* * * * *

* * * * *

(e) * * *

(2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.

(i) In general.

(ii) Wage expense safe harbor.

(A) In general.

(B) Wage expense included in cost of goods sold.

(iii) Small business simplified overall method safe harbor.

(iv) Examples.

* * * * *

* * * * *

(i) * * *

(7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.

(i) In general.

(ii) Definition of qualifying in-kind partnership.

(iii) Other rules.

(iv) Example.

(8) Partnerships owned by members of a single expanded affiliated group for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.

(i) In general.

(ii) Attribution of activities.

(A) In general.

(B) Attribution between EAG partnerships.

(C) Exceptions to attribution.

(iii) Other rules.

(iv) Examples.

* * * * *

(a) In general.

(b) Partnerships.

(1) In general.

(i) Determination at partner level.

(ii) Determination at entity level.

(2) Disallowed losses or deductions.

(3) Partner’s share of paragraph (e)(1) wages.

(4) Transition rule for definition of W-2 wages and for W-2 wage limitation.

(5) Partnerships electing out of subchapter K.

(6) Examples.

(c) S corporations.

(1) In general.

(i) Determination at shareholder level.

(ii) Determination at entity level.

(2) Disallowed losses and deductions.

(3) Shareholder’s share of paragraph (e)(1) wages.

(4) Transition rule for definition of W-2 wages and for W-2 wage limitation.

(d) Grantor trusts.

(e) Non-grantor trusts and estates.

(1) Allocation of costs.

(2) Allocation among trust or estate and beneficiaries.

(i) In general.

(ii) Treatment of items from a trust or estate reporting qualified production activities income.

(3) Transition rule for definition of W-2 wages and for W-2 wage limitation.

(4) Example.

(f) Gain or loss from the disposition of an interest in a pass-thru entity.

(g) No attribution of qualified activities.

* * * * *

* * * * *

(b) * * *

(4) Losses used to reduce taxable income of expanded affiliated group.

(i) In general.

(ii) Examples.

* * * * *

* * * * *

(i) * * *

(5) Tax Increase Prevention and Reconciliation Act of 2005.

(6) Losses used to reduce taxable income of expanded affiliated group.

* * * * *

* * * * *

(e) * * *

(2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. The term W-2 wages includes only amounts described in paragraph (e)(1) of this section (paragraph (e)(1) wages) that are properly allocable to domestic production gross receipts (DPGR) (as defined in §1.199-3) for purposes of section 199(c)(1). A taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances.

(ii) Wage expense safe harbor—(A) In general. A taxpayer using either the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR for a taxable year by multiplying the amount of paragraph (e)(1) wages for the taxable year by the ratio of the taxpayer’s wage expense included in calculating qualified production activities income (QPAI) (as defined in §1.199-1(c)) for the taxable year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or adjusted gross income, if applicable) for the taxable year, without regard to any wage expense disallowed by section 465, 469, 704(d), or 1366(d). A taxpayer that uses the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) to determine QPAI must use the same expense allocation and apportionment methods that it uses to determine QPAI to allocate and apportion wage expense for purposes of this safe harbor. For purposes of this paragraph (e)(2)(ii), the term wage expense means wages (that is, compensation paid by the employer in the active conduct of a trade or business to its employees) that are properly taken into account under the taxpayer’s method of accounting.

(B) Wage expense included in cost of goods sold. For purposes of paragraph (e)(2)(ii)(A) of this section, a taxpayer may determine its wage expense included in cost of goods sold (CGS) using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, such as using the amount of direct labor included in CGS or using section 263A labor costs (as defined in §1.263A-1(h)(4)(ii)) included in CGS.

(iii) Small business simplified overall method safe harbor. A taxpayer that uses the small business simplified overall method under §1.199-4(f) may use the small business simplified overall method safe harbor for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under this safe harbor, the amount of paragraph (e)(1) wages that is properly allocable to DPGR is equal to the same proportion of paragraph (e)(1) wages that the amount of DPGR bears to the taxpayer’s total gross receipts.

(iv) Examples. The following examples illustrate the application of this paragraph (e)(2). See §1.199-5(e)(4) for an example of the application of paragraph (e)(2)(ii) of this section to a trust or estate. The examples read as follows:

Example 1. Section 861 method and no EAG. (i) Facts. X, a United States corporation that is not a member of an expanded affiliated group (EAG) (as defined in §1.199-7) or an affiliated group as defined in the regulations under section 861, engages in activities that generate both DPGR and non-DPGR. X’s taxable year ends on April 30, 2011. For X’s taxable year ending April 30, 2011, X has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. All of X’s production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of X’s production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). X is able to specifically identify CGS allocable to DPGR and to non-DPGR. X incurs $900 of research and experimentation 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 of the R&E is included in CGS. X incurs section 162 selling expenses that are not includible in CGS and are definitely related to all of X’s gross income. For X’s taxable year ending April 30, 2011, the adjusted basis of X’s assets is $50,000, $40,000 of which generate gross income attributable to DPGR and $10,000 of which generate gross income attributable to non-DPGR. For X’s taxable year ending April 30, 2011, the total square footage of X’s headquarters is 8,000 square feet, of which 2,000 square feet is set aside for domestic production activities. For its taxable year ending April 30, 2011, X’s taxable income is $1,380 based on the following Federal income tax items:

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

(iii) W-2 wages. X chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:

(A) Step one. X determines that $625 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 1, as shown in the following table:

(B) Step two. X determines that $1,042 of the $3,000 in paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:

(iv) Section 199 deduction determination. X’s tentative deduction under §1.199-1(a) (section 199 deduction) is $124 (.09 x (lesser of QPAI of $1,395 or taxable income of $1,380)) subject to the wage limitation under section 199(b)(1) (W-2 wage limitation) of $521 (50% x $1,042). Accordingly, X’s section 199 deduction for its taxable year ending April 30, 2011, is $124.

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

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

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

(iii) W-2 wages. (A) X’s W-2 wages. X’s W-2 wages are $1,042, the same as in Example 1.

(B) Y’s W-2 wages. Y chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:

(1) Step one. Y determines that $480 of wage expense were taken into account in determining its QPAI in paragraph (ii)(B) of this Example 2, as shown in the following table:

(2) Step two. Y determines that $941 of the $2,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:

(iv) Section 199 deduction determination. The section 199 deduction of the X and Y EAG is determined by aggregating the separately determined taxable income, QPAI, and W-2 wages of X and Y. See §1.199-7(b). Accordingly, the X and Y EAG’s tentative section 199 deduction is $212 (.09 x (lesser of combined QPAI of X and Y of $2,360 (X’s QPAI of $1,455 plus Y’s QPAI of $905) or combined taxable incomes of X and Y of $3,090 (X’s taxable income of $1,380 plus Y’s taxable income of $1,710)) subject to the combined W-2 wage limitation of X and Y of $992 (50% x ($1,042 (X’s W-2 wages) + $941 (Y’s W-2 wages)))). Accordingly, the X and Y EAG’s section 199 deduction is $212. The $212 is allocated to X and Y in proportion to their QPAI. See §1.199-7(c).

Example 3. Simplified deduction method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z is able to specifically identify CGS allocable to DPGR and to non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items:

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

(iii) W-2 wages. Z chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:

(A) Step one. Z determines that $700 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 3, as shown in the following table:

(B) Step two. Z determines that $1,167 of the $3,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:

(iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $116 (.09 x (lesser of QPAI of $1,290 or taxable income of $1,380)) subject to the W-2 wage limitation of $584 (50% x $1,167). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $116.

Example 4. Small business simplified overall method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items:

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

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

(iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $62 (.09 x (lesser of QPAI of $690 or taxable income of $1,380)) subject to the W-2 wage limitation of $750 (50% x $1,500). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $62.

Example 5. Corporation uses employees of non-consolidated EAG member. (i) Facts. Corporations S and B are the only members of a single EAG but are not members of a consolidated group. S and B are both calendar year taxpayers. All the activities described in this Example 5 take place during the same taxable year and they are the only activities of S and B. S and B each use the section 861 method described in §1.199-4(d) for allocating and apportioning their deductions. B is a manufacturer but has only three employees of its own. S employs the remainder of the personnel who perform the manufacturing activities for B. S’s only receipts are from supplying employees to B. In 2010, B manufactures qualifying production property (QPP) (as defined in §1.199-3(j)(1)), using its three employees and S’s employees, and sells the QPP for $10,000,000. B’s total CGS and other deductions are $6,000,000, including $1,000,000 paid to S for the use of S’s employees and $100,000 paid to its own employees. B reports the $100,000 paid to its employees on the 2010 Forms W-2 issued to its employees. S pays its employees $800,000 that is reported on the 2010 Forms W-2 issued to the employees.

(ii) B’s W-2 wages. In determining its W-2 wages, B utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. The entire $100,000 paid by B to its employees is included in B’s wage expense included in calculating its QPAI and is the only wage expense used in calculating B’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, B’s W-2 wages are $100,000 ($100,000 (paragraph (e)(1) wages) x ($100,000 (wage expense used in calculating B’s QPAI)/$100,000 (wage expense used in calculating B’s taxable income))).

(iii) S’s W-2 wages. In determining its W-2 wages, S utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. Because S’s $1,000,000 in receipts from B do not qualify as DPGR and are S’s only gross receipts, none of the $800,000 paid by S to its employees is included in S’s wage expense included in calculating its QPAI. However, the entire $800,000 is included in calculating S’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii)(A) of this section, S’s W-2 wages are $0 ($800,000 (paragraph (e)(1) wages) x ($0 (wage expense used in calculating S’s QPAI)/$800,000 (wage expense used in calculating S’s taxable income))).

(iv) Determination of EAG’s section 199 deduction. The section 199 deduction of the S and B EAG is determined by aggregating the separately determined taxable income or loss, QPAI, and W-2 wages of S and B. See §1.199-7(b). B’s taxable income and QPAI are each $4,000,000 ($10,000,000 DPGR - $6,000,000 CGS and other deductions). S’s taxable income is $200,000 ($1,000,000 gross receipts - $800,000 total deductions). S’s QPAI is $0 ($0 DPGR - $0 CGS and other deductions). B’s W-2 wages (as calculated in paragraph (ii) of this Example 5) are $100,000 and S’s W-2 wages (as calculated in paragraph (iii) of this Example 5) are $0. The EAG’s tentative section 199 deduction is $360,000 (.09 x (lesser of combined QPAI of $4,000,000 (B’s QPAI of $4,000,000 + S’s QPAI of $0) or combined taxable income of $4,200,000 (B’s taxable income of $4,000,000 + S’s taxable income of $200,000))) subject to the W-2 wage limitation of $50,000 (50% x ($100,000 (B’s W-2 wages) + $0 (S’s W-2 wages))). Accordingly, the S and B EAG’s section 199 deduction for 2010 is $50,000. The $50,000 is allocated to S and B in proportion to their QPAI. See §1.199-7(c). Because S has no QPAI, the entire $50,000 is allocated to B.

