When should your business deduct vs. capitalize advertising costs?

If you’re advertising to promote a product or service or even to enhance your company’s reputation or goodwill, you can generally treat these costs as deductible business expenses. But there are some instances when you have to capitalize and depreciate these costs.

What’s at issue?

For years, businesses and the IRS have disputed when companies should deduct advertising costs as current expenses vs. capitalize and depreciate them. Businesses thought they had to capitalize these costs only when they created a new asset. But the U.S. Supreme Court’s landmark INDOPCO Inc. v. Commissioner decision in 1992 changed the landscape.

The Court held that creation of a new asset was a sufficient, but not necessary, condition for classifying a cost as a capital expenditure. Costs must also be capitalized, the Court said, if they produce “significant long-term benefits” — for example, benefits that extend well beyond the tax year in which they’re incurred. In this case, the target of a friendly takeover had to capitalize more than $2 million in investment banking fees, legal fees and other costs related to the transaction.

After the INDOPCO decision, many businesses worried that the IRS would extend the court’s holding to advertising costs under the theory that advertising expenses produce benefits beyond the current year. The IRS alleviated those concerns with Revenue Ruling 92-80, which stated that advertising costs “are generally deductible (as ordinary and necessary business expenses) even though the advertising may have some future effect on business activities, as in the case of institutional or goodwill advertising.”

What are the exceptions?

The IRS ruling provides an exception for certain unusual circumstances. The IRS cited Cleveland Electric Illuminating Co., a U.S. Claims Court case involving an electric company that conducted an advertising campaign to allay public fears about nuclear power. The court required the company to capitalize these expenses because the advertising was “directed towards obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising or with institutional or goodwill advertising.”

You also must capitalize some advertising costs incurred to create a tangible asset expected to last more than one year, such as a billboard or other permanent signage, Web site content, and catalogs.

What about costs related to new or existing businesses?

You can deduct expenses only when they’re related to an existing trade or business. If the company is new, you must capitalize all startup costs, including advertising. These expenses may be amortized and deducted, if elected, once the business is active.

Unfortunately, the distinction between a new and existing business isn’t always clear. In one case, a bank was able to deduct advertising costs related to the development of a new branch because these expenses were used to expand an existing business.

But in another case, when a clothing and cosmetics manufacturer opened a retail store, it had to capitalize the costs associated with the first location, including advertising. Additional retail outlets were then considered expansions of the existing retail business.

Watch out for gray areas

The tax treatment of advertising expenses is complex. A seemingly simple distinction, such as whether a business is considered new or existing, isn’t clear cut. Be sure to properly document these costs and consult your tax advisor.

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Faster than a speeding bullet
Electronic billing systems catching on

It’s taken a few years longer than expected, but electronic billing presentation and payment (EBPP) is catching on with both businesses and customers. Businesses stand to speed up cash flow and save in areas such as employee time and mailing costs and customers enjoy the systems’ convenience.

EBPP systems let businesses send bills by e-mail, post them online or both. Customers can electronically transfer payments in a heartbeat, and either print out or store billing and payment records on their computers.

Significant growth

How fast is EBPP growing? In 2002, 13% of U.S. consumers used it, a big jump from only 2% in 1998, according to financial services research firm Tower Group. And approximately 64 million Americans electronically viewed their credit card and other billing statements in 2003, a 100% increase over 2001, according to technology research company Gartner Inc.

It’s worth noting that in business-to-business transactions, electronic invoice presentation and payment (EIPP) has a longer history and greater acceptance than in the business-to-consumer arena. Gartner estimates that, in 2003, 60% of large U.S. companies sent e-invoices to their customers. These businesses can use their electronic billing experience to set up customer-friendly systems.

Profit incentives

One of the biggest hurdles to enjoying EBPP efficiencies is overcoming consumer resistance — but it’s worth the work. Persuading customers to view statements and pay bills online lets you:

• Stop printing, mailing and storing hard copies of bills and statements, lowering transaction costs,
• Improve customer satisfaction by offering quick and easy bill payment — plus customers can look up their payment histories and transaction details online, reducing customer service phone calls,
• Shorten the invoice-to-payment cycle by roughly 16%, according to Gartner, though that figure varies by business size and industry, and
• Reduce your company’s float — the time it takes a payment to clear so the funds become available.

An EBPP system doesn’t require all customers to enroll — it’s worthwhile to implement with only a small percentage adopting EBPP. The key to building acceptance is persuading customers that the process will be quick, easy and secure. Your system must then live up to that billing, with easily available support from real people. This is the time to prove that your company can maintain personal customer relationships alongside online transactions.

Affordable options

Large organizations integrate EBPP into their “financial supply chain” systems, paying hundreds of thousands of dollars for hardware and software, plus consulting and installation fees.

For small companies, a much more affordable option is outsourcing to an EBPP service provider, a service some banks now provide. The vendor typically charges based on the number of transactions they handle. You can present bills and statements either directly or by aggregation.

The direct billing method is the simplest, using a secure connection between you and each enrolled customer. You e-mail an invoice, and the customer clicks on an embedded link to electronically transfer payment to your bank. You may also let the customer view the invoice on your extranet, a portion of your Web site accessible to customers with the correct passwords.

