The latest round of revisions to the repair and capitalization regulations have made their way out of the IRS, but this time the majority of the regulations were issued as final regulations (TD 9636, https://s3.amazonaws.com/public-inspection.federalregister.gov/2013-21756.pdf) with the regulations under IRC §168(i) reissued as proposed regulations with further revisions (REG 110732-13, https://s3.amazonaws.com/public-inspection.federalregister.gov/2013-21753.pdf).
Late in 2012 the IRS had issued Notice 2012-73 which delayed the effective date of the then temporary regulations. The notice also indicated specifically that the IRS expected to make changes to simplify compliance, and the notice provides that such changes are to be expected in the following provisions:
- De Minimis Rule: § 1.263(a)-2T(g);
- Dispositions: §§ 1.168(i)-1T and 1.168(i)-8T; and
- Safe Harbor for Routine Maintenance: § 1.263(a)-3T(g)
The final regulations did introduce changes to the De Minimis Rule and the Safe Harbor for Routine Maintenance, while the proposed regulations deal with modifications to the dispositions rules.
The final regulations apply to tax years beginning on or after January 1, 2014, though taxpayers may elect to apply the provisions to years beginning on or after January 1, 2012. As well, taxpayers may elect to apply the provisions of the 2011 temporary regulations to tax years beginning on or after January 1, 2012 and before January 1, 2014.
Significant changes in the final regulations as compared to the 2011 temporary regulations are discussed below.
Materials and Supplies
The temporary regulations provided as one of the defined types of “materials and supplies” under Reg. §1.162-3 any unit of property that had a cost of $100 or less. The final regulations raise that amount to $200—still relatively low, but at least a more workable number than the $100 limit.
In the temporary regulations this number had a special significance for most taxpayers due to a limitation on a second optional test that could be used to classify an item as “materials and supplies” and thus not subject to the general capitalization rules of IRC §263(a). The de minimis method allowed a limited recognition of an organization’s capitalization policy used for accounting and financial reporting purposes.
The rule was far from perfect, being subject to an overall aggregate limit that effectively required tracking any item expensed due solely to the capitalization policy, meaning that an entity had to account for these items, although the purpose of the accounting policy on capitalization generally was to reduce the administrative burden of tracking such items.
But even more significant was a second problem—the de minimis election was only available to a taxpayer with an “applicable financial statement” as defined by the temporary regulations.
De Minimis Rule Changes
The IRS noted the criticism they received over the de minimis election and did make certain changes. What the IRS did was create two elective rules. The election that applies to a taxpayer depends upon whether the taxpayer has an applicable financial statement. The IRS also moved the rule from Temporary Reg. §1.263(a)-3T to Reg. §1.263(a)-1, admitting that the rule applies not only to improvements (as opposed to repairs), but also to acquisitions, due to its inclusion in the materials and supplies regulations.
The definition of an applicable financial statement remained unchanged in the final regulations. A taxpayer’s applicable financial is the first financial statement listed below which the taxpayer has for the year in question. If the taxpayer does not have any of these statements, the taxpayer does not have an applicable financial statement and will face a modified limitation.
Applicable financial statements are:
- A statement filed with the Securities and Exchange Commission;
- A statement audited by an independent CPA that is used for credit purposes, reporting to equity holders or for any substantial non-tax purpose or
- A statement other than a tax return required to be provided to an agency of the federal or a state government (other than the IRS or the SEC)
The IRS considered, but rejected, adding financial statements for which a SSARS review report has been issued by a CPA. The IRS argued that since a review does not require there be analysis and testing of an entity’s internal control, it did not serve to address the potential problem the IRS saw with entities failing to consistently follow the policy or insure the policy did not distort financial reporting.
Both entities with and without an applicable financial statement must still have in place, as of the first day of the tax year (thus for a calendar year taxpayer, as of January 1, 2014) a written accounting procedure in place treating all purchases of assets below a certain level as an expense for nontax purposes.
The entity must also follow that policy. For an entity with an applicable financial statement, the expense treatment must be reflected in the applicable financial statement. For entities without such statements, the amount must be treated as an expense in the accounting books and records of the entity.
A complaint about the 2011 temporary regulation’s de minimis rule for those organizations that could use it was that required detailed tracking of the assets in question. That was because the entity has to test the items that were not capitalized due to the accounting policy to insure, in total, the amounts did not exceed the greater of 0.1% of gross receipts reported on the tax return or 2% of depreciation and amortization expense reported on the applicable financial statement.
Commentators complained that this testing requirement defeated the entire non-tax purpose behind these accounting procedures—that is, not to have to waste time tracking and accounting for numerous low value assets. To comply with the 2011 temporary regulations, a significant amount of accounting personnel time would be spent analyzing and tracking these “below the capitalization level” purchases.
In response to that complaint, and to come up with a method to be used by taxpayers without an applicable financial statement, the IRS dropped the aggregate tests and instead went to a per asset “invoice cost” test.
