The U.S. Department of the Treasury and the Internal Revenue Service issued final and re-proposed Tangible Property Regulations on September 19, 2013. This 200+ page long-awaited guidance provides a framework for taxpayers with respect to the treatment of materials and supplies, disposition of MACRS property, capitalization of amounts paid to acquire or produce tangible property, and the determination of whether an expenditure with respect to tangible property is a deductible repair or must be capitalized. The final regulations serve to clarify and expand upon temporary and proposed regulations, which were issued in December 2011.
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Businesses must comply with the rules contained within the final regulations for tax years beginning on or after January 1, 2014. The wide-reaching scope of these regulations will impact the vast majority of businesses and create unique planning opportunities as well as pitfalls. The key to a successful implementation of the final regulations will be to start the planning process prior to the January 1, 2014 effective date. During the planning process, taxpayers need to take into careful consideration the impact the final regulations will have on federal, state, and local taxes. Fixed asset capitalization policies and the expensing of certain costs can have an adverse impact on property tax reporting and may raise audit concerns. A comprehensive understanding of both the regulations and the company’s policies will allow for effective planning, a smooth transition, and maximization of tax savings opportunities.
Which Taxpayers are Impacted, and When?
All taxpayers who incur expenditures to acquire, produce, or improve tangible property will be impacted by the final tangible property regulations. Though taxpayers have until January 1, 2014 to become compliant with these regulations, many taxpayers are considering the advantages of adopting certain provisions of these regulations at an earlier date. At a taxpayer’s discretion, the final regulations, or the former temporary regulations, may be implemented retroactively as early as January 1, 2012. Tax savings and planning opportunities exist for certain taxpayers to adopt these procedures earlier than required, by amending prior year tax returns to take advantage of elections provided in the final regulations. The IRS will be issuing “transition guidance” to assist taxpayers who have elected to apply the regulations for years prior to 2014.
Even if taxpayers wait until January 1, 2014 to comply with the final regulations, planning should take place prior to the start of 2014. All taxpayers affected by the regulations should review their current accounting methods to determine if they are in compliance with the final regulations. It will be advantageous for taxpayers to have a complete understanding of current policies and to ensure that certain procedures are in place prior to implementation.
Highlights of the Final Tangible Property Regulations
The following main areas were impacted as a result of the issuance of the final regulations:
- Materials and Supplies (Reg. 1.162-3);
- Repairs and Maintenance (Reg. 1.162-4);
- Capital Expenditures (Reg. 1.263(a)-1);
- Amounts paid for the acquisition or production of tangible property (Reg. 1.263(a)-2); and
- Amounts paid for the improvement of tangible property (Reg. 1.263(a)-3).
Materials and Supplies
Through the issuance of the final tangible property regulations, the IRS has clarified that prior published guidance that permits certain property to be treated as materials and supplies remains in effect. The cost of non-incidental materials and supplies are generally deducted in the tax year first used or consumed. In response to public comments, the IRS expanded the definition of materials and supplies that may be expensed to include property with an acquisition or production cost of up to $200 (an increase from the original $100 limit established in the temporary regulations).
Repairs and Maintenance
Under the guidance of the temporary regulations, certain routine maintenance need not be capitalized. A safe harbor exists, allowing for an amount paid to be deductible if it is for recurring activities that a taxpayer expects to perform to keep a unit of property in its ordinarily efficient operating condition. To comply with this safe harbor, the taxpayer must reasonably expect to perform these activities more than once during the class life of the unit of property. The final regulations have expanded the routine maintenance safe harbor to allow expensing for routine maintenance activities on a building and its structural components. A taxpayer must reasonably expect to perform the same building maintenance activities more than once over a 10-year period in order to comply with the safe harbor.
A non-revocable annual election has been included with the final regulations to allow taxpayers to opt out of expensing repair and maintenance costs if the taxpayer treats the costs as capital expenditures on its books and records. In turn, these costs would be capitalized and depreciated by the electing taxpayer.
Capital Expenditures: Acquisition/Production of Property
Generally, taxpayers are required to capitalize amounts paid to acquire or produce a unit of real or personal property. In an attempt to simplify the tangible property regulations, the final regulations have removed certain stringent limitations established as part of the temporary regulations. Under the final regulations, a taxpayer with an applicable financial statement may deduct up to $5,000 of the cost of an item of property per invoice/item. Taxpayers without an applicable financial statement may elect the de minimis safe harbor and expense up to $500 per invoice/item. A written accounting procedure detailing the capitalization/expense policy of a business must be in place at the beginning of the tax year.
The de minimis safe harbor is elected annually by including a statement with the taxpayer’s tax return for the year elected. The election applies to all qualifying expenses, including materials and supplies that meet the qualification.
Capital Expenditures: Improvement of Property
The final regulations continue to require capitalization of amounts paid to improve a unit of property. The following three activities are deemed to be improvements to a unit of property:
- A betterment of the unit of property;
- A restoration of the unit of property; or
- An adaptation of the unit of property to a new or different use.
The functional interdependence standard, established within the temporary regulations, continues to exist when identifying a unit of property. In the case of a building, the building (including its structural components) is a unit of property. In addition, the major building systems identified within the temporary regulations are treated as separate units of property for purposes of determining whether there has been a betterment, restoration, or adaptation to the system that must be capitalized.
Again, in an attempt to simplify the provisions for small taxpayers, the final regulations provide a bit of relief to those taxpayers with an unadjusted basis in a building of $1 million or less. These small taxpayers must have average annual gross receipts of $10 million or less during the three proceeding tax years. Taxpayers meeting these guidelines are not required to capitalize improvements if the total amounts paid for repairs, maintenance, and improvements on the building during the tax year do not exceed the lesser of $10,000 or two percent of the unadjusted basis of the building. Amounts deducted under the de minimis rule or the new safe harbor for routine maintenance are counted toward the $10,000 limit.
Re-Proposed MACRS Regulations
The IRS did not finalize or remove the temporary regulations under Code Sec. 168 on general assets accounts and the disposition of depreciable property. Instead, the IRS issued new proposed regulations which will affect all taxpayers that dispose of MACRS property. The issuance of new proposed regulations allows taxpayers to familiarize themselves with the substantial changes contained with the re-proposed regulations and to provide an additional opportunity for taxpayers to comment.
Prior to the 2011 temporary regulations, taxpayers who retired a structural component of a building could not treat the retirement as a disposition and take a loss. The temporary regulations provided for a taxpayer friendly relief to allow taxpayers to claim a loss on the retirement of a component of a unit of property. Taking another step forward, the proposed regulations issued on September 13, 2013 create a “partial disposition” election for assets that are not assigned to a general asset account. If the election is made, a taxpayer may recognize a loss on the retirement of a structural component. If the election is not made, the taxpayer will continue to depreciate the basis of the retired component.
The IRS aims to finalize the proposed regulations in time to coordinate with the same January 1, 2014 effective date as the final repair regulations. However, based on the scheduled hearing dates, it is more likely that finalized regulations will not be issued by January 1, 2014. It is expected that when issued, the effective date will be retroactive to January 1, 2014.
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