Does direct advertising material produced by a third-party printer qualify for the domestic production deduction?
Taxpayer Says: There was sufficient control over the printing process to make gross receipts attributable to printed direct mail advertising and distribution products qualify as “domestic production gross receipts” and the deduction can be claimed.
Internal Revenue Service Says: Because the taxpayer contracted actual printing to third-party printers, the taxpayer did not manufacture any qualifying production property, and the domestic production deduction cannot be claimed.
From Internal Revenue Code Section 199(a) and (b): Section 199, enacted as part of the American Jobs Creations Act of 2004, is in effect for tax years beginning after December 31, 2004. Section 199, commonly referred to as the “Domestic Production Deduction”, allows a taxpayer to deduct, subject to a limitation based on “wages paid”, a specified percentage of the lesser of either (1) its “qualified production activities income” or (2) taxable income. For the years at issue, section 199(a) allows a taxpayer to deduct an amount equal to 3% of the taxpayer’s qualified production activities income for the year. The amount of the deduction cannot exceed 3% of the taxpayer’s taxable income for the year and is also limited to 50% of the “W-2 wages of the taxpayer for the taxable year.”
From Federal Tax Regulation 1.199-3(e)(1): Defines “manufactured, produced, grown, or extracted” to include “manufacturing, producing, growing, extracting, installing, developing, improving, and creating qualified production property (QPP); making QPP out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles.” The regulation further states that when the taxpayer contracts with an unrelated third party for the manufacturing of its products the taxpayer must have the “benefits and burdens of ownership of the QPP under Federal income tax principles during the period the MPGE activity occurs.”
THE CAUSE OF THE DISPUTE
While section 199 of the Internal Revenue Code is called the “domestic production deduction,” you may be able to claim it even when your business is not a traditional “manufacturer.” That’s because “production activities” include mining, oil extraction, farming, construction, architecture, engineering and the production of software, recordings and films.
At issue in this case is how the deduction applies to US companies that manufacture products through agreements with contractor manufacturers. Who bears the benefits and burdens of ownership of the property (printed advertising materials in this case) during the period when the production activity occurs?
The taxpayer was a direct mail advertiser who produced printed advertisements. The taxpayer coordinated the entire direct advertising process from the initial design of the artwork to delivering the printed material to the targeted consumers.
During the 2006 and 2007 tax years, the taxpayer distributed 60 to 80 million packages each week, and spent approximately $125 million per year on turnkey printing needs, $50 million of that for paper and $75 million of it for printing services.
The taxpayer contracted with third-party printers to print the advertising material. Title to the intangible property (the actual design of the art as transmitted in a PDF file to the printer) never transferred to the printers or to the clients. The printing agreements stated “title to and risk of loss” of the product (the printed material) did not transfer to the taxpayer until the products left the printers’ facilities.
The taxpayer says it hired the printers for services, not manufacturing, and that it was in control of the printing process for the materials, though it did not exercise day-to-day control over the printers’ operations.
The taxpayer claimed a section 199 deduction of $1,515,992 for the 2006 tax year and $151,047 for the 2007 tax year.
The IRS disallowed the deduction, and says that in order for the gross receipts received from the sale of advertising mail packages to qualify as domestic production gross receipts (and therefore qualify the taxpayer for the deduction), the mail package must be determined to be qualified production property, manufactured in the United States by the taxpayer.
However, because the taxpayer contracted its actual printing to third-party printers, the IRS argues the taxpayer did not manufacture any qualifying production. Instead, the taxpayer produced only intangible property used by printers to produce tangible personal property in the form of the advertising mail packages. (Note: The intangible property itself might qualify as production property, but the taxpayer retained ownership, and so the electronic files did not constitute or generate “domestic production gross receipts” for purposes of the deduction.)
The tax court considered nine factors in determining whether the taxpayer had the benefits and burdens of ownership of the printed advertisements while they were being printed.
(1) whether legal title passes;
(2) how the parties treat the transaction;
(3) whether an equity interest was acquired;
(4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments;
(5) whether the right of possession is vested in the purchaser and which party has control of the property or process;
(6) which party pays the property taxes;
(7) which party bears the risk of loss or damage to the property;
(8) which party receives the profits from the operation and sale of the property; and
(9) whether the taxpayer actively and extensively participated in the management and operations of the activity.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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