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IRS Proposes Regulations to Reduce Tax Incentives on Food and Beverage Manufacturers

Every business in the Food and Beverage Industry, large and small, should consider the effectiveness of the manufacturing deduction (also known as Section 199 deduction) as part of its business plan in 2016. The tax incentive represents an incredibly valuable benefit for businesses that perform manufacturing and other production activities. While the computations behind the deduction can be daunting, more businesses are finding the effort worthwhile in tax savings.

The tax benefit for this incentive has become so great that the IRS is now trying to curtail the deduction by aggressively imposing their administrative powers, to try to overcome judicial decisions that are taxpayer-friendly. For example, in United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal 2013), the court held that a taxpayer who combined two or more purchased raw materials to assemble a new item is eligible for the manufacturing deduction. Any lean manufacturing or rudimentary operational process in the Food and Beverage Industry utilizes this type of operating mechanism to create the goods for sale. In Dean, the government argued that the activities of a gift basket assembly manufacturing process constituted packaging and repackaging that did not qualify for the deduction. The court disagreed with the government and concluded that the taxpayer produced gift baskets and gift towers, ‘distinct in form and purpose from the individual items’ and sustained the deduction for the taxpayer.

Not accepting the defeat well, the IRS recently proposed new regulations that fly in the face of Dean. The Service is now taking a two-pronged approach in attempting to curtail the deduction for many manufacturers, particularly in the Food and Beverage Industry.

First, the proposed regulations modify an example (Regs. Sec. 1.199-3(e)(5), Example 5) to clarify that certain activities, performed alone, will not be treated as manufacturing activities, unless they are performed as part of other activities that do constitute qualifying processes. Second, the proposed regulations add a new example that is in direct opposition to Dean. The preamble to the proposed regulations explains that if the taxpayer engaged in no other activities, the taxpayer will be treated as not having manufacturing activities. In the new example (Example 9), the IRS and Treasury interpret Regs. Sec. 1.199-3(e)(2) in a situation where the taxpayer is engaged in no other qualifying activities than packaging, repackaging, labeling or minor assembly. The new example has facts that are strikingly similar to the fact in the Dean case.

While the new regulations are just proposed, they are a foretaste of what is yet to come for manufacturers and retailers in the Food and Beverage Industry. Here are our observations on what to do to maximize your manufacturing deduction in this industry:

  • Make sure that the packaging and assembly processes are tied to market research or other market suitability functions in the production process. This concept comes directly from a recent that was another taxpayer victory (See., Precision Dose, Inc. v. United States, No. 3:12-cv-50180 (N.D. Ill. 2015)).
  • Make all packaging and re-packaging processes create unique products so that the gross receipts from the sale of the products (the key part of the calculation-intense methodology of claiming the deduction) result in domestic production gross receipts as defined in the regulations.
  • Carefully analyze the back-end of your lean manufacturing process to ensure that the combination of two or more separately identifiable products into one is actually changing the form and function of the item, resulting in a new product with a different demand (This was recently the focus of the IRS’s Chief Counsel in another recent IRS administrative decision (See, CCA, 201246030)).

In conclusion, the manufacturing deduction is a key planning tool for all of our Food and Beverage Industry clients. The worst type of manufacturing deduction continues to be the one that is not taken. The examples and guidance contained in this article are meant to allow you to take steps to make sure your manufacturing operations maximize your ability to minimize your tax liability as a Food and Beverage manufacturer.

If you have any questions about how these regulations may affect you or your business, please contact your Davis & Kuelthau attorney.