SERVICE PROVIDES SECTION 263A SAFE HARBOR FOR ARTISTS AND OTHER PRODUCERS OF CREATIVE PROPERTIES; BUSINESS EXPENSES DEDUCTIBLE OVER THREE YEARS.

Notice 88-62

This notice provides guidance to certain authors, photographers, artists, and other similarly situated persons regarding the uniform capitalization rules under section 263A of the Internal Revenue Code.

I. Background.

Section 263A of the Code, enacted in the Tax Reform Act of 1986 (Pub. L. 99-514, the "1986 Act"), provides uniform capitalization rules that govern the treatment of costs incurred in the production of property or the acquisition of property for resale. Section 263A was enacted, in part, to prevent the inappropriate mismatching of income and expense that resulted from the current deduction of the costs of producing or acquiring property.

Section 263A(b) of the Code generally provides that the uniform capitalization rules apply to the "production" (including the development or improvement) of real or tangible personal property produced by the taxpayer. Moreover, this section provides that, for purposes of the uniform capitalization rules, the term "tangible personal property" shall include a film, sound recording, video tape, book, or similar property. (See also the legislative history to section 263A contained in 2 H.R. Rep. No. 99-841 (Conf. Rep.), 99th Cong., 2d Sess. II-308, n. 1 (1986)). Based on section 263A(b) and its accompanying legislative history, section 1.263A-1T(a)(5)(iii) of the regulations provides, for example, that section 263A requires the capitalization by authors of the costs of researching, preparing and writing literary works. Similar rules apply to the production of other properties enumerated as tangible properties in section 263A(b).

For example, costs required to be capitalized under section 263A by authors and other similar persons consist of the costs of creating, researching, writing and preparing the literary works and other properties being produced, including costs of travel undertaken for business purposes (e.g., research); depreciation, rent and repairs on equipment and facilities used in producing the properties; all labor and compensation costs (including pension costs, where applicable) of any persons involved in the production activity; office overhead; interest (where required under section 263A(f)); and any other direct or indirect costs relating to the production of such properties as described in 1.263A-1T(b)(2) of the regulations.

Taxpayers are required to allocate and capitalize costs to the particular properties being produced, and to recover such costs under other applicable provisions of the Code. See, e.g., section 167 (depreciation); Rev. Rul. 60-358, 1960-2 C.B. 68, Siegel v. Commissioner, 78 T.C. 659 (1982) (income forecast method); section 1.61-3(a) of the regulations (cost of goods sold).

II. Authority and Need for Safe Harbor.

The Internal Revenue Service has received numerous inquiries from authors, photographers and other persons expressing concern regarding the application of the uniform capitalization rules to their businesses. These concerns have focused both on the allocation and capitalization of costs under section 263A, as well as the amortization or recovery of these capitalized costs under other sections of the Code.

The legislative history of section 263A indicates that Congress was aware of the possible administrative complexities resulting from the application of the uniform capitalization rules to businesses. In response to this concern, Congress granted the Treasury Department authority under section 263A to "adopt other simplifying methods and assumptions where, in the judgment of the Secretary of the Treasury, the costs and other burdens of literal compliance may outweigh the benefits." S. Rep. 99-313, 99th Cong. 2d Sess. 141-42 (1986).

Moreover, in the preamble to temporary regulations under section 263A, published in the Federal Register on March 30, 1987 (52 FR 10057, T.D. 8131), the Internal Revenue Service generally solicited comments and suggestions regarding the use of simplified methods in complying with the uniform capitalization rules under section 263A. In response to this request for comments, the Internal Revenue Service has received numerous suggestions from taxpayers asking that additional simplified methods be provided for individual authors, photographers, and other taxpayers creating various types of property.

III. Elective Safe Harbor -- In General.

Based on the foregoing, this notice provides an elective three- year "safe harbor" for certain authors and other taxpayers with respect to their capitalization of costs under section 263A and the recovery or amortization of such costs under other sections of the Code.

Under the three-year safe harbor provided herein, taxpayers shall aggregate and capitalize all "qualified creative costs" incurred during each taxable year and shall amortize and deduct 50 percent of such aggregate costs in the year they are incurred, 25 percent of such costs in the year following the year in which they are incurred, and the final 25 percent of such costs in the second year following the year in which they are incurred.

