Case — Royalties – Expense or Capitalize?

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TL Case Summ

THE QUESTION

Should royalties paid under licensing agreements for the use of trademarks be capitalized or currently deducted?

THE DISPUTE

Taxpayer Says: Royalty payments are ordinary and necessary business marketing expenses and should be currently deductible.

Internal Revenue Service Says: The payments are indirect licensing costs related to production of property and should be allocated to ending inventory.

THE LAW

From Internal Revenue Code Section 162(a): Permits a deduction for a taxpayer’s ordinary and necessary business expenses paid or incurred during the taxable year in carrying on a trade or business.

From Internal Revenue Code Section Sec. 263A(a)(1)(A) and (2), (b)(1): Requires that a taxpayer’s direct costs and some indirect costs (including taxes) of producing property that is inventory in the hands of the taxpayer be included in inventory costs.

From Federal Tax Regulation 1.162-1(a): Advertising and other selling expenses are examples of deductible business expenses under section 162. However, no item shall be included in deductible business expenses to the extent that the item is used by the taxpayer in computing the cost of property included in its inventory.

From Federal Tax Regulation 1.263A-1(e)(3)(ii)(U): (ii) Examples of indirect costs required to be capitalized.–The following are examples of indirect costs that must be capitalized to the extent they are properly allocable to property produced or property acquired for resale:* * * * * * * (U) Licensing and franchise costs.– Licensing and franchise costs include fees incurred in securing the contractual right to use a trademark, * * * or other similar right associated with property produced or property acquired for resale. These costs include the otherwise deductible portion (e.g., amortization) of the initial fees incurred to obtain the license or franchise and any minimum annual payments and royalties that are incurred by a licensee or a franchisee.

From Federal Tax Regulation 1.263A-1(e)(3)(iii)(A): Some indirect costs are specifically excluded from the capitalization rules. Examples include marketing, selling, advertising, and distribution costs, which are generally deductible business expenses under section 162.

THE CAUSE OF THE DISPUTE

If your business produces inventory and is subject to the “uniform capitalization rules”, you’re generally required to include certain expenses in the cost of your inventory, as opposed to taking a current deduction on your tax return. The idea is to better match your expenses with your revenue by capitalizing costs that result in a future benefit and recognizing the expense as you realize the benefit.

However, the unicap rules specifically allow certain items, such as marketing costs, to be deducted currently. While these expenses may offer future benefits, the future benefits are considered incidental to the primary benefit of current sales.

In this case, royalties were paid for licensing rights to use trademarks in connection with the production of kitchen tools. The tools were stamped with the trademarks during the manufacturing process.

The taxpayer believes the unicap rules do not apply because the licensing rights did not directly benefit production activities and were not part of the cost of inventory. Instead, licensing the trademarks allowed the taxpayer to obtain a marketing advantage, retain customers, and attract new customers.

The IRS says the royalties were licensing fees that granted the right to make kitchen tools using the trademarks. Since the trademarks were used during the production process to produce a more marketable product, they should be included in the valuation of inventory.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 27KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. The royalties paid were licensing costs for the right to use trademarks in connection with production of kitchen tools, and section 263A regulations specifically require that such licensing costs be capitalized.