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By James L. Atkinson
The IRS has launched a compliance initiative focused on deductions for repair and maintenance expenditures. Nearly all companies having sizable annual repair and maintenance costs will feel the effect of this increased audit scrutiny and should begin preparing for the inevitable challenge to deductions for a broad range of repair expenses.
The compliance initiative has been spurred by a wave of requests by taxpayers to change their tax accounting method for repair expenditures. A substantial percentage of the method change requests troubling the IRS resulted from “repair studies” promoted by some tax advisors in anticipation of the issuance of final regulations updating the capitalization rules applicable to costs to acquire, create, or improve tangible property.
Suggesting that the anticipated regulations will preclude taxpayers’ ability to recover costs erroneously capitalized in years preceding the issuance of the final regulations, some advisors have encouraged companies to undertake exhaustive “book scrubs” to locate costs that were erroneously capitalized under current law and to file an accounting method change to recover those costs by means of a “section 481 adjustment.”
Because the section 481 adjustment functions as an immediate deduction for the year in which the accounting method change is effective, the substantial deductions generated through these accounting method changes attracted many companies.
As frequently occurs when a large number of companies undertake nearly identical accounting method changes within a relatively short time period and claim aggregate section 481 adjustments in the billions of dollars, the repair studies have attracted the attention of the IRS. The treatment of repair costs is now a “Tier 1” audit issue, increasing the likelihood of these costs being closely examined on audit and of examination teams having less discretion in resolving the issues than would be the case generally. In designating the treatment of repair costs a Tier 1 issue, the IRS identified the utilities, telecommunications, gaming, retail, restaurant, and hotel industries as having received “significant impact” from the accounting method changes. As such, members of these industries are particularly likely to come under increased scrutiny.
Although the IRS concern arises directly from repair vs. capitalization accounting method changes, experience shows that once a compliance initiative is underway, it is unlikely to remain restricted to its original scope. As such, any taxpayer that incurs substantial annual expenditures for repair or maintenance activities faces heightened audit risk, regardless of whether the company actually requested a change in accounting method for those costs.
Companies having substantial repair and maintenance expenses should begin planning for the (almost) inevitable. A prudent first step for companies that have purchased a “repair study” is obtaining a cold read from a knowledgeable adviser uninvolved in preparing and selling such studies. Obtaining and analyzing the “technical memo” or other documentation supporting the section 481 adjustment will be one of the first steps taken by the IRS. A cold read of these documents is an effective way to begin identifying the weak spots in the study and the areas most likely to be challenged by the IRS. Taking this proactive step allows the company to begin preparing its defenses or (if necessary) taking corrective steps before the IRS places the issue under audit. This step can be as simple as reviewing the technical memo or other documentation supporting the repair study and should not require nearly as much time (or expense) as the original study.
Companies that have made accounting method changes in reliance on repair studies should keep in mind that the “consent” obtained from the IRS provides no immunity against either an audit of the company’s treatment of repair costs or the assertion of a tax deficiency arising from the changed treatment of those costs. In this sense, the “audit protection” obtained by reason of the accounting method change is largely illusory and does not negate the audit risk posed by the IRS compliance initiative.
There is nothing inherently problematic with a company improving the way it accounts for repair and maintenance expenditures. These issues tend to be largely factual, and the strength of the company’s position on audit is purely a function of its facts and how it applied current law to those facts. A quick review of the company’s position is a prudent means of gauging the audit exposure and what if any steps need to be taken at this time.
James L. Atkinson is a partner in the Washington, DC, office of law firm Miller & Chevalier.
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