1. Section 199: Income Attributable to Domestic Production Activities
In order to encourage taxpayers to engage in manufacturing trades or businesses in the United States, Congress enacted § 199. Section 199(a) allows a deduction of 9% of a taxpayer’s “qualified production activities income” or the taxpayer’s taxable income determined without regard to § 199 – whichever is less. A taxpayer’s “qualified production activities income” is taxpayer’s net (§ 199(c)(1)) income derived from “ any lease, rental, license, sale, exchange, or other disposition of” (§ 199(c)(4)(A)(i))
- tangible personal property, computer software, or sound recording, § 199(c)(5),
- a film if at least 50% of the compensation relating to its production is for services performed in the United States, §§ 199(c)(A)(i)(II), 199(c)(6), or
- ”electricity, natural gas, or potable water produced by the taxpayer in the United States. § 199(c)(4)(A)(i)(III).
Such income also includes income derived from –
- ”construction of real property performed in the United States by the taxpayer in the ordinary course of” his/her/its trade or business, § 199(c)(4)(A)(ii), or
- engineering or architectural services performed in the United States by the taxpayer in the ordinary course of his/her/its trade or business, § 199(c)(4)(iii).
A § 199 deduction is limited to 50% of the taxpayer’s W-2 wages paid during the taxable year.
Section 199 is not part of the Code’s methods for determining a taxpayer’s net income. Rather, it is a reward for doing something that Congress wants taxpayers to do, i.e., to engage in manufacturing activities in the United States. And: the more profit a taxpayer can derive from engaging in manufacturing activities, the greater his/her/its deduction. But taxpayer is only entitled to a § 199 deduction in an amount up to half what he/she/it paid in W-2 [i.e., U.S.] wages.
Section 199 represents an effort to make U.S. manufacturers more competitive vis-a-vis foreign competition. It is also intended to encourage exports. By rewarding successful manufacturers, Congress is (likely to be) rewarding exporters.
Congress has pursued this objective in other legislation, but the World Trade Organization found that such legislation violated the General Agreement on Tariffs and Trade.
2. Section 611: The Depletion Deduction
Section 611(a) provides for a deduction in computing taxable income for depletion. This deduction is available for “mines, oil and gas wells, other natural deposits, and timber.” 1 The depletion allowance deduction is similar to the depreciation deduction, infra, in that both deductions are a form of cost recovery of capital investments. Unlike the depreciation deduction, which is an allowance for the gradual consumption of an asset that the taxpayer uses to produce a product (or to provide a service), the depletion allowance deduction is an allowance for the cost recovery of wasting assets that are the product. 2 The depletion allowance is part of the cost of the thing that the taxpayer sells.
Congress enacted the depletion allowance deduction as a means for fossil fuel companies and mine operators to deduct an amount equal to the reduction in value of their mineral reserves as they extracted and sold the mineral. § 611(a). The deduction allows a taxpayer to recover its capital investment so that the investment will not diminish as the minerals are extracted and sold. 3 Despite this purpose, there is no requirement that the taxpayer invest any money in the mineral rights, 4 and taxpayer does not have to have legal title to take advantage of the deduction. 5 First codified in 1913, the depletion allowance deduction was originally limited to mines – and only 5% of the gross value of a mine’s reserves could be deducted in a year. 6 Over time, the depletion allowance deduction has expanded to include resources other than mining – such as oil, gas, and timber – and to allow for deductions greater than 5%.
Anyone with an “economic interest” may share 7 in the depletion allowance deduction. 8 “An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place or standing timber and secures, by any form of legal relationship, income derived from the extraction of the mineral or severance of the timber, to which he must look for a return of his capital.” 9 A broad range of economic interests exists whose owners may claim the depletion allowance deduction.
There are now two ways to calculate a depletion allowance deduction, and taxpayer chooses the one that yields the greater deduction. However, taxpayer may not choose percentage depletion in the case of an interest in timber. 10
Cost Depletion: Under cost depletion, taxpayer allocates annually an equal amount of basis 11 to each recoverable unit. 12 Taxpayer may claim the deduction when it sells the unit 13 or cuts the timber. 14 Depletion allowance deductions – allowed or allowable – reduce taxpayer’s basis in the property until the basis is $0. 15 At that time, taxpayer may shift to percentage depletion, except when taxpayer claims depletion allowance deductions for timber. Recapture of depletion allowance deductions upon sale or exchange of the property is subject to income taxation at ordinary income rates. 16
Percentage Depletion: Percentage depletion is a deduction based on a specified percentage of taxpayer’s gross income from the activity 17 up to 50% of the taxable income from the activity. 18 The limit is 100% of taxable income from oil and gas properties. 19 However, Sections 613(d) and 613A disallow any depletion allowance deduction for oil and gas wells, except for some small independent producers and royalty owners of domestic oil and gas. 20 Their percentage depletion allowance deduction is 15% 21 of gross income, limited to 65% of taxable income. 22 A percentage depletion allowance deduction is available even though taxpayer has no basis remaining in the asset.
The percentage depletion method serves to encourage the further development and exploitation of certain natural resources. This is important in a time when we believe that preservation of natural resources should be national policy. 23 In recent years, depletion allowance deductions have increased significantly: in 2003, total corporate depletion allowance deductions were nearly $10.2 billion, while in 2009, total corporate depletion allowance deductions rose to more than $21.5 billion. 24