assuming all the requirements of
section 199(c) are met, Y’s receipts will
be DPGR.
Some commentators suggested that the
proposed regulations provide a special
rule excluding finance companies from an
EAG. Section 199(d)(4)(A) specifically
November 21, 200510052005–47 I.R.B.

states that all members of an EAG shall
be treated as a single corporation. Nei-
ther the statute nor the legislative history
provide any exceptions that would allow
taxpayers to exclude certain types of com-
panies, including finance companies, from
the EAG. Accordingly, the commentators’
suggestion has not been adopted.
Notwithstanding that a transaction be-
tween members of the same EAG (an intra-
group transaction) generally is taken into
account in determining the section 199 de-
duction, the IRS and Treasury Department
recognize that taxpayers may engage in an
intragrouptransactioninanattempttoob-
tain a section 199 deduction when none
should be available. Accordingly, the pro-
posed regulations retain the anti-avoidance
rule contained in Notice 2005–14. Thus,
if a transaction between members of the
same EAG is engaged in or structured with
a principal purpose of qualifying for, or in-
creasing the amount of, the section 199 de-
duction of the EAG or the portion of the
section 199 deduction allocated to one or
more members of the EAG, adjustments
must be made to eliminate the effect of the
transaction on the computation of the sec-
tion 199 deduction.
Some commentators asked whether
the $25,000,000 and $5,000,000 aver-
age annual gross receipts thresholds for
using the simplified deduction method
and the small business simplified over-
all method, respectively, are applied at
the EAG level, the consolidated group
level, or at the member level. If the EAG
was a single corporation, the $25,000,000
and $5,000,000 average annual gross re-
ceipts thresholds would take into account
the activities of all the members of the
EAG. Accordingly, the $25,000,000 and
$5,000,000 average annual gross receipts
thresholds are applied at the EAG level.
Similarly, the new $10,000,000 total as-
sets threshold for using the simplified
deduction method and the new $5,000,000
current year CGS and deductions thresh-
old for using the small business simplified
overall method also are applied at the
EAG level. The determination of whether
a taxpayer is engaged in the trade or busi-
ness of farming that is not required to use
the accrual method of accounting under
section 447 is determined by taking into
account the activities of all the members
of the EAG. Similarly, the determination
of whether a taxpayer is eligible to use the
cash method as provided in Rev. Proc.
2002–28, and is thus eligible to use the
small business simplified overall method,
is determined by taking into account the
activities of all the members of the EAG.
Commentators requested that the rule
in Notice 2005–14 that requires all mem-
bers of the same EAG to use the same
cost allocation method be changed to al-
low members to use different cost allo-
cation methods. In response to the com-
ments received, the IRS and Treasury De-
partment agree that if an EAG is eligible
to use the simplified deduction method,
each member of the EAG may individu-
ally determine whether it wants to use the
section 861 method or the simplified de-
duction method, notwithstanding that an-
other member of the EAG uses a different
method. Similarly, if the EAG is eligible
to use the small business simplified over-
all method, each member of the EAG may
individually determine whether it wants to
use the section 861 method, the simplified
deduction method, or the small business
simplified overall method, notwithstand-
ing that another member of the EAG uses a
different method. However, if the EAG is
not eligible to use either the simplified de-
duction method or the small business sim-
plified overall method, then all members of
the EAG must use the section 861 method.
Notwithstanding that the members of an
EAG generally are not required to use the
same cost allocation method, each member
of a consolidated group must use the same
cost allocation method. Examples are pro-
vided to illustrate these provisions.
A commentator also asked at what
level thede minimisrule described
in §1.199–1(d)(2) is tested. Section
1.199–1(d)(2) treats all of a taxpayer’s
gross receipts as DPGR if less than 5
percent of the taxpayer’s total gross re-
ceipts are non-DPGR. Thede minimis
rule is intended to eliminate the burden
to a taxpayer of allocating gross receipts
between DPGR and non-DPGR when less
than 5 percent of its total gross receipts
are non-DPGR. When considering the
purpose of thede minimisrule, the IRS
and Treasury Department believe that it is
appropriate that the 5 percent threshold be
determined at the corporation level, rather
than at the EAG or consolidated group
level.
Consolidated Groups
The section 199 deduction of a consol-
idated group (or the section 199 deduction
allocated to a consolidated group that is
a member of an EAG) is allocated to the
members of the consolidated group in pro-
portion to each consolidated group mem-
ber’s QPAI, regardless of whether the con-
solidated group member has separate tax-
able income or loss or W–2 wages for
the taxable year. Further, if two or more
members of a consolidated group engage
in an intercompany transaction, as defined
in §1.1502–13(b)(1), the proposed regu-
lations clarify that if an item of income,
gain, deduction, or loss is not yet taken into
account under §1.1502–13, the intercom-
pany transaction that gave rise to the item
is not taken into account in computing the
section 199 deduction until the time and in
the same proportion that the item is taken
into account under §1.1502–13. For ex-
ample, if corporations X and Y file a con-
solidated Federal income tax return and
X sells QPP it MPGE within the United
States to Y, the transaction is not taken into
account until the time (and in the same pro-
portion) provided in the matching rule of
§1.1502–13(c) or the acceleration rule of
§1.1502–13(d). The proposed regulations
provide examples to illustrate these princi-
ples.
Some commentators suggested that if
X’s receipts from an intercompany trans-
action with consolidated group member Y
are non-DPGR (for example, X licenses
non-QPP to Y) and Y’s CGS and other de-
ductions from the intercompany transac-
tion are taken into account in determining
the consolidated group’s QPAI, the con-
solidated group’s QPAI could be different
than if X and Y were divisions of a sin-
gle corporation, contrary to the general in-
tent of §1.1502–13. The consolidated re-
turn regulations already prevent this result.
Under §1.1502–13(c)(1)(i) and (c)(4), X’s,
Y’s, or both X’s and Y’s separate entity at-
tributes must be redetermined to the extent
necessary to treat X and Y as if they were
divisions of a single corporation. Thus,
X’s income may be redetermined to be
DPGR (notwithstanding section 199(c)(7)
or that the item licensed by X in the in-
tercompany transaction does not otherwise
meet the requirements of section 199(c))
or Y’s CGS and other deductions from
the intercompany transaction may be re-
2005–47 I.R.B.1006November 21, 2005

determined to be not allocable to DPGR,
whichever produces the effect as though X
and Y were divisions of a single corpora-
tion. Similarly, if X MPGE QPP within
the United States and sells the QPP to Y,
but Y does not use the QPP in creating
DPGR, in order to produce the effect as
though X and Y were divisions of a sin-
gle corporation, X’s gross receipts from
the sale of the QPP may be redetermined
to be non-DPGR or Y’s CGS and other de-
ductions may be redetermined to be alloca-
ble to DPGR. In addition, if X MPGE QPP
within the United States and sells the QPP
to Y, and Y sells the QPP to an unrelated
person, X’s gross receipts may be redeter-
mined to be non-DPGR (and non-receipts)
and Y’s CGS and other deductions may be
redetermined to be not allocable to DPGR,
to the extent necessary to produce the ef-
fect as though X and Y were divisions of
a single corporation. The proposed regula-
tions provide examples to illustrate the sit-
uations described above.
Some commentators asked whether the
section 199 deduction results in a down-
ward basis adjustment under §1.1502–32
if the deduction is allocated to a sub-
sidiary member (S) of a consolidated
group. Section 1.1502–32(b)(3)(ii)(B)
already addresses this situation. Al-
though the section 199 deduction is taken
into account under the general operating
rules of §1.1502–32(b)(3)(i), paragraph
(b)(3)(ii)(B) of that section provides that
not only is S’s income taken into ac-
count under the general operating rules of
§1.1502–32(b)(3)(i), but an amount of S’s
income equivalent to the section 199 de-
duction is also treated as being tax-exempt
income under §1.1502–32(b)(3)(ii)(A).
The net result is that the basis that P (S’s
parent) has in its S stock is not reduced on
account of the section 199 deduction. For
example, if S earns $100 and is entitled
to a $9 section 199 deduction, P’s basis
in S increases by $100 because the $100
income and the $9 deduction are taken
into account under §1.1502–32(b)(3)(i)
(resulting in $91 of the increase) and $9 of
the income also is taken into account un-
der §1.1502–32(b)(3)(ii)(A) as tax-exempt
income (resulting in $9 of the increase).
The proposed regulations treat a con-
solidated group as a single member of the
EAG.Forexample,ifA,B,C,S1,andS2
are members of the same EAG, and A, S1,
and S2 are members of the same consol-
idated group (the A consolidated group),
then the A consolidated group is treated as
one member of the EAG. Thus, the EAG
is considered to have three members, the
A consolidated group, B, and C.
Alternative Minimum Tax
Section 199(d)(6),as clarified by the
Congressional Letter, provides that for
purposes of determining AMTI under sec-
tion 55, the section 199 deduction must
be computed in the same manner as for
regular tax, except that in the case of a
corporation, the taxable income limitation
is the corporation’s AMTI. Accordingly,
the proposed regulations provide that for
purposes of determining AMTI under sec-
tion 55, a taxpayer that is not a corporation
maydeductanamountequalto9percent
(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 the
taxpayer’s QPAI for the taxable year, or
the taxpayer’s taxable income for the tax-
able year, determined without regard to
the section 199 deduction (or in the case of
an individual, AGI). In the case of a cor-
poration (including a corporation subject
to tax under section 511(a)), a taxpayer
maydeductanamountequalto9percent
(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 the
taxpayer’s QPAI for the taxable year, or
the taxpayer’s AMTI (as defined in section
55(b)(2)) for the taxable year, determined
without regard to the section 199 deduc-
tion. For purposes of computing AMTI,
QPAI is determined without regard to any
adjustments under sections 56 through 59.
In the case of an individual or a trust, AGI
and taxable income are also determined
without regard to any adjustments under
sections 56 through 59. The amount of the
deduction allowable for purposes of com-
puting AMTI for any taxable year cannot
exceed 50 percent of the W–2 wages of
the employer for the taxable year (as de-
termined under §1.199–2).
Revocation of Election under Section
631(a)
Section 102(c) of the Act allows a tax-
payer to revoke an election under section
631(a) to treat the cutting of timber as a
sale or exchange. Any section 631(a) elec-
tion for a taxable year ending on or before
October 22, 2004, may be revoked under
section 102(c) of the Act for any taxable
year ending after that date. In addition, any
election under section 631(a) for a taxable
year ending on or before October 22, 2004
(and any revocation of the election under
section 102(c) of the Act), is disregarded
for purposes of determining whether the
taxpayer is eligible to make a subsequent
election under section 631(a). A revoca-
tion under section 102(c) of the Act will
remain in effect until the first taxable year
for which the taxpayer makes a new elec-
tion under section 631(a).
Commentators suggested that, if a
taxpayer makes an election under sec-
tion 631(a), section 199 should apply to
any resulting section 1231 gain. A tax-
payer that makes an election under section
631(a) reports the difference between the
fair market value of the timber cut and
its actual cost as section 1231 gain. The
proposed regulations do not adopt the sug-
gestion because timber is real property,
not tangible personal property, and the
cutting of timber does not qualify under
section 199(c)(4)(A)(i)(I). In the case of a
taxpayer who does not make an election
under section 631(a), or a taxpayer who
revokes an election under section 631(a)
pursuant to section 102(c) of the Act, the
cutting and sawing of timber produces
lumber which qualifies as tangible per-
sonal property. The gross receipts derived
by a taxpayer from the sale of lumber it
produces qualify as DPGR (assuming all
the other requirements of section 199(c)
are met).
Proposed Effective Date
The regulations are proposed to be ap-
plicable to taxable years beginning after
December 31, 2004. Section 199 applies
to taxable years of pass-thru entities be-
ginning after December 31, 2004. Accord-
ingly, section 199 does not apply to taxable
years of pass-thru entities beginning be-
fore January 1, 2005. For example, assume
a pass-thru entity has a taxable year be-
ginning July 1, 2004, and ending June 30,
2005, and the owners of the pass-thru en-
tity have calendar taxable years. Because
section 199 first applies to the pass-thru
entity for its taxable year beginning July
1, 2005, the first taxable year in which an
November 21, 200510072005–47 I.R.B.

owner of the pass-thru entity will be eli-
gible to claim a section 199 deduction for
the owner’s allocable orpro ratashare of
items allocated or apportioned to the qual-
ified production activities of the pass-thru
entity will be the calendar year 2006. Con-
versely, assume that a pass-thru entity has
a calendar taxable year beginning January
1, 2005, and has a short taxable year end-
ing on June 30, 2005, due to the termina-
tion of the entity. Assume the owners of
that pass-thru entity have taxable years be-
ginning July 1, 2004, and ending June 30,
2005. Because section 199 first applies to
the owners for their taxable years begin-
ning July 1, 2005, under §1.199–8(g), the
owners of the pass-thru entity will be inel-
igible to claim a section 199 deduction for
the owners’ allocable orpro ratashare of
items allocated or apportioned to the qual-
ified production activities of the pass-thru
entity for their taxable years ending June
30, 2005.
Until the date final regulations are
published in theFederal Register,the
proposed regulations provide that tax-
payersmayrelyontherulessetforthin
the interim guidance on section 199 as set
forth in Notice 2005–14 (Notice) as well as
the proposed regulations under §§1.199–1
through 1.199–8 (proposed regulations).
For this purpose, if the proposed regu-
lations and the Notice include different
rules for the same particular issue, then
the taxpayer may rely on either the rule
set forth in the proposed regulations or the
rule set forth in the Notice. For example,
the Notice and the proposed regulations
both include the small business simplified
overall method, however the eligibil-
ity requirements for the method under the
Notice have been modified in the proposed
regulations. Accordingly, a taxpayer may
rely on the eligibility requirements for the
method set forth in either the Notice or
the proposed regulations. However, if the
proposed regulations include a rule that
was not included in the Notice, taxpayers
arenotpermittedtorelyontheabsence
ofaruletoapplyarulecontrarytothe
proposed regulations. For example, No-
tice 2005–14 does not include any rules
regarding the treatment of hedging trans-
actions whereas the proposed regulations
include such rules. Accordingly, taxpayers
are not permitted to treat hedging transac-
tions contrary to the treatment provided in
the proposed regulations.
Request for Comments
The IRS and Treasury Department in-
vite taxpayers to submit comments on is-
sues relating to section 199. The IRS and
Treasury Department intend to finalize the
proposed regulations as soon as possible
so taxpayers will have the final regulations
as they begin to prepare their 2005 Federal
income tax returns. Accordingly, the IRS
and Treasury Department encourage tax-
payers to submit their comments by Jan-
uary 3, 2006, so they can be given proper
consideration. In particular, the IRS and
Treasury Department encourage taxpayers
to submit comments on the following is-
sues:
1. Questions have arisen as to the ap-
plicability under section 199 of a Large
and Mid-Size Business (LMSB) directive
dated March 14, 2002, “Field Directive
on the Use of Estimates from Probability
Samples,” that authorizes in appropriate
circumstances the use of statistical sam-
pling by taxpayers. LMSB taxpayers are
not precluded from applying the concepts
of the LMSB directive for purposes of sec-
tion 199. The proposed regulations do not
provide specific rules on the use of statis-
tical sampling for 199 purposes, however
comments are requested on how taxpay-
ers can apply statistical sampling to section
199, what specific areas of section 199 sta-
tistical sampling could be applied to, and
whether application of statistical sampling
should be limited to specific areas of sec-
tion 199.
2. Taxpayers are eligible to make cer-
tain elections under the section 861 regu-
lations. For example, §1.861–9T(g)(1)(ii)
permits a taxpayer to elect to determine
the value of its assets on the basis of ei-
ther their tax book value or fair market
value. Some of the elections under the sec-
tion 861 regulations require the consent of
the Commissioner to revoke or to change
to another method. See §§1.861–8T(c)(2),
1.861–9T(i)(2), and1.861–17(e). Because
the section 861 method requires certain
taxpayers to use the rules of the section
861 regulations in a new context, these
taxpayers may want to reconsider previ-
ously made elections under those regula-
tions. The IRS and Treasury Department
intend to issue a revenue procedure grant-
ing taxpayers automatic consent to change
certain elections under the section 861 reg-
ulations. Comments are requested con-
cerning such an automatic consent proce-
dure, including which elections should be
included and the appropriate time period
during which the automatic consent should
apply.
3. The IRS and Treasury Depart-
ment note that there are special rules
regarding the application of the sec-
tion 861 method in the case of affiliated
groups. See section 864(e)(5) and (6); see
also §§1.861–11(d)(7), 1.861–11T(d)(6),
1.861–14(d) and 1.861–14T. Comments
are requested regarding whether addi-
tional guidance is needed to clarify how
the rules under §§1.861–11T(c) and (g)
and 1.861–14T(c) apply under the section
861 method to allocate and apportion in-
terest and other expenses such as research
and experimentation expenses in comput-
ingQPAIofthemembersofsuchaffiliated
groups in which otherwise includible cor-
porations are owned indirectly through
foreign corporations and partnerships.
4. Comments are requested concerning
whether gross receipts derived from the
provision of certain types of online soft-
ware should qualify under section 199 as
being derived from a lease, rental, license,
sale, exchange, or other disposition of the
software and, if so, how to distinguish be-
tween such types of online software.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory as-
sessment is not required. It has also been
determined that section 553(b) of the Ad-
ministrative Procedure Act (5 U.S.C. chap-
ter 5) does not apply. It is hereby certi-
fied that the collection of information in
this regulation will not have a significant
economic impact on a substantial num-
ber of small entities. This certification is
based upon the fact that, as previously dis-
cussed, any burden on cooperatives is min-
imal. Accordingly, a Regulatory Flexibil-
ity Analysis under the Regulatory Flexibil-
ity Act (5 U.S.C. chapter 6) is not required.
Pursuant to section 7805(f) of the Code,
this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advo-
cacy of the Small Business Administration
for comment on their impact on small busi-
ness.
2005–47 I.R.B.1008November 21, 2005

Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written comments
(a signed original and eight (8) copies)
or electronic comments that are submit-
ted timely to the IRS. Comments are re-
quested on all aspects of the proposed reg-
ulations. In addition, the IRS and Trea-
sury Department specifically request com-
ments on the clarity of the proposed rules
and how they can be made easier to under-
stand. All comments will be available for
public inspection and copying.
A public hearing has been scheduled for
Wednesday, January 11, 2006, at 10 a.m.
in the IRS Auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW,
Washington, DC. Due to building security
procedures, visitors must enter at the Con-
stitution Avenue entrance. In addition, all
visitors must presentphoto identification
to enter the building. Because of access
restrictions, visitors will not be admitted
beyond the immediate entrance area more
than 30 minutes before the hearing starts.
For information about having your name
placed on the building access list to attend
the hearing, see the “FOR FURTHER IN-
FORMATION CONTACT” section of this
preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing.
Persons who wish to present oral com-
ments at the hearing must submit elec-
tronic or written comments and an out-
line of the topics to be discussed and the
time to be devoted to each topic (a signed
original and eight (8) copies) by Decem-
ber 21, 2005. A period of 10 minutes will
be allotted to each person for making com-
ments. An agenda showing the scheduling
of the speakers will be prepared after the
deadline for receiving outlines has passed.
Copies of the agenda will be available free
of charge at the hearing.
Drafting Information
The principal authors of these reg-
ulations are Paul Handleman and
Lauren Ross Taylor, Office of Associate
Chief Counsel (Passthroughs and Special
Industries), IRS. However, other person-
nel from the IRS and Treasury Department
participated in their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part1isamendedbyaddingentriesinnu-
merical order to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.199–1 also issued under 26
U.S.C. 199(d).
Section 1.199–2 also issued under 26
U.S.C. 199(d).
Section 1.199–3 also issued under 26
U.S.C. 199(d).
Section 1.199–4 also issued under 26
U.S.C. 199(d).
Section 1.199–5 also issued under 26
U.S.C. 199(d).
Section 1.199–6 also issued under 26
U.S.C. 199(d).
Section 1.199–7 also issued under 26
U.S.C. 199(d).
Section 1.199–8 also issued under 26
U.S.C. 199(d). * * *
Par. 2. Sections 1.199–0 through
1.199–8 are added to read as follows:
§1.199–0 Table of contents.
This section lists the headings that ap-
pear in §§1.199–1 through 1.199–8.
§1.199–1 Income attributable to domestic
production activities.
(a) In general.
(b) Taxable income and adjusted gross
income.
(1) In general.
(2) Examples.
(c) Qualified production activities in-
come.
(1) In general.
(2) Definition of item.
(i) In general.
(ii) Examples.
(d) Allocation of gross receipts.
(1) In general.
(2)De minimisrule.
(3) Examples.
(e) Timing rules for determining QPAI.
(1) Gross receipts and costs recognized
in different taxable years.
(2) Percentage of completion method.
(3) Example.
§1.199–2 Wage limitation.
(a) Rules of application.
(1) In general.
(2) Wages paid by entity other than
common law employer.
(b) No application in determining
whether amounts are wages for employ-
ment tax purposes.
(c) Application in case of taxpayer with
short taxable year.
(d) Acquisition or disposition of a trade
or business (or major portion).
(e) Non-duplication rule.
(f) Definition of W–2 wages.
(1) In general.
(2) Methods for calculating W–2
wages.
(i) Unmodified box method.
(ii) Modified Box 1 method.
(iii) Tracking wages method.
§1.199–3 Domestic production gross
receipts.
(a) In general.
(b) Related persons.
(1) In general.
(2) Exceptions.
(c) Definition of gross receipts.
(d) Definition of manufactured, pro-
duced, grown, or extracted.
(1) In general.
(2) Packaging, repackaging, labeling,
or minor assembly.
(3) Installing.
(4) Consistency with section 263A.
(5) Examples.
(e) Definition of by the taxpayer.
(1) In general.
(2) Special rule for certain government
contracts.
(3) Examples.
(f) Definition of in whole or in signifi-
cant part.
(1) In general.
(2) Substantial in nature.
(3) Safe harbor.
(4) Examples.
(g) Definition of United States.
(h) Definition of derived from the lease,
rental, license, sale, exchange, or other dis-
position.
(1) In general.
(2) Examples.
(3) Hedging transactions.
(i) In general.
(ii) Currency fluctuations.
November 21, 200510092005–47 I.R.B.

(iii) Other rules.
(4) Allocation of gross receipts — em-
bedded services and non-qualified prop-
erty.
(i) In general.
(ii) Exceptions.
(iii) Examples.
(5) Advertising income.
(i) Tangible personal property.
(ii) Qualified films.
(iii) Examples.
(6) Computer software.
(i) In general.
(ii) Examples.
(7) Exception for certain oil and gas
partnerships.
(i) In general.
(ii) Example.
(8) Partnerships owned by members of
a single expanded affiliated group.
(i) In general.
(ii) Special rules for distributions from
EAG partnerships.
(iii) Examples.
(9) Non-operating mineral interests.
(i) Definition of qualifying production
property.
(1) In general.
(2) Tangible personal property.
(i) In general.
(ii) Local law.
(iii) Machinery.
(iv) Intangible property.
(3) Computer software.
(i) In general.
(ii) Incidental and ancillary rights.
(iii) Exceptions.
(4) Sound recordings.
(i) In general.
(ii) Exception.
(5) Tangible personal property with
computer software or sound recordings.
(i) Computer software and sound
recordings.
(ii) Tangible personal property.
(j) Definition of qualified film.
(1) In general.
(2) Tangible personal property with a
film.
(i) Film licensed by a taxpayer.
(ii) Film produced by a taxpayer.
(A) Qualified films.
(B) Nonqualified films.
(3) Derived from a qualified film.
(4) Examples.
(5) Compensation for services.
(6) Determination of 50 percent.
(7) Exception.
(k) Electricity, natural gas, or potable
water.
(1) In general.
(2) Natural gas.
(3) Potable water.
(4) Exceptions.
(i) Electricity.
(ii) Natural gas.
(iii) Potable water.
(iv)De minimisexception.
(5) Example.
(l) Definition of construction performed
in the United States.
(1) Construction of real property.
(i) In general.
(ii)De minimisexception.
(2) Activities constituting construction.
(3) Definition of infrastructure.
(4) Definition of substantial renovation.
(5) Derived from construction.
(i) In general.
(ii) Land safe harbor.
(iii) Examples.
(m) Definition of engineering and ar-
chitectural services.
(1) In general.
(2) Engineering services.
(3) Architectural services.
(4)De minimisexception for perfor-
mance of services in the United States.
(n) Exception for sales of certain food
and beverages.
(1) In general.
(2) Examples.
§1.199–4 Costs allocable to domestic
production gross receipts.
(a) In general.
(b) Cost of goods sold allocable to do-
mestic production gross receipts.
(1) In general.
(2)Allocatingcostofgoodssold.
(3) Special rules for imported items or
services.
(4) Rules for inventories valued at mar-
ket orbona fideselling prices.
(5) Rules applicable to inventories ac-
counted for under the last-in, first-out
(LIFO) inventory method.
(i) In general.
(ii) LIFO/FIFO ratio method.
(iii) Change in relative base-year cost
method.
(6) Taxpayers using the simplified
production method or simplified resale
method for additional section 263A costs.
(7) Examples.
(c) Other deductions allocable or ap-
portioned to domestic production gross re-
ceipts or gross income attributable to do-
mestic production gross receipts.
(1) In general.
(2) Treatment of certain deductions.
(i) In general.
(ii) Net operating losses.
(iii) Deductions not attributable to the
conduct of a trade or business.
(d) Section 861 method.
(1) In general.
(2) Deductions for charitable contribu-
tions.
(3) Research and experimental expen-
ditures.
(4) Deductions related to gross receipts
deemed to be domestic production gross
receipts.
(5) Examples.
(e) Simplified deduction method.
(1) In general.
(2) Members of an expanded affiliated
group.
(i) In general.
(ii) Exception.
(iii) Examples.
(f) Small business simplified overall
method.
(1) In general.
(2) Qualifying small taxpayer.
(3) Members of an expanded affiliated
group.
(i) In general.
(ii) Exception.
(iii) Examples.
(4) Ineligible pass-thru entities.
(g) Average annual gross receipts.
(1) In general.
(2) Members of an EAG.
(h) Total assets.
(1) In general.
(2) Members of an EAG.
(i) Total costs for the current taxable
year.
(1) In general.
(2) Members of an EAG.
§1.199–5 Application of section 199 to
pass-thru entities.
(a) Partnerships.
(1) Determination at partner level.
(2) Disallowed deductions.
(3) Partner’s share of W–2 wages.
(4) Examples.
(b) S corporations.
(1) Determination at shareholder level.
2005–47 I.R.B.1010November 21, 2005

(2) Disallowed deductions.
(3) Shareholder’s share of W–2 wages.
(c) Grantor trusts.
(d) Non-grantor trusts and estates.
(1) Computation of section 199 deduc-
tion.
(2) Example.
(e) Gain or loss from the disposition of
an interest in a pass-thru entity.
(f) Section 199(d)(1)(B) wage limita-
tion and tiered structures.
(1) In general.
(2) Share of W–2 wages.
(3) Example.
(g) No attribution of qualified activities.
§1.199–6 Agricultural and horticultural
cooperatives.
(a) In general.
(b) Written notice to patrons.
(c) Determining cooperative’s qualified
production activities income.
(d) Additional rules relating to pass-
through of section 199 deduction.
(e) W–2 wages.
(f) Recapture of section 199 deduction.
(g) Section is exclusive.
(h) No double counting.
(i) Examples.
§1.199–7 Expanded affiliated groups.
(a) In general.
(1) Definition of expanded affiliated
group.
(2) Identification of members of an ex-
panded affiliated group.
(i) In general.
(ii) Becoming or ceasing to be a mem-
ber of an expanded affiliated group.
(3) Attribution of activities.
(4) Examples.
(5) Anti-avoidance rule.
(b) Computation of expanded affiliated
group’s section 199 deduction.
(1) In general.
(2) Net operating loss carryovers.
(c) Allocation of an expanded affili-
ated group’s section 199 deduction among
members of the expanded affiliated group.
(1) In general.
(2) Use of section 199 deduction to cre-
ate or increase a net operating loss.
(d) Special rules for members of the
same consolidated group.
(1) Intercompany transactions.
(2) Attribution of activities in the con-
struction of real property and the perfor-
mance of engineering and architectural
services.
(3) Application of the simplified deduc-
tion method and the small business simpli-
fied overall method.
(4) Determining the section 199 deduc-
tion.
(i) Expanded affiliated group consists
of consolidated group and non-consoli-
dated group members.
(ii) Expanded affiliated group consists
only of members of a single consolidated
group.
(5) Allocation of the section 199 de-
duction of a consolidated group among its
members.
(e) Examples.
(f) Allocation of income and loss by a
corporation that is a member of the ex-
panded affiliated group for only a portion
of the year.
(1) In general.
(i)Pro rataallocation method.
(ii) Section 199 closing of the books
method.
(iii) Making the section 199 closing of
the books election.
(2) Coordination with rules relat-
ing to the allocation of income under
§1.1502–76(b).
(g) Total section 199 deduction for a
corporation that is a member of an ex-
panded affiliated group for some or all of
its taxable year.
(1)Memberofthesameexpandedaffil-
iated group for the entire taxable year.
(2)Memberoftheexpandedaffiliated
group for a portion of the taxable year.
(3) Example.
(h) Computation of section 199 deduc-
tion for members of an expanded affiliated
group with different taxable years.
(1) In general.
(2) Example.
§1.199–8 Other rules.
(a) Individuals.
(b) Trade or business requirement.
(c) Coordination with alternative mini-
mum tax.
(d) Nonrecognition transactions.
(1) In general.
(2) Section 1031 exchanges.
(3) Section 381 transactions.
(e) Taxpayers with a 52–53 week tax-
able year.
(f) Section 481(a) adjustments.
(g) Effective date.
§1.199–1 Income attributable to domestic
production activities.
(a)In general. A taxpayer may deduct
an amount 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 the taxpayer’s qual-
ified production activities income (QPAI)
(as defined in paragraph (c) of this section)
for the taxable year, or the taxpayer’s tax-
able income for the taxable year (or, in the
case of an individual, adjusted gross in-
come). The amount of the deduction al-
lowable under this paragraph (a) for any
taxable year cannot exceed 50 percent of
the W–2 wages of the employer for the tax-
able year (as determined under §1.199–2).
(b)Taxable income and adjusted gross
income—(1)In general. For purposes of
paragraph (a) of this section, the defini-
tion of taxable income under section 63
applies and taxable income is determined
without regard to section 199. In the case
of individuals, adjusted gross income for
the taxable year is determined after ap-
plying sections 86, 135, 137, 219, 221,
222, and 469, and without regard to sec-
tion 199. For purposes of determining the
tax imposed by section 511, paragraph (a)
of this section is applied using unrelated
business taxable income. For purposes of
determining the amount of a net operating
loss (NOL) carrybackor carryover under
section 172(b)(2), taxable income is deter-
mined without regard to the deduction al-
lowed under section 199.
(2)Examples. The following examples
illustrate the application of this paragraph
(b):
Example 1.(i)Facts. X, a United States corpo-
ration that is not part of an expanded affiliated group
(EAG) (as defined in §1.199–7), engages in produc-
tion activities that generate QPAI and taxable income
(without taking into account the deduction under this
section) of $600 in 2010. During 2010, X incurs W–2
wages of $300. X has an NOL carryover to 2010 of
$500. X’s deduction under this section for 2010 is $9
(.09 x (lesser of QPAI of $600 and taxable income of
$100) subject to the wage limitation of $150 (50% x
$300)).
Example 2.(i)Facts. X, a United States corpo-
ration that is not part of an EAG, engages in produc-
tion activities that generate QPAI and taxable income
(without taking into account the deduction under this
section and an NOL deduction) of $100 in 2010. X
has an NOL carryover to 2010 of $500. X’s deduc-
November 21, 200510112005–47 I.R.B.

