The Section 199 deduction, commonly referred to as the “domestic manufacturing deduction,” is often critical to a manufacturing firm’s tax fortunes. The IRS may put tax returns claiming the deduction under a microscope, especially when businesses have many partners, since only one of the parties participating in a contract arrangement is permitted to claim the tax benefits.
Now the IRS is taking a closer look at matters. Specifically, its Large Business and International (LB&I) division has just updated a directive to field auditors detailing the methods for determining the appropriate party entitled to a Section 199 deduction when one party “contracts out” the manufacturing to another party. The latest directive supersedes prior guidance.
Under Section 199, a business may be able to deduct an amount based on 9 percent of its “qualified production activities income” (QPAI) for the year. The rules are complex, but QPAI is generally equal to domestic production gross receipts, minus the sum of:
For this purpose, domestic production gross receipts include gross receipts derived from the sale, exchange, lease, rental, licensing or other disposition of qualified production property. The property also must be manufactured, produced, grown or extracted, in whole or in significant part, on U.S. soil.
Be aware that other special rules may apply. For instance, if a manufacturing firm’s taxable income before the Section 199 deduction is calculated is lower than its QPAI, the deduction is claimed as a percentage of the taxable income. Furthermore, the annual deduction is limited to 50 percent of the W-2 wages out paid by the firm. This can be a significant limitation for manufacturing firms operating in a cost-efficient manner. On the positive side, note that the Section 199 deduction is available to all types of business entities, including C corporations, S corporations, limited liability companies (LLCs), partnerships and sole proprietors.
It’s no wonder that Section 199 deductions are often contested among various parties. If a firm is in the top tax bracket in 2013, the 9 percent deduction represents a significant tax cut.
“Benefits and Burdens” Rule
According to the applicable regulations, if one taxpayer performs a qualifying activity pursuant to a contract with another party, only the taxpayer with the benefits and burdens of ownership of the property during the time the activity occurs is entitled to claim a deduction for the property. The determination as to which party has the “benefits and burdens” is based on all the relevant facts and circumstances.
On February 1, 2012, the LB&I issued its first directive to examiners on this issue. To help determine the appropriate party entitled to the deduction, the LB&I spelled out a series of questions for auditors, as well as steps to take based on the answers to those questions. After a second directive superseding the initial one was issued on July 24, 2013 (LB&I-04-0713-006), the LB&I has now updated this directive (LB & I-04-1013-008).
The guidance helps auditors who must decide whether or not to challenge a taxpayer’s position that it has the benefits and burdens of ownership under a contract manufacturing arrangement with a “counterparty” (in other words, the other party to the contract). It instructs the auditor to request the following documents from the taxpayer.
As long as these documents are provided, the auditor should not challenge the taxpayer’s assertion that it qualifies as the appropriate party in a contract manufacturing arrangement. In addition, this directive provides the following two points.
The latest directive is identical to LB&I-4-0713-006, except that it drops the requirement stated above that the taxpayer make a certification about financial statement reserves, and also provides that an extension for more time to furnish the documents may be requested. Any extension must be approved by IRS’ Territory Manager.
Bottom line: Make sure you’re on firm ground if you’re contracting with another party concerning qualified manufacturing activities. The contract should be worded for your protection in the event the IRS challenges whether you are the appropriate party for claiming the Section 199 deduction. ©