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An In-Depth Look: Final Capitalization Regs Contain Many Changes Favorable to Taxpayers
(Parker Tax Publishing: September 25, 2013)
In December 2011, the IRS issued temporary regulations regarding the deduction and capitalization of expenditures related to tangible property. Initially, the temporary capitalization regulations were slated to apply to tax years beginning on or after January 1, 2012. Subsequently, the IRS reconsidered that effective date. On November 20, 2012, the IRS issued Notice 2012-73 which provided that, to assist taxpayers in their transitions to the temporary regulations and final regulations, the IRS was changing the applicability date of the 2011 temporary regulations to tax years beginning on or after January 1, 2014, while permitting taxpayers to choose to apply the 2011 temporary regulations to tax years beginning on or after January 1, 2012, and before the applicability date of the final regulations.
On September 19, 2013, the IRS issued final regulations (T.D. 9636) regarding the deduction and capitalization of expenditures related to tangible property. Generally, under the final regulations, a taxpayer must distinguish whether an amount paid is for a repair, in which case it may be currently deducted, or is for an improvement to a unit of property, in which case it must be capitalized. A unit of property is considered improved if the amounts paid for activities performed after the property is placed in service by the taxpayer:
(1) are for a betterment to the unit of property;
(2) restore the unit of property; or
(3) adapt the unit of property to a new or different use.
However, there are numerous safe harbor and de minimis rules under which a taxpayer can avoid capitalizing an item. For example, there is a safe harbor for routine maintenance on property. Under that safe harbor, amounts paid for routine maintenance on a unit of tangible property, or on a building (leased or owned), condo, or cooperative, are deemed not to improve that unit of property and may thus be expensed.
The final regulations made many changes to the temporary regulations that are favorable to taxpayers. The following discussion outlines some of the more significant ones.
Materials and Supplies
The final regulations expand the definition of materials and supplies to include property that has an acquisition or production cost of $200 or less (increased from $100 or less in the temporary regulations), clarify the application of the optional method of accounting for rotable and temporary spare parts, and simplify the application of the de minimis safe harbor to materials and supplies.
The dollar threshold for characterizing a unit of property as a material or supply is increased from property costing $100 or less to property costing $200 or less.
Further, while the final regulations retain the rule permitting a taxpayer to elect to capitalize and depreciate amounts paid for certain materials and supplies, they also provide that this rule only applies to rotable, temporary, or standby emergency spare parts.
De Minimis Safe Harbor Ceiling Rule Replaced With Simplified De Minimis Rule
The temporary regulations required a taxpayer to capitalize amounts paid to acquire or produce a unit of real or personal property, including the related transaction costs. However, a safe harbor ceiling rule provided a de minimis exception that allowed a taxpayer to deduct certain amounts paid for tangible property if the taxpayer had an applicable financial statement (AFS), had written accounting procedures for expensing amounts paid for such property under specified dollar amounts, and treated such amounts as expenses on its AFS. Practitioners complained that the rule was so complex that the administrative burden imposed would outweigh any potential tax benefit. As a result, the final regulations eliminate the de minimis safe harbor ceiling rule.
Instead, the IRS replaced the ceiling rule with a new safe harbor determined at the invoice or item level and based on the policies the taxpayer uses for its financial accounting books and records. A taxpayer with an AFS 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.
Additionally, the final regulations expand the de minimis rule to not only amounts paid for property costing less than a certain dollar amount, but also to amounts paid for property having a useful life less than a certain period of time. Thus, the final regulations provide the 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. Such amounts are deductible under the de minims rule whether the financial accounting procedure applies in isolation or in combination with a financial accounting procedure for expensing amounts paid for property that does not exceed a specified dollar amount. Under either procedure, 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. In addition, an anti-abuse rule is provided to aggregate costs that are improperly split among multiple invoices.
The final regulations add a de minimis rule for taxpayers without an AFS, if accounting procedures are 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.
