Service Provider or Manufacturer?

 Benefits and burdens (“B&B”), a judicially developed federal income tax principle, plays a significant role in various Internal Revenue Code (“IRC”) provisions, including the domestic production activity deduction, interest deductions on home mortgage loans, home sale exclusion, section 263A UNICAP, lease vs. sales, Subpart F provisions, allowance for depreciation and amortization, and various tax credits and grants to determine tax owner of the underlying property or asset.  Under this principle, the tax authorities generally characterize the transaction by analyzing the economic effect of the arrangement based on all facts and circumstances, rather than the labels or forms used by the contracting parties.

Taxpayers often enter into contract manufacturing arrangements with independent third parties to manufacture components or products on behalf of the taxpayers.  Under these contract manufacturing arrangements, the taxpayer generally approaches the contract manufacturer with a formula or design.  The contract manufacturer will quote the parts based on material and labor costs, processes, and tooling.  For an agreed-upon price, the contract manufacturer essentially acts as the taxpayer’s factory, producing and shipping components or products on behalf of the taxpayer.

For various afore-mentioned IRC provisions, only one taxpayer may claim the applicable deductions or credits.  In order to determine whether the taxpayer or the contract manufacturer is entitled to the deductions or credits, an analysis of which party in a contract manufacturing relationship has the B&B under the judicially developed federal income tax principles.   The party in a contract manufacturing arrangement with B&B will be treated as a tax owner of the underlying property or asset, and accordingly is a manufacturer, while the party without the B&B, by default, is treated as a mere service provider for the relevant IRC provisions. In order to determine whether a contracting party is a service provider or a manufacturer, the contract as a whole needs to be carefully analyzed.