Sec. 199 Contract Manufacturing Guidance May Encourage Taxpayers to Agree on Benefits and Burdens

By Ellen Fitzpatrick, CPA, Washington, D.C.

Editor: Greg A. Fairbanks, J.D., LL.M.

Expenses & Deductions

Since Sec. 199’s enactment in 2004, its implementation for taxpayers who use contract manufacturing has been rife with controversy. Sec. 199 allows a taxpayer to deduct 9% (in tax years beginning after 2009) of the taxpayer’s qualified production activities income (QPAI) resulting from domestic production activities. The deduction is limited by the taxpayer’s taxable income and 50% of “W-2 wages” paid for the year. For a taxpayer to generate the domestic production gross receipts (DPGR) needed to determine its QPAI, it must lease, rent, sell, or exchange qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or significant part in the United States. The phrase “by the taxpayer” has produced significant controversy between the IRS and taxpayers that are involved in contract manufacturing arrangements as to which party to the arrangement is allowed to claim the deduction.

Under Regs. Sec. 1.199-3(f)(1), only one taxpayer may claim the Sec. 199 deduction with respect to any qualifying activity performed in connection with the same qualified production property (QPP). The regulation further provides that, in cases where a taxpayer performs qualifying activities pursuant to a contract with another party, only the taxpayer that has the benefits and burdens of ownership of the QPP under federal income tax principles during the period in which the qualifying activity occurs is allowed to claim the Sec. 199 deduction. The regulations do not provide specific guidance on the factors to be considered in determining which party has the benefits and burdens of ownership.

Two examples involving contract manufacturing are provided in Regs. Sec. 1.199-3(f)(4). The first example lists five factors to be considered. However, the example says one taxpayer satisfies four of the five factors and has the benefits and burdens of ownership. The sec ond example assumes that one taxpayer has the benefits and burdens of ownership, even though title to the property does not transfer to the taxpayer until the manufacturing process is complete. This example illustrates only that the taxpayer holding the title is not necessarily the tax owner of the property during manufacturing, but it leaves out what other factors would be required if legal title were not held. While these examples provide a starting framework for determining which party has the benefits and burdens of ownership, they leave open for controversy any contract manufacturing situations where the facts are not so black and white.

To assist field agents, the IRS Large Business & International (LB&I) Division issued a series of directives that provide insight into the factors the IRS considers important in determining on exam whether a taxpayer has the benefits and burdens of ownership under contract manufacturing arrangements. These directives describe circumstances in which the IRS will not challenge the taxpayer’s position that it has the benefits and burdens of ownership.

The first directive (LB&I-04-0112-001) was issued in February 2012. It provided a three-step process an examiner should use. Each step involved asking three questions. If the answer was “yes” to at least two of the three questions, the step was completed. If any two of the three steps were completed, the taxpayer had the benefits and burdens. However, the directive provided that if at least two of the steps were not completed, the agent should determine whether the taxpayer had the benefits and burdens based on all the facts and circumstances, and the agent should not rely solely on the nine questions provided but consider all relevant factors.

The steps in the February 2012 directive focused on contract terms, production activities, and economic risks. The factors to be considered in the directive weighed heavily in favor of the manufacturer in contract manufacturing arrangements and made it difficult for customers providing the design to qualify with respect to the activity. This is in part due to the fact that missing from the questions in the directive was any consideration of who owned the intellectual property rights and whether there were any restrictions placed on the manufacturer with respect to the intellectual property. Which party owned the intellectual property and whether the manufacturer was restricted in its use during manufacturing was one of the five factors in the first example in Regs. Sec. 1.199-3(f)(4).

LB&I took a different approach in a second directive, issued in July 2013 ( LB&I-04-0713-006 ), which superseded the February 2012 directive. Rather than establishing a safe-harbor determination of which party had the benefits and burdens, the IRS stated it would not challenge a taxpayer’s claim of benefits and burdens if the taxpayer was able to provide three statements: one explaining the basis for its determination that it had the benefits and burdens, one (according to a form provided) certifying certain facts and signed by the taxpayer, and one (in a form provided) certifying certain facts and signed by the counterparty to the contract manufacturing arrangement. The taxpayer had to certify, among other things, that it was not required to record a reserve for financial statement purposes under its accounting standard for its determination that it had the benefits and burdens of ownership of the QPP. The counterparty had to certify that it did not and will not claim the Sec. 199 deduction for any tax year covered by the contract.