Example 6. Corporation using employees of consolidated EAG member. The facts are the same as in Example 5 except that B and S are members of the same consolidated group. Ordinarily, as demonstrated in Example 5, S’s $1,000,000 of receipts would not be DPGR and its $800,000 paid to its employees would not be W-2 wages (because the $800,000 would not be properly allocable to DPGR). However, because S and B are members of the same consolidated group, §1.1502-13(c)(1)(i) provides that the separate entity attributes of S’s intercompany items or B’s corresponding items, or both, may be redetermined in order to produce the same effect as if S and B were divisions of a single corporation. If S and B were divisions of a single corporation, S and B would have QPAI and taxable income of $4,200,000 ($10,000,000 DPGR received from the sale of the QPP - $5,800,000 CGS and other deductions) and, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, would have $900,000 of W-2 wages ($900,000 (combined paragraph (e)(1) wages of S and B) x ($900,000 (wage expense used in calculating QPAI)/$900,000 (wage expense used in calculating taxable income))). The single corporation would have a tentative section 199 deduction equal to 9% of $4,200,000, or $378,000, subject to the W-2 wage limitation of 50% of $900,000, or $450,000. Thus, the single corporation would have a section 199 deduction of $378,000. To obtain this same result for the consolidated group, S’s $1,000,000 of receipts from the intercompany transaction are redetermined as DPGR. Thus, S’s $800,000 paid to its employees are costs properly allocable to DPGR and S’s W-2 wages are $800,000. Accordingly, the consolidated group has QPAI and taxable income of $4,200,000 ($11,000,000 DPGR (from the sale of the QPP and the redetermined intercompany transaction) - $6,800,000 CGS and other deductions) and W-2 wages of $900,000. The consolidated group’s section 199 deduction is $378,000, the same as the single corporation. However, for purposes of allocating the section 199 deduction between S and B, the redetermination of S’s income as DPGR under §1.1502-13(c)(1)(i) is not taken into account. See §1.199-7(d)(5). Accordingly, the consolidated group’s entire section 199 deduction of $378,000 is allocated to B.

* * * * *

* * * * *

(f) * * * (1) In general. With the exception of the rules applicable to an expanded affiliated group (EAG) under §1.199-7, qualifying in-kind partnerships under paragraph (i)(7) of this section and §1.199-9(i), EAG partnerships under paragraph (i)(8) of this section and §1.199-9(j), and government contracts under paragraph (f)(2) of this section, only one taxpayer may claim the deduction under §1.199-1(a) with respect to any qualifying activity under paragraphs (e)(1), (k)(1), and (l)(1) of this section performed in connection with the same QPP, or the production of a qualified film or utilities. * * *

* * * * *

(i) * * *

(7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. If a partnership is a qualifying in-kind partnership described in paragraph (i)(7)(ii) of this section, then each partner is treated as having MPGE or produced the property MPGE or produced by the partnership that is distributed to that partner. If a partner of a qualifying in-kind partnership derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of the property that was MPGE or produced by the qualifying in-kind partnership and distributed to that partner, then, provided such partner is a partner of the qualifying in-kind partnership at the time the partner disposes of the property, the partner is treated as conducting the MPGE or production activities previously conducted by the qualifying in-kind partnership with respect to that property. With respect to a lease, rental, or license, the partner is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts derived from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the partner is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account.

(ii) Definition of qualifying in-kind partnership. For purposes of this paragraph (i)(7), a qualifying in-kind partnership is a partnership engaged solely in—

(A) The extraction, refining, or processing of oil, natural gas (as described in paragraph (l)(2) of this section), petrochemicals, or products derived from oil, natural gas, or petrochemicals in whole or in significant part within the United States;

(B) The production or generation of electricity in the United States; or

(C) An activity or industry designated by the Secretary by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter).

(iii) Other rules. Except as provided in this paragraph (i)(7), a qualifying in-kind partnership is treated the same as other partnerships for purposes of section 199. Accordingly, a qualifying in-kind partnership is subject to the rules of this section regarding the application of section 199 to pass-thru entities, including application of the section 199(d)(1)(A)(iii) rule for determining a partner’s share of the amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages) from the partnership under §1.199-5(b)(3). In determining whether a qualifying in-kind partnership or its partners MPGE QPP in whole or in significant part within the United States, see paragraphs (g)(2) and (3) of this section.

(iv) Example. The following example illustrates the application of this paragraph (i)(7). Assume that PRS and X are calendar year taxpayers. The example reads as follows:

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

(8) Partnerships owned by members of a single expanded affiliated group for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. For purposes of this section, if all of the interests in the capital and profits of a partnership are owned by members of a single EAG at all times during the taxable year of the partnership (EAG partnership), then the EAG partnership and all members of that EAG are treated as a single taxpayer for purposes of section 199(c)(4) during that taxable year.

(ii) Attribution of activities—(A) In general. If a member of an EAG (disposing member) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by an EAG partnership, all the partners of which are members of the same EAG to which the disposing member belongs at the time that the disposing member disposes of such property, then the disposing member is treated as conducting the MPGE or production activities previously conducted by the EAG partnership with respect to that property. The previous sentence applies only for those taxable years in which the disposing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the disposing member is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing member is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. Likewise, if an EAG partnership derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by a member (or members) of the same EAG (the producing member) to which all the partners of the EAG partnership belong at the time that the EAG partnership disposes of such property, then the EAG partnership is treated as conducting the MPGE or production activities previously conducted by the producing member with respect to that property. The previous sentence applies only for those taxable years in which the producing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the EAG partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts derived from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the EAG partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. See paragraph (i)(8)(iv) Example 3 of this section.

(B) Attribution between EAG partnerships. If an EAG partnership (disposing partnership) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by another EAG partnership (producing partnership), then the disposing partnership is treated as conducting the MPGE or production activities previously conducted by the producing partnership with respect to that property, provided that each of these partnerships (the producing partnership and the disposing partnership) is owned for its entire taxable year in which the disposing partnership disposes of such property by members of the same EAG. With respect to a lease, rental, or license, the disposing partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account.

(C) Exceptions to attribution. Attribution of activities does not apply for purposes of the construction of real property under paragraph (m)(1) of this section and the performance of engineering and architectural services under paragraphs (n)(2) and (3) of this section, respectively.

(iii) Other rules. Except as provided in this paragraph (i)(8), an EAG partnership is treated the same as other partnerships for purposes of section 199. Accordingly, an EAG partnership is subject to the rules of this section regarding the application of section 199 to pass-thru entities, including the section 199(d)(1)(A)(iii) rule under §1.199-5(b)(3). In determining whether a member of an EAG or an EAG partnership MPGE QPP in whole or in significant part within the United States or produced a qualified film or produced utilities within the United States, see paragraphs (g)(2) and (3) of this section and Example 5 of paragraph (i)(8)(iv) of this section.

(iv) Examples. The following examples illustrate the rules of this paragraph (i)(8). Assume that PRS, X, Y, and Z all are calendar year taxpayers. The examples read as follows:

Example 1. Contribution. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both members of a single EAG for the entire 2007 year. In 2007, X MPGE QPP within the United States and contributes the QPP to PRS. In 2007, PRS sells the QPP for $1,000. Under this paragraph (i)(8), PRS is treated as having MPGE the QPP within the United States, and PRS’s $1,000 gross receipts constitute DPGR. PRS, X, and Y must apply the rules of this section regarding the application of section 199 to pass-thru entities with respect to the activity of PRS, including the section 199(d)(1)(A)(iii) rule for determining a partner’s share of the paragraph (e)(1) wages from the partnership under §1.199-5(b)(3).

Example 2. Sale. X, Y, and Z are the only members of a single EAG for the entire 2007 year. X and Y each own 50% of the capital and profits interests in PRS, a partnership, for PRS’s entire 2007 taxable year. In 2007, PRS MPGE QPP within the United States and then sells the QPP to X for $6,000, its fair market value at the time of the sale. PRS’s gross receipts of $6,000 qualify as DPGR. In 2007, X sells the QPP to customers for $10,000, incurring selling expenses of $2,000. Under paragraph (i)(8)(ii)(A) of this section, X is treated as having MPGE the QPP within the United States, and X’s $10,000 of gross receipts qualify as DPGR. PRS, X and Y must apply the rules of this section regarding the application of section 199 to pass-thru entities with respect to the activity of PRS, including application of the section 199(d)(1)(A)(iii) rule for determining a partner’s share of the paragraph (e)(1) wages from the partnership under §1.199-5(b)(3). The results would be the same if PRS sold the QPP to Z rather than to X. However, if PRS did sell the QPP to Z, and Z was not a member of the EAG for PRS’s entire taxable year, the activities previously conducted by PRS with respect to the QPP would not be attributed to Z, and none of Z’s $10,000 of gross receipts would qualify as DPGR.

Example 3. Lease. X, Y, and Z are the only members of a single EAG for the entire 2007 year. X and Y each own 50% of the capital and profits interests in PRS, a partnership, for PRS’s entire 2007 taxable year. In 2007, PRS MPGE QPP within the United States and then sells the QPP to X for $6,000, its fair market value at the time of the sale. PRS’s gross receipts of $6,000 qualify as DPGR. In 2007, X rents the QPP it acquired from PRS to customers unrelated to X. X takes the gross receipts attributable to the rental of the QPP into account under its method of accounting in 2007 and 2008. On July 1, 2008, X ceases to be a member of the same EAG to which Y, the other partner in PRS, belongs. For 2007, X is treated as having MPGE the QPP within the United States under paragraph (i)(8)(ii)(A) of this section, and its gross receipts derived from the rental of the QPP qualify as DPGR. For 2008, however, because X and Y, partners in PRS, are no longer members of the same EAG for the entire year, the gross rental receipts X takes into account in 2008 do not qualify as DPGR.

Example 4. Distribution. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both members of a single EAG for the entire 2007 year. In 2007, PRS MPGE QPP within the United States, incurring $600 of CGS, and then distributes the QPP to X. X’s adjusted basis in the QPP is $600. X incurs $200 of CGS to further MPGE the QPP within the United States. In 2007, X sells the QPP for $1,500 to an unrelated customer. X is treated as having disposed of the QPP on the date it ceases to own the QPP for Federal income tax purposes. Under paragraph (i)(8)(ii)(A) of this section, X is treated as having MPGE the QPP within the United States, and X’s $1,500 of gross receipts qualify as DPGR.

