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Christopher Hesse
Annette Nellen

Advertising expense and tax reform: How not to broaden the tax base

Proposals for broadening the tax base to lower tax rates may bring some surprises.

July 31, 2014
by Annette Nellen, Esq., CPA

In February, Rep. David Camp, R-Mich., introduced the Tax Reform Act of 2014—a detailed proposal on how to broaden the tax base—to lower the corporate and individual tax rates in a revenue-neutral manner. One of the methods to broaden the base would stretch out advertising deductions for large businesses. This article explains this proposal and analyzes whether it is good tax policy.

Current law

Today, advertising expenses and package design costs are currently deductible on the theory that these costs primarily benefit the current year (Regs. Secs. 1.162-20(a)(2) and 1.263(a)-4(b)(3)(v), -4(c), and -4(d)).  Regs.  Sec. 1.263(a)-4(b)(3)(v) allows package design costs to be deducted when paid or incurred. This rule was adopted to simplify the law and to recognize case law that allowed similar costs to be treated as a current deduction (RJR Nabisco, Inc., T.C. Memo. 1998-252, nonacq., AOD 1999-012).

Under Rev. Rul. 92-80, advertising costs are required to be capitalized only in the “unusual circumstance where advertising is directed toward obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising or with institutional or goodwill advertising.” Today, Regs. Sec. 1.263(a)-4 overrides this ruling by providing that “unusual” advertising may also be currently deductible. Regs. Sec. 1.162-20(a)(2), which allows institutional or goodwill advertising to be currently deducted under Sec. 162, dates back to the 1960s (T.D. 6819 and T.D. 6996). Also, neither the Joint Committee on Taxation nor the Office of Management and Budget (OMB) treats advertising deductions as a “tax expenditure,” indicating they view these expenses as part of a “normal” income tax system, rather than unusual costs.

The proposal

Basics: Camp’s discussion draft of the Tax Reform Act of 2014 (2/21/14; Section 3110) proposes to add Sec. 177, Amortization of Certain Advertising Expenses. “Amortizable advertising expenses” would have to be capitalized and then amortized ratably over 10 years, using a midyear convention.

Formula: “Amortizable advertising expenses” equal the “applicable percentage” of “otherwise deductible advertising expenses.” The “applicable percentage” is 50% starting in 2018. A phase-in rule provides that the applicable percentage is 20% in 2015, 30% in 2016, and 40% in 2017. A taxpayer may elect to use 50% for all years.

Proposed Sec. 177(b) provides an exemption from the capitalization and amortization rule for the year’s “otherwise deductible advertising expenses” that do not exceed $1 million. However, for taxpayers with “otherwise deductible advertising expenses” for the tax year in excess of $1,500,000, the exemption is phased out by double the excess amount over $1,500,000. These dollar amounts are adjusted annually for inflation. “Amortizable advertising expenses” are calculated after any exemption amount is removed from “otherwise deductible advertising expenses.”

If property associated with capitalized advertising is abandoned, no write-off is allowed; instead, the amount continues to be amortized.

Definitions: “Otherwise deductible advertising expenses” are “specified advertising expenses.” This amount must be “paid or incurred for the development, production, or placement (including any form of transmission, broadcast, publication, display, or distribution) of any communication to the general public (or portions thereof) which is intended to promote the taxpayer or a trade or business of the taxpayer (or any service, facility, or product provided pursuant to such trade or business).” This term excludes:

  1. Wages paid or incurred for an employee not primarily engaged in specified advertising work or who does not directly supervise an employee engaged in that work.
  2. Depreciation of tangible property.
  3. Amortization of a Sec. 197 intangible.
  4. “Any discount, coupon, rebate, slotting allowance, sample, prize, loyalty reward point, or any item determined by the Secretary to be similar to any of the foregoing (other than any amount paid or incurred to promote any of the foregoing).”
  5. “Any amount paid or incurred with respect to any communication appearing on tangible property of the taxpayer which—(i) is of a character subject to the allowance for depreciation, or (ii) is properly treated as inventory for purposes of section 471.”
  6. Amounts paid or incurred to create a logo, trademark, or trade name.
  7. Package design costs subject to (new) Sec. 263A(i).
  8. Amounts paid or incurred for marketing research.
  9. Amounts paid or incurred for business meals.
  10. “Any amount paid or incurred as a qualified sponsorship payment (as defined in section 513(i)(2)) with respect to an organization subject to the tax imposed by section 511.”

Example

Assume that for 2018, companies A, B, C, D, E, and F have amounts of “otherwise deductible advertising expenses” (ODAE) as shown in the table below. For each company, the exemption amount of proposed Sec. 177(b), “amortizable advertising expense” (AAE), amortization deduction, and total advertising deduction for 2018 are computed, along with the 2019 deduction. A similar amount would be deductible through 2027 with the final deduction in 2028 equal to the amount in column (V) (due to the midyear convention).

