Section 199 of the Internal Revenue Code was enacted in 2004 to provide a tax benefit to businesses engaged in domestic production activities. Section 199 provides qualifying taxpayers with a tax deduction equal to a specified percentage (generally 9 percent) of their income from domestic production activities. The definition of qualifying production activities for purposes of Section 199 is fairly wide, and the types of taxpayers taking advantage of the Section 199 deduction is much broader than traditional manufacturers. Taxpayers engaged in agriculture, software development, utilities, film production, construction and engineering businesses have all realized significant tax benefits from this provision.
Even though the Section 199 deduction has been in existence for more than a decade, several recent developments have caused taxpayers to reassess their Section 199 calculations. Taxpayers have prevailed in two recent court decisions that could expand the scope of activities qualifying as production activities for purposes of Section 199. Additionally, the IRS issued both proposed and temporary regulations in August 2015 that addressed a wide range of issues under Section 199. Some of the new provisions in the regulations will impact all taxpayers claiming the Section 199 deduction, while other provisions are focused on specific industries and activities. The industry-specific provisions in these regulations are most likely to impact taxpayers in the construction, oil and gas, and film industries.
Most Significant Change
The most significant change in the regulations impacts taxpayers engaged in “contract manufacturing arrangements.” Contract manufacturing arrangements are quite common in some industries and arise where one party hires another party to produce something on their behalf. For example, Retailer A pays Manufacturer B to produce private label clothing that will be sold exclusively in Retailer A’s stores. The issue in these situations is determining whether Retailer A or Manufacturer B is entitled to the Section 199 deduction for the produced clothing. The regulations propose to simplify the existing facts and circumstances analysis for identifying the taxpayer eligible for the deduction by always awarding the Section 199 deduction to the party physically performing the manufacturing activities. While this new standard would make the analysis much more straightforward and reduce controversy between taxpayers and the IRS, some taxpayers’ Section 199 benefit may be significantly reduced or eliminated under the proposed rule.
Defining Non-Qualifying Production
The regulations also attempt to provide guidance in defining activities that are not qualifying production activities. While the definition of production activities is broad, certain activities are specifically excluded as non-production activities. Non-production activities include packaging, re-packaging, labelling and minor assembly. However, in recent court decisions, taxpayers have successfully argued that their activities constituted production rather than non-qualifying packaging or re-packaging activities. As a result of these taxpayer victories, other taxpayers whose activities are similar to packaging, repackaging and assembly may benefit by reviewing their activities to determine if any additional activities could be treated as production activities.
The IRS responded to the beneficial court decisions in the regulations. The IRS included an example mirroring the facts in one of the court decisions, but stating that the activities constituted non-qualifying packaging and re-packaging. The IRS also requested comments from taxpayers on quantitative and qualitative standards that could be used to define non-qualifying minor assembly activities. The regulations covering these provisions are still in proposed form and will not be effective until finalized. As a result, taxpayers still have an opportunity to provide comments and feedback to the IRS on these issues.
What Should You Do?
Many taxpayers set up their Section 199 calculation procedures when Section 199 was first enacted and may not have revisited those procedures for several years. The newly issued guidance provides an excellent opportunity for taxpayers to re-assess their Section 199 calculations to determine if any adjustments can be made to maximize their benefit. Additionally, taxpayers with activities potentially affected by the regulations should consider the possible impact of these provisions on their future Section 199 deductions.