Monday, August 26, 2013

Tax Break for American Manufacturing of Gift Baskets

The section 199 "domestic production activities deduction" is a tax break for companies engaged in certain manufacturing and production activities in the United States, such as Detroit car manufacturers and Minnesota iron mining companies.  The tax break reduces the companies' tax rates by around 3%, after some complicated calculations and requirements.  The domestic production activities deduction is often complained about as a tax break for Big Oil, since the oil companies are entitled to the same tax break as other businesses.

In the landmark case of Dean v. Commissioner, 112 AFTR 2d (2013), the District Court for the Central District of California concluded that manufacturing includes the creation of gift baskets.

The case involved Houdini, Inc., a company that designs, assembles, and sells gift baskets.  Its 300 permanent employees and 4,000 seasonal employees select certain items, such as candy or wine, to make a gift basket.  The gift items, and the basket itself, are purchased in bulk from other companies in China and the United States.  Houdini's employees work in an assembly line in California to put the different items in the basket, and they plastic wrap the resulting basket with decorative bows. 

Treasury Regulation 1.199-3(e)(1) provides that manufacturing includes "making [property] by processing, manipulating, refining, or changing the form of an article."  The District Court concluded that Houdini's production process changed "the form of an article" because the assembly of the gift basket was a "complex production process" using assembly line workers and machines.  The company produced a final item (a gift) that was distinct in form and purpose from the individual items inside (groceries).  The company went beyond merely packaging or labeling a product, which by itself would not have counted as manufacturing.  Accordingly, the taxpayers (owners of Houdini, Inc.) were allowed to claim the section 199 domestic production activities deduction. 

In a separate matter, the Internal Revenue Service in field attorney advise memorandum 20133302F concluded that photo labs are engaged in manufacturing and production activities that qualify for the section 199 domestic production activities deduction.  The photo lab, located in a pharmacy, used its own equipment and "raw materials (the photo paper, ink and other chemicals) to produce a different tangible product in form and function -- finished photos or photo books sold to its customers."

Houdini Inc. and pharmacy photo labs may be considered prime examples of the American manufacturing renaissance.

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