IRS Releases Audit Technique Guide on Capitalization of Tangible Property

(Parker Tax Publishing September 2016)

Last week, the IRS has issued a 202-page Audit Technique Guide titled "Capitalization of Tangible Property". The guide gives auditors detailed instructions regarding what to look for when conducting an audit of a taxpayer's capitalization policies and other capitalization-related issues. ATG on Capitalization of Tangible Property (9/14/2016).

Background

In 2004, the IRS began a project to revise the tangible property regulations. In anticipation of these regulations, many taxpayers changed their method of accounting beginning as early as January 1, 2006. On March 15, 2012, IRS auditors were told to discontinue examination issues relating to whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Code Sec. 263(a) and any correlative issues involving the disposition of structural components of a building or dispositions of tangible depreciable assets. This "stand-down" directive was aimed at conserving IRS resources while permitting taxpayers time to comply with the final regulations.

The final regulations were issued in 2013 and required taxpayers to correct any prior method changes to comply with the regulations for tax years beginning on or after January 1, 2014. Taxpayers were also given the option of applying the regulations to years beginning on or after January 1, 2012. The IRS stand-down period for examining capitalization and disposition issues for a particular taxpayer ended when:

(1) the taxpayer filed a method change for an item covered by the directive for a tax year beginning on or after January 1, 2012 but before January 1, 2014; or

(2) the taxpayer filed its tax return for the first tax year beginning on or after January 1, 2014.

For example, if a taxpayer changed its method of accounting for building units of property (UOPs) in 2012 following the final regulations, the stand-down ends with respect to building UOPs when the method change was filed. The stand-down will continue to apply to plant property until the taxpayer files a Form 3115 to change its method of accounting for those units, or until the taxpayer files its first tax return beginning on or after January 1, 2014.

In filing a Form 3115, taxpayers are generally required to calculate a Code Sec. 481(a) adjustment with respect to any change in the taxpayer's capitalization and disposition accounting methods. This is going to be one of the primary areas that auditors will focus on.

The IRS believes that, as a result of the issuance of the final capitalization regulations, many of the taxpayers that had previously changed their method of accounting may now be using an accounting method for tax purposes that is inconsistent with the final regulations.

IRS Releases Tangible Property Audit Technique Guide

Last week, the IRS issued an Audit Technique Guide (ATG) titled Capitalization of Tangible Property. ATGs are used as a tool by IRS examiners for identifying potential tax issues. The capitalization ATG urges auditors to carefully risk assess and apply the law to a taxpayer's facts and circumstances for issues involving the capitalization and dispositions of tangible property. The ATG lays out the interview questions auditors should ask when conducting an audit of a taxpayer's capitalization methods and asset disposition policies, as well as the audit procedures the auditor should follow in conducting the audit.

In the ATG, the IRS notes that Rev. Proc. 2015-14 identifies the accounting method changes for which statistical sampling may be used and requires that the application of statistical sampling meet specific requirements. The use of statistical sampling is optional, and a taxpayer is free to apply the regulations based on an analysis of 100 percent of applicable expenditures in any year. However, where allowed and properly applied, statistical sampling may result in reduced burden and better utilization of resources for both the taxpayer and the IRS. Rev. Proc. 2011-42 provides taxpayers with guidance regarding the use and evaluation of statistical samples and sampling estimates.

As the IRS notes, capitalization under Code Sec. 263(a) does not change the treatment of any amount that is specifically provided for under any provision of the Code or regulations other than Code Sec. 162(a) or Code Sec. 212. However, the ATG notes that changes that affect the adjusted basis of property will alter computations made under other Code sections. In the ATG, the IRS urges auditors to consider how these changes affect taxable income, and in some cases the tax computation itself.

The ATG alerts auditors to the following prevalent areas of concern.

