In a new Field Directive issued February 1, 2012, the IRS has provided examiners guidance on reviewing facts to determine which party to a transaction has the benefits and burdens of ownership in order to claim the Section 199 Domestic Production Manufacturing Deduction. In the IRS view, only one party can claim the deduction; however, many production processes are multi-phased in which more than one taxpayer contributes to that process and can claim their profits as qualifying.
The Directive is geared towards determining which party has the benefits and burdens of ownership during the period in which the qualifying activity occurs.
In determining the Section 199 deduction, IRS examiners are asked to review three steps:
Step 1 – Contact Terms Review (title, risk of loss, insurance questions)
Step 2 – Production Activities Review (which party developed the process (as opposed to the product)
Step 3 – Economic Risks (make-good provisions, which party supplies the materials, which party bears the risk of profit or loss with price fluctuations)
The Section 199 Directive asks the examiner to review each of these steps and determine whether 2 out of 3 questions are met with each step (essentially a safe harbor in which the taxpayer will pass the benefits and burdens test under Section 199 if 2 out of 3 questions are answered affirmatively in each step; moreover, the taxpayer must satisfy 2 out of the 3 overall steps. If not, the Directive still advises the IRS to review all the facts and circumstances in determining whether the taxpayer meets the overall benefits and burdens test under the Section 199 regulations, even though this safe harbor may not be met.
This Directive is a positive step in that the examiner must review the facts of each case in making the determination as to whether benefits and burdens under Section 199 are met, rather than in some industries, disallowing the deduction based purely on legal standards or National Office views on the legal standard.
Below is a link to the new Section 199 Domestic Production Deduction Field Directive.