The final regulations clarify the treatment under the de minimis safe harbor of transaction costs and other additional costs of acquiring and producing property subject to the safe harbor. To simplify the application of the de minimis rule to tangible property, the final regulations provide that a taxpayer electing to apply the de minimis safe harbor is not required to include in the cost of the tangible property the additional costs of acquiring or producing such property if these costs are not included in the same invoice as the tangible property. However, the final regulations also provide that a taxpayer electing to apply the de minimis safe harbor must include in the cost of such property all additional costs (for example, delivery fees, installation services, or similar costs) of acquiring or producing such property if these costs are included on the same invoice with the tangible property. If an invoice includes amounts paid for multiple tangible properties and the invoice includes additional invoice costs related to the multiple properties, then the taxpayer must allocate the additional invoice costs to each property using a reasonable method. The final regulations specify that a reasonable allocation method includes, but is not limited to, specific identification, a pro rata allocation, or a weighted average method based on each property's relative cost. The final regulations also clarify that additional costs consist of the transaction costs (that is, the facilitative costs under Sec. 1.263(a)-2(f)) of acquiring or producing the property and the costs under Sec. 1.263(a)-2(d) for work performed before the date the unit of tangible property is placed in service.
Example: In 2014, ABC Company buys 10 printers at $250 each for a total cost of $2,500 as indicated by the invoice. Assume that each printer is a unit of property. ABC does not have an AFS. ABC has accounting procedures in place at the beginning of 2014 to expense amounts paid for property costing less than $500, and ABC treats the amounts paid for the printers as an expense on its books and records. The amounts paid for the printers meet the requirements for the de minimis safe harbor. If ABC elects to apply the de minimis safe harbor in 2014, it may not capitalize the amounts paid for the 10 printers or any other amounts meeting the criteria for the de minimis safe harbor. Instead, ABC may deduct these amounts in the tax year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.
Example: ABC Corporation provides consulting services to its customers. ABC does not have an AFS, but it has accounting procedures in place at the beginning of 2014 to expense amounts paid for property costing less than $500. In 2014, ABC pays $600 to an interior designer to shop for, evaluate, and make recommendations regarding purchasing new furniture for ABC's conference room. As a result of the interior designer's recommendations, ABC acquires a conference table for $500 and 10 chairs for $300 each. In 2014, ABC receives an invoice from the interior designer for $600 for his services, and ABC receives a separate invoice from the furniture supplier indicating a total amount due of $500 for the table and $300 for each chair. For 2014, ABC treats the amount paid for the table and each chair as an expense on its books and records, and ABC elects to use the de minimis safe harbor for amounts paid for tangible property that qualify under the safe harbor. The amount paid to the interior designer is a cost of facilitating the acquisition of the table and chairs. ABC is not required to include in the cost of tangible property the additional costs of acquiring such property if these costs are not included in the same invoice as the tangible property. Thus, ABC is not required to include a pro rata allocation of the amount paid to the interior designer to determine the application of the de minimis safe harbor to the table and the chairs. Thus, the amounts paid by ABC for the table and each chair meet the requirements for the de minimis safe harbor and ABC may not capitalize the amounts paid for the table or each chair. In addition, ABC is not required to capitalize the amounts paid to the interior designer as a cost that facilitates the acquisition of tangible property. Instead, ABC can deduct the amounts paid for the table, chairs, and interior designer in the tax year the amounts are paid, provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.
Compliance Tip: The de minimis rule is a safe harbor, elected annually by including a statement on the taxpayer's timely filed original federal tax return for the year elected. If elected, the de minimis safe harbor must be applied to all amounts paid in the tax year for tangible property that meet the requirements of the de minimis safe harbor, including amounts paid for materials and supplies that meet the requirements.
If the taxpayer elects the de minimis safe harbor, it must 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 for such parts).
Special Rules Provided for Small Taxpayers
While the temporary regulations did not provide any special rules for small taxpayers to assist them in applying the general rules for improvements to buildings, the final regulations allow 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 percent 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. A qualifying small taxpayer is a taxpayer whose average annual gross receipts for the three preceding tax years is less than or equal to $10 million.
Compliance Tip: The safe harbor for building property held by small taxpayers may be elected annually on a building-by-building basis by including a statement on the taxpayer's timely filed original federal tax return, including extensions, for the year the costs are incurred for the building.
Under the safe harbor for small taxpayers, a taxpayer includes amounts not capitalized under the de minimis safe harbor election of Sec. 1.263(a)-1(f) and under the routine maintenance safe harbor for buildings (discussed below) to determine the annual amount paid for repairs, maintenance, improvements, and similar activities performed on the building. If the amount paid for repairs, maintenance, improvements, and similar activities performed on a building unit of property exceeds the safe harbor threshold for a tax year, then the safe harbor is not applicable to any amounts spent during the tax year. In that case, the taxpayer must apply the general rules for determining improvements, including the routine maintenance safe harbor for buildings.
