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November 5, 2013

2013 - Issue 45—If you are a taxpayer who has excluded certain activities that you deemed to be mere “packaging” or “assembly” from your Section 199 Domestic Production Activities Deduction (DPAD), now is the time to reassess those activities. A recent California federal district court case, U.S. v. Dean, No. 11-01977 (C.D. Cal. 2013), held that the design and assembly of gift baskets constituted manufacturing under Section 199 and qualified for the deduction.

Section 199

The DPAD was primarily designed to protect United States jobs and replace the extraterritorial income exclusion. It covers a broad range of production activities, including the manufacture of tangible personal property; the production of computer software, sound recordings and certain films; the production of electricity, natural gas or water; and construction, engineering and architectural services.

The DPAD generally allows taxpayers to receive an additional deduction based on qualified production activity income (QPAI) resulting from domestic production. For all years after 2009, the deduction is limited to the lesser of:

  1. 9 percent of qualified production activity income;
  2. 9 percent of taxable income; or
  3. 50 percent of the Form W-2 wages that are deducted in arriving at qualified production activity income.

Qualified production activity income is defined as an amount equal to the excess (if any) of the taxpayer's domestic production gross receipts (DPGR) for such taxable year over expenses (direct and indirect) that are allocable to such production receipts.

Domestic production gross receipts are the taxpayer’s gross receipts derived from one of three qualifying activities:

  1. The lease, rental, license, sale, exchange or other disposition of:

    a. qualifying production property (QPP) that was manufactured, produced, grown or extracted (MPGE) by the taxpayer in whole or significant part within the United States,

    b. any qualified film produced by the taxpayer, or

    c. electricity, natural gas or potable water produced by the taxpayer in the United States;

  2. Construction of real property in the United States performed by a taxpayer engaged in the active conduct of a construction trade or business, in the ordinary course of such trade or business; or
  3. Engineering or architectural services performed in the United States by a taxpayer engaged in the active conduct of an engineering or architectural services trade or business, in the ordinary course of such trade or business, with respect to the construction of real property in the United States.

Gross receipts derived from the performance of services generally do not qualify as domestic production gross receipts.

Qualifying production property is tangible personal property, computer software or sound recordings. Tangible personal property includes any tangible property other than land or buildings (including structural components).

Section 199 does not provide a definition of “manufactured, produced, grown or extracted.” The Section 199 regulations broadly describe MPGE as “manufacturing, producing, growing, extracting, installing, developing, improving, and creating QPP.” This includes “making QPP out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles.”

However, the regulations also provide that if a taxpayer packages, repackages, labels or performs minor assembly of QPP and the taxpayer engages in no other MPGE activity with respect to that QPP, then the taxpayer's packaging, repackaging, labeling or minor assembly does not qualify for the deduction. These terms — packaging, repackaging, labeling and minor assembly — are not defined in the regulations, except for an example that states that customizing automobiles by adding roof racks, sunroofs, etc., is minor assembly and not an MPGE activity.

There is similar “assembly” language in Section 954, which describes the standard used to assess the level of activity (i.e., manufacturing or mere assembling) when purchased components are used to produce the property ultimately sold. An example in the Section 954 regulations states that the assembly of radio kits does not constitute manufacturing, production or construction of tangible personal property. However, the example states that an entity operating an automobile assembly plant that purchases assembled engines, transmissions and other components and that conducts stamping, machining and subassembly operations constitutes the manufacture of a product. The example states that the entity has a substantial investment in tools, jigs, welding equipment and other machinery and equipment used to assemble an automobile and that its operations are considered to be substantial in nature.

The Dean Decision: Transforming a Product’s Demand = Section 199 Manufacturing

The taxpayers in Dean were the owners of an S corporation, Houdini, Inc., that was in the business of “designing, assembling, and selling” gift baskets and gift towers through retail and wholesale distributors. Houdini purchases all the products used in the gift baskets and towers (i.e., pre-packaged candy, chocolate, cheese, wine and crackers) and assembles the final product for sale. Houdini has approximately 300 full-time employees and hires about 4,000 temporary employees during its busy season of August through December. During the holiday season, Houdini can finish up to 80,000 gift baskets in one day.

Houdini workers do not handle unwrapped food during this process. Houdini only uses food it purchases in sealed containers or packages for its gift baskets. Houdini’s assembly process includes placing a cardboard form or Styrofoam base inside the gift basket to provide stability. The food items are then placed into other packaging, such as colorful boxes. The gift box assembly involves machines (although not described in the court’s decision, these machines are most likely conveyer belts) and assembly-line workers who insert items into small boxes and secure items in the basket by gluing or tying them to the basket. A final step includes covering the basket with a heated shrink wrap and adding a bow.

Neither Houdini nor its shareholders claimed any Section 199 deduction on its original returns for the activities described above. Houdini and its shareholders subsequently filed amended returns that claimed the Section 199 deduction and received refunds based on the deduction. The IRS paid the refunds and later filed suit to recover them on the basis that Houdini and its shareholders were not entitled to a deduction under Section 199 because Houdini merely packaged and repackaged items in the gift baskets. Houdini’s shareholders contended that Houdini manufactured or produced gift baskets.

In a somewhat surprising decision (at least based on the responses to the decision by a number of commentators), the California district court agreed that Houdini’s activities rose to the level of MPGE and qualified for the Section 199 deduction. The court held that Houdini’s activities were not merely packaging, but changed the “form and function” of the individual items into a new product with a different demand (i.e., from a grocery item into a holiday gift).

