CFR > Title 26 - Internal Revenue > CHAPTER I—INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY > SUBCHAPTER A—INCOME TAX (Parts 1–19) > PART 1—INCOME TAXES > 1.199-9—Application of section 199 to pass-thru entities for taxable years beginning on or before May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.

1.199-9—Application of section 199 to pass-thru entities for taxable years beginning on or before May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005.

(a) In general. The provisions of this section apply solely for purposes of section 199 of the Internal Revenue Code (Code).
(b) Partnerships— (1) In general— The deduction with respect to the qualified production activities of the partnership allowable under § 1.199-1(a) ( section 199 deduction) is determined at the partner level. As a result, each partner must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of the partner's interest in the partnership. Except as provided by publication pursuant to paragraph (b)(1)(ii) of this section, for purposes of this section, each partner is allocated, in accordance with sections 702 and 704, its share of partnership items (including items of income, gain, loss, and deduction), cost of goods sold (CGS) allocated to such items of income, and gross receipts that are included in such items of income, even if the partner's share of CGS and other deductions and losses exceeds domestic production gross receipts (DPGR) (as defined in § 1.199-3(a)) and regardless of the amount of the partner's share of W-2 wages (as defined in § 1.199-2(e)) of the partnership for the taxable year. A partnership may specially allocate items of income, gain, loss, or deduction to its partners, subject to the rules of section 704(b) and the supporting regulations. Guaranteed payments under section 707(c) are not considered allocations of partnership income for purposes of this section. Guaranteed payments under section 707(c) are deductions by the partnership that must be taken into account under the rules of § 1.199-4. See § 1.199-3(p) and paragraph (b)(6) Example 5 of this section. Except as provided in paragraph (b)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, a partner aggregates its distributive share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the partnership (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its qualified production activities income (QPAI) (as defined in § 1.199-1(c) ).
(ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii) (b) of this chapter), permit a partnership to calculate a partner's share of QPAI at the entity level, instead of allocating, in accordance with sections 702 and 704, the partner's share of partnership items (including items of income, gain, loss, and deduction). If a partnership does calculate QPAI at the entity level—
(A) The partner is allocated its share of QPAI and W-2 wages (as defined in § 1.199-2(e) ), which (subject to the limitations of paragraph (b)(2) of this section and section 199(d)(1)(A)(iii), respectively) are combined with the partner's QPAI and W-2 wages from other sources;
(B) For purposes of computing the partner's QPAI under §§ 1.199-1 through 1.199-9, a partner does not take into account the items from the partnership (for example, a partner does not take into account items from the partnership in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources;
(C) A partner generally does not recompute its share of QPAI from the partnership using another method; however, the partner might have to adjust its share of QPAI from the partnership to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and
(D) A partner's distributive share of QPAI from a partnership may be less than zero.
(2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii) (b) of this chapter), losses or deductions of a partnership that otherwise would be taken into account in computing the partner's section 199 deduction for a taxable year are taken into account in that year only if and to the extent the partner's distributive share of those losses or deductions from all of the partnership's activities is not disallowed by section 465, 469, or 704(d), or any other provision of the Code. If only a portion of the partner's distributive share of the losses or deductions is allowed for a taxable year, a proportionate share of those allowable losses or deductions that are allocated to the partnership's qualified production activities, determined in a manner consistent with sections 465, 469, and 704(d), and any other applicable provision of the Code, is taken into account in computing QPAI and the wage limitation of section 199(d)(1)(A)(iii) for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year, the partner takes into account a proportionate share of those losses or deductions in computing its QPAI for that later taxable year. Losses or deductions of the partnership that are disallowed for taxable years beginning on or before December 31, 2004, are not taken into account in a later taxable year for purposes of computing the partner's QPAI or the wage limitation of section 199(d)(1)(A)(iii) for that taxable year, regardless of whether the losses or deductions are allowed for other purposes.
