OUR THOUGHTS ON:

IRS Large Business Division "Standing Down" from Prior-Year Exam Activity of Capitalization Issues

Tax

By Ron Kramer

On March 15, 2012, the IRS’s Large Business and International (LB&I) Division announced it will cease audits of repair versus capitalization issues for tax years beginning before January 1, 2012. The announced policy is reported in an LB&I directive to its field examiners that was issued on March 15. The LB&I Division of the IRS serves corporations, subchapter S corporations and partnerships with assets greater than $10 million.

The IRS recently issued comprehensive temporary and proposed regulations on repair vs. capitalization of costs relating to tangible property. The temporary regulations apply to tax years beginning on or after January 1, 2012. The IRS has also issued two revenue procedures by which a taxpayer may obtain the automatic consent of the Commissioner of Internal Revenue to change to certain methods of accounting provided in the temporary regulations.

These new revenue procedures (Rev. Proc. 2012-19 and Rev. Proc. 2012-20) waive the scope limitations of Rev. Proc. 2011-14, Section 4.02, for a request to change a method of accounting, which normally apply to a taxpayer under examination, for the taxpayer's first or second taxable year beginning after December 31, 2011. Thus, the two year waiver period effectively gives a taxpayer audit protection for years before 2012.

Examination of Tax Years Beginning Before January 1, 2012

The LB &I directive recognizes this two year waiver and audit protection by instructing agents to discontinue any current exam activity with regard to the capitalization and repair issues, and not to begin any new exam activity with regard to these issues. Agents are instructed to develop and issue a Form 5701 with a Form 886-A, Explanation of Adjustments, containing the following language:

The Service neither accepts nor rejects the position taken in the tax return related to the method to determine the proper treatment of amounts incurred to repair tangible property. [Insert taxpayer name] will be allowed a two-year period to adopt the appropriate method of accounting provided in Rev. Proc. 2012-19 and 2012-20. If an appropriate method is adopted, a change in method of accounting can be made in accordance with Section 4 or 5 of the applicable revenue procedure for all assets. If [Insert taxpayer name] has not changed its accounting method consistent with Revenue Procedures 2012-19 and 2012-20 in its first or second taxable year beginning after December 31, 2011, then the repair expense will be subject to risk assessment and possible examination for tax years ending on or after January 1, 2012.

It appears that the IRS is reserving examinations for issues that arise under the new capitalization regulations.

Examination for Tax Years Beginning on or after January 1, 2012 but before January 1, 2014

The LB&I directive instructs agents when beginning an examination of a return for a taxable year beginning on or after January 1, 2012 but before January 1, 2014, to determine:

  1. If the taxpayer filed a Form 3115, Application for Change in Accounting Method, in accordance with the applicable guidance;
  2. If yes, perform a risk assessment regarding the method change;
  3. If no, and the Waiver Period to file such change is still open, do not examine the Issues. Allow the taxpayer the appropriate time period to file a method change;
  4. If no, and the Waiver Period to file such change has passed, perform a risk assessment regarding the Issues.

For examinations for tax years beginning on or after January 1, 2014, agents are instructed to apply the regulations in effect and follow normal exam procedures.

If your company is currently under examination for repair and capitalization issues, you should expect these issues to be put on hold pending the two year filing period for Form 3115 to adopt the temporary regulations that are effective for 2012.

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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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