Direct Supply , Inc . v. United States of America

In the
United States Court of Appeals
For the Seventh Circuit
____________________
No. 23-1936
DIRECT S UPPLY , I NC .,
Plaintiff-Appellant,
v.
U NITED S TATES OF A MERICA,
Defendant-Appellee.
____________________
Appeal from the United States District Court
for the Eastern District of Wisconsin.
No. 20-C-1095 — Lynn Adelman, Judge.
____________________
A RGUED J ANUARY 22, 2024 — DECIDED M ARCH 22, 2024
____________________
Before EASTERBROOK, S T. EVE, and JACKSON -A KIWUMI ,
Circuit Judges.
EASTERBROOK, Circuit Judge. Section 199 of the Internal
Revenue Code, 26 U.S.C. §199, was in force between 2004 and
2017. It allowed a deduction equal to 9% of receipts from cer-
tain “domestic production activities”, with a cap at 50% of
wages paid to the firm’s workers. The deduction depended on
the “disposition” (§199(c)(4)(A)(i)) of “qualifying production
property” (§199(c)(4)(A)(i)(I)), defined to include “any

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2 No. 23-1936
computer software” (§199(c)(5)(B)). The IRS elaborated on the
word “disposition” in regulations by specifying that §199 al-
lows deductions based on revenues from sales but not reve-
nues from services. 26 C.F.R. §1.199–3(i)(4)(i)(A). Direct Sup-
ply took deductions under §199 before its repeal, but the In-
ternal Revenue Service disallowed them. About $3.5 million
is at stake in this suit seeking a refund. Direct Supply does not
dispute the way the regulations implement the statute but in-
stead argues that it prevails under them.
Among other activities, Direct Supply helps nursing
homes purchase equipment, medical supplies, and furniture.
It devised a system that it calls “Direct Supply DSSI” (which
the parties shorten to “DSSI”) that makes customer-specific
catalogs of items available to purchase. Each customer (usu-
ally a chain comprising many nursing homes) negotiates with
vendors; once customer and vendor agree about what will be
available at what price, Direct Supply places that vendor’s
products in an online catalog that the customer’s authorized
representatives can browse and order from. DSSI consolidates
products from all of a customer’s authorized vendors. Each
customer sees a bespoke catalog created by the efforts of mul-
tiple vendors, the customer, and Direct Supply’s staff. Cus-
tomers promise Direct Supply that, once such a catalog has
been constructed (something that requires a good deal of
work), it will order “substantially all” needed products
through DSSI. Vendors ship to customers directly and bill
them through DSSI. Every customer pays a flat monthly fee
for the catalog’s maintenance, and every vendor pays Direct
Supply a fee based on the value of goods that customers or-
der. The customers’ fees account for no more than 5% of rev-
enue from DSSI and the vendors’ fees about 95%. (We disre-
gard some other fees that don’t amount to much.)

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No. 23-1936 3
The IRS sees DSSI as a service based on software, while
Direct Supply maintains that DSSI is the “disposition” of the
software that runs the system. The district court sided with
the IRS. 635 F. Supp. 3d 685 (E.D. Wis. 2022). It observed that
customers all sign an “Application Service Provider Agree-
ment”; Direct Supply itself thus called DSSI a service. Most of
the revenue that flows to Direct Supply comes from fees that
are a percentage of the vendors’ sales, rather than anything
that measures the value of software—and neither the vendors
nor the customers possess software code or a license to use
any of DSSI’s software. The judge likened DSSI to Amazon’s
system for ordering and delivering goods or the New York
Times’s system for providing reportage over the Internet.
These systems depend on software, but they do not “dispose”
of that software. Indeed, 26 C.F.R. §1.199–3(i)(6)(ii) disallows
deductions under §199 for these kinds of activities.
That understanding is unavoidable as long as it is neces-
sary to distinguish between the disposition of software and
the provision of a service based on software. A part of the gov-
erning regulation, 26 C.F.R. §1.199–3(i)(1)(i), says that to qual-
ify under §199 the receipts must be “directly derived” from
disposition of the qualifying property; Direct Supply’s re-
ceipts were not “directly derived” from software, as opposed
to the goods the vendors sold to the customers. Direct Supply
does not furnish software that a customer can use to create its
own online-ordering systems. Instead Direct Supply itself cre-
ates a system; software does not change hands. Direct Supply
emphasizes that it provides customers with user names and
passwords, but these steps do not dispose of software any
more than they do when Amazon and the Times provide their
customers with the same sort of credentials.

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4 No. 23-1936
Things might be more complex if Direct Supply had at-
tempted to determine how much of the revenue from DSSI
could be traced to the value of software and how much to the
efforts of its staff (and the efforts of both vendors and custom-
ers) to make ordering work, but it has not attempted any such
partition. It treated the whole gross revenue from DSSI as eli-
gible for the §199 deduction, which has to be the one impos-
sible outcome.
Direct Supply had another potential means to show that
there was at least a virtual or implicit disposition of software.
When a system, though nominally a service, provides access
to software “for the customers’ direct use while connected to
the Internet or any other public or private communications
network”, while another person derives income from the sale
or disposition of “substantially identical software”, the re-
ceipts from that “direct use” are deductable under §199. See
26 C.F.R. §1.199–3(i)(6)(iii), (iii)(B), (iv)(A)(1). Direct Supply
observes that at least five firms (Ariba, Basware, Ivalua,
Wallmedien, and Zycus) sell or lease software packages that
customers can use to create their own ordering systems. Yet
again the problem for Direct Supply is that it did not provide
“direct use” of the software underlying DSSI or establish that
DSSI is “substantially identical” from consumers’ perspective
to the products of these other vendors. DSSI is a system for
ordering and billing for merchandise, not for customers to set
up and manage their own databases as the directly sold pack-
ages do.
As Direct Supply sees things, “if Direct Supply had chosen
a different pricing model and its contracts had said, ‘Direct
Supply hereby grants licensee a non-exclusive license to use
DSSI for one year for $X …’ there would be much less

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No. 23-1936 5
controversy on this aspect of the deduction.” Brief 32–33 n.10.
Maybe—though as we’ve remarked DSSI is more than just
software. Direct Supply would have needed to license some-
thing comparable to the packages licensed or sold by Ariba,
Basware, Ivalua, Wallmedien, and Zycus. Even then, all Direct
Supply could have deducted would have been the fees re-
ceived from its customers. What it actually deducted were
fees received from the vendors—and even with the pricing
model that Direct Supply now wishes it had used, it would be
impossible to picture the vendors as acquiring any software
from Direct Supply.
A FFIRMED

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