The Code Sec. 199 domestic production activities deduction (DPAD) can be particularly beneficial. The deduction equals nine percent of income from the manufacture or production of qualified property. Qualified property generally is tangible personal property. Our New York City tax and accounting firm can help you understand how this and other sections of the IRS tax code apply to your business. Contact us to schedule a consultation.
The taxpayer must own the property while it is being produced. While ownership is not an issue in many cases, it is important for taxpayers that enter into a contract manufacturing arrangement. In a contract manufacturing arrangements, one party contracts with another, unrelated party to produce the property for which the deduction is claimed.
Ownership depends on who the benefits and burdens for the property, at the time that the property is manufactured or produced. Determining benefits and burdens depends on all the facts and circumstances. Recent developments have spotlighted the issue of benefits and burdens under Code Sec. 199. These include a Tax Court decision, ADVO, Inc., 141 TC No. 9 (2013), and an IRS Large Business & International Division directive, LB&I-04-1013-008 (2013).
The courts have developed at least eight factors for determining benefits and burdens. The Tax Court in ADVO applied evaluated these factors and determined that the contract manufacturer, not the taxpayer who ultimately sold the product, had the benefits and burdens of ownership at the time the property was produced. The court noted that the contract manufacturer held legal title to the property; was required to manufacture the property; had possession; enjoyed the economic gain or had the risk of loss from the sale of the property; controlled the details of the production process without supervision or management by the taxpayer; and was the party intended to manufacture the property. Therefore, the contract manufacturer was entitled to the Code Sec. 199 deduction, not the taxpayer who ultimately sold the product to customers and clients. This decision was a solid win for the IRS.
IRS examiners have historically used a four-factor test to determine benefits and burdens, gleaned from court cases, regulations, and internal IRS guidance (directives): who controls the details of the manufacturing process; who bears the risk of loss or damage during the manufacturing; who has the economic risk of loss from the sale of the property; and who has legal title to the property during the manufacturing process.
Only party can claim the Code Sec. 199 deduction. The IRS has noted that in a contract manufacturing arrangement, both parties may have some indicia of ownership. It may not be clear which party is entitled to the deduction. The IRS does not want to be whipsawed, where both parties claim the deduction for the same product at the same time.
Certification by taxpayers under audit
To address this problem during an IRS audit, the Large Business & International Division has developed a procedure that allows the parties to the contract manufacturing arrangement to decide between themselves who will claim the deduction. The IRS believes this will save resources for both the taxpayers and for the government.
To claim the deduction, the taxpayer must submit a statement explaining the basis for its claim of benefits and burdens and must certify that it can and will claim the deduction. The other party to the contract manufacturing arrangement must certify that it will not claim the deduction. If the taxpayer follows this procedure, LB&I directs it examiners not to challenge the ownership claim. If the directive does not apply, the examiner (and the taxpayer) must apply all the facts and circumstances to determine who owns the property.
As you can see, the benefits and burdens issue can be particularly complex. Determining whether you have ownership of property for claiming the Code Sec. 199 deduction can be challenging. This firm stands ready to help you understand this question, interpret the factors used to determine benefits and burdens, and assist you with any ownership claims. Please contact our firm so that we can provide tax help in New York City in regard to this issue.