## Facts

- Robinson Knife Manufacturing Co. designed, sourced manufacturing for, and sold kitchen tools, often using third-party trademarks under licensing agreements.
- Under the licenses, Robinson paid royalties computed solely as a percentage of net sales (or sales price) of trademarked products.
- Robinson had no fixed or minimum royalty obligation; if it did not sell a product, it owed no royalty for that product.
- The royalty payment obligation arose only upon sale, not upon production or acquisition of inventory.
- For tax years ending March 1, 2003, and February 28, 2004, Robinson deducted the royalties as ordinary and necessary business expenses under I.R.C. § 162.
- The IRS asserted the royalties were indirect production costs subject to capitalization into inventory under I.R.C. § 263A and Treas. Reg. § 1.263A-1(e).
- The Tax Court agreed with the IRS and sustained deficiencies; Robinson appealed.

## Issues

1. Whether sales-based trademark royalties that become payable only upon sale are “indirect costs properly allocable to property produced” that must be capitalized under I.R.C. § 263A and Treas. Reg. § 1.263A-1(e).
2. Whether such royalties instead are currently deductible selling expenses under I.R.C. § 162.

## Decision

- The Second Circuit reversed the Tax Court.
- Sales-based royalties computed as a percentage of sales and incurred only upon sale were not “properly allocable to property produced” under Treas. Reg. § 1.263A-1(e).
- Because the legal obligation to pay arose only when sales occurred, the royalties were incurred “by reason of” sales rather than production.
- Robinson was entitled to deduct the royalties under § 162 in the year of the related sales rather than capitalize them into inventory under § 263A.

## Legal Principles

- Under § 263A, a taxpayer must capitalize direct costs and the properly allocable share of indirect costs of property produced.
- For Treas. Reg. § 1.263A-1(e), an indirect cost is capitalizable only if it directly benefits, or is incurred by reason of, production (or resale) activities and is properly allocable to the property.
- When a royalty obligation is triggered solely by sales (no liability arises upon production) and is calculated solely by reference to sales revenue, the cost is treated as incurred by reason of sale and is not a capitalizable production cost under § 263A.
- For an accrual-method taxpayer, the event that fixes liability (here, sale) is central to whether a sales-based royalty is treated as a current selling expense rather than an inventory cost.

## Conclusion

The Second Circuit held that Robinson’s sales-contingent trademark royalties were currently deductible selling expenses under § 162 because they were incurred only upon sale and therefore were not indirect costs properly allocable to property produced for purposes of capitalization under § 263A.


Robinson Knife Mfg. Co. v. Commissioner, 600 F.3d 121 (2d Cir. 2010)