Capitalization is a complex area of tax law. But it's an area that is critically important to many business owners.
Edited by Leonard Smith, CPA
Rucci Bardaro & Falzone, PC
December 13, 2013 - Section 263(a) of the Code generally requires the capitalization of amounts paid to acquire, produce, or improve tangible property. On the other hand, taxpayers are allowed to deduct ordinary and necessary business expenses, including the costs of certain supplies, repairs, and maintenance under § 162(a). It is not always easy to distinguish between an asset that must be capitalized and property that is a material or supply used in a trade or business. The line between improvement and repairs or maintenance is not always clear.
Former regulations attempted to define the difference between capital and non-capital expenditures by providing that capital expenditures included amounts paid or incurred to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, or adapt the property to a new or different use. Those regulations also provided that amounts paid or incurred for incidental repairs and maintenance of property were not capital expenditures. These standards were subjective and required a fact-intensive analysis of the taxpayer's situation. Not surprisingly, there has been considerable controversy between taxpayers and the IRS over the proper characterization of these expenses.
The unveiling of these final tangible property capitalization regulations is the culmination of a multi-year effort involving intermediate guidance and taxpayer feedback. With a number of clarifications and new safe harbors, the final regulations represent a collaborative effort between taxpayers and the IRS to bring a degree of certainty to an area of tax law traditionally fraught with controversy. The final regulations are generally effective for tax years beginning on or after January 1, 2014.
Materials and Supplies
Expanded Definition: The final regulations expand somewhat the definition of “material and supplies” set forth in the 2011 temporary regulations by increasing the $100 ceiling for characterizing a unit of property as a material or supply to $200. Taxpayers had expressed concern that the $100 amount would not capture many common supplies, like calculators or coffee makers. With the $200 amount, the IRS attempts to balance concerns over distortions to income that could result from increasing the acquisition cost ceiling with the need to include the typical materials and supplies ordinarily used by many taxpayers.
Election to Capitalize: The final regulations provide an optional election to capitalize certain rotable, temporary, or standby emergency spare parts instead of deducting their cost in the first year they are used or consumed.
Optional Method of Accounting for Rotable and Temporary Parts: A final point of note is the removal in the final regulations of the requirement that the optional method of accounting for rotable and temporary spare parts, if elected, be used for all of a taxpayer's rotable and temporary spare parts in the same trade or business. Recognizing that taxpayers may have pools of rotable or temporary parts that are treated differently for financial statement purposes, the final regulations provide that a taxpayer generally is not required to use the optional method for those pools for which it does not use the optional method of accounting in its books and records.
However, if a taxpayer chooses to use the optional method for any pool for which the taxpayer does not use the optional method in its books and records, then the taxpayer must use the optional method for all its pools of rotable and temporary spare parts in that trade or business (i.e., the IRS does not allow a mix and match except if a taxpayer does so for both tax and financial statement purposes).
Important: De Minimis Safe Harbor
The de minimis exception, as provided in the final regulations, allows taxpayers to deduct certain amounts paid for tangible property (in excess of the $200 limit, mentioned above) if the taxpayer has an “applicable financial statement” (defined as: a certified audited financial statement that is accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional) that is used for (A) Credit purposes; (B) Reporting to shareholders, partners, or similar persons; or (C) Any other substantial non-tax purpose), appropriate written accounting procedures for expensing certain amounts, and treats such amounts as expenses on its applicable financial statement. The deduction is limited to a ceiling of $5,000 per invoice, or per item (as substantiated by the invoice). The de minimis safe harbor also applies to a financial accounting procedure that expenses amounts paid for property with an economic useful life of 12 months or less as long as the amount per invoice or item does not exceed $5,000. If the cost exceeds $5,000 per invoice or item, then the amounts paid for the property will not fall within the de minimis safe harbor.
Taxpayers Without an Applicable Financial Statement: A taxpayer without an applicable financial statement may rely on the de minimis safe harbor only if the amount paid for property does not exceed $500 per invoice, or per item as substantiated by the invoice. If the cost exceeds $500 per invoice or item, then no portion of the cost of the property will fall within the de minimis safe harbor.
Note: The final regulations require that the safe harbor be applied to all eligible materials and supplies (other than rotable, temporary, and standby emergency spare parts subject to the election to capitalize, or rotable and temporary spare parts subject to the optional method of accounting) if the taxpayer elects the de minimis safe harbor.
Amounts Paid to Acquire or Produce Tangible Property
The final regulations provide that a taxpayer must capitalize amounts paid to facilitate the acquisition or production of real or personal property. The final regulations include a special rule for the acquisition of real property providing that, except for amounts specifically identified as inherently facilitative, an amount paid by a taxpayer in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it relates to activities performed in the process of determining whether to acquire real property and which real property to acquire. The final regulations do not expand the deduction of pre-decisional, investigatory costs to personal property (unlike real property acquisitions, personal property acquisitions do not typically raise issues of whether the transaction costs should be characterized as deductible business expansion costs rather than costs to acquire a specific property).
