New legislative, IRS and court rulings provide guidance on

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Accounting Methods Spotlight / Issue 1 / January 2015
Did you know? p1 / Other guidance p3 / Cases p9
New legislative, IRS and court
rulings provide guidance on
tax accounting method issues
This month’s issue of the Accounting Methods Spotlight features brief discussions of expired business
and individual tax provisions recently extended by the President, and recent IRS updates of some
important revenue procedures for methods of accounting. In addition, we have included discussions
on: an IRS ruling that reimbursement payments to utility for system upgrades are not contributions
to capital; IRS tangible property guidance for the cable industry; and the IRS' acceptance of a request
for guidance on capitalization rules for the restaurant industry. In addition, this month's issue
includes recent rulings that a partnership is allowed a loss on a sale under the installment method,
that expenses to restore a power facility are deductible and a taxpayer’s abandonment loss deduction
is sustained, and that patent license royalties must be capitalized. Finally, this issue discusses a Fifth
Circuit finding that proceeds from the sale of partnership interest attributable to unrealized
receivables are not eligible for installment method reporting.
Did you know..?
President signs one-year extension of
expired business and individual tax
provisions
The bill, the Tax Increase Prevention Act of
2014, (H.R. 5771) continues more than 50
currently expired tax provisions for businesses
and individual taxpayers through December
President Barack Obama recently signed into
law, legislation that provides for one-year
retroactive extension of business and
individual tax provisions that expired at the
end of 2013.
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31, 2014, after which they will expire again. The president signed the bill on December
19, 2014.
Key tax accounting related business provisions renewed through December 31, 2014
include the following:

Research credit

50-percent bonus depreciation

15-year recovery for qualified leasehold, restaurant, and retail property

Subpart F income exemption for banking, financing, or insurance businesses

Lookthrough treatment for controlled foreign corporations (CFCs)

Section 179 small business expensing

Renewable electricity production credit

Work opportunity tax credit

Reduction in S corporation built-in gains holding periods

Basis adjustment of S corporation stock for donations

Certain regulated investment company (RIC) provisions
The tax extenders bill also includes provisions for technical corrections and repeal of
certain “deadwood” provisions.
IRS updates revenue procedures for methods of accounting
On January 16, 2015, the IRS issued two new revenue procedures, Rev. Proc. 2015-13
and Rev. Proc. 2015-14, that update the guidance for changes in methods of
accounting for federal income tax purposes.
Rev. Proc. 2015-13 updates and revises the general procedures under Section 446(e)
and Treas. Reg. Sec. 1.446-1(e) to obtain the consent of the Commissioner of Internal
Revenue to make a change in method of accounting. It addresses the general
procedures to obtain non-automatic and automatic consent of the Commissioner for a
change in method of accounting. Rev. Proc. 2015-14 contains the list of automatic
changes in accounting method to which the automatic change procedures in Rev.
Proc. 2015-13 apply.
Rev. Procs. 2015-13 and 2015-14 modify and supersede, for the most part, Rev. Procs.
97-27 and 2011-14 and are generally effective for Forms 3115 filed on or after January
16, 2015, for a year of change ending on or after May 31, 2014.
Rev. Proc. 2015-13 makes significant changes to the previous rules for filing changes
in methods of accounting, including clarifications and modifications related to the
following:

The determination and timing of an issue under consideration

The determination and timing of when a taxpayer is considered to be under
examination

Eligibility for taxpayers under examination to file a Form 3115

Rules related to accounting method changes for foreign corporations and
partnerships