Example 5. Multiple sales. (i) Facts. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both non-consolidated members of a single EAG for the entire 2007 year. PRS produces in bulk form in the United States the active ingredient for a drug. Assume that PRS’s own MPGE activity with respect to the active ingredient is not substantial in nature, taking into account all of the facts and circumstances, and PRS’s direct labor and overhead to MPGE the active ingredient within the United States are $15 and account for 15% of PRS’s $100 CGS of the active ingredient. In 2007, PRS sells the active ingredient in bulk form to X. X uses the active ingredient to produce the finished dosage form drug. Assume that X’s own MPGE activity with respect to the finished dosage form drug is not substantial in nature, taking into account all of the facts and circumstances, and X’s direct labor and overhead to MPGE the finished dosage form drug within the United States are $12 and account for 10% of X’s $120 CGS of the drug. In 2007, X sells the finished dosage form drug to Y and Y sells the finished dosage form drug to customers. Assume that Y’s own MPGE activity with respect to the finished dosage form drug is not substantial in nature, taking into account all of the facts and circumstances, and Y incurs $2 of direct labor and overhead and Y’s CGS in selling the finished dosage form drug to customers is $130.

(ii) Analysis. PRS’s gross receipts from the sale of the active ingredient to X are non-DPGR because PRS’s MPGE activity is not substantial in nature and PRS does not satisfy the safe harbor described in paragraph (g)(3) of this section because PRS’s direct labor and overhead account for less than 20% of PRS’s CGS of the active ingredient. X’s gross receipts from the sale of the finished dosage form drug to Y are DPGR because X is considered to have MPGE the finished dosage form drug in significant part in the United States pursuant to the safe harbor described in paragraph (g)(3) of this section because the $27 ($15 + $12) of direct labor and overhead incurred by PRS and X equals or exceeds 20% of X’s total CGS ($120) of the finished dosage form drug at the time X disposes of the finished dosage form drug to Y. Similarly, Y’s gross receipts from the sale of the finished dosage form drug to customers are DPGR because Y is considered to have MPGE the finished dosage form drug in significant part in the United States pursuant to the safe harbor described in paragraph (g)(3) of this section because the $29 ($15 + $12 + $2) of direct labor and overhead incurred by PRS, X, and Y equals or exceeds 20% of Y’s total CGS ($130) of the finished dosage form drug at the time Y disposes of the finished dosage form drug to Y’s customers.

* * * * *

(p) * * * Thus, partners, including partners in partnerships described in paragraphs (i)(7) and (8) of this section and §1.199-9(i) and (j), may not treat guaranteed payments as DPGR. See §§1.199-5(b)(6) Example 5 and 1.199-9(b)(6) Example 5.

* * * * *

(d) * * *

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

* * * * *

(f) * * *

(5) Trusts and estates. Trusts and estates under §§1.199-5(e) and 1.199-9(e) may not use the small business simplified overall method.

* * * * *

Par. 9. Section 1.199-5 is added to read as follows:

(a) In general. The provisions of this section apply solely for purposes of section 199 of the Internal Revenue Code (Code).

(b) Partnerships—(1) In general—(i) Determination at partner level. The deduction with respect to the qualified production activities of the partnership allowable under §1.199-1(a) (section 199 deduction) is determined at the partner level. As a result, each partner must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of the partner’s interest in the partnership. Except as provided by publication pursuant to paragraph (b)(1)(ii) of this section, for purposes of this section, each partner is allocated, in accordance with sections 702 and 704, its share of partnership items (including items of income, gain, loss, and deduction), cost of goods sold (CGS) allocated to such items of income, and gross receipts that are included in such items of income, even if the partner’s share of CGS and other deductions and losses exceeds domestic production gross receipts (DPGR) (as defined in §1.199-3(a)). A partnership may specially allocate items of income, gain, loss, or deduction to its partners, subject to the rules of section 704(b) and the supporting regulations. Guaranteed payments under section 707(c) are not considered allocations of partnership income for purposes of this section. Guaranteed payments under section 707(c) are deductions by the partnership that must be taken into account under the rules of §1.199-4. See §1.199-3(p) and paragraph (b)(6) Example 5 of this section. Except as provided in paragraph (b)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, a partner aggregates its distributive share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the partnership (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its qualified production activities income (QPAI) (as defined in §1.199-1(c)).

(ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), permit a partnership to calculate a partner’s share of QPAI and W-2 wages as defined in §1.199-2(e)(2) (W-2 wages) at the entity level, instead of allocating to the partner, in accordance with sections 702 and 704, the partner’s share of partnership items (including items of income, gain, loss, and deduction) and amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages). If a partnership does calculate QPAI at the entity level—

(A) Each partner is allocated its share of QPAI (subject to the limitations of paragraph (b)(2) of this section) and W-2 wages from the partnership, which are combined with the partner’s QPAI and W-2 wages from other sources, if any;

(B) For purposes of computing the partner’s QPAI under §§1.199-1 through 1.199-8, a partner does not take into account the items from the partnership (for example, a partner does not take into account items from the partnership in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources;

(C) A partner generally does not recompute its share of QPAI from the partnership using another method; however, the partner might have to adjust its share of QPAI from the partnership to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and

(D) A partner’s distributive share of QPAI from a partnership may be less than zero.

(2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), losses or deductions of a partnership are taken into account in computing the partner’s QPAI for a taxable year only if, and to the extent that, the partner’s distributive share of those losses or deductions from all of the partnership’s activities is not disallowed by section 465, 469, or 704(d), or any other provision of the Code. If only a portion of the partner’s distributive share of the losses or deductions from a partnership is allowed for a taxable year, a proportionate share of those allowed losses or deductions that are allocated to the partnership’s qualified production activities, determined in a manner consistent with sections 465, 469, and 704(d), and any other applicable provision of the Code, is taken into account in computing QPAI for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year under section 465, 469, or 704(d), or any other provision of the Code, the partner takes into account a proportionate share of those allowed losses or deductions that are allocated to the partnership’s qualified production activities in computing the partner’s QPAI for that later taxable year. Losses or deductions of the partnership that are disallowed for taxable years beginning on or before December 31, 2004, however, are not taken into account in a later taxable year for purposes of computing the partner’s QPAI for that later taxable year, whether or not the losses or deductions are allowed for other purposes.

(3) Partner’s share of paragraph (e)(1) wages. Under section 199(d)(1)(A)(iii), a partner’s share of paragraph (e)(1) wages of a partnership for purposes of determining the partner’s wage limitation under section 199(b)(1) (W-2 wage limitation) equals the partner’s allocable share of those wages. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), the partnership must allocate the amount of paragraph (e)(1) wages among the partners in the same manner it allocates wage expense among those partners. The partner must add its share of the paragraph (e)(1) wages from the partnership to the partner’s paragraph (e)(1) wages from other sources, if any. The partner (other than a partner that itself is a partnership or S corporation) then must calculate its W-2 wages by determining the amount of the partner’s total paragraph (e)(1) wages properly allocable to DPGR. If the partner is a partnership or S corporation, the partner must allocate its paragraph (e)(1) wages (including the paragraph (e)(1) wages from a lower-tier partnership) among its partners or shareholders in the same manner it allocates wage expense among those partners or shareholders. See §1.199-2(e)(2) for the computation of W-2 wages and for the proper allocation of any such wages to DPGR.

(4) Transition rule for definition of W-2 wages and for W-2 wage limitation. If a partnership and any partner in that partnership have different taxable years, only one of which begins after May 17, 2006, the definition of W-2 wages of the partnership and the section 199(d)(1)(A)(iii) rule for determining a partner’s share of wages from that partnership is determined under the law applicable to partnerships based on the beginning date of the partnership’s taxable year. Thus, for example, for the taxable year of a partnership beginning on or before May 17, 2006, a partner’s share of W-2 wages from the partnership is determined under section 199(d)(1)(A)(iii) as in effect for taxable years beginning on or before May 17, 2006, even if the taxable year of that partner in which those wages are taken into account begins after May 17, 2006.

(5) Partnerships electing out of subchapter K. For purposes of §§1.199-1 through 1.199-8, the rules of this paragraph (b) apply to all partnerships, including those partnerships electing under section 761(a) to be excluded, in whole or in part, from the application of subchapter K of chapter 1 of the Code.

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

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

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

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

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

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

(iv) Determination of section 199 deduction. X’s tentative section 199 deduction is $33 (.09 x $366, that is, QPAI determined at the partner level) subject to the W-2 wage limitation (50% of W-2 wages). Y’s tentative section 199 deduction is $58 (.09 x $642) subject to the W-2 wage limitation.

Example 2. Section 861 method with R&E expense. (i) Partnership Federal income tax items. X and Y, unrelated United States corporations each of which is engaged in a trade or business, are partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. Neither X nor Y is a member of an affiliated group. X and Y share all items of income, gain, loss, deduction, and credit equally. All of PRS’s domestic production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of PRS’s production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). PRS is not able to identify from its books and records CGS allocable to DPGR and to non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of PRS’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. PRS incurs $900 of research and experimentation expenses (R&E) that are deductible under section 174, $300 of which are performed with respect to SIC AAA and $600 of which are performed with respect to SIC BBB. None of the R&E is legally mandated R&E as described in §1.861-17(a)(4) and none is included in CGS. For 2010, PRS has the following Federal income tax items:

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

(iii) Determination of QPAI. (A) X’s QPAI. Because the section 199 deduction is determined at the partner level, X determines its QPAI by aggregating its distributive share of PRS’s Federal income tax items with all other such items from all other, non-PRS-related activities. For 2010, X does not have any other such tax items. X’s only gross receipts for 2010 are those attributable to the allocation of gross income from PRS. As stated, all of PRS’s domestic production activities that generate DPGR are within SIC AAA. X allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are definitely related to all of PRS’s gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of PRS’s gross receipts is appropriate. For purposes of apportioning R&E, X elects to use the sales method as described in §1.861-17(c). Because X has no direct sales of products, and because all of PRS’s SIC AAA sales attributable to X’s share of PRS’s gross income generate DPGR, all of X’s share of PRS’s section 174 R&E attributable to SIC AAA is taken into account for purposes of determining X’s QPAI. Thus, X’s total QPAI for 2010 is $540, as shown in the following table:

(B) Y’s QPAI. (1) For 2010, in addition to the activities of PRS, Y engages in domestic production activities that generate both DPGR and non-DPGR. With respect to those non-PRS activities, Y is not able to identify from its books and records CGS allocable to DPGR and to non-DPGR. In this case, because non-PRS CGS is definitely related under the facts and circumstances to all of Y’s non-PRS gross receipts, apportionment of non-PRS CGS between DPGR and non-DPGR based on Y’s non-PRS gross receipts is appropriate. For 2010, Y has the following non-PRS Federal income tax items:

(2) Because Y has DPGR as a result of activities outside PRS, Y must aggregate its distributive share of PRS’s Federal income tax items with such items from all its other, non-PRS-related activities. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are definitely related to all of Y’s gross income. Based on the facts and circumstances of the specific case, apportionment of such expenses between DPGR and non-DPGR on the basis of Y’s gross receipts (including Y’s share of PRS’s gross receipts) is appropriate. For purposes of apportioning R&E, Y elects to use the sales method as described in §1.861-17(c).