Assets that are expensed per the capitalization policy in place at the beginning of the year, and which are reflected as an expense on the applicable financial statement or in the books and records (as applicable to the taxpayer) will not be tested against the capitalization regulations if the invoice price of each individual asset is less than:
- $5,000 for an organization with an applicable financial statement
- $500 for an organization without an applicable financial statement
The overall result of these changes is that organizations with written and consistently applied capitalization policies will be able to treat items costing less than $500 (or $5,000 if they have an applicable financial statement) as materials and supplies or repairs if the organization makes the de minimis election.
If the organization does not have such a statement or fails to make the election (which must be made on the taxpayer’s return via a statement attached), the “protected” expenditure amount drops to $200.
While the regulations themselves do not mention it, the preamble to the final regulations reminds taxpayers and, rather explicitly, agents that amounts expended beyond this level do not automatically need to be capitalized—or even that a higher capitalization policy cannot be justified. Rather, such policies must be tested to see if they materially misstate income.
De Minimis Small Taxpayer Real Estate Safe Harbor
Another criticism of the de minimis rule in the 2011 temporary regulations was that it did not apply to real property. The IRS responded to this criticism in a limited fashion, creating a small taxpayer real estate de minimis safe harbor expenditure limitation which the taxpayer may elect to apply.
First, the rule only applies to taxpayers with average gross receipts of less than $10 million in the prior three years (thus the “small taxpayer” part of the rule). Second, the rule only applies to a building whose unadjusted basis is $1,000,000 or less. If the taxpayer is leasing the building, then the total of all lease payments (including a reasonable period of renewal based on the terms of the contract) is used for the $1,000,000 test.
If the taxpayer qualifies, then we end up with the same sort of aggregate amount test that the IRS backed away from with regard to the general de minimis test. In this case the taxpayer must look at the total of all expenditures that relate to maintenance, improvements and similar expenditures. The taxpayer may not use any other rule (such as the $200 materials and supply limit or the routine maintenance safe harbor) to exclude items from this total.
All such expenditures will be treated as not subject to the capitalization rule if they total less than the lesser of 2% of the unadjusted basis of the property or $10,000.
Routine Maintenance Safe Harbor
The IRS also addressed criticism that the routine maintenance safe harbor excluded real property. Under the routine maintenance safe harbor, expenditures would not be considered an improvement to property (and thus subject to capitalization under Reg. §1.263(a)-3) if the expenditures are reasonably expected to be incurred by the taxpayer more than once during the class life of the property.
The IRS explains in the preamble that due to the long class lives for real property, the agency did not believe the “two times in the class life” test was appropriate for real estate. However, the final regulations introduce a special rule for routine maintenance in real estate, applying the standard rule except substituting 10 years for the class life.
Thus, if maintenance is expected to be performed at least twice during 10 years by the taxpayer, the maintenance can be covered by the routine maintenance safe harbor.
The IRS also clarified that merely because the taxpayer ends up not actually performing the maintenance twice during the class life for a particular asset, that does not mean the treatment was in error. But the IRS does caution that the taxpayer’s experience must be considered for future treatments
Effectively, there is no right to “Monday morning quarterbacking” by an IRS examining agent based solely on events that occur after the asset is placed in service, but information available to the taxpayer when the asset is placed in service (including the taxpayer’s prior experience with such assets) is fair game.
Financial Statement Conformity
Although retaining the de minimis election conformity requirement, the IRS removed a number of other references to financial statement treatment in the regulations, agreeing that a taxpayer might have different motivations for accounting reporting, and those motivations should not result in different treatments for taxpayers otherwise in the same situation.
Remaining Temporary and Proposed Regulations
The IRS did not finalize the regulations for general asset accounts and partial asset dispositions covered by regulations under IRC §168(i). Rather, the IRS issued new proposed regulations but, for now, kept in place the temporary regulations. The IRS apparently prefers to get one more round of comments regarding their proposed changes to these regulations before making them final, though the agency indicated they expect to issue final regulations by the end of the this year.
Primarily the IRS has attempted to remove certain mandatory treatments regarding partial dispositions under the 2011 temporary regulations, moving back to the older rules. As well, the IRS no longer proposes to automatically treat each significant structural component of a building as a separate asset, rather defaulting to treating the building as a single asset.
The IRS also provided an “audit correction” option. Should the IRS later treat an expenditure as one that must be capitalized for replacing a significant component of the building, the taxpayer may seek permission for an accounting method change to write off the old asset rather than now being required to depreciate both the improvement and the portion of the building asset that represents the original component.
Time to Start Advising Clients
Now that the rules are basically in place (aside from those for dispositions mentioned above), clients need to work on getting ready for these regulations. At a minimum, consideration should be given to documenting capitalization policies and insuring that the they are consistently followed by the client.
The implications of these new regulations will give instructors such as myself something to talk about for this year’s update courses (as if there isn’t enough already with the net investment income tax, the implications of the Windsor decision, dealing with shared responsibility payment and other rules related to the Affordable Care Act). I will certainly discuss the matter in my December 18 Current Federal Tax Developments course (live and webcast) and the industry focused Tax Update for Financial Executives (live and webcast) on January 13.