Section 481(a) adjustment periods

Window periods

Audit protection

Scope limitations for filing a Form 3115

Where to file and submit additional information

The year of implementation of non-automatic method changes
Rev. Proc. 2015-14 updates the List of Automatic Changes from previous guidance.
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Overall, as compared to the previous rules, the changes in these revenue procedures
are dramatic. Taxpayers considering filing method changes are strongly advised to
familiarize themselves with the new rules.
More details on Rev. Procs. 2015-13 and 2015-14 are forthcoming in our Tax Insights.
Other guidance
IRS rules reimbursement payments to utility for system upgrades are
not contributions to capital
In PLR 201451007, the IRS ruled that payments a utility received from a corporate
municipal instrumentality as reimbursement for upgrades made to the taxpayer’s
electric transmission system do not constitute contributions to capital under Section
118(a) and are therefore not excludible from gross income.
The taxpayer, an electric and gas utility, owns and maintains an electric transmission
system through which it services customers within the state. During the years in
question, a neighboring state experienced an increased demand for electricity in one
of its growing metropolitan areas. To respond to the rising needs, the corporate
municipal instrumentality entered into a contract with a third party corporation to
develop a transmission line which would connect its own transmission grid with the
grid in the taxpayer’s state. The connection intertied to the taxpayer’s system and was
owned and operated by the taxpayer.
In order to sustain the increased energy flows from the interconnected system, the
taxpayer was required to make several upgrades to its electric transmission system.
Under the agreement, a corporate municipal instrumentality and political subdivision
of the neighboring state would reimburse the taxpayer for any upgrades made to its
transmission system. The state received the rights to a predetermined percentage of
the systems transmission capacity to service its customers in the metropolitan area.
The taxpayer requested a ruling as to whether the reimbursement payments from the
corporate municipal instrumentality constituted a contribution to capital which
would be excludible from gross income under Section 118(a). Under Treas. Reg. Sec.
1.118-1 contributions to capital include land or other property contributed to a
corporation by a governmental unit or by a civic group for the purpose of inducing the
corporation to locate its business in a particular community.
In the PLR, the IRS looked to prior case law for guidance on whether the payment
qualifies as a non-shareholder contribution to capital. In United States v. Chicago,
Burlington & Quincy Railroad Co., 412 U.S. 401, 413 (1973), the Court examined two
earlier cases (Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1954) and Brown
Shoe Co. v. Commissioner, 339 U.S. 583 (1950)) to identify a distinguishing
characteristic of a non-shareholder contribution to capital. In Detroit Edison, the
Court ruled that payments made to an electric utility to construct power lines that
would extend the utility’s service to the homes of the contributors constituted
payments for service rather than non-shareholder contributions to capital.
Alternatively, the Court in Brown Shoe held that contributions a community group
made to Brown Shoe to move or expand its factory operations within the community
were considered non-shareholder contributions to capital. In examining these two
cases, the Court determined that a distinguishing factor in determining whether a
payment should constitute a non-shareholder contribution to capital was the purpose
motivating the contribution. In Detroit Edison, the payments were made with the
expectation that direct services would be received in return while in Brown Shoe the
only intended benefit was for the community at large. Thus, a payment may constitute
a non-shareholder contribution to capital when the purpose motivating the
contribution is for the benefit of a community or group at large, and not for a direct
benefit or recompense to the contributor. Based on this analysis, the IRS looked to
the corporate municipal instrumentality’s motivation for making the reimbursement
payments to the taxpayer. The taxpayer asserted that the project would benefit the
public at large in the neighboring state with more reliable energy transmission
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leading to other indirect benefits. The IRS acknowledged that there would be benefits
to the general public but determined that the municipal instrumentality’s primary
motivation was to provide direct benefits to its own customers. As such, the IRS
concluded that the reimbursement payments did not constitute contributions to
capital under Section 118(a) and were therefore not excludible from gross income.
IRS provides tangible property guidance for cable industry
The IRS recently released Rev. Proc. 2015-12, which provides several safe harbor
methods of accounting for tangible property costs of cable system operators, and
related automatic accounting method change procedures. This revenue procedure
supersedes Rev. Proc. 2003-63, which provided guidance regarding computing
depreciation for cable TV distribution systems.
Cable system operators often incur significant costs to maintain, replace, or improve
property used in providing service to customers. Taxpayers and the IRS have
