Advo, Inc. v. Comm'r

• Decision Date: 24 October 2013
• Docket Number: No. 17247–10.,17247–10.
• Citation: 141 T.C. 298,141 T.C. No. 9
• Court: U.S. Tax Court
• Parties: ADVO, INC. & Subsidiaries, Petitioner v. COMMISSIONER of INTERNAL REVENUE, Respondent.

141 T.C. No. 9

141 T.C. 298

ADVO, INC. & Subsidiaries, Petitioner

v.COMMISSIONER of INTERNAL REVENUE, Respondent.

No. 17247–10.

United States Tax Court.

Oct. 24, 2013

Decision for IRS.

R disallowed a deduction P claimed under I.R.C. sec. 199 of $1,515,992 for the 2006 tax year and $151,047 for the short 2007 tax year. R determined that P was not considered to have manufactured, produced, grown, or extracted qualifying production property under I .R.C. sec. 199 with respect to P's direct advertising mailings.

Held: P did not have the benefits and burdens of ownership of the direct advertising materials and is not entitled to the I.R.C. sec. 199 deduction.

Michael P. Walutes, Craig A. Raabe, John R. Shaugnessy, Jr., Gary D. Yeats, and Scott E. Sebastian, for petitioner.^*

Donald K. Rogers, Charles E. Buxbaum, and William T. Derick, for respondent.

WHERRY, Judge:

This case is before the Court on a petition for redetermination of deficiencies in income tax respondent determined for petitioner's 2006 tax year and short 2007 tax year.

The only issue for decision in this Opinion in this bifurcated case is whether petitioner is entitled to a section 199 ¹ deduction for manufactured, produced, grown, or extracted qualifying production property with respect to petitioner's direct advertising mailings.²

FINDINGS OF FACT

The parties' stipulation of facts, with accompanying exhibits, and the stipulations of settled issues are incorporated herein by this reference. At the time petitioner filed the petition, its principal place of business was in Connecticut.

Petitioner, ADVO, Inc. (ADVO), was the common parent of the consolidated group ADVO, Inc., & Subsidiaries for the tax years ending September 24, 2005, and September 30, 2006, and for the short taxable year ending March 2, 2007. On March 3, 2007, ADVO was acquired by Valassis Communications, Inc., and continues to exist as its wholly owned subsidiary.

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. The advertising material can be either “solo direct mail” or “cooperative direct mail.” For solo direct mail, the printed advertising material of a single advertiser is delivered in a stand-alone envelope or as a postcard to a residential recipient. For cooperative direct mail, also known as a shared mail package, the printed advertising material for several different advertisers is consolidated into a single delivery mechanism (such as an envelope or sleeve) and delivered as a single unit to residential recipients. This allows ADVO's clients to share the advertisements' costs of mailing and postage to reach the target consumers' mailboxes.

ADVO's clients are typically businesses whose products and services are used by the general population or specific subgroups thereof. These businesses include supermarkets, quick-serve restaurants, drug stores, discount and department stores, home furnishing stores, and other retailers. Print advertising companies, such as newspapers, regional and local mailers, direct marketing firms, so-called shoppers and pennysavers, in the same type of business as ADVO, compete primarily on the ability to effectively target the delivery of the client's advertisement to the consumer households with the highest propensity to purchase the product being advertised on a cost-effective basis. The companies also compete on the extent to which they provide coverage, the reliability of delivery, and most importantly the ability to provide a satisfactory return on the advertiser's investment.

Either ADVO's clients supply the advertising material for ADVO to distribute (client-supplied material) or ADVO supplies the materials for distribution (ADVO-supplied material). When ADVO supplied the advertising material, ADVO contracted with third-party commercial printers to print it. The section 199 deductions at issue were attributable to direct mail advertising involving only the ADVO-supplied material.

ADVO's shared mail packages were distributed weekly, and each included a “wrap” and various “inserts.” A detached address label (DAL), also known as a missing child card, was also associated with each shared mail package. The DAL was a card with the address of the consumer recipient and a missing child's information printed on one side and an advertisement printed on the other side. During the years at issue the wrap was a branded turnkey product known as “Shopwise.” The Shopwise wrap was printed on both sides of a single sheet of paper and folded in half, and then multiple inserts were loosely inserted into the wrap to form the shared mail package, all in accordance with specifications defined by ADVO. An insert was a printed advertising piece for a single advertiser.