(3) Partner's share of W-2 wages. Under section 199(d)(1)(A)(iii), a partner's share of W-2 wages of a partnership for purposes of determining the partner's section 199(b) wage limitation is the lesser of the partner's allocable share of those wages (without regard to section 199(d)(1)(A)(iii) ), or 2 times 3 percent of the QPAI computed by taking into account only the items of the partnership allocated to the partner for the taxable year of the partnership. Except as provided by publication in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii) (b) of this chapter), this QPAI calculation is performed by the partner using the same cost allocation method that the partner uses in calculating the partner's section 199 deduction. The partnership must allocate W-2 wages (prior to the application of the wage limitation) among the partners in the same manner as wage expense. The partner must add the partner's share of the W-2 wages from the partnership, as limited by section 199(d)(1)(A)(iii), to the partner's W-2 wages from other sources, if any. If QPAI, computed by taking into account only the items of the partnership allocated to the partner for the taxable year (as required by the wage limitation of section 199(d)(1)(A)(iii)) is not greater than zero, then the partner may not take into account any W-2 wages of the partnership in applying the wage limitation of § 1.199-2 (but the partner will, nevertheless, aggregate its distributive share of partnership items including wage expense with those items not from the partnership in computing its QPAI when determining its section 199 deduction). See § 1.199-2 for the computation of W-2 wages, and paragraph (g) of this section for rules regarding pass-thru entities in a tiered structure.
(4) Transition percentage rule for W-2 wages. With regard to partnerships, for purposes of section 199(d)(1)(A)(iii)(II) the transition percentages determined under section 199(a)(2) shall be determined by reference to the partnership's taxable year. Thus, if a partner uses a calendar year taxable year, and owns an interest in a partnership that has a taxable year ending on April 30, the partner's section 199(d)(1)(A)(iii) wage limitation for the partnership's taxable year beginning on May 1, 2006, would be calculated using 3 percent, even though the partner includes the partner's distributive share of partnership items from that taxable year on the partner's 2007 Federal income tax return.
(5) Partnerships electing out of subchapter K. For purposes of §§ 1.199-1 through 1.199-9, the rules of this paragraph (b) apply to all partnerships, including those partnerships electing under section 761(a) to be excluded, in whole or in part, from the application of subchapter K of chapter 1 of the Code.
(6) Examples. The following examples illustrate the application of this paragraph (b). Assume that each partner has sufficient adjusted gross income or taxable income so that the section 199 deduction is not limited under section 199(a)(1)(B); that the partnership and each of its partners (whether individual or corporate) are calendar year taxpayers; and that the amount of the partnership's W-2 wages equals wage expense for each taxable year. The examples are as follows:

Code of Federal Regulations

Example 1. Section 861 method with interest expense. (i) Partnership Federal income tax items. X and Y, unrelated United States corporations, are each 50% partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. X and Y share all items of income, gain, loss, deduction, and credit 50% each. Both X and Y are engaged in a trade or business. PRS is not able to specifically identify CGS allocable to DPGR and non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of PRS's gross income, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. For 2006, the adjusted basis of PRS's business assets is $5,000, $4,000 of which generate gross income attributable to DPGR and $1,000 of which generate gross income attributable to non-DPGR. For 2006, PRS has the following Federal income items:
DPGR $3,000
Non-DPGR 3,000
CGS (includes $200 of W-2 wages) 3,240
Section 162 selling expenses (includes $300 of W-2 wages) 1,200
Interest expense (not included in CGS) 300
(ii) Allocation of PRS's items of income, gain, loss, deduction, or credit. X and Y each receive the following distributive share of PRS's items of income, gain, loss, deduction or credit, as determined under the principles of § 1.704-1(b)(1)(vii) :
Gross income attributable to DPGR ($1,500 (DPGR) − $810 (allocable CGS, includes $50 of W-2 wages)) $690
