Audit Guide Covers Capitalization Rules
Practitioners have been making use of a resource arising from the IRS’ ongoing audit initiative concerning capitalization rules. The IRS issued Capitalization v. Repairs Audit Technique Guide (LB&I-4-0910-023) as a framework for examining agents to follow when determining whether a business’s expenses should be capitalized or an immediate deduction allowed, particularly those for repair and maintenance (see “From The Tax Adviser: How the IRS Examines Repair and Maintenance Costs,” JofA, Feb. 2011, page 62). The audit guide will be applied both to routine field examinations and to requests for a change in accounting method (CAM). Besides CAMs to adjust capitalized costs to repair costs, it is also intended to guide disposition of CAMs to change “unit of property” identification or to alter the treatment of disposed property. Taxpayers who have already received consent to change their accounting method may still have deductions challenged upon examination. The guide states that neither advance consents nor automatic consents can be construed as a determination by the commission that the taxpayer is using the appropriate method, and that this determination can be confirmed only after review by an agent.
The audit guide is the most recent step in a process begun in the 1990s, when the IRS focused its attention on capitalization disputes relating to the treatment of the costs of intangibles. The Supreme Court’s decision in INDOPCO Inc. v. Commissioner, 503 U.S. 79 (1992), began a decade-long process of clarifying the treatment of intangible property costs. In 2003, the government issued regulations under Treas. Reg. §§ 1.263(a)-4 and 1.263(a)-5 to settle many of these issues. These regulations were implemented using a “modified cutoff rule,” which limited the time frame for calculating a proposed IRC § 481 adjustment to costs incurred after the initial INDOPCO regulations were proposed. As a result, the benefit of requesting a CAM was significantly reduced for those who made the request after the regulations were adopted.
In March 2008, the IRS released proposed regulations for amounts paid to acquire, produce or repair tangible property (Treas. Reg. §§ 1.263(a)-1 through 1.263(a)-3). The proposed regulations broadened and clarified the definition of “repair and maintenance.” Practitioners, aware of the modified cutoff rule limits included in the INDOPCO regulations related to intangible property, were concerned that the proposed regulations might include a similar time restriction when they were finalized. This concern has resulted in an increase in Form 3115 filings. These CAM requests attempt to capture expenses before the potential cutoff date that might be limited under the new regulations. Procedurally, taxpayers do not have to wait for formal IRS consent before implementing the change; however, the taxpayer has no assurance that the IRS will allow the change upon examination. Perhaps because of all the CAM requests received, the IRS Large and Mid-Size Business Division (now Large Business and International Division) elevated the status of the repairs vs. capitalization CAM to a Tier I issue in January 2010. The identification of this issue as one of high strategic importance to the IRS means that taxpayers could face increased scrutiny of their CAM requests or their ongoing repair and maintenance expenditures.
The capitalization vs. repairs audit guide is a road map for how field agents will determine whether an expenditure qualifies as a currently deductible repair or is required to be capitalized. It gives a step-by-step explanation of how examinations will be conducted, what questions agents will ask, what documents they will request, and what related issues may be relevant. The audit guide suggests, for instance, that an examiner review both general ledger and fixed asset details to expose the impact of basis adjustments, insurance proceeds, retired assets, repairs and bonus depreciation. Since the difference between a cost that must be capitalized and an expense is a highly factual determination, this document provides great insight into a field agent’s decision-making process.
Six appendices to the audit guide provide additional background and history concerning specific accounting method changes such as capitalization vs. repairs, unit of property or dispositions. The appendices cite legal precedent, current law and Treasury regulations that the IRS believes will apply to each set of facts. Appendix B, for example, provides extensive scenarios that distinguish a cost that must be capitalized (a betterment, a restoration or a new or different use) from a cost that can be expensed. The audit guide notes that the facts and circumstances of each taxpayer’s case must be weighed closely when determining whether the CAM is appropriate, and that the burden of proof lies with the taxpayer. The audit guide is a significant resource for those who wish to properly document a business’s policy whether to repair or capitalize, or for those who are substantiating CAM requests.
—Dayna E. Roane, CPA, M.Tax., (dayna@perryco.com) provides tax planning, consulting and compliance services at Perry & Roane PC, Boulder, Colo.
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