ADVO marketed the Shopwise wrap to potential customers by selling “page positions” on the wrap, including Billboard, Inside Page, and Outside Page, as well as multipage options; each wrap could accommodate advertising for one or more customers. ADVO sold the Shopwise wrap across hundreds of wrap zones nationally, and each wrap zone could have a different Shopwise wrap with different advertisers. There were approximately 580 wrap zones, and each one was composed of a cluster of ZIP Codes.

ADVO developed and marketed a portfolio of ADVO-supplied inserts, each of which was differentiated by a set of defined product specifications, which included paper dimensions, paper weight, and bleed availability. An ADVO client could choose to advertise on both sides of a single page insert or on an insert consisting of multiple pages. ADVO sold ADVO-supplied inserts for distribution via both ZIP Codes and “ADVO Targeting Zones” (ATZ). An ATZ is a cluster of consumers, located on specific mail delivery routes, averaging approximately 3,500 households and is smaller than a wrap zone to allow for finer targeting of marketing materials to potential consumers. ATZs were proprietary configurations of households developed by ADVO which took into account demographic and psychographic information and could target the potential buying habits of the target consumers.³ ADVO had about 133 million mailing addresses in its system.

ADVO classified its ADVO-supplied material as either “turnkey” or “custom.” A turnkey product was a print product that was included in ADVO's portfolio of products that met specifications defined by ADVO. A lump sum which included the advertising services, printing, and distribution was billed to the client for turnkey products.⁴ The pricing for turnkey products was one rate for the entire process: creating the advertisement, producing the advertisement, delivering the advertisement, and targeting the desired end consumers. ADVO handled everything from the design of the advertisement through distribution of the turnkey product, and specifications were designed to facilitate cost-efficient assembly and distribution of the shared mail packages. The DAL, Shopwise wrap, and ADVO-supplied inserts were turnkey products.

A custom print product was an insert that was not part of ADVO's portfolio of turnkey products because of the client's specifications for the insert. ADVO billed two separate charges for custom inserts: one for the printing and one for the advertising and distribution.

We discuss infra the general process for ADVO's products. Much of the trial was dedicated to the minutest details of the process, and we by no means list every single step. Our intention is not to discount those important and necessary steps not mentioned but to give merely a general idea of how the cooperative mailings were produced.

The Sales Process

During the years at issue ADVO employed around 600 sales executives. The sales force was responsible for selling advertising space in the shared mail package. ADVO distributed 60 to 80 million packages every week of the year.

The Design Process

In varying degrees, ADVO's graphic print department assisted ADVO's clients with the design of the advertisement graphics. The graphic design requirements with respect to ADVO-supplied materials generally fell into three categories: “rough art”, “reprint with changes”, and “client-supplied art”. Rough art made up 45% to 50% of the graphic art work designed by ADVO and it was anything from a sketch on the back of a napkin to an advertisement created from a client's general concept for a product or service the client wanted to advertise. Reprint with changes made up 30% to 35% of the graphic art work designed by ADVO and involved circumstances where a previously developed graphic design was reused after ADVO made changes, such as to the coupon expiration dates or as required for a different holiday promotion. In these two situations, ADVO retained ownership of all intellectual property associated with the artwork and advertisement.⁵ Client-supplied art made up the final 15% to 20% of the graphic work. When ADVO's clients supplied the art, the client retained the ownership of intellectual property related to that art. Client-supplied art still required ADVO's artwork department to analyze and normalize the files in order to make sure that they were printable. ADVO produced between 106,000 and 107,000 graphic designs per year.

ADVO employed 40 to 45 graphic print coordinators whose role was to coordinate among ADVO's sales organization, ADVO's graphics personnel working on a design, and the third-party printers. The graphic print coordinators understood the graphic art applications used to create graphic designs, the development of four-color photography as supported by the CMYK ⁶ printing, and the printing process itself, to ensure the best printable product according to the functional capabilities of the specific printing...