Gross income attributable to non-DPGR ($1,500 (non-DPGR) − $810 (allocable CGS, includes $50 of W-2 wages)) 690
Section 162 selling expenses (includes $150 of W-2 wages) 600
Interest expense (not included in CGS) 150
(iii) Determination of QPAI. (A) X's QPAI. Because the section 199 deduction is determined at the partner level, X determines its QPAI by aggregating, to the extent necessary, its distributive share of PRS's Federal income tax items with all other such items from all other, non-PRS-related activities. For 2006, X does not have any other such items. For 2006, the adjusted basis of X's non-PRS assets, all of which are investment assets, is $10,000. X's only gross receipts for 2006 are those attributable to the allocation of gross income from PRS. X allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of § 1.199-4(d) . In this case, the section 162 selling expenses (including W-2 wages) are definitely related to all of PRS's gross receipts. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of PRS's gross receipts is appropriate. X elects to apportion its distributive share of interest expense under the tax book value method of § 1.861-9T(g) . X's QPAI for 2006 is $366, as shown below:
Code of Federal Regulations 448
DPGR $1,500
CGS allocable to DPGR (includes $50 of W-2 wages) (810)
Section 162 selling expenses (includes $75 of W-2 wages) ($600 × $1,500/$3,000) (300)
Interest expense (not included in CGS) ($150 × $2,000 (X's share of PRS's DPGR assets)/$12,500 (X's non-PRS assets ($10,000) and X's share of PRS assets ($2,500))) (24)
X's QPAI 366
(B) Y's QPAI. (1) For 2006, in addition to the activities of PRS, Y engages in production activities that generate both DPGR and non-DPGR. Y is able to specifically identify CGS allocable to DPGR and to non-DPGR. For 2006, the adjusted basis of Y's non-PRS assets attributable to its production activities that generate DPGR is $8,000 and to other production activities that generate non-DPGR is $2,000. Y has no other assets. Y has the following Federal income tax items relating to its non-PRS activities:
Gross income attributable to DPGR ($1,500 (DPGR) − $900 (allocable CGS, includes $70 of W-2 wages)) $600
Gross income attributable to non-DPGR ($3,000 (other gross receipts) − $1,620 (allocable CGS, includes $150 of W-2 wages)) 1,380
Section 162 selling expenses (includes $30 of W-2 wages) 540
Interest expense (not included in CGS) 90
(2) Y determines its QPAI in the same general manner as X. However, because Y has other trade or business activities outside of PRS, Y must aggregate its distributive share of PRS's Federal income tax items with its own such items. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of § 1.199-4(d) . In this case, Y's distributive share of PRS's section 162 selling expenses (including W-2 wages), as well as those selling expenses from Y's non-PRS activities, are definitely related to all of its gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of Y's gross receipts is appropriate. Y elects to apportion its distributive share of interest expense under the tax book value method of § 1.861-9T(g) . Y has $1,290 of gross income attributable to DPGR ($3,000 DPGR ($1,500 from PRS and $1,500 from non-PRS activities)—$1,710 CGS ($810 from PRS and $900 from non-PRS activities)). Y's QPAI for 2006 is $642, as shown below:
DPGR ($1,500 from PRS and $1,500 from non-PRS activities) $3,000
CGS allocable to DPGR ($810 from PRS and $900 from non-PRS activities) (includes $120 of W-2 wages) (1,710)
Section 162 selling expenses (includes $180 of W-2 wages) ($1,140 ($600 from PRS and $540 from non-PRS activities) × ($1,500 PRS DPGR $1,500 non-PRS DPGR)/($3,000 PRS total gross receipts $4,500 non-PRS total gross receipts)) (456)
Interest expense (not included in CGS) ($240 ($150 from PRS and $90 from non-PRS activities) × $10,000 (Y's non-PRS DPGR assets ($8,000) and Y's share of PRS DPGR assets ($2,000))/$12,500 (Y's non-PRS assets ($10,000) and Y's share of PRS assets ($2,500))) (192)
Code of Federal Regulations 449
Y's QPAI 642
