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In PLR 202121002, the IRS has ruled that a taxpayer that inadvertently elected to capitalize underwriting fees under Treas. Reg. Section 1.263(a)-5(d)(4) for eight tax years on its consolidated federal income tax returns may revoke the election for later open tax years, but not for earlier tax years for which the granting of relief would prejudice the government's interests.

Facts

Taxpayer is the common parent of an affiliated group of corporations that filed a consolidated federal income tax return on a calendar-year basis. All members of the group used the overall accrual method of accounting during the years at issue.

From tax year 1 through tax year 8, Taxpayer inadvertently elected under Treas. Reg. Section 1.263(a)-5(d)(4) to capitalize certain expenses for underwriting services incurred by members of the Taxpayer's consolidated group (i.e., the Borrowers) in connection with various borrowings. Employees of the underwriter provided conventional underwriting services to the Borrowers, including acting as bookrunner and principal underwriter on Borrower's borrowings. The underwriter is a disregarded entity that is wholly owned by a member of Taxpayer's consolidated group.

Usually, Taxpayer applies US Generally Accepted Accounting Principles (GAAP) to eliminate intercompany transactions for consolidated reporting. However, fees paid between different segments within Taxpayer's consolidated group, such as the underwriting activity, are treated as if each business segment were a transaction with a third party. Therefore, for financial reporting purposes, Taxpayer capitalized the underwriting fees and amortized them over the life of the debt on a straight-line basis.

Taxpayer typically follows financial accounting treatment for federal income tax purposes unless there is a reason to deviate. Taxpayer's corporate tax function was unaware of the financial accounting treatment applied to the intercompany underwriting fees. Consequently, during the years at issue, Taxpayer followed book treatment and capitalized the underwriting fees paid to the underwriter.

In tax year 9, Taxpayer's corporate tax function became aware of the financial accounting treatment of the intercompany underwriting fees and realized that treatment presented significant tax issues. Later that year, the tax staff discovered the election made under Treas. Reg. Section 1.263(a)-5(d)(4), but it was too late to change the treatment of the underwriting fees on the tax year 8 consolidated tax return.

For tax years 1 through 3 and 7 and 8, Taxpayer requested permission to revoke its inadvertent elections made under Treas. Reg. Section 1.263(a)-5(d)(4). Beginning with tax year 9, Taxpayer also intends to deduct the underwriting fees paid to the underwriter.

Analysis

Treas. Reg. Section 1.263(a)-5(a)(9) requires taxpayers to capitalize an amount paid to facilitate a borrowing.

Treas. Reg. Section 1.263(a)-5(d)(1), in part, treats employee compensation as an amount that does not facilitate a transaction described in Treas. Reg. Section 1.263(a)-5(a). For an affiliated group of corporations filing a consolidated federal income tax return, Treas. Reg. Section 1.263(a)-5(d)(2)(ii) treats a payment by one member of a group to a second member of the group for services performed by an employee of the second member as employee compensation if the services were provided when both members were affiliated.

Notwithstanding the general rule in Treas. Reg. Section 1.263(a)-5(d)(1), Treas. Reg. Section 1.263(a)-5(d)(4) allows a taxpayer to elect to capitalize employee compensation as amounts that facilitate a transaction. The election is made separately for each transaction and applies to employee compensation, overhead, or de minimis costs, or any combination thereof. The election is made by treating the amounts to which the election applies as amounts that facilitate the transaction in the taxpayer's timely filed original federal income tax return (including extensions) for the tax year during which the amounts are paid. The election is revocable for each tax year for which it was made only with the IRS's advance consent.

For tax year 1, the period of limitations on assessment is open under IRC Section 6501(a). If relief were granted for tax year 1, the IRS noted, tax years 2 and 3 would be affected, as amounts capitalized in those years would need to be reversed. The IRS noted, however, that the period of limitations for assessments were closed under IRC Section 6501(a) for tax years 2 and 3. Because the IRS is barred from reviewing those years and cannot ensure that changes made to those years under this ruling would not be detrimental to the government, the IRS concluded Taxpayer had not overcome the "ordinarily prejudiced" standard in Treas. Reg. Section 301.9100-3(c)(1)(ii). Therefore, the IRS ruled that Taxpayer may not revoke its elections under Treas. Reg. Section 1.263(a)-5(d)(4) for tax years 1 through 3.

Granting the relief for tax years 1 through 3, the IRS emphasized, also raised "hindsight" concerns that Taxpayer was unable to overcome. Because tax years 1 through 3 preceded enactment of the Tax Cut and Jobs Act, Taxpayer would recover its expenses under a 35% rate, thereby yielding a deduction-rate benefit.

For tax years 7 and 8, which remain open for assessment under IRC Section 6501(a), the IRS ruled that Taxpayer acted reasonably and in good faith, and granting relief to revoke the election under Treas. Reg. Section 1.263(a)-5(d)(4) will not prejudice the government's interests. "Taxpayer's internal accounting and tax staff and external tax consultants failed to identify the inadvertent capitalization election for federal tax purposes resulting from following capitalization for financial accounting purposes despite exercising reasonable diligence." Therefore, the IRS granted Taxpayer 60 calendar days from the date of the ruling to revoke the elections for tax years 7 and 8.

Additionally, the IRS pointed out that Taxpayer must amend the consolidated tax return for tax year 9 and any other consolidated tax returns that may be affected by the removal of the capitalized amounts that will be deducted in tax years 7 and 8.

Implications

The ruling serves as a reminder that an inadvertent election can be made under Treas. Reg. Section 1.263(a)-5(d)(4) to capitalize certain transaction costs (i.e., employee compensation, overhead or de minimis costs) merely by not deducting those costs on the taxpayer's timely filed original federal income tax return. Once the election is made, it cannot be revoked without the IRS's consent. It also demonstrates that payments from one member of a consolidated group to a member of the same group in exchange for services rendered in connection with a transaction, when appropriate, can be treated as employee compensation under Treas. Reg. 1.263(a)-5(d)(1).

Treas. Reg. Section 1.263(a)-5(d)(4) provides no standard under which the IRS determines whether to grant a taxpayer's request to revoke the election. In such instances, the IRS ordinarily will apply the standards of Treas. Reg. Sections 301.9100-1 et. seq. See Revenue Procedure 2021-1, Section 5.16. Here, the IRS noted that "this situation is analogous to those situations concerning taxpayers who have not made a particular election provided in the regulations because after exercising due diligence (taking into account the taxpayer's experience and the complexity of the return or issue), the taxpayer was unaware of the necessity for the election, or because taxpayers received inadequate or incorrect advice from either an attorney or accountant knowledgeable in tax matters, and subsequently seek extensions of time under [Treas. Reg. Section] 301.9100-1 … ." Under Taxpayer's facts, application of Treas. Reg. Sections 301.9100-1 et. seq. to the proposed revocation proved fatal to the request for tax years 1 through 3 given that the statute of limitations for years 2 and 3 was closed and that Taxpayer would derive a tax rate benefit in those years.

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