New Safe Harbor for Routine Building Maintenance
While the temporary regulations contained a safe harbor for expensing routine maintenance of personal property, there was no safe harbor for routine maintenance for building property. In the final regulations, the IRS has added such a safe harbor. The inclusion of a routine maintenance safe harbor for buildings is aimed at alleviating 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 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 the 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 a lessee's) use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. The temporary regulations provided that the activities are 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 a specified period. The temporary regulations provided that the routine maintenance safe harbor did not apply to building property.
In the final regulations, the IRS kept the routine maintenance safe harbor and added a routine maintenance safe harbor for buildings. 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 final regulations make the following additional changes and clarifications to the safe harbor for routine maintenance, which are applicable to both buildings and other property:
1. the routine maintenance can be performed any time during the life of the property provided that the activities qualify as routine under the regulations;
2. for purposes of determining whether a taxpayer is performing routine maintenance, the final regulations remove the taxpayer's treatment of the activity on its AFS from the factors to be considered;
3. taxpayers may have several different reasons for capitalizing maintenance activities on their AFS, and such treatment may not be indicative of whether the activities are routine;
4. the final regulations clarify the applicability of the routine maintenance safe harbor by adding the following three items to the list of exceptions from the routine maintenance safe harbor: (i) amounts paid for a betterment to a unit of property, (ii) amounts paid to adapt a unit of property to a new or different use, and (iii) amounts paid for repairs, maintenance, or improvement of network assets; and
5. the exception relating to amounts paid for property for which a taxpayer has taken a basis adjustment resulting from a casualty loss is slightly modified to be consistent with the revised casualty loss restoration rule.
OBSERVATION: 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.
Changes to Betterments Rule
The temporary regulations provided that an amount paid results in a betterment, and accordingly, an improvement that must be capitalized, if it:
(1) ameliorates a material condition or defect that existed before the acquisition of the property or arose during the production of the property;
(2) results in a material addition to the unit of property (including a physical enlargement, expansion, or extension); or
(3) results in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property or its output.
As applied to buildings, an amount results in a betterment to the building if it results in a betterment to the building structure or any of the building systems. The final regulations no longer phrase the betterment test in terms of amounts that result in a betterment. Rather, 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. According to the IRS, eliminating the results in standard is aimed at reducing controversy for expenditures that span more than one tax year or when the outcome of the expenditure is uncertain when the expenditure is made.
Because taxpayers may apply different standards for capitalizing amounts on their AFSs and such standards may not be controlling for whether the activities are betterments for federal tax purposes, the final regulations remove the taxpayer's treatment of the expenditure on its financial statement as a factor to be considered in performing a betterment analysis under the final regulations.
The temporary regulations provided that, when an expenditure is necessitated by a particular event, the determination of whether an expenditure is for the betterment of a unit of property is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately before the event necessitating the expenditure. The final regulations retain this general rule but clarify that the rule applies when the event necessitating the expenditure is either normal wear and tear or damage to the unit of property during the taxpayer's use of the property. Thus, the final regulations clarify that the appropriate comparison rule focuses on events affecting the condition of the property and not on business decisions made by taxpayers. In addition, the final regulations confirm that the rule does not apply to wear, tear, or damage that occurs prior to the taxpayer's acquisition or use of the property. In these situations, the amelioration of a material condition or defect rule may apply.
Changes to Restorations Rule
The temporary regulations provided that an amount is paid to restore, and therefore improve, a unit of property if it meets one of six tests:
(1) it is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss);
(2) it is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
(3) it is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or relating to a casualty event (i.e., the casualty loss rule);
(4) it returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
(5) it results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or
(6) it is for the replacement of a major component or a substantial structural part of the unit of property (i.e., the major component rule).
The final regulations generally retain the restoration standards in the temporary regulations but revise both the major component rule and the casualty loss rule. The final regulations clarify the definition of major component, and, more significantly, add a new definition for major components and substantial structural parts of buildings.