(iv) PRS W-2 wages allocated to X and Y under section 199(d)(1)(A)(iii). Solely for purposes of calculating the PRS W-2 wages that are allocated to them under section 199(d)(1)(A)(iii) for purposes of the wage limitation of section 199(b), X and Y must separately determine QPAI taking into account only the items of PRS allocated to them. X and Y must use the same methods of allocation and apportionment that they use to determine their QPAI in paragraphs (iii)(A) and (B) of this Example 1, respectively. Accordingly, X and Y must apportion deductible section 162 selling expenses that include W-2 wage expense on the basis of gross receipts, and must apportion interest expense according to the tax book value method of § 1.861-9T(g) . (A) QPAI of X and Y, solely for this purpose, is determined by allocating and apportioning each partner's share of PRS expenses to each partner's share of PRS gross income of $690 attributable to DPGR ($1,500 DPGR−$810 CGS, apportioned based on gross receipts). Thus, QPAI of X and Y solely for this purpose is $270, as shown below:
DPGR $1,500
CGS allocable to DPGR (810)
Section 162 selling expenses (including W-2 wages) ($600 × ($1,500/$3,000)) (300)
Interest expense (not included in CGS) ($150 × $2,000 (partner's share of adjusted basis of PRS's DPGR assets)/$2,500 (partner's share of adjusted basis of total PRS assets)) (120)
QPAI 270
(B) X's and Y's shares of PRS's W-2 wages determined under section 199(d)(1)(A)(iii) for purposes of the wage limitation of section 199(b) are $16, the lesser of $250 (partner's allocable share of PRS's W-2 wages ($100 included in total CGS, and $150 included in selling expenses) and $16 (2 × ($270 × .03)). (v) Section 199 deduction determination. (A) X's tentative section 199 deduction is $11 (.03 × $366 (that is, QPAI determined at partner level)) subject to the wage limitation of $8 (50% × $16). Accordingly, X's section 199 deduction for 2006 is $8. (B) Y's tentative section 199 deduction is $19 (.03 × $642 (that is, QPAI determined at the partner level) subject to the wage limitation of $133 (50% × ($16 from PRS and $250 from non-PRS activities)). Accordingly, Y's section 199 deduction for 2006 is $19.

Code of Federal Regulations

Example 2. Section 861 method with R&E expense. (i) Partnership items of income, gain, loss, deduction or credit. X and Y, unrelated United States corporations each of which is engaged in a trade or business, are partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. Neither X nor Y is a member of an affiliated group. X and Y share all items of income, gain, loss, deduction, and credit 50% each. All of PRS's domestic production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of PRS's production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). PRS is not able to specifically identify CGS allocable to DPGR and to non-DPGR and, therefore, apportions CGS to DPGR and non-DPGR based on its gross receipts. PRS incurs $900 of research and experimentation expenses (R&E) that are deductible under section 174, $300 of which are performed with respect to SIC AAA and $600 of which are performed with respect to SIC BBB. None of the R&E is legally mandated R&E as described in § 1.861-17(a)(4) and none is included in CGS. PRS incurs section 162 selling expenses (that include W-2 wage expense) that are not includible in CGS and are definitely related to all of PRS's gross income. For 2006, PRS has the following Federal income tax items:
DPGR (all from sales of products within SIC AAA) $3,000
Non-DPGR (all from sales of products within SIC BBB) 3,000
CGS (includes $200 of W-2 wages) 2,400
Section 162 selling expenses (includes $100 of W-2 wages) 840
Code of Federal Regulations 450
Section 174 R&E-SIC AAA 300
Section 174 R&E-SIC BBB 600
(ii) Allocation of PRS's items of income, gain, loss, deduction, or credit. X and Y each receive the following distributive share of PRS's items of income, gain, loss, deduction, or credit, as determined under the principles of § 1.704-1(b)(1)(vii) :
Gross income attributable to DPGR ($1,500 (DPGR)−$600 (CGS, includes $50 of W-2 wages)) $900
Gross income attributable to non-DPGR ($1,500 (other gross receipts)−$600 (CGS, includes $50 of W-2 wages)) 900
Section 162 selling expenses (includes $50 of W-2 wages) 420
Section 174 R&E-SIC AAA 150
Section 174 R&E-SIC BBB 300
