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Use of Third-Party Contract Manufacturer Precludes Sec. 199 Deduction; Taxpayer Lacked Benefits and Burdens of Ownership (Parker Tax Publishing: November 07, 2013)

In a case of first impression, the Tax Court was asked to decide how Code Sec. 199 applies to U.S. corporations that manufacture products through agreements with contract manufacturers. The court had to determine whether a taxpayer's gross receipts attributable to printed direct mail advertising qualified as domestic production gross receipts (DPGR) such that the taxpayer was eligible for the Code Sec. 199 domestic production activities deduction (DPAD). In this case, the taxpayer supplied advertising material to clients, but contracted with third-party commercial printers to print it. The IRS argued that because the taxpayer contracted out the actual printing to third-party printers, it did not manufacture any qualifying production property and could not take the deduction. ADVO, Inc. & Sub v. Comm'r, 141 T.C. No. 9 (10/24/13).

In ADVO, the Tax Court sided with the IRS and concluded that because the taxpayer did not have the benefits and burdens of ownership of the direct advertising materials, it was not considered to have manufactured, produced, grown, or extracted qualifying production property under Code Sec. 199 and was thus was not entitled to the deduction.

OBSERVATION: This case has broad implications for a number of companies that use U.S.-based contract manufacturers. The issue of whether or not a company can claim that it is the manufacturer of a product it sells when it contracts with third parties to assist in producing the product is one of the biggest areas of dispute between the IRS and taxpayers taking the Code Sec. 199 deduction. Another case currently before the Tax Court involves L. Brands, Inc., the owner of Victoria's Secret and Bath & Body Works stores. The issue in that dispute is whether or not L. Brands can claim the Code Sec. 199 deduction for lotions sold by Victoria's Secret but made by an outside contractor.

Practice Tip: In July 2013, in recognition of the fact that the IRS and taxpayers could expend significant resources to determine which party may claim the Code Sec. 199 deduction in situations where third-party contract manufacturers are used, the IRS issued a Large Business & International Directive, LB&I-04-0713-006 (7/24/13), which provides that the IRS will not challenge a taxpayer's claim that it has the benefits and burdens of ownership for purposes of a Code Sec. 199 deduction if that taxpayer provides a certification executed by both parties designating the party who is to receive the Code Sec. 199 deduction. An acceptable form of certification is included as an exhibit to the guidance.


ADVO, Inc. (ADVO) was the common parent of the consolidated group ADVO, Inc., & Subsidiaries for the tax years ending September 24, 2005, and September 30, 2006, and for the short tax year ending March 2, 2007. On March 3, 2007, ADVO was acquired by Valassis Communications, Inc. and continues to exist as its wholly owned subsidiary.

During 2005, 2006, and 2007, ADVO distributed direct mail advertising in the United States. Direct mail advertisers such as ADVO distribute advertising material through the U.S. Postal Service (USPS) to residential recipients, who are the targeted potential customers for the products and services sold by ADVO's clients, the advertisers. The advertising material can be either solo direct mail or cooperative direct mail. For solo direct mail, the printed advertising material of a single advertiser is delivered in a stand-alone envelope or as a postcard to a residential recipient. For cooperative direct mail, also known as a shared mail package, the printed advertising material for several different advertisers is consolidated into a single delivery mechanism (such as an envelope or sleeve) and delivered as a single unit to residential recipients. This allows ADVO's clients to share the advertisements' costs of mailing and postage to reach the target consumers' mailboxes. Either ADVO's clients supply the advertising material for ADVO to distribute (client-supplied material) or ADVO supplies the materials for distribution (ADVO-supplied material). When ADVO supplies the advertising material, it contracts with third-party commercial printers to print it.

The Code Sec. 199 deductions at issue were attributable to direct mail advertising involving only the ADVO-supplied material.

ADVO's shared mail packages were distributed weekly, and each included a wrap and various inserts. During the years at issue, the wrap was a branded turnkey product known as Shopwise. ADVO sold the Shopwise wrap across hundreds of wrap zones nationally, and each wrap zone could have a different Shopwise wrap with different advertisers.

ADVO developed and marketed a portfolio of ADVO-supplied inserts, each of which was differentiated by a set of defined product specifications, which included paper dimensions, paper weight, and bleed availability. ADVO sold ADVO-supplied inserts for distribution via both ZIP Codes and ADVO Targeting Zones (ATZ). ATZs were proprietary configurations of households developed by ADVO, which took into account demographic and other information and could target the potential buying habits of the target consumers. ADVO had about 133 million mailing addresses in its system.

