Principles of Capitalization (Portfolio 509)

Tax Management Portfolio, Principles of Capitalization, No. 509-2nd, explores the theory and practical application of the fundamental principles determining whether an expenditure may be currently deducted as an ordinary and necessary business expense or whether instead it must be capitalized and recovered through another tax accounting mechanism, such as depreciation.  To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

Tax Management Portfolio, Principles of Capitalization, No. 509-2nd, explores the theory and practical application of the fundamental principles determining whether an expenditure may be currently deducted as an ordinary and necessary business expense or whether instead it must be capitalized and recovered through another tax accounting mechanism, such as depreciation. Other Tax Management Portfolios provide in-depth analysis of the Uniform Capitalization Rules of §263A. This Portfolio instead focuses upon the more traditional capitalization principles underlying §263(a), the decades of case law interpreting those principles, and the government's recent efforts to rationalize this area through the issuance of regulations.

This Portfolio provides a comprehensive review and analysis of the tax accounting principles underlying the capitalization concept, including the clear reflection of income and matching requirements of §446. The Portfolio applies these theoretical underpinnings in addressing the tax treatment of a wide variety of business expenditures, including the direct and indirect costs incurred to acquire, create, repair and maintain tangible property. The Portfolio also addresses the tax treatment of costs incurred to acquire or create intangible property under the so-called “INDOPCO regulations” as well as costs incurred in connection with various business transactions, including corporate reorganizations. Finally, the Portfolio considers a variety of other expenditures incurred by business taxpayers, including software and website design expenditures, advertising, and business reengineering costs.

For a discussion of the cost recovery of expenditures required to be capitalized under these principles, see Kelly, 530 T.M., Depreciation: General Concepts; Non-ACRS Rules, 531 T.M., Depreciation: MACRS and ACRS, and 532 T.M., First-Year Expensing and Additional Depreciation. For a discussion of the uniform capitalization rules, see 576 T.M., Uniform Capitalization Rules: Inventory; Self-Constructed Assets; Real Estate, and 577 T.M., Uniform Capitalization Rules: Method Change Rules and Special Topics. In-depth coverage of specific topics also can be found in other Portfolios.

Authors

James L. Atkinson

James L. Atkinson (B.A, University of South Carolina Honors College, summa cum laude; J.D., University of Illinois College of Law, summa cum laude) is a principal with KPMG LLP (Washington National Tax). Mr. Atkinson formerly was the IRS Associate Chief Counsel (Income Tax & Accounting), and has taught federal tax accounting as an adjunct professor of law at the Georgetown University Law Center.

