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Temp regs cover allocation of Sec. 199 wages in short tax year and in acquisition or disposition

T.D. 9731, 08/26/2015, Reg. § 1.199-2, Reg. § 1.199-2T, Reg. § 1.199-8, Reg. § 1.199-8T

IRS has issued temporary regs that provide guidance for purposes of the Code Sec. 199 domestic production activities deduction (DPAD) on the allocation of W-2 wages paid by two or more taxpayers that are employers of the same employees during a calendar year, and the determination of W-2 wages if the taxpayer has a short tax year. The text of the temporary regs also serves as that of contemporaneously issued proposed regs.

For contemporaneously issued Code Sec. 199 proposed regs, see ¶ 27.

Background. Under Code Sec. 199(a)(1), a taxpayer may deduct an amount equal to 9% of the lesser of (A) the taxpayer’s qualified production activities income for the tax year, or (B) taxable income (determined without regard to Code Sec. 199) for the tax year. The DPAD under Code Sec. 199(a)(1) can’t exceed 50% of the W-2 wages of the taxpayer for the tax year.

W-2 wages means, with respect to any person for any tax year of such person, the sum of the amounts in Code Sec. 6051(a)(3) (total wages subject to Code Sec. 3401(a) income tax withholding) and Code Sec. 6051(a)(8) requiring W-2 reporting (elective deferrals under Code Sec. 402(g)(3), Code Sec. 457 deferred compensation and employee’s designated Roth contributions) paid by such person with respect to employment of employees by such person during the calendar year ending during such tax year. (Code Sec. 199(b)(2)(A))

RIA observation: As a result of the 50%-of-W-2-wages limitation on the DPAD, the more a taxpayer may treat as paid in W-2 wages for a tax year, the greater may be the amount of the Code Sec. 199 deduction for that tax year.

Code Sec. 199(b)(3) authorizes IRS to provide for the application of Code Sec. 199(b) in cases of a short tax year or where the taxpayer acquires, or disposes of, the major portion of a trade or business, or the major portion of a separate unit of a trade or business, during the tax year. The former final reg (former Reg. § 1.199-2(c)) provided that if a taxpayer (a successor) acquired a trade or business, the major portion of a trade or business, or the major portion of a separate unit of a trade or business from another taxpayer (a predecessor), then, for purposes of computing the respective Code Sec. 199 deduction of the successor and of the predecessor, the W-2 wages paid for that calendar year were to be allocated between the successor and the predecessor based on whether the wages were for employment by the successor or for employment by the predecessor. Thus, the W-2 wages were allocated based on whether the wages were for employment for a period during which the employee was employed by the predecessor or for employment for a period during which the employee was employed by the successor. This wage allocation was made regardless of which permissible method was used by a predecessor or a successor for reporting wages on Form W-2 as provided in Rev Proc 2004-53, 2004-2 CB 320.

In Rev Proc 2006-47, 2006-2 CB 869, Sec. 6.02(A), IRS provides that the amount of W-2 wages for a taxpayer with a short tax year includes only those wages subject to Federal income tax withholding that are reported on Form W-2, “Wage and Tax Statement,” for the calendar year ending with or within that short tax year.

However, in certain situations, a short tax year may not include a calendar year ending within such short tax year. The former Reg §1.199-2(c) dis not address these situations and did not reflect the amendment made by the Tax Increase Prevention Act of 2014.

Solely for purposes of Code Sec. 199, IRS is revising the final regs to provide guidance on the application of Code Sec. 199(b)(3) to a short tax year that doesn’t include a calendar year ending within the short tax year. The language of former Reg §1.199-2(c) has been removed and is replaced with a cross reference to the temporary regs.

Temporary regs. The temporary regs provide rules for calculating W-2 wages for purposes of the W-2 wage limitation in the case of an acquisition or disposition of a trade or business, the major portion of a trade or business, or the major portion of a separate unit of a trade or business during the tax year, or a short tax year.

Specifically, they provide a rule for acquisitions and dispositions if one or more taxpayers may be considered the employer of the employees of the acquired or disposed of trade or business during that calendar year. In that case, the temporary regs provide that the W-2 wages paid during the calendar year to employees of the acquired or disposed of trade or business are allocated between each taxpayer based on the period during which the employees of the acquired or disposed of trade or business were employed by the taxpayer. (Reg. § 1.199-2T(c)(1))

The temporary regs also provide a rule to apply in the case of a short tax year in which there is no calendar year ending within such short tax year (short-tax-year rule). Wages paid by a taxpayer during the short tax year to employees for employment by such taxpayer are treated as W-2 wages for such short tax year for purposes of Code Sec. 199(b)(1). (Reg. § 1.199-2T(c)(2))

The temporary regs describe types of transactions that are considered either an acquisition or disposition for purposes of Code Sec. 199(b)(3): an incorporation, a formation, a liquidation, a reorganization, or a purchase or sale of assets. (Reg. § 1.199-2T(c)(3)(i))

In addition, the regs contain cross references to Reg. § 1.199-2(a) (dealing with rules on the application of the W-2 wage limitation), Reg. § 1.199-2(b) (dealing with rules in the case of a taxpayer with a short tax year), Reg. § 1.199-2(d) (dealing with the non-duplication rule), and Reg. § 1.199-2(e) (dealing with the definition of W-2 wages). (Reg. § 1.199-2T(c)(3)(iii)) IRS recognizes that these rules continue to apply to taxpayers that use the temporary regs. For example, the non-duplication rule of Reg. § 1.199-2(d) applies such that a taxpayer that includes wages as W-2 wages based on the temporary regs, including by filing an amended return for a short tax year, may not treat those wages as W-2 wages for any other tax year. Also, wages qualifying as W-2 wages of one taxpayer based on these temporary regs cannot be treated as W-2 wages of another taxpayer.

Effective date. The temporary regs are applicable for tax years beginning on or after Aug. 27, 2015, and expire on Aug. 24, 2018. A taxpayer may apply Reg. § 1.199-2T(c) to tax years for which the limitations for assessment of tax has not expired beginning before Aug. 27, 2015. (Reg. § 1.199-8T(i)(10))

References: For 50%-of-W-2-wages limitation on domestic production activities deduction, see FTC 2d/FIN ¶  L-4387; United States Tax Reporter ¶  1994.002  TaxDesk ¶  307,894; TG ¶  16552.

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