Sec. 199 “Benefits and Burdens” Analysis: Key Guidance

By Christine Kowal, CPA, Washington

Editor: Annette B. Smith, CPA

Expenses & Deductions

Subject to a W-2 wage limitation, the Sec. 199 deduction is computed as a percentage (generally 9% for 2010 and thereafter) of the lesser of a taxpayer's qualified production activities income (QPAI) or taxable income.

In general, a taxpayer's QPAI equals the excess of its domestic production gross receipts (DPGR) over the sum of the cost of goods sold allocable to those receipts and other expenses, losses, or deductions that are properly allocable to those receipts. DPGR includes the taxpayer's gross receipts from any lease, rental, license, sale, exchange, or other disposition of qualifying production property that the taxpayer manufactured, produced, grew, or extracted (MPGE, or qualifying activity) in whole or in significant part within the United States; qualified films; and electricity, natural gas, or potable water produced by the taxpayer in the United States (hereinafter referred to collectively as qualifying property).

Taxpayers frequently enter into contractual agreements with unrelated parties to perform some or all of the activities to qualifying property (contract manufacturing). In general, only one taxpayer may claim the Sec. 199 deduction for any qualifying activity performed in connection with qualifying property. Regs. Sec. 1.199-3(f)(1) provides that if a taxpayer performs a qualifying activity under a contract with another party, then only the taxpayer that has the benefits and burdens of the property during the period the qualifying activity occurs is treated as engaging in a qualifying activity. The Sec. 199 regulations state that the analysis is to be based on all the facts and circumstances and provide examples illustrating certain factors that are relevant in determining which party has the benefits and burdens of ownership.

The IRS's primary objective with respect to any contract manufacturing arrangement is ensuring that only one party to the contract can claim to have the benefits and burdens during any qualifying activity. This protects the IRS from being "whipsawed," i.e., being subject to claims by both parties to have the benefits and burdens during a qualifying activity.

Key Factors

The Sec. 199 regulations do not provide a list of factors to consider in applying the benefits-and-burdens test, but they do include two examples that illustrate how the facts-and-circumstances determination applies. These examples highlight several factors analyzed in determining which taxpayer to a contract possesses the benefits and burdens, including:

  • Whether there is an express restriction on the unrelated party's use of intellectual property provided for use in manufacturing the property;
  • Whether the taxpayer retains control over the manufacturing of the property;
  • Who retains legal title to the property during the qualifying activity; and
  • Who bears the risk of loss or damage during the manufacturing process.

In the author's experience, IRS examiners have analyzed the following four factors in determining which party possesses the benefits and burdens during the qualifying activity: (1) title to property; (2) control of details of the manufacturing process; (3) economic risk of loss/gain; and (4) risk of loss due to damage.

LB&I Directives

In February 2012, the IRS Large Business and International Division (LB&I) issued Directive LB&I-04-0112-001 (the initial directive), providing examiners a three-step process for determining whether a taxpayer has the benefits and burdens of ownership in a contract manufacturing arrangement. The three steps related to contract terms, production activities, and economic risks.

In July 2013, the LB&I issued ­Directive LB&I-04-0713-006 (the second directive), instructing examiners not to challenge a taxpayer's claim that it has the benefits and burdens if that taxpayer provides a statement explaining why the taxpayer qualifies and also provides a certification executed by each party to the contract designating which party will claim the Sec. 199 deduction. The second directive is a safe harbor that, if met, means that the IRS will not challenge a taxpayer's benefits-and-burdens claim.

The second directive also states that if a taxpayer does not want to, or cannot, avail itself of the second directive (e.g., because the counterparty will not provide the necessary certification to the taxpayer), it should not be presumed that the taxpayer does not have the benefits and burdens. Rather, in that case the examiner is instructed to apply regular audit procedures to determine which entity has the benefits and burdens.

On Oct. 29, 2013, the LB&I issued Directive LB&I-04-1013-008 (the third directive), which revised certain procedural aspects of the second directive. These modifications are designed to make the certification process easier, thereby making it possible for more taxpayers to provide the requisite statements and certifications that otherwise could not have been provided under the second directive.

Tax Court Decision

In November 2013, the U.S. Tax Court released its long-awaited decision in ADVO Inc. , 141 T.C. No. 9 (2013), finding in favor of the IRS. The central issue was whether ADVO or its contract printers had the benefits and burdens of ownership of ADVO's advertising materials during the time the contract printers were printing them. The court addressed how Sec. 199 applies to taxpayers that manufacture products through agreements with contract manufacturers and used a list of nine factors to determine whether ADVO had the benefits and burdens of ownership of the property during the manufacturing process, noting that no one factor was determinative.

These factors—which are based on Grodt & McKay , 77 T.C. 1221 (1981), the Sec. 936 test, and an example in the Sec. 199 regulations—reflect the court's view that the holdings in cases decided under Sec. 263A in connection with production activities are not binding for purposes of Sec. 199.


Each LB&I directive, as well as the ADVO decision, provides further guidance on the historically controversial Sec. 199 benefits-and-burdens analysis. Prospectively, it is anticipated that the IRS will begin to examine contract manufacturing arrangements using, at a minimum, the benefits-and-burdens factors analyzed in ADVO . However, taxpayers should be alert to the continued evolution of benefits-and-burdens guidance and take each piece of guidance into consideration in evaluating whether a taxpayer or the counterparty to a contract manufacturing arrangement bears the benefits and burdens of ownership.

In addition, taxpayers can anticipate future guidance on the Sec. 199 benefits-and-burdens determination from both the IRS—in the form of forthcoming proposed regulations that government officials have said will provide guidance on, among other things, factors to be considered in making a benefits-and-burdens determination—as well as the Tax Court, where L Brands Inc. has asked the court to review the IRS's determination that L Brands did not possess the benefits and burdens during the time its contract manufacturers were performing MPGE activities on L Brands' behalf (see L Brands Inc. , Tax Court Dkt. No. 14121-13).


Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers 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.