Table of Contents

Detailed Analysis
I. Introduction
II. General Capitalization Principles
A. Costs Subject to Capitalization
B. When Costs Are Capitalized
III. Tangible Property Regulations: Overview
Introductory Material
A. In General
B. Amounts Paid
C. Amounts Paid to Sell Property
D. Accounting Method Changes
IV. Materials and Supplies
A. In General
B. Election to Capitalize Certain Materials and Supplies
C. Application of De Minimis Safe Harbor Election to Materials and Supplies
D. Treatment of Rotable and Temporary Spare Parts
E. Dispositions of Materials and Supplies
F. Accounting Method Changes
1. Incidental and Non-Incidental Materials and Supplies
2. Deduction of Rotables When Disposed Of
3. Change to Optional Method for Rotables
V. Tangible Property — Acquisition or Production Costs
A. In General
B. Tangible Property — Acquisition or Production Costs
1. Overview
2. Direct Acquisition or Production Costs
3. Costs for Work Performed Before Date Placed in Service
4. Transaction Costs
a. In General
b. Special Rule for Acquisitions of Real Property
c. Safe Harbor for Employee Compensation and Overhead Costs
5. Costs of Defending or Perfecting Title
6. Costs of Moving or Re-Installing Tangible Property
7. De Minimis Rule
a. General Rules; Applicability
b. Taxpayers With an Applicable Financial Statement
c. Taxpayers Without an Applicable Financial Statement
d. Taxpayers With Both an Applicable Financial Statement and a Nonqualifying Financial Statement
e. Applicable Financial Statement
f. Anti-Abuse Rule
g. Transaction and Other Additional Costs
h. Materials and Supplies
i. Treatment Upon Sale or Disposition
j. Coordination With §263A
k. Consolidated Groups and Other Groups of Entities
l. Time and Manner of Election
8. Accounting Method Changes
VI. Tangible Property — Improvements
A. Background
B. Tangible Property Regulations
1. Introduction
2. Threshold Requirement: Costs Must Be Incurred
3. Unit of Property Definition
a. In General
b. Specific Types of Property
(1) Buildings and Structural Components
(a) In General
(b) Leased Building
(c) Condominiums and Cooperatives
(2) Non-Building Property
(a) In General
(b) Plant Property
(i) Generally
(ii) Electric Generation Assets
(c) Network Assets
(i) Wireline Telecom
(ii) Wireless Telecom
(iii) Cable Television
(iv) Electric Transmission and Distribution
(v) Natural Gas Distribution
(d) Mining Industry Assets
(3) Leased Property (Other Than Leased Buildings)
(4) Improvements to Leased Property
4. Improvement Standards and Safe Harbors
a. Betterments
b. Restorations
c. Adaptations to a New or Different Use
d. Indirect Costs
e. Removal Costs
f. Routine Maintenance Safe Harbor
g. Safe Harbor for Small Taxpayers
h. Building Refresh or Remodeling Project
(1) In General
(2) Remodel-Refresh Safe Harbor
i. Railroad Track Maintenance Allowance Method
5. Optional Regulatory Accounting Method
6. Election to Capitalize Repair and Maintenance Costs
7. Treatment of Capital Expenditures
8. Recovery of Capitalized Amounts
9. Accounting Method Changes to Comply With the Regulations
VII. Acquisition or Creation of Intangible Property
Introductory Material
A. In General
B. Amounts Paid to Acquire an Intangible
C. Amounts Paid to Create Certain Intangibles
1. Amounts Paid to Create a Financial Interest
2. Prepaid Expenses
3. Certain Memberships and Privileges
4. Certain Rights Obtained From a Governmental Agency
5. Certain Contact Rights
6. Certain Contract Termination Payments
7. Certain Real Property Transactions
8. Defense or Perfection of Title to Intangible Property
D. Amounts Paid to Create or Enhance a Separate and Distinct Intangible Asset
E. Transaction Costs
1. Simplifying Conventions
a. Employee Compensation and Overhead
b. $5,000 De Minimis Exception
2. Special Rules for Certain Costs
F. 12-Month Rule
1. In General
2. Duration of Certain Rights
3. Inapplicability
4. Election Not to Apply the 12-Month Rule
G. Pooling
H. Accounting Method Changes
I. Software Development Costs
1. Rev. Proc. 69-21
2. Rev. Proc. 2000-50
3. Intangible Capitalization Regulations
4. Post-2021 Software Development Costs
5. Accounting Method Changes
J. Historical Development
VIII. Business Transaction Costs
A. In General
B. Transactions Subject to the Regulations
1. Acquisitions of Assets Constituting a Trade or Business
2. Acquisitions of Ownership Interests by a Taxpayer
3. Acquisitions of an Ownership Interest in the Taxpayer
4. Restructurings, Recapitalizations, and Reorganizations
5. Transfers Under §351 and §721
6. Formations or Organizations of Disregarded Entities
7. Acquisitions of Capital
8. Stock Issuances
9. Borrowings
10. Writings of Options
C. Facilitative Costs
1. Special Rules for Certain Costs
a. Costs of Asset Sales
b. Costs of Mandatory Stock Distributions
c. Stock Issuance Costs of Open-End Regulated Investment Companies
d. Business Integration Costs
e. Registrar and Transfer Agent Fees
f. Costs of Chapter 11 Bankruptcy Proceedings
2. Costs Attributable to Covered Transactions
a. Definition of Covered Transactions
b. Investigatory Costs
c. Inherently Facilitative Costs
3. Costs of Terminated/Abandoned Transactions
4. Success-Based Fees
a. Generally
b. Elective Safe Harbor
5. Simplifying Conventions
a. Employee Compensation
b. Overhead Costs
c. De Minimis Costs
d. Election to Capitalize Costs Subject to Simplifying Conventions
D. Cost Recovery for Facilitative Costs
1. Tax-Free Acquisitive Transactions
2. Taxable Acquisitions
3. Stock Issuances
4. Borrowings

5. Option Writing Transactions

Working Papers

Table of Worksheets
Worksheet 1 Simplified Decision Tree: All Tangible Property
Worksheet 2 Simplified Decision Tree: Buildings
Worksheet 3 Simplified Decision Tree: Non-Building Property