Manufacturers should review all of their indirect costs to determine which costs are deductible and which costs must be capitalized. Otherwise, a manufacturer could be missing the opportunity to claim deductions that would benefit the bottom line.

A recent case provides new legal authority for deductions in some situations. In Robinson Knife Mfg. Co. v. Commissioner, the Second Circuit Court of Appeals decided that a kitchen gadget producer's royalty costs were deductible expenses. They did not have to be capitalized even though the company used the simplified production method of accounting. The simplified production method is a simplified method of accounting for costs that are required to be capitalized. The Robinson Knife case is binding on the IRS for cases in the Second Circuit and solid authority in disputes with the IRS outside of the Second Circuit.

Robinson Knife paid royalties to use famous trademarks such as Corning and Oneida in connection with sales of kitchen gadgets such as spatulas. Royalties were paid based on actual sales of products. The company could have produced exactly the same quantity and type of items -- that is, it could have performed its production activities in exactly the same way it did -- and the company would have owed no royalties if sales did not occur. The royalties were incurred as a result of sales of inventory.

Because the royalties were not "incurred by reason of production" activities and did not directly benefit production activities, they were not subject to capitalization requirements. Indirect expenses of manufacturers are capitalizable only if, and to the extent, they directly benefit or are incurred by reason of the performance of production activities.

Indirect expenses are costs other than direct material costs and direct labor costs. Indirect costs that are potentially subject to the capitalization requirement include, for example, certain engineering and design costs and certain royalties for the use of patents, manufacturing procedures, or similar intellectual property rights. Such indirect costs are not required to be capitalized, however, if they do not directly benefit and are not incurred by reason of production.

Some indirect costs, such as selling and distribution costs and research, are completely excluded from the capitalization requirement. Certain royalties for use of trademarks appear to be selling costs, but the court did not agree with that position in Robinson Knife. The court based its decision on the sales-based nature of the royalties. Other indirect costs that are excluded from the capitalization requirement are research and experimental expenditures, warranty and product liability costs, among others.

The primary fallacy in the IRS's interpretation or application of the simplified production method in Robinson Knife was an assumption that costs incurred only on the sale of items that are not in ending inventory are allocable in part to ending inventory. If costs that accrued only at the time of sale of products that have already taken place were inventoriable costs, there would be a distortion of taxable income. However, the purpose of inventory accounting is to clearly reflect income by matching income with the costs of producing that income in the same taxable year.

For a long time, the IRS has been considering proposing new regulations to address sales-based royalties under Section 263A, the section of the Internal Revenue Code that provides capitalization requirements. As the judge who wrote the decision in Robinson Knife noted, however, any new regulations would be subject to review by the courts.

After reviewing its current treatment of indirect expenses, a manufacturer should consider whether a change in treatment of any indirect expenses would be appropriate and, if so, what steps could or should be taken in connection with a possible change in accounting method, if needed. Of course, such a review would need to be done keeping in mind other tax and business considerations particular to the company.

This article is intended for general informational purposes only and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Please consult an attorney for specific advice applicable to your situation.

Alice A. Joseffer, a partner at the law firm Hodgson Russ LLP, regularly counsels clients on tax issues related to all types of transactions, including mergers and acquisitions, recapitalizations, executive compensation arrangements, and personal income and estate planning for business executives and their families.