Final Regulations on the Capitalization of Tangible Property
Dear
Clients and Friends,
The
IRS and Treasury recently issued final tangible property
capitalization regulations. The final regulations attempt to
bring clarity to a complicated area of tax law. Many taxpayers
own tangible property that they maintain and repair. Taxpayers
may keep spare parts on hand in case the property breaks down,
and in some cases, a taxpayer may improve the property. The
final regulations address the proper characterization and tax
treatment of expenditures related to these maintenance, repair,
and improvement activities.
Below
is a brief overview of some of the significant provisions of the
final regulations that differ from the provisions of the
temporary regulations (issued in 2011) they replace and remove.
Please note that these regulations do not finalize temporary
regulations addressing the definition of “disposition” for
depreciable property. Revised regulations that address that
issue were proposed concurrently with the final regulations.
Background
Section
263(a)
of the Code generally requires the capitalization of amounts
paid to acquire, produce, or improve tangible property. On the
other hand, taxpayers are allowed to deduct ordinary and
necessary business expenses, including the costs of certain
supplies, repairs, and maintenance under §162(a). It is
not always easy to distinguish between an asset that must be
capitalized and property that is a material or supply used in a
trade or business. The line between improvement and repairs or
maintenance is not always clear.
Former
regulations attempted to define the difference between capital
and non-capital expenditures by providing that capital
expenditures included amounts paid or incurred to add to the
value, or substantially prolong the useful life, of property
owned by the taxpayer, or adapt the property to a new or
different use. Those regulations also provided that amounts paid
or incurred for incidental repairs and maintenance of property
were not capital expenditures. These standards were subjective
and required a fact-intensive analysis of the taxpayer's
situation. Not surprisingly, there has been considerable
controversy between taxpayers and the IRS over the proper
characterization of these expenses.
The
unveiling of these final tangible property capitalization
regulations is the culmination of a multi-year effort involving
intermediate guidance and taxpayer feedback. With a number of
clarifications and new safe harbors, the final regulations
represent a collaborative effort between taxpayers and the IRS
to bring a degree of certainty to an area of tax law
traditionally fraught with controversy. The final regulations
are generally effective for tax years beginning on or after
January 1, 2014.
Materials
and Supplies
Expanded
Definition:
The final regulations expand somewhat the definition of
“material and supplies” set forth in the 2011 temporary
regulations by increasing the $100 ceiling for characterizing a
unit of property as a material or supply to $200. Taxpayers had
expressed concern that the $100 amount would not capture many
common supplies, like calculators or coffee makers. With the
$200 amount, the IRS attempts to balance concerns over
distortions to income that could result from increasing the
acquisition cost ceiling with the need to include the typical
materials and supplies ordinarily used by many taxpayers. Like
the temporary regulations, the final regulations give the IRS
authority to change the amount of this threshold between
deductible costs and expenses that must be capitalized, and to
identify specific items as material and supplies, through
published guidance.
Election
to Capitalize:
Another difference between the 2011 temporary regulations and
the final regulations is the optional election to capitalize
certain materials and supplies instead of deducting their cost
in the first year they are used or consumed. As presented in the
temporary regulations, the requirement to elect to capitalize
material and supply costs was inconsistent with prior revenue
rulings that distinguished certain rotable, temporary, and
standby emergency spare parts from materials and supplies and
permitted taxpayers to treat that property as depreciable
assets. The final regulations characterize rotable, temporary,
or standby emergency spare parts as materials and supplies and
modify the election so that it is available only for these
parts.
Optional
Method of Accounting for Rotable and Temporary Parts:
A final point of note is the removal in the final regulations of
the requirement that the optional method of accounting for
rotable and temporary spare parts, if elected, be used for all
of a taxpayer's rotable and temporary spare parts in the same
trade or business. Recognizing that taxpayers may have pools of
rotable or temporary parts that are treated differently for
financial statement purposes, the final regulations provide that
a taxpayer generally is not required to use the optional method
for those pools for which it does not use the optional method of
accounting in its books and records. However, if a taxpayer
chooses to use the optional method for any pool for which the
taxpayer does not use the optional method in its books and
records, then the taxpayer must use the optional method for all
its pools of rotable and temporary spare parts in that trade or
business.