tion under this section for 2010 is $0 (.09 x (lesser of
QPAI of $100 and taxable income of $0)).
(ii)Carryover to 2011. X’s taxable income for
purposes of determining its NOL carryover to 2011
is $100. Accordingly, X’s NOL carryover to 2011 is
$400 ($500 NOL carryover to 2010 - $100 NOL used
in 2010).
(c)Qualified production activities in-
come—(1)In general. QPAI for any tax-
able year is an amount equal to the excess
(if any) of the taxpayer’s domestic produc-
tion gross receipts (DPGR) over the sum of
the cost of goods sold (CGS) that is alloca-
ble to such receipts, other deductions, ex-
penses, or losses (collectively, deductions)
directly allocable to such receipts, and a
ratable portion of deductions that are not
directly allocable to such receipts or an-
other class of income. See §§1.199–3 and
1.199–4. For purposes of this paragraph
(c), QPAI is determined on an item-by-
item basis (and not, for example, on a di-
vision-by-division, product line-by-prod-
uct line, or transaction-by-transaction ba-
sis) and is the sum of QPAI derived by
the taxpayer from each item (as defined
in paragraph (c)(2) of this section). For
purposes of this determination, QPAI from
each item may be positive or negative.
DPGR and its related CGS and deductions
must be included in the QPAI computa-
tion regardless of whether, when viewed
in isolation, the DPGR exceeds the CGS
and deductions allocated and apportioned
thereto. For example, if a taxpayer has $3
of QPAI from the sale of a shirt and derives
($1) of QPAI from the sale of a hat, the tax-
payer’sQPAIis$2.
(2)Definition of item—(i)In general.
Except as otherwise provided in this para-
graph, the termitemmeans, for purposes of
§§1.199–1 through 1.199–8, the property
offered for sale to customers that meets
all of the requirements under this section
and §1.199–3. If the property offered for
sale does not meet these requirements, a
taxpayer must treat as the item any por-
tion of the property offered for sale that
meets these requirements. However, in no
case shall the portion of the property of-
fered for sale that is treated as the item ex-
clude any other portion that meets these
requirements. Innoeventmayanitem
consist of two or more properties offered
for sale that are not packaged and sold to-
gether as one item. In addition, in the case
of property customarily sold by weight or
by volume, the item is determined using
the custom of the industry (for example,
barrels of oil). In the case of construc-
tion (as defined in §1.199–3(l)(1)) or en-
gineering and architectural services (as de-
fined in §1.199–3(m)(1)), a taxpayer may
use any reasonable method, taking into ac-
count all of the facts and circumstances, to
determine what construction activities and
engineering or architectural services con-
stitute an item.
(ii)Examples. The following exam-
ples illustrate the application of paragraph
(c)(2)(i) of this section:
Example 1. X manufactures leather and rubber
shoe soles in the United States. X imports shoe up-
pers, which are the parts of the shoe above the sole.
X manufactures shoes for sale by sewing or other-
wise attaching the soles to the imported uppers. If
the shoes do not meet the requirements under this sec-
tion and §1.199–3, then under paragraph (c)(2)(i) of
this section, X must treat the sole as the item if the
sole meets the requirements under this section and
§1.199–3.
Example 2. The facts are the same as inExample
1except that X also buys some finished shoes from
unrelated parties and resells them to retail shoe stores.
X sells shoes in individual pairs. X ships the shoes in
boxes, each box containing 50 pairs of shoes, some
of which X manufactured, and some of which X pur-
chased. X cannot treat a box of 50 pairs of shoes as
an item, because the box of shoes is not sold at retail.
Example 3. Y manufactures toy cars in the United
States. Y also purchases cars that were manufac-
tured by unrelated parties. In addition to packaging
some cars individually, Y also packages some cars
in sets of three. Some of the cars in the sets may
have been manufactured by Y and some may have
been purchased. The three-car packages are sold by
toy stores at retail. Y must treat each three-car pack-
age as the item. However, if the three-car package
does not meet the requirements under this section and
§1.199–3, Y must treat a toy car in the three-car pack-
age as the item, provided the toy car meets the re-
quirements under this section and §1.199–3.
Example 4. The facts are the same asExample 3
except that the toy store follows Y’s recommended
pricing arrangement for the individual toy cars for
sale to customers at three for $10. Frequently, this
results in retail customers purchasing three individual
cars in one transaction. Y must treat each toy car as an
item and cannot treat three individual toy cars as one
item, because the individual toy cars are not packaged
together for retail sale.
Example 5. Z produces in bulk form in the
United States the active ingredient for a pharmaceu-
tical product. Z sells the active ingredient in bulk
form to FX, a foreign corporation. This sale qualifies
as DPGR assuming all the other requirements of this
section and §1.199–3 are met. FX uses the active
ingredient to produce the finished dosage form drug.
FX sells the drug in finished dosage to Z, which sells
the drug to customers. Under paragraph (c)(2)(i)
of this section, if the finished dosage does not meet
the requirements under this section and §1.199–3, Z
must treat the active ingredient portion as the item
if the ingredient meets the requirements under this
section and §1.199–3.
(d)Allocation of gross receipts—(1)In
general. A taxpayer must determine the
portion of its gross receipts that is DPGR
and the portion of its gross receipts that
is non-DPGR. Applicable Federal income
tax principles apply to determine whether a
transaction is, in substance, a lease, rental,
license, sale, exchange or other disposi-
tion, or whether it is a service (or some
combination thereof). For example, if a
taxpayer leases, rents, licenses, sells, ex-
changes, or otherwise disposes of quali-
fyingproductionproperty(QPP)(asde-
fined in §1.199–3(i)(1)), the gross receipts
of which constitute DPGR, and engages in
transactions with respect to similar prop-
erty, the gross receipts of which do not con-
stitute DPGR, the taxpayer must allocate
its gross receipts from all the transactions
based on a reasonable method that is sat-
isfactory to the Secretary based on all of
the facts and circumstances and that accu-
rately identifies thegross receipts that con-
stitute DPGR. Factors taken into consider-
ation in determining whether the method
is reasonable include whether the taxpayer
uses the most accurate information avail-
able; the relationship between the gross re-
ceipts and the method chosen; the accu-
racy of the method chosen as compared
with other possible methods; whether the
method is used by the taxpayer for in-
ternal management or other business pur-
poses; whether the method is used for other
Federal or state income tax purposes; the
time, burden, and cost of using various
methods; and whether the taxpayer ap-
plies the method consistently from year to
year. Thus, if a taxpayer can, without un-
due burden or expense, specifically iden-
tify where an item was manufactured, or
if the taxpayer uses a specific identifica-
tion method for other purposes, then the
taxpayer must use that specific identifica-
tion method to determine DPGR. If a tax-
payer does not use a specific identifica-
tion method for other purposes and can-
not, without undue burden or expense, use
a specific identification method, then the
taxpayer is not required to use a specific
identification methodtodetermineDPGR.
(2)De minimis rule.Allofatax-
payer’s gross receipts may be treated as
DPGR if less than 5 percent of the tax-
payer’s total gross receipts are non-DPGR
(after application of exceptions provided
in §1.199–3(h)(4), (k)(4)(iv), (l)(1)(ii),
(m)(4), and (n)(1) that result in gross
2005–47 I.R.B.1012November 21, 2005

receipts being treated as DPGR). If the
amount of the taxpayer’s gross receipts
that do not qualify as DPGR equals or
exceeds 5 percent of the taxpayer’s total
gross receipts, the taxpayer is required
to allocate all gross receipts between
DPGR and non-DPGR in accordance with
paragraph (d)(1) of this section. If a cor-
poration is a member of an EAG or a
consolidated group, the determination of
whether less than 5 percent of the tax-
payer’s total gross receipts are non-DPGR
is made at the corporation level rather
than at the EAG or consolidated group
level, as applicable. In the case of an
S corporation, partnership, estate or trust,
or other pass-thru entity, the determina-
tion of whether less than 5 percent of
the pass-thru entity’s total gross receipts
are non-DPGR is made at the pass-thru
entity level. In the case of an owner of
a pass-thru entity, the determination of
whether less than 5 percent of the owner’s
total gross receipts are non-DPGR is made
at the owner level, taking into account all
gross receipts earned by the owner from
its activities as well as the owner’s share
of any pass-thru entity’s gross receipts.
(3)Examples. The following examples
illustrate the application of this paragraph
(d):
Example 1. X derives its gross receipts from the
sale of gasoline refined by X within the United States
and the sale of refined gasoline that X acquired (ei-
ther by purchase or in a taxable exchange for gasoline
refined by X in the United States) from an unrelated
party. X does not commingle the gasoline. X must
allocate its gross receipts between the gross receipts
attributable to the gasoline refined by X in the United
States (that qualify as DPGR if all the other require-
ments of §1.199–3 are met) and X’s gross receipts
derived from the resale of the acquired gasoline (that
do not qualify as DPGR) if 5 percent or more of X’s
total gross receipts are not from the sale of gasoline
refined by X within the United States.
Example 2. X manufactures the same type of QPP
at facilities within the United States and outside the
United States which are sold separately. X must al-
locate its gross receipts between the receipts from
the QPP manufactured within the United States and
receipts from the QPP not manufactured within the
United States if 5 percent ormoreofX’stotalgross
receipts are not from the sale of QPP manufactured
by X within the United States.
(e)Timing rules for determining
QPAI—(1)Gross receipts and costs rec-
ognized in different taxable years.Ifa
taxpayer recognizes and reports on a Fed-
eral income tax return gross receipts that
the taxpayer identifies as DPGR, then the
taxpayer must treat the CGS and deduc-
tions related to suchreceipts as relating
to DPGR, regardless of whether such
receipts ultimately qualify as DPGR. Sim-
ilarly, if a taxpayer pays or incurs and
reports on a Federal income tax return
CGS or deductions and identifies such
CGS or deductions as relating to DPGR,
then the taxpayer must treat the gross re-
ceipts related to such CGS or deductions
as DPGR, regardless of whether such re-
ceipts ultimately qualify as DPGR. Similar
rules apply if the taxpayer recognizes and
reports on a Federal income tax return
gross receipts that the taxpayer identifies
as non-DPGR, or pays or incurs and re-
ports on a Federal income tax return CGS
or deductions that the taxpayer identifies
as relating to non-DPGR. The determina-
tion of whether gross receipts qualify as
DPGR or non-DPGR, and whether CGS or
deductions relate to DPGR or non-DPGR,
must be made in accordance with the rules
provided in §§1.199–1 through 1.199–8,
as applicable. If the gross receipts are
recognized in an intercompany transac-
tion within the meaning of §1.1502–13,
see also §1.199–7(d). See §1.199–4 for
allocation and apportionment of CGS and
deductions.
(2)Percentage of completion method.
A taxpayer using the percentage of com-
pletion method under section 460 must de-
termine the ratio of DPGR and non-DPGR
using a reasonable method that accurately
identifies the gross receipts that constitute
DPGR. See paragraph (d)(1) of this sec-
tion for the factors taken into considera-
tion in determining whether the taxpayer’s
method is reasonable.
(3)Example. The following example
illustrates the application of paragraph
(e)(1) of this section:
Example. X, a calendar year accrual method tax-
payer, enters into a contract with Y, an unrelated per-
son, in 2005 for the sale of QPP. In 2005, X receives
an advance payment from Y for the QPP. In 2006, X
manufactures the QPP within the United States and
delivers the QPP to Y. X’s method of accounting re-
quires X to include the entire advance payment in
its gross income for Federal income tax purposes in
2005. Assuming X can determine, using any reason-
able method, that all the requirements of this section
and §1.199–3 will be met, the advance payment qual-
ifies as DPGR in 2005. The CGS and deductions re-
lating to the QPP under the contract are taken into
account under §1.199–4 in determining X’s QPAI in
2006, the taxable year the CGS and deductions are
otherwise deductible for Federal income tax purposes
and must be treated as relating to DPGR in that tax-
able year.
§1.199–2 Wage limitation.
(a)Rules of application—(1)In gen-
eral. The amount of the deduction al-
lowable under §1.199–1(a) (section 199
deduction) to a taxpayer for any taxable
year shall not exceed 50 percent of the
W–2 wages of the taxpayer. For this pur-
pose, except as provided in paragraph (c)
of this section, the Forms W–2, “Wage and
Tax Statement,” used in determining the
amount of W–2 wages are those issued for
the calendar year ending during the tax-
payer’s taxable year for wages paid to em-
ployees (or former employees) of the tax-
payer for employment by the taxpayer. For
purposes of this section, employees of the
taxpayer are limited to employees of the
taxpayer as defined in section 3121(d)(1)
and (2) (that is, officers of a corporate tax-
payer and employees of the taxpayer un-
der the common law rules). For purposes
of section 199(b)(2) and this section, the
termtaxpayermeans employer.
(2)Wages paid by entity other than
common law employer. In determining
W–2 wages, a taxpayer may take into ac-
count any wages paid by another entity and
reported by the other entity on Forms W–2
with the other entity as the employer listed
in Box c of the Forms W–2, provided that
the wages were paid to employees of the
taxpayer for employment by the taxpayer.
If the taxpayer is treated as an employer
described in section 3401(d)(1) because
of control of the payment of wages (that
is, the taxpayer is not the common law
employer of the payee of the wages), the
payment of wages may not be included in
determining W–2 wages of the taxpayer.
If the taxpayer is paying wages as an agent
of another entity to individuals who are
not employees of the taxpayer, the wages
may not be included in determining the
W–2 wages of the taxpayer.
(b)No application in determining
whether amounts are wages for employ-
ment tax purposes. The discussion of
wages in this section is for purposes of
section 199 only and has no application in
determining whether amounts are wages
under section 3121(a) for purposes of
the Federal Insurance Contributions Act
(FICA), under section 3306(b) for pur-
poses of the Federal Unemployment Tax
Act (FUTA), under section 3401(a) for
purposes of the Collection of Income Tax
at Source on Wages (Federal income tax
November 21, 200510132005–47 I.R.B.

withholding), or any other wage related
determination.
(c)Application in case of taxpayer with
short taxable year.In the case of a tax-
payer with a short taxable year, subject
to the rules of paragraph (a) of this sec-
tion, the W–2 wages of the taxpayer for
the short taxable year shall include those
wages paid during the short taxable year
to employees of the taxpayer as deter-
mined under the tracking wages method
described in paragraph (f)(2)(iii) of this
section. In applying the tracking wages
method in the case of ashort taxable year,
the taxpayer must apply the method as
follows—
(1) In paragraph (f)(2)(iii)(A) of this
section, the total amount of wages subject
to Federal income tax withholding and re-
ported on Form W–2 must include only
those wages subject to Federal income tax
withholding that are actually paid to em-
ployees during the short taxable year and
reported on Form W–2 for the calendar
year ending within that short taxable year;
(2) In paragraph (f)(2)(iii)(B) of this
section, only the supplemental unemploy-
ment benefits paid during the short taxable
year that were includedin the total in para-
graph (f)(2)(iii)(A) of this section as mod-
ified by paragraph (c)(1) of this section are
required to be deducted; and
(3) In paragraph (f)(2)(iii)(C) of this
section, only the portion of the amounts re-
ported in Box 12, Codes D, E, F, G, and S,
on Forms W–2, that are actually deferred
or contributed during the short taxable year
may be included in W–2 wages.
(d)Acquisition or disposition of a trade
or business (or major portion).Ifatax-
payer (a successor) acquires a trade or
business, the major portion of a trade or
business, or the major portion of a separate
unit of a trade or business from another
taxpayer (a predecessor), then, for pur-
poses of computing the respective section
199 deduction of the successor and of the
predecessor, the W–2 wages paid for that
calendar year shall be allocated between
the successor and the predecessor based
on whether the wages are for employment
by the successor or for employment by the
predecessor. Thus, in this situation, the
W–2 wages are allocated based on whether
the wages are for employment for a period
during which the employee was employed
by the predecessor or for employment for
a period during which the employee was
employed by the successor, regardless of
which permissible method for Form W–2
reporting is used.
(e)Non-duplication rule. Amounts that
are treated as W–2 wages for a taxable
year under any method may not be treated
as W–2 wages of any other taxable year.
Also, an amount may not be treated as W–2
wages by more than one taxpayer.
(f)Definition of W–2 wages—(1)In
general. Section 199(b)(2) definesW–2
wagesfor purposes of section 199(b)(1)
as the sum of the amounts required to
be included on statements under section
6051(a)(3) and (8) with respect to employ-
ment of employees of the taxpayer for the
calendar year. Thus, the termW–2 wages
includes the total amount of wages as de-
fined in section 3401(a); the total amount
of elective deferrals (within the meaning
of section 402(g)(3)); the compensation
deferred under section 457; and for taxable
years beginning after December 31, 2005,
the amount of designated Roth contribu-
tions (as defined in section 402A). Under
the 2004 and 2005 Form W–2, the elec-
tive deferrals under section 402(g)(3) and
the amounts deferred under section 457
directly correlate to coded items reported
inBox12onFormW–2.Box12,CodeD,
is for elective deferrals to a section 401(k)
cash or deferred arrangement; Box 12,
Code E, is for elective deferrals under a
section 403(b) salary reduction agreement;
Box 12, Code F, is for elective deferrals
under a section 408(k)(6) salary reduction
Simplified Employee Pension (SEP); Box
12, Code G, is for elective deferrals under
a section 457(b) plan; and Box 12, Code
S, is for employee salary reduction con-
tributions under a section 408(p) SIMPLE
(simple retirement account).
(2)Methods for calculating W–2 wages.
For any taxable year, taxpayers may use
one of three methods in calculating W–2
wages. These three methods are subject to
the non-duplication rule provided in para-
graph (e) of this section, and the tracking
wages method is subject to the rule pro-
vided in paragraph (c) of this section, if ap-
plicable.
(i)Unmodified box method. Under the
Unmodified box method, W–2 wages are
calculated by taking, without modifica-
tion, the lesser of—
(A) The total entries in Box 1 of all
Forms W–2 filed with the Social Security
Administration (SSA) by the taxpayer with
respect to employees of the taxpayer for
employment by the taxpayer; or
(B) The total entries in Box 5 of all
Forms W–2 filed with the SSA by the tax-
payer with respect to employees of the tax-
payer for employment by the taxpayer.
(ii)Modified Box 1 method. Under
the Modified Box 1 method, the taxpayer
makes modifications to the total entries in
Box 1 of Forms W–2 filed with respect to
employees of the taxpayer. W–2 wages
under this method are calculated as fol-
lows—
(A) Total the amounts in Box 1 of all
Forms W–2 filed with the SSA by the tax-
payer with respect to employees of the tax-
payer for employment by the taxpayer;
(B) Subtract from the total in paragraph
(f)(2)(ii)(A) of this section amounts in-
cluded in Box 1 of Forms W–2 that are not
wages for Federal income tax withholding
purposes and amounts included in Box 1 of
Forms W–2 that are treated as wages under
section 3402(o) (for example, supplemen-
tal unemployment benefits); and
(C) Add to the amount obtained af-
ter paragraph (f)(2)(ii)(B) of this section
amounts that are reported in Box 12 of
Forms W–2 with respect to employees of
the taxpayer for employment by the tax-
payer and that are properly coded D, E, F,
G, or S.
(iii)Tracking wages method.Underthe
Tracking wages method, the taxpayer ac-
tually tracks total wages subject to Federal
income tax withholding and makes appro-
priate modifications. W–2 wages under
this method are calculated as follows—
(A) Total the amounts of wages subject
to Federal income tax withholding that are
paid to employees of the taxpayer for em-
ployment by the taxpayer and that are re-
ported on Forms W–2 filed with the SSA
by the taxpayer for the calendar year;
(B) Subtract from the total in paragraph
(f)(2)(iii)(A) of this section the supple-
mental unemployment compensation ben-
efits (as defined in section 3402(o)(2)(A))
that were included in the total in paragraph
(f)(2)(iii)(A) of this section; and
(C) Add to the amount obtained af-
ter paragraph (f)(2)(iii)(B) of this section
amounts that are reported in Box 12 of
Forms W–2 with respect to employees of
the taxpayer for employment by the tax-
payer and that are properly coded D, E, F,
G, or S.
2005–47 I.R.B.1014November 21, 2005

§1.199–3 Domestic production gross
receipts.
(a)In general. Domestic production
gross receipts (DPGR) are the gross re-
ceipts (as defined in paragraph (c) of this
section) of the taxpayer that are derived
from (as defined in paragraph (h) of this
section)—
(1) Any lease, rental, license, sale, ex-
change, or other disposition of—
(i) Qualifying production property
(QPP) (as defined in paragraph (i)(1) of
this section) that is manufactured, pro-
duced, grown, or extracted (MPGE) (as
defined in paragraph (d) of this section)
by the taxpayer (as defined in paragraph
(e) of this section) in whole or in signif-
icant part (as defined in paragraph (f) of
this section) within the United States (as
defined in paragraph (g) of this section);
(ii) Any qualified film (as defined in
paragraph (j) of this section) produced
by the taxpayer (in accordance with para-
graph (j) of this section); or
(iii) Electricity, natural gas, or potable
water (as defined in paragraph (k) of this
section) (collectively, utilities) produced
by the taxpayer in the United States (in ac-
cordance with paragraph (k) of this sec-
tion);
(2) Construction (as defined in para-
graph (l) of this section) performed in the
United States (in accordance with para-
graph (l) of this section); or
(3) Engineering or architectural ser-
vices (as defined in paragraph (m) of this
section) performed in the United States for
construction projects in the United States
(in accordance with paragraph (m) of this
section).
(b)Related persons—(1)In general.
DPGR does not include any gross receipts
of the taxpayer derived from property
leased, licensed, or rented by the taxpayer
for use by any related person. A person is
treated as related to another person if both
persons are treated as a single employer
under either section 52(a) or (b) (with-
out regard to section 1563(b)), or section
414(m) or (o).
(2)Exceptions. Paragraph (b)(1) of this
section does not apply to any QPP or qual-
ified films leased or rented by the taxpayer
to a related person if the QPP or qualified
films are held for sublease or rent, or are
subleased or rented, by the related person
to an unrelated person for the ultimate use
of the unrelated person. Similarly, para-
graph (b)(1) of this section does not apply
to the license of QPP or qualified films to
a related person for reproduction and sale,
exchange, lease, rental or sublicense to an
unrelated person for the ultimate use of the
unrelated person.
(c)Definition of gross receipts.The
termgross receiptsmeans the taxpayer’s
receipts for the taxable year that are rec-
ognized under the taxpayer’s methods of
accounting used for Federal income tax
purposes for the taxable year. If the gross
receipts are recognized in an intercom-
pany transaction within the meaning of
§1.1502–13, see also §1.199–7(d). For
this purpose, gross receipts include to-
tal sales (net of returns and allowances)
and all amounts received for services.
In addition, gross receipts include any
income from investments and from inci-
dental or outside sources. For example,
gross receipts include interest (including
original issue discount and tax-exempt
interest within the meaning of section
103), dividends, rents, royalties, and an-
nuities, regardless of whether the amounts
are derived in the ordinary course of the
taxpayer’s trade of business. Gross re-
ceipts are not reduced by cost of goods
sold (CGS) or by the cost of property sold
if such property is described in section
1221(a)(1), (2), (3), (4), or (5). Gross
receipts do not include the amounts re-
ceived in repayment of a loan or similar
instrument (for example, a repayment of
the principal amount of a loan held by
a commercial lender) and, except to the
extent of gain recognized, do not include
gross receipts derived from a non-recog-
nition transaction, such as a section 1031
exchange. Finally, gross receipts do not
include amounts received by the taxpayer
with respect to sales tax or other similar
state and local taxes if, under the appli-
cable state or local law, the tax is legally
imposed on the purchaser of the good or
service and the taxpayer merely collects
and remits the tax to the taxing authority.
If, in contrast, the tax is imposed on the
taxpayer under the applicable law, then
gross receipts include the amounts re-
ceived that are allocable to the payment of
such tax.
(d)Definition of manufactured, pro-
duced, grown, or extracted—(1)In gen-
eral. Except as provided in paragraphs
(d)(2) and (3) of this section, the term
MPGEincludes manufacturing, produc-
ing, growing, extracting, installing, de-
veloping, improving, and creating QPP;
making QPP out of scrap, salvage, or junk
material as well as from new or raw mate-
rial by processing, manipulating, refining,
or changing the form of an article, or by
combining or assembling two or more
articles; cultivating soil, raising livestock,
fishing, and mining minerals. The term
MPGEalso includes storage, handling,
or other processing activities (other than
transportation activities) within the United
States related to the sale, exchange, or
other disposition of agricultural products,
provided the products are consumed in
connection with, or incorporated into, the
MPGE of QPP whether or not by the tax-
payer. The taxpayer must have the benefits
and burdens of ownership of the QPP un-
der Federal income tax principles during
the period the MPGE activity occurs, pur-
suant to paragraph (e)(1) of this section, in
order for gross receipts derived from the
MPGE of QPP to qualify as DPGR.
(2)Packaging, repackaging, labeling,
or minor assembly. If a taxpayer pack-
ages, repackages, labels, or performs mi-
nor assembly of QPP and the taxpayer en-
gages in no other MPGE activity with re-
spect to that QPP, the taxpayer’s packag-
ing, repackaging, labeling, or minor as-
sembly do not qualify as MPGE.
(3)Installing. If a taxpayer installs
an item of QPP and engages in no other
MPGE with respect to the QPP, the tax-
payer’s installing activity does not qualify
as MPGE. However, if the taxpayer installs
an item of QPP MPGE by the taxpayer,
and the taxpayer has the benefits and bur-
dens of ownership of the item of QPP un-
der Federal income tax principles during
the period the installing activity occurs, the
portion of the installing activity that relates
to the item of QPP is MPGE.
(4)Consistency with section 263A.
A taxpayer that has MPGE QPP for the
taxable year should treat itself as a pro-
ducer under section 263A with respect
to the QPP for the taxable year unless
the taxpayer is not subject to section
263A. A taxpayer that currently is not
properly accounting for its production ac-
tivities under section 263A, and wishes
to change its method of accounting to
comply with the producer requirements
of section 263A, must follow the appli-
cable administrative procedures issued
November 21, 200510152005–47 I.R.B.

under §1.446–1(e)(3)(ii) for obtaining
the Commissioner’s consent to a change
in accounting method (for further guid-
ance, for example, see Rev. Proc. 97–27,
1997–1 C.B. 680, or Rev. Proc. 2002–9,
2002–1 C.B. 327, whichever applies (see
§601.601(d)(2) of this chapter)).
(5)Examples. The following examples
illustrate the application of this paragraph
(d):
Example 1. A, B, and C are unrelated taxpayers
and are not cooperatives to which Part I of subchapter
T of the Internal Revenue Code applies. A owns grain
storage bins in the United States in which it stores
for a fee B’s agricultural products that were grown in
the United States. B sells its agricultural products to
C. C processes B’s agricultural products into refined
agricultural products in the United States. The gross
receipts from A’s, B’s, and C’s activities are DPGR
from the MPGE of QPP.
Example 2. The facts are the same as inExample
1except that B grows the agricultural products out-
side the United States and C processes B’s agricul-
tural products into refined agricultural products out-
side the United States. Pursuant to paragraph (d)(1)
of this section, the gross receipts derived by A are
DPGR from the MPGE of QPP within the United
States. B’s and C’s respective activities occur out-
side the United States and, therefore, their respective
gross receipts are non-DPGR.
Example 3. Y is hired to reconstruct and refur-
bish unrelated customers’ tangible personal property.
As part of the reconstruction and refurbishment, Y in-
stalls purchased replacement parts in the customers’
property. Y’s installation of purchased replacement
parts does not qualify as MPGE pursuant to paragraph
(d)(3) of this section because Y did not MPGE the re-
placement parts.
Example 4. The facts are the same as inExample
3except that Y manufacturesthe replacement parts it
uses for the reconstruction and refurbishment of cus-
tomers’ tangible personal property. Y has the ben-
efits and burdens of ownership of the replacement
parts during the reconstruction and refurbishment ac-
tivity and while installing the parts. Y’s gross re-
ceipts from the MPGE of thereplacement parts and
Y’s gross receipts from the installation of the replace-
ment parts, which is an MPGE activity pursuant to
paragraph (d)(3) of this section, are DPGR.
Example 5. Z MPGE QPP within the United
States. The following activities are performed by
Z as part of the MPGE of the QPP while Z has the
benefits and burdens of ownership under Federal
income tax principles: materials analysis and selec-
tion, subcontractor inspections and qualifications,
testing of component parts, assisting customers in
their review and approval of the QPP, routine produc-
tion inspections, product documentation, diagnosis
and correction of system failure, and packaging for
shipment to customers. Because Z MPGE the QPP,
these activities performed by Z are part of the MPGE
of the QPP.
Example 6. X purchases automobiles from
unrelated parties and customizes them by adding
ground effects, spoilers, custom wheels, specialized
paint and decals, sunroofs, roof racks, and similar
accessories. X does not manufacture any of the
accessories. X’s activity is minor assembly under
paragraph (d)(2) of this section which is not an
MPGE activity.
Example 7. The facts are the same as inEx-
ample 6except that X manufactures some of the
accessories it adds to the automobiles. Pursuant to
§1.199–1(c)(2), if an automobile with accessories
does not meet the requirements for being an item, X
must treat each accessory that it manufactures as an
item for purposes of determining whether X MPGE
the item in whole or in significant part within the
United States under paragraph (f)(1) of this section
and whether the installation of the item is MPGE
under paragraph (d)(3) of this section.
Example 8. Y manufactures furniture in the
United States that it sells to unrelated persons. Y
also engraves customers’ names on pens and pen-
cils purchased from unrelated persons and sells the
pens and pencils to such customers. Although Y’s
sales of furniture qualify as DPGR if all the other
requirements of this section are met, Y’s sales of the
engraved pens and pencils do not qualify as DPGR
because Y does not MPGE the pens and pencils.
(e)Definition of by the taxpayer—(1)
In general. With the exception of the rules
applicable to an expanded affiliated group
(EAG) under §1.199–7, certain oil and
gas partnerships under paragraph (h)(7)
of this section, EAG partnerships under
paragraph (h)(8) of this section, and gov-
ernment contracts in paragraph (e)(2) of
this section, only one taxpayer may claim
the deduction under §1.199–1(a) with
respect to any qualifying activity under
paragraph (d)(1) of this section performed
in connection with the same QPP, or the
production of qualified films or utilities. If
one taxpayer performs a qualifying activ-
ity under paragraph (d)(1), (j)(1), or (k)(1)
of this section pursuant to a contract with
another party, then only the taxpayer that
has the benefits and burdens of ownership
of the property under Federal income tax
principles during the period the qualifying
activity occurs is treated as engaging in
the qualifying activity.
(2)Special rule for certain government
contracts. QPP, qualified films, or utili-
ties will be treated as MPGE or otherwise
produced by the taxpayer notwithstanding
the requirements of paragraph (e)(1) of this
section if—
(i) The QPP, qualified films, or utilities
are MPGE or otherwise produced by the
taxpayer pursuant to a contract with the
Federal government; and
(ii) The Federal Acquisition Regulation
(Title 48 CFR) requires that title or risk
of loss with respect to the QPP, qualified
films, or utilities be transferred to the Fed-
eral government before the MPGE of the
QPP, or the production of the qualified
films or utilities, is complete.
(3)Examples. The following examples
illustrate the application of this paragraph
(e):
Example 1. X designs machines that it uses in its
trade or business. X contracts with Y, an unrelated
taxpayer, for the manufacture of the machines. The
contract between X and Y is a fixed-price contract.
The contract specifies that the machines will be man-
ufactured in the United States using X’s design. X
owns the intellectual property attributable to the de-
sign and provides it to Y with a restriction that Y may
only use it during the manufacturing process and has
no right to exploit the intellectual property. The con-
tract specifies that Y controls the details of the man-
ufacturing process while the machines are being pro-
duced; Y bears the risk of loss or damage during man-
ufacturing of the machines; and Y has the economic
loss or gain upon the sale of the machines based on
the difference between Y’s costs and the fixed price.
Y has legal title during the manufacturing process and
legal title to the machines is not transferred to X until
final manufacturing of the machines has been com-
pleted. Based on all of the facts and circumstances,
pursuant to paragraph (e)(1) of this section Y has the
benefits and burdens of ownership of the machines
under Federal income tax principles during the period
the manufacturing occurs and, as a result, Y is treated
as the manufacturer of the machines.
Example 2. X designs and engineers machines
that it sells to customers. X contracts with Y, an un-
related taxpayer, for the manufacture of the machines.
The contract between X and Y is a cost-reimbursable
type contract. X has the benefits and burdens of own-
ership of the machines under Federal income tax prin-
ciples during the period themanufacturing occurs ex-
cept that legal title to the machines is not transferred
to X until final manufacturing of the machines is com-
pleted. Based on all of the facts and circumstances, X
is treated as the manufacturer of the machines under
paragraph (e)(1) of this section.
(f)Definition of in whole or in signif-
icant part—(1)In general.QPPmustbe
MPGE in whole or in significant part by
the taxpayer and in whole or in signifi-
cant part within the United States to qual-
ify under section 199(c)(4)(A)(i)(I). If a
taxpayer enters into a contract pursuant to
paragraph (e)(1) of this section with an
unrelated party for the unrelated party to
MPGE QPP for the taxpayer and the tax-
payer has the benefits and burdens of own-
ership of the QPP under applicable Federal
income tax principles during the period the
MPGE activity occurs, then the taxpayer
is considered to MPGE the QPP under this
section. The unrelated party must perform
the MPGE activity on behalf of the tax-
payer in whole or in significant part within
the United States in order for the taxpayer
to satisfy the requirements of this para-
graph (f)(1).
2005–47 I.R.B.1016November 21, 2005

(2)Substantial in nature.QPPwill
be treated as MPGE in significant part by
the taxpayer within the United States for
purposes of paragraph (f)(1) of this sec-
tion if the MPGE of the QPP by the tax-
payer within the United States is substan-
tial in nature taking into account all of the
facts and circumstances, including the rel-
ative value added by, and relative cost of,
the taxpayer’s MPGE activity within the
United States, the nature of the property,
and the nature of the MPGE activity that
the taxpayer performs within the United
States. Research and experimental activ-
ities under section 174 and the creation of
intangibles do not qualify as substantial in
nature for any QPP other than computer
software (as defined in paragraph (i)(3) of
this section) and sound recordings (as de-
fined in paragraph (i)(4) of this section).
In the case of an EAG member, an EAG
partnership (as defined in paragraph (h)(8)
of this section), or members of an EAG
in which the partners of the EAG partner-
ship are members, in determining whether
the substantial in nature requirement is met
with respect to an item of QPP, all of the
previous activities of the members of the
EAG, the EAG partnership, and all mem-
bers of the EAG in which the partners of
the EAG partnership are members, as ap-
plicable, are taken into account.
(3)Safe harbor. A taxpayer will be
treated as having MPGE QPP in whole
or in significant part within the United
States for purposes of paragraph (f)(1)
of this section if, in connection with the
QPP, conversion costs (direct labor and
related factory burden) of such taxpayer to
MPGE the QPP within the United States
account for 20 percent or more of the tax-
payer’s CGS of the QPP. For purposes of
the safe harbor under this paragraph (f)(3),
research and experimental expenditures
under section 174 and the costs of creating
intangibles do not qualify as conversion
costs for any QPP other than computer
software and sound recordings. In the
case of tangible personal property (as de-
fined in paragraph (i)(2) of this section),
research and experimental expenditures
under section 174 and any other costs in-
curred in the creation of intangibles may
be excluded from CGS for purposes of
determining whether the taxpayer meets
the safe harbor under this paragraph (f)(3).
For purposes of this safe harbor, research
and experimental expenditures under sec-
tion 174 and any other costs of creating
intangibles for computer software and
sound recordings must be allocated to the
computer softwareand sound recordings
to which the expenditures and costs relate
under §1.199–4(b). In the case of an EAG
member, an EAG partnership, or members
of an EAG in which the partners of the
EAG partnership are members, in deter-
mining whether the requirements of the
safe harbor under this paragraph (f)(3) are
met with respect to an item of QPP, all of
the previous conversion costs of the mem-
bers of the EAG, the EAG partnership,
and all members of the EAG in which the
partners of the EAG partnership are mem-
bers, as applicable, to MPGE the QPP are
taken into account. If a taxpayer enters
into a contract with an unrelated party for
the unrelated party to MPGE QPP for the
taxpayer, and the taxpayer is considered
pursuant to paragraph (e)(1) of this section
to MPGE the QPP, then for purposes of
this safe harbor the taxpayer’s conversion
costs shall include both the taxpayer’s
conversion costs as well as the conversion
costs of the unrelated party to MPGE the
QPP under the contract.
(4)Examples. The following examples
illustrate the application of this paragraph
(f):
Example 1. X purchases from Y unrefined oil
extracted outside the United States and X refines the
oil in the United States. The refining of the oil by X
is an MPGE activity that is substantial in nature.
Example 2. X purchases gemstones and precious
metal from outside the United States and then uses
these materials to produce jewelry within the United
States by cutting and polishing the gemstones, melt-
ing and shaping the metal, and combining the fin-
ished materials. X’s activity is substantial in nature
under paragraph (f)(2) of this section. Therefore, X
has MPGE the jewelry in significant part within the
United States.
Example 3. (i) X operates an automobile assem-
bly plant in the United States. In connection with
such activity, X purchases assembled engines, trans-
missions, and certain other components from Y, an
unrelated taxpayer, and Xassembles all of the compo-
nent parts into an automobile. X also conducts stamp-
ing, machining, and subassembly operations, and X
uses tools, jigs, welding equipment, and other ma-
chinery and equipment in the assembly of automo-
biles. On a per-unit basis, X ’s selling price and costs
of such automobiles are as follows:
Selling price: $ 2,500
Cost of goods sold:
Material — Acquired from Y: $ 1,475
Conversion costs (direct labor and factory burden): $325
Total cost of goods sold: $1,800
Gross profit: $700
Administrative and selling expenses: $300
Taxable income: $400
(ii) Although X’s conversion costs are less than
20 percent of total CGS ($325/$1,800, or 18 percent),
the operations conducted by X in connection with the
property purchased and soldare substantial in nature
under paragraph (f)(2) of this section because of the
nature of X’s activity and the relative value of X’s
activity. Therefore, X’s automobiles will be treated
as MPGE in significant part by X within the United
States for purposes of paragraph (f)(1) of this section.
Example 4. X produces a qualified film (as de-
fined in paragraph (j)(1) of this section) and licenses
the film to Y, an unrelated taxpayer, for duplication
of the film onto DVDs. Y purchases the DVDs from
an unrelated person. Unless Y satisfies the safe har-
bor under paragraph (f)(3) of this section, Y’s income
for duplicating X’s qualified film onto the DVDs is
non-DPGR because the duplication is not substantial
in nature relative to the DVD with the film.
Example 5. X imports into the United States QPP
that is partially manufactured. X completes the man-
ufacture of the QPP within the United States and X’s
completion of the manufacturing of the QPP within
the United States satisfies the in whole or in signif-
icant part requirement under paragraph (f)(1) of this
section. Therefore, X’s gross receipts from the lease,
rental, license, sale, exchange, or other disposition of
the QPP qualify as DPGR if all other applicable re-
quirements under this section are met.
Example 6. X manufactures QPP in significant
part within the United States and exports the QPP for
further manufacture outside the United States. As-
suming X meets all the requirements under this sec-
tion for the QPP after the further manufacturing, X’s
gross receipts derived from the lease, rental, license,
sale, exchange, or other disposition of the QPP will
be considered DPGR, regardless of whether the QPP
November 21, 200510172005–47 I.R.B.

