Advanced Tax Topics
Advanced Tax Topics TAX 5015
University of Central Florida
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Chapter 15 Multistate Corporate Taxation 2010 edition updated October 28 2009 Learning Objectives Understand the consequences of state corporate income taxes De ne nexus amp explain its role in state income taxation Distinguish between apportionment and allocation of a multistate cooperation s taxable income Describe the sales payroll and property apportionment factors Apply the unitary theory to state corporate income taxation Understand the states income tax treatment of S corporations partnerships and LLCs Describe some other commonly encountered state amp local taxes I Overview State Corporate Income Taxation A State corporate income taxation is widespread 1 fortysix states and the District of Columbia impose a tax based on a corporation s taxable income 2 the four holdouts no state corporate income tax in Nevada South Dakota exception banks Washington amp Wyoming B Approach most states piggyback onto the Federal income tax base 1 most have adopted part or all ofthe Federal income tax code ie the IRC is used to de ne gross income exclusions amp deductions State taxable income Federal taxable income state tax adjustments 2 typically accounting periods and methods used for Federal purposes are also used for state tax return filing 3 unlike Federal taxes most states have adopted a proportional tax system there is little progressitivity in state corporate income taxes 4 unlike Federal multinational taxes which use complex sourcing amp transfer pricing rules most states use an apportionment formula to assign the total income to the individual states The typical formula is based on some combination of sales within the state property within the state payroll within the state C De nitions 1 Apportionment the means by which a corporation s business income is divided among the states in which it conducts business 2 Allocation the method under which speci c components ofa corporation s income usually nonbusiness income net ofrelated expenses are directly assigned to a certain state 3 Allocations differ from apportionments in that allocable income is assigned to one state nonbusiness income whereas apportionable income business income is divided among several states D A typical formula for computing the state corporate income tax liability Starting point in computing taxable income1 i State modi cation items State tax base i Total net allocable income loss nonbusiness income Total apportionable income loss business income X State s apportionment percentage based on sales pavroll amp propertv Income apportioned to the state i lncome loss allocated to the state State taxable income loss x State tax rate Gross income tax liability for state State s tax credits Net income tax liability for the state Note1 Most states including Florida use either line 28 taxable income before the NOL deduction amp the DRD or line 30 taxable income ofthe Federal corporate tax return Form 1120 In other states the corporation must identify and report each element of income and deduction on the state tax return E Most modi cations to Federal taxable income required for state taxes are needed to re ect differences in state and Federal statutes and to remove income that states are constitutionally prohibited from taxing Some common adjustments to Federal taxable income include the following MA A 01h Federal and municipal bond interest and related expenses are often treated differently for state tax purposes state income taxes paid are often not deductible while federal income taxes paid are sometimes deductible depreciation including MACRS Sec 179 and bonus amp amortization methods may be different for state income tax purposes and therefore may also have to recompute gainslosses on the sale of property NOL deduction is based on state taxable income dividends received from other corporations may be taxed differently for state income tax purposes F UDITPA and the Multistate Tax Commission 1 l A Uniform Division of Income for Tax Purposes Act UDITPA is a model law relating to assignment of income among states for multistate corporations while few states have adopted UDITPA in its entirety most states use UDIPTA as a starting point and adjust it to meet their specific needs and circumstances while others have joined the Multistate Tax Compact MTC to promote fairness and consistency across borders the UDITPA speci es that the sales payroll and property factors are to be equally weighted in the apportionment formula Over the years many states have increased the weight on sales and reduced the weight on other factors a rough breakdown based on 2008 apportionment formulas 14states AK AL CO DE Hl KS LA MO MT NM ND OK Rl UT and DC use UDITPA rules and assign equal weight to each of the three factors sales payroll and property 17 states AR AZ CA CT FL lD KY MA MD NC NH NJ SC TN VT VA and WV place 50 weight on sales and 25 each on property and payroll 14states CT GA IA IL ME MI MS MO NE NY OR SC TX and Wl use sales factor only 4 states lD MN OH and PA weight sales more than 50 but less than 100 Sales are weighted 60 81 60 and 70 respectively 1 state CO uses sales and property