(iii) Determination of QPAI. (A) X's QPAI. Because the section 199 deduction is determined at the partner level, X determines its QPAI by aggregating, to the extent necessary, its distributive shares of PRS's Federal income tax items with all other such items from all other, non-PRS-related activities. For 2006, X does not have any other such tax items. X's only gross receipts for 2006 are those attributable to the allocation of gross income from PRS. As stated, all of PRS's domestic production activities that generate DPGR are within SIC AAA. X allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of § 1.199-4(d) . In this case, the section 162 selling expenses (including W-2 wages) are definitely related to all of PRS's gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of PRS's gross receipts is appropriate. For purposes of apportioning R&E, X elects to use the sales method as described in § 1.861-17(c) . Because X has no direct sales of products, and because all of PRS's SIC AAA sales attributable to X's share of PRS's gross income generate DPGR, all of X's share of PRS's section 174 R&E attributable to SIC AAA is taken into account for purposes of determining X's QPAI. Thus, X's total QPAI for 2006 is $540, as shown below:
DPGR (all from sales of products within SIC AAA) $1,500
CGS (includes $50 of W-2 wages) (600)
Section 162 selling expenses (including W-2 wages) ($420 × ($1,500 DPGR/$3,000 total gross receipts)) (210)
Section 174 R&E-SIC AAA (150)
X's QPAI 540
(B) Y's QPAI. (1) For 2006, in addition to the activities of PRS, Y engages in domestic production activities that generate both DPGR and non-DPGR. With respect to those non-PRS activities, Y is not able to specifically identify CGS allocable to DPGR and to non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of Y's non-PRS gross receipts, apportionment of CGS between DPGR and non-DPGR based on Y's non-PRS gross receipts is appropriate. For 2006, Y has the following non-PRS Federal income tax items:
DPGR (from sales of products within SIC AAA) $1,500
DPGR (from sales of products within SIC BBB) 1,500
Non-DPGR (from sales of products within SIC BBB) 3,000
CGS (allocated to DPGR within SIC AAA) (includes $56 of W-2 wages) 750
CGS (allocated to DPGR within SIC BBB) (includes $56 of W-2 wages) 750
CGS (allocated to non-DPGR within SIC BBB) (includes $113 of W-2 wages) 1,500
Section 162 selling expenses (includes $30 of W-2 wages) 540
Section 174 R&E-SIC AAA 300
Code of Federal Regulations 451
Section 174 R&E-SIC BBB 450
(2) Because Y has DPGR as a result of activities outside PRS, Y must aggregate its distributive share of PRS's Federal income tax items with such items from all its other, non-PRS-related activities. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of § 1.199-4(d) . In this case, the section 162 selling expenses (including W-2 wages) are definitely related to all of Y's gross income. Based on the facts and circumstances of the specific case, apportionment of such expenses between DPGR and non-DPGR on the basis of Y's gross receipts is appropriate. For purposes of apportioning R&E, Y elects to use the sales method as described in § 1.861-17(c) . (3) With respect to sales that generate DPGR, Y has gross income of $2,400 ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities) −$2,100 CGS ($600 from sales of products by PRS and $1,500 from non-PRS activities)). Because all of the sales in SIC AAA generate DPGR, all of Y's share of PRS's section 174 R&E attributable to SIC AAA and the section 174 R&E attributable to SIC AAA that Y incurs in its non-PRS activities are taken into account for purposes of determining Y's QPAI. Because only a portion of the sales within SIC BBB generate DPGR, only a portion of the section 174 R&E attributable to SIC BBB is taken into account in determining Y's QPAI. Thus, Y's QPAI for 2006 is $1,282, as shown below:
DPGR ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities)) $4,500
CGS ($600 from sales of products by PRS and $1,500 from non-PRS activities) (2,100)
Section 162 selling expenses (including W-2 wages) ($420 from PRS $540 from non-PRS activities) x ($4,500 DPGR/$9,000 total gross receipts) (480)
Section 174 R&E-SIC AAA ($150 from PRS and $300 from non-PRS activities) (450)
Section 174 R&E-SIC BBB ($300 from PRS $450 from non-PRS activities) x ($1,500 DPGR/$6,000 total gross receipts allocated to SIC BBB ($1,500 from PRS and $4,500 from non-PRS activities)) (188)
Y's QPAI 1,282
