The IRS has issued comprehensive and complex regulations on the tax treatment of amounts paid to acquire, produce, or improve tangible property. The regulations explain when those payments can be deducted, which confers an immediate tax benefit, and when they must be capitalized.
The regulations must be followed for tax years beginning after Dec. 31, 2013 – whether a calendar year or a fiscal year, such as a fiscal year beginning July 1, 2014. Therefore 2014 tax return preparation is critical to proper implementation of the regulations.
What does this mean for you?
For your 2014 tax filings, unless you qualify as a “small business” (defined below), one or more Forms 3115, Application for Change in Accounting Method, will be included with your tax return. This Form is required by the IRS to adopt the new regulations discussed above.
A copy of the Form 3115 will be attached to your tax return. Additionally, a separate paper copy must be mailed to the IRS in Ogden, Utah. Unlike your tax return filed with the IRS, this separate copy cannot be e-filed and must be mailed on paper.
Capitalization or deduction
The regulations set forth the general rule that amounts paid to improve a unit of property must be capitalized. An improvement is defined as an expenditure that betters a unit of property, restores it, or adapts it to a new and different use.
On the other hand, the regulations allow a current deduction for repairs and maintenance to property. Deductible repair and maintenance expenses are defined in a negative way – they are deductible if not otherwise required to be capitalized.
Unit of property
One key concept in the regulations is the “unit of property” (UOP) that is being improved or repaired. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized.
For example, work on an engine of a vehicle is more likely to be classified as an expenditure that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of being a repair.
Buildings. When it comes to buildings, the regulations generally treat each building and its structural components as one UOP – the “building.” The regulations also list nine specific building systems that are treated as separate from the building structure. An improvement to the building is defined by its effect on those systems, rather than on the building as a whole.
If a taxpayer restores a building structure, such as by replacing the entire roof, the expense is treated as an improvement to the single UOP consisting of the building. If the taxpayer makes an improvement to a building system, such as the HVAC system, that expense is also an improvement to the building UOP.
Building Systems. Building systems are the mechanical parts of the building that create and aid in the functionality of the property. These systems include, but are not limited to, items such as heating, ventilation, and air conditioning (HVAC), plumbing, electrical, escalators, elevators, fire protection and alarm, security, and gas distribution systems.
For example, if the entire HVAC system were to stop working and a repair needed to be made to return the HVAC system to working condition, such repair would have to be capitalized. However, say the HVAC system contained ten separate AC units, and the taxpayer replaced two of them. The cost to replace the two units would not need to be capitalized, as the IRS has stated that the replacement is not expected to materially increase the productivity or efficiency of the HVAC system. However, if the replacement of two units in one year is part of a plan to replace the entire system over a period of time, then the cost of the two units would need to be capitalized.
Property other than buildings. In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can't be placed in service without the other components.
For example, a business buys a battery-powered golf cart for its foreman to use in getting around a large warehouse. It buys the chassis from one vendor and the battery from another, and then assembles the two components. Here, the cart is the UOP, since the chassis can't be placed in service without the battery.
Deducting materials and supplies
A deduction is allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. Materials and supplies are defined to include five specific categories of property used or consumed in the business operations.
UOPs with an economic useful life of no more than 12 months qualify as materials and supplies under this rule. Likewise, certain inexpensive items qualify as materials and supplies. Under the final regulations, this rule applies to UOPs that cost $200 or less to acquire or produce.
Routine maintenance safe harbor
The regulations include a safe harbor that allows certain expenses of routine maintenance to be deducted rather than capitalized. Routine maintenance means recurring activities that keep business property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.
For a building structure or system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, the taxpayer must reasonably expect to perform the activities more than once during the property's class life for depreciation purposes.
Other de minimis safe harbor expensing elections
The regulations also provide for several safe harbor elections which businesses can adopt to simplify the application of these rules, based solely on a dollar threshold of each unit of property acquired. Certain taxpayers which issue audited financial statements can elect to use the expensing election with acquisitions up to $5,000 provided an applicable capitalization policy is in place for the year. Other taxpayer can use a lower threshold of $500 per unit of property.
Small business safe harbor
The recently released Revenue Procedure 2015-20 provides a small business exception for taxpayers with total assets less than $10 million at the start of the year, or average annual gross receipts of $10 million or less for the prior three years. Please note that the total assets and average annual gross receipts tests apply to each separate and distinct trade or business of a taxpayer.
Qualifying small taxpayers do not need to file Form 3115 to adopt the new regulations; they can just start following the regulations as of January 1, 2014.
There may be circumstances where a small business may still need to file Form 3115.
For more information regarding how this affects your business, please contact us.