IRS releases extensive rules that affect businesses with tangible property
The IRS has issued its long-awaited regulations on the tax treatment of expenditures related to tangible property. The regulations are intended to simplify compliance with Section 263 of the Internal Revenue Code, which generally requires the capitalization of amounts paid to acquire, produce or improve tangible property. They focus largely on how to determine whether expenditures are for deductible repairs or capital improvements.
The new regulations (IRS TD 9564 and REG-168745-03) apply to expenditures made on or after Jan. 1, 2012, so they don't apply to 2011 tax returns. For 2012 and beyond, however, the regulations will affect a wide swath of businesses that purchase, lease, produce or improve tangible property, such as buildings, machinery, vehicles, furniture and equipment.
The new regulations have been in the works for years. After several court cases considered the tax treatment of expenditures related to tangible property, in 2006 the IRS released the first set of proposed regulations, which were subsequently withdrawn. The IRS released another set of proposed regulations in 2008; those never took effect.
The latest regulations provide a general framework for capitalization and retain many of the provisions of the 2008 proposed regulations. In addition, they make some significant revisions, including revisions to certain rules for determining whether a unit of property has been repaired or improved. For example, the new regulations clarify the rules for determining the unit of property. They contain some new rules, as well.
Perhaps the most widely applicable provisions are those related to building improvements. An improvement occurs if there was a betterment, restoration or adaptation of a unit of property. Under the new regulations, the unit of property for a building consists of the building and its structural components. In determining whether an expense is for an improvement to the building, the regulations require the taxpayer to apply the improvement standards separately to the primary components of the building ? the building structure or any of the specifically defined building systems:
- Heating, ventilation and air conditioning (HVAC) system,
- Plumbing system,
- Electrical system,
- Fire protection system,
- Security system,
- Gas distribution system, and
- Any other system identified in published guidance.
A cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the enumerated building systems. This standard is likely to mean more capitalization, because the regulations make clear that a taxpayer can't, for example, deduct a project such as the replacement of an entire HVAC system.
On the positive side, the regulations include provisions that expand the definition of "dispositions" to include the retirement of a structural component of a building. As a result, a taxpayer can recognize a loss on the disposition of a structural component that occurs before the disposition of the entire building ? for example, if you install a new roof and dispose of the previous roof. In other words, the taxpayer doesn't have to continue depreciating amounts allocable to structural components that are no longer in service.
The regulations also incorporate more detailed rules for determining the units of property for condominiums, cooperatives and leased property; for the treatment of leasehold improvements (such as erecting a building on, or making a permanent improvement to, leased property); and for additional costs incurred during an improvement, such as related repair and maintenance costs.
Improvements to other tangible property
The regulations generally define the unit of property for real and personal property other than buildings to include all "functionally interdependent" components. Components are functionally interdependent if placing one component in service depends on placing the other component in service. The regulations include special rules for plant property and network assets (for example, railroad tracks, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines), as well as a rule for determining the unit of property for leased property other than buildings.
Unlike the 2008 proposed regulations, though, the new regulations don't require taxpayers to treat a functionally interdependent component as a separate unit of property if the taxpayer initially assigned a different economic useful life to the component for financial reporting or regulatory purposes.
The regulations also provide a safe harbor from capitalization for certain routine maintenance costs for tangible property other than buildings. An activity isn't considered an improvement if the taxpayer expected to perform it as a result of his or her use of the property to keep the property in its ordinarily efficient operating condition. The activity is considered routine if, at the time the property was placed in service, the taxpayer reasonably expected to perform the activity more than once during the property's life.
Materials and supplies
The temporary regulations modify and expand the definition of materials and supplies, which generally can be deducted when used or consumed (rather than capitalized). They define "materials and supplies" as tangible property used or consumed in the taxpayer's operations that is:
- A component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer and that isn't acquired as part of any single unit of property,
- A unit of property that had an economic useful life of 12 months or less, beginning when the property was used or consumed, or
- A unit of property that had an acquisition or production cost of $100 or less.
Also falling under the definition are fuels, lubricants, water and similar items reasonably expected to be consumed within 12 months.
The regulations also provide an alternative, optional method for accounting for rotable and temporary spare parts. The optional method may be used instead of treating the parts as used or consumed in the year of disposition or electing to treat the parts as depreciable assets.
De minimis rule for expensing
The regulations include an exception to capitalization for certain acquisitions. If a taxpayer expenses the purchase price of tangible property for financial reporting purposes, following written accounting procedures for expensing those amounts, the taxpayer can now deduct the amount for tax purposes, up to a threshold.
The aggregate amount paid and not capitalized must be less than or equal to the greater of 0.1% of the gross receipts for the tax year for income tax purposes or 2% of the total depreciation and amortization expense for the tax year.
The de minimis rule applies to the purchase of certain categories of materials and supplies, too. Previously, a taxpayer generally couldn't deduct these expenditures until the goods were used or consumed.
If you have expenditures related to tangible property, the proposed regulations apply to you. Compliance with the proposed regulations may require changes to your current capitalization procedures. Any such changes likely will require the filing of Form 3115, "Application for Change in Accounting Method." Please contact us if you have questions regarding the new regulations and how to best proceed.
To comply with the requirements of IRS Circular 230, we must inform you that the information discussed above is not intended or written to be used, and cannot be used by the recipient or any other taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or to promote, market or recommend to another party any transaction, entity, investment plan, arrangement or other matter.