The Tax Court disallowed a corporate taxpayer’s domestic production activities deduction because, it determined, the taxpayer did not possess the burdens and benefits of ownership of the property produced. The court developed a nine-factor test of the burdens and benefits of ownership that it applied to the facts and circumstances of this case.
Under Sec. 199(a), taxpayers are allowed a deduction equal to the lesser of 3% of taxable income or their qualified production activities income, defined as the gross receipts from the sale of qualified production property (QPP) minus the cost of the QPP sold and minus any expenses allocable to the QPP. The deduction cannot exceed 50% of the W-2 wages of the taxpayer’s employees for the year. Generally, QPP is tangible personal property manufactured, produced, grown, or extracted in the United States. Only one taxpayer can take a Sec. 199 deduction for a manufactured product. When a taxpayer has a contract with an unrelated third party to manufacture the product, the taxpayer must possess the benefits and burdens of ownership during the production process to take the deduction.
ADVO Inc. distributed direct-mail advertising materials of its clients to residential addresses. For some of its clients, ADVO would design the advertising materials and then use third-party printers to print the advertisements. The printing contracts required the printers to use certain paper the printers purchased directly from brokers specified by ADVO. ADVO never took possession of the paper, and it did not guarantee that it would pay the brokers if a printer defaulted. The contracts also required the printers to insure the work in process and specifically stated that the title to and the risk of loss of the printed materials would pass to ADVO when printers delivered the materials to the taxpayer. ADVO deducted $1,515,992 under Sec. 199 on its 2006 federal tax return and $151,047 on its 2007 short-year return. The IRS disallowed the deductions, arguing that ADVO did not manufacture the advertising materials. The taxpayer disagreed and petitioned the Tax Court for relief.
The court stated that to be eligible for the Sec. 199 deduction, “the alleged manufacturer must establish that it is the only taxpayer who may be determined to be the owner of the property with the benefits and burdens of ownership.” After examining the examples in the Sec. 199 Treasury regulations and the factors used by courts when applying the benefits-and-burdens test for Sec. 263A and Sec. 936, the court listed nine factors to be examined when determining the benefits-and-burdens test for Sec. 199: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest is 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 participates in the management and operations of the activity.
The court applied the factors to the facts and circumstances and determined that ADVO was not eligible for the Sec. 199 deduction because: (1) The legal title factor favored the IRS. Despite ADVO’s always possessing the legal title to the intangible ad design property, the contracts clearly stated that legal title to the printed material did not transfer to ADVO until after it was produced. (2) The parties intended that the printers produce the tangible paper advertising material using ADVO’s intangible ad design property and deliver it to ADVO, not that ADVO merely provide printing services, so this factor favored the IRS. (3) The equity interest, present obligation, and property tax factors were neutral because they did not apply in this case. (4) The possession-and-control factor favored the IRS because ADVO never exercised any control over the day-to-day printing operations and did not have the right of possession of the printed material until it was delivered to ADVO. (5) The factor of risk of loss and damage to the property was neutral because the risk that ADVO’s reputation would be damaged due to its untimely delivery of inferior advertising materials was offset by its not bearing any risks while the material was being printed. (6) The profits factor favored the IRS because the printing companies, not ADVO, received the profits from the sale of the printed material upon its delivery to ADVO. (7) The factor of active and extensive participation favored the IRS because ADVO did not extensively participate in the operation of the printing process, a production activity, but rather, extensively participated in the distribution of the printed materials, a service activity.
ADVO, Inc., 141 T.C. No. 9 (2013)
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.