This new directive was, for the most part, favorable guidance for taxpayers who could agree with the other party in a contract manufacturing arrangement which of them would claim the Sec. 199 deduction. However, the directive provided no further clarity concerning which factors to consider in determining the benefits and burdens, leaving even more uncertainty for taxpayers that either could not agree with the counterparty or could agree but did not feel comfortable that their basis for claiming the benefits and burdens would pass IRS scrutiny. In these cases, a taxpayer may have still been required to record a reserve on its financial statements related to the position taken.

In late October 2013, the IRS issued yet another directive (LB&I-04-1013-008), which updated and superseded the July 2013 directive by removing the requirement that a taxpayer not record a reserve for the item on its financial statements. Under this change, taxpayers that agree with the counterparty regarding which party has the benefits and burdens and will claim the Sec. 199 deduction will not be challenged by the IRS, regardless of whether they recorded a reserve for the position on their financial statements.

Less than a week before the IRS issued this third directive, the Tax Court denied the Sec. 199 deduction to a taxpayer in the direct advertising business in ADVO, Inc., 141 T.C. No. 9 (2013), because the taxpayer did not have the benefits and burdens of ownership of direct advertising materials during their printing.

The taxpayer in this case distributed direct-mail advertising materials. Either the taxpayer’s clients supplied the advertising materials for the taxpayer to distribute, or the taxpayer supplied the materials for distribution. When the taxpayer supplied the advertising materials, it contracted with third-party commercial printers to print the materials. The taxpayer provided the third party with the design for the advertising. The Sec. 199 deductions at issue were attributable to direct-mail advertising involving only the taxpayer-supplied materials. The taxpayer contended that its gross receipts attributable to the printed direct-mail advertising qualified as DPGR. The IRS argued that because the taxpayer contracted its printing out to third-party printers, it did not manufacture any QPP.

The Tax Court first had to determine which factors to apply in determining whether the taxpayer had the benefits and burdens. While noting that in interim guidance, Notice 2005-14, the IRS tied the benefits and burdens determination to principles of Secs. 263A and 936, the final regulations do not specifically mention these sections. The court did not include factors used in Suzy’s Zoo, 273 F.3d 875 (9th Cir. 2001), a key case in the determination of ownership for purposes of Sec. 263A, saying they should not be included in the analysis of benefits and burdens under Sec. 199 because Sec. 263A has a broader reach than Sec. 199.

The test under Sec. 936 is not a test of benefits and burdens of ownership but rather aims to determine which taxpayer is in the active conduct of a trade or business. Under Sec. 936, a taxpayer actively conducts a trade or business only if it participates regularly, continually, extensively, and actively in the management and operation of its profit-motivated activity.

The Tax Court decided that the eight factors of Grodt & McKay Realty, Inc. , 77 T.C. 1221 (1981), plus the Sec. 936 test, were useful in determining the benefits and burdens of ownership. After analyzing the following factors, the court determined that the taxpayer did not have the benefits and burdens of ownership during production because (1) legal title did not pass to the taxpayer until the products left the printers’ facilities; (2) the intent of the parties was that the printers would produce the advertising materials; (3) the right of possession and control was not exercised by the taxpayer during the printing process; (4) the third-party printing companies enjoyed the economic gain and bore the loss from the sale of the advertising materials; and (5) the taxpayer did not extensively participate in the operation of the printing presses or in the cutting or folding processes.

The Tax Court noted that other facts were neutral: (1) equity interest; (2) present obligation; (3) property taxes; and (4) risk of loss or damage. Because the court held that the taxpayer did not have the benefits and burdens of ownership, the gross receipts from the printing activity were not DPGR. As a result, the taxpayer was not entitled to claim the Sec. 199 deduction for the tax years at issue.

While the analysis in the case did note the examples in the regulations and that ADVO owned the intellectual property associated with the advertising throughout its production, the court ultimately did not include ownership of the intellectual property among the factors it considered. In most cases of contract manufacturing, the owner of the intellectual property or design enters into a contract with another party to manufacture the physical goods resulting from that design. The physical manufacturer is generally restricted in its use of the intellectual property during the manufacturing process and has no right to exploit the intellectual property. Given such limitations in the use of the property by the manufacturing party and the existence of such a factor in the regulations, it is unclear why the IRS and the Tax Court left it out of their analysis.

Given the recent guidance in this area, taxpayers should consider trying to follow the October 2013 directive to avoid IRS controversy when seeking to claim Sec. 199 deductions related to contract manufacturing, especially those taxpayers that may be relying on their ownership of the associated intellectual property as a determining factor of ownership.


Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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