Originally published on Forbes.com Oct 27th, 2013
While reading a Tax Court decision I usually root for the taxpayer unless they are being really lame. ADVO , Inc. was not being lame, but I am still really glad that they lost. In the first place, I really hate the business that ADVO is involved in:
During 2005, 2006, and 2007, ADVO distributed direct mail advertising in the United States. Direct mail advertisers such as ADVO distribute advertising material through the U.S. Postal Service (USPS) to residential recipients, who are the targeted potential customers for the products and services sold by ADVO’s clients, the advertisers.
If it weren’t for companies like ADVO, I would not have to take out the trash nearly as often.
ADVO’s advertisements made it one of the top 20 print paper users in the United States, consuming approximately 90,000 tons of paper, purchased pursuant to ADVO’s directed buy agreements, each year.
Nowadays I get so little meaningful snail-mail, that I would be tempted to take the label for my unit off the mailbox and paste it to the dumpster, but that probably wouldn’t work and I would probably miss the occasional update from the Holy Cross Alumini Association.
The other thing is that I really hate the deduction they were fighting for. The “domestic production activity deduction” has a lot of complicated language to it, but on a simplistic level, if you are doing the “right” type of business, manufacturing in this case, and are not using too many independent contractors, you get a deduction of 9% of your taxable income (It is more complicated than that, but that is the essence.)
Frankly, the thing that bothers me the most about DPAD is a little irrational. It bothers me that it is an unbalanced entry. OK, guys, let’s debit DPAD – X dollars, now we have to credit ???. That is really silly of me, but the thing is that I live in constant terror that I am going to forget about the DPAD, because it makes so little sense.
The case makes an interesting read in that it gives you a brief tutorial in both the direct mail advertising business and the printing business. Here is an example:
The third-party printers that ADVO contracted with to print the advertising material it created for its clients used a process known as Web offset lithography. During this process a continuous stream of paper is pulled through the press from rolls of paper which can weigh more than one ton each. The process is known as offset printing because the printing plates do not actually touch the paper; instead, the plates transfer ink to rubber blankets (rollers) that, in turn, transfer the image to the paper.
“Web offset lithography” – who knew ?
The detailed discussion was necessary, because in order to qualify for the deduction ADVO had to actually be producing something itself rather than buying stuff that somebody else produced. The fact that what was being produced was 90,000 tons of crap, that was going to be quickly thrown away after annoying someone did not seem to be of any significance. Thoughts like that are among the reasons too numerous to enumerate that disqualify me from being a Tax Court judge.
ADVO apparently micro-managed its printing company vendors even going so far as to what equipment they were required to purchase. The ADVO expert testified
ADVO exercised a comprehensive and unique level of control over the entire production of their printed direct mail products. As a result of their comprehensive policies and processes, ADVO exercised an uncommon level of control even over that portion of the process during which a third party printer fulfilled its assigned role of printing the direct mail piece in accordance with ADVO’s detailed specifications.
That was not enough. There was a lot more to the analysis, but this seems to be the heart of the matter:
……..the third party printers owned or leased and operated the machinery, sometimes purchasing it at the behest of ADVO, but it was always the printers’ property. The third-party printers and their employees set up the machines, loaded the paper, fine-tuned the color keys, ran the printing process, supervised the quality, and then delivered the advertising materials to ADVO
Planners will probably being studying this decision since it may have serious implications:
The broad issue confronted here is how section 199 applies to U.S. corporations that manufacture products through agreements with contract manufactures. That subject is an issue of first impression in this Court.
On the other hand, we could hope that the DPAD is one of the things that goes away in some sort of grand bargain on tax reform. I’m with Joe Kristan who noted in his coverage of the case that”
In a modern interconnected economy, distinguishing between “manufacturing” and other activities is silly.
The law’s unwise distinction between “production” activities and other activities encourages taxpayers to try to qualify, and forces the courts to try to draw distinctions.
You can follow me on twitter @peterreillycpa.