At the end of 2011, the IRS issued comprehensive and far-reaching temporary regulations on the capitalization of costs relating to tangible property. The regulations are generally effective for tax years (or costs incurred in tax years) beginning on or after January 1, 2012.
The IRS has now followed up with transitional guidance on how taxpayers can obtain IRS approval to change their method of accounting to comply with the new regulations. In light of the transitional guidance, the IRS’s Large Business and International Division (LB&I) followed with a Directive that provides guidance on the handling of audits for various years before and after the regulations take effect.
The temporary regulations address two primary areas: (1) whether taxpayers must capitalize or can immediately deduct costs to acquire, produce, or improve tangible property; and (2) whether capitalization of certain expenses requires special adjustments under the depreciation rules. The IRS provided transitional guidance in two revenue procedures to implement the regulations. Because the regulations apply beginning in 2012, the transition guidance applies to accounting method changes for tax years beginning on or after January 1, 2012.
Guideline to IRS auditors.
The LB&I Directive is addressed to LB&I’s examiners and managers, and instructs to cease conducting examinations of repair versus capitalization issues for costs related to tangible property. The Directive applies to both current examinations and new examinations of the repair/capitalization issue for tax years beginning before January 1, 2012, before the regulations apply. Instead, LB&I is reserving its exam activity for issues arising under the temporary capitalization regulations.
Guidelines in change-of-accounting approvals.
Taxpayers need the IRS’s consent to change their method of accounting. The revenue procedures instruct taxpayers how they can obtain automatic IRS consent to change their accounting method(s) to a method permitted under the capitalization-repair temporary regulations. Taxpayers must file Form 3115, Application for Change in Accounting Method, and follow the general procedures for automatic changes described in a 2011 revenue procedure.
Ordinarily, a taxpayer cannot request automatic consent to change its accounting method if particular conditions apply, such as the taxpayer being under audit. The IRS waived these “scope limitations” for a taxpayer that changes its accounting method in its first or second taxable year beginning after December 31, 2011. Waiving the scope limitations allows taxpayers to file automatic changes even if they are under examination, without waiting for a window or requesting the IRS’s consent.
Required adjustments for past years.
Taxpayers changing their method of accounting must make a full Code Sec. 481 adjustment, in effect making the regulations retroactive. Taxpayers who undercapitalized their costs under the regulations must go back and figure out the differences in treatment. If the taxpayer has additional income, the taxpayer can recognize the income over four years, beginning in the year of the change.