In Industry Director Directive on Domestic Production Deduction #3 (3/4/2009) (the “IDD”), the IRS addressed the treatment of post-2004 compensation deductions (e.g., pension expense and medical-related costs) that relate to services rendered prior to 2005. The IDD held that the treatment of such deductions requires an analysis under the “section 861 method”. In lieu of detailed support regarding the lack of a factual relationship between a deduction and domestic production gross receipts (“DPGR”), the IDD allowed taxpayers to treat such deductions as not properly allocable to DPGR, subject to a 10% haircut. The haircut relates to the — sometimes real, sometimes theoretical – possibility that some of the services rendered prior to 2005 may relate to the production of (post-2004) DPGR. The scope of the IDD was limited to expenses not subject to §263A.

The IDD did not address the treatment of post-2004 non-compensatory deductions (e.g., legal settlements and damage awards) that relate to pre-2005 events. Many taxpayers, however, have taken the position that such expenses are not properly allocable to DPGR. In CCA 201446018 (11/14/2014) (the “CCA”), the IRS now has addressed this issue. The CCA provides, generally, that litigation damages award payments in connection with litigation commenced prior to 2005 are not properly allocable to DPGR and, thus, should not reduce qualified production activities income (“QPAI”) in the year the payments are made. Taxpayers who have taken this position (either with respect to litigation damages or other non-compensatory deductions having a pre-2005 genesis) should derive some comfort from the CCA. Taxpayers who have been reluctant to apply the IDD beyond its stated scope (or who, frankly, have not considered the issue) should evaluate whether, in open tax years, QPAI has been reduced inappropriately as a result of pre-2005 non-compensatory events.

(Having survived two paragraphs of this blog post, you are hereby directed to my TaxConnections Tax Library, which contains what I have been told is a very useful Section 199 outline.)

A very important caveat, however, is that the CCA, in addition to having little or no precedential value, applies the section 861 regulations to a specific set of facts. The CCA involves two litigations, each of which (i) was commenced prior to 2005, (ii) related exclusively to products sold prior to 2005, and (iii) was resolved by court-ordered awards rather than by a settlement between the parties. The CCA states, correctly, that the “section 861 method requires the determination of the factual relationship of a deduction to a class of gross income and to the statutory and residual groupings of gross income within that class of gross income.” It should not surprise taxpayers (or their advisors) that IRS Exam will not, in all instances, reach taxpayer-favorable conclusions when presented with facts that differ from those presented in the CCA.

An additional, very important issue is the treatment of costs that arise from pre-2005 events but are included in cost of goods sold in a year to which section 199 applies. By their terms, the IDD and the CCA do not apply to any such amounts. The proper treatment of such amounts requires a careful analysis of Treas. Regs. §1.199-4(b). Based on a not-very-careful analysis of that portion of the section 199 regulations, the IRS has concluded that taxpayers may not exclude such deductions from a QPAI calculation by treating the amounts as prior period costs. See CCA 200946037 (10/26/2009), and the reiteration of its conclusion in CCA 201446018. In the author’s opinion, taxpayers have been too quick to embrace the IRS position with respect to amounts included in cost of goods sold. Given the purpose of §263A, does it make sense that the application of §263A drives a §199 result entirely different from the treatment afforded expenses subject to §861?