On February 25, the IRS issued a warning to taxpayers seeking to ensure deductions for missed domestic manufacturing activities under the now obsolete Section 199.1. The IRS claims that a high percentage of these claims are improperly supported, and the warnings the IRS reviewers recommended incorporate criminal provisions, including penalties for an incorrect reimbursement claim and even referrals to the Office of Professional Responsibility (OPR). The tone of the warning makes it clear that the IRS has serious reservations about such amended return claims. Notwithstanding the concerns identified by the IRS, such claims can be maintained. Taxpayers and their advisors should, however, expect a thorough examination of these documents.
|Eversheds Sutherland observation: The review of the IRS review of deductions under Section 199 following the repeal of the 2017 Act is not new. In 2018, the IRS launched a compliance campaign under Section 199.2.In July 2020, the IRS published a general memorandum on Legal Advice analyzing examples of online software activity that did not meet the deduction requirements of Section 199.3 Despite the IRS review Modified Returns Claiming Section 199 Deductions, taxpayers attempting to increase the NOL readmission capacity of Coronavirus Aid, Relief and Economic Security 4 can find much-needed economic relief through missed Section 199 deductions. However, the IRS warning is an important reminder that caution should be exercised in any attempt to claim missed Section 199 deductions to increase NOL redemption capacity. A modified return in which claimed deductions are claimed in accordance with Section 199 must be supported technically and with appropriate justification.
Section 199 provided a Deduction for Domestic Manufacturing Activities (DPAD), the aim of which was to improve the competitiveness of domestic firms and producers in the global economy.5 The definition of “manufacturing” in Section 199 went beyond its traditional meaning to include agriculture Product manufacturers, software companies, film production companies, electricity, gas and water companies, construction companies, engineering firms and architecture firms. The final rules provided that gross receipts from the sale of computer software made in whole or in part by taxpayers in the United States would qualify for the DPAD
One area of significant controversy under Section 199 has been the treatment of computer software. The regulations limited the deduction for software by excluding gross receipts from customer and technical support, telecommunications services, online services such as internet access services, online banking services and similar services from the “disposition” of computer software.7 Unfortunately, technology is moving faster than Congress, and software regulations soon became inconsistent with the reality of technology – computer software expanded beyond the conventional monitor to include online services, mobile transactions and mobile apps.
Disagreements over the meaning of “disposition of computer software” have given rise to much controversy over the application of Section 199, and such controversy is likely to continue. While Congress repealed Section 199 for tax years beginning after December 31, 2017 as part of the Tax Reduction and Employment Act (TCJA) 8, many tax years are still under review for taxpayers who requested a Section 199 deduction. In 2018, the IRS launched a Section 199 campaign to “ensure that the taxpayer is compliant with the requirements of IRC Section 199 through an entitlement risk assessment and subject-based reviews”. 9 Most recently, in July 2020, the IRS issued a General Legal Notice Memorandum (GLAM) analyzing online software activity that did not meet the deduction requirements of Section 199.10 In GLAM, the taxpayer took a DPAD in relation to gross revenue from software generated by customers was used over the internet to track shipments and insure shipped goods. According to the IRS, the gross income of the taxpayer came from services rather than from access to online software. The pervasive ambiguity surrounding Section 199 prevented many taxpayers from taking advantage of the deduction.
Eversheds Sutherland observation: Before the 2017 tax law amendment, NOLs were fully deductible and could be carried back two years and carried forward twenty years. With the 2017 TCJA, the NOL carryover rules were changed to limit the NOL deduction to 80% of taxable income, prohibit all NOL transfers, and allow NOL transfers indefinitely. Section 2303 (b) of the CARES Act amended Section 172 (b) (1) to provide for a reassignment of NOL in a tax year that is after December 31, 2017 and before January 1, 2021 in each of the five years begins tax years before the tax year in which the loss occurs (repatriation period). Taxpayers who wish to apply for NOL repatriation will receive a six month extension on Forms 1045 or 1139.11
The revival of net loss carryforwards through the CARES Act has breathed new life into Section 199. While the abolition of loss carryforwards in 2017 offered little incentive to wade through the murky waters of Section 199 to make a deduction, taxpayers now have a big incentive. According to the CARES law, the withdrawal period is five years before the NOL. For many taxpayers, the redemption period overlaps the tax years that Section 199 was in effect. Taxpayers may determine that changing the years prior to Section 199 repeal, tax years beginning before December 31, 2017, to adopt the DPAD under Section 199, may increase the NOL take-back capacity. The deduction according to § 199 can be available in tax years with a higher top tax rate for years before the reduction in the corporation tax rate of the TCJA (up to 14% difference in tax rates).
The IRS Warning warns taxpayers that amended tax returns claiming claimed deductions under Section 199 contain a significant percentage of filings that are not properly supported. Taxpayers should review previous IRS decisions and cases to distinguish their facts from situations where the IRS determined that a Section 199 deduction was inappropriate. With appropriate factual and legal support, taxpayers can take full advantage of both provisions.
|Eversheds Sutherland observation: Taxpayers should ensure that documentation supports any Section 199 deduction. Failure to support the deduction could result in penalties being imposed by the IRS, including Section 6676 which penalizes a right to a refund or credit relating to income tax for an “excessive amount”. A penalty of 20 percent of the excess will be imposed unless there is reasonable cause. Other penalties are possible, including referral to the OPR, may affect a counselor’s practice before the IRS.