(iv) PRS W-2 wages allocated to X and Y under section 199(d)(1)(A)(iii). Solely for purposes of calculating the PRS W-2 wages that are allocated to X and Y under section 199(d)(1)(A)(iii) for purposes of the wage limitation of section 199(b), X and Y must separately determine QPAI taking into account only the items of PRS allocated to them. X and Y must use the same methods of allocation and apportionment that they use to determine their QPAI in paragraphs (iii)(A) and (B) of this Example 2, respectively. Accordingly, X and Y must apportion section 162 selling expenses that include W-2 wage expense on the basis of gross receipts, and apportion section 174 R&E expense under the sales method as described in § 1.861-17(c) . (A) QPAI of X and Y, solely for this purpose, is determined by allocating and apportioning each partner's share of PRS expenses to each partner's share of PRS gross income of $900 attributable to DPGR ($1,500 DPGR—$600 CGS, allocated based on PRS's gross receipts). Because all of PRS's SIC AAA sales generate DPGR, all of X's and Y's shares of PRS's section 174 R&E attributable to SIC AAA is taken into account for purposes of determining X's and Y's QPAI. None of PRS's section 174 R&E attributable to SIC BBB is taken into account because PRS has no DPGR within SIC BBB. Thus, X and Y each has QPAI, solely for this purpose, of $540, as shown below:
DPGR (all from sales of products within SIC AAA) $1,500
CGS (includes $50 of W-2 wages) (600)
Section 162 selling expenses (including W-2 wages) ($420 × $1,500/$3,000) (210)
Section 174 R&E-SIC AAA (150)
QPAI 540
Code of Federal Regulations 452
(B) X's and Y's shares of PRS's W-2 wages determined under section 199(d)(1)(A)(iii) for purposes of the wage limitation of section 199(b) are $32, the lesser of $150 (partner's allocable share of PRS's W-2 wages ($100 included in CGS, and $50 included in selling expenses)) and $32 (2 × ($540 × .03)). (v) Section 199 deduction determination. (A) X's tentative section 199 deduction is $16 (.03 × $540 (QPAI determined at partner level)) subject to the wage limitation of $16 (50% × $32). Accordingly, X's section 199 deduction for 2006 is $16. (B) Y's tentative section 199 deduction is $38 (.03 x $1,282 (QPAI determined at partner level) subject to the wage limitation of $144 (50% x $287 ($32 from PRS $255 from non-PRS activities)). Accordingly, Y's section 199 deduction for 2006 is $38.

Code of Federal Regulations

Example 3. Partnership with special allocations. (i) In general. X and Y are unrelated corporate partners in PRS and each is engaged in a trade or business. PRS is a partnership that engages in a domestic production activity and other activities. In general, X and Y share all partnership items of income, gain, loss, deduction, and credit equally, except that 80% of the wage expense of PRS and 20% of PRS's other expenses are specially allocated to X (substantial economic effect under section 704(b) is presumed). In the 2006 taxable year, PRS's only wage expense is $2,000 for marketing, which is not included in CGS. PRS has $8,000 of gross receipts ($6,000 of which is DPGR), $4,000 of CGS ($3,500 of which is allocable to DPGR), and $3,000 of deductions (comprised of $2,000 of wages for marketing and $1,000 of other expenses). X qualifies for and uses the simplified deduction method under § 1.199-4(e) . Y does not qualify to use that method and, therefore, must use the section 861 method under § 1.199-4(d) . In the 2006 taxable year, X has gross receipts attributable to non-partnership trade or business activities of $1,000 and wages of $200. None of X's non-PRS gross receipts is DPGR. (ii) Allocation and apportionment of costs. Under the partnership agreement, X's distributive share of the items of PRS is $1,250 of gross income attributable to DPGR ($3,000 DPGR × $1,750 allocable CGS), $750 of gross income attributable to non-DPGR ($1,000 non-DPGR × $250 allocable CGS), and $1,800 of deductions (comprised of X's special allocations of $1,600 of wage expense ($2,000 × 80%) for marketing and $200 of other expenses ($1,000 × 20%)). Under the simplified deduction method, X apportions $1,200 of other deductions to DPGR ($2,000 ($1,800 from the partnership and $200 from non-partnership activities) × ($3,000 DPGR/$5,000 total gross receipts)). Accordingly, X's QPAI is $50 ($3,000 DPGR × $1,750 CGS × $1,200 of deductions). However, in determining the section 199(d)(1)(A)(iii) wage limitation, QPAI is computed taking into account only the items of PRS allocated to X for the taxable year of PRS. Thus, X apportions $1,350 of deductions to DPGR ($1,800 × ($3,000 DPGR/$4,000 total gross receipts from PRS)). Accordingly, X's QPAI for purposes of the section 199(d)(1)(A)(iii) wage limitation is $0 ($3,000 DPGR × $1,750 CGS × $1,350 of deductions). X's share of PRS's W-2 wages is $0, the lesser of $1,600 (X's 80% allocable share of $2,000 of wage expense for marketing) and $0 (2 × ($0 QPAI × .03)). X's tentative deduction is $2 ($50 QPAI × .03), subject to the section 199(b)(1) wage limitation of $100 (50% × $200 ($0 of PRS-related W-2 wages $200 of non-PRS W-2 wages)). Accordingly, X's section 199 deduction for the 2006 taxable year is $2.