De
Minimis
Safe
Harbor
Both
the temporary and final regulations provide a general rule that
transaction costs associated with acquiring or producing a unit
of property must be capitalized. Both regulations also provide a
de minimis exception to the rule. The final regulations make
significant changes to the de minimis rule, a few of which are
described here.
The
de minimis exception, as provided in the temporary regulations,
allowed a taxpayer to deduct certain amounts paid for tangible
property if the taxpayer had an applicable financial statement,
had appropriate written accounting procedures for expensing
certain amounts and treated those amounts as expenses on its
applicable financial statement. The deduction was limited to a
ceiling that could only be calculated after the end of a tax
year. While the ceiling itself could be calculated relatively
simply, the financial accounting systems employed by most
taxpayers would not allow them to easily determine which costs
the de minimis rule applied to and, therefore, whether or not
applicable costs exceeded the ceiling.
Taxpayers
With an Applicable Financial Statement:
To both address taxpayers' concerns and ensure that the de
minimis safe harbor in the final regulations requires taxpayers
to use a reasonable, consistent methodology clearly reflecting
income for tax purposes, the ceiling was replaced in the final
regulations with a new safe harbor determined at the invoice or
item level and based on the policies that the taxpayer utilizes
for its financial accounting books and records. A taxpayer with
an applicable financial statement may rely on the de minimis
safe harbor of the final regulations only if the amount paid for
property does not exceed $5,000 per invoice, or per item as
substantiated by the invoice.
The
revised de minimis safe harbor also applies to a financial
accounting procedure that expenses amounts paid for property
with an economic useful life of 12 months or less as long as the
amount per invoice or item does not exceed $5,000. If the cost
exceeds $5,000 per invoice or item, then the amounts paid for
the property will not fall within the de minimis safe harbor.
Taxpayers
Without an Applicable Financial Statement: An additional modification of the
de minimis safe harbor in the final regulations is an expansion
to include taxpayers without an applicable financial statement,
but who have accounting procedures in place to deduct amounts
paid for property costing less than a specified dollar amount or
amounts paid for property with an economic useful life of 12
months or less. The de minimis safe harbor for taxpayers without
an applicable financial statement provides a reduced per invoice
(or item) threshold because there is less assurance that the
accounting procedures clearly reflect income. A taxpayer without
an applicable financial statement may rely on the de minimis
safe harbor only if the amount paid for property does not exceed
$500 per invoice, or per item as substantiated by the invoice.
If the cost exceeds $500 per invoice or item, then no portion of
the cost of the property will fall within the de minimis safe
harbor.
Application
to All Eligible Materials and Supplies:
Another significant change to the de minimis safe harbor is that
taxpayers are not permitted, as they were under the temporary
regulations, to select materials and supplies to be expensed
under the de minimis rule. Rather, the final regulations require
that the safe harbor be applied to all eligible materials and
supplies (other than rotable, temporary, and standby emergency
spare parts subject to the election to capitalize, or rotable
and temporary spare parts subject to the optional method of
accounting) if the taxpayer elects the de minimis safe harbor.
Amounts
Paid to Acquire or Produce Tangible Property
The
2011 temporary regulations provided that a taxpayer usually must
capitalize amounts paid to facilitate the acquisition or
production of real or personal property, and in an effort to
alleviate controversy between taxpayers and the IRS, the
temporary regulations included a list of inherently facilitative
amounts. Additional rules regarding these inherently
facilitative amounts were included. Among them were special
rules for inherently facilitative amounts allocable to real or
personal property that ultimately was not acquired.