is imported back into the United States prior to the
lease, rental, license, sale, exchange, or other dispo-
sition of the QPP.
Example 7. X is a retailer that sells cigars and
pipe tobacco that X purchases from an unrelated per-
son. While being displayed and offered for sale by
X, the cigars and pipe tobacco age on X’s shelves
in a room with controlled temperature and humidity.
Although X’s cigars and pipe tobacco may become
more valuable as they age,the gross receipts derived
by X from the sale of the cigars and pipe tobacco are
non-DPGR because the aging of the cigars and pipe
tobacco while being displayed and offered for sale by
X does not qualify as an MPGE activity that occurs in
whole or in significant part within the United States.
(g)Definition of United States.For
purposes of this section, the termUnited
Statesincludes the 50 states, the District
of Columbia, the territorial waters of the
United States, and the seabed and subsoil
of those submarine areas that are adjacent
to the territorial waters of the United States
and over which the United States has ex-
clusive rights, in accordance with interna-
tional law, with respect to the exploration
and exploitation of natural resources. The
termUnited Statesdoes not include pos-
sessions and territories of the United States
or the airspace or space over the United
States and these areas.
(h)Definition of derived from the lease,
rental, license, sale, exchange, or other
disposition—(1)In general.Theterm
derived from the lease, rental, license,
sale, exchange, or other dispositionis de-
fined as, and limited to, the gross receipts
directly derived from the lease, rental,
license, sale, exchange, or other dispo-
sition, even if the taxpayer has already
recognized gross receipts from a previous
lease, rental, license, sale, exchange, or
other disposition of the same property.
Applicable Federal income tax principles
apply to determine whether a transaction
is, in substance, a lease, rental, license,
sale, exchange or other disposition, or
whether it is a service (or some combina-
tion thereof). For example, gross receipts
derived from the sale of QPP includes
gross receipts derived from the sale of
QPP MPGE in whole or in significant part
within the United States by a taxpayer
for sale, as well as gross receipts derived
fromthesaleofQPPMPGEinwholeor
in significant part within the United States
by a taxpayer and used in the taxpayer’s
trade or business before being sold. The
entire amount of lease income including
any interest that is not separately stated
is considered derived from the lease of
QPP or a qualified film. In addition,
the proceeds from business interruption
insurance, governmental subsidies, and
governmental payments not to produce are
treated as gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition to the extent that they are
substitutes for gross receipts that would
qualify as DPGR. The value of property
received by a taxpayer in a taxable ex-
change of QPP MPGE in whole or in
significant part within the United States,
qualified films, or utilities for an unrelated
person’s property is DPGR for the tax-
payer (assuming all the other requirements
of this section are met). However, un-
less the taxpayer further MPGE the QPP
or further produces the qualified films
or utilities received in the exchange, any
gross receipts from the subsequent sale by
the taxpayer of the property received in
the exchange are non-DPGR because the
taxpayer did not MPGE or otherwise pro-
duce such property, even if the property
was QPP, qualified films, or utilities in the
hands of the other person.
(2)Examples. The following exam-
ples illustrate the application of paragraph
(h)(1) of this section:
Example 1. X MPGE QPP within the United
States and sells the QPP to Y, an unrelated person.
Y leases the QPP for 3 years to Z, a taxpayer unre-
lated to both X and Y, and shortly thereafter, X repur-
chases the QPP from Y subject to the lease. At the
end of the lease term, Z purchases the QPP from X.
X’s proceeds derived from the sale of the QPP to Y,
from the lease to Z, and from the sale of the QPP to Z
all qualify as DPGR (assuming all the other require-
ments of this section are met).
Example 2. X MPGE QPP within the United
States and sells the QPP to Y, an unrelated taxpayer,
for $25,000. X finances Y’s purchase of the QPP and
receives total payments of$35,000, of which $10,000
relates to interest and finance charges. The $25,000
qualifies as DPGR but the $10,000 in interest and fi-
nance charges do not qualify as DPGR because the
$10,000 is not derived from the MPGE of QPP within
the United States but rather from X’s lending activity.
Example 3. Cable company X charges sub-
scribers $15 a month for its basic cable television. Y,
an unrelated taxpayer, produces in the United States
all of the programs on its cable channel which it
licenses to X for $.10 per subscriber per month. The
programs are qualified films within the meaning of
paragraph (j)(1) of this section. The gross receipts
derived by Y are derived from a license of a qualified
film produced by Y and are DPGR (assuming all the
other requirements of this section are met).
(3)Hedging transactions—(i)In gen-
eral. For purposes of this section, provided
that the risk being hedged relates to QPP
described in section 1221(a)(1) or property
described in section 1221(a)(8) consumed
in the activity giving rise to DPGR, and
provided that the transaction is a hedging
transaction within the meaning of section
1221(b)(2) and §1.1221–2(b), then—
(A) In the case of a hedge of pur-
chases of property described in section
1221(a)(1), gain or loss on the hedging
transaction must be taken into account in
determining CGS;
(B) In the case of a hedge of sales of
property described in section 1221(a)(1),
gain or loss on the hedging transaction
must be taken into account in determining
DPGR; and
(C) In the case of a hedge of pur-
chases of property described in section
1221(a)(8), gain or loss on the hedging
transaction must be taken into account in
determining DPGR.
(ii)Currency fluctuations.Forpur-
poses of this section, in the case of a trans-
action that manages the risk of currency
fluctuations, the determination of whether
the transaction is a hedging transaction
within the meaning of §1.1221–2(b) is
made without regard to whether the trans-
action is a section 988 transaction. See
§1.1221–2(a)(4). The preceding sentence
applies only to the extent that §1.988–5(b)
does not apply.
(iii)Other rules. See §1.1221–2(e) for
rules applicable to hedging by members
of a consolidated group and §1.446–4 for
rules regarding the timing of income, de-
ductions, gain, or loss with respect to hedg-
ing transactions.
(4)Allocation of gross receipts — em-
bedded services and non-qualified prop-
erty—(i)In general. Except as otherwise
provided in paragraph (h)(4)(ii), paragraph
(l) (relating to construction), and para-
graph (m) (relating to architectural and
engineering services) of this section, gross
receipts derived from the performance
of services do not qualify as DPGR. In
the case of an embedded service, that is,
a service the price of which is not sepa-
rately stated from the amount charged for
the lease, rental, license, sale, exchange,
or other disposition of QPP, qualified
films, or utilities, DPGR includes only
the receipts from the lease, rental, license,
sale, exchange, or other disposition of
the item (if all the other requirements of
this section are met) and not any receipts
attributable to the embedded service by
the taxpayer. In addition, DPGR does not
include the gross receipts derived from
2005–47 I.R.B.1018November 21, 2005

the lease, rental, license, sale, exchange,
or other disposition of property that does
not meet all of the requirements under
this section (non-qualified property). For
example, gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of a replacement part that
is non-qualified property does not qualify
as DPGR.
(ii)Exceptions. There are five excep-
tions to the rules under paragraph (h)(4)(i)
of this section regarding embedded ser-
vices and non-qualified property. A tax-
payer may include in DPGR, if all the other
requirements of this section are met with
respect to the underlying item of property
to which the embedded services or non-
qualified property relate, gross receipts de-
rived from—
(A) A qualified warranty, that is, a war-
ranty that is provided in connection with
the lease, rental, license, sale, exchange, or
other disposition of QPP, qualified films or
utilities if—
(1) In the normal course of the tax-
payer’s business, the price for the warranty
is not separately stated from the amount
charged for the lease, rental, license, sale,
exchange, or other disposition of the prop-
erty; and
(2) The warranty is neither separately
offered by the taxpayer nor separately bar-
gained for with the customer (that is, a cus-
tomer cannot purchase the property with-
out the warranty);
(B) A qualified delivery, that is, a de-
livery or distribution service that is pro-
vided in connection with the lease, rental,
license, sale, exchange, or other disposi-
tion of QPP if—
(1) In the normal course of the tax-
payer’s business, the price for the deliv-
ery or distribution service is not separately
stated from the amount charged for the
lease, rental, license, sale, exchange, or
other disposition of the property; and
(2) The delivery or distribution service
is neither separately offered by the tax-
payer nor separately bargained for with the
customer (that is, a customer cannot pur-
chase the property without delivery or dis-
tribution service);
(C) A qualified operating manual, that
is, a manual of instructions (including
electronic instructions) that is provided in
connection with the lease, rental, license,
sale, exchange, or other disposition of
QPP, qualified films or utilities if—
(1) In the normal course of the tax-
payer’s business, the price for the manual
is not separately stated from the amount
charged for the lease, rental, license, sale,
exchange, or other disposition of the prop-
erty;
(2) The manual is neither separately of-
fered by the taxpayer nor separately bar-
gained for with the customer (that is, a cus-
tomer cannot purchase the property with-
out the manual); and
(3) The manual is not provided in con-
nection with a training course for the cus-
tomer;
(D) A qualified installation, that is, an
installation service (including minor as-
sembly) for QPP that is provided in con-
nection with the lease, rental, license, sale,
exchange, or other disposition of the QPP
if—
(1) In the normal course of the tax-
payer’s business, the price for the instal-
lation service is not separately stated from
the amount charged for the lease, rental, li-
cense, sale, exchange, or other disposition
of the property; and
(2) The installation is neither separately
offered by the taxpayer nor separately bar-
gained for with the customer (that is, a cus-
tomer cannot purchase the property with-
out the installation service); and
(E) Ade minimisamount of gross re-
ceipts from embedded services and non-
qualified property for each item of QPP,
qualified films, or utilities. For purposes
of the preceding sentence, ade minimis
amount of gross receipts from embedded
services and non-qualified property is less
than 5 percent of the total gross receipts de-
rived from the lease, rental, license, sale,
exchange, or other disposition of each item
of QPP, qualified films, or utilities (includ-
ing the gross receipts for the embedded ser-
vices and property described in paragraphs
(h)(4)(ii)(A), (B), (C), (D) and (k)(4)(iv)
of this section). The allocation of the
gross receipts attributable to the embedded
services or non-qualified property will be
deemed to be reasonable if the allocation
reflects the fair market value of the em-
bedded services or property. In the case
of gross receipts derived from the lease,
rental, license, sale, exchange, or other dis-
position of QPP, qualified films, and utili-
ties that are received over a period of time
(for example, a multi-year lease or install-
ment sale), thisde minimisexception is ap-
plied by taking into account the total gross
receipts derived from the lease, rental, li-
cense, sale, exchange, or other disposi-
tion of the item of QPP, qualified films,
or utilities. For purposes of applying this
de minimisexception, the gross receipts
described in paragraphs (h)(4)(ii)(A), (B),
(C), (D) and (k)(4)(iv) of this section are
treated as DPGR. Thisde minimisexcep-
tion does not apply if the prices of the ser-
vices or non-qualified property are sepa-
rately stated by the taxpayer, or if the ser-
vices or non-qualified property are sepa-
rately offered or separately bargained for
with the customer (that is, the customer can
purchase the property without the services
or non-qualified property).
(iii)Examples. The following examples
illustrate the application of this paragraph
(h)(4):
Example 1. X MPGE QPP within the United
States. As part of the sale of the QPP to Z, X trains
Z’s employees on how to use and operate the QPP.
No other services or property are provided to Z in
connection with the sale of the QPP to Z. The QPP
and training services are separately stated in the sales
contract. Because the training services are separately
stated, the training services are not treated as embed-
ded services under thede minimisexception in para-
graph (h)(4)(ii)(E) of this section.
Example 2.ThefactsarethesameasinExample
1except that the training services are not separately
stated in the sales contract and the customer cannot
purchase the QPP without the training services. If the
gross receipts for the embedded training services are
less than 5 percent of the gross receipts derived from
the sale of X’s QPP to Z, including the gross receipts
for the training services, then the gross receipts may
be included in DPGR under thede minimisexception
in paragraph (h)(4)(ii)(E) of this section.
Example 3. X MPGE QPP within the United
States. As part of the sale of the QPP to retailers, X
charges a fee for delivering the QPP. The price of the
QPP and the delivery fee are separately stated in the
sales contract. The retailer’s customers cannot pur-
chase the QPP without paying for the delivery fee.
Because the delivery fee is separately stated, the de-
livery fee does not qualify as DPGR under the qual-
ified delivery exception in paragraph (h)(4)(ii)(B) of
this section or thede minimisexception under para-
graph (h)(4)(ii)(E) of this section.
Example 4. X enters into a single, lump-sum
priced contract with Y, an unrelated taxpayer, and the
contract has the following terms: X will produce QPP
within the United States for Y; X will deliver the QPP
to Y; X will provide a one-year warranty on the QPP;
X will provide operating and maintenance manuals
with the QPP; X will provide 100 hours of training
and training manuals to Y’s employees on the use and
maintenance of the QPP; X will provide purchased
spare parts for the QPP; and X will provide a 3-year
service agreement for the QPP. None of the services
or property was separately offered or separately bar-
gained for. The receipts for the production of the QPP
are DPGR under paragraphs (d)(1) and (f) of this sec-
tion (assuming all the other requirements of this sec-
tion are met). X may include in DPGR the gross re-
November 21, 200510192005–47 I.R.B.

ceipts for delivering the QPP, which is a qualified de-
livery under paragraph (h)(4)(ii)(B) of this section;
the gross receipts for the one-year warranty, which is
a qualified warranty under paragraph (h)(4)(ii)(A) of
this section; and the gross receipts for the operating
and maintenance manuals, each of which is a quali-
fied operating manual under paragraph (h)(4)(ii)(C)
of this section. If the gross receipts for the embed-
ded services consisting of the employee training and
3-year service agreement, and for the non-qualified
property consisting of the purchased spare parts and
the employee training manuals, which are not quali-
fied operating manuals, are in total less than 5 percent
of the gross receipts derived from the sale of X’s QPP
to Y (including the gross receipts for the embedded
services and non-qualified property), those gross re-
ceipts may be included in DPGR (assuming there are
no other embedded services or non-qualified property
under the contract) under thede minimisexception
in paragraph (h)(4)(ii)(E) of this section. If, how-
ever, the gross receipts for the embedded services and
non-qualified property consisting of employee train-
ing, the 3-year service agreement, purchased spare
parts, and employee training manuals equal or exceed
5 percent of the gross receipts derived from the sale
of X’s QPP to Y (including the gross receipts for the
embedded services and non-qualified property), those
gross receipts do not qualify as DPGR under thede
minimisexception in paragraph (h)(4)(ii)(E) of this
section.
(5)Advertising income—(i)Tangible
personal property. A taxpayer’s gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other
disposition of newspapers, magazines,
telephone directories, or periodicals that
are MPGE in whole or in significant part
within the United States include advertis-
ing income from advertisements placed
in those media, but only to the extent
the gross receipts, if any, derived from
the lease, rental, license, sale, exchange,
or other disposition of the newspapers,
magazines, telephone directories, or peri-
odicals are DPGR (without regard to this
paragraph (h)(5)(i)).
(ii)Qualified films. A taxpayer’s gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other dis-
position of a qualified film include prod-
uct-placement income with respect to that
qualified film, that is, compensation for
placing or integrating a product into the
qualified film, but only to the extent the
gross receipts derived from the qualified
film (if any) are DPGR (without regard to
this paragraph (h)(5)(ii)).
(iii)Examples. The following examples
illustrate the application of this paragraph
(h)(5):
Example 1. X MPGE and sells newspapers within
the United States. X’s gross receipts from the news-
papers include gross receipts derived from the sale of
newspapers to customers and payments from adver-
tisers to publish display advertising or classified ad-
vertisements in X’s newspapers. X’s gross receipts
described above are DPGR derived from the sale of
X’s newspapers.
Example 2. The facts are the same as inExample
1except that X also distributes with its newspapers
advertising flyers that are MPGE by the advertiser.
The fees X receives for distributing the advertising
flyers are not derived from the sale of X’s newspapers
because X did not MPGE the advertising flyers that it
distributes. As a result, the distribution fee is for the
provision of a distribution service and is non-DPGR
under paragraph (h)(5)(i) of this section.
Example 3. X produces two television programs
that are qualified films (as defined in paragraph (j)(1)
of this section). X licenses the first television pro-
gram to Y’s television station and X licenses the sec-
ond television program to Z’s television station. Both
television programs contain product placements for
which X received compensation. Z, but not Y, is a
related person to X within the meaning of paragraph
(b)(1) of this section. The gross receipts derived by
X from licensing the qualified film to Y are DPGR.
As a result, pursuant to paragraph (h)(5)(ii) of this
section, all of X’s product placement income for the
first television programis treated as gross receipts
that are derived from the license of the qualified film.
The gross receipts derived by X from licensing the
qualified film to Z are non-DPGR under paragraph
(b)(1) of this section. As a result, pursuant to para-
graph (h)(5)(ii) of this section, none of X’s product
placement income for the second television program
is treated as gross receipts derived from the qualified
film under paragraph (h)(5)(ii) of this section.
(6)Computer software—(i)In general.
Gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition of computer software (as de-
fined in paragraph (i)(3) of this section)
do not include gross receipts derived from
Internet access services, online services,
customer and technical support, telephone
services, online electronic books and jour-
nals, games played through a website,
provider-controlled software online ac-
cess services, and other similar services
that do not constitute the lease, rental, li-
cense, sale, exchange, or other disposition
of computer software that was developed
by the taxpayer.
(ii)Examples. The following examples
illustrate the application of this paragraph
(h)(6):
Example 1. X produces and prints a newspaper
in the United States which it sells to customers. X
also has an online version of the newspaper which
is available only to subscribers. The gross receipts
derived from the sale ofthe newspaper X produces
and prints qualify as DPGR. However, because X’s
gross receipts from the online newspaper subscription
are not derived from the lease, rental, license, sale,
exchange, or disposition of computer software under
paragraph (h)(6)(i) of thissection, the gross receipts
attributable to the online newspaper subscription fees
are non-DPGR under paragraph (h)(6)(i) of this sec-
tion.
Example 2. ThefactsarethesameasinExam-
ple 1except that X’s gross receipts attributable to
the online version of its newspaper are derived from
fees from customers to view the newspaper online
and payments from advertisers to display advertis-
ing online. X’s gross receipts derived from allow-
ing customers online access to X’s newspaper are
non-DPGR because, pursuant to paragraph (h)(6)(i)
of this section, the gross receipts relating to online
newspapers are not derived from the lease, rental, li-
cense, sale, exchange, or other disposition of QPP,
but rather is the provision of an online access service.
As a result, because X’s gross receipts from the on-
line access services are non-DPGR, the related on-
line advertising receipts are similarly non-DPGR un-
der paragraph (h)(5)(i) of this section.
(7)Exception for certain oil and gas
partnerships—(i)In general.Ifapart-
nership is engaged solely in the extrac-
tion, refining, or processing of oil or nat-
ural gas, and distributes the oil or natu-
ral gas or products derived from the oil
or natural gas (products) to one or more
partners, then each partner is treated as ex-
tracting, refining, or processing any oil or
natural gas or products extracted, refined,
or processed by the partnership and dis-
tributed to that partner. Thus, to the ex-
tent that the extracting, refining, or pro-
cessing of the distributed oil or natural gas
or products occurs in whole or in signif-
icant part within the United States, gross
receipts derived by each partner from the
sale, exchange, or other disposition of the
distributed oil or natural gas or products
are treated as DPGR (provided all require-
ments of this section are met). Solely for
purposes of section 199(d)(1)(B)(ii), the
partnership is treated as having gross re-
ceipts in the taxable year of the distribu-
tion equal to the fair market value of the
distributed oil or natural gas or products at
the time of distribution to the partner and
the deemed gross receipts are allocated to
that partner, provided the partner derives
gross receipts from the distributed prop-
erty during the taxable year of the partner
with or within which the partnership’s tax-
able year (in which the distribution occurs)
ends. Costs included in the adjusted basis
of the distributed oil or natural gas or prod-
ucts and any other relevant deductions are
taken into account in computing the part-
ner’s QPAI. See §1.199–5 for the applica-
tion of section 199 to pass-thru entities.
(ii)Example. The following example il-
lustrates the application of this paragraph
(h)(7). Assume that PRS and X are calen-
2005–47 I.R.B.1020November 21, 2005

dar year taxpayers. The example reads as
follows:
Example. X is a partner in PRS, a partnership
which engages solely in the extraction of oil within
the United States. In 2010, PRS distributes oil to X
that PRS derived from its oil extraction. PRS incurred
$600 of CGS, including $500 of W–2 wages (as de-
fined in §1.199–2(f)), extracting the oil distributed
to X, and X’s adjusted basis in the distributed oil is
$600. The fair market value of the oil at the time
of the distribution to X is $1,000. X incurs $200 of
CGS, including $100 of W–2 wages, in refining the
oil within the United States. In 2010, X sells the oil
for $1,500 to a customer. Under paragraph (h)(7)(i)
of this section, X is treated as having extracted the
oil. The extraction and refining of the oil qualify as
an MPGE activity under paragraph (d)(1) of this sec-
tion. 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 refin-
ing costs incurred by X. Thus, X’s QPAI is $700 for
2010. In addition, PRS is treated as having $1,000 of
DPGR solely for purposes of applying the wage lim-
itation of section 199(d)(1)(B)(ii). Accordingly, X’s
share of PRS’s W–2 wages determined under section
199(d)(1)(B) is $72, the lesser of $500 (X’s alloca-
ble share of PRS’s W–2 wages included in CGS) and
$72 (2 x ($400 ($1,000 deemed DPGR less $600 of
CGS) x .09)). X adds the $72 of PRS W–2 wages to
its $100 of W–2 wages incurred in refining the oil for
purposes of section 199(b).
(8)Partnerships owned by members of
a single expanded affiliated group—(i)In
general. For purposes of this section, if
all of the interests in the capital and prof-
its of a partnership are owned by mem-
bers 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. Thus,
if an EAG partnership MPGE or produces
property and distributes, leases, rents, li-
censes, sells, exchanges, or otherwise dis-
poses of that property to a member of an
EAG in which the partners of the EAG
partnership are members, then the MPGE
or production activity conducted by the
EAG partnership will be treated as hav-
ing been conducted by the members of the
EAG. Similarly, if one or more members
of an EAG in which the partners of an
EAG partnership are members MPGE or
produces property and contributes, leases,
rents, licenses, sells, exchanges, or other-
wise disposes of that property to the EAG
partnership, then the MPGE or produc-
tion activity conducted by the EAG mem-
ber (or members) will be treated as hav-
ing been conducted by the EAG partner-
ship. Attribution of activities does not ap-
ply for purposes of the construction of real
property under §1.199–3(l)(1) and the per-
formance of engineering and architectural
services under §1.199–3(m)(2) and (3), re-
spectively. An EAG partnership may not
use the small business simplified overall
method described in §1.199–4(f). Except
as provided in this paragraph (h)(8), an
EAG partnership is treated the same as
other partnerships for purposes of section
199. Accordingly, anEAG partnership is
subject to the rules of §1.199–5 regarding
the application of section 199 to pass-thru
entities, including application of the sec-
tion 199(d)(1)(B) wage limitation under
§1.199–5(a)(3). See paragraphs (f)(2) and
(3) of this section for the aggregation of ac-
tivities and conversion costs among EAG
partnerships and all members of the EAG
in which the partners of the EAG partner-
ship are members.
(ii)Special rules for distributions from
EAG partnerships.IfanEAGpart-
nership distributes property to a part-
ner, then, solely for purposes of section
199(d)(1)(B)(ii), the EAG partnership is
treated as having gross receipts in the tax-
able year of the distribution equal to the
fair market value of the property at the
time of distribution to the partner and the
deemed gross receipts are allocated to that
partner, provided the partner derives gross
receipts from the distributed property dur-
ing the taxable year of the partner with
or within which the partnership’s taxable
year (in which the distribution occurs)
ends. Costs included in the adjusted basis
of the distributed property and any other
relevant deductions are taken into account
in computing the partner’s QPAI.
(iii)Examples. The following examples
illustrate the rules of this paragraph (h)(8).
Assume that PRS, X, Y, and Z all are cal-
endar year taxpayers. The examples read
as follows:
Example 1.Contribution. XandY,bothmem-
bers of a single EAG, are the only partners in PRS,
a partnership, for PRS’s entire 2010 taxable year.
In 2010, X MPGE QPP within the United States
and contributes the property to PRS. In 2010, PRS
sells the QPP for $1,000. PRS’s $1,000 gross re-
ceipts constitute DPGR. PRS, X, and Y must apply
the rules of §1.199–5 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)(B) wage limitation under §1.199–5(a)(3).
Example 2.Sale.X,Y,andZaretheonlymem-
bers of a single EAG. X and Y each own 50% of the
capital and profits interests in PRS, a partnership, for
PRS’s entire 2010 taxable year. In 2010, PRS MPGE
QPP within the United States and then sells the prop-
erty to X for $6,000, its fair market value at the time
of the sale. PRS’s grossreceipts of $6,000 qualify
as DPGR. In 2010, X sells the QPP to customers for
$10,000, incurring selling expenses of $2,000. Under
this paragraph (h)(8), X is treated as having MPGE
the QPP within the United States, and X’s $10,000 of
gross receipts qualify as DPGR ($6,000 of CGS and
$2,000 of other selling expenses are subtracted from
DPGR in determining X’s QPAI). The results would
be the same if PRS sold the property to Z rather than
to X.
Example 3.Distribution. XandY,bothmem-
bers of a single EAG, are the only partners in PRS,
a partnership, for PRS’s entire 2010 taxable year. In
2010, PRS MPGE QPP within the United States, in-
curring $600 of CGS, including $500 of W–2 wages
(as defined in §1.199–2(f)), and then distributes the
QPP to X. X’s adjusted basis in the QPP is $600. At
the time of the distribution, the fair market value of
the QPP is $1,000. X incurs $200 of directly alloca-
ble costs, including $100 of W–2 wages, to further
MPGE the QPP within the United States. In 2010, X
sells the QPP for $1,500 to a customer. Under para-
graph (h)(8)(i) 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. X sub-
tracts from the $1,500 of DPGR the $600 of CGS in-
curred by PRS and the $200 of direct costs incurred
by X. Thus, X’s QPAI is $700 for 2010. In addition,
PRS is treated as having DPGR of $1,000 solely for
purposes of applying the wage limitation of section
199(d)(1)(B)(ii). Accordingly, X’s share of PRS’s
W–2 wages determined under section 199(d)(1)(B) is
$72, the lesser of $500 (X’s allocable share of PRS’s
W–2 wages included in CGS) and $72 (2 x ($400
($1,000 deemed DPGR less $600 of CGS) x .09)).
X adds the $72 of PRS W–2 wages to its $100 of
W–2 wages incurred in MPGE the QPP for purposes
of section 199(b).
Example 4.Multiple sales. X and Y, both
non-consolidated members of a single EAG, are the
only partners in PRS, a partnership, for PRS’s entire
2010 taxable year. PRS produces in bulk form in the
United States the active ingredient for a pharmaceuti-
cal product. 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 conversion costs to MPGE
the active ingredient within the United States are $15
and account for 15 percent of PRS’s $100 CGS of
the active ingredient. PRS sells the active ingredient
in bulk form to X. X uses the active ingredient to
produce the finished dosage form drug. Assume that
X’s own MPGE activity with respect to the drug is
not substantial in nature, taking into account all of the
facts and circumstances, and X’s conversion costs to
MPGE the drug within the United States are $12 and
account for 10 percent of X’s $120 CGS of the drug.
X sells the drug in finished dosage to Y and Y sells
thedrugtocustomers. Yincurs $2 ofconversion
costs and Y’s CGS in selling the drug to customers
is $130. 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 para-
graph (f)(3) of this section because PRS’s conversion
costs account for less than 20 percent of PRS’s CGS
of the active ingredient. X’s gross receipts from
November 21, 200510212005–47 I.R.B.

thesaleofthedrugtoYareDPGRbecauseXis
considered to have MPGE the drug in significant
part in the United States pursuant to the safe harbor
described in paragraph (f)(3) of this section because
the $27 ($15 + $12) of conversion costs incurred
by PRS and X equals or exceeds 20 percent of X’s
total CGS ($120) of the drug at the time the drug
is sold to Y. Similarly, Y’s gross receipts from the
sale of the drug to customers are DPGR because Y
is considered to have MPGE the drug in significant
part in the United States pursuant to the safe harbor
described in paragraph (f)(3) of this section because
the $29 ($15 + $12 + $2) of conversion costs incurred
by PRS, X, and Y equals or exceeds 20 percent of
Y’s total CGS ($130) of the drug at the time the drug
is sold to customers.
(9)Non-operating mineral interests.
DPGR does not include gross receipts
derived from mineral interests other than
operating mineral interests within the
meaning of §1.614–2(b).
(i)Definition of qualifying production
property—(1)In general.QPPmeans—
(i) Tangible personal property (as de-
fined in paragraph (i)(2) of this section);
(ii) Computer software (as defined in
paragraph (i)(3) of this section); and
(iii) Sound recordings (as defined in
paragraph (i)(4) of this section).
(2)Tangible personal property—(i)In
general.Thetermtangible personal prop-
ertyis any tangible property other than
land, buildings (including items that are
structural components of such buildings),
and any property described in paragraph
(i)(3), (i)(4), (j)(1), or (k) of this section.
Property such as production machinery,
printing presses, transportation and office
equipment, refrigerators, grocery coun-
ters, testing equipment, display racks and
shelves, and neon and other signs that
are contained in or attached to a building
constitutes tangible personal property for
purposes of this paragraph (i)(2)(i). Ex-
cept as provided in paragraphs (i)(5)(ii)
and (j)(2)(i) of this section, computer
software, sound recordings, and qualified
films are not treated as tangible personal
property regardless of whether they are
fixed on a tangible medium. However, the
tangible medium on which such property
may be fixed (for example, a videocas-
sette, a computer diskette, or other similar
tangible item) is tangible personal prop-
erty.
(ii)Local law. In determining whether
property is tangible personal property, lo-
cal law is not controlling.
(iii)Machinery. Property that is in the
nature of machinery (other than structural
components of a building) is tangible per-
sonalpropertyevenifsuchpropertyislo-
cated outside a building. Thus, for exam-
ple, a gasoline pump, hydraulic car lift, or
automatic vending machine, although an-
nexed to the ground, is considered tangible
personal property. A structure that is prop-
erty in the nature of machinery or is essen-
tially an item of machinery or equipment
is not an inherently permanent structure
and is tangible personal property. In the
case, however, of a building or inherently
permanent structure that includes property
in the nature of machinery as a structural
component, the property in the nature of
machinery is real property.
(iv)Intangible property.Thetermtan-
gible personal propertydoes not include
property in a form other than in a tangi-
ble medium. For example, mass-produced
books are tangible personal property, but
neither the rights to the underlying manu-
script nor an online version of the book is
tangible personal property.
(3)Computer software—(i)In general.
The termcomputer softwaremeans any
program or routine or any sequence of
machine-readable code that is designed
to cause a computer to perform a desired
function or set of functions, and the docu-
mentation required to describe and main-
tain that program or routine. For purposes
of this paragraph (i)(3), computer software
also includes the machine-readable code
for video games and similar programs,
forequipmentthatisanintegralpartof
other property, and for typewriters, calcu-
lators, adding and accounting machines,
copiers, duplicating equipment, and sim-
ilar equipment, regardless of whether the
code is designed to operate on a computer
(as defined in section 168(i)(2)(B)). Com-
puterprogramsofallclasses,forexample,
operating systems, executive systems,
monitors, compilers and translators, as-
sembly routines, and utility programs, as
well as application programs, are included.
Except as provided in paragraph (i)(5) of
this section, if the medium in which the
software is contained, whether written,
magnetic, or otherwise, is tangible, then
such medium is considered tangible per-
sonal property for purposes of this section.
(ii)Incidental and ancillary rights.
Computer softwarealso includes any
incidental and ancillary rights that are
necessary to effect the acquisition of the
title to, the ownership of, or the right to
use the computer software, and that are
used only in connection with that specific
computer software. Such incidental and
ancillary rights are not included in the
definition of trademark or trade name un-
der §1.197–2(b)(10)(i). For example, a
trademark or trade name that is ancillary
to the ownership or use of a specific com-
puter software program in the taxpayer’s
trade or business and is not acquired for
the purpose of marketing the computer
software is included in the definition of
computer software and is not included in
the definition of trademark or trade name.
(iii)Exceptions. Computer software
does not include any data or information
base unless the data or information base
is in the public domain and is incidental
to a computer program. For this purpose,
a copyrighted or proprietary data or infor-
mation base is treated as in the public do-
main if its availability through the com-
puter program does not contribute signif-
icantly to the cost of the program. For ex-
ample, if a word-processing program in-
cludes a dictionary feature that may be
used to spell-check a document or any por-
tion thereof, the entire program (including
the dictionary feature) is computer soft-
ware regardless of the form in which the
dictionary feature is maintained or stored.
(4)Sound recordings—(i)In general.
The termsound recordingsmeans any
works that result from the fixation of a
series of musical, spoken, or other sounds
under section 168(f)(4). The definition of
soundrecordingsislimitedtothemaster
copy of the recordings (or other copy from
which the holder is licensed to make and
produce copies), and, except as provided
in paragraph (i)(5) of this section, if the
medium (such as compact discs, tapes,
or other phonorecordings) in which the
sounds may be embodied is tangible, the
medium is considered tangible personal
property for purposes of paragraph (i)(2)
of this section.
(ii)Exception.Thetermsound record-
ingsdoes not include the creation of copy-
righted material in a form other than a
sound recording, such as lyrics or music
composition.
(5)Tangible personal property with
computer software or sound record-
ings—(i)Computer software and sound
recordings. If a taxpayer MPGE computer
software or sound recordings that is fixed
on, or added to, tangible personal property
2005–47 I.R.B.1022November 21, 2005

by the taxpayer (for example, a computer
diskette, or an appliance), then for pur-
posesofthissection—
(A) The computer software and the tan-
gible personal property may be treated by
the taxpayer as computer software. If the
taxpayer treats the tangible personal prop-
erty as computer software under this para-
graph (i)(5)(i)(A), any costs under section
174 attributable to the tangible personal
property are not considered in determining
whether the taxpayer’s activity is substan-
tial in nature under paragraph (f)(2) of this
section and are not conversion costs under
paragraph (f)(3) of this section; and
(B) The sound recordings and the tan-
gible personal property with the sound
recordings may be treated by the tax-
payer as sound recordings. If the taxpayer
treats the tangible personal property as
sound recordings under this paragraph
(i)(5)(i)(B), any costs under section 174
attributable to the tangible personal prop-
erty are not considered in determining
whether the taxpayer’s activity is substan-
tial in nature under paragraph (f)(2) of this
section and are not conversion costs under
paragraph (f)(3) of this section.
(ii)Tangible personal property.Ifa
taxpayer MPGE tangible personal prop-
erty but not the computer software or
sound recordings that the taxpayer fixes
on, or adds to, the tangible personal prop-
erty MPGE by the taxpayer (for example,
a computer diskette or an appliance), then
for purposes of this section the tangible
personal property with the computer soft-
ware or sound recordings may be treated
by the taxpayer as tangible personal prop-
erty under paragraph (i)(2) of this section.
For purposes of paragraph (f)(3) of this
section, the taxpayer’s CGS for each item
includes the taxpayer’s cost of licensing
the computer software or sound record-
ings.
(j)Definition of qualified film—(1)In
general.Thetermqualified filmmeans
any motion picture film or video tape un-
der section 168(f)(3), or live or delayed
television programming if not less than 50
percent of the total compensation paid to
all actors, production personnel, directors,
and producers relating to the production
of the motion picture film, video tape, or
television programming is compensation
for services performed in the United States
by those individuals. The termproduc-
tion personnelincludes writers, choreog-
raphers and composers providing services
during the production of a film, casting
agents, camera operators, set designers,
lighting technicians,make-up artists, and
others whose activities are directly related
to the production of the film. The termpro-
duction personneldoes not include, how-
ever, individuals whose activities are an-
cillary to the production, such as advertis-
ers and promoters, distributors, studio ad-
ministrators and managers, studio security
personnel, and personal assistants to ac-
tors. The termproduction personnelalso
does not include individuals whose activ-
ities relate to fixing the film on tangible
personal property. The definition ofquali-
fied filmis limited to the master copy of the
film (or other copy from which the holder
is licensed to make and produce copies),
and, except as provided in paragraph (j)(2)
of this section, does not include tangible
personal property embodying the qualified
film, such as DVDs or videocassettes.
(2)Tangible personal property with a
film—(i)Film licensed to a taxpayer.If
a taxpayer MPGE tangible personal prop-
erty (such as a DVD) in whole or in signif-
icant part in the United States and fixes to
the tangible personal property a film that
the taxpayer licenses from the producer of
the film, then the taxpayer may treat the
tangible personal property with the affixed
film as QPP, regardless of whether the film
is a qualified film. The determination of
whether gross receipts of such a taxpayer
from the lease, rental, license, sale, ex-
change, or other disposition of the tangi-
ble personal property with the affixed film
are DPGR is made under the rules of para-
graphs (d), (e), and (f) of this section. For
purposes of paragraph (f)(3) of this sec-
tion, the taxpayer’s CGS for each item in-
cludes the taxpayer’s cost of licensing the
film from the producer of the film.
(ii)Film produced by a taxpayer.If
a taxpayer produces a film and also fixes
the film on tangible personal property (for
example, a DVD), then for purposes of this
section—
(A)Qualified films. If the film is a qual-
ified film, the taxpayer may treat the tan-
gible personal property on which the qual-
ified film is fixed as part of the qualified
film, in which case the gross receipts de-
rived from the lease, rental, license, sale,
exchange, or other disposition of the tangi-
ble personal property with the affixed qual-
ified film will be DPGR (assuming all the
other requirements of this section are met),
regardless of whether the taxpayer MPGE
the tangible personal property in whole or
in significant part within the United States;
and
(B)Nonqualified films. If the film is
not a qualified film (nonqualified film),
any gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition of the tangible personal prop-
erty with the nonqualified film that are
allocable to the nonqualified film are
non-DPGR. The taxpayer, however, may
treat the tangible personal property (with-
out the nonqualified film) as an item of
QPP. Thus, the determination of whether
gross receipts of such a taxpayer de-
rived from the lease, rental, license, sale,
exchange, or other disposition of the tan-
gible personal property with the affixed
nonqualified film, that are allocable to the
tangible personal property, are DPGR is
made under the rules of paragraphs (d),
(e), and (f) of this section.
(3)Derived from a qualified film.
DPGR includes the gross receipts of the
taxpayer which are derived from any
lease, rental, license, sale, exchange, or
other disposition of any qualified film
produced by the taxpayer. Showing a
qualified film on a television station is
not a lease, rental, license, sale, exchange,
or other disposition of the qualified film.
Ticket sales for viewing qualified films
do not constitute DPGR because the gross
receipts are not derived from the lease,
rental, license, sale, exchange, or other
disposition of a qualified film. Because a
taxpayer that merely writes a screenplay or
other similar material is not considered to
have produced a qualified film under para-
graph (j)(1) of this section, the amounts
that the taxpayer receives from the sale of
the script or screenplay, even if the script
is developed into a qualified film, are not
gross receipts derived from a qualified
film. In addition, revenue from the sale of
film-themed merchandise is revenue from
the sale of tangible personal property and
not gross receipts derived from a qualified
film. Gross receipts derived from a license
of the right to use the film characters are
not gross receipts derived from a qualified
film.
(4)Examples. The following exam-
ples illustrate the application of paragraphs
(j)(2) and (3) of this section:
November 21, 200510232005–47 I.R.B.