only 4 states CO CT MO and SC permit two or more methods 4 states NV SD WA and WY have no state corporate income tax G The Constitutional authority that allows states to tax a corporation s income comes from the Commerce Clause from the US Constitution Over time the Courts have applied a fourpronged test to assess whether the tax is constitutional 1 the tax must be applied to activity that has substantial nexus with the state 2 the tax must be apportioned fairly 3 the tax must not discriminate against interstate commerce 4 the tax must be fairly related to the service provided by the state H Nexus for state corporate income tax purposes 1 nexus is the degree of business activity which must be present before a state can impose tax on an outofstate entity s income 2 sufficient nexus between the corporation and the state typically exists if income is derived from within the state and property is owned or leased within the state persons are employed within the state physical or financial capital is located within the state 3 under Public Law 86272 enacted in 1959 no nexus ifonly connection to state is solicitation for sales order oftangible personal property with orders sent outside the state for approval or rejection and the orders are lled amp shipped from a point outside the state 4 independent contractors may generally engage in the following activities without establishing nexus by company source Public law 86272 solicit sales make sales maintain an instate sales of ce Note See employee vs independent contractor handout chapter 15 web page 5 while corporate income tax many not apply because of insufficient nexus sales tax will likely still apply Tax planning opportunities 1 move payroll andor property to lower taxed states or to states with a more favorable apportionment formula 2 avoid nexus with hightax states structure activities to fall within the protection afforded Public Law 86272 3 create nexus with low or no tax states structure activities to fall outside the protection afforded Public Law 86272 II Apportionment vs Allocation of Income A Apportionment of income l A A O apportionment is the means by which business income is divided among the states in which it conducts business and has nexus business income de ned income that arises from the taxpayer s regular trade or business corporation determines its net income for the company as a whole based on each state s income tax rules then apportions some to each state according to a statemandated approved formula differences in apportionment formulas amp de nitions of taxable income mean less than or more than 100 of modi ed Federal taxable income is subject to a statelevel tax unusual results can occur where the taxpayer generates income in one state and losses in another the apportionment formulas simply are applied to the totals purpose of apportionment to avoid multiple state taxation ofthe same income nonbusiness income usually is allocated to the state in which the incomeproducing asset is located Note Interest amp dividends nonbusiness income are usually taxed where management activities take place Often corporations create a Delaware holding company to avoid taxes on nonbuisness income B Allocation of income 1 2 3 allocation is a method used to directly assign speci c components ofa corporation s income net of related expenses to a speci c state allocable income generally includes income or loss from sale of nonbusiness property income or losses from rents or royalties from nonbusiness real ortangible personal property typically allocable income loss is removed from corporate net income before the state s apportionment formula is applied C Allocable income loss assigned to a state is then combined with income apportionable to the state to arrive at total income subject to tax in the state III Apportionment Factors A Apportionment formulas vary among states 1 traditionally states used a threefactor formula that equally weights sales property and payroll 2 many states now use a modi ed formula where sales factor receives a larger weight tends to pull larger amount ofoutof state corporation39s income into the state may provide tax relief to corporations domiciled in the state since they are likely to pay property taxes amp to employ workers which create tax revenues for the state 3 a ratio is computed for each factor the ratios are summed amp then averaged to determine the state s apportionment factor Note This apportionment formula generally applies to manufacturers wholesalers retailers and similar businesses Special apportionment formulas are often used in agriculture real estate rental construction oil and gas exploration banking insurance airtransportation trucking and public utilities B Sales Factor 1 sales factor is a fraction numerator is total sales within the state denominator is total US sales Note Sales net of returns discounts amp allowances 2 most states follow UDITPA s ultimate destination rule point of delivery is used to determine the location ofthe sale not where shipping originates and where the work is done is used to determine the location of services 3 a throwback rule is used by most states if adopted by the state it requires that outof state sales not subject to tax in