On February 25, the IRS issued a warning to taxpayers seeking to secure missed domestic production activities deductions under the now obsolete section 199.1 The IRS maintains that a high percentage of such claims are not properly supported and the alert notes that IRS examiners have been advised to consider penalty provisions, including penalties for an erroneous claim for refund, and even referrals to the Office of Professional Responsibility (OPR). The tone of the alert makes clear that the IRS has serious reservations about such amended return claims. Notwithstanding concerns identified by the IRS, such claims can be sustained. Nonetheless, taxpayers and their advisors should anticipate close scrutiny of these filings.
| Eversheds Sutherland Observation: IRS Exam scrutiny of section 199 deductions subsequent to the statute’s 2017 repeal is not new. In 2018, the IRS launched a section 199 compliance campaign.2 In July 2020, the IRS issued a General Legal Advice Memorandum analyzing online software activity examples that fail to meet section 199’s deduction requirements.3 Despite the IRS scrutiny of amended returns claiming section 199 deductions, taxpayers seeking to increase the CARES (Coronavirus Aid, Relief, and Economic Security) Act’s4 NOL carryback capacity may find much needed economic relief through missed section 199 deductions. The IRS alert, however, is an important reminder that any attempt to claim missed section 199 deductions in an effort to increase NOL carryback capacity must be undertaken with care; an amended return claiming missed section 199 deductions must be supported technically and with adequate substantiation. |
Section 199 provided for a domestic production activities deduction (DPAD), the goal of which was to enhance the ability of domestic businesses and producers to compete in the global economy.5 Section 199’s definition of “manufacturing” went beyond the traditional meaning and included agricultural products producers, software companies, film production companies, electric, gas, and water companies, construction companies, engineering firms, and architectural firms. Final regulations provided that gross receipts derived from the disposition of computer software produced by the taxpayer in whole or in significant part within the US qualified for the DPAD.6
One area with significant controversy under section 199 has been the treatment of computer software. The regulations limited the deduction for software by excluding gross receipts derived from customer and technical support, telecommunication services, online services such as internet access services, online banking services, and similar services from being considered the “disposition” of computer software.7 Unfortunately, technology moves faster than Congress and the software regulations were soon out of touch with the reality of technology – computer software had expanded beyond the traditional monitor to online services, mobile transactions, and mobile apps.
Disagreements over the meaning of “disposition of computer software” led to numerous controversies over the application of section 199, and such controversies are likely to persist. While Congress repealed section 199 for tax years beginning after December 31, 2017 as a part of the Tax Cuts and Jobs Act (TCJA)8, many tax years remained under examination for taxpayers claiming a section 199 deduction. In 2018, the IRS launched a section 199 campaign to “ensure taxpayer compliance with the requirements of IRC Section 199 through a claim risk review assessment and issue-based examinations.”9 Most recently, in July 2020, the IRS issued a General Legal Advice Memorandum (GLAM) analyzing online software activity that failed to meet section 199’s deduction requirements.10 In the GLAM, the taxpayer took a DPAD related to gross receipts from software used by customers over the internet to track shipments and insure shipped goods. The IRS held that the taxpayer’s gross receipts were derived from services and not from the disposition of online software. The ever-present ambiguity surrounding section 199 prevented many taxpayers from taking advantage of the deduction.
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Eversheds Sutherland Observation: Prior to the 2017 tax law change, NOLs were fully deductible and could be carried back two years and carried forward twenty years. The 2017 TCJA amended the NOL carryback rules to limit the NOL deduction to 80% of taxable income, disallow all NOL carrybacks, and allow NOL carryforwards indefinitely. Section 2303(b) of the CARES Act amended section 172(b)(1) to provide for a carryback of any NOL arising in a taxable year beginning after December 31, 2017, and before January 1, 2021, to each of the five taxable years preceding the taxable year in which the loss arises (the carryback period). Taxpayers wishing to claim the NOL carryback are afforded a six-month extension to file Forms 1045 or 1139.11 The CARES Act’s resurrection of net operating loss carrybacks has given section 199 new life. While the 2017 repeal of loss carrybacks gave little incentive to wade through the murky waters of section 199 to take a deduction, taxpayers now have great incentive. Under the CARES Act, the carryback period is for the five years preceding the NOL. For many taxpayers, the carryback period will overlap with the tax years in which section 199 was in effect. Taxpayers may find that by amending years prior to the repeal of section 199, tax years beginning before December 31, 2017, to take the DPAD under section 199, it will be possible to increase NOL carryback capacity. The section 199 deduction may be available in tax years with a higher top tax rate for years prior to the TCJA’s corporate tax rate reduction (up to 14% difference in tax rates). |
The IRS alert warns taxpayers that amended returns claiming missed section 199 deductions include a significant percentage of filings, which are not properly supported. Taxpayers should review prior IRS rulings and cases to distinguish their facts from situations when the IRS ruled a section 199 deduction was improper. With proper factual and legal support, taxpayers may take full advantage of both provisions.
| Eversheds Sutherland Observation: Taxpayers should ensure that documentation supports any section 199 deduction. Failure to support the deduction may cause the IRS to impose penalties, including section 6676, which penalizes a claim for refund or credit with respect to income tax for an “excessive amount.” It imposes a penalty of 20 percent of the excessive amount unless there is a reasonable cause showing. Other penalties are possible including referral to the OPR, may affect an advisor’s practice before the IRS. |
6 Treas. Reg. § 1.199-3(i)(6)(i).
7 Treas. Reg. § 1.199-3(i)(6)(ii). The IRS created two notable exceptions to this rule in Treas. Reg. 1.199-3(i)(6)(iii).
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