Basis Adjustment Considerations

Events may have occurred that alter the adjusted basis of an asset. Examples may include a Code Sec. 165 casualty loss and the receipt of any related insurance proceeds, transactions with third parties involving Code Secs. 110, 118, or 362, research and development costs under Code Sec. 174, the demolition of buildings covered by Code Sec. 280B, or the capitalization of self-constructed assets or mixed service costs under Code Sec. 263A. Exam adjustments for prior years may also have modified the basis of an asset.

The ATG advises auditors to consider the facts and circumstances in each case to ensure that each asset is properly accounted for and notes that auditors will frequently see basis adjustments due to depreciation rules. Auditors are told to bear in mind that the tax basis used for computing a Code Sec. 481(a) adjustment may be affected by additional first year depreciation under Code Sec. 168(k); the Code Sec. 179 election to expense depreciable assets; and Code Sec. 168(e)(3)(E) qualified retail improvement property, qualified restaurant property, or qualified leasehold improvement property. The ATG includes an example which illustrates the impact a depreciation adjustment can have on asset basis.

Domestic Production Activities Deduction under Section 199

Reg. Sec. 1.199-8(g) provides that in calculating qualified production activities income (QPAI) for purposes of determining a deduction under Code Sec. 199, a Code Sec. 481(a) adjustment, whether positive or negative, requires that an adjustment be made to either the taxpayer's gross receipts, the cost of goods sold, or other deductions. An allocation between domestic production gross receipts (DPGR) and non-DPGR will be necessary based on the taxpayer's allocation or apportionment method. Each year impacted by a Code Sec. 481 adjustment needs to be re-calculated.

As the ATG notes, a taxpayer-favorable Code Sec. 481(a) adjustment could result in a reduction to the permanent Code Sec. 199 deduction whereas a taxpayer unfavorable Code Sec. 481(a) adjustment may increase the Code Sec. 199 deduction. Auditors are advised to make adjustments as appropriate to this computation. The IRS notes that, if a Code Sec. 481(a) adjustment is spread over more than one tax year, then a taxpayer must attribute the Code Sec. 481(a) adjustment among gross receipts, cost of goods sold, or deductions, as applicable, in the same amount for each tax year within the spread period. The ATG provides an illustration of what auditors should look for in such situations.

Self-Constructed Property and Section 263A

Code Sec. 263A applies to real property and tangible personal property produced by a taxpayer for use in its trade or business. Taxpayers subject to Code Sec. 263A generally must capitalize all direct costs and certain indirect costs properly allocable to real and tangible personal property produced. Reg. Sec. 1.263A-1(e)(3)(i) provides that indirect costs are properly allocable to property produced when the costs directly benefit or are incurred by reason of the performance of production activities. Thus, Code Sec. 263A applies to the production of self-constructed assets, including assets produced for the taxpayer under a contract.

The IRS notes that taxpayers that file Forms 3115 to change their method of accounting to comply with the capitalization regulations may also be producing property for purposes of Code Sec. 263A and, for these taxpayers, many of the costs included in a change from capital expenditure to deduction treatment may also be the indirect costs of producing other property in their trade or business, and therefore may be capitalizable under Code Sec. 263A. To the extent that these costs are deducted in a year under audit, the auditor is advised to ensure that the correct amount is allocated to any property produced by the taxpayer in accordance with Code Sec. 263A. Auditors are directed to obtain copies of the taxpayer's Code Sec. 263A calculations for each period under exam in order to perform this review.

Inventory Property and Code Section 263A

Taxpayers subject to Code Sec. 263A generally must capitalize all direct costs and certain indirect costs properly allocable to real and tangible personal property produced for sale to its customers. Taxpayers that file Forms 3115 to change their method of accounting to comply with the regulations, and that are "producers" for purposes of Code Sec. 263A, will need to adjust their Code Sec. 263A calculation to reflect the Code Sec. 481(a) adjustment in the year of change.