destination state be pulled back into origination state also applies to most outof country sales treats such sales as instate sales ofthe origination state also applies if purchaser is the US government C Payroll Factor 1 2 payroll factor is a fraction numerator is total compensation paid or accrued within the state denominator is total US compensation paid or accrued by the corporation compensation includes wages salaries commissions and taxable fringe bene ts etc amounts paid to independent contractors are excluded most states exclude nontaxable fringe bene ts some states exclude amounts paid to corporate officers some states require that deferred compensation amounts be included in the payroll factor eg contributions to 401k plans D Property Factor 1 l A A property factor is a fraction generally includes average value of real and tangible personal property owned or rented numerator is the average value of real and tangible personal property owned or rented and used within the state denominator is the average value ofall US real and tangible personal property owned or rented and used property includes land buildings machinery inventory etc may include construction in progress offshore property outer space property satellites and partnership property intangible property is usually omitted property is typically valued at average historical cost plus additions and improvements some states allow net book value or adjusted basis some states require the use of quarterly or monthly values if beginningending average is not representative leased property when included in the property factor is valued at eight times its annual rental payments used by approximately 40 states E Reporting issues 1 l separate entity reporting each corporation with suf cient nexus is required to le its own return in the state it reportsjust the income allocatedapportioned to the state consolidated returns some states allow require consolidated returns if there are two or more af liated corporations each with income taxable in the state combined reporting some states require permit combined reporting where two or more separate businesses are found to comprise a unitary business Note Businesses can in some instances limit the need to apportion or allocate income by forming separate corporations in order to isolate the income generated within the speci c state States however may ignore the existence of multiple corporations in cases of unitary businesses IV The Unitary Theory of Taxation A Unitary theory de ned a unitary business operates as a unit and cannot be segregated into separate operating reporting divisions within a single company in other words an af liatedintegrated corporation cannot be broken into separate legal entities to avoid apportionment and allocation 1 2 3 each unit deemed to contribute to overall pro ts unitary theory ignores separate legal existence of corporations unitary status is determined under a three pronged test unity of ownership the operation of a division within a single corporation or common ownership more than 50 unity of operation the existence of centralized functions purchasing marketing nance accounting and legal unity of use the existence ofa centralized executive force amp general system of operation control of daytoday operations Note V thout the unitary theory you could create a separate legal entity in each state amp you would report only the income earned in that state no apportionment would be necessary B Practical implications 1 l for states that adopt a unitary approach af liated corporations are combined for the computation oftaxable income amp apportionment purposes required by 13 states Alaska Arizona California Hawaii Idaho Illinois Kansas Maine Minnesota Montana Nebraska New Hampshire North Dakota some other states require combined reporting if certain conditions are met V Taxation of S Corporations A Most states treat S corporations in a manner consistent with the Federal tax treatment 1 no corporatelevel income tax 2 income or loss flows through to its shareholders 3 are usually subject to builtin gains tax amp excess passive investment income penalty tax are subject to most other state amp local taxes must have valid S corporation election at the Federal level to get S corporation treatment in most states some states have other eligibility requirements eg all shareholders must be residents ofthe state some states require a separate statelevel election 01h B Exceptions 1 some states impose an entitylevel tax they are taxed liked regular C corporations Connecticut Louisiana Michigan New Hampshire Tennessee Texas and DC 2 Massachusetts taxes large S corporations gross receipts gt 6 M 3 California taxes S corporations at a reduced rate 15 B Multistate S corporations that are subject to state corporate income tax must apportion and allocate income in the same manner as regular C corporations 1 must file a state tax return in each state with nexus 2 must inform shareholders of their share of income for each state so theirtax returns can be prepared some states allow S corporation to le a single return and pay tax for all its shareholders VI Taxation of Partnerships and LLCs A Most states treat partnerships LLCs and LLPs in a mannerthat parallels