The Tax Court has ruled in ADVO, Inc. v. Commissioner (141 T.C. No. 9) that the domestic production activities deduction (DPAD) under Section 199 was not available for a taxpayer who did not have the benefits and burdens of ownership over the direct advertising materials.

The taxpayer distributed direct mail advertising materials two ways: The taxpayer's clients could supply the advertising materials for the taxpayer to distribute or the taxpayer could supply the materials for distribution. When the taxpayer supplied the advertising materials, the taxpayer contracted with third-party commercial printers to print the materials. The taxpayer provided the third party with the design for the advertising. The Section 199 deductions at issue were attributable to direct mail advertising involving only the taxpayer-supplied materials.

In general, Section 199 allows a taxpayer to deduct a percentage (3% for the year at issue) of income from qualified production activities. The regulations under Section 199 provide that when a 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 qualified production property to claim the deduction.

The taxpayer contended that its gross receipts from printing direct mail advertising qualified as domestic production gross receipts, but the IRS argued that because the taxpayer contracted its actual printing to third parties, it did not actually manufacture any qualified production property.

The Tax Court determined that the taxpayer did not have the benefits and burdens of ownership during production because of the following factors:

  •  Legal title did not pass to the taxpayer until the products left the printers' facilities.
  • The intent of the parties was that the printers would produce the advertising materials.
  • The right of possession and control was not exercised by the taxpayer during the printing process.
  • The third-party printing companies enjoyed the economic gain and bore the loss from the sale of the advertising materials.
  • The taxpayer did not extensively participate in the operation of the printing presses or in the cutting or folding processes.

The Tax Court noted that neutral facts include:

  • equity interest,
  • present obligation,
  • property taxes, and
  • risk of loss or damage.

Because the court held that the taxpayer did not have the benefits and burdens of ownership of the qualified production property, the taxpayer was not entitled to claim the Section 199 deduction for the taxable years at issue.

The Tax Court did not consider the fact that the taxpayer was the owner of the intellectual property contained on the printed materials, and that the contract manufacturer was limited to selling produced materials only to the taxpayer.  

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