Because Section 199 does not specifically define MPGE, the court initially turned to Merriam-Webster’s dictionary to determine the “ordinary, contemporary, common meaning” of manufacture and package. These definitions include for manufacturing, “to make a product suitable for use . . . by hand or by machinery . . . according to an organized plan and with division of labor” and for packaging, “to make into a package . . . in such a way as to heighten its appeal.” Relying on these definitions, the court stated that because Houdini makes products suitable for use as gifts using machinery and according to an organized plan with division of labor, that its activities may qualify as manufacturing or production under Section 199. However, the court also noted that Houdini takes items and puts them together in a package to make them more attractive to the public, so alternatively, Houdini’s activities may only involve packaging.

To resolve this question, the court then looked to the regulations and determined that Houdini’s production process “changes the form of an article.” Specifically, the court found that Houdini’s “complex production process” relies on assembly line workers and machines to produce gift baskets and towers that are “distinct in form and purpose from the individual items inside.” The court noted that 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 court further distinguished Houdini’s activities from the “minor assembly” example in the regulations involving the customization of an automobile. In this example, the customization activities do not qualify for the Section 199 deduction because they are deemed to be only minor assembly. However, in Dean, the court determined that the automobile in the example did not have its form or function changed by the mere addition of customized accessories (such as spoilers, specialized wheels, sunroofs, etc.). On the other hand, the court held that Houdini changes the form and function of the individual food items by creating distinct gifts through its production process. The court stated that in the regulations’ example, the additions to the automobile only enhanced the final product but did not change the nature of the product. By contrast, according to the court, Houdini “creates a new product with a different demand.”

The court also favorably quoted IRS Notice 2005-14, 2005-1 C.B. 498, which states “that the IRS and Treasury believe Congress intended for the deduction under Section 199 to be available for a wide variety of production activities,” and therefore “defines MPGE broadly.” However, in a footnote to the decision, the court gave no deference to Chief Counsel Advice 201246030, which found that a taxpayer that buys pills in bulk and then packages them in blister packs for sale to customers did not qualify for a Section 199 deduction.

As we were going to press with this issue of Tax Advisor Weekly, the Tax Court published a recent decision involving the benefits and burdens of ownership required of taxpayers claiming the Section 199 deduction in contract manufacturing situations (ADVO Inc., et al v. Commissioner, 141 T.C. No. 9). Although Houdini uses third-party contract manufacturers, the benefits and burdens issued was not raised in Dean. In ADVO, the Tax Court held that the taxpayer did not have the benefits and burdens of ownership of the QPP during the MPGE process and, therefore, was not entitled to the Section 199 deduction. In a footnote, the Tax Court in ADVO noted that although Houdini also used third parties to manufacture the food, gift baskets and cardboard or Styrofoam fillers according to Houdini’s specifications, the Court saw no need to distinguish Dean “given the factually specific nature of the benefits and burdens test.”

Alvarez & Marsal Taxand Says:

Although at first blush, the Dean decision may seem somewhat surprising to some observers, the decision does reflect the IRS’s belief, outlined in Notice 2005-14, that the Section 199 deduction should be available for a wide variety of production activities. This is also consistent with the rather broad definition of MPGE provided by the Section 199 regulations. And though this is only a district court case, if the IRS does not appeal the decision, it may signal a willingness on its part to consider a broader range of activities for the Section 199 deduction and allow it to focus on other issues.

There are also specific facts in Dean that make the decision more understandable. One factor that seemed important to the court was Houdini’s large and detailed assembly-line process, which includes division of labor and machinery. In other words, Houdini uses a “manufacturing process” to assemble the gift baskets. Similar to the assembly operations described in the Section 954 regulations’ example, Houdini’s operations are “substantial in nature” and the company has made significant investments in the machinery and equipment it uses to produce its gift baskets.

Additionally, the court emphasized how Houdini’s manufacturing process changed the food items from groceries to highly sought-after holiday gifts. The court described this as a change in “form and function” and as creating “a new product with a different demand” or market. This reasoning may also explain the court’s lack of enthusiasm for CCA 201246030 — in that instance, the pills in question were being sold to the same customers, but there were certain state requirements that the pills be delivered in certain packages for safety reasons. Thus, the market or demand for the pills was not changed by packaging them in the blister packs.

Given this decision, we recommend you take another look at product lines that you may have previously excluded from your Section 199 calculation as being mere “assembly” or “packaging.” This is especially true for items that require an assembly-line process and division of labor to produce, as well as for packaged items that can be sold in to new markets after your assembly process (in other words, they become subject to different customers’ demand).

So don’t look this gift horse in the mouth — take a few moments to reassess your Section 199 methodology to see if additional qualifying activities may be available for you to claim going forward. This could potentially result in a larger Section 199 deduction and lower effective tax rate for you in the future.


Andrew Martin
Senior Director, Atlanta
+1 704 778 4706

Kathleen King, Managing Director, contributed to this article.

For More Information

Kathleen King
Managing Director, Washington DC
+1 202 688 4213

Brett Nowak
Managing Director, San Francisco
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Brian Haneline
Senior Director, Houston
+1 713 503 2848

Carrie Kingston
Senior Director, San Francisco
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Justin Gach
Director, Washington DC
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