Beginning January 1, 2014, businesses with fixed assets will have to apply comprehensive final tax regulations to determine whether expenses for acquiring, producing, maintaining, repairing and replacing tangible assets must be capitalized or may be deducted. At over 200 pages, the final regulations are complex, although much of the framework and provisions are a carry-over from the temporary regulations issued in 2011. The final regulations include some notable taxpayer friendly provisions, safe harbors, clarifications and extensive examples, as further summarized below.
Generally, the final regulations cover five overlapping areas involving allowable deductions or required capitalization of costs incurred with respect to tangible assets. Specifically, under Code Section 162: (i) materials and supplies, and (ii) repairs/maintenance; and under Code Section 263: (iii) capital expenditures; (iv) acquisition or production of tangible property; and (v) improvements to tangible property. As most know, Section 162 allows an ordinary and necessary business deduction for qualifying costs of repairs, maintenance, and supplies, while Section 263 requires taxpayers to capitalize amounts spent to acquire, produce, or improve tangible assets.
I. Materials and Supplies: The final regulations expand what tangible non-inventory items used in business operations may constitute deductible materials and supplies, such as components used to maintain or repair assets, items costing less than $200 or expected to be consumed within a year, and other items identified by the IRS. In addition to certain definitional changes regarding spare parts, the final regulations add de minimis rules and alternative methods for handling these costs.
II. Repairs and Maintenance: The final regulations retain the general deductibility of the costs of routine maintenance -- recurring and anticipated activities performed to keep assets in efficient working order. Otherwise deductible repairs made at the same time as a capitalized improvement may still be deducted if they are not undertaken as part of the improvement. Most notably, the new rules provide two safe harbors:
Routine Maintenance Safe Harbors. The new rules now provide a safe harbor for buildings, which expands upon prior rules allowing the deduction of routine maintenance costs only for property other than buildings. For buildings, routine maintenance includes activities the taxpayer expects to perform to keep the building structure or any building systems in good working condition. For these purposes, “routine” means maintenance expected to be performed more than once in the 10 years following the date the building is placed in service. Similarly, for non-buildings, routine maintenance means recurring activities to keep the asset in good working order, which the taxpayer expects to perform more than once during its depreciation class life.
Per-Building Small Taxpayer Safe Harbor. Taxpayers with gross receipts of $10 million or less may elect to deduct the cost of repairs, maintenance, or improvements made to buildings with an adjusted basis of $1 million or less. This election is only available if such costs (on a building by building basis) do not exceed the lesser of $10,000 or 2% of the building’s adjusted tax basis for each year. For these purposes, amounts deducted under the de minimis rule or routine maintenance safe harbor count towards the limit, and once the limit is exceeded in a year, no amounts are deductible for such building unit of property.
III. De Minimis Capital Expenditures: Taxpayers and practitioners have long debated and varyingly adopted rough justice expensing policies – that is, policies based upon self-derived thresholds under which otherwise capitalized amounts were deducted in a taxable year. The new rules establish safe harbors for deducting such expenditures under certain thresholds.
A high threshold of $5,000 per invoice or item applies to taxpayers that prepare a financial statement filed with a federal or state governmental authority (other than the IRS), or a certified audited financial statement with a report of an independent CPA. A lower threshold of $500 per invoice or item applies to taxpayers without such an applicable financial statement. To apply either rule, a taxpayer must have in place at the beginning of the tax year, a written accounting procedure for treating such expenditures for book purposes. In both cases, the application of the safe harbor is elective in each tax year.
IV. Acquisition or Production of Tangible Property. Unless an exception or de minimis rule applies, amounts paid to acquire tangible real or personal property must be capitalized. The final rules clarify the direct and indirect costs that must be capitalized as including (i) the invoice or base cost, (ii) amounts paid prior to the date the property is placed in service, and (iii) associated “inherently facilitative costs.” This last bucket captures an extensive list of expenditures, including: transportation, valuation, negotiation, contingent commissions, fees/permits, transfer taxes, architectural, engineering and design fees, and costs of effecting a like-kind exchange. Employee compensation and overhead need not be allocated and capitalized, nor, in the case of real property, must expenditures for investigating and evaluating the suitability of potential properties be capitalized.
V. Improvements: While not providing a bright-line test, the final regulations provide more detail and examples to distinguish capitalized improvements from deductible repairs and maintenance costs. Generally, an improvement requiring capitalization is an expenditure that results in a (i) betterment, (ii) restoration, or (iii) adaptation to a new or different use. While essentially retaining definitions of these terms from the former temporary regulations with certain refinements, the new rules may be a mixed bag for taxpayers. They provide clarity for taxpayers, but the extensive examples may recharacterize certain formerly deducted maintenance updates into capitalized betterments.
Effective application of the final regulations requires taxpayers to determine the appropriate “unit of property” for which costs were incurred in order to evaluate whether an improvement (betterment, restoration, or adaptation) requiring capitalization has occurred. For practical purposes, the more deconstructed the unit of property, the more likely it is that work performed will constitute a capitalized improvement rather than a deductible repair.
Essentially, the appropriate unit of property for an asset is defined differently for buildings and their structural components as opposed to other non-building assets. Non-building assets are typically machinery and equipment, network distribution and transmission assets, and other general purposes assets. Generally, the unit of property for these assets is made up of all functionally interdependent components (with some further subdivision for certain plant property and network assets). For these purposes, an interdependent component is one which cannot be placed in service without other components which together form an integrated system.
In contrast, a building’s unit of property is not simply the building itself and its structural components. Consistent with the temporary regulations, the new rules further break down certain of a building’s structures into functional systems, each of which is also a separate unit of property. Under these rules, separate units of property may exist for a building’s: (i) heating; (ii) plumbing, (iii) electrical, (iv) elevator/escalators, (v) fire protection; (vi) security, and (vii) gas systems.
This subdivision of what constitutes the building unit of property can be an analysis game-changer – that is, expenditures with respect to one of these systems, which under prior rules may not have “improved” the whole building, may very well be an improvement of the individual system unit of property, which in turn, requires capitalization.
Taxpayers must comply with the final regulations in tax years beginning on or after January 1, 2014, but have the option to retroactively follow the new rules in tax years beginning on or after January 1, 2012. Taxpayers should carefully note transition rules for any retroactive application of the new regulations.