The
final regulations generally retain the rules from the temporary
regulations addressing facilitative amounts. As in the temporary
regulations, the final regulations include a special rule for
the acquisition of real property providing that, except for
amounts specifically identified as inherently facilitative, an
amount paid by a taxpayer in the process of investigating or
otherwise pursuing the acquisition of real property does not
facilitate the acquisition if it relates to activities performed
in the process of determining whether to acquire real property
and which real property to acquire. The final regulations do not
expand the deduction of pre-decisional, investigatory costs to
personal property because, unlike real property acquisitions,
personal property acquisitions do not typically raise issues of
whether the transaction costs should be characterized as
deductible business expansion costs rather than costs to acquire
a specific property.
In
addition, the final regulations retain the rule that inherently
facilitative amounts allocable to real or personal property are
capital expenditures related to the property, even if the
property is not eventually acquired or produced. The final
regulations also clarify that, except for contingency fees,
inherently facilitative amounts allocable to property not
acquired may be allocated to that property and recovered in
accordance with the applicable provisions of the Code.
Routine
Maintenance and Improvements to Property
The
final regulations include a host of changes and clarifications
to the rules for determining whether an amount improves,
betters, or restores property. This letter highlights a few of
the more significant changes pertaining to buildings, a new safe
harbor for small taxpayers, and determining whether a betterment
has occurred.
Unit
of Property:
One issue addressed in the final regulations is whether a
building, together with its various components, is a single unit
of property. The 2011 temporary regulations generally defined a
building as a unit of property, but required the application of
the improvement standards to the building structure and the
enumerated building systems. The final regulations retain the
unit of property rules contained in the 2011 temporary
regulations. Accordingly, if an amount paid results in a
restoration of a building structure, such as the replacement of
an entire roof, then the expenditure constitutes an improvement
to the building unit of property. Similarly, if an amount paid
results in a betterment to a building system, such as an
improvement to the HVAC system, then the expenditure also
constitutes an improvement to the building unit of property.
Removal
Costs:
Another issue addressed in the final regulations is the
treatment of removal costs. The 2011 temporary regulations did
not provide a separate rule for the treatment of removal costs.
Instead, the temporary regulations addressed component removal
costs as an example of a type of indirect cost that must be
capitalized if the removal costs directly benefit or were
incurred by reason of an improvement. The final regulations
provide that, if a taxpayer disposes of a depreciable asset for
tax purposes, and has taken into account the adjusted basis of
the asset or component of the asset in realizing gain or loss,
the costs of removing the asset or component are not required to
be capitalized under §263(a). The final regulations also
provide that if a taxpayer disposes of a component of a unit of
property and the disposal is not a disposition for tax purposes,
then the taxpayer must deduct or capitalize the costs of
removing the component based on whether the removal costs
directly benefit or are incurred by reason of a repair to the
unit of property or an improvement to the unit of property.
Small
Taxpayer
Safe
Harbor
:
A new safe harbor was added in the final regulations, to aid
small taxpayers applying the general rules for improvements to
buildings, because small taxpayers generally do not have the
administrative means or sufficient documentation or information
to apply the improvement rules to their building structures and
systems. The safe harbor election applies to building property
held by taxpayers with gross receipts of $10,000,000 or less
(“a qualifying small taxpayer”). The final regulations
permit a qualifying small taxpayer to elect to not apply the
improvement rules to an eligible building property if the total
amount paid during the tax year for repairs, maintenance,
improvements, and similar activities performed on the eligible
building does not exceed the lesser of $10,000 or 2% of the
unadjusted basis of the building. Eligible building property
includes a building unit of property that is owned or leased by
the qualifying taxpayer, provided the unadjusted basis of the
building unit of property is $1,000,000 or less.