Example 1. X produces a qualified film in the
United States and duplicates the film onto purchased
DVDs. X sells the DVDs with the qualified film to
customers. Under paragraph (j)(2)(ii)(A) of this sec-
tion, X may treat the DVD with the qualified film as
a qualified film. Accordingly, X’s gross receipts de-
rived from the sale of the qualified film to customers
are DPGR (assuming all the other requirements of
this section are met).
Example 2. The facts are the same as inEx-
ample 1except that the film is a nonqualified film
because the film does not satisfy the 50 percent re-
quirement under (j)(1) of this section and X manu-
factures the DVDs in the United States. Under para-
graph (j)(2)(ii)(B) of this section, X may treat the
DVD without the nonqualified film as tangible per-
sonal property. X’s gross receipts (not including the
gross receipts attributable to the nonqualified film)
derived from the sale of the tangible personal prop-
erty are DPGR (assuming all the other requirements
of this section are met).
Example 3. X produces television programs that
are qualified films. X shows the programs on its
own television station. X sells advertising time slots
to advertisers for the television programs. Because
showing qualified films on a television station is not
a lease, rental, license, sale, exchange, or other dis-
position, pursuant to paragraph (j)(3) of this section,
the advertising income X receives from advertisers is
not derived from the lease, rental, license, sale, ex-
change, or other disposition of qualified films.
Example 4. X produces a qualified film and con-
tracts with Y, an unrelated taxpayer, to duplicate the
film onto DVDs. Y manufactures blank DVDs within
the United States, duplicates X’s film onto the DVDs
in the United States, and sells the DVDs with the
qualified film to X who then sells them to customers.
Y has all of the benefits and burdens of ownership un-
der Federal income tax principles of the DVDs dur-
ing the MPGE and duplication process. Assume Y’s
activities relating to manufacture of the blank DVDs
and duplicating the film onto the DVDs collectively
satisfy the safe harbor underparagraph (f)(3) of this
section. Y’s gross receipts from manufacturing the
DVDs and duplicating the film onto the DVDs are
DPGR. X’s gross receipts from the sale of the DVDs
to customers are DPGR.
(5)Compensation for services.The
termcompensation for servicesmeans all
payments for services performed by actors,
production personnel, directors, and pro-
ducers, including participations and resid-
uals. In the case of a taxpayer that uses the
income forecast method of section 167(g)
and capitalizes participations and residuals
into the adjusted basis of the qualified film,
thetaxpayermustusethesameestimate
of participations and residuals for services
performed by actors, production person-
nel, directors, and producers for purposes
of this section. In the case of a taxpayer
that excludes participations and residuals
from the adjusted basis of the qualified
film under section 167(g)(7)(D)(i), the tax-
payer must determine the compensation
expected to be paid for services performed
by actors, production personnel, directors,
and producers as participations and resid-
uals based on the total forecasted income
used in determining income forecast de-
preciation. Compensation for services in-
cludes all direct and indirect compensa-
tion costs required to be capitalized un-
der section 263A for film producers under
§1.263A–1(e)(2) and (3). Compensation
for services is not limited to W–2 wages
and includes compensation paid to inde-
pendent contractors.
(6)Determination of 50 percent.Atax-
payer may use any reasonable method of
determining the compensation for services
performed in the United States by actors,
production personnel, directors, and pro-
ducers, and the total compensation paid to
those individuals for services relating to
the production of the property. Among
the factors to be considered in determining
whether a taxpayer’s method of allocating
compensation is reasonable is whether the
taxpayer uses that method consistently.
(7)Exception.Aqualified filmdoes
not include property with respect to which
records are required to be maintained un-
der 18 U.S.C. 2257. Section 2257 of Title
18 requires maintenance of certain records
with respect to any book, magazine, pe-
riodical, film, videotape, or other matter
that—
(i) Contains one or more visual depic-
tions made after November 1, 1990, of ac-
tual sexually explicit conduct; and
(ii) Is produced in whole or in part with
materials that have been mailed or shipped
in interstate or foreign commerce, or is
shipped or transported or is intended for
shipment or transportation in interstate or
foreign commerce.
(k)Electricity, natural gas, or potable
water—(1)In general. DPGR includes
gross receipts derived from any lease,
rental, license, sale, exchange, or other
disposition of utilities produced by the
taxpayer in the United States if all other
requirements of this section are met. In the
case of an integrated producer that both
produces and delivers utilities, see para-
graph (k)(4) of this section that describes
certain gross receipts that do not qualify as
DPGR, therefore requiring a taxpayer to
allocate its gross receipts between DPGR
and non-DPGR.
(2)Natural gas.Thetermnatural gas
includes only natural gas extracted from a
natural deposit and does not include, for
example, methane gas extracted from a
landfill. In the case of natural gas, pro-
duction activities include all activities
involved in extracting natural gas from
the ground and processing the gas into
pipeline quality gas.
(3)Potable water.Thetermpotable
watermeans unbottled drinking water. In
the case of potable water, production ac-
tivities include the acquisition, collection,
and storage of raw water (untreated water),
transportation of raw water to a water treat-
ment facility, and treatment of raw water
at such a facility. Gross receipts attribut-
able to any of these activities are included
in DPGR if all other requirements of this
section are met.
(4)Exceptions—(i)Electricity.Gross
receipts attributable to the transmission
of electricity from the generating facil-
ity to a point of local distribution and
gross receipts attributable to the distribu-
tion of electricity to final customers are
non-DPGR.
(ii)Natural gas. Gross receipts attrib-
utable to the transmission of pipeline qual-
ity gas from a natural gas field (or, if treat-
ment at a natural gas processing plant is
necessary to produce pipeline quality gas,
from a natural gas processing plant) to a
local distribution company’s citygate (or
to another customer) are non-DPGR. Like-
wise, gross receipts of a local gas distri-
bution company attributable to distribution
from the citygate to the local customers are
non-DPGR.
(iii)Potable water. Gross receipts at-
tributable to the storage of potable wa-
ter after completion of treatment of the
potable water, as well as gross receipts at-
tributable to the transmission and distribu-
tion of potable water, are non-DPGR.
(iv)De minimis exception.Notwith-
standing paragraphs (k)(4)(i), (ii), and (iii)
of this section, if less than 5 percent of a
taxpayer’s gross receipts derived from a
sale, exchange, or other disposition of util-
ities are attributable to the transmission or
distribution of the utilities, then the gross
receipts derived from that lease, rental, li-
cense, sale, exchange, or other disposition
that are attributable to the transmission and
distribution of the utilities must be treated
for purposes of section 199 as being DPGR
if all other requirements of this section are
met.
2005–47 I.R.B.1024November 21, 2005

(5)Example. The following example
illustrates the application of this paragraph
(k):
Example. X owns a wind turbine in the United
States that generates electricity and Y owns a high
voltage transmission line that passes near X’s wind
turbine and ends near the system of local distribu-
tion lines of Z. X sells the electricity produced at the
wind turbine to Z and contracts with Y to transmit
the electricity produced at the wind turbine to Z who
sells the electricity to customers using Z’s distribu-
tion network. The gross receipts received by X for
the sale of electricity produced at the wind turbine
are DPGR. The gross receipts of Y from transporting
X’s electricity to Z are non-DPGR under paragraph
(k)(4)(i) of this section. Likewise, the gross receipts
of Z from distributing the electricity are non-DPGR
under paragraph (k)(4)(i) of this section. If X made
direct sales of electricity to customers in Z’s service
area and Z receives remuneration for the distribution
of electricity, the gross receipts of Z are non-DPGR
under paragraph (k)(4)(i) of this section. If X, Y, and
Z are related persons (as defined in paragraph (b) of
this section), then X, Y, and Z must allocate gross re-
ceipts to production activities, transmission activities,
and distribution activities.
(l)Definition of construction performed
in the United States—(1)Construction of
real property—(i)In general.Theterm
constructionmeans the construction or
erection of real property (that is, residen-
tial and commercial buildings (including
items that are structural components of
such buildings), inherently permanent
structures other than tangible personal
property in the nature of machinery (see
paragraph (i)(2)(iii) of this section), inher-
ently permanent land improvements, oil
and gas wells, and infrastructure) in the
United States by a taxpayer that, at the
time the taxpayer constructs the real prop-
erty, is engaged in a trade or business (but
not necessarily its primary, or only, trade
or business) that is considered construc-
tion for purposes of the North American
Industry Classification System (NAICS)
on a regular and ongoing basis. A trade
or business that is considered construction
under the NAICS means a construction
activity under the two-digit NAICS code
of 23 and any other construction activity
in any other NAICS code provided the
construction activity relates to the con-
struction of real property such as NAICS
code 213111 (drilling oil and gas wells)
and 213112 (support activities for oil and
gas operations). Tangible personal prop-
erty (for example, appliances, furniture,
and fixtures) that is sold as part of a con-
struction project is not considered real
property for purposes of this paragraph
(l)(1)(i). In determining whether property
is real property, the fact that property is
real property under local law is not con-
trolling. Conversely, property may be real
property for purposes of this paragraph
(l)(1)(i) even though under local law the
property is considered tangible personal
property.
(ii)De minimis exception. For purposes
of paragraph (l)(1)(i) of this section, if less
than 5 percent of the total gross receipts
derived by a taxpayer from a construction
project (as described in paragraph (l)(1)(i)
of this section) are derived from activities
other than the construction of real property
in the United States (for example, from
non-construction activities or the sale of
tangible personal property or land) then the
total gross receipts derived by the taxpayer
from the project are DPGR from construc-
tion.
(2)Activities constituting construction.
Activities constituting construction in-
clude activities performed in connection
with a project to erect or substantially
renovate real property, but do not include
tangential services such as hauling trash
and debris, and delivering materials, even
if the tangential services are essential
for construction. However, if the tax-
payer performing construction also, in
connection with the construction project,
provides tangential services such as de-
livering materials to the construction site
and removing its construction debris, the
gross receipts derived from the tangential
services are DPGR. Improvements to land
that are not capitalizable to the land (for
example, landscaping) and painting are
activities constituting construction only if
these activities are performed in connec-
tion with other activities (whether or not
by the same taxpayer) that constitute the
erection or substantial renovation of real
property and provided the taxpayer meets
the requirements under paragraph (l)(1)
of this section. The taxpayer engaged in
these activities must make a reasonable
inquiry to determinewhether the activ-
ity relates to the erection or substantial
renovation of real property in the United
States. Constructionactivities also include
activities relating to drilling an oil well and
mining and include any activities pursuant
to which the taxpayer could deduct intan-
gible drilling and development costs under
section 263(c) and §1.612–4 and develop-
ment expenditures for a mine or natural
deposit under section 616. The lease,
license, or rental of equipment, for exam-
ple, bulldozers, generators, or computers,
to contractors for use by the contractors
in the construction of real property is not
a construction activity under this para-
graph (l)(2). The termconstructiondoes
not include any activity that is within the
definition of engineering and architectural
services under paragraph (m) of this sec-
tion.
(3)Definition of infrastructure.The
terminfrastructureincludes roads, power
lines, water systems, railroad spurs, com-
munications facilities, sewers, sidewalks,
cable, and wiring. The term also includes
inherently permanent oil and gas plat-
forms.
(4)Definition of substantial renovation.
The termsubstantial renovationmeans the
renovation of a major component or sub-
stantial structural part of real property that
materially increases the value of the prop-
erty, substantially prolongs the useful life
of the property, or adapts the property to a
new or different use.
(5)Derived from construction—(i)In
general. Assuming all the requirements
of this section are met, DPGR derived
from the construction of real property
performed in the United States includes
the proceeds from the sale, exchange, or
other disposition of real property con-
structed by the taxpayer in the United
States (whether or not the property is sold
immediately after construction is com-
pleted and whether or not the construction
project is complete). DPGR derived from
the construction of real property includes
compensation for the performance of con-
struction services by the taxpayer in the
United States. However, DPGR derived
from the construction of real property
does not include gross receipts from the
lease or rental of real property constructed
by the taxpayer or, except as provided in
paragraph (l)(5)(ii) ofthis section, gross
receipts attributable to the sale or other
disposition of land (including zoning,
planning, entitlement costs, and other
costs capitalized to the land such as the
demolition of structures under section
280B). In addition, DPGR derived from
the construction of real property includes
gross receipts from any qualified con-
struction warranty, that is, a warranty that
is provided in connection with the con-
structed real property if—
November 21, 200510252005–47 I.R.B.

(A) In the normal course of the tax-
payer’s business, the price for the con-
struction warranty is not separately stated
from the amount charged for the con-
structed real property; and
(B) The construction warranty is nei-
ther separately offered by the taxpayer nor
separately bargained for with the customer
(that is, the customer cannot purchase the
constructed real property without the con-
struction warranty).
(ii)Land safe harbor. For purposes of
paragraph (l)(5)(i) of this section, a tax-
payer may allocate gross receipts between
the proceeds from the sale, exchange, or
other disposition of real property con-
structed by the taxpayer and the gross
receipts attributable to the sale, exchange,
or other disposition of land by reducing
its costs related to DPGR under §1.199–4
by costs of the land and any other costs
capitalized to the land (collectively, land
costs) (including zoning, planning, enti-
tlement costs, and other costs capitalized
to the land such as the demolition of struc-
tures under section 280B and land costs
in any common improvements as defined
in section 2.01 of Rev. Proc. 92–29,
1992–1 C.B. 748, (see §601.601(d)(2) of
this chapter)) and by reducing its DPGR
by those land costs plus a percentage. The
percentage is based on the number of years
that elapse between the date the taxpayer
acquires the land, including the date the
taxpayer enters into the first option to ac-
quire all or a portion of the land, and ends
on the date the taxpayer sells each item of
real property on the land. The percentage
is 5 percent for years zero through 5; 10
percent for years 6 through 10; and 15
percent for years 11 through 15. Land
held by a taxpayer for 16 or more years is
not eligible for the safe harbor under this
paragraph (l)(5)(ii) and the taxpayer must
allocate gross receipts between land and
qualifying real property.
(iii)Examples. The following examples
illustrate the application of this paragraph
(l)(5):
Example 1. X, who is in the trade or business
of construction under NAICS code 23 on a regular
and ongoing basis, purchases a building in the United
States and retains Y, an unrelated taxpayer (a general
contractor), to oversee a substantial renovation of the
building (within the meaning of paragraph (l)(4) of
this section). Y retains Z (a subcontractor) to install
a new electrical system in the building as part of that
substantial renovation. The amounts that Y receives
from X for construction services, and amounts that
Z receives from Y for construction services, qual-
ify as DPGR under paragraph (l)(5)(i) of this sec-
tion provided Y and Z meet all of the requirements
of paragraph (l)(1) of this section. The gross receipts
that X receives from the subsequent sale of the build-
ing do not qualify as DPGR because X did not en-
gage in any activity constituting construction under
paragraph (l)(2) of this section even though X is in
the trade or business of construction. The results
would be the same if X and Y were members of the
same EAG under §1.199–7(a). However, if X and Y
were members of the same consolidated group, see
§1.199–7(d)(2).
Example 2. X is engaged as an electrical con-
tractor under NAICS code 238210 on a regular and
ongoing basis. X purchases the wires, conduits, and
other electrical materials that it installs in construc-
tion projects in the United States. In a particular con-
struction project, all of the wires, conduits, and other
electrical materials installed by X for the operation
of that building are considered structural components
of the building. X’s gross receipts derived from in-
stalling that property are derived from the construc-
tion of real property under paragraph (l)(1) of this sec-
tion. However, X’s gross receipts derived from the
purchased materials do not qualify as DPGR.
Example 3. X is in a trade or business that is
considered construction under the two-digit NAICS
code of 23. X buys unimproved land. X gets the land
zoned for residential housing through an entitlement
process. X grades the land and sells the land to home
builders. The gross receipts that X receives from the
sale of the land do not qualify as DPGR under para-
graph (l)(5)(i) of this section because the gross re-
ceipts are not derived from the construction of real
property.
Example 4. The facts are the same as inExam-
ple 3except that X builds roads, sewers, sidewalks,
and installs power and water lines on the land. The
gross receipts that X receives that are attributable to
the sale of the roads, sewers, sidewalks, and power
and water lines, which qualify as infrastructure under
paragraph (l)(3) of this section, are DPGR. X’s gross
receipts from the land including capitalized costs of
entitlements do not qualify as DPGR under paragraph
(l)(5)(i) of this section because the gross receipts are
not derived from the construction of real property.
Example 5. (i) X is engaged in the business activ-
ities of constructing housing within the meaning of
paragraph (l)(1) of this section. On June 1, 2005, X
pays $50,000,000 for 1,000 acres of land that X will
develop as a new housing development. In 2008, after
the expenditure of $10,000,000 for entitlement costs,
X receives permits to begin construction. After this
expenditure, X’s land costs total $60,000,000. The
development consists of 1,000 houses to be built on
half-acre lots over 5 years. On January 31, 2010, the
first house is sold for $300,000. Construction costs
for each house are $170,000. Common improve-
ments consisting of streets, sidewalks, sewer lines,
playgrounds, clubhouses, tennis courts, and swim-
ming pools that X is contractually obligated or re-
quired by law to provide cost $55,000 per lot. The
common improvements include $30,000 in land costs
underlying the common improvements.
(ii) Pursuant to the land safe harbor under para-
graph (l)(5)(ii) of this section, X calculates the to-
tal costs under §1.199–4 for each house sold in 2010
as $195,000 (total costs of $255,000 ($170,000 in
construction costs plus $55,000 in common improve-
ments (including $30,000 in land costs) plus $30,000
in land costs for the lot), which are reduced by land
costs of $60,000). X calculates the DPGR for each
house sold by May 31, 2010, by taking the gross re-
ceipts of $300,000 and reducing that amount by land
costs of $60,000 plus a percentage of $60,000. As
X acquired the land on June 1, 2005, and sold the
houses on the land between January 31, 2010, and
May 31, 2010, the percentage reduction for X is 5
percent because X has held the land for not more than
5 years from the anniversary of the date of acquisi-
tion. Thus, the DPGR for each house is $237,000
($300,000 - $60,000 - $3,000) with costs for each
house of $195,000 for a calculation of QPAI for each
house of $42,000.
Example 6.ThefactsarethesameasinExample
5except some of the houses are sold between June
1, 2010, and December 31, 2010. X calculates the
DPGR for each house sold between June 1, 2010, and
December 31, 2010, by taking the gross receipts of
$300,000 and reducing that amount by land costs of
$60,000 plus a percentage of $60,000. As X acquired
the land on June 1, 2005, and sold the houses on the
land between June 1, 2010, and December 31, 2010,
the percentage reduction for X is 10 percent because
X has held the land for more than 5 years but not
more than 10 years from the anniversary of the date
of acquisition. Thus, the DPGR for each house is
$234,000 ($300,000 - $60,000 - $6,000) with costs
for each house of $195,000 for a calculation of QPAI
for each house of $39,000.
(m)Definition of engineering and
architectural services—(1)In general.
DPGR includes gross receipts derived
from engineering or architectural services
performed in the United States for a con-
struction project described in paragraph
(l) of this section. At the time the taxpayer
performs the engineering or architectural
services, the taxpayer must be engaged
in a trade or business (but not necessarily
its primary, or only, trade or business)
that is considered engineering or architec-
tural services for purposes of the NAICS,
for example NAICS codes 541330 (engi-
neering services) or 541310 (architectural
services), on a regular and ongoing ba-
sis. DPGR includes gross receipts derived
from engineering or architectural services,
including feasibility studies for a con-
struction project in the United States, even
if the planned construction project is not
undertaken or is not completed.
(2)Engineering services. Engineering
services in connection with any con-
struction project include any professional
services requiring engineering educa-
tion, training, and experience and the
application of special knowledge of the
mathematical, physical, or engineering
sciences to those professional services
such as consultation, investigation, eval-
uation, planning, design, or responsible
2005–47 I.R.B.1026November 21, 2005

supervision of construction for the pur-
pose of assuring compliance with plans,
specifications, and design.
(3)Architectural services. Architec-
tural services in connection with any
construction project include the offering
or furnishing of any professional services
such as consultation,planning, aesthetic
and structural design, drawings and spec-
ifications, or responsible supervision of
construction (for the purpose of assuring
compliance with plans,specifications, and
design) or erection, in connection with any
construction project.
(4)De minimis exception for perfor-
mance of services in the United States.
If less than 5 percent of the total gross
receipts derived by a taxpayer from en-
gineering or architectural services per-
formed in the United States for a construc-
tion project (described in paragraph (l) of
this section) are derived from services not
relating to a construction project described
in paragraph (l) of this section (for exam-
ple, the services are performed outside the
United States or in connection with prop-
erty other than real property) then the total
gross receipts derived by the taxpayer are
DPGR from engineering or architectural
services performed in the United States
for a construction project.
(n)Exception for sales of certain food
and beverages—(1)In general.DPGR
does not include gross receipts of the tax-
payer that are derived from the sale of food
or beverages prepared by the taxpayer at
a retail establishment. Aretail establish-
mentis defined as tangible property (both
real and personal) leased, occupied, or oth-
erwise used by the taxpayer in its trade or
business of selling food or beverages to
the public at which retail sales are made.
In addition, a facility that prepares food
and beverages solely for take out service
or delivery is a retail establishment (for
example, a caterer). A facility at which
food or beverages are prepared will not
be treated as a retail establishment if less
than 5 percent of the gross receipts from
the sale of food or beverages at that fa-
cility during the taxable year are attribut-
able to retail sales. If a taxpayer’s facil-
ity is a retail establishment in the United
States, then, for purposes of this section,
the taxpayer may allocate its gross receipts
between gross receipts derived from the re-
tail sale of the food and beverages prepared
and sold at the retail establishment (which
are non-DPGR) and gross receipts derived
from the wholesale sale of the food and
beverages prepared at the retail establish-
ment (which are DPGR). Wholesale sales
are sales of food and beverages to be resold
by the purchaser. The exception for sales
of certain food and beverages also applies
to food and beverages for non-human con-
sumption. Aretail establishmentdoes not
include the bonded premises of a distilled
spirits plant or wine cellar, or the premises
of a brewery (other than a tavern on the
brewery premises). See Chapter 51 of Ti-
tle 26 of the United States Code and the
implementing regulations thereunder.
(2)Examples. The following examples
illustrate the application of this paragraph
(n):
Example 1. X buys coffee beans and roasts those
beans at a facility in the United States, the only activ-
ity of which is the roasting and packaging of roasted
coffee beans. X sells the roasted coffee beans through
a variety of unrelated third-party vendors and also
sells roasted coffee beans at X’s retail establishments.
At X’s retail establishments, X prepares brewed cof-
fee and other foods. To the extent that the gross re-
ceipts of X’s retail establishments represent receipts
from the sale of coffee beans roasted at the facility, the
receipts are DPGR. To the extent the gross receipts of
X’s retail establishments represent receipts from the
retail sale of brewed coffee or food prepared at the re-
tail establishments, the receipts are non-DPGR. How-
ever, pursuant to §1.199–1(c)(2), X must allocate part
of the receipts from the retail sale of the brewed cof-
fee as DPGR to the extent of the value of the coffee
beans that were roasted at the facility and that were
used to brew coffee.
Example 2. Y operates a bonded winery in
California. Bottles of wine produced by Y at the
bonded winery are sold to consumers at the taxpaid
premises. Pursuant to paragraph (n)(1) of this sec-
tion, the bonded premises is not considered a retail
establishment and is treated as separate and apart
from the taxpaid premises, which is considered a re-
tail establishment for purposes of paragraph (n)(1) of
this section. Accordingly, the wine produced by Y in
the bonded premises and sold by Y from the taxpaid
premises is not considered to have been produced at
a retail establishment, and the sales of the wine are
DPGR (assuming all the other requirements of this
section are met).
§1.199–4 Costs allocable to domestic
production gross receipts.
(a)In general. To determine its quali-
fied production activities income (QPAI)
(as defined in §1.199–1(c)) for a taxable
year, a taxpayer must subtract from its do-
mestic production gross receipts (DPGR)
(as defined in §1.199–3(a)) the cost of
goods sold (CGS) allocable to DPGR, the
amount of expenses or losses (deductions)
directly allocable toDPGR, and a ratable
portion of other deductions not directly
allocable to DPGR or to another class
of income. Paragraph (b) of this section
provides rules for determining CGS al-
locable to DPGR. Paragraph (c) of this
section provides rules for determining
the deductions allocated and apportioned
to DPGR and a ratable portion of de-
ductions that are notdirectly allocable
to DPGR or to another class of income.
Paragraph (d) of this section provides
that a taxpayer generally must determine
deductions allocated and apportioned to
DPGR or to gross income attributable
to DPGR using the rules of the regula-
tions at §§1.861–8 through 1.861–17 and
§§1.861–8T through 1.861–14T (the sec-
tion 861 regulations), subject to the rules
in paragraph (d) of this section (the section
861 method). Paragraph (e) of this sec-
tion provides that certain taxpayers may
apportion deductions to DPGR using the
simplified deduction method. Paragraph
(f) of this section provides a small business
simplified overall method that a qualifying
small taxpayer may use to apportion CGS
and deductions to DPGR.
(b)Cost of goods sold allocable to
domestic production gross receipts—(1)
In general. When determining its QPAI,
a taxpayer must reduce DPGR by the
CGS allocable to DPGR. A taxpayer de-
termines its CGS allocable to DPGR in
accordance with this paragraph (b) or, if
applicable, paragraph (f) of this section.
In the case of a sale, exchange, or other
disposition of inventory, CGS is equal to
beginning inventory plus purchases and
production costs incurred during the tax-
able year and includedininventorycosts,
less ending inventory. CGS is determined
under the methods of accounting that the
taxpayer uses to compute taxable income.
See sections 263A, 471, and 472. Ad-
ditional section 263A costs, as defined
in §1.263A–1(d)(3), must be included in
determining CGS. In the case of a sale,
exchange, or other disposition (including,
for example, theft, casualty, or abandon-
ment) of non-inventory property, CGS for
purposes of this section includes the ad-
justed basis of the property. CGS allocable
to DPGR for a taxable year may include
the inventory cost and adjusted basis of
qualifying production property (QPP) (as
defined in §1.199–3(i)(1)), a qualified film
(as defined in §1.199–3(j)(1)), or electric-
ity, natural gas, and potable water (as
November 21, 200510272005–47 I.R.B.

defined in §1.199–3(k)) (collectively, util-
ities) that will, or have, generated DPGR
notwithstanding thatthe gross receipts at-
tributable to the sale of the QPP, qualified
films, or utilities will, or have been, in-
cluded in the computation of gross income
for a different taxable year. For exam-
ple, advance payments related to DPGR
may be included in gross income under
§1.451–5(b)(1)(i) in a different taxable
year than the related CGS allocable to that
DPGR. CGS allocable to DPGR includes
inventory valuation adjustments such as
writedowns under the lower of cost or
market method. If non-DPGR is treated
as DPGR pursuant to §§1.199–1(d)(2) and
1.199–3(h)(4), (k)(4)(iv), (l)(1)(ii), (m)(4),
or (n)(1), CGS related to such gross re-
ceipts that are treated as DPGR must be
allocated or apportioned to DPGR.
(2)Allocating cost of goods sold.A
taxpayer must use a reasonable method
that is satisfactory to the Secretary to allo-
cate CGS between DPGR and non-DPGR.
Whether an allocation method is rea-
sonable is based on all of the facts and
circumstances including whether the tax-
payer uses the most accurate information
available; the relationship between CGS
and the method used; the accuracy of the
method chosen as compared with other
possible methods; whether the method is
used by the taxpayer for internal man-
agement and other business purposes;
whether the method is used for other Fed-
eral or state income tax purposes; the
availability of costing information; the
time, burden, and cost of using various
methods; and whether the taxpayer ap-
plies the method consistently from year
to year. If a taxpayer does, or can, with-
out undue burden or expense, specifically
identify from its books and records CGS
allocable to DPGR, the CGS allocable
to DPGR is that amount irrespective of
whether the taxpayer uses another allo-
cation method to allocate gross receipts
between DPGR and non-DPGR. A tax-
payer that cannot, without undue burden
or expense, use a specific identification
method to determine CGS allocable to
DPGR is not required to use a specific
identification method to determine CGS
allocable to DPGR. Ordinarily, if a tax-
payer uses a method to allocate gross
receipts between DPGR and non-DPGR,
the use of a different method to allocate
CGS that is not demonstrably more accu-
rate than the method used to allocate gross
receipts will not be considered reasonable.
Depending on the facts and circumstances,
reasonable methods may include methods
based on gross receipts, number of units
sold, number of units produced, or total
production costs.
(3)Special rules for imported items or
services. The cost of any item or service
brought into the United States (as defined
in §1.199–3(g)) without an arm’s length
transfer price may not be treated as less
than its value immediately after it entered
the United States for purposes of determin-
ingtheCGStobeusedinthecomputation
of QPAI. When an item or service is im-
ported into the United States that had been
exported by the taxpayer for further man-
ufacture, the increase in cost may not ex-
ceed the difference between the value of
the property when exported and the value
of the property when imported back into
the United States after further manufac-
ture. For this purpose, the value of prop-
erty is its customs value as defined in sec-
tion 1059A(b)(1).
(4)Rules for inventories valued at mar-
ket or bona fide selling prices.Ifpartof
CGS is attributable to inventory valuation
adjustments, CGS allocable to DPGR in-
cludes inventory adjustments to QPP that
is MPGE in whole or in significant part
within the United States, qualified films
produced in the United States, or utilities
produced in the United States. Accord-
ingly, taxpayers that value inventory under
§1.471–4 (inventories at cost or market,
whichever is lower) or §1.471–2(c) (sub-
normal goods atbona fideselling prices)
must allocate a proper share of such ad-
justments (for example, writedowns) to
DPGR based on a reasonable method that
is satisfactory to theSecretary based on
all of the facts and circumstances. Fac-
tors taken into account in determining
whether the method is reasonable include
whether the taxpayer uses the most accu-
rate information available; the relationship
between the adjustment and the allocation
base chosen; the accuracy of the method
chosen as compared with other possible
methods; whether the method is used
by the taxpayer for internal management
or other business purposes; whether the
method is used for other Federal or state
income tax purposes; the time, burden,
and cost of using various methods; and
whether the taxpayer applies the method
consistently from year to year. If a tax-
payer does, or can, without undue burden
or expense, specifically identify from its
books and records the proper amount of
inventory valuation adjustments allocable
to DPGR, then the taxpayer must allocate
that amount to DPGR. A taxpayer that
cannot, without undue burden or expense,
use a specific identification method to
determine the proper amount of inventory
valuation adjustments allocable to DPGR
is not required to use a specific identifi-
cation method to allocate adjustments to
DPGR.
(5)Rules applicable to inventories ac-
counted for under the last-in, first-out
(LIFO) inventory method—(i)In gen-
eral. This paragraph applies to inventories
accounted for using the specific goods
last-in, first-out (LIFO) method or the
dollar-value LIFO method. Whenever a
specific goods grouping or a dollar-value
pool contains QPP, qualified films, or util-
ities that produces DPGR and goods that
do not, the taxpayer must allocate CGS at-
tributable to that grouping or pool between
DPGR and non-DPGR using a reasonable
method. Whether a method of allocating
CGS between DPGR and non-DPGR is
reasonable must be determined in accor-
dance with paragraph (b)(2) of this section.
In addition, this paragraph (b)(5) provides
methods that a taxpayer may use to allo-
cate CGS for inventories accounted for
using the LIFO method. If a taxpayer uses
the LIFO/FIFO ratio method provided in
paragraph (b)(5)(ii) of this section or the
change in relative base-year cost method
provided in paragraph (b)(5)(iii) of this
section, the taxpayer must use that method
for all inventory accounted for under the
LIFO method.
(ii)LIFO/FIFO ratio method.Atax-
payer using the specific goods LIFO
method or the dollar-value LIFO method
may use the LIFO/FIFO ratio method.
The LIFO/FIFO ratio method is applied
with respect to all LIFO inventory of a
taxpayer on a grouping-by-grouping or
pool-by-pool basis. Under the LIFO/FIFO
ratio method, a taxpayer computes the
CGS of a grouping or pool allocable to
DPGR by multiplying the CGS of QPP,
qualified films, or utilities in the grouping
or pool that produced DPGR computed
using the first-in, first-out (FIFO) method
by the LIFO/FIFO ratio of the grouping or
pool. The LIFO/FIFO ratio of a grouping
2005–47 I.R.B.1028November 21, 2005