The aggregation method is more complicated because it relies on a third party, the aggregator, to route billing and payment information to customers. But customers may prefer this method, which lets them access a single Internet location to receive and pay bills from various creditors. In either case, customers pay via pre-authorized bank account debits, electronic bank-to-creditor transfers or credit card transactions.

Win-win deal

When software developers such as Intuit introduced electronic bill payment in the mid-1980s, and e-commerce took off in the 1990s, some thought hard-copy bills, invoices and checks would soon go the way of manual typewriters and carbon paper. Today, consumers are still moving out of the “wait and see” stage. But it appears EBPP will prevail, because the advantages for both businesses and consumers are just too great to ignore.

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Motivate your sales force by fine-tuning compensation

Hoping to jump start revenues, some business owners keep looking for new and different ways to structure salespeople’s pay. Unfortunately, there’s no magic bullet. Each company must customize its compensation plan to motivate its sales force and to fulfill its business objectives.

Of course, that doesn’t mean you should settle on one compensation strategy and never change it — even the most effective plans need adjustment over time. It’s an excellent idea to fine-tune your plan yearly to incorporate new goals and respond to industry and market changes, competitive pressures, and shifts in your merchandise or services.

The major compensation elements are salary (or hourly wage) and commission. Combining the two may be the best option for keeping your sales staff loyal, motivated and focused on customer satisfaction.

Salary provides security

Want to ensure salespeople a stable income and emphasize customers’ best interests? Consider an industry-competitive straight salary or hourly wage. Salespeople receiving a salary will:

• Know what income to expect regardless of sales volume or economic downturns,
• Have less motivation to sell customers unneeded products and services in order to earn more money, and
• Be more likely to cooperate with each other, rather than compete for customers and sales.

From a management point of view, fixed compensation costs make budgeting and forecasting easier. Straight salaries also let managers include nonsales activities such as collection calls, managing inventory, customer service and market research in salespeople’s job descriptions. The downside? They don’t motivate staff to sell aggressively. Without commission or other sales-volume rewards, you and your sales manager must personally motivate your salespeople.

Fixed salaries work best in situations where sales vary drastically because of conditions beyond salespeople’s control, such as seasonal swings.

Commission lights a fire

The other side of the compensation coin is paying straight commissions. Companies usually base commissions on a percentage of either sales or profit margin. Actual percentages vary widely, but like base salaries, they must be industry-competitive for you to retain good people.

Commissions motivate salespeople to develop their sales skills and be aggressive, and they often eliminate poor performers. But if your compensation plan strongly emphasizes commission, salespeople may spend too much energy focusing on making a few big sales. They may also make promises your company can’t keep or sell services your clients don’t need. If so, you and your sales manager will have to:

• Emphasize long-term customer satisfaction and discourage salespeople from moving customers up to more expensive merchandise they may not need or making promises that can’t be fulfilled,
• Consider offering draws on commission to ease anxiety during slow sales periods, and
• Split commissions when appropriate to encourage cooperation — but don’t discourage superstars by limiting the amount of commission a salesperson can earn.

Some companies vary commission levels to help achieve goals — for example, building market share by paying higher commissions on sales to new customers. But this risks encouraging poor service to older, loyal customers.

When deciding how to structure commissions, remember that a percentage of sales is simpler for salespeople to calculate on their feet. A percent of profit margin motivates them to favor your most profitable products but dissuades them from negotiating prices too far down just to make a sale.

Combinations spark success

Most companies combine salary and commission, sometimes adding other incentives as well. Paying a low base salary along with commissions creates security and helps retain good salespeople during tough times while still motivating them to improve their selling skills. You can manipulate the salary levels and commission percentages to tilt the balance one way or the other.

Many businesses also pay salespeople quarterly or annual bonuses, based on the company’s or division’s gross profit or revenue, but tied to individual performance. For example, everyone receives a certain minimum bonus, but some above-average achievers get twice that amount, with triple the minimum for a few superachievers. Here are some more bonus tips:

• Structure bonuses so they’re not a large percentage of compensation. Otherwise average salespeople can coast along on the coattails of the top performers.
• Base bonuses on profit rather than revenue. This gives salespeople an incentive to hold down expenses and cooperate with other employees. And focusing on revenue performance might motivate salespeople with negotiating authority to lower prices in order to boost sales volume — especially near the end of the bonus period.
• Consider quarterly instead of yearly bonuses, if you want to emphasize short-term objectives over long-term ones — and vice versa.

Some companies use spiffs, or flat rewards, on slow-moving products or the last few products left on the floor from a discontinued line. Of course, it might be better to discount the product by the same amount and let the customer decide whether to purchase it.

Occasional contests create short-term enthusiasm and give winners a psychological boost. But if you run contests too often, the excitement level will ebb, and you risk creating the perception that those who don’t win are losers.

Simple plans work best

When structuring your compensation plan, keep it simple. Don’t combine more than two or three methods, or salespeople won’t be able to remember the formula. Also, before you finalize a payment structure, project total sales and sales compensation during the first period you’ll be using it. That way, you’ll ensure the plan will help, rather than hurt, your company’s bottom line.

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