Routine
Maintenance:
The temporary regulations provided that the costs of performing
certain routine maintenance activities for property other than a
building or the structural components of a building are not
required to be capitalized as an improvement. Under this routine
maintenance safe harbor, an amount paid was deemed not to
improve a unit of property if it was for the recurring
activities that a taxpayer (or a lessor) expected to perform as
a result of the taxpayer's (or the lessee's) use of the unit of
property to keep the unit of property in its ordinarily
efficient operating condition. Activities were routine only if,
at the time the unit of property was placed in service, the
taxpayer reasonably expected to perform the activities more than
once during the property's alternative depreciation system class
life (regardless of whether the property was depreciated under
the alternative depreciation system). The safe harbor did not
apply to building property, because the 40-year class life could
allow major remodeling or restoration projects to be deducted
under the safe harbor, regardless of the nature or extent of the
work involved.
The
final regulations contain a safe harbor for routine maintenance
for buildings. The inclusion of a routine maintenance safe
harbor for buildings is expected to alleviate some of the
difficulties that could arise in applying the improvement
standards for certain restorations to building structures and
building systems. The final regulations use 10 years as the
period of time in which a taxpayer must reasonably expect to
perform the relevant activities more than once. The IRS chose
the 10-year period because of concern that use of a longer
period would permit the inappropriate deduction of many major
remodeling and restoration projects.
The
final regulations make a number of additional changes and
clarifications to the safe harbor for routine maintenance, which
are applicable to both buildings and other property. Among these
clarifications is the provision that amounts incurred for
activities falling outside the routine maintenance safe harbor
are not necessarily expenditures required to be capitalized.
Amounts incurred for activities that do not meet the routine
maintenance safe harbor are subject to analysis under the
general rules for improvements.
Betterments:
The rules pertaining to betterments are among those changed by
the final regulations. The 2011 temporary regulations defined
when an amount paid results in a betterment, and accordingly, an
improvement, to buildings and other property. Among other
changes to the betterment rules, the final regulations
reorganize and clarify the types of activities that constitute
betterments to property. In an effort to reduce controversy for
expenditures that span more than one tax year or when the
outcome of the expenditure is uncertain when the expenditure is
made, the final regulations also change the betterment test so
that it no longer is stated in terms of amounts that “result
in” a betterment. Instead, the final regulations provide that
a taxpayer must capitalize amounts that are reasonably expected
to materially increase the productivity, efficiency, strength,
quality, or output of a unit of property or that are for a
material addition to a unit of property.
Election
to Capitalize Repair and Maintenance Costs
The
2011 temporary regulations did not contain an election for
taxpayers to capitalize expenditures made with respect to
tangible property that would otherwise be deductible. In
recognition of the significant administrative burden reduction
achieved by permitting a taxpayer to follow for tax purposes the
capitalization policies used for its books and records, the
final regulations permit a taxpayer to elect to treat amounts
paid for repair and maintenance of tangible property as amounts
paid to improve that property and as an asset subject to the
allowance for depreciation, as long as the taxpayer incurs the
amounts in carrying on a trade or business and the taxpayer
treats the amounts as capital expenditures on its books and
records used for regularly computing income.
A
taxpayer that elects this treatment must apply the election to
all amounts paid for repair and maintenance to tangible property
that it treats as capital expenditures on its books and records
in that tax year. A taxpayer making the election must begin to
depreciate the cost of the improvements when the improvements
are placed in service by the taxpayer under the applicable
provisions of the Code and regulations. Once made, the election
may not be revoked.
A
taxpayer that capitalizes repair and maintenance costs under the
election is still eligible to apply the de minimis safe harbor,
the safe harbor for small taxpayers, and the routine maintenance
safe harbor to repair and maintenance costs that are not treated
as capital expenditures on its books and records.
Applicability
Dates
The
final regulations generally apply to tax years beginning on or
after January 1, 2014.
Capitalization is a complex area of tax law, but an area that is
critically important to many taxpayers. The final regulations
are a step in the direction of clarity. However the transition
to and application of the new rules is certain to remain a
complicated matter. As always, please call me if you have any
questions or would like to discuss these topics further.
Sincerely
yours,
Terri L. Winters, CPA
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