LB&I Guidance on Benefits-and-Burdens-of-Ownership Analysis Under Sec. 199

By Kathleen Meade, CPA, MST, New York City

Editor: Kevin D. Anderson, CPA, J.D.

Expenses & Deductions

The IRS Large Business & International (LB&I) Division issued a directive (LB&I-4-0112-001), dated Feb. 1, 2012, that provides guidance to field examiners in determining whether a taxpayer conducting production activities under a contract manufacturing arrangement with an unrelated third party meets the benefits-and-burdens-of-ownership requirement outlined in the domestic production activities deduction rules under Sec. 199.

The benefits-and-burdens issue has generated considerable controversy between the IRS and taxpayers since the deduction was created by the American Jobs Creation Act of 2004, P.L. 108-357. The directive is intended to simplify and expedite the often complex and subjective facts-and-circumstances analysis that the Sec. 199 regulations require taxpayers to perform to determine whether they have met the benefits-and-burdens requirement.


Under Sec. 199, taxpayers are allowed to deduct a specified percentage of the lesser of (1) qualified production activities income resulting from specified domestic production activities; or (2) taxable income determined without regard to the Sec. 199 deduction. For 2010 and later tax years the specified percentage is generally 9% (Sec. 199(a)(1)). As noted in the directive, taxpayers frequently enter into contractual arrangements with unrelated parties to perform some or all of the production activities potentially qualifying for the deduction. However, the rules governing the tax treatment of these arrangements under Sec. 199 stipulate that only one taxpayer may claim the Sec. 199 deduction for a particular activity. Specifically, Regs. Sec. 1.199-3(f)(1) provides that, if one taxpayer performs a qualifying activity under a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property during the period the qualifying activity occurs is entitled to claim a deduction under Sec. 199 for that property.

According to the Sec. 199 regulations, determining which party meets the benefits-and-burdens requirement is based on all of the facts and circumstances. Regs. Sec. 1.199-3(f)(4) contains two examples illustrating various factors relevant to the benefits-and-burdens determination for nongovernment contracts (a third example involves a government contract). The two examples cite various ownership factors contained in the extensive body of case law addressing this issue, including whether the taxpayer owns the intellectual property associated with the qualified property, controls the production process details, bears the risk of loss or damage during production, realizes economic gain or loss upon disposition of the qualified property, or possesses legal title to the qualified property during the production process.

In an attempt to address the significant complexity and controversy associated with the benefits-and-burdens issue, the LB&I formed a 199 group consisting of representatives from the IRS, taxpayers, and practitioners. The group drafted a list of factors that were ranked and commented on by the group members, and in late 2010 indicated its intent to issue guidance designed to simplify the benefits-and-burdens analysis. That guidance was issued in the form of the directive, which outlines a three-step process containing nine factors, several of which were included in the list developed by the 199 group. The key points outlined in the directive are summarized below.

Three-Step Process

The directive outlines three “steps” (contract terms, production activities, and economic risks), each of which consists of three yes/no questions (i.e., nine questions in total) addressing specific factors relevant to determining whether a taxpayer meets the benefits-and-burdens requirement under Sec. 199. The directive instructs examiners to apply the step process as follows. If the answer is “yes” to at least two of the questions in the step, the step is completed (i.e., the benefits-and-burdens requirement is deemed satisfied for that step). If any two of the three steps are completed, the taxpayer has met the benefits-and-burdens requirement for purposes of Sec. 199. Conversely, if at least two of the three steps are not completed (i.e., the benefits-and-burdens requirement is not satisfied for at least two of the three steps), the examiner is then instructed to perform a facts-and-circumstances analysis to determine whether the taxpayer has met the benefits-and-burdens requirement.

The directive further instructs examiners that the facts-and-circumstances analysis “should consider all relevant factors” and not rely solely on the nine factors cited in the directive. Finally, the directive specifies that the guidance is applicable only where the contract parties are not treated as related persons under Sec. 199(c)(7). The three steps and nine questions outlined in the directive are reproduced below (emphasis added in all questions):

Step 1: Contract terms

  1. Did the taxpayer have title to the work in process (WIP)?
  2. Did the taxpayer have risk of loss over the WIP?
  3. Was the taxpayer primarily responsible for insuring the WIP?

Step 2: Production activities

  1. Did the taxpayer develop the qualifying activity process (determined without regard to who designed the property, provided the specifications for the property, or holds intellectual rights to the property)?
  2. Did the taxpayer exercise oversight and direction over the employees engaged in the qualifying activity (determined without regard to who designed the property, provided the specifications for the property, or holds intellectual rights to the property)?
  3. Did the taxpayer conduct more than 50% of the quality control tests over the WIP while the qualifying activity was occurring?

Step 3: Economic risks

  1. Was the taxpayer primarily liable under the “make-good” provisions of the contract, for example, the warranty, quality-of-work, spoilage, overconsumption, or indemnification provisions?
  2. Did the taxpayer provide more than 50%, based on cost, of the raw materials and components used to produce the property?
  3. Did the taxpayer have the greater opportunity for profit increase or decrease from production efficiencies and fluctuations in the cost of labor and factory overhead?

Taxpayers affected by the directive (i.e., claiming a Sec. 199 deduction for qualifying activities performed under contract manufacturing arrangements) should review their current contracts to determine whether they are likely to meet the benefits-and-burdens requirement using the three-step process or must continue to perform the more onerous facts-and-circumstances analysis mandated by the Sec. 199 regulations. Determining appropriate responses to the questions may be complicated by the following considerations:

Several key terms are not clearly defined: For example, no measurement basis is specified for a taxpayer to determine whether it conducted “more than 50% of the quality control tests.” Similarly, no guidance (such as a threshold percentage) is provided to determine which party is “primarily” responsible for insuring the WIP, “primarily” liable under the “‘make-good’ provisions” or has “the greater opportunity for profit increase or decrease” where, as is common in many contract manufacturing arrangements, both parties are required under various circumstances to assume a significant share of these responsibilities and risks. Guidance is needed in this area to avoid confusion for taxpayers and disagreements with the IRS on exam.

Several of the factors may not result in a definitive determination of ownership: In particular, the three questions under the first step (contract terms) cite factors that commonly apply to both parties, making it difficult to clearly determine the owner of the property under this criterion. For example, to ensure that proper care and due diligence are exercised by both parties in discharging their contractual responsibilities, many third-party manufacturing arrangements require both parties to maintain an insurable interest in the property, bear the risk of loss or damage under various circumstances or events, and retain title to their respective materials and components. Similarly, given the complex pricing and cost reimbursement terms common to many contracts, it is often difficult to determine which party has the “greater opportunity for profit increase or decrease” under step three.

Thus, determining ownership under the factors contained in the directive may be a complex, subjective, and potentially contentious process, which may result in taxpayers’ being unable to avail themselves of the simplified three-step process and forced to continue performing the burdensome facts-and-circumstances analysis required under the Sec. 199 regulations.


Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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