the Federal tax treatment 1 entity is a taxreporting not a taxpaying entity 2 income loss and credit items are allocated and apportioned among the partners according to the terms ofthe partnership agreement 1510 B Some states 1 require entity to make estimated tax payments for outof state partners 2 apply an entitylevel tax on operating income 3 allow composite returns to be led for outofstate partners C Generally an instate partner computes the income tax resulting from all of the owthrough income including income from entities operating in other sates 1 the partner is typically allowed a credit for income taxes paid to other states on this income VII Other State Taxes and Fees A Sales and use taxes 1 sales tax imposed on the gross receipts from the retail sale of tangible personal property amp some services 2 use tax imposed on tangible personal property brought into the state from a state that imposes no sales tax or imposes a sales tax at a lower rate B Property taxes a type of ad valorem tax a tax based on value imposed on the value of real property ortangible personal property C Franchise tax a tax on the privilege of doing business in a state generally imposed on the value ofthe capital common stock paidin capital and retained earnings within the state D Excise taxes taxes imposed on a wide variety of items such as gasoline liquor cigarettes and on certain services such as hotel amp motel rooms E Unemployment taxes a tax imposed on employers with employees who might become eligible for that state s unemployment benefits F Incorporation fees a fee on domestic corporations for the privilege of incorporating within the state G License fees fees for the privilege of conducting certain types of professions trades or businesses within their borders Chapter 19 Income Taxation of Trusts amp Estates 2010 edition updated October 28 2009 Learning Objectives Understand the basic concepts concerning trusts and estates Distinguish between principal and income Explain how to calculate the tax liability of a simple trust Understand the signi cance of distributable net income DNI Understand concept of income in respect of decedent IRD I Trusts amp Estates Overview A The function of estates amp trusts 1 estate defined a transitional legal entity that comes into existence upon the death of an individual it is used during the period oftime in which the decedent s legal affairs are being settled it is used by the executoradministrator of the estate to manage the assets owned by the decedent it collects and conserves an individual s assets satis es all liabilities and distributes the remaining assets to heirs once all legal requirements are satisfied the estate terminates amp ownership passes to beneficiaries or heirs 2 trust de ned a legal arrangement in which an individual the grantor transfers legal ownership of assets to one party the trustee and the legal right to enjoy amp bene t from those assets to a second party the bene ciary or bene ciaries it takes title to property for purpose of protecting or conserving it forthe bene ciary it is usually designed for the protection ofthe bene ciary the terms ofthe trust the duties of the trustee and the rights of the various beneficiaries are speci ed in the legal document the trust instrument the grantor has unlimited discretion such that a trust can be a very flexible document B Basic concepts and de nitions 1 l 0150 6 Principal or corpus is the initial assets transferred by the grantor plus certain additions or deductions as required by the provisions ofthe trust instrument or state law Income is the earnings derived from the principal Certain gains losses or deductions may be considered adjustments to principal Grantor the party that transfers assets to the trust Trustee the party that administers the trust Income Bene ciary the party or parties who receives the income when distributed by the trustee under the provisions of the trust instrument Remainderman the party who eventually receives the principal C Some common reasons for using trusts 1 l A A 01 O 1 Life insurance trust holds life insurance policies on the insured removes proceeds of policies from gross estate if irrevocable trust safeguards against receipt of proceeds by young or inexperienced bene ciary Living revocable trust holds all assets owned by an individual simpli es probate since bene ciaries are established for trust provides privacy for asset transfers simpli es asset management Trust for minors provides funds for college education shifts income to lowerbracket taxpayers allows parents to retain some control over children s use of assets Blind trust holds assets of grantor without hisher input or in uence often used while grantor holds political office or some other sensitive position Retirement trust a special taxexempt trust that manages asset contributions under a quali ed retirement plan Alimony trust manages assets ofan eXspouse and ensures they will be transferred on a prescribed schedule to named bene ciaries Liquidation trust 0 manages assets and nal dissolution ofa corporation undergoing a complete liquidation C The nature oftrust amp estate duciary taxation 1 trusts 2 trust a and estates are separate taxpayers duciary must le Form 1041 o for