or pool is equal to the total CGS of the
grouping or pool computed using the LIFO
method over the total CGS of the grouping
or pool computed using the FIFO method.
(iii)Change in relative base-year cost
method. A taxpayer using the dollar-value
LIFO method may use the change in rela-
tive base-year cost method. The change in
relative base-year cost method is applied
with respect to all LIFO inventory of a tax-
payer on a pool-by-pool basis. The change
in relative base-year cost method deter-
mines the CGS allocable to DPGR by in-
creasing or decreasing the total production
costs (section 471 costs and additional sec-
tion 263A costs) of QPP, qualified films,
and utilities that generate DPGR by a por-
tion of any increment or liquidation of the
dollar-value pool. The portion of an incre-
ment or liquidation allocable to DPGR is
determined by multiplying the LIFO value
of the increment or liquidation (expressed
as a positive number) by the ratio of the
change in total base-year cost (expressed
as a positive number) of the QPP, quali-
fying films, and utilities that will generate
DPGR in ending inventory to the change
in total base-year cost (expressed as a pos-
itive number) of all goods in the ending in-
ventory. The portion of an increment or
liquidation allocable to DPGR may be zero
but cannot exceed the amount of the incre-
ment or liquidation. Thus, a ratio in excess
of 1.0 must be treated as 1.0.
(6)Taxpayers using the simplified
production method or simplified resale
method for additional section 263A costs.
A taxpayer that uses the simplified produc-
tion method or simplified resale method
to allocate additional section 263A costs,
as defined in §1.263A–1(d)(3), to end-
ing inventory must follow the rules in
paragraph (b)(2) of this section to deter-
mine the amount of additional section
263A costs allocable to DPGR. Alloca-
ble additional section 263A costs include
additional section263A costs included in
beginning inventory as well as additional
section 263A costs incurred during the
taxable year. Ordinarily, if a taxpayer uses
the simplified production method or the
simplified resale method, then additional
section 263A costs should be allocated in
the same proportion as section 471 costs
are allocated.
(7)Examples. The following examples
illustrate the application of this paragraph
(b):
Example 1.Advance payments. T, a calendar
year taxpayer, is a manufacturer of furniture in the
United States. Under its method of accounting, T
includes advance payments in gross income when
the payments are received. In December 2005, T
receives an advance payment of $5,000 from X with
respect to an order of furniture to be manufactured
for a total price of $20,000. In 2006, T produces and
ships the furniture to X. In 2006, T incurs $14,000
of section 471 and additional section 263A costs to
produce the furniture ordered by X. T receives the
remaining $15,000 of the contract price from X in
2006. T must include the $5,000 advance payment in
income and DPGR in 2005. The remaining $15,000
of the contract price must be included in income and
DPGR when received by T in 2006. T must include
the $14,000 it incurred to produce the furniture in
CGS and CGS allocable to DPGR in 2006. See
§1.199–1(e)(1) forrules regarding gross receipts and
costs recognized in different taxable years.
Example 2.Use of standard cost method.X,a
calendar year taxpayer, manufactures item A in a fac-
tory located in the United States and item B in a fac-
torylocatedinCountryY.ItemAisproducedbyX
in significant part within the United States and the
sale of A generates DPGR. X uses the FIFO inventory
method to account for its inventory and determines
the cost of item A using a standard cost method. At
the beginning of its taxable year, X’s inventory con-
tains 2,000 units of item A at a standard cost of $5
per unit. X did not incur significant cost variances in
previous taxable years. During the 2005 taxable year,
X produces 8,000 units of item A at a standard cost
of $6 per unit. X determines that with regard to its
production of item A it has incurred a significant cost
variance. When X reallocates the cost variance to the
units of item A that it has produced, the production
cost of item A is $7 per unit. X sells 7,000 units of
item A during the taxable year. X can identify from
its books and records that CGS related to sale of item
A is $45,000 ((2,000 x $5) + (5,000 x $7)). Accord-
ingly, X has CGS allocable to DPGR of $45,000.
Example 3.Change in relative base-year cost
method. (i) Y elects, beginning with the calendar
year 2005, to compute its inventories using the dol-
lar-value, LIFO method under section 472. Y estab-
lishes a pool for items A and B. Y produces item A in
significant part within the United States and the sales
of item A generate DPGR. Y does not produce item
B in significant part within the United States and the
sale of item B does not generate DPGR. The compo-
sition of the inventory for the pool at the base date,
January 1, 2005, is as follows:
ItemUnitUnit costTotal cost
A2,000
$ 5.00$ 10,000
B
1,250
4.00
5,000
Total
$ 15,000
(ii) Y uses a standard cost method to allocate all
direct and indirect costs (section 471 and additional
section 263A costs) to the units of item A and item
B that it produces. During 2005, Y incurs $52,500 of
section 471 costs and additional section 263A costs
to produce 10,000 units of item A and $114,000 of
section 471 costs and additional section 263A costs
to produce 20,000 units of item B.
(iii) The closing inventory of the pools at Decem-
ber 31, 2005, contains 3,000 units of item A and 2,500
units of item B. The closing inventory of the pool
at December 31, 2005, shown at base-year and cur-
rent-year cost is as follows:
ItemQuantity
Base-year
costAmount
Current-year
costAmount
A3,000
$5.00$15,000$5.25$15,750
B
2,500
4.0010,000
5.7014,250
Totals
$25,000$30,000
November 21, 200510292005–47 I.R.B.

(iv) The base-year costof the closing LIFO in-
ventory at December 31, 2005, amounts to $25,000,
and exceeds the $15,000 base-year cost of the open-
ing inventory for the taxable year by $10,000 (the in-
crement stated at base-year cost). The increment val-
ued at current-year cost is computed by multiplying
the increment stated at base-year cost by the ratio of
the current-year cost of the pool to total base-year cost
of the pool (that is, $30,000/$25,000, or 120 percent).
The increment stated at current-year cost is $12,000
($10,000 x 120%).
(v) The change in relative base-year cost of item
A is $5,000 ($15,000 - $10,000). The change in rel-
ative base-year cost (theincrement stated at base-
year cost) of the total inventory is $10,000 ($25,000
- $15,000). The ratio of the change in base-year cost
of item A to the change in base-year cost of the total
inventory is 50% ($5,000/$10,000).
(vi) CGS allocable to DPGR is $46,500, com-
puted as follows:
Current-year production costs related to DPGR
$52,500
Less: Increment stated at current-year cost
$12,000
Ratio
50%
Total( 6,000)
Total
$46,500
Example 4.Change in relative base-year cost
method. (i) The facts are the same as inExample 3
except that, during the calendar year 2006, Y expe-
riences an inventory decrement. During 2006, Y in-
curs $66,000 of section 471 costs and additional sec-
tion 263A costs to produce 12,000 units of item A and
$150,000 of section 471 costs and additional section
263A costs to produce 25,000 units of item B.
(ii) The closing inventory of the pool at December
31, 2006, contains 2,000 units of item A and 2,500
units of item B. The closing inventory of the pool at
December 31, 2006, shown at base-year and current-
year cost is as follows:
ItemQuantity
Base-year
costAmount
Current-year
costAmount
A2,000
$5.00$10,000$5.50$11,000
B
2,500
4.0010,0006.00
15,000
Totals
$20,000$26,000
(iii) The base-year cost of the closing LIFO inven-
tory at December 31, 2006,amounts to $20,000, and
is less than the $25,000 base-year cost of the open-
ing inventory for that year by $5,000 (the decrement
stated at base-year cost). This liquidation is reflected
by reducing the most recent layer of increment. The
LIFO value of the inventory at December 31, 2006 is:
Base costIndexLIFO value
January 1, 2005, base cost
$15,000
1.00
$15,000
December 31, 2005, increment5,000
1.206,000
Total
$21,000
(iv) The change in relative base-year cost of item
A is $5,000 ($15,000 -$10,000). The change in rel-
ative base-year cost of the total inventory is $5,000
($25,000 - $20,000). The ratio of the change in base-
year cost of item A to the change in base-year cost of
the total inventory is 100% ($5,000/$5,000).
(v) CGS allocable to DPGR is $72,000, computed
as follows:
Current-year production costs related to DPGR
$66,000
Plus: LIFO value of decrement
$6,000
Ratio100%
Total6,000
Total
$72,000
Example 5.LIFO/FIFO ratio method.(i)The
facts are the same as inExample 3except that Y uses
the LIFO/FIFO ratio method to determine its CGS
allocable to DPGR.
(ii) Y’s CGS related to item A on a FIFO basis is
$46,750 ((2,000 units at $5) + (7,000 units at $5.25)).
(iii) Y’s total CGS computed on a LIFO basis is
$154,500 (beginning inventory of $15,000 plus total
production costs of $166,500 less ending inventory of
$27,000).
(iv) Y’s total CGS computed on a FIFO basis is
$151,500 (beginning inventory of $15,000 plus total
production costs of $166,500 less ending inventory of
$30,000).
(v) The ratio of Y’s CGS computed using the
LIFO method to its CGS computed using the FIFO
method is 102% ($154,500/$151,500). Y’s CGS re-
lated to DPGR computed using the LIFO/FIFO ratio
method is $47,685 ($46,750 x 102%).
Example 6.LIFO/FIFO ratio method.(i)The
facts are the same as inExample 4except that Y uses
the LIFO/FIFO ratio method to compute CGS alloca-
ble to DPGR.
(ii) Y’s CGS related to item A on a FIFO basis
is $70,750 ((3,000 units at $5.25) + (10,000 units at
$5.50)).
(iii) Y’s total CGS computed on a LIFO basis is
$222,000 (beginning inventory of $27,000 plus total
2005–47 I.R.B.1030November 21, 2005

production costs of $216,000 less ending inventory of
$21,000).
(iv) Y’s total CGS computed on a FIFO basis is
$220,000 (beginning inventory of $30,000 plus total
production costs of $216,000 less ending inventory of
$26,000).
(v) The ratio of Y’s CGS computed using the
LIFO method to its CGS computed using the FIFO
method is 101% ($222,000/$220,000). Y’s CGS re-
lated to DPGR computed using the LIFO/FIFO ratio
method is $71,457 ($70,750 x 101%).
(c)Other deductions allocable or ap-
portioned to domestic production gross re-
ceipts or gross income attributable to do-
mestic production gross receipts—(1)In
general. In determining its QPAI, a tax-
payer must subtract from its DPGR, in ad-
dition to its CGS allocable to DPGR, the
deductions that are directly allocable to
DPGR, and a ratable portion of deductions
that are not directly allocable to DPGR
or to another class of income. A tax-
payer generally must allocate and appor-
tion these deductions using the rules of the
section 861 method. In lieu of the section
861 method, certain taxpayers may appor-
tion these deductions using the simplified
deduction method provided in paragraph
(e) of this section. Paragraph (f) of this
section provides a small business simpli-
fied overall method that may be used by a
qualified small taxpayer, as defined in that
paragraph. A taxpayer using the simpli-
fied deduction method or the small busi-
ness simplified overall method must use
that method for all deductions. A taxpayer
eligible to use the small business simpli-
fied overall method may choose at any
time to use the small business simplified
overall method, the simplified deduction
method, or the section 861 method for a
taxable year. A taxpayer eligible to use the
simplified deduction method may choose
at any time to use the simplified deduc-
tion method or the section 861 method for
a taxable year.
(2)Treatment of certain deduc-
tions—(i)In general. The rules provided
in this paragraph (c)(2) apply to net oper-
ating losses and certain other deductions
for purposes of allocating and apportion-
ing deductions to DPGR or gross income
attributable to DPGR for all of the meth-
ods provided by this section.
(ii)Net operating losses. A deduction
under section 172 for a net operating loss
is not allocated or apportioned to DPGR or
gross income attributable to DPGR.
(iii)Deductions not attributable to the
conduct of a trade or business. Deductions
not attributable to the conduct of a trade or
business are not allocated or apportioned
to DPGR or gross income attributable to
DPGR. For example, the standard deduc-
tion provided by section 63(c) and the de-
duction for personal exemptions provided
by section 151 are not allocated or appor-
tioned to DPGR or gross income attribut-
able to DPGR.
(d)Section 861 method—(1)In gen-
eral. A taxpayer must allocate and appor-
tion its deductions using the allocation and
apportionment rules provided by the sec-
tion 861 method under which section 199
is treated as an operative section described
in §1.861–8(f). Accordingly, the taxpayer
applies the rules of the section 861 regula-
tions to allocate and apportion deductions
(including its distributive share of deduc-
tions from pass-thru entities) to gross in-
come attributable to DPGR. If the taxpayer
applies the allocation and apportionment
rules of the section 861 regulations for an
operative section other than section 199,
the taxpayer must use the same method of
allocation and the same principles of ap-
portionment for purposes of all operative
sections (subject to the rules provided in
paragraphs (c)(2) and (d)(2) and (3) of this
section). See §1.861–8(f)(2)(i).
(2)Deductions for charitable contribu-
tions. Deductions for charitable contri-
butions (as allowed under sections 170,
873(b)(2), and 882(c)(1)(B)) must be rat-
ably apportioned between gross income at-
tributable to DPGR and other gross income
based on the relative amounts of gross in-
come. For individuals, this provision ap-
plies solely to deductions for charitable
contributions that are attributable to the ac-
tual conduct of a trade or business.
(3)Research and experimental expendi-
tures. Research and experimental expendi-
tures must be allocated and apportioned in
accordance with §1.861–17 without taking
into account the exclusive apportionment
rule of §1.861–17(b).
(4)Deductions related to gross re-
ceipts deemed to be domestic production
gross receipts. If non-DPGR is treated as
DPGR pursuant to §§1.199–1(d)(2) and
1.199–3(h)(4), (k)(4)(iv), (l)(1)(ii), (m)(4),
or (n)(1), deductions related to such gross
receipts that are treated as DPGR must be
allocated or apportioned to gross income
attributable to DPGR.
(5)Examples. The following examples
illustrate the operation of the section 861
method. Assume that with respect to the
allocation and apportionment of interest
expense, §1.861–10T does not apply in the
following examples. The examples read as
follows:
Example 1.General section 861 method.(i)X,
a United States corporation that is not a member of
an expanded affiliated group (EAG) (as defined in
§1.199–7), engages in activities that generate both
DPGR and non-DPGR. All of X’s production activ-
ities that generate DPGR are within Standard Indus-
trial Classification (SIC) Industry Group AAA (SIC
AAA)). All of X’s production activities that gener-
ate non-DPGR are within SIC Industry Group BBB
(SIC BBB). X is able to identify from its books and
records CGS allocable to DPGR and to non-DPGR.
X incurs $900 of research and experimentation ex-
penses (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 §1.861–17(a)(4) and none of the
R&E is included in CGS. X incurs section 162 sell-
ing expenses (that include W–2 wages as defined in
§1.199–2(f)) that are not includible in CGS and not
directly allocable to any gross income. For 2010, the
adjusted basis of X’s assets that generate gross in-
come attributable to DPGR and to non-DPGR is, re-
spectively, $4,000 and $1,000. For 2010, X’s taxable
income is $1,380 based on the following Federal in-
come tax items:
November 21, 200510312005–47 I.R.B.

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
Non-DPGR(allfromsalesofproductswithinSICBBB)..................................
$3,000
CGSallocabletoDPGR(includes$100ofW–2wages...................................($600)
CGS allocable
tonon-DPGR(includes$100ofW–2wages)...............................
($1,800)
Section162sellingexpenses(includes$100ofW–2wages)...............................($840)
Section174R&E–SICAAA........................................................
($300)
Section174R&E–SICBBB........................................................
($600)
Interestexpense(notincludedinCGS)................................................
($300)
Charitablecontributions............................................................
($180)
X’s taxable
income ...............................................................
$1,380
(ii)X’s QP
AI. X chooses to allocate and apportion
its deductions to gross income attributable to DPGR
under the section 861 method of this paragraph (d).
In this ca
se, the section 162 selling expenses (includ-
ing W–2 wages) are definitely related to all of X’s
gross income. Based on the facts and circumstances
of this spe
cific case, apportionment of those expenses
between DPGR and non-DPGR on the basis of X’s
gross receipts is appropriate. For purposes of appor-
tioning R
&E, X elects to use the sales method as de-
scribed in §1.861–17(c). X elects to apportion in-
terest expense under the tax book value method of
§1.861–9T
(g). X has $2,400 of gross income attrib-
utable to DPGR (DPGR of $3,000 - CGS of $600 (in-
cludes $100 of W–2 wages) allocated based on X’s
books and
records). X’s QPAI for 2010 is $1,320, as
shown below:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGSallocabletoDPGR(includes$100ofW–2wages) .............................................($600)
Section 162 selling expenses (includes $100 of W–2 wages)
($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($420)
Intere
st expense (not included in CGS) ($300 x ($4,000 (X’s DPGR assets)/
$5,000(X’stotalassets)))............................................................($240)
Charitable contributions (not included in CGS) ($180 x ($2,400 gross income attributable to DPGR/
$3,600totalgrossincome))...........................................................($120)
Section174R&E–SICAAA...................................................................
($300)
X’sQPAI..................................................................................
$1,320
(iii)Section 199 deduction determination.X’s
tentative deduction under §1.199–1(a) (section 199
deduction) is $119 (.09 x (lesser of QPAI of $1,320
and taxable income of $1,380)) subject to the wage
limitation of $150 (50% x $300). Accordingly, X’s
section 199 deduction for 2010 is $119.
Example 2.Section 861 method and EAG.(i)
Facts. The facts are the same as inExample 1ex-
cept that X owns stock in Y, a United States corpora-
tion, equal to 75 percent of the total voting power of
stock of Y and 80 percent of the total value of stock
of Y. X and Y are not members of an affiliated group
as defined in section 1504(a). Accordingly, the rules
of §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 ex-
pense (see §1.861–11T(d)(6)) and are also members
of an EAG. For 2010, the adjusted basis of Y’s assets
that generate gross income attributable to DPGR and
to non-DPGR is, respectively, $21,000 and $24,000.
All of Y’s activities that generate DPGR are within
SIC Industry Group AAA (SIC AAA). All of Y’s ac-
tivities that generate non-DPGR are within SIC In-
dustry Group BBB (SIC BBB). None of X’s and Y’s
sales are to each other. Y 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
Y’s gross receipts, apportionment of CGS between
DPGR and non-DPGR based on gross receipts is ap-
propriate. For 2010, Y’s taxable income is $1,910
based on the following tax items:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
No
n-DPGR(allfromsalesofproductswithinSICBBB).............................................
$3
,000
CGSallocatedtoDPGR(includes$300ofW–2wages) .............................................($1,200)
CGSallocatedtonon-DPGR(includes$300ofW–2wages)..........................................($1,200)
Section162sellingexpenses(includes$300ofW–2wages)..........................................($840)
Section174R&E–SICAAA...................................................................
($100)
Section174R&E–SICBBB...................................................................
($200)
Interestexpense(notincludedinCGSandnotsubjectto§1.861–10T)..................................
($500)
Charitablecontributions.......................................................................
($50)
Y’staxableincome ..........................................................................
$1,910
(ii)QPAI.(A)X’s QPAI. Determination of X’s
QPAI is the same as inExample 1except that interest
is apportioned to gross income attributable to DPGR
based on the combined adjusted bases of X’s and Y’s
assets. See §1.861–11T(c). Accordingly, X’s QPAI
for 2010 is $1,410, as shown below:
2005–47 I.R.B.1032November 21, 2005

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGSallocatedtoDPGR(includes$300ofW–2wages) .............................................($600)
Section 162 selling expenses (includes $100 of W–2 wages)
$840 x ($3,000
DPGR/$6,000totalgrossreceipts))........................................
($420)
Interest expense (not included in CGS and not subject to §1.861–10T) ($300 x ($25,000 (tax book value of X’s
andY’sDPGRassets)/$50,000(taxbookvalueofX’sandY’stotalassets)))...................($150)
Charitable contributions (not included in CGS) ($180 x ($2,400 gross income attributable to DPGR/$3,600
totalgrossincome)) ................................................................
($120)
Section174R&E–SICAAA...................................................................
($300)
X’sQPAI..................................................................................
$1,410
(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 re-
ceipts). Y’s QPAI for 2010 is $1,005, as shown be-
low:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGSallocatedtoDPGR(includes$300ofW–2wages) .............................................($1,200)
Section 162 selling expenses (includes $300 of W–2 wages)
($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($420)
Interest expense (not included in CGS and not subject to §1.861–10T) ($500 x ($25,000 (tax book value of X’s
andY’sDPGRassets)/$50,000(taxbookvalueofX’sandY’stotalassets)))....................($250)
Charitable contributions (not included in CGS) ($50 x ($1,800 gross income attributable to DPGR/$3,600
totalgrossincome)) ................................................................
($25)
Section174R&E–SICAAA...................................................................
($100)
Y’sQPAI..................................................................................
$1,005
(iii)Section 199 deduction determination.The
section 199 deduction of the X and Y EAG is de-
ter
mined by aggregating theseparately determined
QPAI, taxable income, and W–2 wages of X and Y.
See §1.199–7(b). Accordingly, the X and Y EAG’s
ten
tative section 199 deduction is $217 (.09 x (lesser
of combined taxable incomes of X and Y of $3,290
(X’s taxable income of $1,380 plus Y’s taxable in-
co
me of $1,910) and combined QPAI of $2,415 (X’s
QPAI of $1,410 plus Y’s QPAI of $1,005)) subject to
the wage limitation of $600 (50% x ($300 (X’s W–2
wa
ges) + $900 (Y’s W–2 wages))). Accordingly, the
X and Y EAG’s section 199 deduction for 2010 is
$217. The $217 is allocated to X and Y in proportion
to
their QPAI. See §1.199–7(c).
(e
)Simplified deduction method—(1)
In
general. A taxpayer with average an-
n
ual gross receipts (as defined in para-
g
raph (g) of this section) of $25,000,000
o
r less, or total assets at the end of the
t
axable year (as defined in paragraph (h)
o
f this section) of $10,000,000 or less,
may use the simplified deduction method
to apportion deductions between DPGR
and non-DPGR. This paragraph does not
apply to CGS. Under the simplified de-
duction method, a taxpayer’s deductions
(except the net operating loss deduction
as provided in paragraph (c)(2)(ii) of this
section and deductions not attributable to
the actual conduct of a trade or business
as provided in paragraph (c)(2)(iii) of this
section) are ratably apportioned between
DPGR and non-DPGR based on relative
gross receipts. Accordingly, the amount of
deductions apportioned to DPGR is equal
to the same proportion of the total deduc-
tions that the amount of DPGR bears to
total gross receipts. Whether an owner
of a pass-thru entity may use the simpli-
fied deduction method is determined at the
level of the owner of the pass-thru en-
tity. Whether a trust or an estate may
use the simplified deduction method is de-
termined at the trust or estate level. In
the case of a trust or estate, the simpli-
fied deduction method is applied at the
trust or estate level, taking into account
the trust’s or estate’s DPGR, non-DPGR,
and other items from all sources, includ-
ing its distributive or allocable share of
those items of any lower-tier entity, prior
to any charitable or distribution deduc-
tion. In the case of an owner of any other
pass-thru entity, the simplified deduction
method is applied at the level of the owner
of the pass-thru entity taking into account
the owner’s DPGR, non-DPGR, and other
items from all sources including its dis-
tributive or allocable share of those items
of the pass-thru entity.
(2)Members of an expanded affiliated
group—(i)In general. Whether the mem-
bers of an EAG may use the simplified de-
duction method is determined by reference
to the average annual gross receipts and to-
tal assets of the EAG. If the average an-
nual gross receipts of the EAG are less than
or equal to $25,000,000 or the total assets
of the EAG at the end of its taxable year
are less than or equal to $10,000,000, each
member of the EAG may individually de-
termine whether to use the simplified de-
duction method, regardless of the cost allo-
cation method used by the other members.
(ii)Exception. Notwithstanding para-
graph (e)(2)(i) of this section, all members
of the same consolidated group must use
the same cost allocation method.
(iii)Examples. The following exam-
ples illustrate the application of paragraph
(e)(2) of this section:
Example 1. Corporations X, Y, and Z are the
o
nly three members of an EAG. Neither X, Y, nor
Z is a member of a consolidated group. X, Y, and
Z have average annual gross receipts of $2,000,000,
$
7,000,000, and $13,000,000, respectively. X, Y,
and Z each have total assetsat the end of the taxable
year of $5,000,000. Because the average annual
gross receipts of the EAG are less than or equal to
$25,000,000, each of X, Y,and Z may use either
the simplified deduction method or the section 861
method.
Example 2.ThefactsarethesameasinExample
1except that X and Y are members of the same con-
solidated group. X, Y, and Z may use either the sim-
plified deduction method or the section 861 method.
November 21, 200510332005–47 I.R.B.

However, X and Y must use the same cost allocation
method.
Example 3. ThefactsarethesameasinExam-
ple 1except that Z’s average annual gross receipts
are $17,000,000. Because the average annual gross
receipts of the EAG are greater than $25,000,000 and
the total assets of the EAG at the end of the taxable
year are greater than $10,000,000, X, Y, and Z must
each use the section 861 method.
(f)Small business simplified overall
method—(1)In general. A qualifying
small taxpayer may use the small business
simplified overall method to apportion
CGS and deductions between DPGR and
non-DPGR. Under the small business
simplified overall method, a taxpayer’s
total costs for the current taxable year (as
defined in paragraph (i) of this section)
are apportioned between DPGR and other
receipts based on relative gross receipts.
Accordingly, the amount of total costs
for the current taxable year apportioned
to DPGR is equal to the same proportion
of total costs for the current taxable year
that the amount of DPGR bears to total
gross receipts. In the case of a pass-thru
entity, whether the small business simpli-
fied overall method may be used by such
entity is determined at the pass-thru entity
level and, if such entity is eligible, the
small business simplified overall method
is applied at the pass-thru entity level.
(2)Qualifying small taxpayer. For pur-
poses of this paragraph (f), aqualifying
small taxpayeris—
(i) A taxpayer that has both average
annual gross receipts (as defined in para-
graph (g) of this section) of $5,000,000 or
less and total costs for the current taxable
year of $5,000,000 or less;
(ii) A taxpayer that is engaged in the
trade or business of farming that is not re-
quired to use the accrual method of ac-
counting under section 447; or
(iii) A taxpayer that is eligible to use
the cash method as provided in Rev. Proc.
2002–28, 2002–1 C.B. 815 (that is, cer-
tain taxpayers with average annual gross
receipts of $10,000,000 or less that are
not prohibited from using the cash method
under section 448, including partnerships,
S corporations, C corporations, or individ-
uals). See §601.601(d)(2) of this chapter.
(3)Members of an expanded affiliated
group—(i)In general. Whether the mem-
bers of an EAG may use the small busi-
ness simplified overall method is deter-
mined by reference to all the members of
the EAG. If both the average annual gross
receipts and the total costs for the cur-
rent taxable year of the EAG are less than
or equal to $5,000,000; the EAG, viewed
as a single corporation, is engaged in the
trade or business of farming that is not re-
quired to use the accrual method of ac-
counting under section 447; or the EAG,
viewed as a single corporation, is eligible
tousethecashmethodasprovidedinRev.
Proc. 2002–28, then each member of the
EAG may individually determine whether
to use the small business simplified over-
all method, regardless of the cost alloca-
tion method used by the other members.
(ii)Exception. Notwithstanding para-
graph (f)(3)(i) of this section, all members
of the same consolidated group must use
the same cost allocation method.
(iii)Examples. The following exam-
ples illustrate the application of paragraph
(f)(3) of this section:
Example 1. Corporations L, M, and N are the
only three members of an EAG. Neither L, M, nor
N is a member of a consolidated group. L, M, and N
have average annual gross receipts and total costs for
the current taxable year of $1,000,000, $1,500,000,
and $2,000,000, respectively. Because both the aver-
age annual gross receipts and total costs for the cur-
rent taxable year of the EAG are less than or equal to
$5,000,000, each of L, M, and N may use the small
business simplified overall method, the simplified de-
duction method, or the section 861 method.
Example 2. The facts are the same as inExam-
ple 1except that M and N are members of the same
consolidated group. L, M, and N may use the small
business simplified overall method, the simplified de-
duction method, or the section 861 method. However,
M and N must use the same cost allocation method.
Example 3. The facts are the same as inExample
1except that N has average annual gross receipts of
$4,000,000. Unless the EAG, viewed as a single cor-
poration, is engaged in the trade or business of farm-
ing that is not required to use the accrual method of
accounting under section 447, or the EAG, viewed as
a single corporation, is eligible to use the cash method
as provided in Rev. Proc. 2002–28, because the aver-
age annual gross receipts of the EAG are greater than
$5,000,000, L, M, and N are all ineligible to use the
small business simplified overall method.
(4)Ineligible pass-thru entities.Qual-
ifying oil and gas partnerships under
§1.199–3(h)(7), EAG partnerships under
§1.199–3(h)(8), and trusts and estates un-
der §1.199–5(d) may not use the small
business simplified overall method.
(g)Average annual gross receipts—(1)
In general. For purposes of the simplified
deduction method and the small business
simplified overall method, average annual
gross receipts means the average annual
gross receipts of the taxpayer for the 3 tax-
able years (or, if fewer, the taxable years
during which the taxpayer was in exis-
tence) preceding the current taxable year,
even if one or more of such taxable years
began before the effective date of section
199. In the case of any taxable year of less
than 12 months (a short taxable year), the
gross receipts shall be annualized by mul-
tiplying the gross receipts for the short pe-
riod by 12 and dividing the result by the
number of months in the short period.
(2)Members of an EAG. To compute
the average annual gross receipts of an
EAG, the gross receipts, for the entire tax-
able year, of each corporation that is a
member of the EAG at the end of its tax-
able year that ends with or within the tax-
able year of the computing member (as de-
scribed in §1.199–7(h)) are aggregated.
(h)Total assets—(1)In general.For
purposes of the simplified deduction
method provided by paragraph (e) of this
section, total assets means the total assets
the taxpayer has at the end of the taxable
year that are attributable to the taxpayer’s
trade or business. In the case of a C cor-
poration, the corporation’s total assets at
the end of the taxable year is the amount
requiredtobereportedonScheduleLof
the Form 1120, “United States Corpora-
tion Income Tax Return,” in accordance
with the Form 1120 instructions.
(2)Members of an EAG. To compute
the total assets at the end of the taxable
year of an EAG, the total assets, at the end
of its taxable year, of each corporation that
is a member of the EAG at the end of its
taxable year that ends with or within the
taxable year of the computing member are
aggregated.
(i)Total costs for the current taxable
year—(1)In general. For purposes of the
small business simplified overall method,
total costs for the current taxable year
means the total CGS and deductions (ex-
cluding the net operating loss deduction
as provided in paragraph (c)(2)(ii) of this
section and deductions not attributable
to the conduct of a trade or business as
provided in paragraph (c)(2)(iii) of this
section) for the current taxable year.
(2)Members of an EAG. To compute
the total costs for the current taxable year
of an EAG, the total costs for the entire
taxable year of each corporation that is a
memberoftheEAGattheendofthetax-
able year that ends with or within the tax-
able year of the computing member are ag-
gregated.
2005–47 I.R.B.1034November 21, 2005

§1.199–5 Application of section 199 to
pass-thru entities.
(a)Partnerships—(1)Determination at
partner level. The deduction allowable un-
der §1.199–1(a) (section 199 deduction) is
determined at the partner level. As a re-
sult, each partner must compute its deduc-
tion separately. For purposes of this sec-
tion, each partner is allocated, in accor-
dance with sections 702 and 704, its share
of partnership items (including items of in-
come, gain, loss, and deduction), cost of
goods sold (CGS) allocated to such items
of income, and gross receipts that are in-
cluded in such items of income, even if the
partner’s share of CGS and other deduc-
tions and losses exceeds domestic produc-
tion gross receipts (DPGR) (as defined in
§1.199–3(a)). A partnership may specially
allocate items of income, gain, loss, or de-
duction to its partners, subject to the rules
of section 704(b) and the supporting reg-
ulations. To determine its section 199 de-
duction for the taxable year, a partner gen-
erally aggregates its distributive share of
such items, to the extent they are not oth-
erwise disallowed by the Internal Revenue
Code, with those items it incurs outside the
partnership (whether directly or indirectly)
for purposes of allocating and apportion-
ing deductions to DPGR and computing
its qualified production activities income
(QPAI) (as defined in §1.199–1(c)). How-
ever, if a partnership uses the small busi-
ness simplified overall method described
in §1.199–4(f), then each partner is allo-
cated its share of QPAI and W–2 wages (as
defined in §1.199–2(f)), which (subject to
the limitation under section 199(d)(1)(B))
are combined with the partner’s QPAI and
W–2 wages from other sources. Under this
method, a partner’s distributive share of
QPAI from a partnership may be less than
zero.
(2)Disallowed deductions. Deductions
of a partnership that otherwise would be
taken into account in computing the part-
ner’s section 199 deduction are taken into
account only if and to the extent the part-
ner’s distributive share of those deduc-
tions from all of the partnership’s activi-
ties is not disallowed by section 465, 469,
704(d), or any other provision of the In-
ternal Revenue Code. If only a portion
of the partner’s distributive share of the
losses or deductions is allowed for a tax-
able year, a proportionate share of those
allowable losses or deductions that are al-
located to the partnership’s qualified pro-
duction activities, determined in a manner
consistent with sections 465, 469, 704(d),
and any other applicable provision of the
Internal Revenue Code, is taken into ac-
count in computing the section 199 deduc-
tion for that taxable year. To the extent
that any of the disallowed losses or deduc-
tions are allowed in a later taxable year, the
partner takes into account a proportionate
share of those losses or deductions in com-
puting its QPAI for that later taxable year.
(3)Partner’s share of W–2 wages.Un-
der section 199(d)(1)(B), a partner’s share
of W–2 wages of a partnership for pur-
poses of determining the partner’s section
199(b) limitation is the lesser of the part-
ner’s allocable share of those wages (with-
out regard to section 199(d)(1)(B)), or 2
times 9 percent (3 percent for taxable years
beginning in 2005 or 2006, and 6 per-
cent for taxable years beginning in 2007,
2008, or 2009) of the QPAI computed by
taking into account only the items of the
partnership allocated to the partner for the
taxable year of the partnership. In gen-
eral, this QPAI calculation is performed
by the partner using the same cost alloca-
tion method that the partner uses in cal-
culating the partner’s section 199 deduc-
tion. However, if a partnership uses the
small business simplified overall method
described in §1.199–4(f), the QPAI used
by each partner to determine the wage lim-
itation under section 199(d)(1)(B) is the
same as the share of QPAI allocated to the
partner. Each partner must compute its
share of W–2 wages from the partnership
in accordance with section 199(d)(1)(B)
(with W–2 wages being allocated to the
partner in the same manner as is wage ex-
pense), and then add that share to its W–2
wages from other sources, if any. The ap-
plication of section 199(d)(1)(B) therefore
means that if QPAI, computed by taking
into account only the items of the partner-
ship allocated to the partner for the taxable
year, is not greater than zero, the partner
may not take into account any W–2 wages
of the partnership in computing the part-
ner’s section 199 deduction. See §1.199–2
for the computation of W–2 wages, and
paragraph (f) of this section for rules re-
garding pass-thru entities in a tiered struc-
ture.
(4)Examples. The following examples
illustrate the application of this paragraph
(a). Assume that each partner has suf-
ficient adjusted gross income or taxable
income so that the section 199 deduction
is not limited under section 199(a)(1)(B);
that the partnership and each of its partners
(whether individual or corporate) are cal-
endar year taxpayers; and that the amount
of the partnership’s W–2 wages equals
wage expense for each taxable year. The
examples read as follows:
Example 1.Section 861 method with interest ex-
pense.(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 50% each. PRS is not
able to identify from its books and records CGS al-
locable to DPGR and non-DPGR. In this case, be-
cause CGS is definitely related under the facts and cir-
cumstances to all of PRS’s gross income, apportion-
ment of CGS between DPGR and non-DPGR based
on gross receipts is appropriate. For 2010, the ad-
justed basis of PRS business assets is $5,000, $4,000
of which generate gross income attributable to DPGR
and $1,000 of which generate gross income attribut-
able to non-DPGR. For 2010, PRS has the following
Federal income tax items:
November 21, 200510352005–47 I.R.B.

