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IRS Temporary Regulations May Permanently Impact Manufacturers

September 14, 2016 | Michael Fitzgerald

Michael Fitzgerald | Tax Partner

Mike has been in public accounting since 2005 and primarily serves closely held/privately held companies operating in a wide variety of industries, including: manufacturing, distribution, private equity, high technology...

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In September 2015, the IRS issued several proposed and temporary regulations under a notice of proposed rulemaking, REG-136459-09. This notice covered a range of topics related to the Domestic Production Activities Deduction (DPAD), including deductions for oil-related activities, production and construction definitions, film licensing, and changing which party is eligible for the deduction when property is produced on behalf of another (e.g. “contract manufacturing”).

Companies that outsource all, or a portion, of their manufacturing process will want to pay particular attention to how the rules are likely to change for determining qualification for DPAD. 

What’s Changed

The rules for the DPAD have evolved over the years, and currently both manufacturers and their subcontractors face a confusing and uncertain “test” when attempting to determine which party is eligible for the deduction. Specifically, the party seeking to claim the DPAD must be able to show that they bear the “benefits and burdens” of ownership over the manufactured property while the qualifying activity occurs. Unfortunately, making this determination is seldom clear-cut in the real world and the IRS remains concerned that, due to the confusion, multiple parties are claiming the deduction related to a single activity.

The goal of the October proposal is to limit the deduction to one taxpayer per instance through simplification of the existing rules. Under the proposed rule, the taxpayer that actually performs the act of production (“qualifying activity”) is the only party eligible for the deduction, regardless of any other Illustration of IRS Proposed Rulefactors.

For example: Company A in Boulder, CO, markets and sells granola outsources the actual production to another company (Company B in San Francisco, CA), which has the personnel, facilities, and processes in place to mix the oats, honey, nuts, and other ingredients into a final product. Company A retains title to the property and maintains insurance on the goods, oversees quality control functions and testing of the finished product. According to the IRS’ proposed rule changes Company B would be eligible for the Domestic Production Activities Deduction, while Company A would not.

It is important to note that none of the new IRS proposals are currently binding, but may become so at any time. So, until the new rules are finalized, companies may choose whether to apply the existing rules or adopt the proposed rules.

What It Means

In practice, many of the same companies that have been taking the DPAD all along may still do so. However, considering that the deduction can be a significant source of tax savings for a business, all companies should assess their position. 

In anticipation of the proposed rules becoming mandatory, companies that hire manufacturing contractors should ask themselves the following questions:


1. Have we taken on unnecessary expenses to qualify for a deduction we will no longer receive? For example, insurance and quality control may be fairly transferred to the contract manufacturer. 

2. Should we bring the qualifying activity (manufacturing activity) in-house? In some cases, the availability of the deduction might be the “tipping point” necessary to begin manufacturing the product directly. 

3. Does it make more or less sense for us to move this production process overseas? In some cases, the loss of the deduction may change the economic calculus in favor of an overseas manufacturing option.


On the other hand, companies who manufacture goods under contract with an outside party, especially those that had not considered claiming the DPAD in the past, should speak with their tax advisor regarding the proposed changes.

Conclusion

While newly proposed regulations from the IRS are not yet binding, it’s a good time for manufacturing companies to reevaluate their current approaches to the DPAD. Those who have not previously considered it should consult with a CPA to see if they might be eligible now or when the regulations become mandatory. Manufacturers who have chosen to outsource some, or all, of their processes should take the time to consider how to move forward, perhaps with some significant changes to their processes. As always: manufacturing contractors who might have previously assume they do not qualify for the deduction should carefully weigh their options and consider speaking with their tax advisor. 

EKS&H helps manufacturers with a range of issues, from accounting to tax and audit, to technology and talent. We have over 300 Colorado-based manufacturing clients, and partner with many industry organizations, including the Colorado Advanced Manufacturing Alliance (CAMA), the Colorado Association of Commerce & Industry (CACI), and the National Association of Manufacturers (NAM).

To learn more about how EKS&H can help your manufacturing company find all the tax deductions it qualifies for, please contact Senior Manager Mike Fitzgerald at 303-796-4383 or mfitzgerald@eksh.com.
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