(3) With respect to sales that generate DPGR, Y has gross income of $2,400 ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities) - $2,100 CGS ($600 from sales of products by PRS and $1,500 from non-PRS activities)). Because all of the sales in SIC AAA generate DPGR, all of Y’s share of PRS’s section 174 R&E attributable to SIC AAA and the section 174 R&E attributable to SIC AAA that Y incurs in its non-PRS activities are taken into account for purposes of determining Y’s QPAI. Because only a portion of the sales within SIC BBB generate DPGR, only a portion of the section 174 R&E attributable to SIC BBB is taken into account in determining Y’s QPAI. Thus, Y’s QPAI for 2010 is $1,282, as shown in the following table:

(iv) Determination of section 199 deduction. X’s tentative section 199 deduction is $49 (.09 x $540, that is, QPAI determined at the partner level) subject to the W-2 wage limitation (50% of W-2 wages). Y’s tentative section 199 deduction is $115 (.09 x $1,282) subject to the W-2 wage limitation.

Example 3. Partnership with special allocations. (i) In general. X and Y are unrelated corporate partners in PRS and each is engaged in a trade or business. PRS is a partnership that engages in a domestic production activity and other activities. In general, X and Y share all partnership items of income, gain, loss, deduction, and credit equally, except that 80% of the wage expense of PRS and 20% of PRS’s other expenses are specially allocated to X. Under all the facts and circumstances, these special allocations have substantial economic effect under section 704(b). In the 2010 taxable year, PRS’s only wage expense is $2,000 for marketing, which is not included in CGS. PRS has $8,000 of gross receipts ($6,000 of which is DPGR), $4,000 of CGS ($3,500 of which is allocable to DPGR), and $3,000 of deductions (comprised of $2,000 of wage expense for marketing and $1,000 of other expenses). X qualifies for and uses the simplified deduction method under §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 receipts attributable to non-partnership trade or business activities of $1,000 and wage expense of $200. None of X’s non-PRS gross receipts is DPGR. For purposes of this Example 3, with regard to both X and PRS, paragraph (e)(1) wages equal wage expense for the 2010 taxable year.

(ii) Allocation and apportionment of costs. Under the partnership agreement, X’s distributive share of the Federal income tax items of PRS is $1,250 of gross income attributable to DPGR ($3,000 DPGR - $1,750 allocable CGS), $750 of gross income attributable to non-DPGR ($1,000 non-DPGR - $250 allocable CGS), and $1,800 of deductions (comprised of X’s special allocations of $1,600 of wage expense ($2,000 x 80%) for marketing and $200 of other expenses ($1,000 x 20%)). Under the simplified deduction method, X apportions $1,200 of other deductions to DPGR ($2,000 ($1,800 from the partnership and $200 from non-partnership activities) x ($3,000 DPGR/$5,000 total gross receipts)). Accordingly, X’s QPAI is $50 ($3,000 DPGR - $1,750 CGS - $1,200 of deductions). X has $1,800 of paragraph (e)(1) wages ($1,600 (X’s 80% share) from PRS + $200 (X’s own non-PRS paragraph (e)(1) wages)). To calculate its W-2 wages, X must determine how much of this $1,800 is properly allocable under §1.199-2(e)(2) to X’s total DPGR (including X’s share of DPGR from PRS). Thus, X’s tentative section 199 deduction for the 2010 taxable year is $5 (.09 x $50), subject to the W-2 wage limitation (50% of X’s W-2 wages).

Example 4. Partnership with no paragraph (e)(1) wages. (i) Facts. A and B, both individuals, are partners in PRS. PRS is a partnership that engages in manufacturing activities that generate both DPGR and non-DPGR. A and B share all items of income, gain, loss, deduction, and credit equally. For the 2010 taxable year, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 and deductions of $800. PRS has no paragraph (e)(1) wages. Each partner’s distributive share of PRS’s Federal income tax items is $500 DPGR, $500 non-DPGR, $200 CGS, and $400 of deductions. A has trade or business activities outside of PRS (non-PRS activities). With respect to those activities, A has total gross receipts of $1,000 ($500 of which is DPGR), CGS of $400 (including $50 of paragraph (e)(1) wages), and deductions of $200 for the 2010 taxable year. B has no trade or business activities outside of PRS. A and B each use the small business simplified overall method under §1.199-4(f).

(ii) A’s QPAI. A’s total CGS and deductions apportioned to DPGR equal $600 (($1,200 ($200 PRS CGS + $400 non-PRS CGS + $400 PRS deductions + $200 non-PRS trade or business deductions)) x ($1,000 total DPGR ($500 from PRS + $500 from non-PRS activities)/$2,000 total gross receipts ($1,000 from PRS + $1,000 from non-PRS activities))). Accordingly, A’s QPAI is $400 ($1,000 DPGR ($500 from PRS + $500 from non-PRS activities) - $600 CGS and deductions).

(iii) A’s W-2 wages and section 199 deduction. A has $50 of paragraph (e)(1) wages ($0 from PRS + $50 from A’s non-PRS activities). To calculate A’s W-2 wages, A determines, under a reasonable method satisfactory to the Secretary, that $40 of this $50 is properly allocable under §1.199-2(e)(2) to A’s DPGR from PRS and non-PRS activities. A’s tentative section 199 deduction is $36 (.09 x $400), subject to the W-2 wage limitation of $20 (50% of W-2 wages of $40). Thus, A’s section 199 deduction is $20.

(iv) B’s QPAI and section 199 deduction. B’s CGS and deductions apportioned to DPGR equal $300 (($200 PRS CGS + $400 PRS deductions) x ($500 DPGR from PRS /$1,000 total gross receipts from PRS)). Accordingly, B’s QPAI is $200 ($500 DPGR - $300 CGS and deductions). B’s tentative section 199 deduction is $18 (.09 x $200), subject to the W-2 wage limitation. In this case, however, the limitation is $0, because B has no paragraph (e)(1) wages. Thus, B’s section 199 deduction is $0.

Example 5. Guaranteed payment. (i) Facts. The facts are the same as in Example 4, except that in 2010 PRS also makes a guaranteed payment of $200 to A for services rendered by A (see section 707(c)), and PRS incurs $200 of wage expense for employees’ salary, which is included within the $400 of CGS (in this case the wage expense of $200 equals PRS’s paragraph (e)(1) wages). The guaranteed payment is taxable to A as ordinary income and is properly deducted by PRS under section 162. Pursuant to §1.199-3(p), A may not treat any part of this payment as DPGR. Accordingly, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 (including $200 of wage expense) and deductions of $1,000 (including the $200 guaranteed payment) for the 2010 taxable year. Each partner’s distributive share of the items of the partnership is $500 DPGR, $500 non-DPGR, $200 CGS (including $100 of wage expense), and $500 of deductions.

(ii) A’s QPAI and W-2 wages. A’s total CGS and deductions apportioned to DPGR equal $591 ($1,300 ($200 PRS CGS + $400 non-PRS CGS + $500 PRS deductions + $200 non-PRS trade or business deductions) x ($1,000 total DPGR ($500 from PRS + $500 from non-PRS activities)/$2,200 total gross receipts ($1,000 from PRS + $200 guaranteed payment + $1,000 from non-PRS activities))). Accordingly, A’s QPAI is $409 ($1,000 DPGR - $591 CGS and other deductions). A’s total paragraph (e)(1) wages are $150 ($100 from PRS + $50 from non-PRS activities). To calculate its W-2 wages, A must determine how much of this $150 is properly allocable under §1.199-2(e)(2) to A’s total DPGR from PRS and non-PRS activities. A’s tentative section 199 deduction is $37 (.09 x $409), subject to the W-2 wage limitation (50% of W-2 wages).

(iii) B’s QPAI and W-2 wages. B’s QPAI is $150 ($500 DPGR - $350 CGS and other deductions). B has $100 of paragraph (e)(1) wages (all from PRS). To calculate its W-2 wages, B must determine how much of this $100 is properly allocable under §1.199-2(e)(2) to B’s total DPGR. B’s tentative section 199 deduction is $14 (.09 x $150), subject to the W-2 wage limitation (50% of B’s W-2 wages).

(c) S corporations—(1) In general—(i) Determination at shareholder level. The section 199 deduction with respect to the qualified production activities of an S corporation is determined at the shareholder level. As a result, each shareholder must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation. Except as provided by publication pursuant to paragraph (c)(1)(ii) of this section, for purposes of this section, each shareholder is allocated, in accordance with section 1366, its pro rata share of S corporation items (including items of income, gain, loss, and deduction), CGS allocated to such items of income, and gross receipts included in such items of income, even if the shareholder’s share of CGS and other deductions and losses exceeds DPGR. Except as provided by publication under paragraph (c)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, the shareholder aggregates its pro rata share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the S corporation (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its QPAI.

(ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), permit an S corporation to calculate a shareholder’s share of QPAI and W-2 wages at the entity level, instead of allocating to the shareholder, in accordance with section 1366, the shareholder’s pro rata share of S corporation items (including items of income, gain, loss, and deduction) and paragraph (e)(1) wages. If an S corporation does calculate QPAI at the entity level—

(A) Each shareholder is allocated its share of QPAI (subject to the limitations of paragraph (c)(2) of this section) and W-2 wages from the S corporation, which are combined with the shareholder’s QPAI and W-2 wages from other sources, if any;

(B) For purposes of computing the shareholder’s QPAI under §§1.199-1 through 1.199-8, a shareholder does not take into account the items from the S corporation (for example, a shareholder does not take into account items from the S corporation in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources;

(C) A shareholder generally does not recompute its share of QPAI from the S corporation using another method; however, the shareholder might have to adjust its share of QPAI from the S corporation to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and

(D) A shareholder’s share of QPAI from an S corporation may be less than zero.

