The Houdini of Manufacturing

How would you define “manufacturing?”

There is a tax deduction tied-in with manufacturing activity. It is called the “domestic production activity deduction,” abbreviated “DPAD” and pronounced “Dee Pad.” 

An accountant calculates the DPAD by putting all revenues and expenses in one of two columns: domestic manufacturing and everything else. We want to know the profit from domestic manufacturing only. There is a bee’s nest of rules and sub-rules in here, but in general the deduction is 9% of the profit from domestic manufacturing. If your tax rate is 35%, then the DPAD translates into a 3.15% reduction in your tax rate.

Not bad for doing what you were going to do anyway.

The key thing is to define manufacturing. The IRS has provided the following:

·        The manufacture, production, growth or extraction of tangible personal property

·        Film production

·        Production of electricity, natural gas or water

·        Construction or renovation of real property

·        Engineering and architectural services in relation to the construction of real property

Many accountants have wondered about that last one. Good lobbying, I guess.

What is not manufacturing? The IRS did not consider food preparation at a retail establishment to be manufacturing, as one example. There actually is a “Starbucks Footnote” in the House-Senate conference committee report explaining that roasting the coffee beans would qualify but brewing and serving the coffee to customers would not.  

Let us introduce Houdini Inc. Here is some text from their website:

Since 1984, Houdini Inc. has been the leading supplier of upscale food and wine gifts to re-seller's throughout the U.S. Our trend-right gift assortments are found at America's foremost warehouse clubs, mass merchandisers, liquor retailers, specialty stores, catalog companies and internet sites.

We know you'll find these baskets represent a remarkable value: comparable products at these prices will not be found anywhere. Come in and shop around to find out why Houdini is the premier supplier of food gifts throughout the United States.

Houdini makes gift baskets. Odds are we have either given or received gift baskets over the years, so we have a grasp of the “activity” involved.

Houdini makes lots of baskets. They employ around 300 people, bring on approximately 4,000 temporaries during their busy period and can crank up to 80,000 baskets in a day. Most of their business is retail, and a good portion of that goes through their website using the business name Wine Country Gift Baskets. Houdini orders the baskets from China, and it fills the baskets with chocolate, cookies, candy, cheeses, crackers, wine or alcohol. They use inserts and spacers to make the baskets merry and festive.

What do you think? Does Houdini have a DPAD here?

Houdini filed its 2005 and 2006 tax returns without claiming the DPAD. They apparently met a smart tax practitioner and filed amended returns claiming a deduction. The numbers were as follows:

·        2005 DPAD of $206,987 and tax refund of $74,618

·        2006 DPAD of $394,770 and tax refund of $140,933 

The IRS issued the refunds.

Then the IRS wanted its money back. Houdini said no, and the IRS filed suit in December 2011. The case went to a District Court in California.

COMMENT: Tax cases from California can be entertaining to read.

The Court starts off addressing the Code section allowing the DPAD:

Section 199 … allows a taxpayer to deduct a specified percentage of ‘qualified production activities income’ for the taxable year.”

The IRS had published the following Regulation: 

If a taxpayer packages, repackages, labels or performs minor assembling … and the taxpayer engages in no other … activity …, the taxpayer’s packaging, repackaging, labeling or minor assembly does not qualify ….”

The IRS argued that Houdini merely packaged and repackaged the cookies, crackers, and wine. Per Regulation (which the IRS itself conveniently wrote), Houdini failed to have a manufacturing activity. No manufacturing activity means no deduction.

Houdini of course disagreed, arguing that the packaging and repackaging would disallow the deduction only if there is no other manufacturing activity. Houdini argued that there was other production activity.

How can Houdini show a manufacturing or production activity?

It helps to have a friendly judge.

The Court notes that Congress did not provide definitions. The IRS had not provided definitions either.  The Court explains that statutory interpretation “begins with the statutory text, and ends there as well if the text is unambiguous.”

The Court sees the following words and goes to the Merriam Webster Dictionary to determine what they mean:

·        Manufacture

o   To make into a product suitable for use

o   To make from raw materials by hand or by machinery

o   To produce according to an organized plan and with division of labor

·        Package

o   To make into a package

o   To present in such a way as to heighten appeal to the public

·        Produce

·        Repackage

The Court determines that Houdini makes products using machinery, according to an organized plan and with division of labor.

            SCORE: One for Houdini.

On the other hand, Houdini takes various items and puts them together in a more attractive form that appeals to the public.

            SCORE: One for the IRS.

We are tied. The Court must keep going.

Defendants [Houdini] argue that Houdini’s production process “changes the form of an article” within the meaning of Treasury Regulation 1.199-3(e)(1).

Houdini first selects various items – chocolates, cookies, candy, cheeses, crackers, wine or alcohol, packaging materials, and a basket or boxes – for its final products. Next the individual items are assembled in a gift basket or gift tower based on one of many detailed plans. This complex production process relies on both assembly line workers and machines. The final products, gift baskets and gift towers, are distinct in form and purpose from the individual items inside. The individual items would typically be purchased by consumers as ordinary groceries. But after Houdini’s production process, they are transformed into a gift that is usually given during the holiday season.”

SCORE: I see two for Houdini.

