IRS Addresses Sec. 199 Requirements for Packaging Manufacturer

By Kathleen Meade, CPA, Woodbridge, N.J.

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

Expenses & Deductions

In November, the IRS Office of Chief Counsel released a memorandum (Chief Counsel Advice (CCA) 201246030) that clarifies how certain eligibility requirements for the Sec. 199 deduction apply to a packaging manufacturer. Most significantly, in addressing the “manufactured, produced, grown, or extracted” (MPGE) requirement outlined in the Sec. 199 rules, the memorandum concluded that the exception for packaging, repackaging, labeling, or minor assembly activities does not apply to disqualify the taxpayer’s sales receipts from meeting the MPGE requirement under Sec. 199. In addition to the MPGE issue, the IRS provided comments as to how the “in whole or in significant part” requirement outlined in the Sec. 199 rules applies to the taxpayer.

MPGE Requirement Satisfied

The taxpayer in CCA 201246030 derived gross receipts from providing medications to health care facilities. Essentially, the taxpayer purchased pills from third parties in bulk and repackaged the pills into blister packs that it manufactured from plastic polyvinyl chloride (PVC) and lidding material. Although the process did not result in any change in the pills’ form or characteristics, the plastic PVC and lidding materials were transformed into blister packs as a result of the taxpayer’s production activities (e.g., heating, molding, sealing, etc.).

Under Sec. 199, taxpayers may deduct a specified percentage of the lesser of (1) qualified production activities income (QPAI) 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)). QPAI is defined in Sec. 199(c)(1) as domestic production gross receipts (DPGR) less cost of goods sold, expenses, losses, and other deductions allocable to such receipts.

With respect to producers of tangible property, Regs. Sec. 1.199-3(a)(1)(i) requires that DPGR be derived from qualifying production property (QPP) that is (1) manufactured, produced, grown, or extracted (2) by the taxpayer (3) in whole or significant part (4) within the United States. For purposes of complying with the MPGE requirement, Regs. Sec. 1.199-3(e)(2) specifies that packaging, repackaging, labeling, or minor assembly activities alone (i.e., with no other MPGE activities performed on the item) are insufficient to qualify as MPGE activities within the meaning of Regs. Sec. 1.199-3(a)(1)(i).

In concluding that the Regs. Sec. 1.199-3(e)(2) exception did not apply to the taxpayer, the IRS cited the fact that the taxpayer performed additional production activities to manufacture the product packaging (blister packs) that exceeded the threshold activities outlined in the exception (i.e., packaging, repackaging, labeling, or minor assembly). Specifically, the taxpayer’s production activities with respect to the packaging materials (e.g., heating, molding, sealing, etc.) resulted in permanent transformation of the raw materials (PVC and lidding) into blister packs, thereby falling within the MPGE definition. Conversely, had the taxpayer not manufactured the packaging and only repackaged and labeled the purchased pills into blister packs manufactured by a third party, then the exception would apply, and the MPGE requirement would not be met because no other MPGE activities would have been performed in addition to the repackaging, labeling, and packaging activities outlined in the exception. The IRS further noted that it considers the MPGE of the blister packs to have been a part of the MPGE of the blister packs containing the pills (that is, the blister pack was a component of the whole item, consisting of blister pack plus pill).

This interpretation of the MPGE requirement is a favorable development for packaging manufacturers because it clarifies that production of the product packaging alone (without also manufacturing the tangible property) may be sufficient to meet the MPGE requirement for Sec. 199 purposes. Therefore, packaging manufacturers not currently claiming a Sec. 199 deduction may want to reevaluate their eligibility in light of this guidance, provided they have similar facts and can meet the other applicable Sec. 199 requirements. Comments provided by the IRS on two of these additional requirements are summarized below.

“In Whole or in Significant Part” Requirement Met for Component

In addition to the MPGE requirement, the memorandum also addressed how the “in whole or in significant part” provisions might apply to a packaging manufacturer and advised taxpayers to consider the so-called “shrink back” provision to qualify receipts derived from any eligible component of the property if the item’s total receipts do not meet the Sec. 199 eligibility requirements.

