Proposed Regulations Seek to Settle Section 199 Deduction Controversy in Contract Manufacturing Arrangements

August 5, 2016

Section 199 of the Internal Revenue Code, referred to as the Domestic Production Activities Deduction (DPAD), offers valuable tax savings to taxpayers, specifically to manufacturers. Section 199 allows a deduction equal to 9% of qualified income.  Qualified income is income earned from manufacturing and production activities, if the manufacturing and production activities primarily occur within the United States.

In certain situations, a company (“contracting company”) might contract with a “contract manufacturer” to produce a particular item.  Section 199 allows only one taxpayer to take the section 199 deduction in connection with qualified property.  So, in a contract manufacturing situation, only the contracting company or the contract manufacturer could take the deduction – not both.  The level of involvement that a contracting company has in the production process varies from contract to contract.  In a contract manufacturing situation, the contracting company (and not the contract manufacturer itself) would be entitled to the section 199 deduction if the contracting company had “benefits and burdens of ownership” over the property being produced.  The benefits and burdens test requires taxpayers to analyze the facts and circumstances and decide whether they are eligible for the section 199 deduction. It is possible that the two parties in a contract manufacturing arrangement could both believe that they are entitled to the deduction.

The IRS’ goals are: (1) to have only one taxpayer take the section 199 deduction, and (2) to simplify the section 199 analysis.  Accordingly, the IRS recently issued proposed regulations which, if finalized, would eliminate the benefits and burdens test and would result in the contract manufacturer having the section 199 deduction (regardless of who has benefits and burdens of ownership).

About the Benefits and Burdens of Ownership Test

The benefits and burdens of ownership test comes, to a large extent, from prior case law.  Court cases over the years have developed a number of factors to determine who has the benefits and burdens of ownership; however, no one factor is controlling, and there is no bright-line test for taxpayers. Factors in the analysis include:

  1. Whether legal title passes
  2. How the parties treat the transaction
  3. Whether an equity interest was acquired
  4. Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchases to make payments;
  5. Which party pays property taxes
  6. Which party bears the risk of loss or damage to the property
  7. Which party receives the profits from the operation and sale of the property
  8. Whether a taxpayer actively and extensively participated in the management of and operations of the activity

Oftentimes, in contract manufacturing arrangements, both parties have some elements of the above factors. This can make it difficult to determine which taxpayer has the benefits and burdens of ownership and who gets the 199 deduction. In these situations, sometimes both taxpayers claim the 199 deduction, and other times neither taxpayer claims the 199 deduction.

In prior years, the IRS issued directives in response to controversy as to who should receive the benefits and burdens of ownership. The most recent directive was issued in 2012 by the Large Business and International division of the IRS. The examination directive stated that the IRS will not challenge a taxpayer’s assertion that they have the benefits and burdens of ownership if: (1) a taxpayer otherwise meets the requirements of 199, and they sign a certification statement attesting that they have the benefits and burdens of ownership, and (2) the other party in the contract manufacturing arrangement signs a certification statement that they will not be claiming the 199 deduction under the contract in which the same qualifying activities were performed during the years examined. This essentially means that if the taxpayer has this certification statement, the IRS will let taxpayers decide among themselves who gets the 199 deduction.

Proposed Regulations

In August 2015, the IRS issued proposed regulations on various aspects of DPAD, the most significant of which affect contract manufacturers. In particular, the proposal seeks to remove the benefits and burdens of ownership test, which is used to determine who is entitled to the Section 199 deduction. Removing the rule would give the 199 deduction to the taxpayer that actually produces or manufactures the qualifying property.

Many taxpayers disagree with eliminating the benefits and burdens of ownership test, as they do not feel it is a correct interpretation of section 199 rules. At the same time, determining which party in a contract manufacturing arrangement has the benefits and burdens of ownership has led to much controversy between taxpayers and the IRS. Moreover, removing the test would relieve administrative burdens on the IRS in trying to settle benefits and burdens disputes.


The new regulations have not yet been finalized, and the IRS has taken comments from taxpayers on the proposed regulations. Based on these comments, changes may be made to the regulations before they are finalized. The proposed regulations would apply to tax years beginning or after the date the regulations become final.

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