(2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), losses or deductions of the S corporation are taken into account in computing the shareholder’s QPAI for a taxable year only if, and to the extent that, the shareholder’s pro rata share of the losses or deductions from all of the S corporation’s activities is not disallowed by section 465, 469, or 1366(d), or any other provision of the Code. If only a portion of the shareholder’s share of the losses or deductions from an S corporation is allowed for a taxable year, a proportionate share of those allowed losses or deductions that are allocated to the S corporation’s qualified production activities, determined in a manner consistent with sections 465, 469, and 1366(d), and any other applicable provision of the Code, is taken into account in computing QPAI for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year under section 465, 469, or 1366(d), or any other provision of the Code, the shareholder takes into account a proportionate share of those allowed losses or deductions that are allocated to the S corporation’s qualified production activities in computing the shareholder’s QPAI for that later taxable year. Losses or deductions of the S corporation that are disallowed for taxable years beginning on or before December 31, 2004, however, are not taken into account in a later taxable year for purposes of computing the shareholder’s QPAI for that later taxable year, whether or not the losses or deductions are allowed for other purposes.

(3) Shareholder’s share of paragraph (e)(1) wages. Under section 199(d)(1)(A)(iii), an S corporation shareholder’s share of the paragraph (e)(1) wages of the S corporation for purposes of determining the shareholder’s W-2 wage limitation equals the shareholder’s allocable share of those wages. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), the S corporation must allocate the paragraph (e)(1) wages among the shareholders in the same manner it allocates wage expense among those shareholders. The shareholder then must add its share of the paragraph (e)(1) wages from the S corporation to the shareholder’s paragraph (e)(1) wages from other sources, if any, and then must determine the portion of those total paragraph (e)(1) wages allocable to DPGR to compute the shareholder’s W-2 wages. See §1.199-2(e)(2) for the computation of W-2 wages and for the proper allocation of such wages to DPGR.

(4) Transition rule for definition of W-2 wages and for W-2 wage limitation. If an S corporation and any of its shareholders have different taxable years, only one of which begins after May 17, 2006, the definition of W-2 wages of the S corporation and the section 199(d)(1)(A)(iii) rule for determining a shareholder’s share of wages from that S corporation is determined under the law applicable to S corporations based on the beginning date of the S corporation’s taxable year. Thus, for example, for the short taxable year of an S corporation beginning after May 17, 2006, and ending in 2006, a shareholder’s share of W-2 wages from the S corporation is determined under section 199(d)(1)(A)(iii) for taxable years beginning after May 17, 2006, even if that shareholder’s taxable year began on or before May 17, 2006.

(d) Grantor trusts. To the extent that the grantor or another person is treated as owning all or part (the owned portion) of a trust under sections 671 through 679, such person (owner) computes its QPAI with respect to the owned portion of the trust as if that QPAI had been generated by activities performed directly by the owner. Similarly, for purposes of the W-2 wage limitation, the owner of the trust takes into account the owner’s share of the paragraph (e)(1) wages of the trust that are attributable to the owned portion of the trust. The provisions of paragraph (e) of this section do not apply to the owned portion of a trust.

(e) Non-grantor trusts and estates—(1) Allocation of costs. The trust or estate calculates each beneficiary’s share (as well as the trust’s or estate’s own share, if any) of QPAI and W-2 wages from the trust or estate at the trust or estate level. The beneficiary of a trust or estate may not recompute its share of QPAI or W-2 wages from the trust or estate by using another method to reallocate the trust’s or estate’s qualified production costs or paragraph (e)(1) wages, or otherwise. Except as provided in paragraph (d) of this section, the QPAI of a trust or estate must be computed by allocating expenses described in section 199(d)(5) in one of two ways, depending on the classification of those expenses under §1.652(b)-3. Specifically, directly attributable expenses within the meaning of §1.652(b)-3 are allocated pursuant to §1.652(b)-3, and expenses not directly attributable within the meaning of §1.652(b)-3 (other expenses) are allocated under the simplified deduction method of §1.199-4(e) (unless the trust or estate does not qualify to use the simplified deduction method, in which case it must use the section 861 method of §1.199-4(d) with respect to such other expenses). For this purpose, depletion and depreciation deductions described in section 642(e) and amortization deductions described in section 642(f) are treated as other expenses described in section 199(d)(5). Also for this purpose, the trust’s or estate’s share of other expenses from a lower-tier pass-thru entity is not directly attributable to any class of income (whether or not those other expenses are directly attributable to the aggregate pass-thru gross income as a class for purposes other than section 199). A trust or estate may not use the small business simplified overall method for computing its QPAI. See §1.199-4(f)(5).

(2) Allocation among trust or estate and beneficiaries—(i) In general. The QPAI of a trust or estate (which will be less than zero if the CGS and deductions allocated and apportioned to DPGR exceed the trust’s or estate’s DPGR) and W-2 wages of a trust or estate are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust’s or estate’s distributable net income (DNI), as defined by section 643(a), for the taxable year that is distributed or required to be distributed to the beneficiary or is retained by the trust or estate. For this purpose, the trust or estate’s DNI is determined with regard to the separate share rule of section 663(c), but without regard to section 199. To the extent that the trust or estate has no DNI for the taxable year, any QPAI and W-2 wages are allocated entirely to the trust or estate. A trust or estate is allowed the section 199 deduction in computing its taxable income to the extent that QPAI and W-2 wages are allocated to the trust or estate. A beneficiary of a trust or estate is allowed the section 199 deduction in computing its taxable income based on its share of QPAI and W-2 wages from the trust or estate, which are aggregated with the beneficiary’s QPAI and W-2 wages from other sources, if any.

(ii) Treatment of items from a trust or estate reporting qualified production activities income. When, pursuant to this paragraph (e), a taxpayer must combine QPAI and W-2 wages from a trust or estate with the taxpayer’s total QPAI and W-2 wages from other sources, the taxpayer, when applying §§1.199-1 through 1.199-8 to determine the taxpayer’s total QPAI and W-2 wages from such other sources, does not take into account the items from such trust or estate. Thus, for example, a beneficiary of an estate that receives QPAI from the estate does not take into account the beneficiary’s distributive share of the estate’s gross receipts, gross income, or deductions when the beneficiary determines whether a threshold or de minimis rule applies or when the beneficiary allocates and apportions deductions in calculating its QPAI from other sources. Similarly, in determining the portion of the beneficiary’s paragraph (e)(1) wages from other sources that is attributable to DPGR (thus, the W-2 wages from other sources), the beneficiary does not take into account DPGR and non-DPGR from the trust or estate.

(3) Transition rule for definition of W-2 wages and for W-2 wage limitation. The definition of W-2 wages of a trust or estate and the section 199(d)(1)(A)(iii) rule for determining the respective shares of wages from that trust or estate, and thus the beneficiary’s share of W-2 wages from that trust or estate, is determined under the law applicable to pass-thru entities based on the beginning date of the taxable year of the trust or estate, regardless of the beginning date of the taxable year of the beneficiary.

(4) Example. The following example illustrates the application of this paragraph (e). Assume that the partnership, trust, and trust beneficiary all are calendar year taxpayers. The example reads as follows:

Example. (i) Computation of DNI and inclusion and deduction amounts. (A) Trust’s distributive share of partnership items. Trust, a complex trust, is a partner in PRS, a partnership that engages in activities that generate DPGR and non-DPGR. In 2010, PRS distributes $10,000 cash to Trust. PRS properly allocates (in the same manner as wage expense) paragraph (e)(1) wages of $3,000 to Trust. Trust’s distributive share of PRS items, which are properly included in Trust’s DNI, is as follows:

(B) Trust’s direct activities. In addition to its cash distribution in 2010 from PRS, Trust directly has the following items which are properly included in Trust’s DNI:

(C) Allocation 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 under §1.652(b)-3(a) to the distributive share of income of PRS. Accordingly, the $5,000 of CGS, $3,000 of selling expenses, and $2,000 of other expenses are subtracted from the gross receipts from PRS ($20,000), resulting in net income from PRS of $10,000. With respect to the Trust’s direct expenses, $1,000 of the trustee commissions, the $1,000 of real estate taxes, and the $2,000 of wage expense are directly attributable under §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 the sum of the balance of the trustee commissions ($2,000), state income and personal property taxes ($5,000), and the other business expenses ($1,000) to the $10,000 of tax-exempt interest. The portion to be attributed to tax-exempt interest is $2,222 ($8,000 x ($10,000 tax exempt interest/$36,000 gross receipts net of direct expenses)), resulting in $7,778 ($10,000 - $2,222) of net tax-exempt interest. Pursuant to its authority recognized under §1.652(b)-3(b), the trustee allocates the entire amount of the remaining $5,778 of trustee commissions, state income and personal property taxes, and other business expenses to the $6,000 of net rental income, resulting in $222 ($6,000 - $5,778) of net rental income.

(D) Amounts included in taxable income. For 2010, Trust has DNI of $28,000 (net dividend income of $10,000 + net PRS income of $10,000 + net rental income of $222 + net tax-exempt income of $7,778). Pursuant to Trust’s governing instrument, Trustee distributes 50%, or $14,000, of that DNI to B, an individual who is a discretionary beneficiary of Trust. Assume that there are no separate shares under Trust, and no distributions are made to any other beneficiary that year. Consequently, with respect to the $14,000 distribution B receives from Trust, B properly includes in B’s gross income $5,000 of income from PRS, $111 of rents, and $5,000 of dividends, and properly excludes from B’s gross income $3,889 of tax-exempt interest. Trust includes $20,222 in its adjusted total income and deducts $10,111 under section 661(a) in computing its taxable income.

(ii) Section 199 deduction. (A) Simplified deduction method. For purposes of computing the section 199 deduction for the taxable year, assume Trust qualifies for the simplified deduction method under §1.199-4(e). The determination of Trust’s QPAI under the simplified deduction method requires multiple steps to allocate costs. First, the Trust’s expenses directly attributable to DPGR under §1.652(b)-3(a) are subtracted from the Trust’s DPGR. In this step, the directly attributable $5,000 of CGS and selling expenses of $3,000 are subtracted from the $15,000 of DPGR from PRS. Second, the Trust’s expenses directly attributable under §1.652(b)-3(a) to non-DPGR from a trade or business are subtracted from the Trust’s trade or business non-DPGR. In this step, $4,000 of Trust expenses directly allocable to the real property rental activity ($1,000 of real estate taxes, $1,000 of Trustee commissions, and $2,000 of wages) are subtracted from the $10,000 of rental income. Third, Trust must identify the portion of its other expenses that is attributable to Trust’s trade or business activities, if any, because expenses not attributable to trade or business activities are not taken into account in computing QPAI. In this step, in this example, the portion of the trustee commissions not directly attributable to the rental operation ($2,000) is directly attributable to non-trade or business activities. In addition, the state income and personal property taxes are not directly attributable under §1.652(b)-3(a) to either trade or business or non-trade or business activities, so the portion of those taxes not attributable to either the PRS interests or the rental operation is not a trade or business expense and, thus, is not taken into account in computing QPAI. The portion of the state income and personal property taxes that is treated as an other trade or business expense is $3,000 ($5,000 x $30,000 total trade or business gross receipts/$50,000 total gross receipts). Fourth, Trust then allocates its other trade or business expenses (not directly attributable under §1.652(b)-3(a)) between DPGR and non-DPGR on the basis of its total gross receipts from the conduct of a trade or business ($20,000 from PRS + $10,000 rental income). Thus, Trust combines its non-directly attributable (other) business expenses ($2,000 from PRS + $4,000 ($1,000 of other business expenses + $3,000 of income and property taxes allocated to a trade or business) from its own activities) and then apportions this total ($6,000) between DPGR and other receipts on the basis of Trust’s total trade or business gross receipts ($6,000 of such expenses x $15,000 DPGR/$30,000 total trade or business gross receipts = $3,000). Thus, for purposes of computing Trust’s and B’s section 199 deduction, Trust’s QPAI is $4,000 ($7,000 ($15,000 DPGR - $5,000 CGS - $3,000 selling expenses) - $3,000). Because the distribution of Trust’s DNI to B equals one-half of Trust’s DNI, Trust and B each has QPAI from PRS for purposes of the section 199 deduction of $2,000. B has $1,000 of QPAI from non-Trust activities that is added to the $2,000 QPAI from Trust for a total of $3,000 of QPAI.

