Business Advisory Services Blog

How Making a Phone From a Soup Can and a Piece of String Can Help You Save On Your Taxes

Can you hear me now? Similar to the clarity of a soup-can phone, the IRS recently ruled and cited very broad interpretations of "manufacturing" for purposes of the domestic production activities deduction ("DPAD") under IRC Section 199. 

In general, the DPAD deduction allows a company that manufactures products a deduction equal to 9% of manufacturing net income.  So far, sounds great; and just as simple as a soup can phone.

But you may be saying “but wait, I’m NOT a manufacturer of goods or products. I’m a service industry, so I don’t qualify for the deduction, right?”

Actually, you may in fact qualify…
The regulations define “manufacturing” as "manufacturing, producing, growing, extracting, installing, developing, improving, and creating property out of scrap, salvage, or junk materials as well as from new or raw materials by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles". 

Traditional examples of qualifying activities are quite obvious: a company that builds automobiles, produces steel bars, or drills for oil.  Now, a company that assembles gift baskets and a retail photo processing unit of a drugstore also qualify according to the IRS.

  
In United States v. Dean (U.S. District Court for the Central District of California), the activities of a gift basket company were ruled to be engaged in manufacturing.  The company designed, assembled, and sold food gift baskets.  The Court described the assembly as a "complex production process" that involved machines and assembly-line workers who would insert and secure different items to the basket by gluing, stacking, or tying items to the basket. 

The case highlights the broad definition of manufacturing.  The combining of two or more items into a new product appear to satisfy the requirement of Section 199. And so, the metal of our soup-can meets the fibers of our string; wah-la, the soup can phone is produced.

In Legal Advice issued by Field Attorneys 20133302F (LAFA), the IRS determined the photo processing activities of a drugstore chain constitute manufacturing under Section 199.  The taxpayer is a domestic pharmacy with retail drugstores.  The retail stores contained self-service photo printer kiosks where customers can order prints, photo books, greeting cards, and picture CDs.  The taxpayer employs photo department employees to maintain the photo kiosks.  The LAFA concludes that the taxpayer takes undeveloped film, film negatives, and digital images provided by the customer and uses its own equipment and raw materials (paper, ink, chemicals) to produce a different tangible product in form and function. 

Both of these cases highlight the broad definition of "manufacturing" for purposes of DPAD.  Companies should review their activities to determine if they can qualify for this deduction in light of recent guidance.

Do you need help determining if you qualify for Section 199 or other business deductions?  We’re ready to talk – and a soup-can phone is not required. Contact Jim Forbes in Skoda Minotti's Tax Planning and Preparation Group at 440-449-6800.

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