Principles of Capitalization (Portfolio 509)

Tax Management Portfolio, Principles of Capitalization, No. 509, 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, 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. In-depth coverage of specific topics also can be found in other Portfolios, including Maule, 503 T.M., Deductions: Overview and Conceptual Aspects.

This portfolio may be cited as Atkinson, Rohrs, and Walberg, 509 T.M., Principles of Capitalization.

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.

Jane A. Rohrs, C.P.A.

Jane A. Rohrs, B.A., University of Utah; M.P.A., University of Texas — Austin; formerly a member of the staff of the Joint Committee on Taxation (2009–2011) served as tax legislative accountant; Executive Director — Ernst & Young LLP (National Tax Department (1996–2009); Dallas, TX (1988–1996)); member, American Institute of Certified Public Accountants, member, the American Bar Association.

Glenn Walberg

Glenn Walberg, B.B.A., University of Notre Dame; M.B.A. & M.Acc., University of Wisconsin — Madison; J.D., College of William and Mary; LL.M. (Taxation), Georgetown University.

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
A. Historical Background
B. Overview
C. Accounting Method Changes to Comply with the Tangible Property Regulations
IV. Materials and Supplies
A. In General
B. Election to Capitalize Certain Materials and Supplies
C. Election to Apply the De Minimis Rule
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 — General Rules for Capital Expenditures
A. In General
B. Amounts Paid
C. Amounts Paid to Sell Property
D. Accounting Method Changes
E. Effective Dates and Transition Rules
VI. Tangible Property — Acquisition or Production Costs
A. In General
B. Acquisition or Production Costs Rules Under the Tangible Property Regulations
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 for Acquisitions of Property
5. Costs of Defending or Perfecting Title
6. Other Costs Not Required to Be Capitalized Under the Tangible Property Regulations
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. Sale or Disposition
j. Coordination with Section 263A
k. Consolidated Groups and Other Groups of Entities
l. Time and Manner of Election
8. Accounting Method Changes
VII. Tangible Property — Improvements
A. Background
B. Tangible Property Regulations
1. Introduction; Effective Dates
2. General Rules and Definitions
3. Unit of Property Definition
a. In General
b. Specific Types of Property
(1) Buildings and Structural Components
(2) Condominiums and Cooperatives
(3) Plant Property
(a) In General
(b) Steam or Electric Power Generation Property
(4) Network Assets
(5) Leased Property (Other than Leased Buildings)
(6) Improvements to Leased Property
(7) Mining Industry
4. Improvement Standards and Safe Harbors
a. Betterments
b. Restorations
c. Adaptations to a New or Different Use
d. Safe Harbor for Small Taxpayers
e. Routine Maintenance Safe Harbor
f. Building Refresh or Remodeling Project
(1) In General
(2) Remodel-Refresh Safe Harbor
g. Plan of Rehabilitation Doctrine Obsoleted
h. Removal Costs
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
VIII. Acquisition or Creation of Intangible Property
A. Overview
B. In General
C. Amounts Paid to Acquire an Intangible
D. 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
E. Amounts Paid to Create or Enhance a Separate and Distinct Intangible Asset
F. Amounts Paid to Facilitate the Acquisition or Creation of an Intangible (Transaction Costs)
1. Simplifying Conventions
a. Employee Compensation and Overhead
b. $5,000 De Minimis Exception
2. Special Rules for Certain Costs
G. 12-Month Rule
1. In General
2. Duration of Certain Rights
3. Inapplicability
4. Election Not to Apply the 12-Month Rule
H. Pooling
I. Accounting Method Changes
J. Software Development Costs
1. Revenue Procedure 69-21
2. Revenue Procedure 2000-50
3. Intangible Property Regulations
IX. Business Transaction Costs
A. In General
B. Organizations and Formations of New Businesses
1. Capitalization of Investigatory and Pre-opening Costs
2. Amortization of Organizational Costs
C. Acquisitions of Existing Businesses
1. In General
2. Acquisitions to Expand Existing Businesses
3. Acquisitions to Start New Businesses
D. Transaction Costs Incurred in Business Acquisitions, Reorganizations, and Recapitalizations
1. Transactions Subject to the Regulations
a. Acquisitions of Assets Constituting a Trade or Business
b. Acquisitions of Ownership Interests by a Taxpayer
c. Acquisitions of a Taxpayer's Ownership Interests
d. Restructurings, Recapitalizations, and Reorganizations
e. Transfers Under Sections 351 and 721
f. Formations or Organizations of Disregarded Entities
g. Acquisitions of Capital
h. Stock Issuances
i. Borrowings
j. Writings of Options
2. Facilitative Costs
a. Determining Facilitative Costs
(1) Examples of Facilitative Costs
(a) Valuation Costs
(b) Registrar and Transfer Agent Fees for Categorized Transactions
(2) Examples of Non-Facilitative Costs
(a) Consideration Paid in Transactions
(b) Costs of Mandatory Stock Distributions
(c) Stock Issuance Costs of Open-Ended Regulated Investment Companies
(d) Business Integration Costs
(e) Registrar and Transfer Agent Fees for Maintenance Activities
b. Costs of Activities Associated with Several Transactions
(1) Costs of a Borrowing
(2) Costs of Asset Sales
(3) Costs of Chapter 11 Bankruptcy Proceedings
(4) Costs of Terminated Agreements
(5) Costs of Abandoned Transactions
c. Exceptions to Facilitative Costs
(1) Costs Attributable to Covered Transactions
(a) Definition of Covered Transactions
(i) Taxable Acquisitions of Assets
(ii) Taxable Acquisitions of Ownership Interests
(iii) Certain Reorganizations
(b) Costs of Activities Performed Before a Bright-Line Date
(c) Inherently Facilitative Amounts of Covered Transactions
(2) Costs Addressed by Simplifying Conventions
(a) Simplifying Convention for Employee Compensation Costs
(b) Simplifying Convention for Overhead Costs
(c) Simplifying Convention for De Minimis Costs
(d) Election to Capitalize Costs Subject to Simplifying Conventions
d. Success-Based Fees as Facilitative Costs
3. Cost Recovery for Facilitative Costs
a. Tax-Free Acquisitive Transactions
b. Taxable Acquisitive Transactions
c. Stock Issuance Transactions
d. Borrowing Transactions
e. Option Writing Transactions

