Expiring Deductions and New Capitalization Rules Take Center Stage in Year-End Tax Planning for Businesses (Parker Tax Publishing: October 25, 2013)

As the year winds to a close, practitioners will want to review with their business clients any last-minute strategies that can help reduce taxes for 2013 or 2014. In particular, several developments late in the year have provided multiple tax planning opportunities, not to mention pitfalls, if certain elections are missed.

Practice Aid: See our Sample Client Letter dealing with 2013 year-end planning issues for businesses.

The following are some of the major areas that practitioners should be thinking about when addressing year-end planning issues with their business clients.

Amounts Eligible for Expensing Drop Significantly in 2014

One of the biggest deductions available to all businesses, and one that will be dramatically reduced in 2014, is the Code Sec. 179 expensing election. This is the last year for expensing up to $500,000 of Section 179 property. It is also the last year in which the maximum amount that may be expensed is reduced where the taxpayer places into service more than $2 million of Section 179 property. For tax years beginning after 2013, the maximum amount that may be expensed drops to $25,000, and this amount is reduced where the taxpayer places into service more than $200,000 of Section 179 property. [Note: Despite the higher overall expensing limit in 2013, a $25,000 limitation applies to sport utility vehicles (SUVs) and certain other vehicles.]

Bonus Depreciation Generally Not Available after 2013

Another big deduction scheduled to expire at the end of the year for most taxpayers is the bonus depreciation deduction. Under the bonus depreciation provisions, taxpayers can elect to claim a special additional depreciation allowance to recover part of the cost of certain qualified property placed in service during the tax year. The allowance applies only for the first year the taxpayer places the property in service and is an additional deduction taken after any Code Sec. 179 deduction and before calculating regular depreciation under MACRS for the year.

OBSERVATION: Although the additional first year depreciation deduction is generally scheduled to disappear after 2013, the placed-in-service date is extended through 2014 for certain long-lived property and transportation property.

Expiration of Shorter Recovery Period for Certain Leasehold Improvements, Restaurant Buildings and Improvements, and Qualified Retail Improvements

For qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property placed in service in 2013, a 15-year recovery period applies rather than the normal 39-year recovery period used for nonresidential real property. That shorter recovery period is not available for property placed in service after 2013. Instead, the 39-year recovery period will apply.

New Capitalization Rules

In September, the IRS issued final capitalization regulations that affect all businesses that acquire, produce, or improve tangible property. Thus, there are few businesses that are not affected by these rules. The regulations apply to tax years beginning on or after January 1, 2014. However, taxpayers can adopt the final regulations for tax years beginning on or after January 1, 2012. Because the final regulations include more taxpayer-friendly provisions than the temporary regulations, early adoption of these rules could result in significant refunds for clients. Practitioners should review the client's current fixed asset policies and compare them to the final rules to evaluate whether early adoption of the final regulations is advisable.

OBSERVATION: The IRS said separate revenue procedures would be issued under which taxpayers can obtain automatic consent to change their method of accounting to use the final regulations for a tax year beginning on or after January 1, 2012. Until those procedures are issued, however, it is unclear how the final regulations apply to earlier years and how taxpayers should be making changes relating to prior years. The original goal was to have these procedures published by the end of October. However, the government shutdown will most likely delay the issuance of these procedures to November or December.

It's important to generally review with clients the correct book and tax treatment of the various types of costs under these new capitalization rules. For example, material and supply costs can make up a large portion of a business entity's expenditures. Materials and supplies are described under the final regulations as tangible property used or consumed in the taxpayer's operations that is not inventory and is either (1) a component acquired to maintain, repair, or improve a unit of tangible property; (2) fuel, lubricants, water, or similar items that are reasonably expected to be consumed in 12 months or less; (3) a unit of property that has an economic useful life of 12-months or less; and (4) a unit of property with an acquisition or production cost of less than $200. The tax treatment of these costs depends on whether the material or supply is considered incidental or non-incidental. Non-incidental materials and supplies are deducted in the year used or consumed. Incidental materials and supplies, which are those carried on hand and for which no record of consumption is kept or for which no physical count is taken, are deducted in the year paid or incurred.

Under the final regulations, amounts paid to acquire or produce tangible property must be capitalized. Practitioners should review with clients exactly which type of expenditures constitute amounts paid to acquire or produce so such amounts can be correctly categorized on the taxpayer's books. For example, such amounts do not include materials and supplies, nor do they include costs subject to a de minimis rule. Amounts paid to acquire or produce do include, however, amounts paid to (1) acquire or produce a unit of real or personal property; (2) defend or protect title to a unit of real or personal property; or (3) facilitate the acquisition or production of real or personal property.

