New product or different presentation?

Courts and the IRS differ over a key qualification for the domestic production activities deduction.
By John W. McKinley, CPA, CGMA, J.D., LL.M., and Eric Zilber

New product or different presentation?
Image by baranozdemir/iStock

Since its inception, the Sec. 199 domestic production activities deduction (DPAD) has caused great confusion to many taxpayers trying to comply with its provisions. Though its intent was simple—to provide relief to U.S. manufacturers—its implementation has spawned a labyrinth of litigation, administrative rules, and procedures.

The IRS recently published proposed regulations (REG-136459-09) to better define and provide guidance on various DPAD provisions. Though the proposed regulations have implications for a wide range of the deduction's aspects, this article focuses on a key but often problematic provision—that qualifying production property (QPP) eligible for the DPAD must have been manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States (Sec. 199(c)(4)(A)(i)(I)).

The proposed regulations regarding what activities qualify as manufacturing, producing, growing, or extracting (MPGE) are at odds in one respect with a district court's recent decision in Precision Dose, Inc., No. 3:12-CV-50180 (N.D. Ill. 9/24/15). This court ruling is especially relevant in terms of its interpretation of an earlier district court case, Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013), which established a broader definition of what constitutes MPGE under Regs. Sec. 1.199-3(e). Specifically, the courts in both cases rejected the IRS's arguments that the taxpayers did not engage in MPGE activities with respect to the claimed QPP because they only repackaged it, and Regs. Sec. 1.199-3(e)(2) provides that repackaging is not an MPGE activity. As a result of these setbacks in the courts, the IRS seeks to strengthen its position administratively through the proposed regulations.


In general, Sec. 199(a) permits a qualifying taxpayer a deduction for the lesser of 9% of qualified production activities income (QPAI) for the tax year or taxable income (determined without regard to Sec. 199). The deduction is further limited to 50% of the taxpayer's W-2 wages paid in the tax year allocable to domestic production gross receipts (DPGR). QPAI is determined by subtracting cost of goods sold and other associated expenses, losses, and deductions from the taxpayer's DPGR (Sec. 199(c)). DPGR include gross receipts derived from "any lease, rental, license, sale, exchange, or other disposition of ... [QPP] which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States" (Sec. 199(c)(4)(A)(i)).

Nowhere do the statutory provisions of Sec. 199 define what constitutes MPGE. The regulations to Sec. 199 define MPGE as involving any of a variety of activities that include—besides manufacturing, producing, growing, and extracting QPP—installing, developing, improving, or creating it (Regs. Sec. 1.199-3(e)(1)). QPP can be derived not only from new or raw material but also from scrap, salvage, or junk. In either case, the material must have been subjected to processing, manipulating, refining, or otherwise changing its form, or by combining or assembling two or more articles.

Several agricultural and mining activities are specifically enumerated: cultivating soil, raising livestock, fishing, and mining materials. Also included with respect to the sale, exchange, or other disposition of agricultural products are their storage, handling, and other processing within the United States (other than transportation). However, Regs. Sec. 1.199-3(e)(2) provides that solely packaging, repackaging, labeling, or performing minor assembly of QPP does not constitute MPGE if the taxpayer does not engage in any other MPGE activity. Similarly, under Regs. Sec. 1.199-3(e)(3), merely installing QPP, in the absence of any other MPGE activity, does not qualify as MPGE.

When Regs. Sec. 1.199-3(e)(2) was implemented, it was not particularly clear what was meant by solely packaging, repackaging, labeling, or performing minor assembly. Undoubtedly, this is why the recently proposed regulations express the IRS's disagreement with the district court's interpretation in Dean, which limited the application of the repackaging exclusion in Regs. Sec. 1.199-3(e)(2). In its proposed regulations, the IRS included a new example of the application of Regs. Sec. 1.199-3(e)(2), setting forth facts similar to those in Dean to illustrate an activity it considers to not be MPGE under the exception (Prop. Regs. Sec. 1.199-3(e)(5), Example (9)). However, after the Sec. 199 proposed regulations were published in August 2015, Precision Dose, Inc., was decided on Sept. 24, 2015, following the reasoning set forth in Dean. This disconnect between the proposed regulations and the two cases may create confusion for taxpayers trying to determine whether goods or products that may be MPGE meet the requirements in Regs. Sec. 1.199-3(e)(1) or fall into the exception in Regs. Sec. 1.199-3(e)(2).


In Dean, Houdini Inc., an S corporation, filed amended tax returns for 2005 and 2006 to claim the DPAD. Houdini created gift baskets by purchasing empty baskets from Chinese suppliers, along with food items and packing materials. It operated an assembly line of workers who filled the baskets with the items. In the same way, it also created "gift towers" of items in stacked sets of decorative boxes. The gift baskets and towers, after further wrapping and decorative packaging, were then sold. After the company claimed the deduction, the taxpayers (one of Houdini's two shareholders and his wife) also filed amended returns claiming portions of the deduction and refunds due for both years, which the IRS paid.

