SECTION 2. BACKGROUND

.01 Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to § 199) for the taxable year (or, in the case of an individual, adjusted gross income (AGI)). Section 199(b)(1) limits the deduction for a taxable year to 50 percent of the W–2 wages paid by the taxpayer during the calendar year that ends in such taxable year.

.02 Section 199(c)(1) defines QPAI for any taxable year as an amount equal to the excess (if any) of (A) the taxpayer’s domestic production gross receipts (DPGR) for such taxable year, over (B) the sum of (i) the cost of goods sold (CGS) that are allocable to such receipts; and (ii) other expenses, losses, or deductions (other than the deduction under § 199) that are properly allocable to such receipts.

.03 Section 199(c)(2) provides that the Secretary shall prescribe rules for the proper allocation of items described in § 199(c)(1) for purposes of determining QPAI. Such rules shall provide for the proper allocation of items whether or not such items are directly allocable to DPGR.

.04 Section 199(c)(4)(A) defines DPGR to mean the taxpayer’s gross receipts that are derived from: (i) any lease, rental, license, sale, exchange, or other disposition of (I) qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States; (II) any qualified film produced by the taxpayer; or (III) electricity, natural gas, or potable water (collectively, utilities) produced by the taxpayer in the United States; (ii) in the case of a taxpayer engaged in the active conduct of a construction trade or business, construction of real property performed in the United States by the taxpayer in the ordinary course of such trade or business; or (iii) in the case of a taxpayer engaged in the active conduct of an engineering or architectural services trade or business, engineering or architectural services performed in the United States by the taxpayer in the ordinary course of such trade or busi

come so that the § 199 deduction is not limited by § 199(a)(1)(B), and that the partnership and each of its partners (whether individual or corporate) are calendar year taxpayers.

Example . Small business simplified overall method . A, an individual, and X, a corporation, are partners in PRS. PRS engages in manufacturing activities that generate both DPGR and non-DPGR. X, but not A, has other manufacturing activities that generate DPGR and W–2 wages. A and X share all items of income, gain, loss, deduction, and credit equally. For the 2010 taxable year, PRS has total costs of no more than $5 million, and it qualifies and chooses to calculate QPAI and W–2 wages at the entity level under section 3.03(c) of this revenue procedure for the 2010 taxable year. For 2010, PRS has total gross receipts of $2,000x ($1,000x of which is DPGR), CGS of $900x (including $400x of wage expenses), and deductions of $700x (including $50x of R&E expenditures under § 174(a) and $100x of § 179 expenses). In this example, the paragraph (e)(1) wages are equal to the $400x of wage expenses. PRS uses the safe harbor under § 1.199–2T(e)(2)(iii) to calculate W–2 wages. Accordingly, PRS’s W–2 wages equal $200x ($400x of wages described in § 1.199–2(e)(1) multiplied by ($1,000x DPGR divided by $2,000x total gross receipts)). Pursuant to section 3.05(f) of this revenue procedure, PRS disregards A’s election under § 59(e) to write off A’s share of R&E expenditures over 10 years. In addition, pursuant to section 3.05(e) of this revenue procedure, PRS disregards any limitation under § 179(b) on A’s ability to deduct A’s share of the § 179 expenses. Under the small business simplified overall method, PRS’s CGS and deductions apportioned to DPGR equal $800x (($900x CGS plus $700x of other deductions) multiplied by ($1,000x DPGR divided by $2,000x total gross receipts)). Accordingly, PRS’s QPAI is $200x ($1,000x DPGR minus $800x CGS and other deductions). Under section 3.06(a) of this revenue procedure, PRS’s QPAI is allocated $100x to A and $100x to X. Under section 3.06(b) of this revenue procedure, PRS’s W–2 wages are allocated $100x to A and $100x to X. Because A engages in no other activities generating DPGR, A’s tentative deduction is $9x (its $100x share of QPAI from PRS multiplied by .09), subject to the § 199(b)(1) wage limitation (50% of A’s $100x share of W–2 wages from PRS, as defined by § 1.199–2T(e)(2)). Because X does engage in other production activities generating DPGR, X must combine its $100x share of QPAI and its $100x share of W–2 wages from PRS with its QPAI and W–2 wages from all other sources, and X is not permitted to recompute its share of QPAI from PRS using another cost allocation method.