As part of the American Jobs Creation Act of 2004, to encourage production of products within the United States, Congress enacted IRC Section 199, allowing for the Domestic Production Activity Deduction (“DPAD”).
In general, the DPAD deduction is permitted to offset income from domestic manufacturing and other domestic production activities. Currently, the deduction generally equals 9% of the smaller of the taxpayer’s income from qualified production activities or the taxpayer’s taxable income. In addition, the deduction is limited to 50% of the taxpayer’s Form W-2 wages that are related to the production activities.
The IRS has issued guidance for its examiners where the manufacturer of products is on a “contract manufacturing” basis. Only one taxpayer may claim the Domestic Production Activity Deduction for the same function performed with respect to the same property. That taxpayer who can benefit from the DPAD deduction is the one with “the benefits and burdens of ownership” of the property while the activity occurs. Hence, with exceptions, if one party performs a qualifying production activity under a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property while the activity occurs is treated as having performed the qualified production activity needed to take this DPAD deduction.
The IRS has established a three step process as guidance for examiners in determining who has the benefits and burdens of ownership:
1. Contract terms – Did the taxpayer have title and risks with respect to the Work in Process?
2. Production activities – Did the taxpayer develop, oversee, and maintain quality control tests over the Work in Process during the production period?
3. Economic risks – Did the taxpayer take on the economic risks related to the production of the property?
The guidance goes on to conclude that, if the examiner finds that the taxpayer did maintain at least two of the three above factors, then the taxpayer has the benefits and burdens of ownership for Section 199 DPAD deduction purposes.
For taxpayers manufacturing primarily in the U.S., the DPAD deduction provides a relatively significant tax benefit. Where the taxpayer is either doing contract manufacturing or work for a customer, or out sourcing contract manufacturing to another party, it is important that the parameters with respect to the benefits and burdens of ownership are fully understood and analyzed based on the facts. This should be done prior to entering into any agreement with the contract manufacturer or customer.
The above is just a summary of the IRS examiner’s guidance with respect to this issue. If you have a contract manufacturing situation that may apply with respect to this new guidance, we will be happy to provide you with the full IRS directive on this issue.