an estate ifgross income gt 600 0 for a trust if gross income gt 600 or if trust reports any taxable income taxable income is subject to highly progressive rates see inside cover oftext book top rate of 35 is applied to taxable income gt 10700 there is no 10 tax rate qualified dividends amp LTCGs are taxed at the usual 150 rates are usually required to make quarterly estimated payments nd estates are allowed a personal exemption estate 600 trust either 300 or 100 see types of trusts 3 trust and estates are NOT entitled to a standard deduction 4 there is no double taxation of income earned by a trust or estate 01 distrib estates and trusts act as conduits for income received owthru entities taxable income of trusts or estates is taxed to the entity or to its bene ciaries to the extent that each has received the accounting income the bene ciaries report the distributed trust income on their individual tax returns if all income is not distributed some will be taxed to fiduciary a deduction for income distributed to bene ciaries is created within the trust this is the mechanism to avoid double taxation uted income has the same character in the hands ofthe bene ciary as it has in the trust 0 in general the income tax consequences for a trust or estate are determined in similar manner as for individuals same definition of gross income exclusions amp deductions D Type oftrusts simple vs complex trusts 1 2 compl simple trust de ned a simple trust must distribute all of its accounting income annually this amount may bear little relationship to the trust s taxable income cannot distribute any of its principal and cannot make contributions to charitable organizations ex trust any trust that is not a simple trust 3 personal exemption 300 ifall income is required to be distributed annually 100 if current income may be retained Note We are covering simple trusts only text pages 121 II Computing the Taxable Income of Trusts amp Estates A The five step process used to compute taxable income Step 1 Compute the entity s accounting income Step 2 Compute entity taxable income before the distribution deduction Step 3 Compute distributable net income DNI and the distribution deduction Step 4 Compute entity taxable income step 2 less the deduction determined in step 3 Step 5 Allocate distributable net income and its character to the bene ciaries if a complex trust may need to use the tier system B Entity s accounting income 1 accounting income is based on the controlling document either the trust agreement or state law determines whether amounts are allocated to corpus or current income if the entity distributes income currently that income should generally correspond to accounting income 2 for a simple trust accounting income is the amount that trustee must distribute to bene ciaries each year 3 generally accounting income does not include capital gains instead this is an increase to principal 4 depreciation may be deducted from income or principal depending on governing law 195 C Common allocations to income and to corpus under the Revised Uniform Principal and Income Act 1 amounts allocable to the income account income 0 ordinary and operating net income from trust assets 0 rent interest dividends 7212 of royalties 0 net pro ts of a business losses are usually charged to corpus expenses 0 12 of duciary feescommissions management conservation or maintenance of property 0 ordinary amp necessary expenses for a trade or business or production of income 0 taxes levied on accounting income 0 depreciation 2 amounts allocable to the principal corpus account receipts 0 capital gainloss on investment assets 0 insurance recoveries on incomeproducing assets 0 casualty gainloss on incomeproducing assets 0 stock dividends amp stock splits o 2712 of royalties expenditures 0 12 of duciary feescommissions management conservation or maintenance of property principal payment on debt extraordinary repairs and capital improvements taxes levied on gains and other items of principal depreciation 0000 D Trust taxable income gross income similarto individual taxpayers less deductionsexpenses similar to individual taxpayers excluding expenses related to taxexempt income including a pro rata share ofthe trustee s fee less personal exemption taxable income before the distribution deduction distribution deduction trust taxable income NA quot0159 prorata amount oftrustee s fees disallowed taxexempt interest trustee fees x amount disallowed all income1 Note1 Excludes income allocable to corpus E Deductible expenses OakA A must be ordinary and necessary expenses paid includes duciary s administration fees trustees and executors fees and tax return preparation fees are NOT considered miscellaneous itemized deductions ie are not subject to the 2 oor there is no limit on complex trust s charitable contribution deduction not an issue for a simple trust F Allocation of indirect expenses l if there is any taxexempt income indirect expenses eg trustee s fees must be allocated pro rata to taxable and taxexempt income this allocation is made based on portion of accounting income that is attributable to taxexempt income G Distribution deduction simple trusts MA A all income accounting net income must be distributed annually