ADVO classified its ADVO-supplied material as either turnkey or custom. A turnkey product was a print product that was included in ADVO's portfolio of products that met specifications defined by ADVO. A lump sum that included the advertising services, printing, and distribution was billed to the client for turnkey products. The pricing for turnkey products was one rate for the entire process: creating the advertisement, producing the advertisement, delivering the advertisement, and targeting the desired end consumers. ADVO handled everything from the design of the advertisement through distribution of the turnkey product, and specifications were designed to facilitate cost-efficient assembly and distribution of the shared mail packages. The DAL, Shopwise wrap, and ADVO-supplied inserts were turnkey products.

A custom print product was an insert that was not part of ADVO's portfolio of turnkey products because of the client's specifications for the insert. ADVO billed two separate charges for custom inserts: one for the printing and one for the advertising and distribution. During the years at issue, ADVO employed around 600 sales executives. The sales force was responsible for selling advertising space in the shared mail package. ADVO distributed 60 to 80 million packages every week of the year.

In varying degrees, ADVO's graphic print department assisted ADVO's clients with the design of the advertisement graphics. The graphic design requirements with respect to ADVO-supplied materials generally fell into three categories: (1) rough art, (2) reprint with changes, and (3) client-supplied art. Rough art made up 45 percent to 50 percent of the graphic art work designed by ADVO, and reprint with changes made up 30 percent to 35 percent of the graphic art work designed by ADVO. In these two situations, ADVO retained ownership of all intellectual property associated with the artwork and advertisement. Client-supplied art made up the final 15 percent to 20 percent of the graphic work. When ADVO's clients supplied the art, the client retained the ownership of intellectual property related to that art. Client-supplied art still required ADVO's artwork department to analyze and normalize the files to make sure that they were printable. ADVO produced between 106,000 and 107,000 graphic designs per year.

Approximately 40 to 45 graphic print coordinators worked for ADVO. They were responsible for coordinating among ADVO's sales organization, ADVO's graphics personnel working on a design, and the third-party printers. In addition, ADVO employed 50 to 60 desktop artists. The desktop artists were responsible for actually creating the advertisements and would also pre-flight all the graphic designs before they were sent to the third-party printer. ADVO's purpose for the preflight process was to ensure that the image the desktop artist saw on the computer screen would accurately print. ADVO also employed 20 to 25 quality control artists who proofread the ads and reviewed the graphic design files to make sure they met the printing specifications for the job.

After the desktop artist created an advertisement art file and it was reviewed by the quality control artist, a low-resolution PDF would be uploaded to the ADVO online graphics gallery for the client to view and approve the advertisements. ADVO maintained a file of all the information for a client's advertising job in a job jacket, which included the order and the artwork. After the client approved the advertisement, it was released to the printer in an Adobe PDF format. The printing process colors were already separated in the PDF sent to the printer.

ADVO's paper supply arrangement between its paper broker and its third-party printers was known in the paper and printing industries as a directed buy agreement. Under this agreement, a broker sold paper ADVO prespecified to ADVO's third-party printers for use in fulfilling the printers' contracts with ADVO. The third-party printers ordered and purchased the paper directly from the broker, and the paper was shipped directly to the printers. ADVO's advertisements made it one of the top 20 print paper users in the United States, consuming approximately 90,000 tons of paper, purchased pursuant to ADVO's directed buy agreements, each year. The printers understood that, absent special specific authorization from ADVO, they were not allowed to use that paper for any of their clients but ADVO.

ADVO never took physical possession of the raw paper stock and did not pay for any paper until the print contract was completed and it received an invoice from the printer. ADVO did not guarantee payment to the broker in the event a printer defaulted on the purchase contract. ADVO spent approximately $125 million per year on its turnkey printing needs, $50 million of that for paper and $75 million of it for printing services. ADVO contracted with third-party printers to print the advertising material. For the years at issue, ADVO entered into printing agreements with various printers and the contracts each contained similar Risk of Loss sections, which provided that title to and risk of loss, damage to, and delay of the manufactured products passed to ADVO upon delivery to ADVO's branch facility, F.O.B. ADVO's dock. All mechanicals, paper, film, plates, etc., not supplied by ADVO or its clients but used to perform the services under the agreements remained the exclusive property of the printer, unless otherwise agreed in writing.

The third-party printers were required to maintain insurance with respect to all of ADVO's work in progress and all materials. Insurance limits did not limit the printer's liability to ADVO, and ADVO was not responsible for the deductible. All of the policies were to extend coverage to ADVO as loss payee.

