Encyclopaedia Britannica, Inc. v. Commissioner of Internal Revenue
685 F.2d 212, 1982 U.S. App. LEXIS 16748, 50 A.F.T.R.2d (RIA) 5547 (1982)
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Rule of Law:
Expenditures incurred to create or acquire an asset that yields income over a period of years must be capitalized, even if they represent expenses for services, unless they are non-capital in nature, normal, and recurrent for a business that produces a series of income-generating assets, making specific allocation difficult.
Facts:
- Encyclopaedia Britannica decided to publish a book titled 'The Dictionary of Natural Sciences'.
- Being temporarily short-handed, Encyclopaedia Britannica hired David-Stewart Publishing Company to research, prepare, edit, and arrange the manuscript and illustrative material for the book.
- Under the contract, David-Stewart agreed to work closely with Encyclopaedia Britannica's editorial board to ensure the work conformed to Encyclopaedia Britannica's ideas and desires.
- David-Stewart was contemplated to turn over a complete manuscript to Encyclopaedia Britannica, which Encyclopaedia Britannica would then copyright, publish, and sell.
- Encyclopaedia Britannica agreed to pay David-Stewart advances against the royalties Encyclopaedia Britannica expected to earn from the book.
- The book was intended to yield Encyclopaedia Britannica income over a period of years.
- The commissioning of the manuscript from David-Stewart was somewhat out of the ordinary for Encyclopaedia Britannica, which usually prepared such books in-house.
Procedural Posture:
- Encyclopaedia Britannica treated the advances paid to David-Stewart as immediately deductible ordinary and necessary business expenses.
- The Internal Revenue Service (IRS) disallowed these deductions and assessed tax deficiencies against Encyclopaedia Britannica.
- Encyclopaedia Britannica petitioned the Tax Court for a redetermination of its tax liability.
- The Tax Court held in favor of Encyclopaedia Britannica, ruling that the expenditures were for 'services' rather than the acquisition of an asset, and were therefore immediately deductible.
- The Internal Revenue Service (IRS) petitioned the United States Court of Appeals for the Seventh Circuit for review of the Tax Court’s decision.
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Issue:
Does the Internal Revenue Code require capitalization of payments made by a publishing company to an independent contractor for the preparation of a book manuscript intended to generate income over several years, where the expenditure is unambiguously tied to a specific capital asset?
Opinions:
Majority - Posner, Circuit Judge
Yes, the payments made by Encyclopaedia Britannica to David-Stewart for the manuscript must be capitalized. The court reasoned that under Internal Revenue Code Sections 162(a) and 263(a), expenditures must be matched with the income they generate, meaning costs for assets that produce income over several years should be capitalized. Since 'The Dictionary of Natural Sciences' was intended to yield income over a period of years, the payments to create it are capital expenditures, analogous to the costs of putting a building into shape to be rented, as discussed in Commissioner of Internal Revenue v. Idaho Power Co. The court distinguished the Faura line of cases, which allow authors to deduct expenses immediately, by limiting their principle to situations where a taxpayer produces a series of income-generating assets, making complex expense allocation difficult. Here, the expenditures were unambiguously identified with a specific capital asset, the manuscript. Furthermore, the court noted that hiring an outside company for a complete manuscript was 'somewhat out of the ordinary' for Encyclopaedia Britannica, making the expense non-recurrent rather than a normal, recurring business expense that might be immediately deductible.
Analysis:
This case clarifies the fundamental tax principle of matching expenses with income over an asset's useful life. It reinforces that costs directly associated with creating or acquiring a long-term income-generating asset must be capitalized, regardless of whether they are for 'services' or a tangible product. The decision limits the application of exceptions, like the Faura rule for authors, to situations involving routine expenses for a series of capital assets where individual allocation is impractical. It highlights that the 'ordinary' nature of an expense in Section 162 refers not just to its recurrence but to its non-capital character and alignment with a taxpayer's typical business operations when acquiring specific capital assets, thus preventing taxpayers from immediately deducting substantial, non-recurrent acquisition costs.