historically experienced some difficulty in identifying units of property within an
integrated cable network and determining whether costs to maintain or improve such
property should be deducted as repairs under Section 162 or capitalized as
improvements under Section 263(a). In the wake of the final repairs regulations, the
IRS has issued this industry-specific guidance to reduce uncertainty in relation to
several commonly disputed areas.
Rev. Proc. 2015-12 first addresses the deductibility and capitalization of expenditures
to maintain, replace, or improve cable network assets by providing two safe harbor
methods. The first safe harbor, the network asset maintenance allowance method,
generally permits a taxpayer to deduct 12% of cable network asset additions
capitalized for financial accounting purposes. Alternatively, the units of property
method provides safe harbor units of property that can be used to apply the
capitalization standards in the tangible property regulations.
The revenue procedure also addresses the deductibility and capitalization of costs for
installations of customer drops and customer premises equipment (CPE). A customer
drop is the property that connects the final interconnection point within a cable
distribution network (the ‘tap’) with the customer premises. Customer drops cover
both external property used to run the cable from the tap to the exterior of the
premises and the internal property needed to connect the cable within the customer’s
home or office. To determine whether such property should be expensed or
capitalized, Rev. Proc. 2015-12 provides alternative approaches. First, the specific
identification method provides that the costs of installing initial external drops must
be capitalized, but the costs of installing external drop replacements that do not result
in a betterment or adapt the property to a new or different use, and internal drops,
may be deducted. Alternatively, the safe-harbor allocation method provides that 12%
of total customer drops may be treated as initial external drops and capitalized, and
88% of total customer drops may be treated as internal drops or replacement drops
and deducted. This safe harbor applies as long as the external drop replacements
factually do not result in a betterment or adapt the property to a new or different use.
Additionally, this section provides that the labor costs to install CPE may be deducted,
regardless of which alternative a taxpayer uses.
Rev. Proc. 2015-12 provides additional guidance regarding depreciation of cable
network assets which is consistent with prior guidance under Rev. Proc. 2003-63.
Fiber optic transfer nodes and trunk lines used in a cable distribution network should
be treated as the asset for computing depreciation. Also, for purposes of determining
the appropriate depreciation recovery period for cable distribution network assets
performing one-way and two-way communication services, the primary use may be
determined in any reasonable manner that is consistently applied. A reasonable
manner may include gross receipts or subscriber count, but not bandwidth.
Alternatively, the revenue procedure provides a safe harbor method, under which
primary use is determined by an allocation based on revenue (where revenue from
video services is deemed to be one-way, revenue from telephony, home monitoring,
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and leasing of fiber optics (generally) is deemed to be two-way, and broadband
revenue is allocated between the two, based upon signal traffic either from the
taxpayers records or from published industry averages).
Finally, the revenue procedure provides automatic method changes for all of the
above methods with the exception of the primary use tests, which are treated as
changes in use under the regulations that generally are effected prospectively by
depreciating the asset's remaining basis over its remaining life.
IRS accepts request for guidance on capitalization rules for restaurant
industry
The IRS and Treasury Department have recently accepted a request for guidance
under the Industry Issue Resolution program regarding the capitalization rules as
they apply to the restaurant industry. The request seeks guidance on the capitalization
and deduction of costs related to tangible property including application of unit of
property rules, treatment of refresh and remodel expenses, and rules for general
maintenance and repair expenses.
In the restaurant industry, periodic remodelling is common for stores to attract or
retain customers. For the larger chain restaurants, numerous refresh projects occur
within a given year. Restaurants also incur various other costs relating to tangible
property including the repair and maintenance of equipment. With the release of the
final repair regulations, the restaurant industry has encountered challenges in
determining what portion of these costs should be capitalized as improvements versus
deducted as repairs expense. Additionally, the industry is seeking guidance regarding
the application of the unit of property rules prescribed under the final repairs
regulations.
The IRS has opted not to include restaurants in the retail industry IIR that is
currently in process, but instead to issue separate guidance based on similar
principles. In doing so, the IRS has acknowledged the inherent differences between
traditional retailer properties and restaurants and plans to address the issues that are
specific to restaurants. The restaurant division of the National Retail Federation is in
