Category: Accounting Periods & Methods; Deductions & Credits
Subject: Advertising Costs
Title: Capitalization vs. Expense of Costs
IRC Sections:
Filename: 1196.html
Date Produced: 01/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Facts
Your memorandum to me January 12, 1995 is incorporated by reference into this document.

Taxpayer (TP) is a direct mail marketing organization. TP places advertising inserts into credit card bills. These inserts offer the credit card customer the opportunity to purchase a product or series of products each month over a period of up to six months.

TP currently expenses the cost of its advertising program both for financial accounting as well as tax purposes. For financial accounting purposes, TP is considering capitalizing the cost of this advertising and amortizing that cost over its expected revenue stream (no more than six months).

Issues
The issue is whether TP can continue its practice of currently deducting the cost of advertising for tax purposes.

Answer
The tax literature strongly supports TP's ability to continue currently deducting advertising costs.

Discussion
You cite in you memorandum the IRS ruling, Revenue Ruling 68-360, 1968-2 CB 197, which held that the cost of producing trade catalogs having a useful life in excess of one year must be capitalized and amortized over that useful life.

It is my very strong view that this ruling is not relevant to TP's circumstances. A catalog is a durable item. The advertiser hopes the recipient will keep the catalog on hand and at some point in the future order merchandise from it. Revenue Ruling 68-360 is saying in effect if the catalog has an ascertainable useful life and that useful life exceeds one tax year, the costs thereof must be capitalized and amortized.

In this case, there is no durable item at all. The advertising inserts are placed in a credit card bill. The customer opens the bill and either responds to the advertising or discards it immediately. It seems to me that the potential useful life of this item is only few days, at most. As such, TP's advertising inserts are no different from any other advertising expense: the customer responds right away or not at all. The thing that makes a catalog different is the durable, physical manifestation of the advertising expense. That is clearly not the case here. I feel strongly that TP's situation is merely an example of ordinary adverting expense.

I believe the possibility that the customer will buy into an obligation to purchase products over a six month period does not change the answer. If the customer were committing to a series of purchases exceeding one year, it could possibly be argued that the advertising costs should be capitalized; however, this is not our fact pattern and is therefore moot.

Historically, advertising expenses have enjoyed a fairly liberal treatment for tax purposes. With all advertising, there is an expectation of future benefit, otherwise there would be no advertising. Given that expectation, there is a conceptual question: namely, should adverting expenses be capitalized and amortized or deducted immediately? Regulation Section 1.162-1(a) expressly provides that adverting expenses are deductible. Further, Regulation Section 1.162-20(a)(2) speaks directly to the issue of institutional or goodwill advertising, i.e., advertising directed not at selling a particular product or service but rather to keep the taxpayer's company name in the eyes and on the minds of the pubic. The regulation explicitly sanctions current deduction of this long-term benefit type advertising.

Finally, there was some concern after the Indopco case the that the IRS might attempt to apply the holding broadly and restrict the ability to currently deduct advertising costs. The IRS allayed those fears by issuing Revenue Ruling 92-80, 1992-39 IRB 8, which reiterates the long-standing policy that advertising costs, except in very unusual circumstances, can be currently deducted.

In our telephone conversations, you expressed concern about audit risk. Specifically, does the existence of a large prepaid expense item and a corresponding M-1 item increase the risk that the IRS might raise this issue on examination? Obviously, this a question that cannot be answered with certainty, but is seems fairly clear that a large M-1 item would potentially expose TP to questions in an exam, and that exposure would not exist (or be materially lower) if the M-1 were not there in the first instance (i.e., book and tax treatment were the same). Clearly no one can predict what a given IRS agent might do in a given situation. In the end, TP seems to have a very strong position based on current tax law.