Key implications of IRS nonacquiescence in Second Circuit analysis of manufacturer's royalty payments

Washington National Tax Services

The IRS recently announced (Action on Decision 2011-01) that it will not follow the analysis in the Second Circuit’s decision in Robinson Knife Manufacturing Company Inc., other than in litigating cases appealable to the Second Circuit. In Robinson Knife, the Second Circuit held that a manufacturer’s royalty payments are currently deductible under section 162 if they are (1) calculated as a percentage of sales revenue from inventory and (2) incurred only upon the sale of that inventory.

The IRS issued proposed regulations in December that would follow the result of the Second Circuit’s decision in that sales-based royalties would be taken into account currently, albeit under the regulations as cost of goods sold rather than as a section 162 deduction. Thus, the significance of this AOD relates primarily to the characterization of the costs as opposed to timing.

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