DPGR.....................................................................................
$3,000
Non-DPGR.................................................................................
$3,000
CGS(includes$200ofW–2wages).............................................................$3,240
Section 162 se
llingexpenses(includes$300ofW–2wages)..........................................
$1,200
Interestexpense(notincludedinCGS)...........................................................
$300
(ii)Allocation of PRS’s items of income, gain,
loss, deduction, or credit. X and Y each receive
the following distributive share of PRS’s items of in-
come, gain, loss, deduction or credit, as determined
under the principles of §1.704–1(b)(1)(vii):
Gross income attributable to DPGR ($1,500 (DPGR) - $810 (allocable CGS, includes $50
ofW–2wages))....................................................................
$690
Gross income attributable to non-DPGR ($1,500 (non-DPGR) - $810 (allocable CGS, includes $50
ofW–2wages))....................................................................
$690
Section162sellingexpenses(includes$150ofW–2wages)..........................................$600
Interest
expense(notincludedinCGS)...........................................................
$150
(iii)De
termination of QPAI.(A)X’s QPAI.Be-
cause the section 199 deduction is determined at the
partner level, X determines its QPAI by aggregating,
to the e
xtent necessary, its distributive share of PRS’s
Federal income tax items with all other such items
from all other, non-PRS-related activities. For 2010,
Xdoesn
ot have any other such items. For 2010, the
adjusted basis of X’s non-PRS assets, all of which
are inve
stment assets, is $10,000. X’s only gross re-
ceipts for 2010 are those attributable to the allocation
of gross income from PRS. X allocates and apportions
its ded
uctible items to gross income attributable to
DPGR under the section 861 method of §1.199–4(d).
In this case, the section 162 selling expenses (includ-
ing W–2
wages) are definitely related to all of PRS’s
gross receipts. Based on the facts and circumstances
of this s
pecific 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 dis
tributive share of interest expense under the tax
book value method of §1.861–9T(g). X’s QPAI for
2010 is $366, as shown below:
DPGR.....................................................................................
$1,50
0
CGSallocabletoDPGR(includes$50ofW–2wages) ..............................................($810)
Section162sellingexpenses(includes$75ofW–2wages)($600x$1,500/$3,000)........................($300)
Interest expense (not included in CGS) ($150 x $2,000 (X’s share of PRS’s DPGR assets)/
$12,500(X’snon-PRSassetsandX’sshareofPRSassets)).................................($24)
X’sQPAI..................................................................................
$366
(B)Y’s QPAI.(1) For 2010, in addition to the ac-
tivities 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 produc-
tion 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 ac-
tivities:
Gross income attributable to DPGR ($1,500 (DPGR) - $900 (allocable CGS, includes $70
ofW–2wages))....................................................................
$600
Gross income attributable to non-DPGR ($3,000 (other gross receipts) - $1,620 (allocable CGS, includes
$
150ofW–2wages))...............................................................
$
1,380
Section162sellingexpenses(includes$30ofW–2wages)...........................................$540
Interestexpense(notincludedinCGS)...........................................................
$90
(2) Y determines its QPAI in the same general
manner as X. However, because Y has activities out-
side 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 sec-
tion 861 method of §1.199–4(d). In this case, Y’s dis-
tributive share of PRS’s section 162 selling expenses
(including W–2 wages), as well as those selling ex-
penses from Y’s non-PRS activities, are definitely re-
lated 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 is appropriate. Y elects
to apportion its distributive share of interest expense
under the tax book value method of §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 below:
2005–47 I.R.B.1036November 21, 2005

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 activities) (includes $120 of W–2 wages) . . .($1,710)
Section 162 selling expenses (includes $180 of W–2 wages)
($1,140 ($600
from PRS and $540 from non-PRS activities) x
($1,500 PRS DPGR + $1,500 non-PRS DPGR)/($3,000 PRS
total gross receipts + $4,500 non-PRS total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($456)
Interest expense (not included in CGS) ($240 ($150 from PRS and $90 from non-PRS activities) x
$10,000 (Y’s non-PRS DPGR assets and Y’s share of PRS DPGR
assets)/$12,500(Y’snon-PRSassetsandY’sshareofPRSassets))...........................($192)
Y’sQPAI..................................................................................
$642
(iv)PRS W–
2wagesallocatedtoXandYunder
section 199(d)(1)(B). Solely for purposes of calculat-
ing the PRS W–2 wages that are allocated to them
under sec
tion 199(d)(1)(B) for purposes of the wage
limitation of section 199(b), X and Y must separately
determine QPAI taking into account only the items of
PRS alloc
ated to them. X and Y must use the same
methods of allocation and apportionment that they
use to dete
rmine their QPAI in paragraphs (iii)(A)
and (B) of thisExample 1, respectively. Accord-
ingly, X and Y must apportion deductible section 162
selling e
xpenses which includes W–2 wage expense
on the basis of gross receipts, and apportion interest
expense according to the tax book value method of
§1.861–9
T(g).
(A)QPAIof
X and Y, solely for this purpose, is
determined by allocating and apportioning each part-
ner’s share of PRS expenses to each partner’s share
of PRS gro
ss income of $690 attributable to DPGR
($1,500 DPGR - $810 CGS, apportioned based on
gross receipts). Thus, QPAI of X and Y solely for
this purp
ose is $270, as shown below:
DPGR.....................................................................................
$1,500
CGSallocabletoDPGR ......................................................................
($810)
Section162sellingexpenses(includingW–2wages)($600x($1,500/$3,000))...........................($300)
Interest expense (not included in CGS) ($150 x $2,000 (partner’s share of adjusted basis of
PRS’sDPGRassets)/$2,500(partner’sshareofadjustedbasisoftotalPRSassets))..............($120)
QPAI......................................................................................
$270
(B) X’s and Y’s shares of PRS’s W–2 wages de-
termined under section 199(d)(1)(B) for purposes of
the wage limitation of section 199(b) are $49, the
lesser of $250 (partner’s allocable share of PRS’s
W–2 wages ($100 included in CGS, and $150 in-
cluded in selling expenses) and $49 (2 x ($270 x .09)).
(v)Section 199 deduction determination. (A) X’s
tentative section 199 deduction is $33 (.09 x $366
(that is, QPAI determined at partner level)) subject to
the wage limitation of $25 (50% x $49). Accordingly,
X’s section 199 deduction for 2010 is $25.
(B) Y’s tentative section 199 deduction is $58 (.09
x $642 (that is, QPAI determined at the partner level)
subject to the wage limitation of $150 (50% x ($49
(from PRS)) and $250 (from non-PRS activities)).
Accordingly, Y’s section 199 deduction for 2010 is
$58.
Example 2.Section 861 method with R&E ex-
pense.(i)Partnership items of income, gain, loss, de-
duction or credit. X and Y, unrelated United States
corporations, are partners in PRS, a partnership that
engages in production activities that generate both
DPGR and non-DPGR. Neither X nor Y is a mem-
ber of an affiliated group. X and Y share all items of
income, gain, loss, deduction, and credit 50% each.
All of PRS’s domestic production activities that gen-
erate DPGR are within Standard Industrial Classifi-
cation (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 and, therefore,
apportions CGS to DPGR and non-DPGR based on
its gross receipts. 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 §1.861–17(a)(4) and
none is included in CGS. PRS incurs section 162 sell-
ing expenses (that include W–2 wage expense) that
are not includible in CGS and not directly allocable
to any gross income. For 2010, PRS has the follow-
ing Federal income tax items:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
Non-DPGR(allfromsalesofproductswithinSICBBB).............................................
$3,000
CGS(includes$200ofW–2wages).............................................................$2,400
Section162sellingexpenses(includes$100ofW–2wages)..........................................$840
Section174R&E–SICAAA...................................................................
$300
S
ection174R&E–SICBBB...................................................................
$
600
(ii)Allocation of PRS’s items of income, gain,
loss, deduction, or credit. X and Y each receive
the following distributive share of PRS’s items of in- come, gain, loss, deduction, or credit, as determined
under the principles of §1.704–1(b)(1)(vii):
November 21, 200510372005–47 I.R.B.

Gross income attributable to DPGR ($1,500 (DPGR) - $600 (CGS, includes $50 of W–2 wages)) . . . . . . . . . . . .$900
Gross income attributableto non-DPGR ($1,500 (other gross receipts) - $600
(CGS,includes$50ofW–2wages))....................................................$900
Section 162 se
llingexpenses(includes$50ofW–2wages)...........................................
$420
Section174R&E–SICAAA...................................................................
$150
Section174R&E–SICBBB...................................................................
$300
(iii)Determination of QPAI.(A)X’s QPAI.Be-
cause the section 199 deduction is determined at the
partner level, X determines its QPAI by aggregat-
ing, to the extent necessary, its distributive shares 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 gen-
erate DPGR are within SIC AAA. X allocates and
apportions its deductible items to gross income at-
tributable to DPGR under the section 861 method of
§1.199–4(d). In this case, the section 162 selling ex-
penses (including W–2 wages) 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 §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 determin-
ingX’sQPAI.Thus,X’stotalQPAIfor2010is$540,
as shown below:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,500
CGS(includes$50ofW–2wages)..............................................................($600)
Section 162 selling expenses (including W–2 wages) ($420 x ($1,500 DPGR/$3,000 total gross receipts)). . . . . .($210)
Section174R&E–SICAAA...................................................................
($150)
X’sQPAI..................................................................................
$540
(B)Y’s QPAI.(1) For 2010, in addition to the ac-
tivities 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 al-
locabletoDPGRandtonon-DPGR.Inthiscase,be-
cause CGS is definitely related under the facts and cir-
cumstances to all of Y’s non-PRS gross receipts, ap-
portionment of 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 in-
come tax items:
DPGR(fromsalesofproductswithinSICAAA)...................................................
$1,500
DPGR (from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,500
Non-DPGR (from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGS(allocatedtoDPGRwithinSICAAA)(includes$56ofW–2wages)...............................$750
CGS (allocated to DPGR within SIC BBB) (includes $56 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$750
CGS (allocated to non-DPGR within SIC BBB) (includes $113 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . .$1,500
Section162sellingexpenses(includes$30ofW–2wages)...........................................$540
Section174R&E–SICAAA...................................................................
$300
Section174R&E–SICBBB...................................................................
$450
(2) Because Y has DPGR as a result of activi-
ties 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 activ
ities.
Y allocates and apportions its deductible items to
gross income attributable to DPGR under the section
861 method of §1.199–4(d). In this case, the sect
ion
162 selling expenses (including W–2 wages) are
definitely related to all of Y’s gross income. Based
on the facts and circumstances of the specific c
ase,
apportionment of such expenses between DPGR
and non-DPGR on the basis of Y’s gross receipts
is appropriate. For purposes of apportioning R&E,
Y elects to use the sales method as described in
§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 a
ll
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 ta
ken
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 below:
DPGR ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities . . . . . . . . . . . . . . . . . . . . . . . . . . . .$4,500
CGS($600fromsalesofproductsbyPRSand$1,500fromnon-PRSactivities...........................($2,100)
Section 162 selling expenses (including W–2 wages) ($420 from PRS + $540 from non-PRS activities) x
($4,500 DPGR/$9,000 total gross receipts)). . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($480)
Section 174 R&E–SIC AAA ($150 from PRS and $300 from non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . .($450)
Section 174 R&E–SIC BBB ($300 from PRS + $450 from non-PRS activities) x ($1,500 DPGR/$6,000
total gross receipts allocated to SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
($188)
Y’sQPAI..................................................................................
$1,282
2005–47 I.R.B.1038November 21, 2005

(iv)PRSW–2wagesallocatedtoXandYun-
der section 199(d)(1)(B). Solely for purposes of cal-
culating the PRS W–2 wages that are allocated to X
and Y under section 199(d)(1)(B) for purposes of the
wage limitation of section 199(b), X and Y must sep-
arately determine QPAI taking into account only the
items of PRS allocated to them. X and Y must use
the same methods of allocation and apportionment
that they use to determine their QPAI in paragraphs
(iii)(A) and (B) of thisExample 2, respectively. Ac-
cordingly, X and Y must apportion section 162 sell-
ing expense which includes W–2 wage expense on
the basis of gross receipts, and apportion section 174
R&E expense under the sales method as described in
§1.861–17(c).
(A)QPAIofXandY,solelyforthispurpose,is
determined by allocating and apportioning each part-
ner’s share of PRS expenses to each partner’s share
of PRS gross income of $900 attributable to DPGR
($1,500 DPGR - $600 CGS, allocated based on PRS’s
gross receipts). Because all of PRS’s SIC AAA sales
generate DPGR, all of X’s and Y’s shares of PRS’s
section 174 R&E attributable to SIC AAA is taken
into account for purposes of determining X’s and Y’s
QPAI. None of PRS’s section 174 R&E attributable
to SIC BBB is taken into account because PRS has
no DPGR within SIC BBB. Thus, X and Y each has
QPAI, solely for this purpose, of $540, as shown be-
low:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,500
CGS(includes$50ofW–2wages...............................................................($600)
Section162sellingexpenses(includingW–2wages)($420x$1,500/$3,000)............................($210)
Section174R&E–SICAAA...................................................................
($150)
QPAI......................................................................................
$540
(B) X’
sandY’ssharesofPRS’sW–2wagesde-
termined under section 199(d)(1)(B) for purposes of
the wage limitation of section 199(b) are $97, the
lesse
r of $150 (partner’s allocable share of PRS’s
W–2 wages ($100 included in CGS, and $50 included
in selling expenses)) and $97 (2 x ($540 x .09)).
(v)S
ection 199 deduction determination. (A) X’s
tentative section 199 deduction is $49 (.09 x $540
(QPAI determined at partner level)) subject to the
wage
limitation of $49 (50% x $97). Accordingly,
X’s section 199 deduction for 2010 is $49.
(B) Y’s tentative section 199 deduction is $115
(.09
x $1,282 (QPAI determined at partner level) sub-
ject to the wage limitation of $176 (50% x $352 ($97
from PRS + $255 from non-PRS activities)). Accord-
ing
ly, Y’s section 199 deduction for 2010 is $115.
Example 3.Simplified deduction method with
special allocations.(i)In general.XandYare
unr
elated corporate partners in PRS. PRS engages in
a domestic production activity and other activities.
In general, X and Y share all partnership items of
inc
ome, 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 (substantial economic effect under section
704(b) is presumed). 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
o
f deductions (comprised of $2,000 of wages for
marketing and $1,000 of other expenses). X qualifies
for and uses the simplified deduction method under
§
1.199–4(e). Y does not qualify to use that method
and therefore, must use the section 861 method under
§1.199–4(d). In the 2010 taxable year, X has gross
r
eceipts attributable to non-partnership activities of
$1,000 and wages of $200. None of X’s non-PRS
gross receipts is DPGR.
(ii)Allocation and apportionment of costs. Under
the partnership agreement, X’s distributive share of
the items of the partnership is $1,250 of gross income
attributable to DPGR ($3,000 DPGR - $1,750 alloca-
ble 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 for market-
ing and $200 of other expenses). Under the simpli-
fied deduction method, X apportions $1,200 of other
deductions to DPGR ($2,000 ($1,800 from the part-
nersh
ip and $200 from non-partnership activities) x
($3,000 DPGR/$5,000 totalgross receipts)). Accord-
ingly, X’s QPAI is $50 ($3,000 DPGR - $1,750 CGS
- $1,2
00 of deductions). However, in determining the
section 199(d)(1)(B) wage limitation, QPAI is com-
puted taking into account only the items of the part-
ners
hip allocated to the partner for the taxable year of
the partnership. Thus, X apportions $1,350 of deduc-
tions to DPGR ($1,800 x ($3,000 DPGR/$4,000 total
gros
s receipts from PRS)). Accordingly, X’s QPAI for
purposes of the section 199(d)(1)(B) wage limitation
is $0 ($3,000 DPGR - $1,750 CGS - $1,350 of de-
duc
tions).X’sshareofPRS’sW–2wagesis$0,the
lesser of $1,600 (X’s 80% allocable share of $2,000
of wage expense for marketing) or $0 (2 x ($0 QPAI
x.0
9)). X’s tentative deduction is $5 ($50 QPAI x
.09), subject to the section 199(b)(1) wage limitation
of $100 (50% x $200 ($0 of PRS-related W–2 wages
+$
200 of non-PRS W–2 wages)). Accordingly, X’s
total section 199 deduction for the 2010 taxable year
is $5.
Ex
ample 4.Small business simplified overall
method. A, an individual, and X, a corporation,
are partners in PRS. PRS engages in manufacturing
ac
tivities that generate both DPGR and non-DPGR.
A and X share all items of income, gain, loss, de-
duction, and credit equally. In the 2010 taxable year,
P
RS has total gross receipts of $2,000 ($1,000 of
which is DPGR), CGS of $800 (including $400 of
W–2 wages), and deductions of $800. A and PRS use
t
he small business simplified overall method under
§1.199–4(f). X uses the section 861 method. Under
the small business simplified overall method, PRS’s
CGS and deductions apportioned to DPGR equal
$800 (($800 CGS plus $800 of other deductions) x
($1,000 DPGR/$2,000 totalgross receipts)). Accord-
ingly, PRS’s QPAI is $200 ($1,000 DPGR - $800
CGS and other deductions). Under the partnership
agreement, PRS’s QPAI is allocated $100 to A and
$100toX.A’sshareofpartnership W–2 wages for
purposes of the section 199(d)(1)(B) limitation is
$18, the lesser of $200 (A’s 50% allocable share of
PRS’s $400 of W–2 wages) or $18 (2 x ($100 QPAI
x .09)). A’s tentative deduction is $9 ($100 QPAI x
.09), subject to the section 199(b)(1) wage limitation
of $9 (50% x $18). Assuming that A engages in no
other activities generating DPGR, A’s total section
199 deduction for the 2010 taxable year is $9. X
must use $100 of QPAI and $18 of W–2 wages to
deter
mine its section 199 deduction using the section
861 method.
(b)S corporations—(1)Determination
at shareholder level. The section 199 de-
duction is determined at the shareholder
level. As a result, each shareholder must
compute its deduction separately. For pur-
poses of this section, each shareholder is
allocated, in accordance with section 1366,
itspro ratashare 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 share-
holder’s share of CGS and other deduc-
tions and losses exceeds DPGR. To de-
termine its section 199 deduction for the
taxable year, the shareholder generally ag-
gregates itspro ratashare of such items,
to the extent they are not otherwise disal-
lowed by the Internal Revenue Code, with
those items it incurs outside the S cor-
poration (whether directly or indirectly)
for purposes of allocating and apportion-
ing deductions to DPGR and computing
its QPAI. However, if an S corporation
uses the small business simplified over-
all method described in §1.199–4(f), then
each shareholder is allocated its share of
QPAI and W–2 wages, which (subject to
the limitation under section 199(d)(1)(B))
are combined with the shareholder’s QPAI
and W–2 wages from other sources. Un-
der this method, a shareholder’s share of
QPAI from an S corporation may be less
than zero.
(2)Disallowed deductions. Deductions
of the S corporation that otherwise would
be taken into account in computing the
shareholder’s section 199 deduction are
taken into account only if and to the ex-
tent the shareholder’spro ratashare of the
November 21, 200510392005–47 I.R.B.

losses or deductions from all of the S cor-
poration’s activities are not disallowed by
section 465, 469, 1366(d), or any other
provision of the Internal Revenue Code.
If only a portion of the shareholder’spro
ratashare of the losses or deductions is al-
lowed for a taxable year, a proportionate
share of the losses or deductions allocated
to the S corporation’s qualified production
activities, determined in a manner consis-
tent with sections 465, 469, 1366(d), and
any other applicable provision of the In-
ternal Revenue Code, is taken into account
in computing the section 199 deduction for
that taxable year. To the extent that any
of the disallowed losses or deductions is
allowed in a later taxable year, the share-
holder takes into account a proportionate
share of those losses or deductions in com-
puting its QPAI for that later taxable year.
(3)Shareholder’s share of W–2 wages.
Under section 199(d)(1)(B), an S corpora-
tion shareholder’s share of the W–2 wages
of the S corporation for purposes of de-
termining the shareholder’s section 199(b)
limitation is the lesser of the shareholder’s
allocable share of those wages (without re-
gard to section 199(d)(1)(B)), or 2 times
9 percent (3 percent for taxable years be-
ginning in 2005 or 2006, and 6 percent
for taxable years beginning in 2007, 2008,
or 2009) of the QPAI computed by taking
into account only the items of the S corpo-
ration allocated to the shareholder for the
taxable year. In general, this QPAI calcula-
tion is performed by the shareholder using
the same cost allocation method that the
shareholder uses in calculating the share-
holder’s section 199 deduction. However,
if an S corporation uses the small busi-
ness simplified overall method described
in §1.199–4(f), the QPAI used by each
shareholder to determine the wage limi-
tation under section 199(d)(1)(B) is the
same as the share of QPAI allocated to
the shareholder. Each shareholder must
compute its share of W–2 wages from an
S corporation in accordance with section
199(d)(1)(B) (with W–2 wages being allo-
cated to the shareholder in the same man-
ner as is wage expense), and then add
that share to the shareholder’s W–2 wages
from other sources, if any. The application
of section 199(d)(1)(B) therefore means
that if QPAI, computed by taking into ac-
count only the items of the S corporation
allocated to the shareholder for the taxable
year, is not greater than zero, the share-
holder may not take into account any W–2
wages of the S corporation in computing
the shareholder’s section 199 deduction.
See §1.199–2 for the computation of W–2
wages, and paragraph (f) of this section for
rules regarding pass-thru entities in a tiered
structure.
(c)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, the
owner computes its QPAI with respect to
the owned portion of the trust as if that
QPAI had been generated by activities per-
formed directly by the owner. Similarly,
for purposes of the section 199(b) wage
limitation, the owner of the trust takes
into account the owner’s share of the W–2
wages of the trust that are attributable to
the owned portion of the trust. The section
199(d)(1)(B) wage limitation is not appli-
cable to the owned portion of the trust.
(d)Non-grantor trusts and estates—(1)
Computation of section 199 deduction.
Except as provided in paragraph (c) of
this section, solely for purposes of de-
termining the section 199 deduction for
the taxable year, the QPAI of a trust or
estate must be computed by allocating
expenses described in section 199(d)(5)
under §1.652(b)–3 with respect to directly
attributable expenses, and under the sim-
plified deduction method of §1.199–4(e)
with respect to other expenses described
in section 199(d)(5) (unless the trust or es-
tate does not qualify to use the simplified
deduction method, in which case it must
use the section 861 method of §1.199–4(d)
with respect to such other expenses). For
this purpose, the trust’s or estate’s share of
other expenses from a lower-tier pass-thru
entity is not directlyattributable 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 §1.199–4(f)(4).
The QPAI (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 the
trust or estate are allocated to each ben-
eficiary and to the trust or estate based
on the relative proportion of the trust’s or
estate’s distributable net income (DNI), as
defined by section 643(a), for the taxable
year that is distributed or required to be
distributed to the beneficiary or is retained
by the trust or estate. To the extent that
the trust or estate has no DNI for the tax-
able year, any QPAI and W–2 wages are
allocated entirely to the trust or estate. A
trust or estate may claim 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 ben-
eficiary 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 of
section 199(d)(1)(B)) are aggregated with
the beneficiary’s QPAI and W–2 wages
from other sources. Each beneficiary
must compute its share of W–2 wages
from a trust or estate in accordance with
section 199(d)(1)(B). The application of
section 199(d)(1)(B) therefore means that
if QPAI, computed by taking into account
only the items of the trust or estate allo-
cated to the beneficiary for the taxable
year, is not greater than zero, the benefi-
ciary may not take into account any W–2
wages of the trust or estate in computing
the beneficiary’s section 199 deduction.
See paragraph (f) of this section for rules
applicable to pass-thru entities in a tiered
structure.
(2)Example. The following example
illustrates the application of this paragraph
(d). Assume that the partnership, trust,
and trust beneficiary all are calendar year
taxpayers. The example is as follows:
Example.(i)Computation of DNI and inclusion
and deduction amounts.(A)Trust’s distributive
share of partnership items.Trust,acomplextrust,is
a partner in PRS, a partnership that engages in activ-
ities that generate DPGR and non-DPGR. In 2010,
PRS distributes $10,000 to Trust. Trust’s distributive
share of PRS items, which are properly included in
Trust’s DNI, is as follows:
2005–47 I.R.B.1040November 21, 2005

Gross income attributable to DPGR ($15,000 DPGR - $5,000 CGS (including W–2 wages of $1,000)) . . . . . . . .$10,000
Gross income attributable to other gross receipts ($5,000 other gross receipts - $0 CGS). . . . . . . . . . . . . . . . . . . .$5,000
Selling expenses (includes W–2 wages of $2,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$3,000
Other expense
s(includesW–2wagesof$1,000)...................................................
$2,000
(B)Trust’s direct activities. In addition to receiv-
ing in 2010 the distribution from PRS, Trust also di-
rectly has the following items which are properly in-
cluded in Trust’s DNI:
Dividends..................................................................................
$10,000
Tax-exemptinterest..........................................................................
$10,000
Rentsfromcommercialrealpropertythatissubjecttoasection6166election............................
$10,000
Realestatetaxes.............................................................................
$1,000
Trusteecommissions.........................................................................
$3,000
Stateincomeandpersonalpropertytaxes.........................................................
$5,000
W–2wages ................................................................................
$2,000
Otherbusinessexpenses ......................................................................
$1,000
(C)All
ocation of deductions under §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 un-
der §1.652(b)–3(a) to the distributive share of income
of PRS. Accordingly, the $20,000 of gross receipts
from P
RS is reduced by $5,000 of CGS, $3,000
of selling expenses, and $2,000 of other expenses,
resulting in net income from PRS of $10,000. With
resp
ect to the Trust’s direct expenses, $1,000 of the
trustee commissions, the $1,000 of real estate taxes,
and the $2,000 of W–2 wages are directly attributable
unde
r §1.652(b)–3(a) to the rental income.
(2)Non-directly attributable expenses. Under
§1.652(b)–3(b), the trustee must allocate a portion
of th
e 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 §1.652(b)–3(b), the
tr
ustee 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
20
10, Trust has DNI of $28,000 (net dividend in-
come 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
T
rust. Assume that there are no separate shares un-
der Trust, and no distributions are made to any other
beneficiary that year. Consequently, with respect to
the $14,000 distribution, 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 comput-
ing its taxable income.
(ii)Se
ction 199 deduction.(A)Simplified deduc-
tion method. For purposes of computing the section
199 deduction for the taxable year, assume Trust
quali
fies for the simplified deduction method under
§1.199–4(e). Determining Trust’s QPAI under the
simplified deduction method requires a multi-step
appro
ach to allocating costs. In step 1, the Trust’s
DPGR is first reduced by the Trust’s expenses di-
rectly attributable to DPGR under §1.652(b)–3(a). In
this
step, the $15,000 of DPGR from PRS is reduced
by the directly attributable $5,000 of CGS and sell-
ing expenses of $3,000. In step 2, Trust allocates its
othe
r business expenses on the basis of its total gross
receipts. In this example,the portion of the trustee
commissions not directly attributable to the rental op-
era
tion, as well as the portion of the state income and
personal property taxes not directly attributable to ei-
ther the PRS interests or the rental operation, are not
tra
de or business expenses and, thus, are ignored in
computing QPAI. The portion of the state income and
personal property taxes that is treated as other trade
or
business expenses is $3,000 ($5,000 x $30,000
total trade or business gross receipts/$50,000 total
gross receipts). Trust thencombines its non-directly
at
tributable (other) expenses ($2,000 from PRS +
$4,000 ($1,000 + $3,000) from its own activities)
and then apportions this total between DPGR and
o
ther receipts on the basis of Trust’s total gross re-
ceipts ($6,000 x $15,000 DPGR/$50,000 total gross
receipts = $1,800). Thus, for purposes of computing
T
rust’s and B’s section 199 deduction, Trust’s QPAI
is $5,200 ($7,000 - $1,800). Because the distribution
of Trust’s DNI to B equals one-half of Trust’s DNI,
T
rust and B each has QPAI from PRS for purposes
of the section 199 deduction of $2,600.
(B)Section 199(d)(1)(B) wage limitation.The
wage limitation under section 199(d)(1)(B) must be
applied both at the Trust level and at B’s level. Af-
ter applying this limitation to the Trust’s share of
PRS’s W–2 wages, Trust is allocated $990 of W–2
wages from PRS (the lesser of Trust’s allocable share
of PRS’s W–2 wages ($4,000) or 2 x 9% of PRS’s
QPAI ($5,500)). PRS’s QPAI for purposes of the sec-
tion 199(d)(1)(B) limitation is determined by taking
into account only the items of PRS allocated to Trust
($15,000 DPGR - ($5,000 of CGS + $3,000 selling
expenses + $1,500 of other expenses). For this pur-
pose, t
he $1,500 of other expenses is determined by
multiplying $2,000 of other expenses from PRS by
$15,000 of DPGR from PRS, divided by $20,000 of
total
gross receipts from PRS. Trust adds this $990
of W–2 wages to Trust’s own $2,000 of W–2 wages
(thus, $2,990). Because the $14,000 distribution to
B equa
ls one-half of Trust’s DNI, Trust and B each
has W–2 wages of $1,495. After applying the sec-
tion 199(d)(1)(B) wage limitation to B’s share of the
W–2 w
ages allocated from Trust, B has W–2 wages
of $468 from Trust (lesser of $1,495 (allocable share
of W–2 wages) or 2 x .09 x $2,600 (Trust’s QPAI)).
Bhas
W–2 wages of $100 from non-Trust activities
for a total of $568 of W–2 wages.
(C)Section 199 deduction computation.(1)B’s
comp
utation. B is eligible to use the small business
simplified overall method. Assume that B has suf-
ficient adjusted gross income so that the section 199
ded
uction is not limited under section 199(a)(1)(B). B
has $1,000 of QPAI from non-Trust activities which
is added to the $2,600 QPAI from Trust for a total
of $
3,600 of QPAI. B’s tentative deduction is $324
(.09 x $3,600) which is limited under section 199(b)
to $284 (50% x $568 W–2 wages). Accordingly, B’s
se
ction 199 deduction for 2010 is $284.
(2)Trust’s computation. Trust has sufficient tax-
able income so that the section 199 deduction is not
li
mited under section 199(a)(1)(B). Trust’s tentative
deduction is $234 (.09 x $2,600 QPAI) which is lim-
ited under section 199(b) to $748 (50% x $1,495 W–2
wa
ges). Accordingly, Trust’s section 199 deduction
for 2010 is $234.
(e)Gain or loss from the disposition of
an interest in a pass-thru entity.DPGR
generally does not include gain or loss rec-
ognized on the sale, exchange, or other dis-
position of an interest in a pass-thru entity.
However, with respect to partnerships, if
section 751(a) or (b) applies, gain or loss
attributable to assets of the partnership giv-
ing 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
November 21, 200510412005–47 I.R.B.

