Although it’s easy for you and three friends to chip in on a pizza and split the $20 price four ways, it’s not nearly as straightforward for companies that want to share costs to develop new products or assets between one another. Because each company will use the shared development as a means to generate a profit, each must declare its investment into the arrangement for cost accounting as required by the Internal Revenue Service.
Tax Basis for Cost-Sharing Arrangements
If two independently organized companies, even when they’re a parent and a subsidiary, exchange any sort of asset, the IRS requires that companies must pay the fair market value of the good received to the company that produced it. While these regulations prevent a company from internally shifting assets and avoiding taxes that would normally be assessed on their revenue, they also create situations in which companies expose themselves to a large tax liability for sharing developments.
The IRS allows two companies to enter into a cost-sharing arrangement before the development of any mutually beneficial asset as a means to reduce the tax liability involved in a situation. If two companies enter into cost-sharing arrangement, rather than paying the fair market value of any asset it receives, the secondary company splits the cost of developing the asset. Each company projects its future earnings based on the development, and splits the development’s cost based on its portion of future revenues.
Cost-sharing arrangements are easier to understand when you examine an example. The Jones company plans to develop a patent on a new widget, and knows its subsidiary, the Smith company, will greatly benefit by using the patent as well. Rather than waiting to license the new widget to the Smith company, resulting in a large tax liability, the two companies enter into a cost-sharing arrangement. The Jones company spends $100,000 developing the widget and projects the improved widget will result in $20,000 in new sales. The Smith company plans to increase sales by $60,000 with the new technology, so the combined benefit of the widget is $80,000, with Jones receiving 25 percent of the benefit and Smith receiving 75 percent of the benefit. With costs for the new widget split along that ratio, the Smith company must pay $75,000 to the Jones company for the widget, much less than its market value of $150,000 it would have had to pay if it paid the market value to license the widget.
Other Cost-Sharing Agreements
While the IRS’s definition of cost-sharing arrangements is rigid and typically applies to larger corporations, many small companies enter into less-formal cost-sharing arrangements. These arrangements help pool costs for items that can be easily shared, such as advertising, marketing or distribution. Companies typically negotiate these arrangements according to the type, expense and their involvement in them.
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