the process of gathering industry information to assist the IRS in understanding the
nature of the restaurant industry. The goal is to provide guidance which will resolve
issues that are common to a significant number of taxpayers in the industry.
Partnership allowed loss on sale under installment method
In PLR 201451004, the IRS ruled that a limited liability company was able to claim a
loss under Section 165 to the extent that unrecovered basis exceeds the installment
sale price under Section 453. The IRS concluded that such loss should be claimed in
the year in which the events that led to the reduction in sales price occurred.
The taxpayer sold the stock of a Company under an installment sale arrangement,
where the taxpayer received a certain amount at closing, and would receive additional
amounts in subsequent years, including a maximum earn-out based on several
milestones.
On its Year 1 federal income tax return, the taxpayer reported the sale of Company on
the installment method under Section 453 as a contingent payment sale. The taxpayer
determined its share of the maximum selling price, and reported income based on
proceeds received in Year 1 under the installment method. In Year 2, events occurred
that reduced the maximum selling price. The taxpayer reported income for the year
under the installment method. In Year 3, the earn-out period expired before the
company achieved any milestones, reducing the maximum selling price to less than
the taxpayer’s basis in the stock sold, and thus changing the transaction to a loss
rather than a gain transaction. Taxpayer did not receive any proceeds in Year 3.
Under Section 453(a), income from an installment sale must be taken into account
under the installment method. The term "installment sale" refers to a disposition of
property in which at least one payment will be received after the close of the taxable
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year in which the disposition occurs. Under Section 165, a deduction is allowed for
any loss sustained during the taxable year that is not compensated by insurance or
otherwise. Moreover, Treas. Reg. Sec. 1.165-1(d)(1) provides that a loss shall be
allowed only for the taxable year in which the loss is sustained. For this purpose, a
loss is treated as sustained during a taxable year in which the loss occurs as evidenced
by closed and completed transactions and fixed by identifiable events occurring
during the year.
The IRS determined that the taxpayer correctly reported income from the sale on the
installment method in Years 1 and 2. However, in Year 3, events occurred that
changed the transaction to a loss transaction. The taxable year during which Taxpayer
sustained a loss is governed by Section 165. Since the earn-out period expired in Year
3, the maximum remaining amount the taxpayer could receive under the terms of the
installment sale established the identifiable event that gave rise to the loss. As a
result, the taxpayer may claim a loss deduction in Year 3.
Expenses to restore power facility are deductible and abandonment
loss sustained
In a partially redacted private letter ruling (PLR 201451014), the IRS concluded that
the expenses incurred by a regulated public utility to restore a nuclear generating
facility to its pre-contaminated state, are deductible under Section 162 and are not
subject to capitalization under Section 263(a). Further, as the taxpayer ultimately
determined it was not feasible to restart the facility and took appropriate steps to
abandon it, the IRS concluded that the utility sustained an abandonment loss within
the meaning of Section 165(a) but will not be entitled to claim a deduction until all
related claims are resolved.
The taxpayer is a regulated public utility. A steam leak occurred at certain facilities
that the taxpayer owns, due to significant, unexpected and excessive wear. The steam
generators were designed and manufactured by a third party. After months of analysis
and tests, the taxpayer submitted a restart plan to the Nuclear Regulatory
Commission (NRC). The NRC determined that the operating license would need to be
modified prior to restart of the facilities. As a result of mounting costs and
uncertainties, the taxpayer determined that the repair or restart of the facilities was
not feasible. Taxpayer then formally notified the NRC that it permanently ceased
operation of the facilities.
The taxpayer severed a substantial number of employees, and sought a reduction in
its state property tax base to reflect the impairment. The taxpayer wrote down its
investment in the facilities for financial accounting purposes. The taxpayer then
submitted a Notice of Dispute to the third party for all damages caused by its failed
design and manufacture of the steam generators that led to the shutdown and
permanent retirement of the facilities in question. The dispute resolution process was
unsuccessful so the taxpayer initiated binding arbitration proceedings against the
third party to recover damages. The arbitration proceedings were ongoing at the time
the ruling request was filed. In addition, the facilities in question were covered by
accidental property damage insurance, as well as accidental outage insurance. The
accidental outage insurance was cancelled due to the permanent retirement of the
facilities, however the taxpayer has notified the insurance company of its potential
claims for loss recovery under both policies.
The taxpayer also represented that it has incurred and will continue to incur expenses