Upon receipt of the electronic file, the printer performed certain procedures with respect to the file and then determined whether the client's graphic design could be ganged together or combined with the client's other graphic designs. Ganging involves the arrangement of the advertisements of multiple advertisers for placement on the set of printer plates used with respect to a single press run. When ganging is feasible, the printer then typically uses the electronic file in the computer for creation of the press run printing plates. ADVO prohibited its third-party printers from ganging jobs for the printer's other clients on the same press run used for ADVO's products. The printer executes additional manufacturing and/or production steps with little active direct involvement by ADVO. After the press run, the printer cuts and/or folds the individual print product into shippable packages and then ships the product to ADVO-designated locations.

Code Sec. 199 Deduction

Under Code Sec. 199, taxpayers can take a deduction for a percentage of their income attributable to certain production activities that take place within the United States (i.e., domestic production activities). For 2010 and later years, the domestic production activities deduction is equal to 9 percent of the lesser of the taxpayer's qualified production activities income (QPAI) or its taxable income. The deduction percentage was limited to 3 percent in 2005 and 2006 and 6 percent in 2007, 2008, and 2009.

QPAI is computed by determining the taxpayer's domestic production gross receipts (DPGR) and then reducing the DPGR by the cost of goods sold and other expenses, deductions, and losses (computed without regard to the Code Sec. 199 deduction) that are properly allocable to DPGR. Generally, DPGR includes the gross receipts of the taxpayer that are derived from any lease, rental, license, sale, exchange, or disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States.

The amount of the deduction is also limited to 50 percent of the W-2 wages of the taxpayer for the tax year.

Taxpayer and IRS Arguments

ADVO argued that its gross receipts attributable to its printed direct mail advertising qualified as DPGR, thus allowing it to take a Code Sec. 199 deduction. In making its case for the deduction, ADVO relied on the Tax Court's decision in Suzy's Zoo v. Comm'r, 114 T.C. 1 (2000), in which the Tax Court held that held that a corporation, which developed cartoon characters for its line of paper products and then contracted with independent printing companies, was the owner of the paper products through production and until they were sold for the purposes of Code Sec. 263A. The printers in Suzy's Zoo would receive original drawings, photograph the drawings, create proofs, and then use their own ink and paper to print the products.

The IRS countered that because ADVO contracted its actual printing out to third-party printers, it did not manufacture any QPP. It argued that Suzy's Zoo involved a Code Sec. 263A dispute and was not determinative of the Code Sec. 199 dispute in the instant case.

Tax Court's Analysis

The Tax Court began its analysis by noting that the critical issue was whether ADVO manufactured the advertising mailing packages or produced only intangible property used by printers to produce tangible personal property in the form of the advertising mail packages. At a minimum, the court stated, the original ADVO electronic file for each print job constituted QPP under Code Sec. 199(c)(5)(A) or (B) as either computer software or tangible personal property manufactured and/or produced by ADVO.

The problem, the court observed, was that ADVO, unlike some printers or publishers, never sold, leased, rented, licensed, exchanged, or otherwise disposed of the prepress electronic file. ADVO instead elected to retain ownership thereof and used the file as a tool for the manufacturing and producing of the mailing packages advertising materials. Therefore, the court said, the electronic files themselves did not constitute or generate DPGR for purpose of determining a Code Sec. 199(a) deduction.

The printed advertising materials were manufactured and produced by someone in the United States, the court observed, and that someone was entitled to the Code Sec. 199 deduction to the extent they otherwise qualified for the deduction. Here, the question was whether ADVO or the contract printer was the appropriate recipient, because only one of them was entitled to the deduction. Thus, the issue was whether ADVO had QPP that was MPGE by it in whole or in significant part within the United States.

The court looked to Reg. Sec. 1.199-3(e)(1), which defines MPGE to include manufacturing, producing, growing, extracting, installing, developing, improving, and creating QPP; making QPP out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles. The regulation further states that when the taxpayer contracts with an unrelated third party for the manufacturing of its products, the taxpayer must have the benefits and burdens of ownership of the QPP under federal income tax principles during the period the MPGE activity occurs.

The court noted that neither party challenged the validity of Reg. Sec. 1.199-3(e)(1), nor that the benefits and burdens standard should be applied. The court observed that Notice 2005-14, initial interim guidance to taxpayers on Code Sec. 199 released in 2005, explained that the benefits and burdens of ownership standard under federal income tax principles was based on the principles under Code Sec. 936 and Code Sec. 263A. The final regulations under Code Sec. 199 did not specifically mention those Code sections. However, the court found the preamble to the final Code Sec. 199 regulations instructive in that it emphasized the importance of the fact-specific benefits and burdens test for each individual situation and implied that the original connection of the test to Code Sec. 936 and Code Sec. 263A still applied.

The court concluded that, although the factors used to determine ownership under Code Sec. 263A are helpful in determining ownership under Code Sec. 199, it was not bound by its holding in Suzy's Zoo.

