Tangible Property Regulations: Frequently Asked Questions
Since 2004 the IRS has worked on issuing regulations that address a fundamental tax question: Should a cost related to tangible property be capitalized or expensed? Such a simple question had led to much confusion and controversy between the IRS and taxpayers, so in late 2011 the IRS attempted to remedy the problem, issuing temporary regulations that address the issue.
Will these new regulations accomplish that goal? It’s unclear. However, one thing’s for sure: The regulations are here, they’re effective for 2012, and all taxpayers with tangible property need to address them. To help you understand the new regulations, let’s examine some frequently asked questions.
Will the new tangible property regulations apply to my company?
The regulations affect all taxpayers with tangible property. They apply anytime tangible property is acquired, depreciated, improved, or disposed of and regardless of a taxpayer’s size, industry, or entity type. They apply to property that a taxpayer either owns or leases. They also apply to property owned by a foreign subsidiary corporation for purposes of computing the corporation’s earnings and profits. In short, the regulations have very broad application and will apply to nearly all businesses.
Why did the IRS undertake such a major rule-making effort in this area?
Prior to these regulations, the standards that applied to acquiring, capitalizing, and disposing of property and improvements were largely established by a series of court cases and administrative rulings. The IRS believed these standards became difficult to discern and apply in practice, so it launched the tangible property regulation project with the goals of increasing consistency and decreasing controversy between taxpayers and the IRS.
Whether the regulations accomplish their goals remains to be seen. In their current form they contain over 250 pages of complex rules and examples. In addition, many of the key rules remain subject to the same type of facts and circumstances–based determinations that tended to create uncertainty prior to the issuance of these regulations.
Given that these new regulations likely affect my business, what key changes should I be aware of?
As noted above, the regulations effectively address the entire life cycle of tangible property—from acquisition to improvement to disposition. Consequently, they provide new rules in a number of areas, including:
Materials and supplies. You must generally capitalize and depreciate the cost of units of property. However, for materials and supplies, you can use different, and often accelerated, methods to recover your costs. The regulations contain a specific definition of the term materials and supplies and detail a number of optional accounting methods or annual elections related to materials and supplies.
Acquisitions of property. The regulations provide rules relating to the costs that must be capitalized when you acquire or produce property, including facilitative costs paid in the process of investigating or otherwise pursuing the acquisition of property.
Property improvements. At the heart of the regulations are rules for assessing whether costs must be capitalized as improvements or deducted as repair expenses. Generally, costs resulting in the betterment, restoration, or adaptation of a unit of property must be capitalized. The regulations contain definitions for the terms betterment, restoration, and adaptation and provide numerous examples illustrating these concepts. They also include specific guidance on identifying the unit of property that must be analyzed to assess whether a capital improvement has occurred. Importantly, when you assess a potential improvement to a building, the building structure and its building systems (such as its electrical system) are all treated as separate units of property. These smaller units of property increase the likelihood that you must capitalize costs related to the building.
Routine maintenance safe harbor. The regulations contain a safe harbor applicable to maintenance costs associated with personal property. If you meet the requirements for using the safe harbor, this rule allows you to immediately deduct these costs as repair expenses.
De minimis rule. The new regulations create a de minimis rule. Within certain limitations, this rule allows you to deduct the cost of tangible property that you expense on your books under a written capitalization policy. Among other requirements, you must have an “applicable financial statement” (generally an audited financial statement) to use the de minimis rule. An election is also available to apply this rule to materials and supplies costs.
Dispositions. The regulations contain specific rules that govern when you must account for dispositions of property. One important change in this area is that you now claim a loss on a disposed structural component of a building. As a result, if you fail to deduct the basis of disposed property in the correct year, this rule could cause you to lose the deduction entirely. However, the regulations also grant you greater flexibility by making “general asset account” elections. This election could decrease the risk associated with failing to recognize a disposition in the correct year.
To which taxable years do the new regulations apply?
The tangible property regulations are effective for tax years beginning on or after January 1, 2012, so you generally need to apply the new rules to any assets acquired or produced beginning in 2012. Also, if you need to change your business’s accounting methods to comply with the regulations, you may need to consider the effect of the regulations on transactions that occurred in prior years. In particular, you’ll need to revisit repair studies or repair expense positions on prior tax returns to determine whether any changes are necessary. The effect of the new rules on transactions that occurred in prior years is generally accounted for through a “Section 481(a) adjustment” and not by amending prior returns. Depending on the circumstance, the Section 481(a) adjustment may increase or decrease taxable income.