associated with the decontamination, dismantlement, removal, disposal of the
structures, systems and components, and the decommissioning of the facilities in
question.
Abandonment loss
Taxpayer requested a ruling that it abandoned facilities within the meaning of Section
165 but that it is not entitled to claim the loss until its claims are resolved.
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Under Section 165, a deduction is allowed for any loss sustained during the taxable
year that is not compensated by insurance or otherwise. Moreover, Treas. Reg. Sec.
1.165-1(d)(2)(i) provides that if a casualty or other event occurs which may result in a
loss and, in the year of such casualty or event, there exists a claim for reimbursement
with respect to which there is a reasonable prospect of recovery, no portion of the loss
with respect to such reimbursement may be received is sustained, for purposes of
Section 165, until it can be ascertained with reasonable certainty whether or not such
reimbursement will be received. Whether or not such reimbursement will be received
may be ascertained with reasonable certainty, for example, by a settlement of the
claim, by an adjudication of the claim, or by an abandonment of the claim.
In addition, Section 1.165-2(c) provides for the allowance under Section 165(a) of
losses arising from the permanent withdrawal of depreciable property from use in the
trade or business or in the production of income. Section 1.167(a)-8(a)(4) provides
the intent of the taxpayer must be irrevocably to discard the asset so that it will
neither be used again by him nor retrieved by him for sale, exchange or other
disposition.
In the ruling, the IRS discussed reasonable prospect of recovery, as well as the
abandonment of real property, relying on a rich history of cases including: Estate of
Scofield v. Commissioner, 266 F.2d 154, 159 (6th Cir. 1959); Jeppsen v.
Commissioner, 128 F.3d 1410, 1414 (10th Cir. 1997); Seminole Rock & Sand Co. v.
Commissioner, 19 T.C. 259 (1952), acq., 1953-1 C.B. 6; A.J. Industries, Inc. v. United
States, 503 F.2d 660 (9th Cir. 1974); and, Hanover v. Commissioner, T.C. Memo.
1979-332.
The IRS determined that the taxpayer had sufficiently indicated its intent to abandon
the facilities in question. According to the IRS, the taxpayer took steps to abandon the
units by removing the nuclear fuel from the units. It submitted documents to the NRC
that prevent it from operating the facilities. It altered its insurance to a level
indicative of its non-operational status. Finally, it issued press releases concerning the
abandonment of the plant, wrote-off the assets on its books and included statements
about the abandonment in its financial statements. The taxpayer had also commenced
the initial activity phase of radiological decommissioning with the appropriate filing
with the NRC. Taxpayer severed a substantial number of operational employees who
will not be engaged in the decommissioning of the facility. It sought and received a
reduction in its state property tax base to reflect the impairment.
As a result the IRS concluded that the taxpayer sustained an abandonment loss within
the meaning of Section 165(a).
However, pursuant to Section 165(a), despite the loss, the taxpayer will not be entitled
to claim a deduction if the loss is compensated for by insurance or otherwise. The
taxpayer is pursuing its claims against the third party and has represented that it has
a valid claim and a reasonable prospect of recovery. Further, taxpayer has
outstanding insurance claims and represented that it also has a reasonable prospect
of recovering damages from its insurance company. Since the taxpayer has a
reasonable prospect of recovering its damages, the IRS ruled that the deduction of the
abandonment loss should be deferred until the arbitration proceeding is concluded
and all insurance claims are resolved.
Ordinary and necessary expenses
Taxpayer also requested a ruling that it is entitled to claim its ordinary and necessary
business expenses under Section 162, regardless of the contingent possibility of
recovery of these expenses.
Section 162 generally allows a deduction for the ordinary and necessary expenses paid
or incurred during the taxable year in carrying on any trade or business. In Rev. Rul.
94-38, the IRS ruled that costs incurred to clean up land and treat groundwater that
the taxpayer had contaminated with hazardous waste from its business were
deductible under Section 162 and not required to be capitalized under Section 263,
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except for the cost of constructing groundwater treatment facilities, because the costs
did not materially add to the value of the land, appreciably prolong its life, or adapt it
to a new or different use.
In Rev. Rul. 98-25, the IRS ruled that costs incurred to replace underground storage
tanks containing waste by-products, were deductible as ordinary and necessary
business expenses under Section 162. In United Dairy Farmers, Inc v. United States,
107 F. Supp.2d 937 (S.D. Ohio 2000) aff'd, 267 F.3d 510 (6th Cir. 2001), the taxpayer
purchased two convenience stores, both of which had underground storage tanks that
had leaked and contaminated the soil. The taxpayer was not aware of the leaks at the
time of purchase. Thus, the taxpayer’s expenses for remediation of the contaminated
soil permanently enhanced the value of the property, rather than restoring it to its
condition at the time of purchase. As a result, the court held that the remediation
costs must be capitalized under Section 263.
