Sales-Based Royalties Are Deductible

Tax Alert
03.24.10

In Robinson Knife Manufacturing Co., Inc. v. Commissioner, decided on March 19, 2010, the Second Circuit reversed the Tax Court’s holding that the taxpayer must include sales-based royalties in the cost of its inventory, thereby preventing the taxpayer from recovering the cost of the royalty until it sold the inventory.  The Second Circuit held that a taxpayer that (1) calculates the royalty as a percentage of sales revenue from inventory and (2) incurs the royalty only upon the sale of that inventory may immediately deduct the cost of the royalty as a matter of law.  Because the Court held that royalties meeting these two criteria are deductible as a matter of law, taxpayers do not need to examine the reasons for their royalty payments. 

The timing of this decision is especially significant because the IRS currently is aggressively auditing taxpayers that account for sales-based royalties.  The IRS has not yet announced whether it will follow the decision in Robinson Knife or instead continue to pursue the issue, at least for taxpayers outside of the Second Circuit. 

In addition, Treasury and the IRS National Office may be close to completing guidance on how taxpayers should account for sales-based royalties (although it is unclear what impact the Robinson Knife decision will have on timing).  Treasury and the IRS National Office could issue guidance consistent with the Second Circuit’s decision, but they might instead seek to require taxpayers to capitalize royalties and perhaps permit them to allocate the royalties entirely to cost of goods sold (the IRS’s current position is to require taxpayers to include some royalty costs in ending inventory). 

While guidance requiring taxpayers to capitalize sales-based royalties might be subject to taxpayer challenge, a method that permits taxpayers to allocate the royalties entirely to cost of goods sold would allow most taxpayers to recover the royalty immediately.

What the Robinson Knife Decision Means to You

If you include sales-based royalties in ending inventory costs, you must continue to follow your established method of accounting unless you receive consent from the Commissioner to change to a different method.  You can request such consent by filing a Form 3115 under the procedures of Rev. Proc. 97-27, 1997-1 C.B. 680.  It is unclear whether the Commissioner will grant taxpayers consent to either deduct royalties or to allocate them entirely to cost of goods sold, especially when Treasury and the IRS National Office have not yet issued the forthcoming guidance.  Thus, unless your taxable year is about to close, you should consider waiting until Treasury and the IRS National Office publish the guidance and then follow the procedures under the guidance for requesting consent to change to another method, if the guidance permits a more favorable method than your current method. 

If you currently deduct sales-based royalties and are under examination, you should consider the costs and benefits of protesting an examination proposed change in method of accounting, if any.  An examination proposed change in method of accounting, generally to a simplified method that results in an over-capitalization of costs to inventory, is especially onerous because you will need the consent of the Commissioner to change to a more reasonable facts-and-circumstances method.  Thus, you should give serious consideration to protesting such an examination imposed change in method, bearing in mind that, while it is binding only in the Second Circuit, the Robinson Knife decision creates significant hazards for the IRS. 

If you currently deduct sales-based royalties and are not currently under examination, you could file an accounting method change application and receive “audit protection.”  In light of the Robinson Knife decision, however, you might not want to change to a method of including sales-based royalties in ending inventory costs, and it is not clear that the Commissioner will grant consent for you to change to any other method.  Therefore, while it entails some risk, you might instead consider waiting for Treasury and the IRS National Office to issue the forthcoming guidance and then follow the procedures under that guidance to change to a permitted method if the guidance does not permit you to use your existing method.

For more information, please contact:

Patricia Sweeney, psweeney@milchev.com, 202.626.5926

James Atkinson

Dwight Mersereau

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