Following this, in 2011, the government filed a lawsuit in federal district court against the taxpayers under Sec. 7405, claiming that the tax had been erroneously refunded. At issue was whether the gift baskets and towers were MPGE or if Houdini had simply repackaged the items, as the government claimed. The government asserted that under Regs. Sec. 1.199-3(e)(2), the activity was not MPGE, making the refund erroneous. The government likened the activity to that of a car being customized, which under Regs. Sec. 1.199-3(e)(5), Example (6), is minor assembly, which is not an MPGE activity.

The taxpayers claimed that the gift baskets and towers were manufactured or produced within the meaning of Regs. Sec. 1.199-3(e)(1), arguing that Houdini changed the form of an article by selecting the items and then creating and assembling the gift baskets and towers. Though any of the items could be bought at a store, the taxpayers claimed that their rearrangement in a presentable way created a collection that was different from the individual items.

The court held that Houdini changed the form and function of the individual items in its production process. The IRS has said that Congress intended for MPGE to be defined broadly to encompass "a wide variety of production activities," the court noted (quoting Notice 2005-14). The court held that Houdini's process was more similar to manufacturing a car by assembling parts from various suppliers than customizing a car by performing minor assembly work, as in the regulations' example. Customizing a car does not change its nature, while combining various items into a gift basket creates a new product with a different demand than that of its items individually, the court said.

Displeased with the decision in Dean, the IRS included in the proposed regulations it issued in August 2015 a new example of non-MPGE packaging, repackaging, labeling, or minor assembly that appears to target the court's holding. Prop. Regs. Sec. 1.199-3(e)(5), Example (9), essentially replicates the facts in Dean—a business sells gift baskets containing various products packaged together. The business purchases the baskets and their contents from third parties, plans how to arrange the products in the baskets, sometimes relabels the content items, and performs the arrangement on an assembly line in a production facility. The business performs no other activity besides packaging, repackaging, labeling, or minor assembly. Thus, the proposed example states, the business did not engage in any MPGE of QPP.


However, only days after the proposed regulations were issued, another district court issued a taxpayer-favorable ruling on the issue in Precision Dose, Inc. Precision Dose created and sold unit dose delivery systems to medical facilities. After purchasing a bulk amount of drugs, Precision Dose sealed them in nonreusable single-dose containers and sold them. In 2015, Precision Dose sought a refund of federal income taxes for 2007 and 2008 arising from deductions under Sec. 199, which the IRS denied, stating that Precision Dose engaged only in repackaging, placing the activity under Regs. Sec. 1.199-3(e)(2). Precision Dose contended that it engaged in MPGE.

In its ruling, the District Court for the Northern District of Illinois noted that the unit doses could come into existence only due to Precision's process, even though the company did not create the containers and drugs. The court stated these facts were analogous to those in Dean in that the taxpayer engaged in repackaging, but that other production activities involved, including market research, mixing studies, design, and testing, constituted a "complex production process that results in a distinct final product" (Precision Dose, Inc., slip op. at 4, quoting Dean, 945 F. Supp. 2d at 1118 n. 10). Given the precedent set by the Dean court, the court ruled in favor of Precision Dose.


The IRS would seem likely to contend in future similar controversies that these cases were incorrectly decided and that its proposed regulations, especially once they are adopted as final, would have prevented both holdings. However, it is unclear as of this writing how the example in the regulations necessarily fails the courts' touchstone of a "complex production process that results in a distinct final product," especially where a taxpayer can persuasively claim that the packaging, repackaging, labeling, or minor assembly was not the only activity involved.

Thus, it may be helpful for taxpayers that are uncertain whether their activities qualify as MPGE or are repackaging to note certain key aspects of the "complex" production processes that the courts found persuasive:

  • The processes relied upon assembly line workers and machines;
  • The form, purpose, and resulting demand of the final products were distinct from that of their constituent items before the process began; and
  • Subassembly of the items into the final form did not constitute a majority of the process resulting in the final product.

Other factors also were deemed to contribute to the claim that MPGE activities were occurring, such as thorough market research of the product, extensive testing of the product, and working with intermediary vendors in developing the proper product.

As long as a similarly complicated or involved process allows a company to claim that a unique product is created, not simply a repackaging of items, this would appear sufficient to constitute an activity that qualifies as MPGE. Taxpayers can document in detail their activities that go beyond physical processes of packaging, repackaging, labeling, or minor assembly that contribute to or, preferably, are essential to their QPP and that go beyond merely adding value to its constituent parts.

Given the IRS's stance, however, it clearly would be prudent for any taxpayer or tax professional to weigh all of the circumstances surrounding claims that an activity meets the definition of MPGE, including the possibility of IRS audit and/or litigation, before claiming a DPAD based on that activity. Although the IRS will likely continue to take the position that activities similar to those in Dean and Precision Dose, Inc., are not MPGE, it may be worth noting that although the government filed an appeal of the district court's decision in Precision Dose, Inc., to the Seventh Circuit, the government then dropped the appeal, stating only that the U.S. solicitor general decided not to pursue it further (Precision Dose, Inc., No. 15-3614 (7th Cir. 1/14/16), unopposed motion for voluntary dismissal of appeal).

About the authors

John W. McKinley ( is a lecturer in accounting and taxation at Cornell University in Ithaca, N.Y., from where Eric Zilber (, a CPA candidate, graduated in December 2015 with a B.S. in applied economics and management, with concentrations in accounting and finance.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at or 919-402-4434.

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