Retain Ownership Standard in Manufacturing Deduction Rules, Firm Says

This comment is in response to the proposed changes to the regulations under Section 199 of the Internal Revenue Code ("Code"). In particular, this comment addresses the change to the definition of "by the taxpayer."

The current regulations provide that if a taxpayer performs qualifying activities pursuant to a contract with another taxpayer, then only the taxpayer that has the burdens and benefits of ownership under Federal income tax principles during the period the qualifying activity takes place is treated as performing the qualifying activity. However, the proposed changes would eliminate this rule and provide that only the taxpayer performing the activities will be entitled to take the deduction under Section 199 of the Code. The preamble states that this change is necessary to "reduce administrative burden on taxpayers and the IRS in evaluating factors related to the benefits and burdens of ownership," provide rules that are "consistent with the statute's goal of incentivizing domestic manufacturers and producers," and "prevent more than one taxpayer from being allowed a deduction under Section 199."

We believe this approach is inconsistent with the statute and, in fact, undermines the statute's purpose. The "benefits and burdens" test provides a well-established rule that both the IRS and taxpayers can use to determine who is the owner of property. This standard is consistent with the statute because only the taxpayer that owns the property can generate domestic production gross receipts by selling, leasing, or disposing of the property. There has been one Tax Court case, ADVO Inc, Inc. & Subsidiaries v. Commissioner, 141 T.C. 298 (2013), that has applied the benefits and burdens and the court applied the test with relative ease. In fact, the case law concerning the "benefits and burdens" test is well established and has been used for over 30 years since its inception in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981). This standard limits the deduction to only one taxpayer: the taxpayer that actually owns the property and generates domestic production gross receipts in selling, leasing, or disposing of qualifying property.

While the proposed rule would prevent more than one taxpayer from claiming the Section 199 deduction, in many circumstances the rule would result in no taxpayer being able to claim the deduction. For example, suppose Taxpayer A is in the business of turning raw material into a finished product and selling that finished product to consumers. Taxpayer A subcontracts with Taxpayer B, whose sole activity is performing manufacturing services, to perform the manufacturing work. Taxpayer A takes the finished product and sells the product to consumers. Under the proposed rule, neither Taxpayer A nor Taxpayer B can take a deduction under Section 199. Taxpayer A cannot take the deduction because it is not treated as performing any qualifying activity. Taxpayer B cannot take the deduction because it does not have any domestic production gross receipts as it does not sell, lease, exchange, or otherwise dispose of the property on which it performs work.

Such a result is contrary to the purpose of Section 199 to incentivize domestic manufacturing and production. In fact, this rule would encourage domestic taxpayers to use offshore contractors to conduct their manufacturing activity as those contractors are often cheaper than domestic contractors and the taxpayer that owns the property would be unable to claim the Section 199 deduction by using domestic contractors. Additionally, there is no logical basis for treating services performed by employees as work done by their employer but not services a performed by a contractor for that same taxpayer.

The current rule using the benefits and burdens of ownership standard accomplishes the statute's goals. It provides an incentivize to use domestic workers to perform manufacturing work and permits only one taxpayer, the property's owners, to claim the deduction under Section 199. Changing the rule could result in situations where no taxpayer is able to claim a deduction and could lead to an increase in outsourcing contract work.

For these reasons, we urge the IRS and the Treasury Department not to change the "benefits and burdens of ownership" standard in the Regulations under Section 199.