Emerging post-Indopco issues: rationale and strategies.

Introduction

The centerfield of emerging audit issues can be directly traced to Indopco v. United States, 112 S. Ct. 1039 (1992), in which the Supreme Court, not surprisingly, required the capitalization of the costs of a friendly merger that changed the corporate structure and promised long-term synergistic benefits to the taxpayer. In the course of the opinion, the Court (also not surprisingly) eliminated the "separate and distinct asset" requirement suggested in the Lincoln Savings case.(1)

While the Indopco opinion did approve of the longstanding requirement of matching income and expense, the decision has two troublesome aspects. First, it unconvincingly proclaimed that capitalization, and not deduction, is the "norm." Second, the critical exculpatory phrase set forth by the Court -- allowing a taxpayer to claim an immediate deduction despite the "mere presence of an incidental future benefit" -- was not defined.

In a profusion of public and private rulings, industry specialization (ISP) issue papers, and other pronouncements of policy, the Internal Revenue Service has endeavored to clarify and solidify its position.(2) Although the IRS repeatedly asserts that Indopco "does not change the fundamental legal principles for determining [if the expenditure] must be capitalized,"(3) the Court's decision has sparked a renewed focus on capitalization issues. It is a tattoo on the wrist of every revenue agent, with the result being a hemorrhage of fashionable, new capitalization issues with no foreseeable end in sight. And despite the "no fundamental change" disclaimer, the IRS does not seem particularly apologetic about the outpouring of controversy. Rather, the IRS argues that perhaps it was sleeping in prior periods and it should not be criticized for waking up. The accompanying tables follow the major post-Indopco capitalization issues which are being debated, broken down into six categories.(4)

Suggested Taxpayer Strategies

It seems that the more the IRS rules, the less sure the taxpayer's footing. For example, what's good for soil remediation may not be good for asbestos remediation. Further, saving future operating costs seems to fare better than creating future streams of income flow. Could policy be above conscience, as we were fore-warned?

Herein follow a few strategies for dealing with the emerging issues:

* Never call the product or program "new"; convince the advertising department to call it a typical annual (or periodic) improvement.

* Frame the question in terms of whether the long-term benefits are 'significant." A trip through Webster's, beginning with "incidental," leads to "significant." This more taxpayer-friendly concept can be found in Rev. Rul. 95-32, as well as in Indopco.

* A renewable contract should be phrased 'renewable annually at option of X," rather than "a perpetual contract terminable at will."

* Try to separate and quantify the dollar costs of long-and short-term benefits. If the cost of the long-term benefits is less than 20 percent of the "total costs, taxpayers could argue that this is not significant.

* Isolate the principal purpose of the expenditure. If the principal focus is short-term, then the long-term benefit may not, by definition, be significant. A whiff of the principal purpose analysis appears in Rev. Rul. 92-80 (advertising capitalized if "directed towards obtaining future benefits") and Rev. Rul. 94-77 (severance pay "principally related" to prior services).

* If undertaking a project that clearly has both capital and expense items, keep items as separate as possible, including separate G&A accounts, separate contractors, and, if feasible, undertake activities at separate times and places.

* Adopt a policy of current repairs or maintenance programs, thus avoiding a need for major catch-up overhauls.

* Do not capitalize expenditures for book purposes if at all possible. Even though the National Office may eventually bail out the taxpayer (see Rev. Rul. 95-36 or TAM 9438001), the Schedule M adjustment will raise a red flag which the agent will find irresistible.

* If some or all of the expenditures are likely to be capitalized, prepare an analysis of the expected useful life or otherwise establish the wasting aspects of the benefits to prevent the creation of a nonamortizable asset. (1) Commissioner v. Lincoln Savings and Loan Association, 403 U.S. 345 (1971). (2) For example, the IRS at one point suggested a four-part inquiry into whether certain environmental remediation costs were subject to capitalization: Did the remediation cost (1) increase the value, (2) prolong the useful life, (3) create a new or different use, or (4) exceed an "incidental" threshold? Tax Notes, Aug. 16, 1993, at 925. Query whether the first three tests define 'incidental" or whether the fourth test a separate test? (3) See, e.g., Rev. Rul. 94-12, 1994-1 C.B. 36. (4) For a thorough and thoughtful analysis of the area, see Glenn Carrington, Capitalization After Indopeo, 53D N.Y.U. 25-1 (1995).

Irving Salem and John J. Clair, Jr.(*) The authors wish to thank their associate, Scott Gluck, for his valuable assistance in preparing this article.