Rev. Rul. 81-150

ISSUE

Is a management fee deductible in the year paid under the circumstances described below?

FACTS

P is a limited partnership organized to acquire an offshore drilling rig and to engage in contract drilling of oil and gas wells for major oil companies. The drilling rig will be constructed by a shipbuilding company, and will have a useful life of 10 years. The drilling rig is expected to be completed in July, 1981, at which time it will be placed in operation.

In 1980, P paid the managing partner a management fee of 325x dollars. The management fee is to compensate the managing partner for supervising construction and financing of the drilling rig and for managing the partnership during construction of the drilling rig.

P uses the cash method of accounting for receipts and expenditures and reports income on a calendar year basis. P proposes to deduct the management fee in the year paid.

LAW AND ANALYSIS

Section 162 of the Internal Revenue Code provides for a deduction of all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.

Section 263(a) of the Code provides, generally, that no deduction shall be allowed for capital expenditures.

Section 1.263(a)-2(a) of the Income Tax Regulations provides that the term capital expenditures includes the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.

Section 195(a) of the Code provides that start-up expenditures paid or incurred after July 29, 1980, in taxable years ending after such date, may, at the election of the taxpayer, be treated as deferred expenses to be deducted over a period of not less than 60 months as may be selected by the taxpayer (beginning with the month in which the business begins).

Section 195(b) defines "start-up expenditure" to mean any amount paid or incurred in connection with investigating the creation or acquisition of an active trade or business, or creating an active trade or business, and which, if paid in connection with the expansion of an existing trade or business, would be allowable as a deduction for the taxable year in which paid or incurred.

Section 195(c)(1) requires that an election under this section be made not later than the time prescribed by law for filing the return for the taxable year in which the business begins (including extensions thereof).

In Woodward v. Commissioner, 397 U.S. 572 (1970), 1970-1 C.B. 56, the Supreme Court of the United States distinguished costs that are deductible under section 162 of the Code from costs that are capital expenditures. The court stated that: "It has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures."

In the present case, the management fee is to compensate the managing partner for supervising construction and financing of the drilling rig and for managing the partnership during construction of the drilling rig. The portion of the fee attributable to the supervision of construction and financing of the drilling rig is a cost incurred in the acquisition of a capital asset; as such, it is a capital expenditure, to be treated as part of the cost of the drilling rig. Such portion of the management fee is not a start-up expenditure within the meaning of section 195(b) of the Code.

With regard to the deductibility of the remaining portion of the management fee, it should be noted that, in order to qualify as a deductible business expense under section 162 of the Code, an expense must be (a) incurred in carrying on a trade or business, (b) ordinary and necessary, and (c) paid or incurred during the taxable year. See Commissioner v. Lincoln Savings and Loan Ass'n, 403 U.S. 345 (1971), 1971-2 C.B. 116.

In Richmond Television Corporation v. United States, 345 F.2d 901 (4th Cir. 1965), the taxpayer, a corporation organized to operate a television station, applied for a broadcasting license in 1952. Prior to receipt of its broadcasting license and commencement of its broadcasting activities in 1956, the taxpayer incurred expenses in training prospective employees. The taxpayer deducted these expenses as business expenses under section 162 of the Code in taxable years 1952 through 1956.

In addressing the issue of the deductibility of business expenses, the court, in Richmond Television, stated that a taxpayer "has not 'engaged in carrying on a trade or business' within the intendment of section 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized." The court held that the taxpayer was not "engaged in carrying on a trade or business" until the broadcasting license was issued and broadcasting commenced. Because the expenditures for training prospective employees were made before the license was issued and before broadcasting commenced, the court held that they were capital expenditures and not deductible under section 162(a) of the Code.

In the present case, P will not be engaged in carrying on a trade or business until July, 1981, when the drilling rig will be completed and placed in operation. Because the management fee will be paid to the managing partner prior to July, 1981, the portion of the fee that is attributable to the management of the partnership during construction of the drilling rig will not be deductible as a business expense under section 162 of the Code. To the extent that such fee or portion thereof will be paid or incurred after July 29, 1980, however, it is a start-up expenditure within the meaning of section 195 of the Code because it was paid in creating an active trade or business and would have been currently deductible had the business already commenced operation. Should P make an election, in accordance with the provisions of section 195(c) of the Code, to treat the start-up expenditure as a deferred expense, it shall be allowed as a ratable deduction over such period of not less than 60 months as may be selected by P beginning with July, 1981.

HOLDING

The portion of the management fee that is attributable to the supervision of construction and financing of the drilling rig is a capital expenditure, as defined in section 263 of the Code, and is treated as part of the cost of the drilling rig. The portion of the management fee that is attributable to the management of the partnership during construction of the drilling rig is not deductible in the year paid, under section 162 of the Code, but must be capitalized; that part of this amount paid or incurred after July 29, 1980, is a start-up expenditure which P may elect to deduct under section 195 of the Code.

¹ Also released as News Release IR-81-52, dated May 7, 1981.