IRS expects to issue 12-month rule.

• Author: Packard, Pamela
• Position: Capitalization of expenditures

On 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...