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Proposed IRS Regulations Oppose Court Decision



Annette Nellen

Continuing with my list of ten news items and activities from 2015 that I think have particular tax policy relevance.  Today, for my fourth item is an odd and unfortunate way that the IRS is telling us they disagree with a 2013 court decision. In August 2015, the IRS issued proposed regulations under Section 199, Income attributable to domestic production activities – REG–136459–09 (8/27/15). This provision was added in 2004 and provides a “bonus” deduction for taxpayers engaged in domestic manufacturing which is broadly defined to include some construction, film production, and software development. It is a fairly complex provision that involves numerous definitions and allocations to identify the specified income that then generally produces a 9% deduction for the taxpayer.

The issue helps show the complexity that is involved when special rules exist. Special rules require precise definitions to know what qualifies and what does not. The particular issue I’m referring to what constitutes minor assembly (no 199 deduction) versus production (generates a 199 deduction).

Per the IRS, one purpose of the proposed regulations is to clarify this distinction AND attempt to reverse a 2013 District Court decisions. Per the preamble to the proposed regulations:

“Section 1.199–3(e)(2) provides that if a taxpayer packages, repackages, labels, or performs minor assembly of QPP and the taxpayer engages in no other MPGE activities with respect to that QPP, the taxpayer’s packaging, repackaging, labeling, or minor assembly does not qualify as MPGE with respect to that QPP. This rule has been the subject of recent litigation. See United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) (concluding that the taxpayer’s activity of preparing gift baskets was a manufacturing activity and not solely packaging or repackaging for purposes of section 199). The Treasury Department and the IRS disagree with the interpretation of § 1.199–3(e)(2) adopted by the court inUnited States v. Dean, and the proposed regulations add an example (Example 9) that illustrates the appropriate application of this rule in a situation in which the taxpayer is engaged in no other MPGE activities with respect to the QPP other than those described in § 1.199–3(e)(2).”

Example 9 is the Dean case with an opposite conclusion than reached by the court. The court noted that there were no other cases on this issue. It described Dean’s gift basket creation process as complex and involving a production process. Per the court: “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.”

The IRS did not appeal the Dean case or issue an Action on Decision (such as to say it does not agree with the case (nonacquiescence). It is not known if the IRS asked Congress to clarify Section 199 to support its position in the Dean case.

And, interestingly enough, a few weeks after the proposed reg was issued, the District Court for the Northern District of Illinois issued an opinion in Precision Dose, Inc., No. 12C50180 (9/24/15), that cited the Dean case in support of its conclusion that a producer of medicines packaged in single dose containers was not involved in minor assembly. The court primarily refers to therather than the statute. This court, though, states what it thinks is minor assembly (putting items in a grocery cart). Per the court:

“The government argues Dean is wrongly decided. It contends the Dean court failed to understand that all Houdini’s activities were just part of the repackaging process and thus did not take those activities outside the (e)(2) exception. However, the court disagrees. Dean correctly determined that Houdini was creating an entirely new product — a gift basket or gift tower — which was not simply a method of repackaging the components included in the baskets or towers. A gift basket is not simply a container of stuff — like a grocery cart in which the items had been dropped when pulled from the shelf. It is a unique product itself. Likewise, a unit dose is a unique product. Plaintiff is entitled to the Section 199 deduction.”

The regulations are proposed. I don’t see that any comments are posted yet on it (at least on the Federal Register website). I assume commentators will address the issue of writing a regulation to support its losing position. If the IRS ends up finalizing the regs as they are, courts do not need to follow them. They can find that they are contrary to the statute.  Perhaps Congress will step in.  We’ll see. But this all just seems like an odd way to oppose a court decision where the IRS lost, and not a good use of time to resolve the matter.

What do you think?

My list so far of news and activities of 2015 with tax policy relevance (no ranking involved):

1. Congress can alter our tax system via a lot of non-tax bills – here

2. IRS funding challenges – here 

3. Justice Kennedy called for a review of the 1992 Quill decision – here

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Annette Nellen, CPA, Esq., is a professor in and director of San Jose State University’s graduate tax program (MST), teaching courses in tax research, accounting methods, property transactions, state taxation, employment tax, ethics, tax policy, tax reform, and high technology tax issues.

Annette is the immediate past chair of the AICPA Individual Taxation Technical Resource Panel and a current member of the Executive Committee of the Tax Section of the California Bar. Annette is a regular contributor to the AICPA Tax Insider and Corporate Taxation Insider e-newsletters. She is the author of BNA Portfolio #533, Amortization of Intangibles.

Annette has testified before the House Ways & Means Committee, Senate Finance Committee, California Assembly Revenue & Taxation Committee, and tax reform commissions and committees on various aspects of federal and state tax reform.

Prior to joining SJSU, Annette was with Ernst & Young and the IRS.

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