Sec. 199 contract manufacturing guidance may encourage taxpayers to agree on benefits and burdens.

• Author: Fitzpatrick, Ellen

Since Sec. 199's enactment in 2004, its implementation for taxpayers who use contract manufacturing has been rife with controversy. Sec. 199 allows a taxpayer to deduct 9% (in tax years beginning after 2009) of the taxpayer's qualified production activities income (QPAI) resulting from domestic production activities. The deduction is limited by the taxpayer's taxable income and SO% of "W-2 wages" paid for the year. For a taxpayer to generate the domestic production gross receipts (DPGR) needed to determine its QPAI, it must lease, rent, sell, or exchange qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or significant part in the United States. The phrase "by the taxpayer" has produced significant controversy between the IRS and taxpayers that are involved in contract manufacturing arrangements as to which party to the arrangement is allowed to claim the deduction.

Under Regs. Sec. 1.199-3(f)(1), only one taxpayer may claim the Sec. 199 deduction with respect to any qualifying activity performed in connection with the same qualified production property (QPP). The regulation further provides that, in cases where a taxpayer performs qualifying activities pursuant to a contract with another party, only the taxpayer that has the benefits and burdens of ownership of the QPP under federal income tax principles during the period in which the qualifying activity occurs is allowed to claim the Sec. 199 deduction. The regulations do not provide specific guidance on the factors to be considered in determining which party has the benefits and burdens of ownership.

Two examples involving contract manufacturing are provided in Regs. Sec. 1.199-3(f)(4). The first example lists five factors to be considered. However, the example says one taxpayer satisfies four of the five factors and has the benefits and burdens of ownership. The second example assumes that one taxpayer has the benefits and burdens of ownership, even though title to the property does not transfer to the taxpayer until the manufacturing process is complete. This example illustrates only that the taxpayer holding the title is not necessarily the tax owner of the property during manufacturing, but it leaves out what other factors would be required if legal title were not held. While these examples provide a starting framework for determining which party has the benefits and burdens of ownership, they leave open for controversy any...