(B) W-2 wages. For the 2010 taxable year, Trust chooses to use the wage expense safe harbor under §1.199-2(e)(2)(ii) to determine its W-2 wages. For its taxable year ending December 31, 2010, Trust has $5,000 ($3,000 from PRS + $2,000 of Trust) of paragraph (e)(1) wages reported on 2010 Forms W-2. Trust’s W-2 wages are $2,917, as shown in the following table:

(C) Section 199 deduction computation. (1) B’s computation. B is eligible to use the small business simplified overall method. Assume that B has sufficient adjusted gross income so that the section 199 deduction is not limited under section 199(a)(1)(B). Because the $14,000 Trust distribution to B equals one-half of Trust’s DNI, B has W-2 wages from Trust of $1,459 (50% x $2,917). B has W-2 wages of $100 from trade or business activities outside of Trust and attributable to DPGR (computed without regard to B’s interest in Trust pursuant to §1.199-2(e)) for a total of $1,559 of W-2 wages. B has $1,000 of QPAI from non-Trust activities that is added to the $2,000 QPAI from Trust for a total of $3,000 of QPAI. B’s tentative deduction is $270 (.09 x $3,000), limited under the W-2 wage limitation to $780 (50% x $1,559 W-2 wages). Accordingly, B’s section 199 deduction for 2010 is $270.

(2) Trust’s computation. Trust has sufficient adjusted gross income so that the section 199 deduction is not limited under section 199(a)(1)(B). Because the $14,000 Trust distribution to B equals one-half of Trust’s DNI, Trust has W-2 wages of $1,459 (50% x $2,917). Trust’s tentative deduction is $180 (.09 x $2,000 QPAI), limited under the W-2 wage limitation to $730 (50% x $1,459 W-2 wages). Accordingly, Trust’s section 199 deduction for 2010 is $180.

(f) Gain or loss from the disposition of an interest in a pass-thru entity. DPGR generally does not include gain or loss recognized on the sale, exchange, or other disposition of an interest in a pass-thru entity. However, with respect to a partnership, if section 751(a) or (b) applies, then gain or loss attributable to assets of the partnership giving rise to ordinary income under section 751(a) or (b), the sale, exchange, or other disposition of which would give rise to DPGR, is taken into account in computing the partner’s section 199 deduction. Accordingly, to the extent that cash or property received by a partner in a sale or exchange of all or part of its partnership interest is attributable to unrealized receivables or inventory items within the meaning of section 751(c) or (d), respectively, and the sale or exchange of the unrealized receivable or inventory items would give rise to DPGR if sold, exchanged, or otherwise disposed of by the partnership, the cash or property received by the partner is taken into account by the partner in determining its DPGR for the taxable year. Likewise, to the extent that a distribution of property to a partner is treated under section 751(b) as a sale or exchange of property between the partnership and the distributee partner, and any property deemed sold or exchanged would give rise to DPGR if sold, exchanged, or otherwise disposed of by the partnership, the deemed sale or exchange of the property must be taken into account in determining the partnership’s and distributee partner’s DPGR to the extent not taken into account under the qualifying in-kind partnership rules. See §§1.751-1(b) and 1.199-3(i)(7).

(g) No attribution of qualified activities. Except as provided in §1.199-3(i)(7) regarding qualifying in-kind partnerships and §1.199-3(i)(8) regarding EAG partnerships, an owner of a pass-thru entity is not treated as conducting the qualified production activities of the pass-thru entity, and vice versa. This rule applies to all partnerships, including partnerships that have elected out of subchapter K under section 761(a). Accordingly, if a partnership manufactures QPP within the United States, or produces a qualified film or produces utilities in the United States, and distributes or leases, rents, licenses, sells, exchanges, or otherwise disposes of such property to a partner who then, without performing its own qualifying activity, leases, rents, licenses, sells, exchanges, or otherwise disposes of such property, then the partner’s gross receipts from this latter lease, rental, license, sale, exchange, or other disposition are treated as non-DPGR. In addition, if a partner manufactures QPP within the United States, or produces a qualified film or produces utilities in the United States, and contributes or leases, rents, licenses, sells, exchanges, or otherwise disposes of such property to a partnership which then, without performing its own qualifying activity, leases, rents, licenses, sells, exchanges, or otherwise disposes of such property, then the partnership’s gross receipts from this latter disposition are treated as non-DPGR.

* * * * *

(b) * * *

(4) Losses used to reduce taxable income of expanded affiliated group—(i) In general. The amount of an NOL sustained by any member of an EAG that is used in the year sustained in determining an EAG’s taxable income limitation under section 199(a)(1)(B) is not treated as an NOL carryover or NOL carryback to any taxable year in determining the taxable income limitation under section 199(a)(1)(B). For purposes of this paragraph (b)(4), an NOL is considered to be used if it reduces an EAG’s aggregate taxable income, regardless of whether the use of the NOL actually reduces the amount of the section 199 deduction that the EAG would otherwise derive. An NOL is not considered to be used to the extent that it reduces an EAG’s aggregate taxable income to an amount less than zero. If more than one member of an EAG has an NOL used in the same taxable year to reduce the EAG’s taxable income, the members’ respective NOLs are deemed used in proportion to the amount of their NOLs.

(ii) Examples. The following examples illustrate the application of this paragraph (b)(4). For purposes of these examples, assume that all relevant parties have sufficient W-2 wages so that the section 199 deduction is not limited under section 199(b)(1). The examples read as follows:

Example 1. (i) Facts. Corporations A and B are the only two members of an EAG. A and B are both calendar year taxpayers, and they do not join in the filing of a consolidated Federal income tax return. Neither A nor B had taxable income or loss prior to 2010. In 2010, A has QPAI and taxable income of $1,000, and B has QPAI of $1,000 and an NOL of $1,500. In 2011, A has QPAI of $2,000 and taxable income of $1,000 and B has QPAI of $2,000 and taxable income prior to the NOL deduction allowed under section 172 of $2,000.

(ii) Section 199 deduction for 2010. In determining the EAG’s section 199 deduction for 2010, A’s $1,000 of QPAI and B’s $1,000 of QPAI are aggregated, as are A’s $1,000 of taxable income and B’s $1,500 NOL. Thus, for 2010, the EAG has QPAI of $2,000 and taxable income of ($500). The EAG’s section 199 deduction for 2010 is 9% of the lesser of its QPAI or its taxable income. Because the EAG has a taxable loss in 2010, the EAG’s section 199 deduction is $0.

(iii) Section 199 deduction for 2011. In determining the EAG’s section 199 deduction for 2011, A’s $2,000 of QPAI and B’s $2,000 of QPAI are aggregated, giving the EAG QPAI of $4,000. Also, $1,000 of B’s NOL from 2010 was used in 2010 to reduce the EAG’s taxable income to $0. The remaining $500 of B’s 2010 NOL is not considered to have been used in 2010 because it reduced the EAG’s taxable income below $0. Accordingly, for purposes of determining the EAG’s taxable income limitation under section 199(a)(1)(B) in 2011, B is deemed to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income. Thus, B’s taxable income in 2011 is $1,500 which is aggregated with A’s $1,000 of taxable income. The EAG’s taxable income limitation in 2011 is $2,500. The EAG’s section 199 deduction is 9% of the lesser of its QPAI of $4,000 or its taxable income of $2,500. Thus, the EAG’s section 199 deduction in 2011 is 9% of $2,500, or $225. The results would be the same if neither A nor B had QPAI in 2010.

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

Example 3. The facts are the same as in Example 1 except that B is not a member of any EAG in 2011. Because $1,000 of B’s NOL was used in 2010 to reduce the EAG’s taxable income to $0, B is considered to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income for purposes of the taxable income limitation under section 199(a)(1)(B), just as in Example 1. Thus, for purposes of determining B’s taxable income limitation in 2011, B is considered to have taxable income of $1,500, and B has a section 199 deduction of 9% of $1,500, or $135.

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

* * * * *

* * * * *

(h) Disallowed losses or deductions. * * * For taxpayers that are partners in partnerships, see §§1.199-5(b)(2) and 1.199-9(b)(2). For taxpayers that are shareholders in S corporations, see §§1.199-5(c)(2) and 1.199(c)(2).

(i) * * *

(5) Tax Increase Prevention and Reconciliation Act of 2005. Sections 1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 are applicable for taxable years beginning on or after October 19, 2006. A taxpayer may apply §§1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 to taxable years beginning after May 17, 2006, and before October 19, 2006, regardless of whether the taxpayer otherwise relied upon Notice 2005-14, 2005-1 C.B. 498 (see §601.601(d)(2)(ii)(b) of this chapter), the provisions of REG-105847-05, 2005-2 C.B. 987, or §§1.199-1 through 1.199-8.

(6) Losses used to reduce taxable income of expanded affiliated group. Section 1.199-7(b)(4) is applicable for taxable years beginning on or after February 15, 2008. For taxable years beginning on or after October 19, 2006, and before February 15, 2008, see §1.199-7T(b)(4) (see 26 CFR part 1 revised as of April 1, 2007).

