## Facts

- Encyclopaedia Britannica, Inc. planned to publish *The Dictionary of Natural Sciences* but, due to limited internal capacity, contracted with David–Stewart Publishing Company to research and prepare a complete manuscript under Britannica’s editorial supervision.
- The contract contemplated delivery of a finished manuscript that Britannica would copyright, publish, and sell.
- Britannica agreed to pay David–Stewart advances against future royalties expected from sales of the book.
- Britannica claimed current deductions for the advances as “ordinary and necessary” business expenses under I.R.C. § 162(a).
- The IRS disallowed the deductions, asserting the advances were capital expenditures under I.R.C. § 263(a).
- The Tax Court held the payments deductible, reasoning they were payments for services given Britannica’s editorial control.
- The Commissioner appealed.

## Issues

1. Whether advances paid to a third party to deliver a completed manuscript constitute currently deductible business expenses under I.R.C. § 162(a).
2. Whether such advances are capital expenditures under I.R.C. § 263(a) because they are part of the cost of acquiring an income-producing asset with value extending beyond the taxable year.

## Decision

- The Seventh Circuit reversed the Tax Court.
- The court held the advances were capital expenditures for acquiring a capital asset (the manuscript and associated exploitable rights).
- Editorial supervision and service-like contract language did not convert the acquisition cost of the manuscript into currently deductible expenses.
- The court limited its holding to the advances at issue and did not decide the treatment of other project-related costs (e.g., separate editorial expenses).

## Legal Principles

- I.R.C. § 162(a) permits deductions for ordinary and necessary business expenses, but I.R.C. § 263(a) bars current deductions for capital expenditures even if they are ordinary and necessary.
- Costs incurred to acquire or create a separate income-producing asset with usefulness extending beyond the current tax year generally must be capitalized.
- Tax characterization turns on economic substance rather than contractual labels; payments described as “services” may be capital if they function as acquisition costs of a capital asset.
- Where the taxpayer’s payments are tied to obtaining and exploiting a completed work expected to generate income over multiple years, capitalization is required.

## Conclusion

The court held that Britannica’s advances to obtain a completed manuscript were part of the cost of acquiring a long-lived, income-producing intangible and therefore had to be capitalized under § 263(a) rather than deducted currently under § 162(a).


Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212 (7th Cir. 1982)