distribution deduction is the lesser of accounting income or distributable net income DNI both are reduced by net taxexempt income earned by trust amount deductible by trust is taxed to bene ciaries irrespective of amount they actually receive taxed similar to partnerships amp S corporations H Distributable net income DNI amp the distribution deduction 1 computation of DNI taxable income before the distribution deduction plus personal exemption previously deducted plus net capital losses plus net taxexempt interest net of expenses less capital gains added to principal distributable net income DNI distribution deduction lesser of distributable net income minus net taxexempt income or accounting net income minus net taxexempt income 2 notes about the DNI it represents 0 the maximum income that may be taxed to the bene ciary and o the maximum deduction available to the fiduciary it does NOT include income unavailable for distribution capital gains added to principle it may include nontaxable income that is available for distribution all expenses that are deductible for tax purposes enter into the DNI calculation even those allocated to corpus l NOL and capital loss carryover 1 NOL is not passed through to bene ciaries unless trust terminates NOL can be carried back and fonNard are unusual in a trust unless engages in a business net capital loss lesser of 3000 or excess of capital losses over capital gains Simple trusts distribute all income however so have no other income to offset Capital losses can be carried over by trust 3 if not used before trust terminates are passed through to bene ciaries l III Taxation ofBeneficiaries A Amount taxable to bene ciaries simple trusts 1 DNI is the maximum taxable amount 2 may be less if DNI includes taxexempt interest 3 if more than one income bene ciary apportion elements of DNI ratably 4 each type of DNI must be allocated proportionately to income bene ciaries to prevent manipulation oftax liabilities by assigning for example taxexempt income to high bracket taxpayers and taxable income to low bracket taxpayers IV Property distributions A Generally entity does not recognize gain or loss 1 bene ciary takes same basis in asset as it had in the estate or trust 2 distribution absorbs distributable net income DNI and quali es for a distribution deduction to extent ofthe lesser of basis to beneficiary fair value on date ofdistribution 3 trustee or executor can elect to recognize gains and losses on assets distributed in kind bene ciary s basis in asset would be fair value distribution absorbs distributable net income DNI and quali es for a distribution deduction equal to fair value on date of distribution V Income of a Decedent A Income in respect of decedent IRD NA 01 A A O most individuals are on a cash basis at death the individual may have earned but not received as income such items as interest on CD s bonds or savings salary commission bonuses 401 K dividends received after date of death with record date before death income in respect ofa decedent IRD must be included in the gross income of the party entitled to receive it ie the estate or bene ciary w as part ofthe gross estate for transfer tax purposes likewise deductions in respect of a decedent DRD may be deducted by the party required to pay them ifthey are deductible expenses and they reduce the value ofthe gross estate the recipient may claim an income tax deduction a miscellaneous itemized deduction not subject to 2 floor in the amount of the extra transfer tax due as result of the net IRD counted as part ofthe estate properties classi ed as IRD do not receive a stepup in basis retain the same basis they had in hands of decedent TAX 5015 More on the relatively new domestic production activities deduction DPAD l The quali ed domestic production activities deduction DPAD A Created by the American Jobs Creation Act of 2004 the DPAD replaces a number of export subsidies that were deemed by the World Trade Organization to be illegal export subsidies 1 First it was the use of foreign sales corporations FSC 2 Then it was the extraterritorial income ETI exclusion the ETl is currently being phased out over 20042006 B Certain domestic manufacturers can claim a deduction equal to 9 of quali ed production activities income QPAI It is phased in as follows 3 in 2005 amp 2006 6 in 2007 amp 2008 and 9 thereafter C Some oddities about the DPAD 1 It does not require exporting or any activity outside the United States it is no longer an international tax issue 2 It provides benefits to more businesses than just those considered manufacturers 3 It is a deduction based on net income from certain activities therefore it does not require an additional cash out ow its effect is similar to a tax rate reduction or tax credit Note It appears that it is becoming a very complex calculation with cumbersome recordkeeping requirements and with many unanswered questions D The deduction is available to individuals partnerships S corporations C corporations estates and trusts For passthrough entities the deduction flows through to the individual owners partners and shareholders as a separately stated item ll Components ofthe deduction A The quali ed production activities deduction DPAD 36 9 x