* * * * *

* * * * *

(b) * * *

(1) * * *

(ii) * * *

(B) For purposes of computing the partner’s QPAI under §§1.199-1 through 1.199-9, a partner does not take into account the items from the partnership (for example, a partner does not take into account items from the partnership in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources;

* * * * *

(c) * * *

(1) * * *

(ii) * * *

(B) For purposes of computing the shareholder’s QPAI under §§1.199-1 through 1.199-9, a shareholder does not take into account the items from the S corporation (for example, a shareholder does not take into account items from the S corporation in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources;

* * * * *

(e) * * *

(2) * * * (i) In general. The QPAI of a trust or estate (which will be less than zero if the CGS and deductions allocated and apportioned to DPGR exceed the trust’s or estate’s DPGR) and W-2 wages of a trust or estate are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust’s or estate’s distributable net income (DNI), as defined by section 643(a), for the taxable year that is distributed or required to be distributed to the beneficiary or is retained by the trust or estate. For this purpose, the trust or estate’s DNI is determined with regard to the separate share rule of section 663(c), but without regard to section 199. To the extent that the trust or estate has no DNI for the taxable year, any QPAI and W-2 wages are allocated entirely to the trust or estate. A trust or estate is allowed the section 199 deduction in computing its taxable income to the extent that QPAI and W-2 wages are allocated to the trust or estate. A beneficiary of a trust or estate is allowed the section 199 deduction in computing its taxable income based on its share of QPAI and W-2 wages from the trust or estate, which (subject to the wage limitation as described in paragraph (e)(3) of this section) are aggregated with the beneficiary’s QPAI and W-2 wages from other sources, if any.

* * * * *

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

Approved February 1, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

(a) Description. Section 1221(b)(3) allows an electing taxpayer to treat the sale or exchange of a musical composition or copyright in a musical work created by the taxpayer’s personal efforts (or having a basis determined by reference to the basis of such property in the hands of a taxpayer whose personal efforts created such property) as the sale or exchange of a capital asset. As a consequence, gain or loss from the sale or exchange is treated as capital gain or loss. An election may be made for sales and exchanges in taxable years beginning after May 17, 2006.

(b) Time and manner for making the election. An election described in this section is made separately for each musical composition (or copyright in a musical work) sold or exchanged during the taxable year. An election must be made on or before the due date (including extensions) of the income tax return for the taxable year of the sale or exchange. An election is to be made on Schedule D, “Capital Gains and Losses,” of the appropriate income tax form (for example, Form 1040, “U.S. Individual Income Tax Return;” Form 1065, “U.S. Return of Partnership Income;” Form 1120, “U.S. Corporation Income Tax Return”) by treating the sale or exchange as the sale or exchange of a capital asset, in accordance with the form and its instructions.

(c) Revocability of election. An election described in this section is revocable with the consent of the Commissioner. To seek consent to revoke an election, a taxpayer must submit a request for a letter ruling under the appropriate revenue procedure. See, for example, Rev. Proc. 2007-1, 2007-1 C.B. 1 (updated annually). Alternatively, an automatic extension of 6 months from the due date of the taxpayer’s income tax return (excluding extensions) is granted to revoke an election, provided the taxpayer timely filed the taxpayer’s income tax return and, within this 6-month extension period, the taxpayer files an amended income tax return that treats the sale or exchange as the sale or exchange of property that is not a capital asset. See §601.601(d)(2)(ii)(b) of this Chapter.

(d) Effective/applicability date. (1) The rules of this section apply to sales and exchanges in taxable years beginning after May 17, 2006.

(2) Expiration date. This section expires on February 8, 2011.

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

Approved January 28, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

Par. 2. Section 301.6020-1T is removed.

Par. 3. Section 301.6020-1 is added to read as follows:

(a) Preparation of returns—(1) In general. If any person required by the Internal Revenue Code or by the regulations to make a return fails to make such return, it may be prepared by the Commissioner or other authorized Internal Revenue Officer or employee provided such person consents to disclose all information necessary for the preparation of such return. The return upon being signed by the person required to make it shall be received by the Commissioner as the return of such person.

(2) Responsibility of person for whom return is prepared. A person for whom a return is prepared in accordance with paragraph (a)(1) of this section shall for all legal purposes remain responsible for the correctness of the return to the same extent as if the return had been prepared by him.

(b) Execution of returns—(1) In general. If any person required by the Internal Revenue Code or by the regulations to make a return (other than a declaration of estimated tax required under section 6654 or 6655) fails to make such return at the time prescribed therefore, or makes, willfully or otherwise, a false, fraudulent or frivolous return, the Commissioner or other authorized Internal Revenue Officer or employee shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise. The Commissioner or other authorized Internal Revenue Officer or employee may make the return by gathering information and making computations through electronic, automated or other means to make a determination of the taxpayer’s tax liability.

(2) Form of the return. A document (or set of documents) signed by the Commissioner or other authorized Internal Revenue Officer or employee shall be a return for a person described in paragraph (b)(1) of this section if the document (or set of documents) identifies the taxpayer by name and taxpayer identification number, contains sufficient information from which to compute the taxpayer’s tax liability, and purports to be a return. A Form 13496, “IRC Section 6020(b) Certification,” or any other form that an authorized Internal Revenue Officer or employee signs and uses to identify a set of documents containing the information set forth in this paragraph as a section 6020(b) return, and the documents identified, constitute a return under section 6020(b). A return may be signed by the name or title of an Internal Revenue Officer or employee being handwritten, stamped, typed, printed or otherwise mechanically affixed to the return, so long as that name or title was placed on the document to signify that the Internal Revenue Officer or employee adopted the document as a return for the taxpayer. The document and signature may be in written or electronic form.

(3) Status of returns. Any return made in accordance with paragraph (b)(1) of this section and signed by the Commissioner or other authorized Internal Revenue Officer or employee shall be good and sufficient for all legal purposes except insofar as any Federal statute expressly provides otherwise. Furthermore, the return shall be treated as the return filed by the taxpayer for purposes of determining the amount of the addition to tax under sections 6651(a)(2) and (3).

(4) Deficiency procedures. For deficiency procedures in the case of income, estate, and gift taxes, see §§6211 through 6216, inclusive, and §§301.6211-1 through 301.6215-1, inclusive.

(5) Employment status procedures. For pre-assessment procedures in employment taxes cases involving worker classification, see section 7436 (proceedings for determination of employment status).

(6) Examples. The application of this paragraph (b) is illustrated by the following examples:

Example 1. Individual A, a calendar-year taxpayer, fails to file his 2003 return. Employee X, an Internal Revenue Service employee, opens an examination related to A’s 2003 taxable year. At the end of the examination, X completes a Form 13496, “IRC Section 6020(b) Certification,” and attached to it the documents listed on the form. Those documents explain examination changes and provide sufficient information to compute A’s tax liability. The Form 13496 provides that the Service employee identified on the form certifies that the attached pages constitute a return under section 6020(b). When X signs the certification package, the package constitutes a return under paragraph (b) of this section because the package identifies A by name, contains A’s taxpayer identifying number (TIN), has sufficient information to compute A’s tax liability, and contains a statement stating that it constitutes a return under section 6020(b). In addition, the Service will determine the amount of the additions to tax under section 6651(a)(2) by treating the section 6020(b) return as the return filed by the taxpayer. Likewise, the Service will determine the amount of any addition to tax under section 6651(a)(3), which arises only after notice and demand for payment, by treating the section 6020(b) return as the return filed by the taxpayer.

Example 2. Same facts as in Example 1, except that, after performing the examination, X does not compile any examination documents together as a related set of documents. X also does not sign and complete the Form 13496 nor associate the forms explaining examination changes with any other document. Because X did not sign any document stating that it constitutes a return under section 6020(b) and the documents otherwise do not purport to be a section 6020(b) return, the documents do not constitute a return under section 6020(b). Therefore, the Service cannot determine the section 6651(a)(2) addition to tax against nonfiler A for A’s 2003 taxable year on the basis of those documents.

Example 3. Individual C, a calendar-year taxpayer, fails to file his 2003 return. The Service determines through its automated internal matching programs that C received reportable income and failed to file a return. The Service, again through its automated systems, generates a Letter 2566, “30 Day Proposed Assessment (SFR-01) 910 SC/CG.” This letter contains C’s name, TIN, and has sufficient information to compute C’s tax liability. Contemporaneous with the creation of the Letter 2566, the Service, through its automated system, electronically creates and stores a certification stating that the electronic data contained as part of C’s account constitutes a valid return under section 6020(b) as of that date. Further, the electronic data includes the signature of the Service employee authorized to sign the section 6020(b) return upon its creation. Although the signature is stored electronically, it can appear as a printed name when the Service requests a paper copy of the certification. The electronically created information, signature, and certification is a return under section 6020(b). The Service will treat that return as the return filed by the taxpayer in determining the amount of the section 6651(a)(2) addition to tax with respect to C’s 2003 taxable year. Likewise, the Service will determine the amount of any addition to tax under section 6651(a)(3), which arises only after notice and demand for payment, by treating the section 6020(b) return as the return filed by the taxpayer.

Example 4. Corporation M, a quarterly taxpayer, fails to file a Form 941, “Employer’s QUARTERLY Federal Tax Return,” for the second quarter of 2004. Q, a Service employee authorized to sign returns under section 6020(b), prepares a Form 941 by hand, stating Corporation M’s name, address, and TIN. Q completes the Form 941 by entering line item amounts, including the tax due, and then signs the document. The Form 941 that Q prepared and signed constitutes a section 6020(b) return because the Form 941 purports to be a return under section 6020(b), the form contains M’s name and TIN, and it includes sufficient information to compute M’s tax liability for the second quarter of 2004.

(c) Cross references—(1) For provisions that a return executed by the Commissioner or other authorized Internal Revenue Officer or employee will not start the running of the period of limitations on assessment and collection, see section 6501(b)(3) and §301.6501(b)-1(e).

(2) For determining the period of limitations on collection after assessment of a liability on a return executed by the Commissioner or other authorized Internal Revenue Officer or employee, see section 6502 and §301.6502-1.

(3) For additions to the tax and additional amounts for failure to file returns, see section 6651 and §301.6651-1, and section 6652 and §301.6652-1, respectively.

(4) For additions to the tax for failure to pay tax, see section 6651 and §301.6651-1.

(5) For criminal penalties for willful failure to make returns, see sections 7201, 7202 and 7203.

(6) For criminal penalties for willfully making false or fraudulent returns, see sections 7206 and 7207.

(7) For civil penalties for filing frivolous income tax returns, see section 6702.

(8) For authority to examine books and witnesses, see section 7602 and §301.7602-1.

(d) Effective/Applicability date. This section is applicable on February 20, 2008.

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

Approved February 5, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

(a) Release of lien—(1) Liability satisfied or unenforceable. The appropriate official shall issue a certificate of release for a filed notice of Federal tax lien, no later than 30 days after the date on which he finds that the entire tax liability listed in such notice of Federal tax lien either has been fully satisfied (as defined in paragraph (a)(4) of this section) or has become legally unenforceable. In all cases, the liability for the payment of the tax continues until satisfaction of the tax in full or until the expiration of the statutory period for collection, including such extension of the period for collection as is agreed to.