the partner’s section 199 deduction. Ac-
cordingly, to the extent that money or prop-
erty received by a partner in a sale or ex-
change for all or part of its partnership in-
terest is attributable to unrealized receiv-
ables or inventory items within the mean-
ing 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 or exchanged or oth-
erwise disposed of by the partnership, the
money or property received 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 or ex-
changed by the partnership, the deemed
sale or exchange of the property must be
taken into account in determining the part-
nership’s and distributee partner’s DPGR.
See §1.751–1(b).
(f)Section 199(d)(1)(B) wage limita-
tion and tiered structures—(1)In general.
If a pass-thru entity owns an interest, di-
rectly or indirectly, in one or more pass-
thru entities, the wage limitation of section
199(d)(1)(B) must beapplied at each tier
(that is, separately for each entity). Thus,
at each tier, the owner of a pass-thru en-
tity calculates the amounts described in
sections 199(d)(1)(B)(i) (allocable share)
and 199(d)(1)(B)(ii) (twice the applicable
percentage of QPAI from that entity) sep-
arately with regard to its interest in that
pass-thru entity.
(2)Share of W–2 wages. For purposes
of section 199(d)(1)(B)(i) and section
199(b), the W–2 wages of the owner of
an interest in a pass-thru entity (upper-tier
entity) that owns an interest in one or more
pass-thru entities (lower-tier entities) are
equal to the sum of the owner’s allocable
share of W–2 wages of the upper-tier en-
tity, as limited in accordance with section
199(d)(1)(B), and the owner’s own W–2
wages. The upper-tier entity’s W–2 wages
are equal to the sum of the upper-tier en-
tity’s allocable share of W–2 wages of the
next lower-tier entity, as limited in accor-
dance with section 199(d)(1)(B), and the
upper-tier entity’s own W–2 wages. The
W–2 wages of each lower-tier entity in a
tiered structure, in turn, is computed as
described in the preceding sentence. Al-
though all wages paid during that taxable
year are taken intoaccount in computing
QPAI, only the W–2 wages as described in
§1.199–2 are taken into account in com-
puting the W–2 wage limitation.
(3)Example. The following example
illustrates the application of this paragraph
(f). Assume that each partnership and each
partner (whether or not an individual) is a
calendar year taxpayer. The example is as
follows:
Example. (i) In 2010, A, an individual, owns a
50% interest in a partnership, UTP, which in turn
owns a 50% interest in another partnership, LTP.
All partnership items are allocated in proportion to
these ownership percentages. Both partnerships are
eligible for and use the small business simplified
overall method under §1.199–4(f). LTP has QPAI
of $400 ($900 DPGR - $450 CGS (which includes
W–2 wages of $100) - $50 other deductions). Before
taking into account its distributive share from LTP,
UTP has QPAI of ($500) ($500 DPGR - $500 CGS
(which includes W–2 wages of $200) - $500 other
deductions). UTP’s distributive share of LTP’s QPAI
is $200.
(ii) UTP’s share of LTP’s W–2 wages for pur-
poses of the section 199(d)(1)(B) limitation is $36,
the lesser of $50 (UTP’s allocable share of LTP’s
W–2 wages paid) or $36 (2 x ($200 QPAI x .09)). Af-
ter taking into account its distributive share from LTP,
UTP has QPAI of ($300) and W–2 wages of $236. A’s
distributive share of UTP’s QPAI is ($150). A’s limi-
tation under section 199(d)(1)(B) with respect to A’s
interest in UTP is $0, the lesser of $118 (A’s allocable
share of UTP’s W–2 wages paid) or $0 (because A’s
share of QPAI, ($150), is less than zero).
(g)No attribution of qualified activi-
ties. Except as provided in §1.199–3(h)(7)
regarding certain qualifying oil and gas
partnerships and §1.199–3(h)(8) regarding
EAG partnerships, for purposes of section
199, an owner of a pass-thru entity is not
treated as conducting the qualified produc-
tion activities of the pass-thru entity, and
vice versa. This rule applies to all part-
nerships, including partnerships that have
elected out of subchapter K under sec-
tion 761(a). Accordingly, if a partnership
MPGE QPP within the United States, or
otherwise produces a qualified film or util-
ities in the United States, and distributes
or leases, rents, licenses, sells, exchanges,
or otherwise disposes of the property to
a partner who then leases, rents, licenses,
sells, exchanges, or otherwise disposes
of the property, the partner’s gross re-
ceipts from this latter lease, rental, license,
sale, exchange, or other disposition are
not treated as DPGR under §1.199–3. In
addition, if a partner MPGE QPP within
the United States, or otherwise produces
a qualified film or utilities in the United
States, and contributes or leases, rents,
licenses, sells, exchanges, or otherwise
disposes of the property to a partnership
which then leases, rents, licenses, sells,
exchanges, or otherwise disposes of the
property, the partnership’s gross receipts
from this latter disposition are not treated
as DPGR under §1.199–3.
§1.199–6 Agricultural and horticultural
cooperatives.
(a)In general. This section applies to
a cooperative to which Part I of subchap-
ter T of the Internal Revenue Code applies
and its patrons if the cooperative has man-
ufactured, produced, grown, or extracted
(MPGE) (as defined in §1.199–3(d)) in
whole or significant part (as defined in
§1.199–3(f)) within the United States (as
defined in §1.199–3(g)) any agricultural or
horticultural product, or has marketed agri-
cultural or horticultural products. For this
purpose, agricultural or horticultural prod-
ucts also include fertilizer, diesel fuel, and
other supplies used in agricultural or hor-
ticultural production. If any amount of a
patronage dividend or per-unit retain al-
location received by apatron is allocable
to the qualified production activities in-
come (QPAI) (as defined in §1.199–1(c))
of the cooperative, would be allowable as a
deduction under §1.199–1(a) (section 199
deduction) by the cooperative, and is des-
ignated as such in a written notice to the
patron during the payment period defined
under section 1382(d), then such amount
is deductible by the patron as a section
199 deduction. For this purpose, patron-
age dividends and per-unit retain alloca-
tions include any advances on patronage or
per-unit retains paid in money during the
taxable year.
(b)Written notice to patrons.Inor-
der for a patron to qualify for the section
199 deduction, paragraph (a) of this sec-
tion requires that the cooperative designate
in a written notice the amount of the pa-
tron’s patronage dividend or per-unit re-
tain allocation that is allocable to QPAI
and deductible by the cooperative. This
written notice designating the patron’s por-
tion of the section 199 deduction must be
mailed by the cooperative to its patrons
no later than the 15
th
day of the ninth
month following the close of the taxable
year. The cooperative may use the same
written notice, if any, that it uses to no-
2005–47 I.R.B.1042November 21, 2005

tify patrons of their respective allocations
of patronage dividends, or may use a sep-
arate timely written notice(s) to comply
with this section. The cooperative must
report the amount of the patron’s section
199 deduction on Form 1099-PATR, “Tax-
able Distributions Received From Cooper-
atives,” issued to the patron.
(c)Determining cooperative’s qualified
production activities income. In determin-
ing the portion of the cooperative’s QPAI
that would be allowable as a section 199
deduction by the cooperative, the cooper-
ative’s taxable income is computed with-
out taking into account any deduction al-
lowable under section 1382(b) or (c) (re-
lating to patronage dividends, per-unit re-
tain allocations, and nonpatronage distri-
butions) and, in the case of a cooperative
engaged in the marketing of agricultural
and/or horticultural products, the coopera-
tive is treated as having MPGE in whole or
in significant part within the United States
any agricultural or horticultural products
marketed by the cooperative that its pa-
trons have MPGE.
(d)Additional rules relating to
pass-through of section 199 deduction.
The cooperative may, at its discretion,
pass through all, some, or none of the
section 199 deduction to its patrons. A
cooperative member of a federated coop-
erative may pass through the section 199
deduction it receives from the federated
cooperative to its member patrons. Pa-
trons may claim the section 199 deduction
for the taxable year in which they receive
the written notice from the cooperative
informing them of the section 199 amount
without regard to the taxable income limi-
tation under §1.199–1(a) and (b).
(e)W–2 wages. The W–2 wage limita-
tion described in §1.199–2 shall be applied
at the cooperative level whether or not the
cooperative chooses to pass through some
or all of the section 199 deduction. Any
section 199 deduction that has been passed
through by a cooperative to its patrons is
not subject to the W–2 wage limitation a
second time at the patron level.
(f)Recapture of section 199 deduction.
If the amount of the section 199 deduction
that was passed through to patrons exceeds
the amount allowable as a section 199 de-
duction as determined on audit or reported
on the amended return, recapture of the ex-
cess will occur at the cooperative level.
(g)Section is exclusive. This section
is the exclusive method for cooperatives
and their patrons to compute the amount of
the section 199 deduction. Thus, a patron
may not deduct any amount with respect
to a patronage dividend or a per-unit retain
allocation unless the requirements of this
section are satisfied.
(h)No double counting. A patronage
dividend or per-unit retain allocation re-
ceived by a patron of a cooperative is not
QPAI in the hands of the patron.
(i)Examples. The following examples
illustrate the application this section:
Example 1. (i) Cooperative X markets corn
grown by its members within the United States for
sale to retail grocers. For its calendar year ended
December 31, 2005, Cooperative X has gross re-
ceipts of $1,500,000, all derived from the sale of
corn grown by its members. Cooperative X’s W–2
wages for 2005 total $500,000. Cooperative X has
no other costs. Patron A is a member of Cooperative
X. Patron A is a cash basis taxpayer and files Federal
income tax returns on a calendar year basis. All corn
grown by Patron A in 2005 is sold through Coopera-
tive X and Patron A is eligible to share in patronage
dividends paid by Cooperative X for that year.
(ii) Cooperative X is an agricultural cooperative
described in paragraph (a) of this section. Accord-
ingly, this section applies to Cooperative X and its pa-
trons and all of Cooperative X’s gross receipts from
the sale of its patrons’ corn qualify as domestic pro-
duction gross receipts (as defined §1.199–3(a)). Co-
operative X’s QPAI under paragraph (c) of this sec-
tion is $1,000,000. Cooperative X’s section 199 de-
duction for its taxable year 2005 is $30,000 (.03 x
$1,000,000). Since this amount is less than 50% of
Cooperative X’s W–2 wages, the entire amount is de-
ductible.
Example 2. (i)ThefactsarethesameasinEx-
ample 1except that Cooperative X decides to pass its
entire section 199 deduction through to its members.
Cooperative X declares a patronage dividend for its
2005 taxable year of $1,000,000, which it pays on
March 15, 2006. Pursuant to paragraph (b) of this sec-
tion, Cooperative X notifies members in written no-
tices which accompany the patronage dividend notifi-
cation that it is allocating to them the section 199 de-
duction it is entitled to claim in the taxable year 2005.
On March 15, 2006, Patron A receives a $10,000 pa-
tronage dividend from Cooperative X. In the notice
that accompanies the patronage dividend, Patron A
is designated a $300 section 199 deduction. Under
paragraph (d) of this section, Patron A may claim a
$300 section 199 deduction for the taxable year end-
ing December 31, 2006, without regard to the taxable
income limitation under §1.199–1(a) and (b). Coop-
erative X must report the amount of Patron A’s sec-
tion 199 deduction on Form 1099-PATR, “Taxable
Distributions Received From Cooperative,” issued to
the Patron A for the calendar year 2006.
(ii) Under section 199(d)(3)(A), Cooperative X is
required to reduce its patronage dividend deduction
of $1,000,000 by the $30,000 section 199 deduction
passed through to members (whether or not Cooper-
ative X pays patronage on book or tax net earnings).
As a consequence, Cooperative X is entitled to a pa-
tronage dividend deduction for the taxable year end-
ing December 31, 2005, in the amount of $970,000
($1,000,000 - $30,000) and to a section 199 deduc-
tion in the amount of $30,000 ($1,000,000 x .03). Its
taxable income for 2005 is $0.
Example 3. (i) The facts are the same as inEx-
ample 1except that Cooperative X paid out $500,000
to its patrons as advances on expected patronage net
earnings. In 2005, Cooperative X pays its patrons a
$500,000 ($1,000,000 - $500,000 already paid) pa-
tronage dividend in cash or a combination of cash
and qualified written notices of allocation. Under
sections 199(d)(3)(A) and 1382, Cooperative X is al-
lowed a patronage dividend deduction of $470,000
($500,000 - $30,000 section 199 deduction), whether
patronage net earnings are distributed on book or tax
net earnings.
(ii) The patrons will havereceived a gross amount
of $1,000,000 from Cooperative X ($500,000 paid
during the taxable year as advances and the additional
$500,000 paid as qualified patronage dividends). If
Cooperative X passes through its entire section 199
deduction to its members by providing the notice re-
quired by paragraph (b) of this section, the patrons
will be allowed a $30,000 section 199 deduction, re-
sulting in a net $970,000 taxable distribution from
Cooperative X. Pursuant to paragraph (h) of this sec-
tion, the $1,000,000 received by the patrons from Co-
operative X is not QPAI in the hands of the patrons.
§1.199–7 Expanded affiliated groups.
(a)In general.Allmembersofanex-
panded affiliated group (EAG) are treated
as a single corporation for purposes of sec-
tion 199. Notwithstanding the preceding
sentence, except as otherwise provided in
the Internal RevenueCode and regulations
(see, for example, sections 199(c)(7) and
267, §1.199–3(b), paragraph (a)(3) of this
section, and the consolidated return reg-
ulations), each member of an EAG is a
separate taxpayer that computes its own
taxable income or loss, qualified produc-
tion activites income (QPAI) (as defined in
§1.199–1(c)), and W–2 wages (as defined
in §1.199–2(f)). If members of an EAG are
also members of a consolidated group, see
paragraph (d) of this section.
(1)Definition of expanded affiliated
group. 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).
(2)Identification of members of an ex-
panded affiliated group—(i)In general.A
corporation must determine if it is a mem-
ber of an EAG on a daily basis.
(ii)Becoming or ceasing to be a mem-
ber of an expanded affiliated group.If
November 21, 200510432005–47 I.R.B.

a corporation becomes or ceases to be a
member of an EAG, the corporation is
treated as becoming or ceasing to be a
member of the EAG at the end of the day
on which its status as a member changes.
(3)Attribution of activities. In general,
if a member of an EAG (the disposing
member) derives gross receipts (as de-
fined in §1.199–3(c)) from the lease,
rental, license, sale, exchange, or other
disposition (as defined in §1.199–3(h))
ofqualifyingproductionproperty(QPP)
(as defined in §1.199–3(i)) that was man-
ufactured, produced, grown or extracted
(MPGE) (as defined in §1.199–3(d)), in
whole or in significant part (as defined
in §1.199–3(f)), in the United States (as
defined in §1.199–3(g)), a qualifed film
(as defined in §1.199–3(j)) that was pro-
duced in the United States, or electricity,
natural gas, or potable water (as defined
in §1.199–3(k)) (collectively, utilities)
that was produced in the United States by
another member or members of the same
EAG, the disposing member is treated as
conducting the activities conducted by
each other member of the EAG with re-
spect to the QPP, qualified film, or utilities
in determining whether its gross receipts
are domestic production gross receipts
(DPGR) (as defined in §1.199–3(a)).
However, attribution of activities does not
apply for purposes of the construction of
real property under §1.199–3(l) or the per-
formance of engineering and architectural
services under §1.199–3(m). A member
of an EAG must engage in a construction
activity under §1.199–3(l)(2), provide en-
gineering services under §1.199–3(m)(2),
or provide architectural services under
§1.199–3(m)(3) in order for the member’s
gross receipts to be derived from construc-
tion, engineering, or architectural services.
(4)Examples. The following exam-
ples illustrate the application of paragraph
(a)(3) of this section:
Example 1. Corporations M and N are members
of the same EAG. M is engaged solely in the trade
or business of manufacturing furniture in the United
States that it sells to unrelated persons. N is engaged
solely in the trade or business of engraving compa-
nies’ names on pens and pencils purchased from un-
related persons and then selling the pens and pencils
to such companies. If N was not a member of an
EAG, its activities would not qualify as MPGE. Ac-
cordingly, although M’s sales of the furniture qual-
ify as DPGR (assuming all the other requirements of
§1.199–3 are met), N’s sales of the engraved pens and
pencils do not qualify as DPGR because neither N nor
another member of the EAG MPGE the pens and pen-
cils.
Example 2. For the entire 2006 taxable year, Cor-
porations A and B are members of the same EAG.
A is engaged solely in the trade or business of man-
ufacturing QPP in the United States. A and B each
own 45 percent of partnership C and unrelated per-
sons own the remaining 10 percent. C is engaged
solely in the trade or business of manufacturing the
same type of QPP in the United States as A. In 2006,
B purchases and then resells the QPP manufactured
in 2006 by A and C. B also resells QPP it purchases
from unrelated persons. If only B’s activities were
considered, B would not qualify for the deduction un-
der §1.199–1(a) (section 199 deduction). However,
because B is a member of the EAG that includes A, B
is treated as conducting A’s manufacturing activities
in determining whether B’s gross receipts are DPGR.
C is not a member of the EAG and thus C’s MPGE ac-
tivities are not attributed to B in determining whether
B’s gross receipts are DPGR. Accordingly, B’s gross
receipts attributable to itssale of the QPP it purchases
from A are DPGR (assuming all the other require-
ments of §1.199–3 are met). B’s gross receipts attrib-
utable to its sale of the QPP it purchases from C and
from the unrelated persons are non-DPGR because no
member of the EAG MPGE the QPP. If rather than re-
selling the QPP, B rented the QPP it acquired from A
to unrelated persons, B’s gross receipts attributable to
the rental of the QPP would also be DPGR (assuming
all the other requirements of §1.199–3 are met).
(5)Anti-avoidance rule. If a transaction
between members of an EAG is engaged
in or structured with a principal purpose
of qualifying for, or increasing the amount
of, the section 199 deduction of the EAG
or the portion of the section 199 deduction
allocated to one or more members of the
EAG, adjustments must be made to elim-
inate the effect of the transaction on the
computation of the section 199 deduction.
(b)Computation of expanded affili-
ated group’s section 199 deduction—(1)
In general. The section 199 deduction
for an EAG is determined by aggregating
each member’s taxable income or loss,
QPAI, and W–2 wages. For this purpose,
a member’s QPAI is determined under
§1.199–1. For purposes of this determi-
nation, a member’s QPAI may be positive
or negative. A member’s taxable income
or loss and QPAI shall be determined by
reference to the member’s methods of
accounting.
(2)Net operating loss carryovers.In
determing the taxable income of an EAG,
if a member of an EAG has a net operating
loss (NOL) carryback or carryover to the
taxable year, then the amount of the NOL
used to offset taxable income cannot ex-
ceed the taxable income of that member.
(c)Allocation of an expanded af-
filiated group’s section 199 deduction
among members of the expanded affiliated
group—(1)In general. An EAG’s sec-
tion 199 deduction is allocated among the
members of the EAG in proportion to each
member’s QPAI regardless of whether the
EAG member has taxable income or loss
or W–2 wages for the taxable year. For
this purpose, if a member has negative
QPAI, the QPAI of the member shall be
treated as zero.
(2)Use of section 199 deduction to cre-
ate or increase a net operating loss.Not-
withstanding §1.199–1(b), which gener-
ally prevents the section 199 deduction
from creating or increasing an NOL, if a
member of an EAG has some or all of the
EAG’s section 199 deduction allocated to
it under paragraph (c)(1) of this section and
the amount allocated exceeds the mem-
ber’s taxable income(determined prior to
allocation of the section 199 deduction),
the section 199 deduction will create an
NOL for the member. Similarly, if a mem-
ber of an EAG, prior to the allocation of
some or all of the EAG’s section 199 de-
duction to the member, has an NOL for the
taxable year, the portion of the EAG’s sec-
tion 199 deduction allocated to the mem-
ber will increase the member’s NOL.
(d)Special rules for members of the
same consolidated group—(1)Intercom-
pany transactions. In the case of an in-
tercompany transaction between consoli-
dated group members S and B (intercom-
pany transaction, S, and B as defined in
§1.1502–13(b)(1)), S takes an intercom-
pany transaction into account in comput-
ingthesection199deductionatthesame
time and in the same proportion as S takes
into account the income, gain, deduction,
or loss from the intercompany transaction
under §1.1502–13.
(2)Attribution of activities in the con-
struction of real property and the perfor-
mance of engineering and architectural
services. Notwithstanding paragraph
(a)(3) of this section, a disposing member
(as described in suchparagraph) is treated
as conducting the activities conducted by
each other member of the consolidated
group with respect to the construction of
real property under §1.199–3(l) and the
performance of engineering and architec-
tural services under §1.199–3(m).
(3)Application of the simplified de-
duction method and the small business
simplified overall method. For purposes of
applying the simplified deduction method
2005–47 I.R.B.1044November 21, 2005

under §1.199–4(e) and the small busi-
ness simplified overall method under
§1.199–4(f), a consolidated group deter-
mines its QPAI by reference to its mem-
bers’ DPGR, non-DPGR, cost of goods
sold (CGS), and all other deductions, ex-
penses, or losses (deductions), determined
on a consolidated basis.
(4)Determining the section 199 deduc-
tion—(i)Expanded affiliated group con-
sists of consolidated group and non-con-
solidated group members.IfanEAGin-
cludes corporations that are members of
the same consolidated group and corpora-
tions that are not members of the same con-
solidated group, in computing the taxable
income of the EAG, the consolidated tax-
able income or loss, QPAI, and W–2 wages
of the consolidated group, not the separate
taxable income or loss, QPAI, and W–2
wages of the members of the consolidated
group, are aggregated with the taxable in-
come or loss, QPAI, and W–2 wages of the
non-consolidated group members. For ex-
ample, if A, B, C, S1, and S2 are members
ofthesameEAG,andA,S1,andS2are
members of the same consolidated group
(the A consolidated group), the A consoli-
dated group is treated as one member of the
EAG. Accordingly, the EAG is considered
to have three members, the A consolidated
group, B, and C. The consolidated taxable
income or loss, QPAI, and W–2 wages of
the A consolidated group are aggregated
with the taxable income or loss, QPAI, and
W–2 wages of B and C in determining the
EAG’s section 199 deduction.
(ii)Expanded affiliated group consists
only of members of a single consolidated
group. If all the members of an EAG are
members of the same consolidated group,
the consolidated group’s section 199 de-
duction is determined by reference to the
consolidated group’s consolidated taxable
income or loss, QPAI, and W–2 wages, not
the separate taxable income or loss, QPAI,
and W–2 wages of its members.
(5)Allocation of the section 199 de-
duction of a consolidated group among its
members. The section 199 deduction of a
consolidated group (or the section 199 de-
duction allocated to a consolidated group
that is a member of an EAG) must be
allocated to the members of the consoli-
dated group in proportion to each consol-
idated group member’s QPAI, regardless
of whether the consolidated group mem-
ber has separate taxable income or loss
or W–2 wages for the taxable year. For
purposes of allocating the section 199 de-
duction of a consolidated group among its
members, any redetermination of a cor-
poration’s receipts from an intercompany
transaction as DPGR or non-DPGR or as
non-receipts, and anyredetermination of
a corporation’s CGS or other deductions
from an intercompany transaction as ei-
ther allocable to or not allocable to DPGR
under §1.1502–13(c)(1)(i) or (c)(4) is not
taken into account. Also, for purposes
of this allocation, if a consolidated group
member has negative QPAI, the QPAI of
the member shall be treated as zero.
(e)Examples. The following examples
illustrate the application of paragraphs (b),
(c), and (d) of this section:
Example 1. Corporations X and Y are members of
the same EAG but are not members of a consolidated
group. X and Y each use the section 861 method de-
scribed in §1.199–4(d) for allocating and apportion-
ing their deductions. X incurs $5,000 in costs in man-
ufacturing a machine, all of which are capitalized. X
is entitled to a $1,000 depreciation deduction for the
machine in the current taxable year. X rents the ma-
chine to Y for $1,500. Y uses the machine in man-
ufacturing QPP within the United States. Y incurs
$1,400 of CGS in manufacturing the QPP. Y sells the
QPP to unrelated persons for $7,500. Pursuant to sec-
tion 199(c)(7) and §1.199–3(b), X’s rental income is
non-DPGR (and its related costs are not attributable
to DPGR). Accordingly, Y has $4,600 of QPAI (Y’s
$7,500 DPGR received from unrelated persons - Y’s
$1,400 CGS allocable to such receipts - Y’s $1,500
of rental expense), X has $0 of QPAI, and the EAG
has $4,600 of QPAI.
Example 2. The facts are the same as inExample
1except that X and Y are members of the same con-
solidated group. Pursuant to section 199(c)(7) and
§1.199–3(b), X’s rental income ordinarily would not
be DPGR (and its related costs would not be allocable
to DPGR). However, because X and Y are members
of the same consolidated group, §1.1502–13(c)(1)(i)
provides that the separate entity attributes of X’s
income or Y’s expenses, or both X’s income and Y’s
expenses, may be redetermined in order to produce
the same effect as if X and Y were divisions of a
single corporation. If X and Y were divisions of
a single corporation, X and Y would have QPAI
of $5,100 ($7,500 DPGR received from unrelated
persons - $1,400 CGS allocable to such receipts
- $1,000 depreciation deduction). To obtain this
same result for the consolidated group, X’s rental
income is recharacterized as DPGR, which results
in the consolidated group having $9,000 of DPGR
(the sum of Y’s DPGR of $7,500 + X’s DPGR of
$1,500) and $3,900 of costs allocable to DPGR
(the sum of Y’s $1,400 CGS + Y’s $1,500 rental
expense + X’s $1,000 depreciation expense). For
purposes of determining how much of the consoli-
dated group’s section 199 deduction is allocated to
X and Y, pursuant to paragraph (d)(5) of this section,
the redetermination of X’s rental income as DPGR
under §1.1502–13(c)(1)(i) is not taken into account
(X’s costs are considered to be allocable to DPGR
because they are allocableto the consolidated group
deriving DPGR). Accordingly, for this purpose, X
is deemed to have ($1,000) of QPAI (X’s $0 DPGR
- X’s $1,000 depreciation deduction). Because X
is deemed to have negative QPAI, also pursuant to
paragraph (d)(5) of this section, X’s QPAI is treated
as zero. Y has $4,600 of QPAI (Y’s $7,500 DPGR
- Y’s $1,400 CGS allocable to such receipts - Y’s
$1,500 of rental expense). Accordingly, X is allo-
cated $0/($0 + $4,600) of the consolidated group’s
section 199 deduction andY is allocated $4,600/($0
+ $4,600) of the consolidated group’s section 199
deduction.
Example 3.(i)Facts. Corporations A and B
are the only two members of an EAG but are not
members of a consolidated group. A and B each file
Federal income tax returns on a calendar year basis.
The average annual gross receipts of the EAG are less
than or equal to $25,000,000 and A and B each use
the simplified deduction method under §1.199–4(e).
In 2006, A MPGE televisions within the United
States. A has $10,000,000 of DPGR from sales of
televisions to unrelated persons and $2,000,000 of
DPGR from sales of televisions to B. In addition,
A has gross receipts from computer consulting ser-
vices with unrelated persons of $3,000,000. A has
CGS of $6,000,000. A is able to determine from its
books and records that $4,500,000 of its CGS are
attributable to televisions sold to unrelated persons
and $1,500,000 are attributable to televisions sold to
B (see §1.199–4(b)(2)). A has other deductions of
$4,000,000. A has no other items of income, gain,
or deductions. In 2006, B sells the televisions it pur-
chased from A to unrelated persons for $4,100,000
and pays $100,000 for administrative services per-
formed in 2006. B has no other items of income,
gain, or deductions.
(ii)QPAI.(A)A’s QPAI. In order to determine
A’s QPAI, A subtracts its $6,000,000 CGS from its
$12,000,000 DPGR. Under the simplified deduction
method, A then apportions its remaining $4,000,000
of deductions to DPGR in proportion to the ratio
of its DPGR to total gross receipts. Thus, of A’s
$4,000,000 of deductions, $3,200,000 is apportioned
to DPGR ($4,000,000 x $12,000,000/$15,000,000).
Accordingly, A’s QPAI is $2,800,000 ($12,000,000
DPGR - $6,000,000 CGS - $3,200,000 deductions
apportioned to its DPGR).
(B)B’s QPAI. Although B did not MPGE the
televisions it sold, pursuant to paragraph (a)(3) of
this section, B is treated as conducting A’s MPGE of
the televisions in determining whether B’s gross re-
ceipts are DPGR. Thus, B has $4,100,000 of DPGR.
In order to determine B’s QPAI, B subtracts its
$2,000,000 CGS from its $4,100,000 DPGR. Under
the simplified deduction method, B then apportions
its remaining $100,000 of deductions to DPGR in
proportion to the ratio of its DPGR to total gross
receipts. Thus, because B has no other gross receipts,
all of B’s $100,000 of deductions is apportioned
to DPGR ($100,000 x $4,100,000/$4,100,000).
Accordingly, B’s QPAI is $2,000,000 ($4,100,000
DPGR - $2,000,000 CGS - $100,000 deductions
apportioned to its DPGR).
Example 4.(i)Facts. The facts are the same
as inExample 3except that A and B are members
of the same consolidated group, B does not sell the
televisions purchased from A until 2007, and B’s
$100,000 paid for administrative services are paid
November 21, 200510452005–47 I.R.B.

in 2007 for services performed in 2007. In addition,
in 2007, A has $3,000,000 in gross receipts from
computer consulting services with unrelated persons
and $1,000,000 in related deductions.
(ii)Consolidated group’s 2006 QPAI.Thecon-
solidated group’s DPGR and total gross receipts
in 2006 are $10,000,000 and $13,000,000, respec-
tively, because, pursuant to paragraph (d)(1) of this
section and §1.1502–13, the sale of the televisions
from A to B is not taken into account in 2006. In
order to determine the consolidated group’s QPAI,
the consolidated group subtracts its $4,500,000
CGS from the televisions sold to unrelated persons
from its $10,000,000 DPGR. Under the simplified
deduction method, the consolidated group appor-
tions its remaining $4,000,000 of deductions to
DPGR in proportion to the ratio of its DPGR to
total gross receipts. Thus, $3,076,923 ($4,000,000 x
$10,000,000/$13,000,000) is allocated to DPGR. Ac-
cordingly, the consolidated group’s QPAI for 2006 is
$2,423,077 ($10,000,000 DPGR - $4,500,000 CGS -
$3,076,923 deductions apportioned to its DPGR).
(iii)Allocation of consolidated group’s 2006 sec-
tion 199 deduction to its members. Because B’s only
activity during 2006 is the purchase of televisions
from A, B has no DPGR or deductions and thus, no
QPAI, in 2006. Accordingly, the entire section 199
deduction in 2006 for the consolidated group will be
allocated to A.
(iv)Consolidated group’s 2007 QPAI.Pursuantto
paragraph (d)(1) of this section and §1.1502–13(c),
A’s sale of televisions to B in 2006 is taken into
account in 2007 when B sells the televisions to unre-
lated persons. However, because A and B are mem-
bers of a consolidated group, §1.1502–13(c)(1)(i)
provides that the separate entity attributes of A’s
income or B’s expenses, or both A’s income and B’s
expenses, may be redetermined in order to produce
the same effect as if A and B were divisions of a
single corporation. Accordingly, A’s $2,000,000 of
gross receipts are redetermined to be non-DPGR and
non-receipts and B’s $2,000,000 CGS are redeter-
mined to be not allocable to DPGR. Notwithstanding
that A’s receipts are redetermined to be non-DPGR
and non-receipts, A’s CGS are still considered to
be allocable to DPGR because they are allocable
to the consolidated group deriving DPGR. Accord-
ingly, the consolidated group’s DPGR in 2007 is
$4,100,000 from B’s sales of televisions, and its
total receipts are $7,100,000 ($4,100,000 DPGR
plus $3,000,000 non-DPGR from A’s computer
consulting services). To determine the consolidated
group’s QPAI, the consolidated group subtracts A’s
$1,500,000 CGS from the televisions sold to B from
its $4,100,000 DPGR. Under the simplified deduc-
tion method, the consolidated group apportions its
remaining $1,100,000 of deductions ($1,000,000
from A and $100,000 from B) to DPGR in propor-
tion to the consolidated group’s ratio of its DPGR to
total gross receipts. Thus, $635,211 ($1,100,000 x
$4,100,000/$7,100,000) is allocated to DPGR. Ac-
cordingly, the consolidated group’s QPAI for 2007
is $1,964,789 ($4,100,000 DPGR - $1,500,000 CGS
- $635,211 deductions apportioned to its DPGR),
the same QPAI that would result if A and B were
divisions of a single corporation.
(v)Allocation of consolidated group’s 2007 sec-
tion 199 deduction to its members.(A)A’s QPAI.
For purposes of allocating the consolidated group’s
section 199 deduction to its members, pursuant to
paragraph (d)(5) of this section, the redetermination
of A’s $2,000,000 in receipts as non-DPGR and
non-receipts is disregarded. Accordingly, for this
purpose, A’s DPGR is $2,000,000 (receipts from the
sale of televisions to B taken into account in 2007)
and its total receipts are $5,000,000 ($2,000,000
DPGR + $3,000,000 non-DPGR from its computer
consulting services). In determining A’s QPAI, A
subtracts its $1,500,000 CGS from the televisions
sold to B from its $2,000,000 DPGR. Under the sim-
plified deduction method, A apportions its remaining
$1,000,000 of deductions in proportion to the ra-
tio of its DPGR to total receipts. Thus, $400,000
($1,000,000 x $2,000,000/$5,000,000) is allocated
to DPGR. Thus, A’s QPAI is $100,000 ($2,000,000
DPGR - $1,500,000 CGS - $400,000 deductions
allocated to its DPGR).
(B)B’s QPAI. B’s DPGR and its total gross
receipts are each $4,100,000. For purposes of
allocating the consolidated group’s section 199 de-
duction to its members, pursuant to paragraph (d)(5)
of this section, the redetermination of B’s $2,000,000
CGS as not allocable to DPGR is disregarded. In
determining B’s QPAI, B subtracts its $2,000,000
CGS from the televisions purchased from A from
its $4,100,000 DPGR. Under the simplified deduc-
tion method, B apportions its remaining $100,000
deductions in proportion to the ratio of its DPGR
to total receipts. Thus, all $100,000 ($100,000
x $4,100,000/$4,100,000) is allocated to DPGR.
Thus, B’s QPAI is $2,000,000 ($4,100,000 DPGR -
$2,000,000 CGS - $100,000 deductions allocated to
its DPGR).
(C)AllocationtoAandB. Pursuant to para-
graph (d)(5) of this section, the consolidated
group’s section 199 deduction for 2007 is allo-
cated $100,000/($100,000 + $2,000,000) to A and
$2,000,000/($100,000 + $2,000,000) to B.
Example 5. Corporations S and B are members
of the same consolidated group. In 2006, S manu-
factures office furniture for B to use in B’s corporate
headquarters and S sells the office furniture to B. S
and B have no other activities in the taxable year. If S
and B were not members of a consolidated group, S’s
gross receipts from the sale of the office furniture to B
would be DPGR (assuming all the other requirements
of §1.199–3 are met) and S’s CGS or other deduc-
tions, expenses, or losses from the sale to B would be
allocable to S’s DPGR. However, because S and B are
members of a consolidated group, the separate entity
attributes of S’s income or B’s expenses, or both S’s
income and B’s expenses, may be redetermined un-
der §1.1502–13(c)(1)(i) or (c)(4) in order to produce
the same effect as if S and B were divisions of a sin-
gle corporation. If S and B were divisions of a single
corporation, there would be no DPGR with respect to
the office furniture because there would be no lease,
rental, license, sale, exchange, or other disposition of
the furniture by the single corporation (and no CGS or
other deductions allocable to DPGR). Thus, in order
to produce the same effect as if S and B were divisions
of a single corporation, S’s gross receipts are redeter-
mined as non-DPGR. Accordingly, the consolidated
group has no DPGR (and no CGS or other deductions
allocated or apportioned to DPGR) and receives no
section 199 deduction in 2006.
Example 6. Corporations X, Y, and Z are mem-
bers of the same EAG but are not members of a con-
solidated group. X, Y, and Z each files Federal in-
come tax returns on a calendar year basis. Assume
thattheEAGhasW–2wagesinexcessofthesec-
tion 199(b) wage limitation. Prior to 2006, X had
no taxable income or loss. In 2006, X has $0 of
taxable income and $2,000 of QPAI, Y has $4,000
of taxable income and $3,000 of QPAI, and Z has
$4,000 of taxable income and $5,000 of QPAI. Ac-
cordingly, the EAG has taxable income of $8,000,
the sum of X’s taxable income of $0, Y’s taxable in-
come of $4,000, and Z’s taxable income of $4,000.
The EAG has QPAI of $10,000, the sum of X’s QPAI
of $2,000, Y’s QPAI of $3,000, and Z’s QPAI of
$5,000. Because X’s, Y’s, and Z’s taxable years all
began in 2006, the transition percentage under section
199(a)(2) is 3 percent. Thus, the EAG’s section 199
deduction for 2006 is $240 (3% of the lesser of the
EAG’s taxable income of $8,000 or the EAG’s QPAI
of $10,000). Pursuant to paragraph (c)(1) of this sec-
tion, the $240 section 199 deduction is allocated to X,
Y, and Z in proportion to their respective amounts of
QPAI, that is $48 to X ($240 x $2,000/$10,000), $72
to Y ($240 x $3,000/$10,000), and $120 to Z ($240
x $5,000/$10,000). Although X’s taxable income for
2006 determined prior to allocation of a portion of the
EAG’s section 199 deduction to it was $0, pursuant to
paragraph (c)(2) of this section X will have an NOL
for 2006 equal to $48. Because X’s NOL for 2006
cannot be carried back to a previous taxable year, X’s
NOL carryover to 2007 will be $48.
(f)Allocation of income and loss by a
corporation that is a member of the ex-
panded affiliated group for only a portion
of the year—(1)In general. A corporation
that becomes or ceases to be a member of
an EAG during its taxable year must allo-
cate its taxable income or loss, QPAI, and
W–2 wages between the portion of the tax-
able year that it is a member of the EAG
and the portion of the taxable year that it
is not a member of the EAG. In general,
this allocation of items must be made by
using thepro rataallocation method de-
scribed in paragraph (f)(1)(i) of this sec-
tion. However, a corporation may elect to
use the section 199 closing of the books
method described in paragraph (f)(1)(ii) of
this section. Neither thepro rataallocation
method nor the section 199 closing of the
books method is a method of accounting.
(i)Pro rata allocation method. Under
thepro rataallocation method, an equal
portion of a corporation’s taxable income
or loss, QPAI, and W–2 wages for the tax-
able year is assigned to each day of the cor-
poration’s taxable year. Those items as-
signed to those days that the corporation
was a member of the EAG are then aggre-
gated.
(ii)Section 199 closing of the books
method. Under the section 199 closing
of the books method, a corporation’s tax-
2005–47 I.R.B.1046November 21, 2005

