In CCA 201642033 (released on October 14, 2016), the Office of Chief Counsel – International division (IRS) concluded that a taxpayer's loss on the sale of equipment used to produce qualified production property (QPP) does not reduce the taxpayer’s qualified production activities income (QPAI). The IRS determined that, under the Section 199 regulations, the adjusted basis of the equipment should be treated as cost of goods sold (COGS) and allocated to non-domestic production gross receipts (non-DPGR), as the equipment itself was not QPP.

Facts

The taxpayer purchased equipment to produce QPP and the sales of the QPP generated domestic production gross receipts (DPGR). The taxpayer properly capitalized the equipment depreciation to DPGR. After using the equipment for three years to produce the QPP, the taxpayer sold the equipment for less than its adjusted basis. The gross receipts from the sale of the equipment did not generate DPGR because the taxpayer did not manufacture, produce, grow or extract (MPGE) the equipment.

Law and analysis

Section 199 allows a deduction equal to 9 percent of the lesser of (a) the taxpayer’s QPAI for the tax year or (b) taxable income determined (without regard to Section 199) for the tax year. Section 199 further limits the deduction to 50% of the W-2 wages attributable to qualifying activities.

Section 199(c)(1) defines QPAI as the amount equal to the excess, if any, of the taxpayer's DPGR for such tax year, over the sum of: (i) the COGS that are allocable to such receipts, and (ii) other expenses, losses, or deductions that are properly allocable to such receipts.

Section 199(c)(4)(A)(i)(l) defines the term DPGR as the gross receipts of the taxpayer that are derived from any lease, rental, license, sale, exchange, or other disposition of QPP that was MPGE by the taxpayer in whole or in significant part within the United States.

Under Treas. Reg. Section 1.199-3(c), gross receipts are not reduced by COGS or the cost of property sold if the property is inventory property under Section 1221(a)(1) or depreciable property used in a trade or business under Section 1221(a)(2). In addition, Treas. Reg. Section 1.199-4(b)(1) provides, in part, that “[i]n the case of a sale, exchange, or other disposition … of non-inventory property, COGS for purposes of [Section 199] includes the adjusted basis of the property.” Further, Treas. Reg. Section 1.199-4(b)(2) requires a taxpayer to use a reasonable method based on all the facts and circumstances to allocate COGS between DPGR and non-DPGR.

Although the equipment produced only QPP that generated DPGR, the gross receipts from the sale of the equipment are non-DPGR because the equipment is not QPP that was MPGE by the taxpayer. As such, the IRS concluded the taxpayer’s adjusted basis of the equipment (treated as COGS under Treas. Reg. Section 1.199-4(b)(1)) should be allocated to non-DPGR. Therefore, the taxpayer's loss on the sale of equipment used to produce QPP will not reduce the taxpayer’s QPAI.

Implications

The CCA concludes that if a taxpayer sells property that is used to produce QPP, but which is not QPP itself, the gross receipts from such sale are non-DPGR and the adjusted basis of the property treated as COGS under the Section 199 regulations is allocable to non-DPGR. Therefore, any loss on the property will not decrease QPAI, a favorable and non-controversial outcome for the taxpayer in this circumstance because the Section 199 deduction may be larger.

The analysis in the CCA suggests that any gain on the sale of property that is used to produce QPP, but which is not QPP itself, is non-DPGR and the adjusted basis of the property would be treated as allocable to non-DPGR. The result would be that any gain on the property will not increase QPAI, an outcome in circumstances that are related to, but different, from the taxpayer’s, that is unfavorable because the Section 199 deduction would be smaller.

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