When does my company have to comply with the regulations?
Although the effective date for these regulations is January 1, 2012, the IRS has granted taxpayers a two-year window to automatically make the accounting method changes necessary to comply with these rules. During this window you can make the appropriate method changes without the application of certain scope limitations that normally apply to automatic method changes. In addition, the IRS won’t generally engage in any audit activity related to these changes during this two-year period.
While a two-year implementation window is available, deferring implementation of the regulations until 2013 may result in greater costs. This is due to the potentially increased complexity of making accounting method changes in 2013 instead of 2012 as well as possible missed elections in 2012 that cannot be rectified via an accounting method change. In addition, taxpayers that may want to use the new de minimis rule must have a written capitalization policy in place as of the first day of the year of the change—an important step that could be missed if assessment is deferred. Therefore, assessing the impact of the regulations for 2012 as soon as possible is highly recommended.
How can my company correctly apply these rules and take full advantage of any opportunities they create?
You’ll need to examine your current tax methods of accounting for materials and supplies, tangible property acquisitions and dispositions, improvements, and repair expenses. In many cases these methods will likely be the same ones used for your financial statements. You must then compare your current methods with those available under the new regulations. After making this assessment, you’ll need to make the appropriate accounting method changes and Section 481(a) adjustments. In addition, most companies will need to implement new methods of collecting, tracking, and accounting for certain asset-related information to comply with the regulations going forward.
Since these regulations could create unfavorable adjustments to my company's taxable income, why should I implement them now?
There are a number of reasons to take a proactive approach. First, the regulations have the force of law and therefore must be complied with to correctly compute taxable income. Second, the IRS expects that nearly all businesses will be required to file at least one accounting method change to comply with the new regulations. Thus, the failure to make accounting method changes to conform to the regulations may raise a red flag with the IRS. Third, if the IRS does audit and change your return to comply with these rules, you’ll be liable for any underpayment of tax as well as any associated interest and penalties. In such a situation you may also need to file amended returns for prior years. If your company is a partnership or S corporation, the partners or shareholders may become liable for underpayments of tax, interest, and penalties, and they may also need to file amended returns.
On the other hand, if you comply with the regulations, you can adopt the accounting methods and make the elections best suited for your particular circumstances. This will allow you to take advantage of a number of favorable rules contained in the regulations. Also, complying with these rules allows you to spread any unfavorable adjustments over a four-year period. In contrast, if an unfavorable adjustment is imposed by the IRS, the adjustment will likely need to be made in a single year. Finally, conforming to these rules can help you avoid exposure to additional interest, penalties, and amended return filings.
Why are the regulations temporary? Shouldn't my company defer implementing these rules until the IRS issues final regulations?
The temporary regulations have the same weight as final regulations, and taxpayers must begin complying with them in 2012. As temporary regulations, they’ll expire at the end of 2014 unless the IRS issues them in final form before then. The IRS has indicated that it plans to issue final tangible property regulations as soon as possible, likely at the beginning of 2013. Further, the final regulations aren’t expected to vary significantly from the temporary regulations.
My company has used a conservative capitalization policy in the past and hasn't aggressively deducted repair expenses. Do we face any real risk if we choose not to comply with these regulations?
First, it’s important to note that the regulations contain no general rule related to a dollar capitalization threshold (although property costing $100 or less can be accounted for as materials and supplies). Therefore, a conservative capitalization policy alone won’t ensure compliance. While you may be able to reach a similar result under the regulations using the de minimis rule, you must still verify that you meet the requirements to use the de minimis rule and should positively make an accounting method change to use that method.
Second, the scope of the regulations isn’t limited to the capital improvement versus deductible repair issue. The regulations also contain rules relating to the proper time to account for dispositions of property. These disposition rules won’t be addressed through a conservative capitalization policy, and optimizing your results may require additional elections and changes in accounting methods related to dispositions.
Third, if your capitalization policy is too conservative, you may benefit from taking advantage of certain aspects of the regulations that permit accelerated deductions (such as the routine maintenance safe harbor and the classification of items as materials and supplies). Therefore, reexamining your current accounting methods in light of these new regulations is highly recommended.
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The new tangible property regulations are complex. Moss Adams LLP can help you assess your company’s alternatives under the regulations, implement any accounting method changes, and maintain the appropriate information in future years. For more information, contact your Moss Adams tax professional.
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