Opinion ID: 357
Heading Depth: 4
Heading Rank: 2

Heading: How To Allocate

Text: Although the dispute in this case is about whether Robinson's royalties must be capitalized and not about how they must be allocated, some discussion of the relevant allocation methods is necessary to an understanding of why the parties care whether Robinson's royalties are deducted or capitalized. The regulations provide for two methods of allocating costs to inventory. The first is the facts and circumstances method, see 26 C.F.R. § 1.263A-1(f), which most taxpayers use. This method acknowledges that it is often impossible to tell the cost of a particular item sold, and so it uses one of several complicated and administratively expensive processes to approximate that cost and allocate it to particular goods. See id.; see also Leslie J. Schneider, Federal Income Taxation of Inventories § 5.01[1], [6][d] (2010) (noting that the various forms of the facts-and-circumstances method are expensive to administer because they differ from financial accounting rules and the pre-§ 263A rules). The other method, the simplified production method, was created to help manufacturers who, in 1986, would have had to make substantial modifications to their cost accounting methods in order to comply with the new § 263A. See W. Eugene Seago, Inventory Tax Accounting and Uniform Capitalization § 2:47 (2009). Such companies were given the option of grandfathering themselves out of the facts and circumstances method and thereby avoiding the associated administrative costs. The simplified production method, using a ratio found in the regulations, allocates a pool of costs between ending inventory and cost of goods sold. See 26 C.F.R. § 1.263A-2(b). The simplified production method is administratively cheaper than the facts and circumstances method, but it may result in distortions of income unfavorable to the taxpayer because it can force the taxpayer to allocate costs to ending ( i.e., ongoing) inventory when a more accurate method would have permitted much quicker cost recovery by allocating most or all of those same costs to inventory that was sold. [6] Robinson elected the simplified production method. If the allocation methods in the regulations worked perfectly, this case would never have been litigated. Under a perfect allocation system, every cent Robinson paid in sales-based royalties would be allocated to exactly those inventory items whose sale triggered Robinson's obligation to pay. Because it is the sale of kitchen tools that triggers Robinson's obligation to pay royalties, all Robinson's royalties would be allocated to those inventory items that are sold, at the same time as, and therefore during the same taxable year as, the royalties are incurred. The result would be that Robinson would recover the cost of the royalties immediately just as it would if, as Robinson claims, the royalties were deductible rather than subject to capitalization. In reality, the allocation methods do not work perfectly. And Robinson, presumably to save administrative costs, elected the least accurate of the permissible methods. A significant amount of money, therefore, rides on whether Robinson can deduct its royalty payments. If Robinson cannot deduct the payments immediately, then a substantial portion of them will be allocated to ending inventory, and Robinson will have to wait until a later taxable year to recover those costs.