In the current case, the taxpayer represented that the contamination being
remediated all occurred while taxpayer owned and operated the facilities. The vast
majority of the expenses will merely restore the facility to its pre-contaminated state
and will not adapt the property to a new or different use, increase its value beyond its
pre-contaminated state, or prolong its useful life. The taxpayer further represented
that to the extent it incurs expenditures to purchase equipment used in the
decommissioning process or to erect temporary facilities, those costs would be
capitalized under Section 263(a). Similarly, taxpayer represented that to the extent it
incurs costs to construct an independent fuel storage installation for nuclear waste,
such costs would be capitalized under Section 263(a). As a result, the IRS concluded
that the expenses that merely restore the facility to its pre-contaminated state and
that do not adapt the property to a new or different use or increase its value beyond
its pre-contaminated state or prolong its useful life are deductible pursuant to Section
162 and are not subject to capitalization under Section 263(a).
The IRS also discussed several other cases including Burnett v. Commissioner, 356
F.2d 755 (5th Cir. 1966), Charles Baloian Co. v. Commissioner, 68 T.C. 620 (1977),
Electric Tachometer v. Commissioner, 37 T.C. 158 (1961), and Varied Investments,
Inc. v. United States, 31 F.3d 651 (8th Cir,. 1994). All of these cases dealt with
expenses for which there was a fixed right to reimbursement and therefore are not
deductible under Section 162. As a general rule, a taxpayer may not claim a Section
162 business expense deduction to the extent the taxpayer has a fixed right to
reimbursement. Furthermore, a taxpayer may not claim a Section 165 loss deduction
to the extent the taxpayer has a claim for reimbursement for which there is a
reasonable prospect of recovery. A fixed right to reimbursement exists where a right
has matured without further substantial contingency and any payment by the
taxpayer could be considered an advance or a payment on behalf of another. Thus, if
there is substantial contingency as to a future reimbursement, the taxpayer may still
be entitled to a deduction.
In PLR 201451014 the IRS concluded that since the taxpayer does not have a fixed
right to reimbursement from the third party, but merely a contingent claim that is
being contested, this contested liability does not preclude the taxpayer from claiming
the Section 162 expenses in the year they are incurred.
Patent license royalties must be capitalized
In a heavily redacted field attorney advice, FAA 20145101F, the IRS determined that
royalties paid under a patent license are indirect costs that are properly allocable to
the production of property and must be capitalized.
During the years in issue, the taxpayer entered an agreement in which exclusive rights
under a patent were licensed to the taxpayer. In exchange for the license and rights
granted under the agreement, the taxpayer agreed to pay royalties. Specifically, the
royalties were paid to secure contractual rights associated with the production of
certain inventory.
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Section 263A(a) provides that certain direct and indirect costs of producing inventory
must be included in the cost of inventory. Treas. Reg. Section 1.263A-1(e)(3)(i)
defines indirect costs as all costs other than direct material costs and direct labor
costs (in the case of property produced). Taxpayers subject to Section 263A must
capitalize all indirect costs properly allocable to property produced. Indirect costs are
properly allocable to property produced when the costs directly benefit or are
incurred by reason of the performance of production activities.
Treas. Reg. Section 1.263A-1(e)(3)(ii) provides a non-exclusive list of indirect costs
that must be capitalized to the extent they are properly allocable to property
produced. Specifically, Section 1.263A-1(e)(3)(ii)(U) states that licensing and
franchise costs include fees incurred in securing the contractual right to use a
trademark, corporate plan, manufacturing procedure, special recipe, or other similar
right associated with property produced or property acquired for resale, and that
these costs include the otherwise deductible portion of the initial fees incurred to
obtain the license or franchise and any minimum annual payments and royalties that
are incurred by a licensee or a franchisee.
The IRS concluded that because the royalties paid under the agreement were incurred
to secure contractual rights associated with the production of property, the royalties
are indirect costs that directly benefit or are incurred by reason of the production of
the inventory. As a result, the royalties must be capitalized under Section 263A and
Treas. Reg. Section 1.263A-1.
The taxpayer argued that the patent is not necessary for the physical production of the
inventory in question. However, the taxpayer presented no facts to support this
claim. Furthermore, the IRS stated that even if it assumed that the patent was not
necessary for the physical production of the inventory, this assumption alone would
be insufficient to change the result that the royalties are required to be capitalized
under Section 263A.
The IRS also rejected the taxpayer’s argument that Robinson Knife Mfg. Co., Inc., 600
F.3d 121 (2nd Cir. 2010), nonacq., 2011-1 C.B. 836, allows for a current deduction of
the royalties paid. In Robinson Knife, the court held that royalties paid for the right