One of the more favorable changes in the final regulations, which may require practitioners to work with their clients to obtain the best results, is the general de minimis rule under which items may be expensed. The maximum amount that may be expensed depends on whether the taxpayer has an applicable financial statement (AFS) and a written capitalization policy. If the taxpayer has an AFS and written capitalization policy, the maximum amount of an item that may be expensed per invoice amount is $5,000. An AFS can be an SEC financial statement, an audited financial statement, or any other financial statement, other than a tax return, that is filed with a government entity. The written capitalization policy must be in effect as of January 1, 2014, if a calendar-year business wants to use the de minimis rule for 2014. So practitioners will want to impress upon clients the importance of having such a policy in place before the beginning of the taxpayer's next tax year. It's also important to caution clients that they must follow this policy. Thus, if the policy says that everything under $1,000 is going to be expensed, the taxpayer's books should not show any items under $1,000 that are capitalized. For taxpayers without an AFS but with a written capitalization policy, the maximum per item amount that may be expensed is $500. In both cases, the item must be expensed in the financial statements according to the written capitalization policy.

The final regulations contain several elections that may be beneficial to a client and that should be reviewed with the client.

For example, taxpayers may elect to capitalize repair and maintenance costs that would otherwise be deductible. Some taxpayers may prefer to do this to have conformity between book and tax and just generally make accounting for costs easier. Once the item is capitalized, depreciation is taken when the asset is placed in service. Practitioners should stress that this is an all-or-none election and it is irrevocable. Taxpayers can't choose to capitalize some items for books and then expense those items for tax purposes.

OBSERVATION: A taxpayer that capitalizes repair and maintenance costs under this election is still eligible to apply certain safe harbor rules to repair and maintenance costs that are not treated as capital expenditures on its books and records.

There is a safe harbor for small taxpayers to avoid having to capitalize amounts paid for improvements to eligible building property. So practitioners will want to review with a client whether or not they qualify for this election and whether the taxpayer has property that might come within the election. A qualifying taxpayer is one with average annual gross receipts for the three preceding tax years of less than or equal to $10 million. Property qualifies if it has an unadjusted basis of $1 million or less. Certain leased property also qualifies. If the taxpayer meets the requirements, the lesser of 2 percent of the property's unadjusted basis or $10,000 of repairs, maintenance, and improvements and similar activities may be expensed.

There is also a safe harbor for routine maintenance of property other than a building. If a business client provides such maintenance, this should be reviewed. There are a number of exceptions for maintenance that may seem like routine maintenance but don't fall within the safe harbor and have to be capitalized.

After reviewing the client's records and discussing with the client the effects of the capitalization regulations on the client's business, practitioners will need to determine the optimal year, if any, to make any tax method changes and elections relating to the regulations and prepare amended returns for earlier years, if necessary.

Change in Disposition Rules for MACRS Assets

Also in September, the IRS issued proposed regulations on dispositions of MACRS property, which are expected to be finalized later this year and which will be effective for tax years beginning on or after January 1, 2014. Like the capitalization regulations, these rules affect almost all taxpayers. Once the proposed regulations are finalized, they will replace temporary regulations, which taxpayers may choose to apply to tax years beginning on or after January 1, 2012. The temporary regulations will not apply to tax years beginning on or after January 1, 2014. Taxpayers can adopt the proposed regulations for tax years beginning on or after January 1, 2012. So, to the extent a client is currently using provisions of the temporary regulations that are inconsistent with the proposed regulations, which presumably reflect what the final regulations will look like, practitioners will need to file a change in accounting method and work with clients to revise how dispositions of MACRS property are accounted for. The following are some of the more significant changes made by the proposed regulations.

(1) The proposed regulations also provide that the disposition rules apply to a partial disposition of an asset. This allows taxpayers to claim a loss upon the disposition of a structural component (or a portion thereof) of a building or upon the disposition of a component (or a portion thereof) of any other asset without identifying the component as an asset before the disposition event. This new rule helps minimize circumstances in which an original part and any subsequent replacements of the same part are required to be capitalized and depreciated simultaneously. While the partial disposition rule is generally elective, it must be applied to a disposition of a portion of an asset as a result of certain nonrecognition events.

(2) The partial disposition rules under the proposed regulations specify how taxpayers must treat the disposition of an asset's component. Thus, the rule in the temporary regulations allowing taxpayers to use any reasonable, consistent method to treat an asset's components as the asset for disposition purposes is no longer available in the proposed regulations.

(3) The proposed regulations change the rule in the temporary regulations that each structural component of a building, condominium, or cooperative is the asset for tax disposition purposes. Instead, the proposed regulations provide that a building (including its structural components), a condominium (including its structural components), or a cooperative (including its structural components) is the asset for disposition purposes. The change allows taxpayers to forgo a loss upon the disposition of a structural component of a building without making a general asset account election.

(4) Under a new rule in the proposed regulations, if a taxpayer disposes of a portion of an asset and the partial disposition rule applies to that disposition, the taxpayer must account for the disposed portion in a single asset account beginning in the tax year in which the disposition occurs.

