On October 24th, 2013, in Advo, Inc. & Subsidiaries, Petitioner v. Commissioner of Internal Revenue, Respondent (“Advo”), 141 T.C. No. 9, the United States Tax Court held that the taxpayer did not have the “benefits and burdens of ownership” of the direct advertising materials, and was therefore not entitled to the IRC section 199 Domestic Production Activities Deduction (“DPAD” or “DPD”). The only issue decided by the court in its opinion was whether the Petitioner was entitled to a section 199 deduction for manufactured, produced, grown, or extracted qualifying production property with respect to the Petitioner’s direct advertising mailings.

During the tax years in question, 2006 and 2007, Advo distributed direct mail advertising in the United States. Advo either received the advertising material from its clients, or Advo supplied the materials to distribute. If Advo supplied the material to distribute, it contracted with third party commercial printers. The relationship between Advo and its third party commercial vendors was at issue in this case.

Advo’s graphic print department assisted its clients with the design of the advertisement graphics. The graphic design requirements in regards to Advo supplied clients fell into three categories: “rough art,” “reprint with changes,” and “client-supplied art.” In the first two categories, Advo retained ownership of all intellectual property associated with the artwork and advertisements. In the third category, Advo’s client retained the ownership of the intellectual property related to the art. Advo’s graphic design department was responsible for developing the graphic design files before they were sent to a third party printer, who was responsible for printing the advertisement. The contracts between Advo and its third party printers contained “risk of loss” provisions, that generally stated title to and risk of loss, damage to, and delay of the manufactured products shall pass to Advo upon delivery to Advo’s branch facility. Advo’s third party printers were required to maintain insurance with respect to all of Advo’s work in progress and all materials. Though not referred to the in findings of the case, it is notable that the court did not challenge the underlying printing activity has qualifying domestic production activity.

The party entitled to the § 199 deduction – the taxpayer or its third-party contractors – was the party that bore the “benefits and burdens of ownership.” The Court reviewed nine factors prescribed by section 199:

A. Whether legal title passes;
B. How the parties treated the transaction;
C. Whether an equity interest was acquired;
D. Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments;
E. Whether the right of possession is vested in the purchaser and which party has control of the property or process;
F. Which party pays the property taxes;
G. Which party bears the risk of loss or damage to the property;
H. Which party receives the profits from the operation and sale of the property; and
I. Whether the contracting party actively and extensively participates in the management and operations of the activity.

After examining all of the facts and circumstances in the case, the court held that Advo did not have the benefits and burdens of ownership while the advertising material was printed.

In response to the Tax Court’s holding in Advo, Inc. & Subsidiaries v. Commissioner of Internal Revenue, the IRS issued updated guidance (LB&I-04-1013-008) for Examiners on IRC section 199 benefits and burdens of ownership analysis in contract manufacturing arrangements. In a simplified approach, the guidance set out a three-part protocol for determining whether a taxpayer bears the benefits and burdens of ownership for purposes of § 199. LB&I Examiners should request:

1. a statement that explains the basis for the Taxpayer’s determination that it had the benefits and burdens of ownership in the year or years under examination;
2. a certification statement signed by the taxpayer; and
3. a certification statement signed by the counterparty.

The Taxpayer should provide the benefits and burden statements, as well as the Certification Statements, for each contract to the examiner within thirty days of that date that an information document request is issued to the Taxpayer with respect to the section 199 deduction. If the Taxpayer provides the benefits and burdens statement and Certification Statements, the Examiner should not challenge that the Taxpayer has the benefits and burdens of ownership for purposes of section 199.