The three-year safe harbor provided in this notice substantially reduces the administrative complexities of complying with the uniform capitalization rules by eliminating the necessity to amortize the capitalized costs under the income forecast method for taxpayers otherwise required to use such method. (The income forecast method requires the taxpayer to estimate the future expected income to be received from the property in issue, in addition to only allowing the taxpayer to amortize the property's capitalized costs for the periods during which the taxpayer recognizes income from such property).

Moreover, the three-year safe harbor provided here eliminates any need for the taxpayer to allocate total costs incurred in the taxpayer's trade or business between (i) costs that are required to be

capitalized under section 263A and costs that are permitted to be expensed; and (ii) costs incurred with respect to separate properties produced by the taxpayer (e.g., various manuscripts being created by an author). It is anticipated that the 50 percent portion of total aggregate qualified creative costs deducted in the year such costs are incurred under the safe harbor, reasonably approximates the amounts of both otherwise deductible costs incurred during that taxable year and the amortization of costs required to be capitalized under section 263A for that year.

IV. Properties Covered By Safe Harbor.

This three-year safe harbor is available only for the qualified creative costs paid or incurred ("incurred") in producing "creative properties" defined as films, sound recordings, video tapes, books (including, for example, articles and poems), photographs, plays and other dramatic works, musical and dance compositions (including accompanying words), graphic and pictorial compositions, fine art paintings and sculptures, and other similar fine art products (but not including jewelry).

No other properties other than those defined herein as creative properties are eligible for this safe harbor. For example, section 263A is itself applicable, in part, to the production of a film, sound recording, video tape, book or "similar property." The term "similar property" in section 263A is not limited to properties which are defined as creative properties in this notice. Thus, the term "similar property" in section 263A may include specific types of properties other than, and in addition to, the properties defined herein as being eligible for the three-year safe harbor. Similarly, certain properties (e.g., paintings and sculptures) defined as creative properties for purposes of this notice are tangible properties and hence subject to the capitalization rules of section 263A without reference to the provisions of section 263A(b) providing that certain enumerated properties shall be treated as tangible for purposes of the uniform capitalization rules.

Taxpayers electing to use the three-year safe harbor in accounting for the costs of producing any creative property to which this three-year safe harbor applies shall be deemed to have also elected to use the three-year safe harbor in accounting for the production of any other creative property to which the safe harbor applies. Thus, for example, a taxpayer producing both books and films who elects to use the three-year safe harbor in accounting for the production of the books must also use the three-year safe harbor with respect to the production of the films.

V. Qualified Creative Costs -- In General.

The three-year safe harbor provided herein only applies to "qualified creative costs" which are defined as certain costs incurred by a self-employed individual (except as provided in section VIII herein), in the production of creative properties where the personal efforts of such individual predominantly create such properties. Qualified creative costs do not include the costs paid or incurred by a person in his capacity as an employee, nor do they include costs incurred by an individual in producing creative properties where the personal efforts of such individual do not predominantly create such properties (e.g. where the properties are predominantly created by persons other than the individual such as employees or independent contractors).

With respect to any properties predominantly created by employees of the individual or by independent contractors hired by the individual, the provisions of this safe harbor are not available in accounting for the costs of producing such properties under section 263A. (Qualified creative costs do, however, include amounts paid by an individual to employees or independent contractors assisting in the production of the creative properties, if the personal efforts of such individual predominantly create such properties.)

Moreover, except as provided in section VIII herein, qualified creative costs do not include costs incurred by any person other than an individual. For example, except as provided in section VIII, qualified creative costs do not include costs incurred by a partnership, trust, or corporation.

For purposes of the three-year safe harbor, qualified creative costs consist of all costs incurred by the taxpayer in the trade or business or activity conducted for profit (collectively, "trade or business") of producing creative properties that would be otherwise deductible under the Internal Revenue Code of 1986, excluding the provisions of section 263A. Thus, qualified creative costs consist of: (i) all costs required to be capitalized under section 263A and the regulations thereunder with respect to the production of creative properties ("section 263A costs"); and (ii) all other costs incurred and otherwise deductible by the taxpayer in the trade or business of producing creative properties.

VI. Qualified Creative Costs -- Examples.

Qualified creative costs eligible for this safe harbor would generally include, for example, depreciation deductions taken with respect to a computer or automobile (i.e., equipment and facilities) used to produce creative properties, since these costs are required to be capitalized under section 263A as a cost of producing such properties. In contrast, qualified creative costs would not include the costs of purchasing a computer or an automobile that will be used to produce creative properties because, although such purchase costs are capitalized (see, e.g. section 263), they are not capitalized under section 263A as costs of producing creative properties. Moreover, such costs are not otherwise deductible by the taxpayer.

