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By James L. Atkinson, Esq.
Miller & Chevalier Chartered, Washington, DC
The IRS has begun a new audit initiative focusing on whether repair and maintenance expenses are currently deductible or instead must be capitalized and recovered through depreciation. Ironically, the increased IRS scrutiny of repair expenditures both results from and is likely to be ameliorated by the government's on-going efforts to provide more readily administrable standards for making these determinations.
During much of the 1990s, capitalization disputes between the IRS and taxpayers largely centered on the treatment of costs related to "intangibles" following the Supreme Court's decision in INDOPCO, Inc. v. Comr., 503 U.S. 79 (1992). After a decade of administrative controversy and litigation regarding such costs, in 2003 the government issued the so-called "INDOPCO regulations" under §§1.263(a)-4 and -5 to resolve many of these disputes. Shortly before completing the INDOPCO regulations project, the IRS announced that it would begin a similar effort to simplify and clarify the capitalization rules applicable to tangible property. The resulting "proposed tangibles regulations" were issued in March 2008.
The government implemented accounting method changes required by the INDOPCO regulations using a "modified cut-off" rule. This meant that while taxpayers could change their existing accounting methods to reflect the new capitalization rules, in computing the "§481 adjustment" required as part of the method change, they could not take into account any costs incurred prior to the date on which the regulations were initially proposed. When the government issued the proposed tangibles regulations, taxpayers were concerned that when finalized, they would impose a similar rule for implementing accounting method changes required by those new rules. This would strand otherwise deductible costs incurred prior to the "cut-off date" in the depreciable basis of the tangible property, requiring those costs to be recovered gradually through depreciation rather than immediately through the §481 adjustment.
In light of this concern, a large number of taxpayers quickly filed accounting method change requests with the IRS before the proposed tangibles regulations could be finalized. Many of these taxpayers also undertook "repair studies" to identify previously overlooked repair deductions that could be recovered immediately as part of the accounting method change. Doing so allowed taxpayers to take advantage of the rules generally applicable to accounting method changes, including an unlimited §481 adjustment that includes a variety of repair costs incurred both before and after the potential "cut-off date." The method changes could be made based only on current law, however, and could not take into account more liberal standards proposed in the tangibles regulations. The trade off was a potentially larger §481 adjustment (operating as an immediate reduction to income) in exchange for basing that redetermination on current, narrower capitalization standards.
The extremely high volume of resulting accounting method changes did not go unnoticed by the IRS. The government's reaction was two fold. First, taxpayers were provided with "automatic consent" to change the manner in which they accounted for repair costs. Procedurally, this avoids the need to wait for formal consent from the IRS before implementing the change, but leaves the taxpayer without any indication from the IRS as to its views of the merits of the taxpayer's new accounting method. That now must wait for review by the taxpayer's exam team. Second, the Large & Mid-Size Business Division (LMSB) added the treatment of repair costs to its list of "Tier 1 issues," meaning those that attract the most attention on audit.
Consistent with the designation of the tax treatment of these costs as a Tier 1 issue, many taxpayers are encountering increased scrutiny of their treatment of otherwise routine repair and maintenance expenditures. While the IRS audit initiative appears to have resulted at least in part from the high volume of accounting method change requests, the heightened audit activity is not restricted to those taxpayers who have made such a method change. Instead, any taxpayer that has incurred substantial expenditures for repair and maintenance costs should expect to have its tax treatment of those costs closely scrutinized on audit.
In preparation for such an audit, taxpayers should ensure that they have properly documented the costs underlying the claimed deduction. Taxpayers who engaged an outside service provider to perform a repair study are likely to receive an information document request (IDR) asking for a copy of the repair study engagement letter; copies of all presentation materials prepared by or on behalf of the company; why the accounting method change was made at this time; how the company's financial accounting treatment has changed as a result of the accounting method change; and whether any cost segregation studies previously were performed in relation to this request. The IDR also will ask other detailed questions probing the nature of the assets and the costs within the scope of the accounting method change and how the taxpayer determined and computed the amount of repair costs included in the §481 adjustment and those to be currently deducted under the new accounting method. As with other highly factual issues, documentation will be critical in overcoming the IRS's skepticism and sustaining the deduction.
Taxpayers who previously received "consent" from the IRS to change their accounting method are not immune to these audit challenges. The characterization of a particular activity as a deductible repair rather than a capital improvement is an inherently factual one. Even where the IRS has consented to the taxpayer's use of a new accounting method, IRS examination teams retain the authority and responsibility to review the taxpayer's facts to ensure that the taxpayer is correctly applying the approved legal standard to those facts. As such, the "consent" obtained from the IRS allows use of a particular standard, but does not insulate the taxpayer against fact-based challenges to its tax treatment of specific costs.
When finalized, the proposed tangibles regulations are likely to eliminate many of the capitalization disputes involving tangible property in the same way that the INDOPCO regulations eliminated many of the disputes surrounding intangible assets. While Treasury and the IRS have stated publicly that they hope to complete work on the tangibles regulations by the end of calendar year 2010, it is uncertain at this time the extent to which that guidance will finalize the proposed tangibles regulations issued in March 2008, or instead propose a new set of standards subject to further public comment before becoming final rules.
For more information, in BNA's Tax Management Portfolios, see Maule, 590 T.M., Taxation of Real Estate Transactions — An Overview, and in Tax Practice Series, see ¶2200, Repairs Of Tangible Property Used in a Trade or Business, and ¶2920, Capital Expenditures.
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