The U.S. District Court for the Northern District of Illinois recently upheld a taxpayer’s domestic production activities deduction (DPAD) in Precision Dose, Inc. v. United States of America. Case No. 12 C 50180. The deduction is based in large part on qualifying production property that a taxpayer manufactures, produces, grows or extracts in whole or significant part within the United States. However, if a taxpayer only packages, repackages, labels or performs minor assembly on property and engages in no other manufacturing activity with respect to the property, the taxpayer’s packaging, repackaging, labeling or minor assembly does not qualify as manufacturing or production for DPAD purposes.
In Precision Dose, the taxpayer sold unit doses of medication, which were liquid drugs sealed in cups or syringes intended as a single dose. The court ruled that while the taxpayer did not produce the drugs, cups or syringes, the taxpayer did produce the unit doses by applying its manufacturing process to create a unit dose composed of the individual drugs, cups and syringes. For example, the taxpayer worked with customers to “identify needs for new unit dose products,” worked with vendors to develop cups and syringes that were suitable for each unit dose drug and tested plastics to “determine compatibility with specific drugs for use in the cups or syringes.” The court reasoned that these activities and others demonstrated that the taxpayer engaged in a “complex production process that results in a distinct final product.” The court based much of its reasoning on United States v. Dean, in which the U.S. District Court for the Central District of California held that a taxpayer that designed gift baskets qualified for the section 199 deduction.
Taxpayers should note that the IRS’ past actions indicate that it may not follow this court ruling in audit. In particular, the IRS recently issued proposed regulations and stated in the preamble that it did not agree with the Dean court’s ruling. The Service included an example with virtually identical facts to Dean and the example concludes that the taxpayer only engaged in minor assembly and did not perform any manufacturing or production activity. The Service has requested comments on the proposed regulations and will hold public hearings on the regulations on December 16, 2015.
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