able income or loss, QPAI, and W–2 wages
for the period during which the corpora-
tion was a member of an EAG are com-
puted by treating the corporation’s taxable
year as two separate taxable years, the first
of which ends at the close of the day on
whichthecorporation’sstatusasamem-
ber of the EAG changes and the second of
which begins at the beginning of the day
after the corporation’s status as a member
of the EAG changes.
(iii)Making the section 199 closing of
the books election. A corporation makes
the section 199 closing of the books elec-
tion by making the following statement:
“The section 199 closing of the books
election is hereby made with respect to
[insert name of corporation and its em-
ployer identification number] with respect
to the following periods [insert dates of
the two periods between which items are
allocated pursuant to the closing of the
books method].” The statement must be
filed with the corporation’s timely filed
(including extensions) Federal income tax
return for the taxable year that includes
the periods that are subject to the election.
Once made, a section 199 closing of the
books election is irrevocable.
(2)Coordination with rules relat-
ing to the allocation of income under
§1.1502–76(b). If §1.1502–76(b) (relating
to items included in a consolidated return)
applies to a corporation that is a member of
an EAG, any allocation of items required
under this paragraph (f) is made only after
the allocation of the corporation’s items
pursuant to §1.1502–76(b).
(g)Total section 199 deduction for a
corporation that is a member of an ex-
panded affiliated group for some or all of
its taxable year—(1)Member of the same
expanded affiliated group for the entire
taxable year. If a corporation is a mem-
ber of the same EAG for its entire taxable
year, the corporation’s section 199 deduc-
tion for the taxable year is the amount of
the section 199 deduction allocated to the
corporation by the EAG under paragraph
(c)(1) of this section.
(2)Member of the expanded affiliated
group for a portion of the taxable year.If
a corporation is a member of an EAG only
for a portion of its taxable year and is either
not a member of any EAG or is a member
of another EAG, or both, for another por-
tion of the taxable year, the corporation’s
section 199 deduction for the taxable year
is the sum of its section 199 deductions for
each portion of the taxable year.
(3)Example. The following example
illustrates the application of paragraphs (f)
and (g) of this section:
Example. Corporations X and Y, calendar year
corporations, are members of the same EAG for the
entire 2005 taxable year. Corporation Z, also a cal-
endar year corporation, is a member of the EAG of
which X and Y are members for the first half of 2005
and not a member of any EAG for the second half
of 2005. During the 2005 taxable year, Z does not
join in the filing of a consolidated return. Z makes
a section 199 closing of the books election. As a re-
sult, Z has $80 of taxable income and $100 of QPAI
that is allocated to the first half of the taxable year
and a $150 taxable loss and ($200) of QPAI that is
allocated to the second half of the taxable year. Tak-
ing into account Z’s taxable income, QPAI, and W–2
wages allocated to the first half of the taxable year
pursuant to the section 199 closing of the books elec-
tion, the EAG has positive taxable income and QPAI
for the taxable year and W–2 wages in excess of the
section 199(b) wage limitation. Because the EAG has
both positive taxable income and QPAI and sufficient
W–2 wages, and because Z has positive QPAI for the
first half of the year, a portion of the EAG’s section
199 deduction is allocated to Z. Because Z has nega-
tive QPAI for the second half of the year, Z is allowed
no section 199 deduction for the second half of the
taxable year. Thus, despite the fact that Z has a $70
taxable loss and ($100) of QPAI for the entire 2005
taxable year, Z is entitled to a section 199 deduction
for the taxable year equal to the section 199 deduc-
tion allocated to Z as a member of the EAG.
(h)Computation of section 199 deduc-
tion for members of an expanded affiliated
group with different taxable years—(1)In
general. If members of an EAG have dif-
ferent taxable years, in determining the
section 199 deduction of a member (the
computing member), the computing mem-
ber is required to take into account the tax-
able income or loss, QPAI, and W–2 wages
of each group member that are both—
(i) Attributable to the period that the
member of the EAG and the computing
member are both members of the EAG;
and
(ii) Taken into account in a taxable year
that begins after the effective date of sec-
tion 199 and ends with or within the tax-
able year of the computing member with
respect to which the section 199 deduction
is computed.
(2)Example. The following example
illustrates the application of this paragraph
(h):
Example. (i) Corporations X, Y, and Z are mem-
bers of the same EAG. Neither X, Y, nor Z is a mem-
ber of a consolidated group. X and Y are calendar
year taxpayers and Z is a June 30 fiscal year taxpayer.
Each corporation has taxable income that exceeds its
QPAI and has sufficient W–2 wages to avoid the lim-
itation under section 199(b). For its taxable year end-
ing June 30, 2005, Z’s QPAI is $4,000. For the tax-
able year ending December 31, 2005, X’s QPAI is
$8,000 and Y’s QPAI is ($6,000). For its taxable year
ending June 30, 2006, Z’s QPAI is $2,000.
(ii) Because Z’s taxable year ending June 30,
2005, began on July 1, 2004, prior to the effective
date of section 199, Z is not allowed a section 199
deduction for its taxable year ending June 30, 2005.
(iii) In computing X’s and Y’s respective section
199 deductions for their taxable years ending Decem-
ber 31, 2005, Z’s items from its taxable year ending
June 30, 2005, are not taken into account because
Z’s taxable year began before the effective date of
section 199. Instead, only X’s and Y’s taxable in-
come, QPAI, and W–2 wages from their respective
taxable years ending December 31, 2005, are aggre-
gated. The EAG’s QPAI for this purpose is $2,000
(X’s QPAI of $8,000 + Y’s QPAI of ($6,000)). Be-
cause the taxable years of the computing members, X
and Y, began in 2005, the transition percentage un-
der section 199(a)(2) is 3 percent. Accordingly, the
EAG’s section 199 deduction is $60 ($2,000 x .03).
The $60 deduction is allocated to each of X and Y in
proportion to their respective QPAI as a percentage of
the QPAI of each member of the EAG that was taken
into account in computing the EAG’s section 199 de-
duction. Pursuant to paragraph (c)(1) of this section,
in allocating the section 199 deduction between X and
Y, because Y’s QPAI is negative, Y’s QPAI is treated
as being $0. Accordingly, X’s section 199 deduction
for its taxable year ending December 31, 2005, is $60
($60 x $8,000/($8,000 + $0)). Y’s section 199 deduc-
tion for its taxable year ending December 31, 2005,
is $0 ($60 x $0/($8,000 + $0)).
(iv) In computing Z’s section 199 deduction for
its taxable year ending June 30, 2006, X’s and Y’s
items from their respective taxable years ending De-
cember 31, 2005, are taken into account. Therefore,
X’s and Y’s taxable income or loss, QPAI, and W–2
wages from their taxable years ending December 31,
2005, are aggregated with Z’s taxable income or loss,
QPAI, and W–2 wages from its taxable year ending
June 30, 2006. The EAG’s QPAI is $4,000 (X’s QPAI
of $8,000 + Y’s QPAI of ($6,000) + Z’s QPAI of
$2,000). Because the taxable year of the computing
member, Z, began in 2005, the transition percentage
under section 199(a)(2) is 3 percent. Accordingly, the
EAG’s section 199 deduction is $120 ($4,000 x .03).
A portion of the $120 deduction is allocated to Z in
proportion to its QPAI as a percentage of the QPAI of
each member of the EAG thatwas taken into account
in computing the EAG’s section 199 deduction. Pur-
suant to paragraph (c)(1) of this section, in allocat-
ing a portion of the $120 deduction to Z, because Y’s
QPAI is negative, Y’s QPAI is treated as being $0.
Z’s section 199 deduction for its taxable year ending
June 30, 2006, is $24 ($120 x $2,000/($8,000 + $0 +
$2,000)).
§1.199–8 Other rules.
(a)Individuals. Inthecaseofanin-
dividual, the deduction under §1.199–1(a)
(section 199 deduction) is equal to the ap-
plicable percentage of the lesser of the tax-
payer’s qualified production activities in-
come (QPAI) (as defined in §1.199–1(c))
November 21, 200510472005–47 I.R.B.

for the taxable year, or adjusted gross in-
come (AGI) for the taxable year deter-
mined after applying sections 86, 135, 137,
219, 221, 222, and 469, and without regard
to section 199.
(b)Trade or business requirement. Sec-
tion 1.199–3 is applied by taking into ac-
count only items that are attributable to the
actual conduct of a trade or business.
(c)Coordination with alternative min-
imum tax. For purposes of determin-
ing alternative minimum taxable income
(AMTI) under section 55, a taxpayer that
is not a corporation may deduct an amount
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 the taxpayer’s QPAI for
the taxable year, or the taxpayer’s taxable
income for the taxable year, determined
without regard to the section 199 deduc-
tion (or in the case of an individual, AGI).
For purposes of determining AMTI in
the case of a corporation (including a
corporation subjectto tax under section
511(a)), a taxpayer may deduct an amount
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 the taxpayer’s QPAI for
the taxable year, or the taxpayer’s AMTI
for the taxable year, determined without
regard to the section 199 deduction. For
purposes of computing AMTI, QPAI is
determined without regard to any adjust-
ments under sections 56 through 59. In
the case of an individual or a trust, AGI
and taxable income are also determined
without regard to any adjustments under
sections 56 through 59. The amount of the
deduction allowable under this paragraph
(c) for any taxable year cannot exceed 50
percent of the W–2 wages of the employer
for the taxable year (as determined under
§1.199–2).
(d)Nonrecognition transactions—(1)
In general. Except as provided for an ex-
panded affiliated group (EAG) (as defined
in §1.199–7) and EAG partnerships (as
defined in §1.199–3(h)(8)), if property is
transferred by the taxpayer to an entity in
a transaction to which section 351 or 721
applies, then whether the gross receipts
derived by the entity are domestic produc-
tion gross receipts (DPGR) (as defined in
§1.199–3) shall be determined based on
the activities performed by the entity with-
out regard to the activities performed by
the taxpayer prior to the contribution of the
property to the entity. Except as provided
in §1.199–3(h)(7) and (8) (exceptions for
certain oil and gas partnerships and EAG
partnerships), if property is transferred by
a partnership to a partner in a transaction
to which section 731 applies, then whether
gross receipts derived by the partner are
DPGR shall be determined based on the
activities performed bythe partner without
regard to the activities performed by the
partnership before the distribution of the
property to the partner.
(2)Section 1031 exchanges.Ifatax-
payer exchanges property for replacement
property in a transaction to which section
1031 applies, then whether the gross re-
ceipts derived from the lease, rental, li-
cense, sale, exchange, or other disposi-
tion of the replacement property are DPGR
shall be determined based solely on the ac-
tivities performed by the taxpayer with re-
spect to the replacement property.
(3)Section 381 transactions.Ifacorpo-
ration (the acquiring corporation) acquires
the assets of another corporation (the target
corporation) in a transaction to which sec-
tion 381(a) applies, the acquiring corpora-
tion shall be treated as performing those
activities of the target corporation with re-
spect to the acquired assets of the target
corporation. Therefore, to the extent that
the acquired assets of the target corpora-
tion would have given rise to DPGR if
leased, rented, licensed, sold, exchanged,
or otherwise disposed of by the target cor-
poration, then the assets will give rise to
DPGR if leased, rented, licensed, sold, ex-
changed, or otherwise disposed of by the
acquiring corporation.
(e)Taxpayers with a 52–53 week tax-
able year. For purposes of applying
§1.441–2(c)(1) in the case of a taxpayer
using a 52–53 week taxable year, any ref-
erence in section 199(a)(2) (the phase-in
rule), §§1.199–1 through 1.199–7, and this
section to a taxable year beginning after a
particular calendar year means a taxable
year beginning after December 31st of that
year. Similarly, any reference to a taxable
year beginning in a particular calendar
year means a taxable year beginning after
December 31st of the preceding calendar
year. For example, a 52–53 week taxable
year that begins on December 26, 2004, is
deemed to begin on January 1, 2005, and
the transition percentage for that taxable
year is 3 percent.
(f)Section 481(a) adjustments.For
purposes of determining QPAI, a section
481(a) adjustment, whether positive or
negative, taken into account during the
taxable year that is solely attributable
to either gross receipts, cost of goods
sold (CGS), or deductions, expenses, or
losses (deductions) must be allocated or
apportioned in the same manner as the
gross receipts, CGS, or deductions to
which it is attributable. See §§1.199–1(d),
1.199–4(b), and 1.199–4(c) for rules re-
lated to the allocation and apportionment
of gross receipts, CGS, and deductions.
For example, if a taxpayer changes its
method of accounting for inventories from
the last-in, first-out (LIFO) method to the
first-in, first-out (FIFO) method, the tax-
payer is required to allocate the resulting
section 481(a) adjustment, whether posi-
tive or negative, in the same manner as the
CGS computed for the taxable year with
respect to those inventories. If a section
481(a) adjustment is not solely attributable
to either gross receipts, CGS, or deduc-
tions (for example, the taxpayer changes
its overall method of accounting from an
accrual method to the cash method and
the section 481(a) adjustment cannot be
specifically identified with either gross
receipts, CGS, or deductions), the section
481(a) adjustment, whether positive or
negative, must be attributed to, or among,
gross receipts, CGS, or deductions using
any reasonable method that is satisfactory
to the Secretary andallocated or appor-
tioned in the same manner as the gross
receipts, CGS, or deductions to which it is
attributable. Factors taken into considera-
tion in determining whether the method is
reasonable include whether the taxpayer
uses the most accurate information avail-
able; the relationship between the section
481(a) adjustment and the apportionment
base chosen; the accuracy of the method
chosen as compared with other possible
methods; and the time, burden, and cost of
using various methods. If a section 481(a)
adjustment is spread over more than one
taxable year, a taxpayer must attribute the
section 481(a) adjustment among gross re-
ceipts, CGS, or deductions, as applicable,
in the same manner for each taxable year
within the spread period. For example,
if a taxpayer, using a reasonable method,
determines that a section 481(a) adjust-
2005–47 I.R.B.1048November 21, 2005

ment that is required to be spread over four
taxable years should be attributed entirely
to gross receipts, then the taxpayer must
attribute the section 481(a) adjustment en-
tirely to gross receipts in each of the four
taxable years of the spread period.
(g)Effective date. The final regulations
will be applicable to taxable years begin-
ning after December 31, 2004. In the case
of pass-thru entities described in §1.199–5,
the final regulations will be applicable to
taxable years of pass-thru entities begin-
ning after December 31, 2004. Until the
date final regulations are published in the
Federal Register, taxpayers may rely on
the interim guidance on section 199 as set
forth in Notice 2005–14, 2005–7 I.R.B.
498 (see §601.601(d)(2) of this chapter),
as well as the proposed regulations under
§§1.199–1 through 1.199–7, and this sec-
tion. For this purpose, if the proposed reg-
ulations and Notice 2005–14 include dif-
ferent rules for the same particular issue,
then the taxpayer may rely on either the
rule set forth in the proposed regulations
or the rule set forth in Notice 2005–14.
However, if the proposed regulations in-
clude a rule that was not included in No-
tice 2005–14, taxpayers are not permitted
to rely on the absence of a rule to apply a
rule contrary to the proposed regulations.
Kevin M. Brown,
Acting Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on November 3,
2005, 8:45 a.m., and published in the issue of the Federal
Register for November 4, 2005, 70 F.R. 67219)
November 21, 200510492005–47 I.R.B.

Definition of Terms
Revenue rulings and revenue procedures
(hereinafter referred to as “rulings”) that
have an effect on previous rulings use the
following defined terms to describe the ef-
fect:
Amplifieddescribes a situation where
no change is being made in a prior pub-
lished position, but the prior position is be-
ingextendedtoapplytoavariationofthe
fact situation set forth therein. Thus, if
an earlier ruling held that a principle ap-
plied to A, and the new ruling holds that the
same principle also applies to B, the earlier
ruling is amplified. (Compare withmodi-
fied,below).
Clarifiedis used in those instances
where the language in a prior ruling is be-
ing made clear because the language has
caused, or may cause, some confusion.
It is not used where a position in a prior
ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.
Modifiedis used where the substance
of a previously published position is being
changed. Thus, if a prior ruling held that a
principle applied to A but not to B, and the
new ruling holds that it applies to both A
and B, the prior ruling is modified because
it corrects a published position. (Compare
withamplifiedandclarified, above).
Obsoleteddescribes a previously pub-
lished ruling that is not considered deter-
minative with respect to future transac-
tions. This term is most commonly used in
a ruling that lists previously published rul-
ings that are obsoleted because of changes
in laws or regulations. A ruling may also
be obsoleted because the substance has
been included in regulations subsequently
adopted.
Revokeddescribes situations where the
position in the previously published ruling
is not correct and the correct position is
beingstatedinanewruling.
Supersededdescribes a situation where
the new ruling does nothing more than re-
state the substance and situation of a previ-
ously published ruling (or rulings). Thus,
the term is used to republish under the
1986 Code and regulations the same po-
sition published under the 1939 Code and
regulations. The term is also used when
it is desired to republish in a single rul-
ing a series of situations, names, etc., that
were previously published over a period of
time in separate rulings. If the new rul-
ing does more than restate the substance
of a prior ruling, a combination of terms
is used. For example,modifiedandsu-
persededdescribes a situation where the
substance of a previously published ruling
is being changed in part and is continued
without change in part and it is desired to
restate the valid portion of the previously
published ruling in a new ruling that is self
contained. In this case, the previously pub-
lished ruling is first modified and then, as
modified, is superseded.
Supplementedis used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and that
list is expanded by adding further names in
subsequent rulings. After the original rul-
ing has been supplemented several times, a
new ruling may be published that includes
the list in the original ruling and the ad-
ditions, and supersedes all prior rulings in
the series.
Suspendedis used in rare situations
to show that the previous published rul-
ings will not be applied pending some
future action such as the issuance of new
or amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.
Abbreviations
The fol
lowing abbreviations in current use
and for
merly used will appear in material
publis
hedintheBulletin.
A—Individual.
Acq.—A
cquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank
.
B.T.A.—Board of Tax Appeals.
C—Individual.
C.B.—Cu
mulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Coo
perative.
Ct.D.—Court Decision.
CY—County.
D—Decede
nt.
DC—Dummy Corporation.
DE—Donee.
Del. Order
—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Emp
loyer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduc
iary.
FC—Foreign Country.
FICA—Federal Insurance Contributions Act.
FISC—Fo
reign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Fed
eral Unemployment Tax Act.
FX—Foreign corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grante
e.
GP—General Partner.
GR—Grantor.
IC—Insura
nce Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited
Partner.
LR—Lessor.
M—Minor.
Nonacq.—No
nacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Persona
l Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Pa
rtnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Re
al Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsi
diary.
S.P.R.—Statement of Procedural Rules.
Stat.—Statutes at Large.
T—Target
Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Trans
feree.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpay
er.
TR—Trust.
TT—Trustee.
U.S.C.—Uni
ted States Code.
X—Corporation.
Y—Corporation.
Z—Corporat
ion.
2005–47 I.R.B.iNovember 21, 2005

Numerical Finding List
1
Bulletins 2005–27 through 2005–47
Announcements:
2005-46, 2005-27 I.R.B.63
2005-47, 2005-28 I.R.B.71
2005-48, 2005-29 I.R.B.111
2005-49, 2005-29 I.R.B.119
2005-50, 2005-30 I.R.B.152
2005-51, 2005-32 I.R.B.283
2005-52, 2005-31 I.R.B.257
2005-53, 2005-31 I.R.B.258
2005-54, 2005-32 I.R.B.283
2005-55, 2005-33 I.R.B.317
2005-56, 2005-33 I.R.B.318
2005-57, 2005-33 I.R.B.318
2005-58, 2005-33 I.R.B.319
2005-59, 2005-37 I.R.B.524
2005-60, 2005-35 I.R.B.455
2005-61, 2005-36 I.R.B.495
2005-62, 2005-36 I.R.B.495
2005-63, 2005-36 I.R.B.496
2005-64, 2005-37 I.R.B.537
2005-65, 2005-38 I.R.B.587
2005-66, 2005-39 I.R.B.613
2005-67, 2005-40 I.R.B.678
2005-68, 2005-39 I.R.B.613
2005-69, 2005-40 I.R.B.681
2005-70, 2005-40 I.R.B.682
2005-71, 2005-41 I.R.B.714
2005-72, 2005-41 I.R.B.692
2005-73, 2005-41 I.R.B.715
2005-74, 2005-42 I.R.B.764
2005-75, 2005-42 I.R.B.764
2005-76, 2005-42 I.R.B.765
2005-77, 2005-44 I.R.B.855
2005-78, 2005-44 I.R.B.918
2005-79, 2005-45 I.R.B.941
2005-80, 2005-46 I.R.B.967
2005-81, 2005-45 I.R.B.941
2005-82, 2005-45 I.R.B.941
2005-83, 2005-45 I.R.B.941
Notices:
2005-48, 2005-27 I.R.B.9
2005-49, 2005-27 I.R.B.14
2005-50, 2005-27 I.R.B.14
2005-51, 2005-28 I.R.B.74
2005-52, 2005-28 I.R.B.75
2005-53, 2005-32 I.R.B.263
2005-54, 2005-30 I.R.B.127
2005-55, 2005-32 I.R.B.265
2005-56, 2005-32 I.R.B.266
2005-57, 2005-32 I.R.B.267
2005-58, 2005-33 I.R.B.295
Notices— Continued:
2005-59, 2005-35 I.R.B.443
2005-60, 2005-39 I.R.B.606
2005-61, 2005-39 I.R.B.607
2005-62, 2005-35 I.R.B.443
2005-63, 2005-35 I.R.B.448
2005-64, 2005-36 I.R.B.471
2005-65, 2005-39 I.R.B.607
2005-66, 2005-40 I.R.B.620
2005-67, 2005-40 I.R.B.621
2005-68, 2005-40 I.R.B.622
2005-69, 2005-40 I.R.B.622
2005-70, 2005-41 I.R.B.694
2005-71, 2005-44 I.R.B.863
2005-72, 2005-47 I.R.B.976
2005-73, 2005-42 I.R.B.723
2005-74, 2005-42 I.R.B.726
2005-75, 2005-45 I.R.B.929
2005-76, 2005-46 I.R.B.947
2005-77, 2005-46 I.R.B.951
2005-78, 2005-46 I.R.B.952
2005-79, 2005-46 I.R.B.952
2005-80, 2005-46 I.R.B.953
2005-81, 2005-47 I.R.B.977
2005-82, 2005-47 I.R.B.978
2005-84, 2005-46 I.R.B.959
2005-85, 2005-46 I.R.B.961
Proposed Regulations:
REG-106030-98, 2005-42 I.R.B.739
REG-144615-02, 2005-40 I.R.B.625
REG-150088-02, 2005-43 I.R.B.774
REG-150091-02, 2005-43 I.R.B.780
REG-131739-03, 2005-36 I.R.B.494
REG-130241-04, 2005-27 I.R.B.18
REG-138362-04, 2005-33 I.R.B.299
REG-138647-04, 2005-41 I.R.B.697
REG-149436-04, 2005-35 I.R.B.454
REG-156518-04, 2005-38 I.R.B.582
REG-158080-04, 2005-43 I.R.B.786
REG-104143-05, 2005-41 I.R.B.708
REG-105847-05, 2005-47 I.R.B.987
REG-111257-05, 2005-42 I.R.B.759
REG-114371-05, 2005-45 I.R.B.930
REG-114444-05, 2005-45 I.R.B.934
REG-121584-05, 2005-37 I.R.B.523
REG-122857-05, 2005-39 I.R.B.609
REG-129782-05, 2005-40 I.R.B.675
REG-133578-05, 2005-39 I.R.B.610
Revenue Procedures:
2005-35, 2005-28 I.R.B.76
2005-36, 2005-28 I.R.B.78
2005-37, 2005-28 I.R.B.79
2005-38, 2005-28 I.R.B.81
2005-39, 2005-28 I.R.B.82
Revenue Procedures— Continued:
2005-40, 2005-28 I.R.B.83
2005-41, 2005-29 I.R.B.90
2005-42, 2005-30 I.R.B.128
2005-43, 2005-29 I.R.B.107
2005-44, 2005-29 I.R.B.110
2005-45, 2005-30 I.R.B.141
2005-46, 2005-30 I.R.B.142
2005-47, 2005-32 I.R.B.269
2005-48, 2005-32 I.R.B.271
2005-49, 2005-31 I.R.B.165
2005-50, 2005-32 I.R.B.272
2005-51, 2005-33 I.R.B.296
2005-52, 2005-34 I.R.B.326
2005-53, 2005-34 I.R.B.339
2005-54, 2005-34 I.R.B.353
2005-55, 2005-34 I.R.B.367
2005-56, 2005-34 I.R.B.383
2005-57, 2005-34 I.R.B.392
2005-58, 2005-34 I.R.B.402
2005-59, 2005-34 I.R.B.412
2005-60, 2005-35 I.R.B.449
2005-61, 2005-37 I.R.B.507
2005-62, 2005-37 I.R.B.507
2005-63, 2005-36 I.R.B.491
2005-64, 2005-36 I.R.B.492
2005-65, 2005-38 I.R.B.564
2005-66, 2005-37 I.R.B.509
2005-67, 2005-42 I.R.B.729
2005-68, 2005-41 I.R.B.694
2005-69, 2005-44 I.R.B.864
2005-70, 2005-47 I.R.B.979
2005-71, 2005-47 I.R.B.985
Revenue Rulings:
2005-38, 2005-27 I.R.B.6
2005-39, 2005-27 I.R.B.1
2005-40, 2005-27 I.R.B.4
2005-41, 2005-28 I.R.B.69
2005-42, 2005-28 I.R.B.67
2005-43, 2005-29 I.R.B.88
2005-44, 2005-29 I.R.B.87
2005-45, 2005-30 I.R.B.123
2005-46, 2005-30 I.R.B.120
2005-47, 2005-32 I.R.B.261
2005-48, 2005-32 I.R.B.259
2005-49, 2005-30 I.R.B.125
2005-50, 2005-30 I.R.B.124
2005-51, 2005-31 I.R.B.163
2005-52, 2005-35 I.R.B.423
2005-53, 2005-35 I.R.B.425
2005-54, 2005-33 I.R.B.289
2005-55, 2005-33 I.R.B.284
2005-56, 2005-35 I.R.B.427
2005-57, 2005-36 I.R.B.466
2005-58, 2005-36 I.R.B.465
1
A cumulative list of all revenue rulings, revenueprocedures, Treasury decisions, etc., publishedin Internal Revenue Bulletins 2005–1 through 2005–26 is in Internal Revenue Bulletin
2005–26, dated June 27, 2005.
November 21, 2005ii2005–47 I.R.B.

Revenue Rulings— Continued:
2005-59, 2005-37 I.R.B.505
2005-60, 2005-37 I.R.B.502
2005-61, 2005-38 I.R.B.538
2005-62, 2005-38 I.R.B.557
2005-63, 2005-39 I.R.B.603
2005-64, 2005-39 I.R.B.600
2005-65, 2005-41 I.R.B.684
2005-66, 2005-41 I.R.B.686
2005-67, 2005-43 I.R.B.771
2005-68, 2005-44 I.R.B.853
2005-69, 2005-44 I.R.B.852
2005-70, 2005-45 I.R.B.919
2005-71, 2005-45 I.R.B.923
2005-72, 2005-46 I.R.B.944
Social Security Contribution and Benefit
Base; Domestic Employee Coverage
Threshold:
2005-85, 2005-46 I.R.B.961
Tax Conventions:
2005-47, 2005-28 I.R.B.71
2005-72, 2005-41 I.R.B.692
2005-77, 2005-44 I.R.B.855
Treasury Decisions:
9208, 2005-31 I.R.B.157
9209, 2005-31 I.R.B.153
9210, 2005-33 I.R.B.290
9211, 2005-33 I.R.B.287
9212, 2005-35 I.R.B.429
9213, 2005-35 I.R.B.440
9214, 2005-35 I.R.B.435
9215, 2005-36 I.R.B.468
9216, 2005-36 I.R.B.461
9217, 2005-37 I.R.B.498
9218, 2005-37 I.R.B.503
9219, 2005-38 I.R.B.538
9220, 2005-39 I.R.B.596
9221, 2005-39 I.R.B.604
9222, 2005-40 I.R.B.614
9223, 2005-39 I.R.B.591
9224, 2005-41 I.R.B.688
9225, 2005-42 I.R.B.716
9226, 2005-43 I.R.B.772
9227, 2005-45 I.R.B.924
9228, 2005-47 I.R.B.972
2005–47 I.R.B.iiiNovember 21, 2005

Finding List of Current Actions on
Previously Published Items
1
Bulletins 2005–27 through 2005–47
Announcements:
84-26
Obsoleted by
REG-149436-04, 2005-35 I.R.B.454
2004-72
Updated and superseded by
Ann. 2005-59, 2005-37 I.R.B.524
2005-36
Modified by
Rev. Proc. 2005-66, 2005-37 I.R.B.509
2005-53
Corrected by
Ann. 2005-61, 2005-36 I.R.B.495
Notices:
89-111
Amplified by
Notice 2005-61, 2005-39 I.R.B.607
2001-42
Modified by
Rev. Proc. 2005-66, 2005-37 I.R.B.509
2004-57
Superseded by
Notice 2005-79, 2005-46 I.R.B.952
2005-4
Modified by
Notice 2005-62, 2005-35 I.R.B.443
Notice 2005-80, 2005-46 I.R.B.953
2005-10
Clarified by
Notice 2005-64, 2005-36 I.R.B.471
2005-38
Modified by
Notice 2005-64, 2005-36 I.R.B.471
2005-51
Modified and superseded by
Notice 2005-57, 2005-32 I.R.B.267
2005-60
Superseded by
Notice 2005-84, 2005-46 I.R.B.959
2005-66
Supplemented by
Notice 2005-81, 2005-47 I.R.B.977
Proposed Regulations:
REG-108524-00
Corrected by
Ann. 2005-68, 2005-39 I.R.B.613
Proposed Regulations— Continued:
REG-142686-01
Withdrawn by
Ann. 2005-55, 2005-33 I.R.B.317
REG-100420-03
Corrected by
Ann. 2005-57, 2005-33 I.R.B.318
REG-102144-04
Corrected by
Ann. 2005-56, 2005-33 I.R.B.318
Revenue Procedures:
64-54
Obsoleted by
Rev. Rul. 2005-43, 2005-29 I.R.B.88
66-33
Obsoleted by
Rev. Rul. 2005-43, 2005-29 I.R.B.88
69-13
Obsoleted by
Rev. Rul. 2005-43, 2005-29 I.R.B.88
70-8
Modified by
Rev. Proc. 2005-46, 2005-30 I.R.B.142
71-1
Obsoleted by
Rev. Rul. 2005-43, 2005-29 I.R.B.88
72-22
Obsoleted by
Rev. Rul. 2005-43, 2005-29 I.R.B.88
83-77
Superseded by
Rev. Proc. 2005-63, 2005-36 I.R.B.491
87-8
Obsoleted by
Rev. Proc. 2005-44, 2005-29 I.R.B.110
87-9
Obsoleted by
Rev. Proc. 2005-44, 2005-29 I.R.B.110
89-20
Superseded by
Rev. Proc. 2005-52, 2005-34 I.R.B.326
90–11
Modified by
Rev. Proc. 2005-40, 2005-28 I.R.B.83
90-30
Section4supersededby
Rev. Proc. 2005-54, 2005-34 I.R.B.353
Section5supersededby
Rev. Proc. 2005-55, 2005-34 I.R.B.367
Section6supersededby
Rev. Proc. 2005-56, 2005-34 I.R.B.383
Revenue Procedures— Continued:
Section7supersededby
Rev. Proc. 2005-58, 2005-34 I.R.B.402
Section8supersededby
Rev. Proc. 2005-59, 2005-34 I.R.B.412
90-31
Section4supersededby
Rev. Proc. 2005-52, 2005-34 I.R.B.326
Section5supersededby
Rev. Proc. 2005-54, 2005-34 I.R.B.353
Section6supersededby
Rev. Proc. 2005-55, 2005-34 I.R.B.367
Section7supersededby
Rev. Proc. 2005-56, 2005-34 I.R.B.383
Section8supersededby
Rev. Proc. 2005-58, 2005-34 I.R.B.402
Section9supersededby
Rev. Proc. 2005-59, 2005-34 I.R.B.412
93-22
Obsoleted by
Rev. Proc. 2005-44, 2005-29 I.R.B.110
98-18
Obsoleted by
Rev. Proc. 2005-45, 2005-30 I.R.B.141
99-39
Superseded by
Rev. Proc. 2005-60, 2005-35 I.R.B.449
2000-27
Modified and superseded by
Rev. Proc. 2005-66, 2005-37 I.R.B.509
2000-31
Superseded by
Rev. Proc. 2005-60, 2005-35 I.R.B.449
2000-49
Superseded by
Rev. Proc. 2005-41, 2005-29 I.R.B.90
2001-9
Superseded by
Rev. Proc. 2005-60, 2005-35 I.R.B.449
2001-16
Superseded by
Rev. Proc. 2005-42, 2005-30 I.R.B.128
2002-9
Modified and amplified by
Rev. Rul. 2005-42, 2005-28 I.R.B.67
Rev. Proc. 2005-35, 2005-28 I.R.B.76
Rev. Proc. 2005-43, 2005-29 I.R.B.107
Rev. Proc. 2005-47, 2005-32 I.R.B.269
2002-49
Modified, amplified, and superseded by
Rev. Proc. 2005-62, 2005-37 I.R.B.507
1
A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2005–1 through 2005–26 is in Internal Revenue Bulletin 2005–26, dated June 27, 2005.
November 21, 2005iv2005–47 I.R.B.

Revenue Procedures— Continued:
2004-50
Superseded by
Rev. Proc. 2005-49, 2005-31 I.R.B.165
2004-54
Superseded by
Rev. Proc. 2005-65, 2005-38 I.R.B.564
2004-58
Superseded by
Rev. Proc. 2005-69, 2005-44 I.R.B.864
2004-59
Modified by
Rev. Proc. 2005-71, 2005-47 I.R.B.985
2004-64
Modified by
Ann. 2005-71, 2005-41 I.R.B.714
2005-1
Amplified by
Rev. Proc. 2005-68, 2005-41 I.R.B.694
2005-3
Amplified by
Rev. Proc. 2005-61, 2005-37 I.R.B.507
Rev. Proc. 2005-68, 2005-41 I.R.B.694
2005-6
Modified by
Rev. Proc. 2005-66, 2005-37 I.R.B.509
2005-10
Superseded by
Rev. Proc. 2005-67, 2005-42 I.R.B.729
2005-16
Modified by
Rev. Proc. 2005-66, 2005-37 I.R.B.509
2005-65
Corrected by
Ann. 2005-78, 2005-44 I.R.B.918
Revenue Rulings:
65-109
Obsoleted by
Rev. Rul. 2005-43, 2005-29 I.R.B.88
68-549
Obsoleted by
Rev. Rul. 2005-43, 2005-29 I.R.B.88
74-203
Revoked by
Rev. Rul. 2005-59, 2005-37 I.R.B.505
82-29
Modified and clarified by
Rev. Proc. 2005-39, 2005-28 I.R.B.82
2005-41
Corrected by
Ann. 2005-50, 2005-30 I.R.B.152
Treasury Decisions:
9149
Removed by
T.D. 9221, 2005-39 I.R.B.604
9186
Corrected by
Ann. 2005-53, 2005-31 I.R.B.258
9193
Corrected by
Ann. 2005-62, 2005-36 I.R.B.495
9205
Corrected by
Ann. 2005-63, 2005-36 I.R.B.496
9206
Corrected by
Ann. 2005-49, 2005-29 I.R.B.119
9207
Corrected by
Ann. 2005-52, 2005-31 I.R.B.257
9210
Corrected by
Ann. 2005-64, 2005-37 I.R.B.537
2005–47 I.R.B.vNovember 21, 2005
U.S. GPO: 2005—320–797/20032