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accrual method of accounting for the year in issue. Petitioner
incurred $999,151 for the exclusive and nontransferable right to
use the patent. Petitioner did not allocate any of the $999,151
paid under the agreement to the goods it produced, including
inventory remaining at the end of the year. Rather, petitioner
deducted the entire $999,151 as “Other Deductions” on line 26 of
its 1995 Federal income tax return as an ordinary and necessary
business expense pursuant to section 162 or, alternatively, as a
depreciation deduction under section 167. Petitioner used a
simplified production method to calculate inventory costs during
the 1995 taxable year, allocating $510,124 in administrative,
service, and support department costs to production under section
263A. In allocating section 263A costs to inventory, petitioner
used an absorption ratio calculated by dividing section 263A
costs by the costs of production other than section 263A costs.
In a notice of deficiency, respondent determined that
petitioner failed to include or allocate the $999,151 in
royalties to production pursuant to section 263A. Specifically,
based on petitioner’s allocation formula, which is not in
dispute, respondent determined that $26,971 of the $999,151 was
allocable to the ending inventory and was required to be
capitalized and included in petitioner’s cost of inventory.
Accordingly, respondent determined a deficiency of $9,170 for the
1995 taxable year.
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Last modified: May 25, 2011