Manufacturer builds case for $5.7M Section 199 deduction

gears hand[Download the PDF]
Case study

The client manufactures can machinery and has total assets of about $1.8 billion and annual revenues of approximately $500 million. This U.S.-based company operates in two locations in the United States and seven countries.   

The situation
Because the company manufactures in the United States, it made sense to analyze whether it qualified for the Internal Revenue Code (IRC) Section 199 domestic production activities deduction (DPAD). The deduction was established to create tax benefits for companies that manufacture products in the United States. It can be significant — either 9% of a company’s taxable income or 9% of its qualified production activities income (for tax years 2010 and forward). Despite what seemed like a natural fit with DPAD, though, the manufacturer hadn’t pursued the deduction and wasn’t interested in doing so. Grant Thornton LLP’s Federal Tax Services team had been providing the manufacturer’s tax compliance services and worked with Grant Thornton’s Strategic Federal Tax Services (SFTS) team in evaluating an opportunity for the deduction.  
The challenges
The Grant Thornton team had to overcome obstacles — perceived and real. The company viewed itself as more of an assembly line than a manufacturer. Its financial executives also believed the company would have trouble meeting a safe harbor requirement that direct labor and overhead account for 20% or more of the end product’s overall costs. Given that this manufacturer created massive machines made of high cost industrial steel, the raw materials cost significantly more than the labor to weld and assemble the machinery. As a result, the company struggled to meet the safe harbor threshold.

Another accounting firm had previously warned the company that applying for the DPAD would create risk. Not only would the company  be subject to increased IRS scrutiny, it would also need to identify the actual labor hours that went into every piece of every part of the machines. This was a daunting prospect for the manufacturer to attempt alone, and its financial executives assumed the cost would be exorbitant if they hired a third party to estimate the time expenditures.

The manufacturer, which had just been acquired by a foreign company, had some unfavorable tax adjustments, resulting in taxable income of about $60 million. The SFTS team, along with the Tax team, agreed to approach the subject with the CFO. The CFO was convinced that DPAD posed too much risk because of the company’s inability to meet the safe harbor.

What the team did
The SFTS team met with the CFO several times regarding the examples in the Treasury regulations and the significant amount of recent case law supporting the overall qualification for DPAD. Together, the SFTS team and the CFO estimated a preliminary deduction on one of the end products. At that point, the CFO was won over and engaged the team for a Phase I analysis to calculate the total benefit.

To become familiar with the manufacturing operations, team members toured the plant and conducted interviews about the operations and manufacturing process. They analyzed the identified revenue streams and the relevant costing data to determine which streams and costs qualified.

Because the manufacturer didn’t meet the safe harbor threshold, the team built a facts-and-circumstances case, as prescribed in the IRC Section 199 Treasury regulations, to support the overall deduction. Team members combed Treasury regulation examples, court cases, revenue rulings and private letter rulings for similar facts patterns to draw parallel conclusions.   

The outcome
The manufacturer’s deduction for 2012 was $5.7 million, and it reduced the company's tax liability by $2 million. This resulted in a large overpayment to be applied to the 2013 tax liability. In 2013, the manufacturer produced more in its foreign plants, reducing the portion of its revenue that could be treated as qualified production activities, so the overall deduction was reduced. But the manufacturer hadn’t anticipated qualifying for DPAD in 2012 and 2013, meaning the company still could reduce its 2013 third-quarter estimated tax payment by $3 million.

More good news is that there have been no questions or challenges from the IRS, and the once-skeptical CFO said the outcome made her look good to her bosses and the board.

Rob Levin
+1 404 475 0190

Colette Gagnet
+1 303 813 3487

Tax professional standards statement
This document supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document, we encourage you to contact us or an independent tax adviser to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this document is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.