07 April 2020 District Court finds publisher entitled to IRC Section 199 deduction In Meredith Corp. v. United States (Meredith),1 the U.S. District Court for the Southern District of Iowa (court) held that a magazine publisher could claim an IRC Section 199 deduction related to its publications, and thus was entitled to a refund from the IRS. The court applied an eight-factor test in determining that the publisher, as opposed to the printers contracted to print the publications, carried the "benefits and burdens" of ownership in the publications during the manufacturing process and thus was entitled to the IRC Section 199 deduction. Observation: The Meredith decision is only the second decision evaluating the "benefits and burdens of ownership" under IRC Section 199. The taxpayer in the first case, ADVO Inc. v. Commissioner (ADVO), 141 T.C. 298 (2013), was also a publisher that used a contractor to produce its publications. The ADVO case was decided in favor of the government. The magazine publisher contracted with printing companies to print its publications. The publisher: (1) bought the paper and then supplied it to the printers; (2) owned the paper the entire time it was in the printers' possession; (3) created the content to be printed; (4) directed the printers how to print the content; and (5) often had employees at the printers checking the quality of the printing. The publisher claimed an IRC Section 199 deduction for its publications in tax years 2006 to 2012. One of the publisher's printers also claimed the IRC Section 199 deduction during some of the tax years at issue. The IRS disallowed the publisher's IRC Section 199 deductions and assessed additional tax totaling over $12 million for the tax years at issue. In 2016, the publisher paid the additional tax and filed for a refund in 2017. When the IRS took no action, the publisher filed a lawsuit to request a refund as permitted under IRC Section 6532(a)(1). IRC Section 199 allows taxpayers to deduct an amount based on "[i]ncome attributable to domestic production activities." When a qualifying activity is performed under a contract, Treas. Reg. Section 1.199-3(f)(1) treats only the party with the benefits and burdens of property ownership during the period in which the qualifying activity occurs as engaging in the qualifying activity. The U.S. district court judge conducted a bench trial; as such the judge was both the fact finder and determined the ultimate legal conclusions based on the facts. In finding in the taxpayer's favor, the court relied on Eighth Circuit precedent, Upham v. Commissioner, 923 F.2d 1328 (8th Cir. 1991) (a non-IRC Section 199 benefits-and-burdens case), to determine ownership using factors in a benefits-and-burdens analysis. The court used the findings of fact in discussing the factors considered to determine which party had the benefits and burdens of ownership. Specifically, the court looked at the publisher's role and intent in purchasing paper (including cost control and quality control), the publisher's ownership of the paper, and restrictions on the printers with respect to the paper. The court also noted the intangible and intellectual property created by the publisher with respect to the publications. In addition, the findings of fact discussed the publisher and printers' interactions, the detailed standards established for the printers, the printers' machinery, and the publisher's ownership of the paper throughout the process. The court highlighted the testimony of some witnesses who asserted that the printers owned the "work in progress" but conceded that the title to the paper was never transferred to the printers. The court reviewed (1) the publisher's activities with respect to quality control during the printing process; (2) witness testimony that the printers were providing a service; (3) the costs and risks borne by the printers and the publisher (including the 2008 costs of materials and labor, property tax payment, insurance, obligations with respect to defective publications, and cost sharing and exclusive costs borne by the parties); and (4) contract negotiations in which the publisher engaged during the years at issue to establish its claim to the IRC Section 199 deduction for production activities (although some contract terms were changed, the court found that the underlying activities did not change). In its conclusions of law, the court reviewed the legislative and regulatory history of IRC Section 199 and found that publishers were clearly intended to be included as "manufacturers" for purposes of IRC Section 199. The court concluded, "In sum, the Treasury regulations show that a product's designer — rather than a manufacturer — can claim [an IRC Section] 199 deduction but must have (1) the benefits and burdens of ownership (2) during the [production] period." The court also analyzed whether the publisher's production of editorial and preprint processes, or only physical production of the tangible property, could be included as part of the production period. This analysis reflected the court's prior reasoning in its denial of the publisher's summary judgment motion. See Meredith Corp. v. Commissioner, 405 F. Supp 3d 795 (S.D. Iowa 2019) (taxpayer's content creation, layout design and other pre-print activities should not be considered in determining which party had benefits and burdens of ownership, as such activities created intangible assets that are not qualified production property). The court also concluded, however, that the pre-production activities can be considered in determining the IRC Section 199 deduction once the publisher is found to have the benefits and burdens of ownership. The dispositive issue addressed in the court's conclusions of law was whether the publisher "had the benefits and burdens of ownership of the physical magazines while they were being physically produced." The court considered the following factors relevant in its "benefits and burdens" analysis: "(1) who holds legal title; (2) the contracting parties' intent; (3) who holds equity in the publications; (4) who exerts more control over the publications, including but not limited to the right of possession and who actively participated in management of activity; (5) who bears the risk of loss; (6) who receives the profits or other benefits from the disposition of the property; (7) who maintains ownership of the underlying rights in the publications; and (8) who pays property taxes."
