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.
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.