Code of Federal Regulations

Example 4. Partnership with no W-2 wages. (i) Facts. A, an individual, and B, an individual, are partners in PRS. PRS is a partnership that engages in manufacturing activities that generate both DPGR and non-DPGR. A and B share all items of income, gain, loss, deduction, and credit equally. In the 2006 taxable year, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 and deductions of $800. PRS has no W-2 wages. A and B each use the small business simplified overall method under § 1.199-4(f) . A has trade or business activities outside of PRS. With respect to those activities, A has total gross receipts of $1,000 ($500 of which is DPGR), CGS of $400 (including $50 of W-2 wages) and deductions of $200 for the 2006 taxable year. B has no trade or business activities outside of PRS and pays $0 of W-2 wages directly for the 2006 taxable year. A's distributive share of the items of the partnership is $500 DPGR, $500 non-DPGR, $200 CGS, and $400 of deductions. (ii) Section 199(d)(1)(A)(iii) wage limitation. A's CGS and deductions apportioned to DPGR from PRS equal $300 (($200 CGS $400 of other deductions) × ($500 DPGR/$1,000 total gross receipts)). Accordingly, for purposes of the wage limitation of section 199(d)(1)(A)(iii), A's QPAI is $200 ($500 DPGR × $300 CGS and other deductions). A's share of partnership W-2 wages after application of the section 199(d)(1)(A)(iii) limitation is $0, the lesser of $0 (A's 50% allocable share of PRS's $0 of W-2 wages) or $12 (2 × ($200 QPAI × .03)). B's share of PRS's W-2 wages also is $0. (iii) Section 199 deduction computation. A's total CGS and deductions apportioned to DPGR equal $600 (($200 PRS CGS $400 outside trade or business CGS $400 PRS deductions $200 outside trade or business deductions) × ($1,000 total DPGR ($500 from PRS $500 from outside trade or business)/$2,000 total gross receipts ($1,000 from PRS $1,000 from outside trade or business)). Accordingly, A's QPAI is $400 ($1,000 DPGR × $600 CGS and deductions). A's tentative deduction is $12 ($400 QPAI × .03), subject to the section 199(b)(1) wage limitation of $25 (50% × $50 total W-2 wages). A's section 199 deduction for the 2006 taxable year is $12. B's total section 199 deduction for the 2006 taxable year is $0 because B has no W-2 wages for the 2006 taxable year.
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Example 5. Guaranteed payment. (i) Facts. The facts are the same as Example 4 except that in 2006 PRS also makes a guaranteed payment of $200 to A for services, and PRS pays $200 of W-2 wages to PRS employees, which is included within the $400 of CGS. See section 707(c). This guaranteed payment is taxable to A as ordinary income and is properly deducted by PRS under section 162. Pursuant to § 1.199-3(p) , A may not treat any part of this payment as DPGR. Accordingly, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 (including $200 of W-2 wages) and deductions of $1,000 (including the $200 guaranteed payment) for the 2006 taxable year. A's distributive share of the items of the partnership is $500 DPGR, $500 non-DPGR, $200 CGS, and $500 of deductions. (ii) Section 199(d)(1)(A)(iii) wage limitation. A's CGS and deductions apportioned to DPGR from PRS equal $350 (($200 CGS $500 of other deductions) × ($500 DPGR/$1,000 total gross receipts)). Accordingly, for purposes of the wage limitation of section 199(d)(1)(A)(iii), A's QPAI is $150 ($500 DPGR × $350 CGS and other deductions). A's share of partnership W-2 wages after application of the section 199(d)(1)(A)(iii) limitation is $9, the lesser of $100 (A's 50% allocable share of PRS's $200 of W-2 wages) or $9 (2 × ($150 QPAI × .03)). B's share of PRS's W-2 wages after application of section 199(d)(1)(A)(iii) also is $9. (iii) A's section 199 deduction computation. A's total CGS and deductions apportioned to DPGR equal $591 (($200 PRS CGS $400 outside trade or business CGS $500 PRS deductions $200 outside trade or business deductions) × ($1,000 total DPGR ($500 from PRS $500 from outside trade or business)/$2,200 total gross receipts ($1,000 from PRS $200 guaranteed payment $1,000 from outside trade or business)). Accordingly, A's QPAI is $409 ($1,000 DPGR × $591 CGS and other deductions). A's tentative deduction is $12 ($409 QPAI × .03), subject to the section 199(b)(1) wage limitation of $30 (50% × $59 ($9 PRS W-2 wages $50 W-2 wages from A's trade or business activities outside of PRS)). A's section 199 deduction for the 2006 taxable year is $12. (iv) B's section 199 deduction computation. B's QPAI is $150 ($500 DPGR × $350 CGS and other deductions). B's tentative deduction is $5 ($150 QPAI × .03), subject to the section 199(b)(1) wage limitation of $5 (50% × $9). Assuming that B engages in no other activities generating DPGR, B's section 199 deduction for the 2006 taxable year is $5.
