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IRS Releases New Audit Techniques Guide

On September 14, 2016, the IRS released an Audit Techniques Guide (ATG) related to the recently released Tangible Property Regulations (TPR). The Audit Techniques Guide gives IRS agents a tool to help them identify potential tax issues related to the capitalization, acquisition, and dispositions of tangible property. The Tangible Property Regulations provide specific guidance related to the capitalization of improvement costs, the treatment of acquisition costs and tangible property dispositions, and the treatment of material and supply costs. Now that the IRS has provided agents with the ATG, the expectation is that IRS exam activity will pick up in this area. 

The ATG is almost 200 pages and divided into 18 chapters, each covering a different part of the TPR.  Each chapter contains a summary of the relevant law and is followed by “Audit Procedures.” The Audit Procedures contain questions for agents to ask, facts for agents to consider, and information to be requested by the IRS agent. The questions and information requests are tailored to the topic covered in the specific chapter. Each chapter advises the agents that, “The examiner should only request documents that are pertinent to the facts and circumstances in each case,” however, it is left to the agent to assess whether certain issues are worth pursuing. 
Highlights of the ATG
General considerations

In the “General” chapter, agents are told to ask if the taxpayer performed a TPR study. If so, the agents are asked to consider:

  • Years affected by the study
  • Assets affected by the study (did the taxpayer look back to all years, or only some years?). 
  • How the taxpayer determined which assets to analyze (random sampling, word search, certain years, etc.)
  • How to properly define units of property (UOP)
  • Information considered when performing the analysis (invoices, work-order requests, etc.) Note: If insufficient information was considered, the IRS may deny certain deductions.
  • Computation of Schedule M items (book-tax differences)

Other considerations

  • Did the taxpayer change its de minimis policy?
  • How does the taxpayer account for materials and supplies?
  • Did the taxpayer include an “election to capitalize” in the return?
  • Did the taxpayer’s TPR adjustments take into account the effect on other sections (263A, 199)?

Unit of property changes
The ATG asks agents to consider whether the taxpayer properly applied the UOP rules.  In addition to asking the questions listed above, the ATG requires the agent to consider specifically any section 481(a) adjustment and determine the type of property that would be impacted by the change. This property may include buildings, property other than buildings, plant property, network assets, and more.
For example, in the case of a lessee of real property, the IRS would likely confirm that a lessee used only the leased portion of the building as the UOP as opposed to the entire building. 
Amounts paid to acquire or produce property
The ATG asks questions related to amounts paid to acquire or produce property. These questions focus on whether there are any capitalizable indirect acquisition costs that the taxpayer deducted. Capitalizable indirect acquisition costs could include legal and professional fees, transaction costs, engineering costs, design costs, etc. that are related to the acquisition of an item of property. The IRS will look at a taxpayer’s capitalization policy to determine if the treatment of such costs is discussed in that policy. 
The ATG also discusses abandonment costs and termination costs, and notes that, if a taxpayer took an abandonment loss, the IRS will ask whether the abandonment loss (or termination cost deduction) was proper and whether the taxpayer has records to support the termination or abandonment.
De minimis safe harbor
A chapter in the ATG covers the de minimis safe harbor. For this topic, the IRS states that it will likely ask the following:

  • Does the taxpayer have an applicable financial statement?
  • If the taxpayer has an applicable financial statement, did it have a written policy in place as of the first day of the tax year?
  • Does the company actually follow that policy? Did the taxpayer properly identify the asset to which it applied de minimis? Specifically, did a taxpayer attempt to split an asset to get the costs under the applicable threshold.

To the extent amounts were deducted in excess of the de minimis threshold (or if a taxpayer did not make the election), the IRS will consider whether the taxpayer’s deductions “clearly reflect income.”
Improvement rules (Betterment, Restoration, New or Different Use)
The ATG covers in detail betterments, restorations, and new or different use respectively. It generally asks whether the taxpayer performs its TPR analysis in accordance with the final regulations. It specifically advises agents to “review” repair and maintenance accounts for periods under examination to make sure the taxpayer did not deduct items that should have been capitalized under the TPR.  When reviewing TPR studies, the IRS will ask taxpayers what information they reviewed when analyzing expenses (invoices, cost detail, etc.). 
Safe Harbors – special rules – other provisions
A chapter in the ATG relates specifically to safe harbors and other special provisions.
Among other things, it asks about the routine maintenance safe harbor (RMSH) and specifically discusses whether the taxpayer applied the RMSH to property that the taxpayer adapted to a new or different use. It is fair to assume that the IRS could ask other questions to ensure that the taxpayer applied the rule properly. While not specifically mentioned in the ATG, the IRS might also ask whether the costs resulted in a betterment to the UOP – in which case the RMSH does not apply. 
There are questions in the ATG relating to a variety of industry specific optional methods. And while the ATG asks whether the taxpayer made an election to capitalize repair and maintenance costs, it seems to be concerned only with whether a taxpayer consistently applied that election to all assets in that particular year. 
Materials and supplies
The ATG asks whether materials and supplies are (for a producer) properly capitalized to inventory and if the materials and supplies are actually spare parts related to a piece of equipment which would affect the treatment of those costs. It further asks whether the taxpayer is using the de minimis safe harbor as this would simplify the analysis as it relates to incidental materials and supplies.
If a taxpayer has materials and supplies on the balance sheet, the IRS will analyze whether those items meet the definition of materials and supplies or whether those items should really be treated as depreciable fixed assets. 
Leased property
The ATG discusses whether a lease is properly categorized for tax. The concept of “capital” versus “operating” does not exist for tax, so a taxpayer would be asking whether it actually owns property or whether it is leasing such property. The ATG also asks agents to consider whether section 110 was properly applied (relating to the receipt of tenant improvement allowances) and whether the parties treated the allowance as qualified under section 110. 
The ATG devotes a significant amount of text to the subject of dispositions. In general, it asks if the taxpayer has performed a “disposition” study and advises on specific project related items that an agent must consider. The agent is asked to read the engagement letter to determine the extent of the study, read study and presentation materials, and determine if any basis adjustments was recorded on an asset by asset basis.
Like the abandonment analysis, an agent must consider whether the property deducted as a disposition was actually disposed. For example, if a landlord built a building and built out a certain leased space the first time  if the space is later demolished to accommodate a second tenant – the question will be whether the landlord really disposed of the entire first build-out or only part of the build-out. This is important because the treatment of full dispositions might be different than partial dispositions. 

Learn More
The above summary highlights only some of the issues raised by the Audit Techniques Guide. The ATG is almost 200 pages and contains many detailed questions and information requests. Taxpayers should familiarize themselves with the general requirements in the TPR and the focus areas in the ATG to ensure that they are prepared in the event the IRS audits this issue. 
For additional information or assistance with IRS examinations, please contact Richard Shevak, Director, at 862-245-5029.

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