The IRS raises its hand and reminds the Court of the example in Regulation 1.199-3(e):

X purchases automobiles from unrelated persons and customizes them by adding ground effects, spoilers, custom wheels, specialized paint and decals, sunroofs, roof racks, and similar accessories. X does not manufacture any of the accessories. X’s activity is minor assembly …., which is not ….[a production] activity.

Houdini’s activity is not distinguishable from the example, argues the IRS. Its activity is a service – packaging and repackaging – that adds final value to a product but does not rise to the level of production. 

The Court then decides:

Unlike X, which does not change the form or function of the car by adding accessories to it, Houdini changes the form and function of the individual items by creating distinct gifts. Furthermore, the Court considers Houdini’s complex production process as more similar to purchasing various automobile parts from suppliers – such as the frame, engine, wheels, etc – and assembling them to create the car itself, which is undoubtedly manufacturing.

Can you believe it? Houdini won!

My thoughts? If you have read my posts, you know that I am usually pro-taxpayer. That said, I believe this is an ill-reasoned decision and lacking in common sense. A key concept to manufacturing is transformation. The final product is similar, but different. Whether we are discussing smelting ore to make engine blocks or planting seeds for a crop – what follows is different from what went before. Quite frankly, using the Court’s reasoning I would find a meal prepared by Iron Chef Morimoto to be closer to manufacturing than putting candy bars and wine bottles into baskets. 

Summerlin, Las Vegas and Not Paying Taxes Until 2039

Let me ask you a question, and then we will discuss how taxpayers and the IRS get into high-stakes battles.

Our topic today will be “home construction.” Let’s say that there is a contractor. He buys the land, grades and prepares the dirt, and sends over employees to frame, roof, wrap and finish a house.  Would we say that he is a “home construction contractor?” Yes, we would.

Let’s change this up. Say that he still buys and preps the land, but he sends over subcontractors rather than employees. Is he still a home construction contractor? Yes, we would still consider him as such.

Switch the focus to the subcontractor. Would you consider the roofer to be a home construction contractor? If one allows the terms contractor and subcontractor to be interchangeable for this purpose, then we would say yes. The overall contract is a home construction contract, so arguably any division of such contract would also be a home construction contract. Any slice of a red velvet cake is still cake.

One more. Let’s say that a third party purchases and rezones the land, clears and grades, installs water and sewer lines, builds roads and installs landscaping. He then sells individual lots to homebuilders. What we have described is commonly called a “developer.” Would we consider the developer to be a home construction contractor?

Thus begins the tax issues of Howard Hughes Corporation and its Summerlin development in Las Vegas. This thing is massive, covering almost 35 square miles on the west side of the city.  The development covers an area approximately half the size of the District of Columbia. Summerlin does not expect to sell-out its lots until 2039. Hopefully I will have been long retired and be dipping my feet in an ocean somewhere while enjoying an afternoon mojito.

There are two general tax accounting methods for contractors. One is called the percentage-of-completion method, and the second is called the completed-contract method.

·         Under the percentage-of-completion, one recognizes income as the work progresses. Say that a contract with $5 million estimated profit is 40% complete. The taxpayer reports $2 million in profit ($5 million times 40%) to the IRS. The IRS likes this method.

·         Under the completed-contract, one does not report any income to the IRS until the job is done. In the above example, the taxpayer reports -0- profit, as the job is only 40% complete. The IRS does not like this method as much.

The IRS starts by saying that every contractor must use percentage-of-completion, but it allows a few exceptions to use completed-contract. One exception for completed-contract is for a home construction contract.

Ah, you already see where we are going with this, don’t you?

Howard Hughes Corporation is arguing that it can use the completed-contract because it is a home construction contractor. They are telling the IRS “see you in 2039.” 

The IRS is having none of this. They argue that Howard Hughes Corporation is a home construction contractor the same way The Phantom Menace was a watchable Stars Wars movie. That means that Howard Hughes Corporation defaults to the percentage-of-completion method. The IRS wants its taxes – plus interest and penalties, of course.

Each side has an argument. For example, in Foothill Ranch Company Partnership the IRS conceded that a contract for the sale of land by a developer was a long-term construction contract. In a Field Service Advise dated 5/8/97, the IRS stated that contracts for the sale of land requiring the seller to provide infrastructure or common improvements are construction contracts.

Rest assured that Howard Hughes Corporation has tax advisors who know this.

The IRS in turn determined in TAM 200552012 that a land development company selling lots through related entities did not qualify for completed contract, as the company did not actually build dwelling units. The IRS parsed words in a Code section with the cutting skills of Iron Chef Morimoto, noting that the statute uses the word “and” rather than the word “or.”

            Sigh. Can you believe what I do for a living?

The real estate, especially the development, industry is closely watching the resolution of this case. This is big-bucks. That said, does it make you uncomfortable to take an accounting method – by itself non-controversial – and stretch it to Dali-like and surrealist proportions? This is how tax law too often gets made.

I anticipate that the IRS will assert an argument involving contract aggregation and division. Once the land is implicated with further construction activity, the contracts (land and construction) will be aggregated. The ultimate sale (in our case, the home) will accelerate tax recognition on any underlying contract (in this case, the land). Might be a nightmare for accountants to trace all this, but it makes more sense than Howard Hughes Corporation delaying paying taxes on the sale of Summerlin lots until 2039.