The IRS's ruling on year 2000 costs

Nation's Business, Jan, 1998

By now most business people know about the year 2000 problem, in which software that tracks years by using the last two digits must be modified to recognize the year 2000. While business owners have been rushing to revise software, the Internal Revenue Service only recently ruled that the cost of fixing the year 2000 problem can be deducted in the year the cost was incurred.

The November ruling amounted to a change of course for the IRS. The agency initially leaned toward calling the year 2000 costs "improvements" that either prolong the life or increase the value of the software. As such, the costs would have to be depreciated over a number of years.

Immediate deduction of year 2000 costs appears to signal an IRS shift away from strict interpretation of a 1992 Supreme Court case on deductibility of business expenses. In Indopco Inc. vs. the United States, the court ruled that the legal and professional fees paid by a company to find a "white knight" -- a friendly company to merge with -- to fend off a hostile takeover bid could not be deducted in the year incurred. The court said any costs associated with the friendly merger provided a "future benefit' to the company and must be capitalized -- deducted over a period of years.

Since that decision, the IRS has argued aggressively that any cost that provides a future benefit should be capitalized. To date, the IRS has tried to have companies capitalize the costs of advertising, employee training, and some environmental cleanup expenses. These efforts have been rejected by the courts.

"It's significant that the [IRS] didn't apply Indopco. It's a major victory for common sense," says Harry Cohen, a partner with San Francisco accounting firm Stonefield Josephson.

Says Robert Zarzar, a partner with Price Waterhouse in Washington, D.C.: "Taxes are always an issue, but businesses will do and pay whatever it takes to get ready for the year 2000."

Both the American Institute of Certified Public Accountants and the American Bar Association had asked the IRS for direction on how to treat year 2000 costs. The answer amounts to a major holiday gift to all businesses in need of year 2000 repairs.

The author is a CPA and business writer in South Bend, Ind.