SECTION 2. BACKGROUND

Section 199(a)(1) allows a deduction equal to 9 percent (3 percent for taxable years beginning in 2005 or 2006, and 6 percent for taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the QPAI of the taxpayer for the taxable year, or (B) taxable income (determined without regard to § 199) for the taxable year (or, for an individual, adjusted gross income).

Section 199(b)(1) limits the deduction for a taxable year to 50 percent of the W–2 wages paid by the taxpayer for the taxable year. For this purpose, § 199(b)(2)(A) defines the term W–2 wages to mean, with respect to any person for any taxable year of such person, the sum of the amounts described in § 6051(a)(3) and (8) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year.

Section 199(c)(1) defines QPAI for any taxable year as an amount equal to the excess, if any, of the taxpayer’s domestic production gross receipts (DPGR) over the sum of the cost of goods sold (CGS) allocable to DPGR and other expenses, losses, or deductions (other than the deduction allowed by § 199) (deductions) that are properly allocable to such receipts. Section 1.199–4(b) of the Income Tax Regulations provides rules for determining CGS allocable to DPGR. Section 1.199–4(c) provides rules for determining the deductions that are properly allocable to DPGR or to gross income attributable to DPGR. Section 1.199–4(a) and (d) provides that a taxpayer generally must allocate and apportion its deductions using the § 861 method, as determined under the rules of §§ 1.861–8 through 1.861–17 and §§ 1.861–8T through 1.861–14T, subject to the rules in § 1.199–4(d). Section 1.199–4(e) provides that an eligible taxpayer may use the simplified deduction method to apportion deductions between DPGR and non-DPGR. Section 1.199–4(f) provides that a qualifying small taxpayer may use the small business simplified

2007–23 I.R.B. 1345 June 4, 2007

§ 1.199–4(e) or the small business simplified overall method of § 1.199–4(f) for calculating QPAI. If the entity uses the simplified deduction method, then it may calculate W–2 wages using either the wage expense safe harbor or another reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances. If the entity uses the small business simplified overall method, then it may calculate W–2 wages using either the small business simplified overall method safe harbor or another reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances.

.04 Changes in method . For purposes of § 199, the following changes will not constitute changes in method of accounting to which the statutory and regulatory provisions of §§ 446 and 481 apply:

(a) A change in an eligible entity’s method for calculating QPAI at the entity level among those methods described in section 3.03 of this revenue procedure; and

(b) A change from calculating QPAI and W–2 wages at the entity level to calculating such amounts at the partner or shareholder level, or vice versa.

.05 Rules for calculating QPAI at the entity level . Solely for calculating QPAI and W–2 wages at the entity level in accordance with its applicable cost allocation method for the taxable year, an eligible entity as described in section 3.01 of this revenue procedure must apply the following rules:

(a) A partnership must take into account any separately stated items described in § 702(a)(1) through (7) and any nonseparately stated items described in § 702(a)(8);

(b) An S corporation must take into account any separately stated items described in § 1366(a)(1)(A) and any nonseparately stated items described in § 1366(a)(1)(B);

(c) Income items, the inclusion of which ordinarily is determined at the partner or shareholder level, must be included by the partnership or S corporation;

(d) Expense items, the deduction or capitalization of which is determined at the partner or shareholder level, must be subtracted by the partnership or S corporation;

(e) Any limitation on the deduction of expense items that is ordinarily applied at

W–2 wages from the entity, which then are to be combined with the partner’s or shareholder’s QPAI and W–2 wages from other sources, if any.

Whether a partnership or S corporation is an eligible entity (as defined in section 3.01 of this revenue procedure), and thus able to calculate QPAI and W–2 wages on behalf of some or all of its partners or shareholders, is determined at the entity level. Similarly, the determination as to what cost allocation method an eligible entity may use (specifically, the § 861 method, the simplified deduction method, or the small business simplified overall method) is determined and applied at the entity level (subject to any additional conditions, rules, and procedures as may be provided by publication in the Internal Revenue Bulletin).