to use certain trademarks in the manufacturing of kitchen tools were not allocable to
the property produced because they were sales-based royalties. These royalties were
calculated as a percentage of net sales and only incurred upon the sale of the
products. The IRS did not acquiesce in that case, but stated that regardless of its nonacquiescence in the Robinson Knife, the decision in that case only provided for the
deduction of royalty payments that are (1) calculated as a percentage of sales revenue
from certain inventory, and (2) incurred only upon the sale of such inventory. The
royalties in the current FAA meet neither requirement. Accordingly, the IRS
determined that the decision in Robinson Knife has no bearing on the case at issue,
and the royalties must be capitalized under Section 263A and Treas. Reg. Section
1.263A-1.
Cases
Fifth Circuit concludes proceeds from sale of partnership interest
attributable to unrealized receivables are not eligible for installment
method reporting
In Lori M. Mingo v. Commissioner, 5th Circuit, No. 13-60801, the Fifth Circuit Court
affirmed a US Tax Court decision that part of a note attributable to unrealized
receivables that a partner received in exchange for her partnership interest, could not
be reported under the installment method and instead was ordinary income to the
partner in the year of the sale. Further, the Court determined that the IRS did not
abuse its discretion in requiring the change to a proper method of accounting in the
year following the initial year of recognition, though the statute of limitations on the
initial year had expired. Finally, the Court concluded that IRS appropriately
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calculated a Section 481(a) cumulative catch-up adjustment related to the accounting
method change.
The taxpayer was a partner in the management consulting and technology services
business of PwC. PwC subsequently sold the consulting business to IBM in 2002. As
part of this transaction, the taxpayer received a convertible promissory note (note) in
exchange for her interest. A portion of that amount was attributable to unrealized
receivables of the consulting business. The taxpayer had the right to convert all or any
portion of the unpaid principal balance into IBM common stock at any time after the
first anniversary of closing. IBM would pay interest on the unpaid principal balance
semi-annually, and the outstanding principal and any accrued and unpaid interest
was due and payable on the fifth anniversary of the transaction's closing.
The taxpayer reported the sale of her partnership interest as an installment sale on
her 2002 tax return and reported only interest income from the note for 2003
through 2006. The taxpayer later converted the entire note into shares of IBM stock
in two transactions in 2007. She reported these amounts as long-term capital gain on
her 2007 tax return.
The IRS issued a notice of deficiency for 2003 and determined that the amount the
taxpayer received in 2002 for her partnership interest, to the extent it was
attributable to partnership unrealized receivables, could not be reported under the
installment method. The IRS concluded that the treatment of the sale as an
installment sale was an improper method of accounting. Therefore, the IRS required
the taxpayer to change her method of accounting and computed a Section 481(a)
adjustment for 2003.
The Court agreed with the IRS that the amount of the proceeds from the sale of the
unrealized receivable should have been reported as ordinary income in the year of
sale, and that the taxpayer’s accounting method did not clearly reflect income with
respect to the portion of the note attributable to partnership unrealized receivables.
The Court also determined that the taxpayer’s use of the installment method to report
the note implicated the proper timing for reporting income. Accordingly, the sale of
the taxpayer’s partnership interest was a material item for purposes of Reg. Sec.
1.446-1(e)(2)(ii)(a). Based on the facts presented, the Court found that the taxpayer
had established a pattern of consistent treatment, and therefore a method of
accounting under the installment method of reporting, for this material item.
The Court therefore upheld the IRS’s Section 481(a) adjustment for 2003 as necessary
to remedy the omission of ordinary income that occurred in 2002. The Court stressed
that once IRS determines that a taxpayer's method of accounting does not clearly
reflect income, it has broad discretion to select a method of accounting that it believes
properly reflects the income of the taxpayer. Further, the Court determined that the
IRS appropriately calculated a Section 481(a) adjustment relating to change in
method of accounting to correct any omissions or duplications resulting from the
change.
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For a deeper discussion of how these issues might affect your business, please
contact:
Annette Smith, Washington, DC
+1 (202) 414-1048
[email protected]
Christine Turgeon, New York
+1 (646) 471-1660
[email protected]
Adam Handler, Los Angeles
+1 (213) 356-6499
[email protected]
George Manousos, Washington, DC
+1 (202) 414-4317
[email protected]
Jennifer Kennedy, Washington, DC
+1 (202) 414-1543
[email protected]
Dennis Tingey, Phoenix
+1 (602) 364-8107
[email protected]
Thomas Sehman, Minneapolis
+1 (612) 596-3940
[email protected]
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firm of which is a separate legal entity.
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