the lesser of 1 quali ed production activities income QPAI 2 taxable income without regard to the DPAD but adjusted for any NOL carryfonNard Note1 The DQPAD is subject to the W 2 wage limitation 50 ofemployers W 2 wages Originally this includes all wages paid to all workers not just the wages paid to employees engaged in quali ed production activities New regulations require that the limit includes only wages associated with quali ed production activities Note2 lfthe deduction cannot be used in the current year because ofthe taxable income or W 2 wage limitation it is lost forever B Quali ed production activities income QPAI domestic production gross receipts DPRG allocable expenses QPAI is determined on an itembyitem basis no grouping is permitted 1 domestic production gross receipts DPRG includes but is not limited to gross receipts from a lease license sale or other disposition ofqualified production property QPP that was manufactured produced grown or extracted MPGE by the taxpayer in whole or signi cant part within the US b qualified lms largely created in the US 0 production ofelectricity natural gas or potable water Cl construction but not selfconstruction performed in the US e engineering amp architectural services for domestic construction Note1 Does not include gross receipts from the sale of food and beverages prepared at a retail business services or related parties controlled business af liated groups Note2 Must apportion gross receipts that qualify from those that don t qualify Must use a reasonable method that is satisfactory to the IRS For example from products produced in the US from those produced outside the US Note3 There are several de minimis safe harbortests 1 No apportionment necessary if less than 5 oftotal gross receipts are from nonquali ed activities No apportionment ifembedded service element in a contract lt 5 selling price 2 less allocable expenses a cost of goods sold in accordance with the general principals of Section 263A In a typical scenario this would include direct materials direct labor factory overhead and a portion of its mixed service costs b other deductions expenses and losses directly allocable to those receipts selling amp marketing expenses 0 a ratable portion of other deductions expenses and losses that is not directly allocable to those receipts general amp administrative expenses Note1 The second and third categories may be allocated by one ofthree methods see item xxx below lll More on the term quali ed production property QPP that was manufactured produced grown or extracted MPGE by the taxpayer in whole or signi cant part within the US A Quali ed production property QPP 1 includes tangible personal property computer software and sound recordings 2 does not include land buildings other structural components of buildings or intangible property B Manufactured produced grown or extracted includes 1 activities relating to manufacturing producing growing extracting installing developing improving and creating QPP 2 making QPP out of scrap salvage orjunk material as well as from new or raw materials 3 combining or assembling two or more articles 4 cultivating soil raising livestock shing and mining minerals C By the taxpayer in whole or significant part two tests 1 a broad substantial in nature test based on all facts amp circumstances 2 a cost safe harbor taxpayer incurs conversion cost direct labor amp factory overhead gt 20 of the property s cost of goods sold 3 two categories of costs are excluded packaging repackaging labeling and minor assembly activities will probably be subject of controversy design amp development costs associated with the creation or licensing of intangible property with respect to the production oftangible QPP the manufactured product must be broken down into its tangible amp intangible portion components IV Three methods for allocation amp apportionment of direct amp indirect costs A The Section 861 Regulations 1 may be used by all taxpayers but must be used by taxpayers with average annual gross receipts gt 25M 2 timeconsuming mechanical and accurate rules already in place used by US taxpayers to allocate amp apportion income between foreign sources amp domestic sources 3 will now be used to allocate amp apportion income between qualified amp non quali ed production activities B Simpli ed deduction method 1 for taxpayers with average annual gross receipts over the three prior years lt 25M or total assets at the end ofthe taxable year lt 10M 2 the deductions are apportioned to DPRG in the same proportions as DPRG bears to total gross receipts B Smallbusiness simpli ed overall method 1 for taxpayers with average annual gross receipts over the three prior years lt 5M 2 all deductions including cost of goods sold are apportioned to DPRG in the same proportions as DPRG bears to total gross receipts Note Government officials believe more that 99 of C corporations will qualify as small taxpayers V Tax planning opportunities A Identify what activities qualify for the DPAD B Put in place processes for gathering the data to calculate QPAI C Develop methods for data analysis D Accumulate appropriate information to substantiate amount deducted
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