 

(I)
ODAE

(II) Exemption amount per Sec. 177(b)1

(III)
(I) less (II)

(IV)
AAE
[(III) x 50%]

(V)
2018 amortization
(IV) ÷ 10,
midyear convention

2018 deduction
(II) + (IV)2 + (V)

 

% of  total

2019 deduction

 

% of total

A

$400,000

$400,000

$0

$0

$0

$400,000

100

$0

-

B

$900,000

$900,000

$0

$0

$0

$900,000

100

$0

-

C

$1,200,000

$1,000,000

$200,000

$100,000

$5,000

$1,105,000

92

$10,000

0.8

D

$1,700,000

$600,000

$1,100,000

$550,000

$27,500

$1,177,500

69

$55,000

3.2

E

$2,000,000

$0

$2,000,000

$1,000,000

$50,000

$1,050,000

52.5

$100,000

5.0

F

$5,000,000

$0

$5,000,000

$2,500,000

$125,000

$2,625,000

52.5

$250,000

5.0

Table notes:
1If ODAE exceeds $1,500,000, the exemption can be calculated as follows: $1 million – [(ODAE – $1,500,000) × 2]. The exemption cannot be less than zero. If ODAE does not exceed $1,500,000, the exemption is the lesser of $1 million or ODAE.
2 (IV) is included in this summation because it represents both the 50% of ODAE that is amortized and the 50% that is not amortized (i.e., deducted in the year paid or incurred).

Analysis

Complexity: Adding a new, complex provision in a comprehensive tax reform bill misses an opportunity to instead work toward simplification of the law. The definitions, exceptions, exemptions, and phaseout of proposed Sec. 177 are difficult to navigate. Regulations would be required, and judicial interpretation likely would follow enactment. For example, it would be difficult for companies to determine which wages are “specified advertising expenses.” Guidance would be needed on the meaning of “primarily related” as used in proposed Sec. 177(d)(3)(A) on excepted wages, which would likely be a subjective determination, causing continued complexity and uncertainty. 

A more specific definition of advertising would also be required. For example, would the wages paid to employees in a company’s public relations office (typically the office that issues press releases) be considered “specified advertising expenses”? Would costs of the legal department or outside counsel to ensure that advertising laws are complied with be considered “specified advertising expenses”? What about costs of maintaining a website, placing the company’s logo and URL in emails, and using social media? Today, these questions do not have to be answered as all of these expenses are currently deductible. They would become new issues if Sec. 177 were to be enacted.

The proposed amortization rule would also make it more important to distinguish between advertising and charitable contributions, such as when a company donates money to a charitable organization and is acknowledged on the organization’s website or written materials. This issue exists today, but if the taxpayer has not reached its charitable contribution deduction limitation for the year, the issue is moot. Under proposed Sec. 177, the distinction becomes more critical because a portion of advertising would be amortized over 10 years rather than currently deducted (unless the $1 million exemption applies).

Proposed Sec. 177 would require new records to track wages included in “specified advertising expenses.” In addition, the records kept to identify advertising expenses for financial reporting purposes would no longer match what is allowed as advertising for tax purposes. New amortization records would be needed that are not needed for financial reporting purposes. Finally, each year’s advertising expense would result in 11 years of book-tax differences to track.

Predictability: For taxpayers with advertising expenditures between $1 million to $2 million, they would be unsure each year how much of their advertising expenditures would be deductible. In addition, because some advertising expenses are excluded from “specified advertising expenses,” such as those of an employee involved in advertising, but not “primarily” so engaged, it would not be obvious to all taxpayers throughout the year which advertising expenses are subject to amortization and which are currently deductible.

Accounting principles: Proposed Sec. 177 would cause a significant change in the calculation of taxable income by converting a current deduction into an 11-year amortization. The federal income tax has always treated advertising as a current deduction. Advertising is a classic example of a recurring expenditure. Generally, businesses must continually advertise to stay in business.

Also, as noted in Encyclopaedia Britannica, Inc., 685 F.2d 212 (7th Cir. 1982): “Most of the ‘ordinary,’ in the sense of recurring, expenses of a business are noncapital in nature and most of its capital expenditures are extraordinary in the sense of nonrecurring.” Spreading out a current expense over 11 years violates the “ordinary and necessary” deduction rule of Sec. 162, as well as the “clear reflection of income” requirement of Sec. 446.

Finally, despite the proposed treatment noted in the Section-by-Section Summary (page 56) of package design costs being included in the costs of producing the packaging and capitalized, Sec. 177 could result in those costs having a shorter life than some more ordinary advertising expenditures.

Economic efficiency and competitiveness: Advertising is a key expenditure for a business to promote its product, mission, values, and business. Requiring 50% of current-year advertising expenditures to be expensed over 10 years increases the cost of advertising. This can pose a competitive disadvantage in the local, national, and international marketplaces.

Looking forward

Camp has made a significant step forward in tax reform by making specific proposals for how to achieve revenue neutrality with lower tax rates. He calls the proposal a “discussion draft” so the provisions can be critiqued. Ideally, good tax policy and international competitiveness will inform the final plan. Under this approach, proposed Sec. 177 needs a replacement.

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Annette Nellen, Esq., CPA, CGMA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and a blog.