(2) Bond accepted. The appropriate official shall issue a certificate of release of any tax lien if he is furnished and accepts a bond that is conditioned upon the payment of the amount assessed (together with all interest in respect thereof), within the time agreed upon in the bond, but not later than 6 months before the expiration of the statutory period for collection, including any agreed upon extensions. For provisions relating to bonds, see sections 7101 and 7102 and §§301.7101-1 and 301.7102-1.

(3) Certificate of release for a lien which has become legally unenforceable. The appropriate official shall have the authority to file a notice of Federal tax lien which also contains a certificate of release pertaining to those liens which become legally unenforceable. Such release will become effective as a release as of a date prescribed in the document containing the notice of Federal tax lien and certificate of release.

(4) Satisfaction of tax liability. For purposes of paragraph (a)(1) of this section, satisfaction of the tax liability occurs when—

(i) The appropriate official determines that the entire tax liability listed in a notice of Federal tax lien has been fully satisfied. Such determination will be made as soon as practicable after tender of payment; or

(ii) The taxpayer provides the appropriate official with proof of full payment (as defined in paragraph (a)(5) of this section) with respect to the entire tax liability listed in a notice of Federal tax lien together with the information and documents set forth in paragraph (a)(7) of this section. See paragraph (a)(6) of this section if more than one tax liability is listed in a notice of Federal tax lien.

(5) Proof of full payment. As used in paragraph (a)(4)(ii) of this section, the term proof of full payment means—

(i) An internal revenue cashier’s receipt reflecting full payment of the tax liability in question;

(ii) A canceled check in an amount sufficient to satisfy the tax liability for which the release is being sought;

(iii) A record, made in accordance with procedures prescribed by the Commissioner, of proper payment of the tax liability by credit or debit card or by electronic funds transfer; or

(iv) Any other manner of proof acceptable to the appropriate official.

(6) Notice of a Federal tax lien which lists multiple liabilities. When a notice of Federal tax lien lists multiple tax liabilities, the appropriate official shall issue a certificate of release when all of the tax liabilities listed in the notice of Federal tax lien have been fully satisfied or have become legally unenforceable. In addition, if the taxpayer requests that a certificate of release be issued with respect to one or more tax liabilities listed in the notice of Federal tax lien and such liability has been fully satisfied or has become legally unenforceable, the appropriate official shall issue a certificate of release. For example, if a notice of Federal tax lien lists two separate liabilities and one of the liabilities is satisfied, the taxpayer may request the issuance of a certificate of release with respect to the satisfied tax liability and the appropriate official shall issue a release.

(7) Taxpayer requests. A request for a certificate of release with respect to a notice of Federal tax lien shall be submitted in writing to the appropriate official. The request shall contain the information required in the appropriate IRS Publication.

(b) Discharge of specific property from the lien—(1) Property double the amount of the liability. (i) The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code if he determines that the fair market value of that part of the property remaining subject to the Federal tax lien is at least double the sum of the amount of the unsatisfied liability secured by the Federal tax lien and of the amount of all other liens upon the property which have priority over the Federal tax lien. In general, fair market value is that amount which one ready and willing but not compelled to buy would pay to another ready and willing but not compelled to sell the property.

* * * * *

(2) Part payment; interest of United States valueless—(i) Part payment. The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code if there is paid over to him in partial satisfaction of the liability secured by the Federal tax lien an amount determined by him to be not less than the value of the interest of the United States in the property to be so discharged. In determining the amount to be paid, the appropriate official will take into consideration all the facts and circumstances of the case, including the expenses to which the government has been put in the matter. In no case shall the amount to be paid be less than the value of the interest of the United States in the property with respect to which the certificate of discharge is to be issued.

(ii) Interest of the United States valueless. The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to the Federal tax lien if he determines that the interest of the United States in the property to be so discharged has no value.

(3) Discharge of property by substitution of proceeds of sale. The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code if such part of the property is sold and, pursuant to a written agreement with the appropriate official, the proceeds of the sale are held, as a fund subject to the Federal tax liens and claims of the United States, in the same manner and with the same priority as the Federal tax liens or claims had with respect to the discharged property. This paragraph does not apply unless the sale divests the taxpayer of all right, title, and interest in the property sought to be discharged. Any reasonable and necessary expenses incurred in connection with the sale of the property and the administration of the sale proceeds shall be paid by the applicant or from the proceeds of the sale before satisfaction of any Federal tax liens or claims of the United States.

(4) Right of substitution of value—(i) Issuance of certificate of discharge to property owner who is not the taxpayer. If an owner of property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code submits an application for a certificate of discharge pursuant to paragraph (b)(5) of this section, the appropriate official shall issue a certificate of discharge of such property after the owner either deposits with the appropriate official an amount equal to the value of the interest of the United States in the property, as determined by the appropriate official pursuant to paragraph (b)(6) of this section, or furnishes an acceptable bond in a like amount. This paragraph does not apply if the person seeking the discharge is the person whose unsatisfied liability gave rise to the Federal tax lien. Thus, if the property is owned by both the taxpayer and another person, the other person may obtain a certificate of discharge of the property under this paragraph, but the taxpayer may not.

(ii) Refund of deposit and release of bond. The appropriate official may, in his discretion, determine that either the entire unsatisfied tax liability listed on the notice of Federal tax lien can be satisfied from a source other than the property sought to be discharged, or the value of the interest of the United States is less than the prior determination of such value. The appropriate official shall refund the amount deposited with interest at the overpayment rate determined under section 6621 or release the bond furnished to the extent that he makes this determination.

(iii) Refund request. If a property owner desires an administrative refund of his deposit or release of the bond, the owner shall file a request in writing with the appropriate official. The request shall contain such information as the appropriate IRS Publication may require. The request must be filed within 120 days after the date the certificate of discharge is issued. A refund request made under this paragraph neither is required nor is effective to extend the period for filing an action in court under section 7426(a)(4).

(iv) Internal Revenue Service’s use of deposit if court action not filed. If no action is filed under section 7426(a)(4) for refund of the deposit or release of the bond within the 120-day period specified therein, the appropriate official shall, within 60 days after the expiration of the 120-day period, apply the amount deposited or collect on such bond to the extent necessary to satisfy the liability listed on the notice of Federal tax lien, and shall refund, with interest at the overpayment rate determined under section 6621, any portion of the amount deposited that is not used to satisfy the liability. If the appropriate official has not completed the application of the deposit to the unsatisfied liability before the end of the 60-day period, the deposit will be deemed to have been applied to the unsatisfied liability as of the 60^th day.

(5) Application for certificate of discharge. Any person desiring a certificate of discharge under this paragraph (b) shall submit an application in writing to the appropriate official. The application shall contain the information required by the appropriate IRS Publication. For purposes of this paragraph (b), any application for certificate of discharge made by a property owner who is not the taxpayer, and any amount submitted pursuant to the application, will be treated as an application for discharge and a deposit under section 6325(b)(4) unless the owner of the property submits a statement, in writing, that the application is being submitted under another paragraph of section 6325 and not under section 6325(b)(4), and the owner in writing waives the rights afforded under paragraph (b)(4), including the right to seek judicial review.

(6) Valuation of interest of United States. For purposes of paragraphs (b)(2) and (b)(4) of this section, in determining the value of the interest of the United States in the property, or any part thereof, with respect to which the certificate of discharge is to be issued, the appropriate official shall give consideration to the value of the property and the amount of all liens and encumbrances thereon having priority over the Federal tax lien. In determining the value of the property, the appropriate official may, in his discretion, give consideration to the forced sale value of the property in appropriate cases.

* * * * *

(h) As used in this section, the term appropriate official means either the official or office identified in the relevant IRS Publication or, if such official or office is not so identified, the Secretary or his delegate.

(i) Effective/applicability date. This section applies to any release of lien or discharge of property that is requested after January 31, 2008.

Par. 3. Section 301.6503(f)-1 is amended as follows:

1. The section heading is revised.

2. The undesignated paragraph is designated as paragraph (a), a paragraph heading is added, and a new sentence is added immediately prior to the Example.

3. In newly designated paragraph (a), the language “a district director” is removed and the language “the appropriate official” is added in its place, the language “the district director” is removed and the language “the appropriate official” is added in its place, and in the Example the language “district director” is removed and the language “appropriate official” is added in its place, wherever it appears.

4. Paragraphs (b), (c), and (d) are added.

The revisions and additions read as follows:

(a) Wrongful seizure. * * * The following example illustrates the principles of this section:

* * * * *

(b) Discharge of wrongful lien for substitution of value. If a person other than the taxpayer submits a request in writing for a certificate of discharge for a filed Federal tax lien under section 6325(b)(4), the running of the period of limitations on collection after assessment under section 6502 for any liability listed in such notice of Federal tax lien shall be suspended for a period equal to the period beginning on the date the appropriate official receives a deposit or bond in the amount specified in §301.6325-1(b)(4)(i) and ending on the date that is 30 days after the earlier of—

(1) The date the appropriate official no longer holds, or is deemed to no longer hold, within the meaning of paragraph (b)(4)(iv) of this section, any amount as a deposit or bond by reason of taking such actions as prescribed in sections 6325(b)(4)(B) and (C); or

(2) The date the judgment secured under section 7426(b)(5) becomes final.

(c) As used in this section, the term appropriate official means either the official or office identified in the relevant IRS Publication or, if such official or office is not so identified, the Secretary or his delegate.

(d) Effective/applicability date. This section applies to any request for a certificate of discharge made after January 31, 2008.

Par. 4. In §301.7426-1, paragraphs (a)(4), (b)(5), and (d) are added.

(a) * * *

(4) Substitution of value. A person who obtains a certificate of discharge under section 6325(b)(4) with respect to any property may, within 120 days after the day on which the certificate is issued, bring a civil action against the United States in a district court of the United States for a determination of whether the value of the interest of the United States (if any) in such property is less than the value determined by the appropriate official. A civil action under this provision shall be the exclusive judicial remedy for a person other than the taxpayer who obtains a certificate of discharge for a filed notice of Federal tax lien.

(b) * * *

(5) Substitution of value. If the court determines that the determination by the appropriate official of the value of the interest of the United States in the property exceeds the actual value of such interest, the court may grant a judgment ordering a refund of the amount deposited, or a release of the bond, to the extent that the aggregate of those amounts exceeds the value as determined by the court.

* * * * *

(d) Paragraphs (a)(4) and (b)(5) of this section apply to any request for a certificate of discharge made after January 31, 2008.

[The text of proposed §1.1221-3 is the same as the text of §1.1221-3T(a) through (d)(1) published elsewhere in this issue of the Bulletin.]

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.