MA Alerts

new IrS rules affecting 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(a) of the Internal Revenue Code (IRC), which generally requires the capitalization of amounts paid to acquire, produce, or improve tangible property. Their primary focus regards how to determine whether expenditures are for deductible repairs or capital improvements; however, several other issues are addressed as well.

The regulations—issued in temporary form—generally apply to tax years beginning on or after January 1, 2012, although some portions apply to expenditures paid or incurred on or after January 1, 2012. The regulations will affect virtually all taxpayers that purchase, lease, produce, or improve tangible property, including buildings, machinery, vehicles, furniture, and equipment. Although temporary, the regulations have the same binding effect as final regulations.

Background

The new regulations have been in the works for years. After several court cases considered the tax treatment of expenditures related to tangible property, the IRS released the first set of proposed regulations in 2006, which were subsequently withdrawn. The IRS released another set of proposed regulations in 2008 that were withdrawn with the issuance of these temporary regulations.

The temporary regulations provide a general framework for capitalization and retain many of the provisions of the 2008 proposed regulations. While many of the standards and tests that were in the proposed regulations have been retained, the temporary regulations make some significant revisions, including to certain rules for determining whether a unit of property has been repaired or improved and regarding the de minimis safe harbor threshold for capitalization.

Building Improvements

Perhaps the most widely applicable provisions relate to the tax treatment of improvements made to tangible property. Any improvement to tangible property must generally be capitalized. A unit of property has been improved when activities are performed after the property has been placed in service that result in a betterment, restoration, or adaptation of the property to a new or different use.

The regulations provide that the unit of property for a building consists of the building and its structural components. However, determining whether an expense is an improvement to the building requires the taxpayer to apply the improvement principles separately to the primary components of the building—the building structure or any specifically defined building systems. The specifically defined building systems include:

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 requirement 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. An example would be if a new roof is installed and the previous roof is disposed of. In this case a loss could be recognized on the undepreciated cost of the old roof. In other words, the taxpayer doesn’t have to continue depreciating amounts allocable to structural components that are no longer in service, as had been the case under prior rules.

The regulations also incorporate more detailed rules for determining: the units of property for condominiums, cooperatives, and leased property; the treatment of leasehold improvements, such as erecting a building on or making a permanent improvement to leased property; and 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 in service depends on placing the other 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 an additional rule for determining the unit of property for leased property other than buildings.

Unlike the 2008 proposed regulations, 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. However, the temporary regulations retain and expand the depreciation consistency rule that requires the taxpayer to use the same unit of property for capitalization purposes as for depreciation purposes.

The regulations also provide a safe harbor from capitalization for certain routine maintenance costs for tangible property other than buildings. A maintenance activity isn’t considered an improvement if the taxpayer is expected to perform the activity to keep the property in its ordinarily efficient operating condition. And 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. Examples could include inspecting, cleaning, or testing a unit of property or replacing parts of a unit of property with comparable replacement parts.

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 either:

Fuels, lubricants, water, and similar items that are reasonably expected to be consumed within 12 months also fall under the definition.

The regulations also provide an alternative, optional method for accounting for rotable and temporary spare parts 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 may be able to 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 percent of the gross receipts for the tax year for income tax purposes or 2 percent of the total depreciation and amortization expense for the tax year. Other requirements must also be met to be eligible for the de minimis rule.

The de minimis rule may apply to the purchase of certain categories of materials and supplies, but only if the taxpayer so elects.

Moving Forward

These regulations are comprehensive and will apply to virtually all businesses. The IRS is expected to issue additional guidance to provide procedures for taxpayers to change their method of accounting in accordance with the regulations. Changing methods to comply with the new rules will likely require the taxpayer to file Form 3115, Application for Change in Accounting Method, and it will generally require an IRC Section 481(a) adjustment to report the cumulative effect of the method change.

If you have any questions about how the temporary regulations will affect your company and what planning opportunities may exist now that the regulations have been issued, please contact a Moss Adams LLP professional.