Working Papers

Table of Worksheets
Worksheet 1 Tier I Industry Director's Directive on the Planning and Examination of Repairs vs. Capitalization Change in Accounting Method (CAM) #1
Worksheet 2 Tier I Industry Director's Directive on the Planning and Examination of Repairs vs. Capitalization Change in Accounting Method (CAM) #2
Worksheet 3 Updated LB&I Directive for Taxpayers Who Adopted a Method of Accounting Relating to the Conversion of Capitalized Assets to Repair Expense Under IRC §263(a)
Worksheet 4 Industry Directory's Directive #1 on Examination of IRC §165 Casualty Losses
Worksheet 5 Industry Directory's Directive #2 on Examination of IRC §165 Casualty Losses
Worksheet 6 Field Guidance on the Planning and Examination of the Cyclical Overhauls, Betterments, and Rebuilds of Locomotives For Class I Railroads
Worksheet 7 Field Guidance on the Planning and Examination of the Cyclical Overhauls, Betterments, and Rebuilds of Freight Cars for Class I Railroads
Worksheet 8 Field Guidance on the Planning and Examination of the Heavy Maintenance Visit (HMV) on Airframes
Worksheet 9 [Reserved.]
Worksheet 10 [Reserved.]
Worksheet 11 [Reserved.]
Worksheet 12 [Reserved.]
Worksheet 13 [Reserved.]
Worksheet 14 [Reserved.]
Worksheet 15 Pro-forma Information Document Request for Tier I Repairs vs. Capitalization Change in Accounting Method
Worksheet 16 Sample Form 3115, Application for Change in Accounting Method (Repair Regulations)