Qualified creative costs also include all other costs incurred by the taxpayer that would be otherwise deductible in the trade or business of producing creative properties. Thus, such costs include the costs of marketing, selling, advertising and distributing creative properties undertaken by an individual in the trade or business of producing creative properties. For example, costs incurred by a taxpayer in promoting or selling a finished manuscript or photograph would be qualified creative costs and thus would be subject to the provisions of this three-year safe harbor. In addition, qualified creative costs include all office overhead (e.g., general and administrative costs), and all otherwise deductible interest expense incurred in the trade or business of producing creative properties, regardless of whether such costs would be required to be capitalized under section 263A.

Moreover, qualified creative costs include the costs of producing properties that are sold (or otherwise disposed of, in their entirety) by the taxpayer in the same taxable year that such costs are incurred. For example, costs incurred by a taxpayer in writing an article (or producing a photograph) that the taxpayer sells in its entirety to a magazine in the same year that the costs are incurred would be qualified creative costs and thus would be subject to this three-year safe harbor.

Similarly, costs incurred by a taxpayer in a hobby are not qualified creative costs eligible for this safe harbor because (i) such costs are not section 263A costs; and (ii) qualified creative costs only consist of costs incurred in a trade or business or an activity conducted for profit.

VII. Mechanics of Three-Year Safe Harbor.

Assume, for example, that a photographer elects to use the three-year safe harbor beginning in 1987 when the taxpayer incurs a total of $16,000 in qualified creative costs consisting of all the taxpayer's section 263A costs, and all other costs incurred that year in the photography business that would be otherwise deductible by the taxpayer. Under the three-year safe harbor, the photographer would capitalize $16,000 of costs in 1987 and would expense $8,000 of these costs in 1987, and $4,000 of these costs in each of 1988 and 1989. In addition, assume that the photographer incurs a total of $20,000 in qualified creative costs in 1988. The photographer would capitalize $20,000 of costs in 1988 and would expense $10,000 of these costs in 1988, and $5,000 of these costs in each of 1989 and 1990.

VIII. Availability of Safe-Harbor to Certain Entities.

The three-year safe harbor may be used with respect to a corporation or partnership engaged in the trade or business of producing creative properties (an "eligible corporation" or "eligible partnership"), but only if the requirements of this section VIII are met. A corporation or partnership may use the three- year safe harbor if substantially all of such entity is owned by one "qualified employee owner", as defined herein. For purposes of this provision, ownership by any members of such qualified employee owner's family, as defined in section 267(c)(4) of the Code, shall be treated as ownership by the qualified employee owner.

A qualified employee owner shall be deemed to own substantially all of a corporation if such individual owns at least 95 percent (by value) of the stock of such corporation. Similarly, a qualified employee owner shall be deemed to own substantially all of a partnership if such individual has an interest in partnership profits and capital of at least 95 percent.

A qualified employee owner is an individual employed by an eligible corporation or eligible partnership where the personal efforts of such qualified employee owner produce creative properties for such corporation or partnership. Moreover, "qualified creative costs" eligible for this safe harbor only include costs incurred in the production of creative properties where the personal efforts of the qualified employee owner predominantly create such properties. Qualified creative costs do not include any of the costs of creating properties where the personal efforts of the qualified employee owner do not predominantly create such properties (e.g., where the properties are predominantly created by persons other than the qualified employee owner such as other employees or independent contractors). With respect to any properties predominantly created by persons other than the qualified employee owner, the provisions of this safe harbor are not available in accounting for the costs of producing such properties under section 263A.

Any corporation or partnership meeting the requirements of this section VIII may use the three-year safe harbor provided in this notice in accounting for qualified creative costs, subject to all the requirements, conditions and procedures of this notice applicable to individuals electing such safe harbor (except where expressly noted).

IX. Election to Use Three-Year Safe Harbor

Taxpayers may automatically elect to use the three-year safe harbor by determining and reporting their taxable income under such safe harbor on a timely filed (with regard to extensions) Federal income tax return for the first taxable year (including, but not limited to the first taxable year ending after December 31, 1986) to which the provisions of section 263A apply to the particular taxpayer's production of creative properties.

In addition, with respect to the taxpayer's first taxable ending after December 31, 1986 (typically, the calendar 1987 year), taxpayers may automatically elect to use the three-year safe harbor by determining and reporting their taxable income under the safe harbor on an amended Federal income tax return for such year filed within 270 days after this notice is published in the Internal Revenue Bulletin.

