Pass-through owners 2018 DPAD from fiscal year entities also addressed
In Sept. 2018, the IRS announced that amended returns or refund claims relating to the now repealed section 199 Domestic Production Activity Deduction (DPAD) would be the focus of one of the many Large Business and International (LB&I) Compliance Campaigns. The IRC Section 199 – Claims Risk Review campaign’s stated objective is to ensure compliance with the section 199 requirements through “a claim risk review assessment and issue-based examinations of claims with the greatest compliance risk.” (See previous tax alert: IRS LB&I division announces five additional compliance campaigns.) The IRS has now released a directive (LB&I-04-1118-016) providing IRS LB&I examiners with guidance on the risk review assessment process for when a taxpayer files an amended return or claim for refund relating to the DPAD.
Prior to its repeal, section 199 allowed for a tax deduction equal to nine percent of the lesser of a taxpayer’s Qualified Production Activities Income (QPAI) or the taxpayer’s taxable income, limited to 50 percent of the taxpayer’s allocable W-2 wages for the year. For a C corporation the deduction is easily claimed at the corporation level. S corporations or partnerships may also claim the deduction but the deduction is computed at the shareholder or partner level. The S corporation or partnership must first compute QPAI for its domestic production activities and then report the DPAD components to the shareholder or partner in a statement attached to Form K-1 so that the shareholder or partner may compute QPAI on an individual level.
The Tax Cuts and Jobs Act of 2017 (TCJA) repealed the DPAD for taxable years beginning after Dec. 31, 2017. A taxpayer may not claim the DPAD for 2018 and beyond unless it:
- Has a taxable year that began before Jan. 1, 2018,
- Is a shareholder or partner in an S Corporation or partnership with a taxable year that began before Jan. 1, 2018, which engaged in eligible DPAD activities,
- Is a beneficiary of an estate or trust with a taxable year that began before Jan. 1, 2018, which engaged in eligible DPAD activities, or
- Is a patron of an agricultural or horticultural cooperative with a taxable year that began before Jan. 1, 2018, which engaged in eligible DPAD activities.
The IRS recently addressed how these taxpayers may claim the DPAD in its draft instructions for the draft Form 1040. A taxpayer should enter its share of DPAD on the dotted line next to Schedule 1, Line 36 and identify it as “DPAD,” and then include that amount on line 36. (See previous tax alert: Owners of fiscal year pass through entity may claim 2018 DPAD.)
The IRS added the IRC Section 199 – Claims Risk Review campaign to combat a heightened risk of non-compliance on amended returns and claims for refund associated with claiming the DPAD. For taxable years prior to the repeal of DPAD, the IRS LB&I has established a process for risk assessing the amended returns or claim for refund. Claims for refund filed with the Ogden Campus or with an examiner will go through a risk review process, including consideration of materiality. Informal claims for refund, amended returns not filed with the Ogden Campus, or Joint Committee cases must be submitted to the service’s Corporate Income and Losses Practice Network for assessment by the risk review team.
Examiners will use the same examination process outlined in Publication 5125, LB&I Examination Process. Of note, this process requires that in order to be a valid claim, a claim must:
- Set forth in detail each ground upon which credit or refund is claimed,
- Present facts sufficient to apprise the IRS of the exact basis for the claim, and
- Contain a written declaration that it is made under penalties of perjury.
The new directive also advises that a section 6676, Erroneous Claim for Refund or Credit, penalty can be assessed in certain cases. Examiners can assess the penalty when appropriate, based on the facts and circumstances of the issue. Section 6676 assess a penalty equal to 20 percent of the excessive claim that the IRS determines was made erroneously and without reasonable cause.
The newly issued directive demonstrates the IRS’s previously stated position that it will apply heightened scrutiny to DPAD claims made on amended returns and claims for refund. LB&I examiners are required to risk assess the claims for potential noncompliance and assess penalties where warranted. However, the directive also confirms that a taxpayer with pass-through DPAD elements may still claim the deduction on its 2018 return where the entity engaged in the DPAD activity had a tax year that began prior to 2018. Taxpayers should use care when claiming this deduction and consult their tax advisers to ensure compliance with the DPAD rules and regulations.