Business taxpayers were required to adopt the new Repair and Capitalization Rules contained in final regulations for their 2014 tax year filings. The professional tax and business communities spent a good portion of 2015 grappling with how to satisfy the requirements of these new rules.
A change of accounting method was required to adopt the new rules. Such a change generally requires the filing of Form 3115. IRS provided a procedure where this form could be filed for the 2014 tax year on an automatic basis and without a user fee. While there are a number of specific change items contained in the regulations, the IRS also provided rules whereby certain groups of changes could be consolidated onto a single form. However, this required analysis of expenses for prior years (to determine if amounts should have been capitalized) and capitalized costs (to determine if amounts should have been expensed), viewed through the prism of the new repair and capitalization rules. The net result (which could be additional income or deduction) is referred to as the” Section 481 adjustment.” Significant issues arose, particularly for small businesses, as to how to accurately determine this amount.
The IRS had initially indicated that if a business return for 2014 was filed without a Form 3115 adopting these new rules, it would be subject to heightened scrutiny for audit. However, as a result of pressure from representatives of small businesses, IRS issued Revenue Procedure 2015-20, which provides an alternate method for adopting certain of the changes of accounting methods for small businesses. The Revenue Procedure applies to taxpayer with one or more “separate and distinct trades or businesses” that have either:
- Less than $10 million of assets on the first day of the 2014 tax year; or
- Average gross receipts of $10 million or less for the prior three tax years.
The thresholds apply at the separate and distinct trades or businesses level and not at the taxpayer level. Therefore, if the taxpayer has assets and gross income in excess of the thresholds, the taxpayer might be able to elect the new procedure for each separate and distinct trade or business. This new procedure requires no statement to be attached to the return and no Form 3115. More significantly, this method does not require a computation of a Section 481 adjustment. However, the cost of simplicity is that if the taxpayer has excess deductions as part of the Section 481 deduction (which could be taken in 2014), this adjustment would be lost under the simplified method.
The key question now is how these rules apply to taxpayers for 2015 and beyond.
TAKE ADVANTAGE OF ANNUAL ELECTIONS
The regulations provide six elective provisions which are not automatic. They must be elected to apply annually on a timely filed tax return for amounts paid or incurred. The provisions are:
- $5,000/$500 deductible under the De Minimis Safe Harbor Rule.
- 2%/$10,000 expensing under the Safe Harbor for Small Buildings.
- Partial asset dispositions.
- Materials and supplies election to capitalize and depreciate.
- Employee compensation or overhead election to capitalize.
- Repair and maintenance costs election to capitalize.
It is important to note that adoption of the new regulations in 2014 and even making a particular election in 2014 does not cause the rule to apply in future years. There must be an affirmative election made on the tax return for the year to which the election applies.
De Minimis Rule. The final regulations provide a “de minimis” rule which avoids the need to capitalize certain costs where certain conditions are satisfied.
Those with an Applicable Financial Statement (AFS) must have a written policy at the beginning of the tax year providing for the expensing of either
- items costing less than a stated dollar amount, or
- items which have a useful life of not more than twelve months - but in each case limited to items costing no more than $5,000.
An AFS is defined as:
- a financial statement required to be filed with the SEC (e.g., Form 10-K or annual shareholder statement);
- certified audited financial statement with a report of an independent certified public accountant (or similar professional for a foreign entity) for credit purposes, reporting to shareholders, or other substantial non-tax purposes; or
- a financial statement for a federal or state agency. Those without an AFS must have a written policy at the beginning of the year to expense either
- items costing less than a stated dollar amount, or
- items which have a useful life of not more than
The Service recognizes that the $500 limit for those without an AFS is considered by many to be too low. In Revenue Procedure 2015-20, IRS requested comments concerning whether the $500 de minimis amount should be increased. Commenters to the Proposed Regulations have suggested a $2,500 limit.
The de minimis rule applies on a per item basis. Consequently, you must analyze each item cost to determine which items can fall under this rule. The cost of an item includes its allocable share of additional costs invoiced (e.g., delivery charges, installation charges, etc.). If multiple items are covered by a single invoice, the additional charges must be “reasonably allocated” to each item. Reasonable methods can include specific identification, pro rata, weighted average based on relative costs. Under a surprising rule, the regulations provide that if the additional charges are separately billed, they do not have to be included in determining the per item charge.
Small Taxpayer Safe Harbor. The new regulations permit the deduction of costs which would otherwise be considered improvements to certain real estate up to certain dollar amounts. This applies to those with average annual gross receipts over the prior three years of $10 million or less. If you make an affirmative election on your income tax return, then improvements and other costs related to a property with an unadjusted basis of $1 million or less can be deducted to the extent of the lesser of $10,000 or 2% of the unadjusted basis of the property. This analysis is done on a per property basis. Consequently, a taxpayer can have some real properties which will qualify under this rule (and to which the election will apply) and others which do not qualify.
Lessees of property can take advantage of this rule for improvements made to leased real estate. In this case, the basis of the property is calculated as the non-discounted rent expected to be paid over the lease term, including reasonably anticipated lease extensions.
Partial Asset Dispositions. This is a significant rule for tax planning purposes. Final Regulations under Section 168 contain a “partial disposition” rule which permits a loss to be claimed on the disposition of a structural component (or portion thereof) of a building or other asset without having to identify the component as a separate asset prior to the disposition event. The intention of this rule minimizes the situation where the original part and the replaced part are both capitalized into the current cost of an asset and are being simultaneously depreciated. For example, if you replace the roof on your building and the cost of the new roof is capitalized, this rule permits you to deduct the remaining basis of the old roof being replaced.