The rules governing the “in whole or in significant part” requirement are outlined in Regs. Sec. 1.199-3(g). Under Regs. Sec. 1.199-3(g)(2), the MPGE activities performed in the United States by the taxpayer are generally required to be “substantial in nature,” taking into account all of the facts and circumstances, including the relative value added by, and relative cost of, the taxpayer’s MPGE activity within the United States, the nature of the QPP, and the nature of the MPGE activity that the taxpayer performs within the United States. The MPGE of a key component of QPP does not, in itself, meet the substantial-in-nature requirement with respect to the QPP under Regs. Sec. 1.199-3(g)(2).

As an alternative to applying the subjective facts-and-circumstances criteria, the taxpayer may meet the substantial-in-nature requirement under the more objective safe harbor outlined in Regs. Sec. 1.199-3(g)(3). For receipts derived from sales of tangible property, the safe harbor is met if the direct labor and overhead incurred by the taxpayer to produce the property within the United States account for 20% or more of the taxpayer’s cost of goods sold of the property.

Regs. Sec. 1.199-3(d)(1) specifies that DPGR is determined on an item-by-item basis rather than at the division, product line, or transaction level. The term “item” generally means the form in which the property is offered to customers in the normal course of the taxpayer’s business. However, if the receipts for the entire item do not qualify as DPGR, then, under the shrink-back rule, any component of the item may be treated as the item if the receipts from the component qualify as DPGR.

Applying the foregoing facts-and-circumstances criteria to determine whether the packaging manufacturer’s U.S. production activities were substantial in nature, the IRS concluded in the CCA that the receipts for the entire item (blister pack containing the pills) did not appear to meet the requirement because the taxpayer’s MPGE activities with respect to the pills component were not substantial in nature. However, the receipts derived from the component that was manufactured by the taxpayer (i.e., the blister pack) could qualify “in whole or in significant part” under the shrink-back rule, assuming the other Sec. 199 requirements were met.

In support of its decision to disqualify the pills, the IRS noted that the taxpayer performed conversion activities only on the packaging, not on the pills. In the IRS’s view, processing of the pills was limited to repackaging, labeling, and packaging—none of which resulted in any change to the form or characteristics of the pills or contributed substantially to the value of the finished product. Consequently, based on the taxpayer’s particular facts and circumstances, the IRS did not consider the taxpayer’s MPGE activities with respect to the pills to be substantial in nature.

Therefore, because the receipts attributable to the pills component were deemed ineligible for the Sec. 199 deduction (i.e., non-DPGR), the taxpayer could not treat the receipts from the entire item (the blister pack containing the pills) as qualified receipts under Sec. 199 and would then be required to assess the eligibility of the remaining component(s) under the shrink-back rule outlined above. Under this rule, the taxpayer would apply the various DPGR requirements to the packaging component and, if that component qualified under Sec. 199, would then allocate the total item gross receipts between the qualified (blister pack) and nonqualified (pills) components to determine the amount of qualified receipts eligible for the Sec. 199 deduction (i.e., DPGR).

The substantial-in-nature provisions under Sec. 199 have generated significant controversy in the examination of taxpayers’ returns, particularly for taxpayers attempting to apply the complex facts-and-circumstances criteria to items that do not meet the safe-harbor threshold (i.e., conversion costs are less than 20% of the item’s total cost of sales). Thus, CCA 201246030 provides helpful insight into the IRS’s approach to interpreting and applying these complex rules to packaging manufacturers so these taxpayers may better assess their Sec. 199 eligibility and their potential IRS examination risk in this area. Affected taxpayers, including those manufacturing packaging for nonpharmaceutical products, should review the memorandum to determine whether they should address possible examination exposure or, alternatively, to pursue opportunities to obtain or increase a Sec. 199 deduction.


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.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.