Federal Tax Series Part 2
Overview – After years of court battles, temporary regulations and administrative guidelines, the IRS has issued the Final Regulations (TD 9636). The IRS interpretative regulations provide guidelines on how and when a taxpayer is allowed to deduct a repair expense as opposed to capitalize a business expense when purchasing and improving tangible or real properties. The 200 pages of regulations are relatively more taxpayer friendly than their predecessors. Yet the Final Regulations are still complex and require time and investment from taxpayers to assure compliance with its guidelines. This article will cover essential aspects of the Final Regulations. The ramifications of these regulations are vast since they apply to all businesses, regardless of industry. Many taxpayers have not yet changed their financial and administrative procedures to follow the new regulations and become compliant with such changes.
Applicable Date – Whether a taxpayer is on a calendar basis or fiscal year, he must apply the Final Regulations to taxable years after Dec. 31, 2013. The taxpayer has the option to amend his tax returns for tax years beginning on Jan. 1, 2012, and apply the changes retroactively. Before summarizing the Final Regulations, we should clarify what is a repair as opposed to capitalization in regard to tax concepts. A repair produces immediate tax benefit by expensing a payment in the current tax year. You can capitalize an improvement and expense the total payment over many tax years based on depreciation rules.
Our discussion regarding these regulations spans two main Internal Revenue Code (IRC) sections. IRC section 263 states that any amount to acquire, produce or improve tangible property must be capitalized unless there is an exception. IRC section 162 deals with ordinary and necessary business expenses, which includes repairs and maintenance.
Example of Repair vs. Capitalize – If you repair an air conditioning unit for one of your buildings, and the repair does not materially increase the economic life of the unit, you can deduct the repair as an expense in the year you pay for it. However, if your payment to fix the air-conditioning unit created an improvement in its useful life or created a new and different use for this unit, then the payment must be capitalized over the economic life of the unit. The economic life is defined by IRS tables as “useful life” or “recovery period” depending on the property.
The concept of “Unit of Property” (UOP) is an important delineation for repair and capitalization. If you consider a vehicle as a UOP, then a repair of its engine is classifiable as a repair if you have not changed the use of the vehicle. However, if you deem the engine as a UOP by itself, then it’s necessary to capitalize the expense over its useful life; thus, it is not a repair. As you can see, facts and circumstances determine what might be considered a repair vs. capitalization. It is important for business owners to discuss the nature and use of the property with a tax adviser.
There is good news regarding materials and supplies. In general, one can expense the amount paid for materials and supplies that is usable during a 12-month period. The Final Regulations also state that when the cost of any UOP, purchased or produced, is $200 or less, you can expense it.
In addition, if there is routine and regular maintenance that keeps a UOP in efficient operating condition, such regular maintenance (e.g., cleaning, testing, inspection and replacement of worn parts) falls under repair and maintenance and is expensable.
De Minimis Safe Harbor – The Final Regulations allow taxpayers to deduct the amount paid for the purchase of a tangible property when it is also expensed for its financial statements. There are two limits for two main groups of taxpayers. One group includes taxpayers who are required to have Applicable Financial Statements (AFS.) AFS can be certified financial statements distributed for internal or external purposes (e.g., to financial institutions, creditors, investors, governmental agencies, etc.). For such taxpayers, the safe harbor limit is $5,000 per invoice or per item. If a taxpayer does not need to have AFS, the safe harbor limit is $500 per invoice or item. You must substantiate such deductions by actual invoices and policies. This means for your business to be able to use the safe harbor, you must have accounting procedures and written policies in place to state that your business is expensing tangible properties.
This De Minimis Safe Harbor requires an annual election statement that you must attach to your tax return. A late election is permissible with an amended tax return ONLY if the IRS consents. In other words, you snooze, you lose.
Per Building Safe Harbor for Small Taxpayers is another taxpayer-friendly guideline added by the Final Regulations. Who is a qualified small taxpayer for this purpose? If your annual gross receipts are $10 million or less during the three preceding tax years, consider yourself a qualified small taxpayer. If you qualify, then you must overcome a second hurdle. Namely, your total amount paid for maintenance, repair and improvement should not exceed more than $10,000 or 2 percent of the building’s unadjusted basis. If you meet both criteria, then you can deduct it as an expense in the current tax year instead of depreciating over the years. The Building Safe Harbor for Small Taxpayers requires an annual election statement. You must attach the election statement to your tax return. A late election is acceptable with an amended tax return ONLY if the IRS consents. Again, don’t be late.
Catch-22 – Since conformity to the Final Regulations (TD 9636) is considered a change in accounting, and such a modification in accounting requires IRS approval, it creates a Catch-22. To alleviate this issue to some extent, the IRS issued Revenue Procedure 2014-16. This provides automatic consent from the IRS when and if a taxpayer adopts the stated above Final Regulations. Nevertheless, a competent tax consultant must file Form 3115, “Application for Change in Accounting Method,” for your business. If you would like to see a “foreign language” that is no longer spoken and long forgotten, try looking at Rev. Proc. 2014-16 and the corresponding Description of Change Numbers (DCN), which must be inputted on Form 3115. It brings to mind Alan Turing, an English mathematician and computer scientist who was a code breaker for the United Kingdom during World War II. Like Turing, who helped the Allies win World War II by decoding enemy communications, my colleagues help our clients to maneuver around this IRS-created maze.
Peter J. Cordua, CPA is the Managing Member of Pennsauken, N.J.-based Cordua, Pastore & Associates, LLC. He offers tax and financial consulting to clients nationwide. Contact Cordua at (856) 486-2299 ext. 209, email@example.com or visit www.corduapastore.com.