The IRS and Treasury recognized that oftentimes the replaced asset is not separately identified in the depreciation records of the company in order to determine its basis. In this situation, the taxpayer can use “reasonable methods” to determine what portion of the adjusted basis of an asset relates to the disposed of portion. The intention of this rule is to avoid the need for an expensive study.
The nonexclusive methods in the regulations include:
- l Discounting the cost of the replacement asset by the Producer Price Index for Finished Goods (and its successor, the Producer Price Index for Final Demand). The Proposed Regulations had permitted use of the Consumer Price Index, but this index was abandoned in the Final Regulations. The Final Regulations provide that this discount method is appropriate only if the replacement is not a “betterment,” as defined under the regulations.
- l Pro Rata allocation based on replacement cost of the disposed of asset and other assets held in a multiple asset account.
- l Use of a study allocating cost of assets to the components.
From a planning perspective, the partial asset disposition rule provides incentive to record a more detailed breakdown of an asset’s cost on the depreciation schedule. Cost segregation studies (while not required in order to take this deduction) can provide information as to the cost of the disposed asset and may avoid methodology issues at a later date.
2014 was the last year IRS and Treasury permitted taxpayers to make a “late partial disposition” election. This permitted a write-off of the remaining basis of assets which had been replaced prior to 2014. However, while this late election can no longer be made, it is important not to ignore this rule with respect to assets replaced in 2015 and subsequent years.
“BAR” STANDARD AND SECTION 263A
The new regulations create a policy standard for capitalization which may also now permit a deduction. The IRS National Office has indicated that, even within the new regulations, the costs may have to be capitalized under a different Code Section.
The regulations provide that an item is not capitalizable unless it is a betterment, an adaptation to new use, or a restoration.
A Betterment constitutes an amount paid which either:
- Improves a material condition or defect which existed prior to the acquisition of the property or which arose during production.
- Is reasonably expected to materially increase the unit of property (UOP) [physical enlargement, expansion or extension).
- Is reasonably expected to produce a material increase in the capacity, productivity, efficiency, strength or quality of the Unit of Property.
Generally there is no betterment if the property is being brought back to its prior condition in the hands of the taxpayer. However, if the work corrects wear and tear in the hands of a different owner, this is considered a betterment of the property.
The regulations do not provide bright-line tests concerning how to define “material.” This requires a facts and circumstances analysis. The examples in the regulations suggest that a 10% increase in capacity or productively would not require capitalization.
An Adaptation to New Use generally means putting the property to a new or different use. For example, converting a manufacturing building into a showroom is such an adaptation. However, combining multiple spaces into a single space would not qualify.
Most difficult issues arise with the definition of a Restoration – i.e., a cost that meets one of six tests:
- Replacing a component of the Unit of Property where a loss has been taken for the component.
- Replacing a component of the Unit of Property and the adjusted basis of the component is used to determine gain or loss on the disposition.
- Repairing damage to a Unit of Property for which a casualty loss has been taken.
- Replacing the Unit of Property to its ordinarily efficient operating condition – but only if the property had deteriorated to a state of disrepair and is no longer functional for its intended use.
- The restoration results in a rebuild of the Unit of Property to a “like new” condition after the end of its class life.
- The restoration replaces a “major component” or “substantial structural part” of the Unit of Property.
The expenditure must be compared to a “Unit of Property,” generally defined as components of property which are functionally interdependent. However, for “plant property,” the taxpayer cannot look solely to the manufacturing line (which would be comprised of functionally interdependent items), but must further consider the equipment in individual components which serve discrete and important functions. This may effectively cause each piece of equipment on a manufacturing line to be treated as a separate Unit of Property.
With respect to a building, the Unit of Property is not only the overall structure, but also includes eight enumerated building systems: HVAC, plumbing, electrical, escalators, elevators, fire protection and alarm systems, security systems, and gas distribution systems. Defining a Unit of Property as smaller components increases the chances of having to capitalize an expenditure.
A “major component” focuses on the function of the component in the Unit of Property. If it performs a discrete and critical function in the UOP, it is a Major Component. A “substantial structural part” compares the expenditure to the overall unit of property to determine if it is substantial.
For example, the replacement of an entire roof may not constitute a betterment. In addition, the roof does not constitute a separate building system; so the Restoration analysis is generally done with respect to the overall building, as the Unit of Property. Even though the roof may not constitute a substantial structural part of the overall building, the entire roof will constitute a “major component.” Under the IRS analysis, the roof performs a discrete and critical function with respect to the building. This cost must be capitalized as a Restoration.
The regulations contain several examples covering the replacement of other elements of a building (e.g., a roof membrane), which do not constitute major components and are not required to be capitalized.
IRS National Office has stated that these new regulations under IRC Section 263A do not end the analysis as to whether an item must be capitalized. If there is another code section which requires the item to be capitalized, then it cannot be currently deducted. IRS is reviewing IRC Section 263A, which applies to a “producer” of self-constructed assets. For purposes of this Code Section, “production” includes “construction.”
The IRS National Office has considered the situation of certain tenant fit-up costs which might fall outside of the BAR capitalization rules and would be currently deductible under the repair and capitalization rules of Section 263A. However, the IRS suggested that this work could constitute “construction” and may be required to be capitalized. Consequently, taxpayers must be prepared for an attack by IRS on aggressive deduction positions.