The IRS issued new eligibility guidelines last year that attempt to clarify which companies are eligible for the manufacturers' deduction under Section 199 of the tax code when multiple parties manufacture a product. Contractual manufacturing arrangements have historically been the source of much confusion when it comes to this deduction. This article explains the deduction and how the new guidelines are intended to make it easier for manufacturers to comply with its requirements.
How the Deduction Works
The manufacturers' deduction — also known as the Sec. 199 or domestic production activities deduction — allows a federal income tax deduction when manufacturers derive income from selling, leasing or renting items made in the United States, as well as from unrelated energy and motion picture production. This deduction equals 9% of the lesser of a business's qualified production activities income (QPAI) or its taxable income (or adjusted gross income for individuals, estates and trusts). Also, the deduction cannot exceed 50% of W-2 wages paid to the manufacturer's employees.
For most domestic manufacturers, QPAI usually equals taxable income. Products manufactured entirely outside the United States, as well as leasing or licensing activities to a related party, typically are not eligible for the manufacturers' deduction.
You may, however, qualify for the deduction if your products are partially produced in the United States. Safe harbor rules allow a deduction if at least 20%of a product's total costs result from domestically incurred direct labor and overhead costs incurred domestically.
Why New Guidelines Were Needed
A lack of specificity in the law and the complexity of the contractual agreements make it difficult to determine exactly who is eligible for the deduction. In July 2013, the IRS issued new guidelines for tax examiners to use when determining manufacturers' deduction eligibility for manufacturing contracts that involve unrelated parties.
Only one taxpayer may claim the deduction for a qualifying activity performed with respect to a qualifying property. But sometimes multiple manufacturers work on the same product. Tax regulations provide that, if more than one taxpayer performs a qualifying activity pursuant to a contract with another, only the taxpayer with the "benefits and burdens of ownership" will be treated as the producer and, therefore, be eligible for the deduction.
For example, a medical device manufacturer might source components from three dozen different suppliers for its line of replacement knees and hips. Here, the company that markets the final product is considered the producer for tax purposes. Consequently, the company is eligible for the manufacturers' deduction — because it assembles the medical devices, takes legal liability for any defects and pays taxes on the proceeds of the finished products.
What to Expect During an IRS Examination
The IRS decided its nine-part "benefits and burdens" test was impractical, overly complicated and costly for manufacturers and the tax agency, so it modified the requirements. When deciding who is eligible for the manufacturers' deduction under the new guidelines, IRS examiners will request three documents:
- A statement that explains the basis for the taxpayer's determination that it had the benefits and burdens of ownership in the year(s) under examination;
- A certification statement signed by the taxpayer; and
- A certification statement signed by the counterparty.
These three statements are required for each manufacturing contract and cannot be amended during the life of the contract.
Manufacturers and their counterparties have 30 days to respond to IRS requests. Those who fail to provide the requisite forms are likely to undergo further IRS scrutiny — and may be ineligible for tax savings under Sec. 199.
How to Minimize IRS Scrutiny and Maximize Eligibility
If you enter into contractual manufacturing arrangements, do not automatically assume you are eligible for the manufacturers' deduction. Before contracting with another entity, discuss who will legitimately possess the benefits and burdens of ownership for a qualifying activity performed under the contract and make sure everyone is willing to complete the requisite paperwork.
Will Expanded Section 179 Expensing Go Away in 2014?
A tax incentive designed to encourage companies to invest in new equipment and other fixed assets, Section 179 expensing, was reduced sharply effective January 1, 2014. As of this writing, Congress has yet to extend the enhancements.
Fixed assets are generally capitalized and depreciated over their useful lives, which can be up to 39 years. But Sec. 179 allows businesses to immediately deduct a certain amount of qualifying purchases for federal income tax purposes. Expanded Sec. 179 expensing has saved manufacturers significant taxes in recent years.
A wide variety of assets qualify for Sec. 179 expensing, including machines, large tools, heavy-duty vehicles, computers, software and office furniture. Purchases and leases of both new and used equipment that are put into service before December 31 are typically eligible.
For 2010 through 2013, the Sec. 179 expensing limit was $500,000, phasing out by $1 for every dollar of expense beyond $2 million. On January 1, 2014, these limits dropped dramatically, to $25,000 and $200,000 respectively. So, manufacturers that have become accustomed to this tax incentive may want to set aside additional funds for their yearend tax obligations.
However, many consider it likely that Congress will extend the 2013 limits, or at least make some sort of increase to the 2014 amounts, retroactive to January 1, 2014. In fact, it may have even happened by the time you are reading this. Check with your financial advisor for the latest information on Sec. 179 expensing.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