Routine Maintenance and Improvements to Property
The final regulations include a host of changes and clarifications to the rules for determining whether an amount improves, betters, or restores property. This letter highlights a few of the more significant changes pertaining to buildings, a new safe harbor for small taxpayers, and determining whether a “betterment,” has occurred.
Unit of Property: One issue addressed in the final regulations is whether a building, together with its various components, is a single unit of property. The final regulations generally defined a building as a unit of property, but require the application of the improvement standards to the building structure and the enumerated building systems. Accordingly, if an amount paid results in a restoration of a building structure, such as the replacement of an entire roof, then the expenditure constitutes an improvement to the building unit of property. Similarly, if an amount paid results in a betterment to a building system, such as an improvement to the HVAC system, then the expenditure also constitutes an improvement to the building unit of property.
Removal Costs: Another issue addressed in the final regulations is the treatment of removal costs. The final regulations provide that, if a taxpayer disposes of a depreciable asset for tax purposes, and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, the costs of removing the asset or component are not required to be capitalized under § 263(a). The final regulations also provide that if a taxpayer disposes of a component of a unit of property and the disposal is not a disposition for tax purposes, then the taxpayer must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property.
Small Taxpayer Safe Harbor: A new safe harbor was included in the final regulations, to aid small taxpayers applying the general rules for improvements to buildings, because small taxpayers generally do not have the administrative means or sufficient documentation or information to apply the improvement rules to their building structures and systems. The safe harbor election applies to building property held by taxpayers with gross receipts of $10,000,000 or less (“a qualifying small taxpayer”). The final regulations permit a qualifying small taxpayer to elect to not apply the improvement rules to an eligible building property if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. Eligible building property includes a building unit of property that is owned or leased by the qualifying taxpayer, provided the unadjusted basis of the building unit of property is $1,000,000 or less.
Routine Maintenance Safe Harbor: The final regulations provide the costs of performing certain routine maintenance activities for property are not required to be capitalized as an improvement. Under this routine maintenance safe harbor, an amount paid is deemed not to improve a unit of property if it is for the recurring activities that a taxpayer (or a lessor) expects to perform as a result of the taxpayer's (or the lessee's) use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. Activities are routine only if, at the time the unit of property was placed in service, the taxpayer reasonably expected to perform the activities more than once during the property's alternative depreciation system class life (regardless of whether the property was depreciated under the alternative depreciation system), except for buildings and building components. For building and building components, the final regulations use 10 years as the period of time in which a taxpayer must reasonably expect to perform the relevant activities more than once. For example, since you would not expect to replace your car’s transmission more than once over its 5-year life, it must be capitalized and since a retail store does not intend to provide a facelift more than once within 10 years, these costs must also be capitalized. A new set of tires on your car would depend upon how many miles are logged within 5 years.
The final regulations make a number of additional changes and clarifications to the safe harbor for routine maintenance, which are applicable to both buildings and other property. Among these clarifications is the provision that amounts incurred for activities falling outside the routine maintenance safe harbor are not necessarily expenditures required to be capitalized. Amounts incurred for activities that do not meet the routine maintenance safe harbor are subject to analysis under the general rules for improvements.
Betterments: The final regulations reorganize and clarify the types of activities that constitute betterments to property. In an effort to reduce controversy for expenditures that span more than one tax year or when the outcome of the expenditure is uncertain when the expenditure is made, the final regulations provide that a taxpayer must capitalize amounts that are reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of a unit of property or that are for a material addition to a unit of property.
Election to Capitalize Repair and Maintenance Costs
The final regulations permit a taxpayer to elect to treat amounts paid for repair and maintenance of tangible property as amounts paid to improve that property, as long as the taxpayer incurs the amounts in carrying on a trade or business and the taxpayer treats the amounts as capital expenditures on its books and records used for regularly computing income. A taxpayer that elects this treatment must apply the election to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its books and records in that tax year. Once made, the election may not be revoked.
A taxpayer that capitalizes repair and maintenance costs under the election is still eligible to apply the de minimis safe harbor, the safe harbor for small taxpayers, and the routine maintenance safe harbor to repair and maintenance costs that are not treated as capital expenditures on its books and records.
Capitalization is a complex area of tax law, but an area that is critically important to many taxpayers. The final regulations are a step in the direction of clarity. However the transition to and application of the new rules is certain to remain a complicated matter. Please feel free to call or email us with any questions, or on how to move forward regarding these final regulations.