#11511 - Capitalization - U.S. Income Tax Law

CAPITALIZATION

1. Capitalization—Think of it as just another way to make income match up with deductions. Remember, §1016 requires you to take these deductions into account—can’t double-deduct.

   1. Our Roadmap for Capitalization:

      1. §167

         • Is it property, subject to wear and tear, AND either

         • Used in trade/business, OR held for production of income

      2. If yes, then go to §168:

         • Determine basis, recovery period, depreciation method, applicable convention

   2. Depreciation: §167(a) allows a deduction as depreciation for a reasonable amount of exhaustion, wear and tear for property subject to wear and tear, and that is either used in the T/B or held for production of income. Depreciation is allowed on the basis calculated under §1011.

      1. §263(a): No depreciation deductions for buildings or other permanent improvements to property.

      2. §1016(a)(2) says to adjust your basis by the amount of depreciation deductions you take. So if you wind up selling a §168 asset, and you get more for it than the accelerated depreciation system would have provided for, you wind up paying taxes on a gain b/c your adjusted basis is so low.

   3. Depreciation Methods

      1. Straight-line: Just take the basis and divide evenly by number of years in recovery period

      2. Double-declining: Basically just double the straight-line amount for each year

         • Watch out for first year probably being a half year

      3. Salvage always treated as zero. So you deduct for depreciation all the way til you reach 0 asset value. But of course if you wind up selling for more than zero, you have to pay taxes on gain that that reflects (§1016(a)(2)).

   4. Accelerated Cost Recovery System (§168(a)): For tangible property, §167(a) depreciation deduction should be determined by using:

      1. the applicable depreciation method

         • Except as otherwise provided, for all tangible assets, the correct method is the double declining balance method, and then switch to straight-line method in the first year in which that provides higher allowance (§168(b))

         • TP must use 150% declining method for any 15-year or 20-year property, property used in farming, smart electric meters, and then switch to straight line in first year in which s-l yields a larger allowance (§168(b))

         • TP can elect to use 150% method for other property, but then must use that method for all property of that class placed in service in that tax year

      2. the applicable recovery period, and

         • §168(c) lists applicable recovery periods. For most assets, it is the same as the number of years (e.g., 3 year property has 3-year recovery period). For certain types like residential rental property, its 27.5 years.

         • §168(e) lists the class life years. For example, automobiles are 5-year.

      3. the applicable convention

         • In general, except as otherwise provided, half-year convention is the applicable convention (§168(d)).

         • For real property, use half-month convention §168(d)(2)

         • If more than 40% of the non-residential property was placed in service during the last quarter of the taxable year, then use mid-quarter convention for all property placed in service in that year (§168(d)(3)

   5. Uniform Capitalization Rule (§263A): denies immediate deductions for costs of producing property that taxpayer will either use in his business or sell as inventory (including the proportionate share of costs like rent and utility bills allocable to those items). But TP is eventually able to deduct those costs when the goods placed in inventory are later sold.

   6. Intangible Property

      1. Amortization of Goodwill and Other Intangible Assets (§197)

         • Deductions allowed on amortizable assets, ratably over the 15-year period beginning w/ the month in which it was acquired.

         • Asset must be held in connection w/ conduct of trade of business or a §212 activity (§197(c))

         • §197(d) Includes: goodwill, going concern value, business books/records, operating systems, patents and IP, licenses, permits, or other govt-granted rights, non-compete covenants; customer-based intangibles, including mkt share or other value arising out of customer relationships.

           • §197(c) excludes other items not covered in (d) which are created by the taxpayer

      2. Indopco Line

         • Indopco v Commissioner (US 1992, p 629)—Natl Starch being acquired by Unilever, it tried to deduct its costs (lawyer and banker fees) as §162 ordinary and necessary. Court wouldn’t let it deduct the costs , b/c it says it will reap benefits from the acquisition over a long period of time, so should treat them as capital expense.

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