The final regulations separate major component, which focuses on the function of the component in the unit of property, from substantial structural part, which focuses on the size of the replacement component in relation to the unit of property. A major component is defined as a part or combination of parts that performs a discrete and critical function in the operation of the unit of property. The final regulations define a substantial structural part as a part or combination of parts that comprises a large portion of the physical structure of the unit of property. The final regulations clarify that an incidental component of a unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally does not, by itself, constitute a major component. In the case of buildings, the final regulations provide that an amount is for the replacement of a major component or substantial structural part if the replacement includes a part or combination of parts that (1) comprises a major component or a significant portion of a major component of the building structure or any building system, or (2) comprises a large portion of the physical structure of the building structure or any building system.
The final regulations revise the casualty loss rule to permit a deduction, where otherwise permissible, for amounts spent in excess of the adjusted basis of the property damaged in a casualty event. Thus, a taxpayer is still required to capitalize amounts paid to restore damage to property for which the taxpayer has properly recorded a basis adjustment, but the costs required to be capitalized under the casualty loss rule are limited to the excess of (1) the taxpayer's basis adjustments resulting from the casualty event, over (2) the amount paid for restoration of damage to the unit of property that also constitutes a restoration under the other criteria of Reg. Sec. 1.263(a)-3(k)(1) (excluding the casualty loss rule). Casualty related expenditures in excess of this limitation are not treated as restoration costs and may be properly deducted if they otherwise constitute ordinary and necessary business expenses (for example, repair and maintenance expenses).
Changes to Rules Requiring Capitalization for the Adaption to a New or Different Use
The temporary regulations required a taxpayer to capitalize amounts paid to adapt a unit of property to a new or different use (that is, a use inconsistent with the taxpayer's intended ordinary use at the time the property was originally placed in service by the taxpayer). As applied to buildings, the new or different use standard is applied separately to the building structure and its building systems.
The final regulations retain the substantive rules of the temporary regulations but add additional examples to illustrate the rules. The final regulations provide that if an amount adapts the unit of property in a manner inconsistent with the taxpayer's intended ordinary use of the property when placed in service, the amount must be capitalized as an adaptation of the unit of property to a new or different use.
Election to Capitalize Repair and Maintenance Costs
The temporary regulations did not contain an election for taxpayers to capitalize expenditures made with respect to tangible property that would otherwise be deductible under these regulations. Under the final regulations, a taxpayer can elect to treat amounts paid during the tax year for repair and maintenance to 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.
Under the final regulations, 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 such improvements when the improvements are placed in service by the taxpayer under the applicable provisions of the Code and regulations.
Compliance Tip: The election is made by attaching a statement to the taxpayer's timely filed original federal tax return (including extensions) for the tax year in which the improvement is placed in service. Once made, the election cannot be revoked.
A taxpayer that capitalizes repair and maintenance costs under this 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.
Effective Dates
The final regulations generally apply to tax years beginning on or after January 1, 2014. However, a taxpayer may choose to apply the final regulations to tax years beginning on or after January 1, 2012. For taxpayers choosing this early application, certain provisions of the final regulations apply only to amounts paid or incurred in tax years beginning on or after January 1, 2012. For taxpayers choosing to apply the final regulations to tax years beginning on or after January 1, 2012, or where applicable, to amounts paid or incurred in tax years beginning on or after January 1, 2012, the final regulations provide transition relief for taxpayers that did not make certain elections (for example, the election to apply the de minimis safe harbor or the election to apply the safe harbor for small taxpayers) on their timely filed original federal tax return for their 2012 or 2013 tax year (the applicable tax year). Specifically, for tax years beginning on or after January 1, 2012, and ending on or before September 19, 2013, a taxpayer is permitted to make these elections by filing an amended federal tax return (including any applicable statements) for the applicable tax year on or before 180 days from the due date including extensions of the taxpayer's federal tax return for the applicable tax year, notwithstanding that the taxpayer may not have extended the due date.
Finally, a taxpayer may also choose to apply the temporary regulations to tax years beginning on or after January 1, 2012, and before January 1, 2014. For taxpayers choosing to apply the temporary regulations to these tax years, certain provisions of the temporary regulations apply only to amounts paid or incurred in tax years beginning on or after January 1, 2012, and before January 1, 2014.
Change in Method of Accounting
The final regulations provide that, generally, a change to comply with the final regulations is a change in method of accounting to which the provisions of Code Sec. 446 and Code Sec. 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in the final regulations must obtain IRS consent. In general, a taxpayer seeking a change in method of accounting to comply with these regulations must take into account a full adjustment under Code Sec. 481(a).
Parker Tax Publishing Staff Writers
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