Observation: The court found the trial testimony of both the publisher's and the government's witnesses persuasive as to how the parties perceived the arrangement and focused on the inconsistencies from the government's witnesses in acknowledging that the publisher retained title to the paper throughout the production process and asserting that the printers had sold the publisher a product.
Observation: Throughout the decision, the court emphasizes that the ownership of the paper remained with the publisher at all times under the contracts. It is unclear if the printers would be required to abandon their property (the unprinted paper) as a result of abandoning the transaction (i.e., printing contract), or if the court makes that assumption. Based on contract excerpts in the court's analysis of the legal title factor, it appears that paper remains the sole property of the publisher under the contracts throughout the production process.
Observation: In discussing this factor, the court cited a regulation example that discusses design activities and intellectual property and notes that these should be considered in evaluating this factor. In ADVO, the Tax Court did not specifically identify the ownership of the underlying rights in the publication as a benefits-and-burdens factor.
Observation: The court notes that the title passage terms "create tension with other provisions of the contract that suggest the paper on which the printers printed remained Plaintiff's property throughout production … Nevertheless, the Court concludes such tension is better assessed under other benefits and burdens of ownership, such as intent … " Observation: The court limited its analysis of risk of loss to losses from damage, both immediate and "downstream." For immediate losses (property destruction), the contracts required the printer to have insurance on the publisher-supplied materials and copies of the publications until shipped. The publisher also carried insurance to cover property loss and lost profits, although the publisher's insurance was not required by the contract. The court observed that the downstream risk of loss (defective production) fell on the publisher. The court stated that the printers would lose printing fees, while the publisher would suffer greater loss in advertising revenue in compensating an unsatisfied client.
Observation: The court contrasted the specific facts present in this case to the ADVO case when evaluating the day-to-day control exercised by the publisher. The court's analysis of this factor reflects the details of the course of conduct between the parties, which were outlined in the court's finding of facts. The court was also persuaded by the assertions of the publisher's expert witness regarding this factor, as the expert witness was the government's expert witness in the ADVO case.
The court found for the publisher because most of the benefits and burdens of ownership factors were Observation: Throughout its decision, the court frequently mentioned that the publisher purchased and retained ownership of the paper used in the production of its publications. This ownership was an important consideration in assessing the contracting parties' intent, equity in the property, economic profit or loss, and property taxes (three of which the court found weighed in the publisher's favor). The prominence this ownership had in the court's findings indicates that it was the most persuasive evidence presented by the publisher. The court concluded that "it might seem more natural for a tax deduction meant to promote manufacturing to go to hands-on manufactures. But that is neither the law Congress authored nor the regulations the Treasury prescribed. And given decades of tax law that treated taxpayers who never touched a machine as a manufacturer, [IRC Section] 199 is no anomaly." The Meredith decision is an important case in that it describes, in more detail and using examples of the testimony of witnesses, its rationale more thoroughly than the Tax Court's decision in ADVO. The Meredith court diverged from ADVO in the application of some of the benefits-and-burden factors. There are several other similar cases pending, or for which stipulated decisions have been entered, for which the benefits and burdens of ownership is the determinative issue (see, for example, YP LLC, Partnership v. Commissioner, Tax Court Dkt. No. 23101-18 (publisher); L Brands, Inc. v. Commissioner, Tax Court Dkt. No. 14121-13 (personal care products; stipulated decision) HIBU Group (USA), Inc. v. Commissioner, Tax Court Dkt. No. 1043-16 (publisher; stipulated decision); AT&T Advertising, L.P. v. United States, Fed. Court of Claims Dkt. No. 16-272 (publisher); Bare Escentuals, Inc. v. Commissioner, Tax Court Dkt. No. 30729-15 (personal care products; stipulated decision)). The Meredith decision could provide useful guidance to the U.S. Court of Federal Claims in AT&T Advertising, L.P. v United States (Dkt. No. 16-272), which presents very similar facts. In denying taxpayer's motion for summary judgment in that case, the court cited Meredith and ADVO on the issue of whether the taxpayer had the benefits and burdens of ownership during the production process. See AT&T Advertising, L.P. v United States at 125 A.F.TR. 2d 2020–1130 (March 5, 2020). Like Meredith, AT&T Advertising appears to retain title to the paper used by its contract printers; the circumstances under which the printing services are performed and the contract terms are also similar to those of the taxpayer in Meredith. As the court in AT&T Advertising denied summary judgment, finding a genuine dispute of material facts regarding which party maintained the benefits and burdens of ownership, the case will now be set for trial. For taxpayers under examination for IRC Section 199 deduction claims, the Meredith case provides important insights into (1) the value of live testimony by persons with first-hand knowledge, (2) the importance of retaining title to the most significant raw material, (3) the relevance of contract terms, and (4) the significance of details about the interactions between a taxpayer and contract manufacturer when establishing the taxpayer's benefits and burdens of property ownership during the production process.
Document ID: 2020-0903 | |||||||||||