OBSERVATION: The IRS is expected to issue a revenue procedure detailing how taxpayers are to apply the various changes in the proposed regulations. Practitioners with clients that are currently using general asset accounts (GAAs) should review with their clients whether they want to undo a prior GAA election based on changes in the proposed regulations. The procedure is also expected to advise how to implement the proposed regulations for prior years (i.e., years beginning on or after January 1, 2012).

Because the proposed regulations provide significant changes to the rules in the temporary regulations, and provide taxpayers with more simplified methods of accounting for dispositions of MACRS assets, it's important to review with clients the effect these changes will have on their particular business.

Affordable Care Act

Given the amount of confusion regarding the Affordable Care Act (i.e., Obamacare), practitioners may want to review with their clients how the law will impact their business.

(1) A qualified small employer may be eligible for a credit for contributions to purchase health insurance for its employees. The amount of the credit increases from 35 percent (25 percent for tax-exempt organizations) of eligible premium payments in 2013 to 50 percent (35 percent for tax-exempt organizations) in 2014.

(2) Employers must report the cost of employer-sponsored group health plan coverage on employee W-2s.

(3) The employer mandate that was suppose to take effect on January 1, 2014, has been delayed and will not take effect until January 1, 2015. Under the employer mandate, a penalty is imposed on certain large employers that do not offer health insurance coverage, offer health insurance coverage that is unaffordable, or offer health insurance coverage that consists of a plan under which the plan's share of the total allowed cost of benefits is less than 60 percent. The penalty is assessed for any month in which a full-time employee is certified to the employer as having purchased health insurance through a state exchange with respect to which a premium tax credit or cost-sharing reduction is allowed or paid to the employee.

Expiration of Work Opportunity Credit

For 2013, a business is eligible for a 40 percent credit for qualified first-year wages paid or incurred during the tax year to individuals who are members of a targeted group of employees. This credit is not available after 2013.

Generally, this credit is equal to 40 percent of the qualified first-year wages of members of a targeted group of employees who worked 400 or more hours during the year for the employer. The credit is reduced to 25 percent of the qualified first-year wages for employees who worked between 120 and 400 hours for the employer. No credit is available for the qualified first-year wages for employees who worked less than 120 hours.

The wages taken into account cannot be taken into account in computing the employer's compensation deduction. Practitioners should explore whether this in an option for any of their business clients.

Gain or Loss on Dispositions of Partnership and S Corporation Interests Are Subject to the Net Investment Income Tax

A new 3.8 percent tax on net investment income above a threshold amount took effect for 2013. The threshold amount is $200,000 ($250,000 if married filing jointly or $125,000 for married filing separately). For purposes of calculating the net investment income tax, net investment income includes net gain on the disposition of property, other than property held in a trade or business that is a passive activity or a trade or business of trading in financial instruments or commodities, over allowable deductions allocable to such net gain. In most cases, an interest in a partnership or S corporation is not property held in a trade or business. Therefore, gain or loss from the sale of a partnership interest or S corporation stock is subject to the net investment income tax. Similarly, distributions from a passive partnership interest will be subject to the tax.

Practitioners should review with S corporation owners and partners whether or not they will be subject to the 3.8 percent net investment income tax and, if so, the expected impact of these taxes.

Expiration of Reduced Recognition Period for S Corporation Built-in Gains

An S corporation may owe the built-in gains tax if it has net recognized built-in gain during the applicable recognition period. Generally, the applicable recognition period is 10 years. However, for purposes of determining the net recognized built-in gain for tax years beginning in 2012 or 2013, the recognition period was reduced from 10 years to five years. Thus, no tax is imposed on the net recognized built-in gain of an S corporation if the fifth tax year in the recognition period preceded 2012 or 2013. This rule applies separately with respect to any C corporation asset transferred in a carryover basis transaction to the S corporation.

After 2013, the recognition period returns to 10 years. Thus, after 2013, to escape gain recognition on property with built-in gain, the property will have to be held for more than 10 years.

Increased Tax on Distributions to Owners

Another change that impacts business owners is the higher tax rate on dividend distributions (20 percent for taxpayers with income taxed at the 39.6 percent rate), as well as the 3.8 percent net investment income tax on such distributions, if certain thresholds are exceeded. The threshold amounts are $200,000, $250,000 if married filing jointly, or $125,000 for married filing separately.

Change for Food Service Employers

Beginning in 2014, automatic tips (e.g., 18 percent gratuity added to checks of six people or more) will be classified as service charges and treated as regular, non-tip wages for income tax and FICA tax withholding purposes, and are not subject to the special reporting and payment rules that apply to tips. Businesses that have been treating such amounts as tips may have to change automated or manual reporting systems in order to comply with the proper treatment of service charges. (Parker Tax Publishing Staff Writers)

Don't miss: An In-Depth Look: Year-End 2013 Tax Planning for Individuals.

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.