IRS Expects to Issue 12-Month Rule

In Jan. 17, 2002, Treasury and the IRS released an advance notice of proposed rulemaking (REG-125638-01) on capitalization. This notice describes rules and standards that Treasury expects to issue as proposed regulations in 2002 on expenditures incurred in acquiring, creating or enhancing certain intangible assets or benefits.

In addition to clarifying which expenditure categories taxpayers will have to capitalize, the proposed regulations will probably have provisions that will reduce Sec. 263(a) administrative and compliance costs. In that regard, the proposed regulations will probably also include safe harbors and simplifying assumptions, including a 12-month rule. The 12-month rule will allow taxpayers to avoid capitalization of expenditures for intangible assets or benefits whose lives are of a relatively short duration. In addition, the proposed regulations will contain de minimis rules, under which certain expenditures below a specified dollar amount will not be subject to capitalization.

Historical Perspective

The issue of whether taxpayers must capitalize expenditures that provide a benefit beyond the end of a tax year has long been a contentious one. The IRS position, which some courts have supported, is that accrual-basis taxpayers must capitalize costs that provide a significant benefit beyond the end of the tax year. The courts have usually held that cash-basis taxpayers can deduct expenditures in the year paid, as long as the benefit beyond the end of the tax year was 12 months or less. The Seventh Circuit rejected this inconsistent treatment in its recent decision in U.S. Freightways Corp., 270 F3d 1137 (2001) (see "Seventh Circuit Takes a Pragmatic Approach on Accrual of Recurring Expenses," TTA, April 2002, p. 229). Notwithstanding this taxpayer-favorable decision, considerable uncertainty continues to exist for taxpayers making expenditures that provide a benefit extending beyond the end of the tax year. In INDOPCO, Inc., 503 US 79 (1992), the Supreme Court stated:

Although the presence of an incidental future benefit may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is important in determining whether the appropriate tax treatment is immediate deduction or capitalization.

The 12-month rule set out in the advance notice is a significant concession by the IRS on the issue of capitalization of expenditures by accrual-method taxpayers.

Application of the 12-Month Rule

Expenditures paid to create or enhance certain intangible rights or benefits are subject to the 12-month rule. Taxpayers do not have to capitalize prepaid items and certain other expenditures, unless these create or enhance intangible rights or benefits beyond 12 months (beginning on the first date on which a taxpayer realizes the rights or benefits attributable to that expenditure) or at the end of the tax year following the tax year in which the taxpayer incurs the expenditure. The proposed rules will not alter the manner in which provisions of the law other than Sec. 263(a) (including Secs. 195 and 263A) apply to determine the correct tax treatment of an item. The rule does not include a specific reference to Sec. 461, and its impact on the proposed regulations is uncertain.

The advance notice gives an example of a calendar-year taxpayer that pays its insurance premium on Dec. 1, 2002, for a 12-month policy beginning the following February. Under the proposed regulations, the taxpayer has to capitalize the entire expenditure in 2002, because the benefit extends beyond the end of 2003. However, if the insurance contract has a term beginning on Dec. 15, 2002, the taxpayer could deduct the entire premium expenditure in 2002 under the 12-month rule.

In addition to safe harbors such as the 12-month rule, the proposed regulations will also provide guidance on the capitalization of certain types of expenditures. Subject to the 12-month rule and possibly a de minimis rule, taxpayers will have to capitalize amounts paid to obtain, modify or terminate a contract or agreement (e.g., leases or supplier contracts). For example, a taxpayer has to capitalize a payment to terminate a lease with a remaining term of 24 months. However, if the lease had a remaining term of only six months, the taxpayer would not have to capitalize the expenditure under the 12-month rule.

An IRS internal memorandum (dated Feb. 26, 2002) explains how the Service wants examiners to handle issues addressed in the advance notice. According to the memorandum, the advance notice does not give examiners the authority to concede issues. However, examiners have to pursue issues on the capitalization of 12-month expenses for ongoing examinations in which capitalization of the expenditures resulted in their preparing Form 5701, Notice of Proposed Adjustments, or Form 4549, Revenue Agent's Report. The memorandum recommends that agents not pursue capitalization of one-year expenses for ongoing examinations in which they have not yet prepared these forms.

Conclusion

The creation of a 12-month rule for expenditures incurred to create or enhance intangible assets will be an important development for taxpayers. It will remove the uncertainty that currently exists for expenditures that provide some benefit beyond the end of a tax year. Proposed regulations will also provide certain de minimis rules and other bright-line tests for capitalizing expenditures that a taxpayer incurs in acquiring, creating or enhancing intangible assets.

From Jeffrey L. Sanders, CPA, Dallas, TX