The court then turned to the examples in the Code Sec. 199 regulations for guidance on the factors relevant in determining which taxpayer has the benefits and burdens of ownership during manufacture and/or production. Of particular interest to the court was Example (1) in Reg. Sec. 1.199-3(f)(4). In the example, X designs machines and contracts with Y, an unrelated person, to manufacture the machines. X owns the intellectual property attributable to the design, and Y is allowed to use that property only to manufacture X's machines. Y has no right to independently exploit the intellectual property. Y controls the details of the manufacturing process, bears the risk of loss or damage during manufacturing, has legal title to the machines during manufacturing, and enjoys the economic gain or bears the loss from the sale of the machines measured by the difference between Y's costs and the fixed contract price. On these facts, the example concludes that Y had the benefits and burdens of ownership during production.

The court also looked to case law in applying the following factors to determine the benefits and burdens of ownership under Code Sec. 199 for the purposes of ADVO's situation: (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 purchaser to make payments; (5) whether the right of possession is vested in the purchaser and which party has control of the property or process; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; (8) which party receives the profits from the operation and sale of the property; and (9) whether ADVO actively and extensively participated in the management and operations of the activity.

With respect to factor (1), the court noted that while title to the intangible property (i.e. the actual design of the art as transmitted on the PDF file) never transferred to the printers or to ADVO's clients, ADVO's printing agreements with its contract printers clearly stated that Title to and risk of loss of the product (i.e. the printed material) does not transfer to ADVO until the products left the printers'facilities. As a result, this factor weighed in favor of the IRS.

With respect to factor (2), the court stated that the parties contemplated and agreed that the third-party printers would print the specific advertising material that ADVO required and then send the printed material to ADVO. It was always their intent, the court observed, that the printers produce the actual tangible paper materials using the ADVO intangible pre-press materials. Thus, the court found that this factor weighted in favor of the IRS.

Factors (3) and (4), the court said, were not significantly relevant in the instant case and thus were neutral.

With respect to factor (5), the court said that it could not find that ADVO exercised day-to-day control over the activities of the printer and, therefore, this factor weighed in favor of the IRS.

With respect to factor (6), the court said that because there was no evidence that ADVO or anyone else paid property taxes on any of the pre-press PDF files or the printed property during the manufacturing process, this factor was neutral.

With respect to factor (7) relating to the party that bore the risk of loss, the court noted that the risk of loss or damage did not transfer to ADVO until the advertising materials had either left the printers' facilities or been delivered to ADVO. ADVO also did not assume any risk with respect to the directed buy paper supply agreements. Although ADVO required its printers to purchase the paper from a specific source, ADVO did not guarantee payments to the broker in the event the printers defaulted on the payments, nor did ADVO reimburse the printer for the paper costs until the printed product had been completed and shipped per ADVO's specifications. The third-party printers were also required to maintain insurance with respect to all of ADVO's work in progress and all materials. Given the insurance and the fact that the risk of loss did not transfer to ADVO until after completion of the manufacturing process, the court concluded that ADVO did not have the burden of the risk of loss or damage with respect to the advertising materials.

As for factor (8), the court noted that the third-party printing companies enjoyed the economic gain or bore the loss from the sale of the advertising material according to the difference between the printing companies' costs and, as to some of the contracts, the fixed contract price. As a result, the court said this factor weighed in favor of the IRS.

Finally, with respect to factor (9), the court concluded that while ADVO did extensively participate in the mailing and dissemination of the advertising materials (i.e. the solo or cooperative mail packages), that function was a service, not QPP. ADVO did not extensively participate in the operation of the printing presses or in the cutting or folding processes, and thus this factor weighed in favor of the IRS.

Because the court determined that ADVO did not bear the benefits and burdens of ownership, the court concluded that ADVO was not entitled to the Code Sec. 199 deduction.


Determining who bears the benefits and burdens of ownership is a highly fact intensive determination. In addition to the factors mentioned above, other factors may be appropriate depending on the situation. In LB&I Directive, LB&I-4-0112-001 (2/1/12), Guidance for Examiners on I.R.C. Sec. 199 Benefits and Burdens of Ownership Analysis in Contract Manufacturing Arrangements, the IRS discusses these additional factors.

Finally, as mentioned in the beginning of the article, LB&I-04-0713-006 (7/24/13) provides that the IRS will not challenge a taxpayer's claim that it has the benefits and burdens for purposes of a Code Sec. 199 deduction if that taxpayer provides a certification executed by both parties designating the party who is to receive the Code Sec. 199 deduction. Thus, a manufacturer may want to include this certification as part of the negotiation process when contracting with a third party to provide additional product services. (Parker Tax Publishing Staff Writers)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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