The ATG advises auditors that this adjustment will affect the Code Sec. 263A costs capitalized as of the beginning of the year of change. For LIFO taxpayers, the adjustment will also affect prior period layers. Reg. Sec. 1.263A-7(b)(2)(i) provides special ordering rules applicable to an accounting method change when multiple changes in method occur in the year of change. Reg. Sec. 1.263A-7(b)(2)(i)(B)(4) provides an exception to the general ordering rules for changes in the case of depreciation if the taxpayer is also changing their method of accounting for Code Sec. 263A in the same year. In this case, the ATG points out, the Code Sec. 481(a) adjustment for depreciation must be made before the adjustment is computed for Code Sec. 263A.

Recommended Actions for Identifying Potential Audit Issues

The ATG provides the general audit procedures that IRS auditors should consider in identifying issues relating to compliance with the capitalization regulations and also provides detailed audit procedures with respect to specified issues. In identifying potential audit issues, auditors are advised to take the following actions:

(1) Determine if the taxpayer filed Form(s) 3115 to change its accounting method following a capitalization-to-repair study or for dispositions prior to 2012;

(2) Determine if the taxpayer filed Form(s) 3115 for tax years beginning on or after January 1, 2012, but before January 1, 2014 to comply with the temporary regulations;

(3) Determine if the taxpayer filed Form(s) 3115 for years beginning on or after January 1, 2012 to comply with the final regulations;

(4) Identify each accounting method change, designated change number, and the applicable revenue procedure governing the change;

(5) Determine if a taxpayer should have, but did not file Form(s) 3115 to comply with the final regulations and/or the disposition regulations;

(6) If a Form 3115 was not filed, determine if the taxpayer adopted a new or different method of accounting for assets acquired or produced, UOPs, improved assets, repairs, dispositions, or for materials or supplies for amounts paid or incurred in the year(s) under audit;

(7) Read annual reports and Forms 10-K. Identify new facilities, expansions of old facilities, or other changes affecting the acquisition, improvement or disposition of fixed assets. Look for any footnotes regarding changes in accounting policy that impact fixed assets including de minimis thresholds; and

(8) Consider the tax return. Review Schedule M and consider any book/tax differences for fixed assets, depreciation and materials and supplies.

In doing an audit risk analysis, auditors are advised to consider whether a taxpayer has changed, or should have changed, its method of accounting for tangible property acquired, produced, improved or disposed by taking the following steps.

(1) Consider any examination activity for prior years including: (i) the amount of the Code Sec. 481(a) adjustment and whether the taxpayer combined and/or netted any Code Sec. 481(a) adjustments on Form(s) 3115; (ii) whether a capitalization to repair study was conducted and if so, when it was conducted, which tax years are impacted, which entities were included in the study, and the population of assets included in the study; (iii) identification of the UOP as defined by the taxpayer; (iv) the method used to reclassify costs and whether the taxpayer used a database word search analysis, reviewed project folders, or interviewed employees with knowledge of assets included in the study; (v) whether a sampling method was used to determine the Code Sec. 481(a) adjustment and, if so, how the population of samples was determined, and if another sampling method was used, what type and why; (vi) a review of the Form(s) 3115 to identify each of the methods changed and whether this has been reconciled with final regulations.

(2) Analyze Schedule M adjustments for book to tax depreciation differences.

(3) Review the taxpayer's written policies regarding asset capitalizations and consider any capitalization threshold statements.

(4) Review the taxpayer's written policies regarding asset dispositions and consider policy changes for dispositions of property.

(5) Determine how the taxpayer accounts for materials and supplies.

(6) Review the current tax return for any new elections involving capitalization.

Conclusion

Practitioners should have a thorough understanding of the capitalization regulations and how they impact their clients. The capitalization ATG can assist by providing practitioners with a road map of what documentation should be included in a client's work papers relating to depreciation calculations and capitalization and asset disposition policies.

For a discussion of the rules relating to capital expenditures, see Parker Tax ¶99,500.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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