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Is it time to re-examine your Section 199 methodology?
If you are a taxpayer who has excluded certain activities that you deemed to be mere "packaging" or "assembly" from your Section 199 Domestic Production Activities Deduction (DPAD), now is the time to reassess those activities. Taxand USA explores the recent California federal district court case US v. Dean and what this ruling may mean for taxpayers.
The DPAD was primarily designed to protect United States jobs and replace the extraterritorial income exclusion. It covers a broad range of production activities, including the manufacture of tangible personal property, the production of computer software, sound recordings and certain films, the production of electricity, natural gas or water, and construction, engineering and architectural services.
The taxpayers in Dean were the owners of an S corporation, Houdini, Inc., that was in the business of "designing, assembling, and selling" gift baskets and gift towers through retail and wholesale distributors. Houdini purchases all the products used in the gift baskets and towers and assembles the final product for sale. Houdini has approximately 300 full-time employees and hires about 4,000 temporary employees during its busy season of August through December. During the holiday season, Houdini can finish up to 80,000 gift baskets in one day.
Neither Houdini nor its shareholders claimed any Section 199 deduction on its original returns for the activities described above. Houdini and its shareholders subsequently filed amended returns that claimed the Section 199 deduction and received refunds based on the deduction. The IRS paid the refunds and later filed suit to recover them on the basis that Houdini and its shareholders were not entitled to a deduction under Section 199 because Houdini merely packaged and repackaged items in the gift baskets. Houdini's shareholders contended that Houdini manufactured or produced gift baskets.
In a somewhat surprising decision (at least based on the responses to the decision by a number of commentators), the California district court agreed that Houdini's activities rose to the level of MPGE and qualified for the Section 199 deduction. The court held that Houdini's activities were not merely packaging, but changed the "form and function" of the individual items into a new product with a different demand (ie, from a grocery item into a holiday gift).
Also published in Thomson Reuters' Taxnet Pro, 15 November 2013
Although at first blush, the Dean decision may seem somewhat surprising to some observers, the decision does reflect the IRS's belief, outlined in Notice 2005-14, that the Section 199 deduction should be available for a wide variety of production activities. This is also consistent with the rather broad definition of MPGE provided by the Section 199 regulations. Though this is only a district court case, if the IRS does not appeal the decision, it may signal a willingness on its part to consider a broader range of activities for the Section 199 deduction and allow it to focus on other issues.
It is recommended for companies to take another look at product lines that they may have previously excluded from their Section 199 calculation as being mere "assembly" or "packaging." This is especially true for items that require an assembly-line process and division of labour to produce, as well as for packaged items that can be sold into new markets after the assembly process.
Do take a few moments to reassess your Section 199 methodology to see if additional qualifying activities may be available for you to claim going forward. This could potentially result in a larger Section 199 deduction and lower effective tax rate for you in the future.