(c) S corporations— (1) In general— The section 199 deduction with respect to the qualified production activities of an S corporation is determined at the shareholder level. As a result, each shareholder must compute its deduction separately. The section 199 deduction will have no effect on the basis of a shareholder's stock in an S corporation. Except as provided by publication pursuant to paragraph (c)(1)(ii) of this section, for purposes of this section, each shareholder is allocated, in accordance with section 1366, its pro rata share of S corporation items (including items of income, gain, loss, and deduction), CGS allocated to such items of income, and gross receipts included in such items of income, even if the shareholder's share of CGS and other deductions and losses exceeds DPGR, and regardless of the amount of the shareholder's share of the W-2 wages of the S corporation for the taxable year. Except as provided by publication under paragraph (c)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, the shareholder aggregates its pro rata share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the S corporation (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its QPAI.
(ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii) (b) of this chapter), permit an S corporation to calculate a shareholder's share of QPAI at the entity level, instead of allocating, in accordance with section 1366, the shareholder's pro rata share of S corporation items (including items of income, gain, loss, and deduction). If an S corporation does calculate QPAI at the entity level—
(A) Each shareholder is allocated its share of QPAI and W-2 wages, which (subject to the limitations under paragraph (c)(2) of this section and section 199(d)(1)(A)(iii), respectively) are combined with the shareholder's QPAI and W-2 wages from other sources;
(B) For purposes of computing the shareholder's QPAI under §§ 1.199-1 through 1.199-9, a shareholder does not take into account the items from the S corporation (for example, a shareholder does not take into account items from the S corporation in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources;
(C) A shareholder generally does not recompute its share of QPAI from the S corporation using another method; however, the shareholder might have to adjust its share of QPAI from the S corporation to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and
(D) A shareholder's share of QPAI from an S corporation may be less than zero.
(2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii) (b) of this chapter), losses or deductions of the S corporation that otherwise would be taken into account in computing the shareholder's section 199 deduction for a taxable year are taken into account in that year only if and to the extent the shareholder's pro rata share of the losses or deductions from all of the S corporation's activities is not disallowed by section 465, 469, or 1366(d), or any other provision of the Code. If only a portion of the shareholder's share of the losses or deductions is allowed for a taxable year, a proportionate share of those allowable losses or deductions that are allocated to the S corporation's qualified production activities, determined in a manner consistent with sections 465, 469, and 1366(d), and any other applicable provision of the Code, is taken into account in computing the QPAI and the wage limitation of section 199(d)(1)(A)(iii) for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year, the shareholder takes into account a proportionate share of those losses or deductions in computing its QPAI for that later taxable year. Losses or deductions of the S corporation that are disallowed for taxable years beginning on or before December 31, 2004, are not taken into account in a later taxable year for purposes of computing the shareholder's QPAI or the wage limitation of section 199(d)(1)(A)(iii) for that taxable year, rega