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Sec. 199 deductions: Use ‘sampling’ to prove your case

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in Small Business Tax

Are you bewildered by the complex rules for the Sec. 199 domestic “manufacturing” deduction? You’re not alone. The IRS already has issued hundreds of mind-numbing pages of regulations on this issue.

Fortunately, it also is taking steps to cut down some of the paperwork.

Alert: The IRS continues to provide guidance to taxpayers in the trenches. The latest missive explains how to use a statistical sampling for this purpose. (IRS Revenue Procedure 2007-35)

But the new IRS procedure goes only so far. It stops short of allowing blanket industry wide samplings without requiring you to apply your particular facts and circumstances.

Here’s the skinny:
The American Jobs Creation Act of 2004 authorized the Sec. 199 deduction.The deduction originally was set at 3% of the lesser of a company’s qualified production activity income (QPAI) or its taxable income. The deduction percentage was hiked to 6% for 2007 through 2009. It’s scheduled to increase again to 9% for 2010 and beyond. QPAI is based on domestic production gross receipts (DPGR) from qualified manufacturing activities.

Furthermore, the IRS limits the annual deduction to 50% of W-2 wages. Production activities must be performed in whole or in significant part on U.S. soil.

Under the new IRS procedure, a statistical sampling may be used for the following purposes:
  • The allocation of gross receipts between DPGR and non-DPGR
  • A determination if gross receipts qualify as DPGR on an item-by-item basis
  • An allocation of cost of goods sold between DPGR and non-DPGR
  • An allocation of deductions properly allocable to DPGR or gross income attributable to DPGR
The guidelines on statistical sampling are generally effective for tax years beginning after May 10, 2007. But you can elect to apply the rules retroactively to tax years beginning after 2004. But once you open the door to statistical sampling, the IRS can challenge your methods.

The new procedure also outlines the technical requirements for statistical samplings. For instance, a sampling must be conducted in an “unbiased scientific manner” and judgment sampling can’t be used. The cost of analyzing data and the availability of more accurate information maybe used to determine if a statistical sample is appropriate.

Tip: The new procedure details six samplings the IRS would approve. Find it at

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