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By Robin L. Greenhouse, Esq., and Dwight N. Mersereau, Esq.
McDermott Will & Emery, Washington, DC
In a recently published Internal Revenue Service (IRS) Chief Counsel Advice (CCA 201313020, March 29, 2013), the IRS National Office concluded that a book publisher's activities in producing the "electronic" versions of books that were "printed" by a third party were not "production" activities for purposes of the §199 deduction (§199 allows a deduction based on a percentage of the taxpayer's profits from producing property in the United States). The IRS National Office's analysis of that issue, however, is flawed. First, as discussed below, the IRS National Office reached its conclusion by analyzing only the production of the "electronic" version of the books, rather than the production of the final printed copies that the taxpayer sold. Second, the IRS National Office made a sweeping rejection of authorities under §263A based on erroneous reasoning.
The taxpayer is a publisher of books and other printed materials. It designs, develops, packages and distributes the books. For example, its activities include market research; resource planning; content and layout development; editing; and developing print specifications, such as the type of paper, page sizes, type of printing process, type of ink, and whether to bind the books with thread, staples or glue. The taxpayer contracted with third parties to print the books according to the taxpayer's design and specifications. It provided the third-party printers with electronic versions of the books that contained the design and print specifications.
The IRS's Analysis
The IRS National Office concluded that the taxpayer's activities produce only electronic, intangible copies of the books, and therefore the taxpayer does not qualify under §199 because §199 applies, with exceptions not relevant, only to taxpayers that produce tangible property. Under §199, however, taxpayers and the IRS are required to determine whether the taxpayer produces the property that the taxpayer regularly sells. Regs. §1.199-3(d)(1)(i). The taxpayer at issue in the CCA does not sell electronic copies of its books; it sells tangible copies of its books, which it contends it produces in significant part, even if it doesn't apply ink to paper.
The IRS's Focus on the Electronic Copy Is Erroneous
The standard used to determine whether a taxpayer produces property in significant part is based on all the facts and circumstances, including the relative value added by, and relative cost of, the taxpayer's production activity, the nature of the property and the nature of the production activity performed by the taxpayer. Regs. §1.199-3(g)(2).
While the taxpayer's design, content, layout and printing specifications do result, as an intermediate step, in electronic copies of the books, those activities essentially control the entire production process, and are an essential and integral part of producing the tangible copy of the book. Certainly the activities of the third-party printers alone could not produce a book.
The taxpayer's argument is supported by Suzy's Zoo v. Comr., 273 F.2d 875 (9th Cir. 2001). The question in that case was whether the taxpayer "produced" greeting cards that the taxpayer had printed by third-party printers. The Ninth Circuit found that the taxpayer produced the greeting cards because the taxpayer "is the owner of the cards from the beginning stage of production due to the degree of control it exercises over the manufacturing process." The court explained how the taxpayer produced the greeting cards through the exercise of control over the third-party printers:
Suzy's Zoo dominates the manufacturing process from the start and gives detailed specifications to the contractors on how its products should be manufactured. It creates the cartoon images imprinted on its products, in the absence of which they would likely not be sold. The creation of these images is a significant, if not the most important, part of the production process. Suzy's Zoo chooses the products and the manner in which they should be produced and employs different contractors to perform each step of production. The contractors are merely the instruments by which Suzy's Zoo produces its products.
The Tax Court, in the opinion below, stated that the taxpayer is the "only `owner'" of the products and further explained that the production process begins with the taxpayer's creation of the design, the most important step in the production process:[Suzy's Zoo's] ownership interest in the paper products attaches at the first stage of their production; i.e., when the cartoon characters are developed and drawn. [Suzy's Zoo] performs this step solely by itself, and this step, which requires the most skill, expertise, and creativity of any step in the process, is critical and indispensible to the paper product's production.
Thus, Suzy's Zoo stands for the proposition that the design and creation of certain printed products is a significant, if not the most important, part of the production of the printed products, and that a taxpayer that creates the design and exerts sufficient control over the printing process is the owner and producer of the property. This analysis may at least inform a court's view of Regs. §1.199-3(g)(2).
The IRS's Sweeping Rejection of §263A Is Erroneous
The IRS National Office stated that Suzy's Zoo and other authorities under §263A are "not useful" for determining whether a taxpayer qualifies under §199 because it believes that a taxpayer can be a producer under §263A and yet not be a producer under §199. The IRS National Office's conclusion, however, is based on a misreading of Suzy's Zoo and §263A, if not §199.
The IRS National Office stated that "§263A cases determine whether a taxpayer is a producer by relying on activities that, under §199, result in the creation of intangible property." Sections 263A and 199, however, look to the same property (the property sold by the taxpayer) and ask the same question (who produced it). The intermediate step of creating an intangible, which the IRS National Office focused on, is simply an incomplete analysis of the issue.
As the previous quotes from Suzy'sZoo demonstrate, the court determined that the taxpayer produced the tangible printed greeting cards, not just the intangible cartoon character designs. It based that holding in part on the influence the taxpayer exercised over the entire production process, which began with the creation of the design, and held that the third-party printers were "merely the instruments by which Suzy's Zoo produces its products."
The fact that the Ninth Circuit, in holding that the taxpayer produced the tangible printed greeting card, looked to the entire production process, including activities that occurred prior to the actual printing, does not make the case irrelevant to a §199 analysis-in fact, doing so is at least consistent with Regs. §1.199-3(g)(2). In both situations the inquiry is, who produced the tangible product that the taxpayer sells?
The IRS National Office, however, focused solely on whether the taxpayer's activities in producing the electronic copies of the books as an intermediate step, in isolation, were qualifying activities. It did so at the request of the IRS Appeals officer. This limited focus, however, makes the CCA largely irrelevant to a proper §199 analysis because the only relevant issue is whether the taxpayer produced the printed books, and that determination cannot be made piecemeal, as it appears the IRS Appeals officer wants to do. To the contrary, as the court held in Suzy's Zoo, the production process begins with the design and ends with the product the taxpayer sells. Therefore, the CCA's sole focus on an intermediate step in the production process, as well as its conclusion that the activities leading up to that intermediate step are irrelevant to determining whether the taxpayer produced the final product, are erroneous.
For more information, in the Tax Management Portfolios, see Benko, 510 T.M., Section 199: Deduction Relating to Income Attributable to Domestic Production Activities, and in Tax Practice Series, see ¶2220, Deduction for Domestic Production Activities.
© 2013 McDermott Will & Emery
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