Question

Digital Designs is a Michigan corporation, owned 100% by its founder Nicole Burke. The average annual gross receipts for the prior three years is $30,000,000. Digital Designs creates cartoon characters that are imprinted on its T-Shirts, magnets, stickers, and various other products. Its revenues largely come from sales of its products to retail stores through independent sales agents who receive a commission. The remainder of its revenues consists of royalties from licensees who pay Digital Designs a fee for the use of its cartoon images.

Digital Designs uses several independent contractors to manufacture its products. In manufacturing its products, Digital Designs creates cartoon characters and sends the original drawing as “flat art” to an independent printer. The printer photographs the cartoon drawing performs color separations and creates a “proof” of a particular product, which is shipped to Digital Designs for approval. The printer provides its own stock of blank T-shirts, paper, and ink, etc. and bears the risk of loss of the supplies and printed goods until they are shipped to Digital Designs. Once Digital Designs approves the proof, it sends a purchase order to the printer. The printer is not permitted to sell the products to anyone and does not have a proprietary interest in the cartoon characters created by Digital Designs. Once the printing is complete, the printer sends the finished products to Digital Designs, whose employees package the products for sale to retailers.

Prepare a memo to Nicole Burke discussing whether Digital Designs is considered a producer for purposes of Section 263A (UNICAP).

Answer 1

In The final Regulations Temporary Regulations relating to the types of costs that must be capitalized under Section 263A by producers of property, Engineering and design costs have been cleared out. The treatment of engineering and design costs was uncertain under the Temporary Regulations, despite their inclusion in the list of indirect costs to be capitalized under Section 263A . However, Reg. 1.263A-1(e)(3)(ii)(P) provides that engineering and design costs that do not qualify as research and experimental expenses under Section 174 are subject to Section 263A .

Thus, the designs produced by Digital Designs qualify as property for the purpose of SEction 263A

However,  for the UNICAP rules to apply, a taxpayer engaged in processing activities generally must be the legal or equitable owner of the property being produced. Since the contractors are not owners of the property they would not come into ambit of 263A and under the exceptions prescribed under Section 263A(g)(2), the producers of property produced for them under contract with a third party will be considered as producer.