Sec. 83 in the context of contract manufacturing.

• Author: Lincolnhol, Lori C.

Sec. 83, which provides rules for the taxation of property transferred in connection with the performance of services, generally is considered in the context of an employer-employee relationship. However, Sec. 83 has applications outside this conventional framework. As illustrated in the following scenario, Sec. 83 may be applied to successfully defer and possibly reduce taxable compensation to independent contractors, including contract manufacturers.

Example: Company A entered into a co-manufacturing agreement with Company B to produce widgets on behalf of B. As part of the agreement, B will place a significant amount of equipment (widget manufacturing assets) at A's manufacturing facility, which A will use to manufacture the widgets on behalf of B. In addition to the co-manufacturing contract, the parties have also entered into a no-charge lease agreement for the widget manufacturing equipment. At the end of the term of the co-manufacturing contract, B will transfer the ownership of the widget manufacturing equipment to A for a nominal price. During the term of the two agreements, A is responsible for the maintenance, insurance, and all property taxes associated with the equipment. However, B will retain title and will transfer title only upon successful completion of the contract period. How should the receipt of the widget manufacturing equipment by A be treated for tax purposes, and when should income, if any, be recognized?

Application of Sec. 83

To determine the tax treatment of the receipt of the widget manufacturing equipment, both the language in the documents and the overall intent of the parties involved must be examined. In this example, A and B have entered into an arrangement whereby A will provide a service to B. As part of that arrangement, B is providing the equipment necessary for A to provide that service. The bargain purchase of the widget manufacturing equipment was intended to both compensate A and encourage it to complete the full term of the contract.

Regs. Sec. 1.61-2(d)(2) provides that

if property is transferred to an independent contractor, as compensation for services, for an amount less than its fair market value, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property at the time of transfer and the amount of its fair market value at the time of the transfer is compensation and shall be included in the gross income of the...