Alternatively, eligible taxpayers who have filed, on or before [date which is thirty days after publication of this notice in the Internal Revenue Bulletin] a Federal income tax return for their first taxable year ending after December 31, 1986, may, if those taxpayers choose, follow the procedures set forth herein (the "1988 election") and automatically adopt the three-year safe harbor for their first taxable year ending after December 31, 1987 (typically, the calendar year 1988). By adopting the 1988 election, taxpayers wishing to use the three-year safe harbor may, if they choose, avoid filing an amended return for their first taxable year ending after December 31, 1986.

Taxpayers are eligible to adopt the 1988 election if, and only if, such taxpayers have properly capitalized the costs of producing creative properties for their first taxable year ending after December 31, 1986, as required by section 263A and the regulations thereunder. Taxpayers who have not properly capitalized their costs of producing creative properties in determining and reporting taxable income on a Federal income tax return filed for their first taxable year ending after December 31, 1986, may not adopt the 1988 election. Such taxpayers may only elect to use the three-year safe harbor by filing an amended return using the three-year safe harbor for their first taxable year ending after December 31, 1986, as described in this section IX.

Taxpayers properly adopting the 1988 election shall take the balance of section 263A capitalized costs, outstanding on their books and records as of the close of their first taxable year ending after December 31, 1986, and shall amortize and deduct 50 percent of such capitalized costs in their first taxable year ending after December 31, 1987, and 50 percent of such costs in the next succeeding taxable year. Such taxpayers shall also apply the three-year safe harbor to qualified creative costs incurred in their first taxable year ending after December 31, 1987, and for all years thereafter.

For example, assume a calendar year taxpayer producing creative properties properly capitalizes the costs of producing such creative properties in determining and reporting taxable income in a 1987 Federal income tax return that is filed on April 15, 1988. The taxpayer has a balance of $12,000 in outstanding section 263A costs on her books and records as of December 31, 1987, i.e., the taxpayer has capitalized, as a cost of producing creative properties, $12,000 of costs in 1987 that have not been amortized or deducted as of the close of the taxable year. The taxpayer may adopt the three-year safe harbor by filing an amended return for 1987 using the three-year safe harbor for that year. Thus, the taxpayer would determine all of the qualified creative costs (including, but not limited to, section 263A costs) incurred in 1987 and apply the three-year safe harbor to those costs and to all qualified creative costs incurred in subsequent years.

Alternatively, the taxpayer may, if she chooses, adopt the 1988 election and, with respect to the $12,000 balance of section 263A costs outstanding at December 31, 1987, amortize and deduct $6,000 of those costs in 1988, and $6,000 of those costs in 1989. The taxpayer would then apply the three-year safe harbor to all qualified creative costs incurred in 1988 and in all subsequent years. Thus, if the taxpayer incurs an additional $18,000 of qualified creative costs in 1988, the total costs deducted in 1988 would be $15,000 ($6,000 + $9,000); the total costs deducted in 1989 would be $10,500 ($6,000 + 4,500), in addition to 50% of the qualified creative costs incurred in 1989. The taxpayer would file a Federal income tax return for 1988 determining and reporting taxable income under these procedures. The taxpayer would not file an amended return for 1987.

Taxpayers automatically electing to use the three-year safe harbor on a Federal income tax return (whether such return is timely filed or is amended, and regardless of whether the 1988 election is adopted) shall note such election of the safe harbor by typing or legibly printing the following statement at the top of page 1 of Schedule C (Form 1040): "Three-Year Safe Harbor Adopted Under the Provisions of Notice 88-62." With respect to corporations and partnerships automatically electing to use the three-year safe harbor, such statement shall be provided on the top of Schedule A, Form 1120, or Schedule A, Form 1065, respectively.

Except as otherwise provided in this notice, taxpayers may not elect the use of the three-year safe harbor for any taxable year, unless consent to such change in method of accounting is obtained from the Commissioner. Moreover, taxpayers electing to use this three-year safe harbor may not discontinue such use unless consent to such change in method of accounting is obtained from the Commissioner. Procedural Information.

This notice serves as an "administrative pronouncement" as that term is described in section 1.6661-(3)(b)(2) of the regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure. Further Information.

For further information regarding this notice, please contact Paulette C. Galanko of the Legislation and Regulations Division at (202) 566-3238 (not a toll-free call).