UPDATE: On February 13th, 2015 the Internal Revenue Service released Revenue Procedure 2015-20 which provides last minute Tangible Property Regulation relief for small businesses.
The Final Tangible Property Regulations T.D. 9636 generally may be adopted and applied beginning on or after January 1, 2014 and in certain circumstances can be elected to be applied retrospectively beginning in 2013.
The new regulations will affect all business entities with depreciable assets including individuals filing Form 1040 reporting profit and loss on Schedule C for business, Schedule E for Rental Property, or Schedule F for Farming. Compliance with the regulations may require a review of prior tax return expenditures to identify any items that are required to be capitalized under the new regulations but were previously expensed under the superseded regulations. During this review, there may be an opportunity for tax savings by identifying assets that were previously capitalized that would have been expensed under the new regulations. If prior year depreciation schedules and expenses have been reviewed and if a cumulative prior year difference is identified, the cumulative difference will need to be reported as a Section 481(a) adjustment on Form 3115 of the 2014 tax return. Failure to file Form 3115 can result in permanent loss of deductions, penalties, and an increased risk of IRS audit.
Under the new regulations, the rules for when a repair and replacement must be capitalized have changed. If the repair and replacement results in the betterment or material change to the original intended use, adapts the asset to a new or different use, restoration of the asset to its original operating condition, or is a relatively large expenditure for a component in relation to the asset as a whole (Also referred to as the BARR Rules) the costs must be capitalized. The new regulations now require buildings to be broken down into nine “building systems” as separate units of property. Generally, the larger the unit of property is, the more likely it is that costs will be characterized as a repair instead of a capital expenditure. If any of the BARR rules apply and a safe-harbor is available, the cost may be expensed; otherwise the cost must be capitalized.
The following are some examples of the more common change in accounting methods and annual elections that taxpayers will need to consider.
Change in Accounting
Deducting non-incidental materials and supplies when used or consumed: amounts paid to acquire those items for which a record of consumption or inventory is kept and can include inventory items for small businesses.
Deducting incidental materials and supplies when paid or incurred: amounts paid to acquire or produce incidental materials and supplies carried on-hand where no record of consumption is kept or when physical inventories are not taken, are deductible in the taxable year in which paid, provided taxable income is clearly reflected (i.e. office supplies).
Safe Harbor for Routine Maintenance: repair costs expected to occur more than once over the life of the unit of property and more than once in a 10 year period for structural components or building systems.
De minimis Safe Harbor: the Temporary Tangible Property Regulations allow taxpayers to adopt a written accounting policy sometimes referred to as a capitalization policy in which they can elect a de minimis safe harbor to expense amounts paid for qualifying property. The safe harbor maximum of $5,000 per invoice (or per item as shown on an invoice) applies to businesses with applicable (audited) financial statements and a maximum of $500 is allowable for those businesses without. Note that the safe harbor does not apply to inventory, land, and rotable parts. These safe harbor thresholds are ONLY available to those businesses that had a written accounting policy in place at the start of the year.
Safe Harbor for Small Taxpayers: small taxpayers can elect not to capitalize total amounts paid for repairs, maintenance, improvements, and similar activities as long as the sum does not exceed the lesser of 1) 2% of the unadjusted cost basis of the eligible building; or 2) $10,000. Qualifying taxpayers must have average gross receipts less than $10 million for the prior 3 years and eligible building property must have an unadjusted basis less than or equal to $1 million.
Partial Disposition Election: make this election if the business has the opportunity to dispose of a major asset (i.e. a roof) previously capitalized and subsequently replaced.
Application of the new regulations is complex and time consuming. Levin Swedler Kennedy has invested a significant amount of resources into researching and developing a clear understanding of the Final Tangible Property Regulations and we are prepared to keep our clients at the forefront of compliance.
Written by: Matthew Migal, MBA