Time is running out for taxpayers to implement the new tangible property regulations. The new rules must be followed beginning in 2014. All taxpayers with tangible business and investment property will need to analyze current accounting practices and potentially institute changes to conform to the new rules. Many taxpayers can leverage the final regulations to increase and accelerate tax deductions. Others may have to defer or recapture deductions as a result of the new rules. And given that many of these rules simply didn't exist a couple of years ago, virtually all taxpayers with tangible property will need to request one or more accounting method changes on their 2014 tax returns to become compliant.
Opportunities under the Tangible Property Regulations
The determination of whether an expenditure had to be capitalized and recovered over several years or could be deducted immediately has always been a point of contention between taxpayers and the IRS. The Treasury Department has attempted to resolve some of these conflicts by implementing new rules that refine and clarify definitions and that simplify determinations by introducing several safe harbors.
Partial Disposition Election— Historically, when a taxpayer replaced a significant component of an asset — such as the roof of a building, an elevator, an HVAC unit, etc. — the taxpayer had to continue to depreciate the old asset as well as the new replacement. Under rules proposed last fall (expected to be finalized this summer with few modifications), taxpayers can now make an election to write off the undepreciated cost basis allocable to the replaced component, presuming the cost of the replacement component is capitalized. And the IRS has provided generous methods for backing in to the cost basis of the replaced asset. Taxpayers that disposed of a significant portion of an asset in previous years can make a late partial disposition election via an automatic accounting method change request to recover the undepreciated basis. The ability to make a late partial disposition election is not expected to be available after 2014.
De Minimis Safe Harbor Election — As a practical matter, virtually every business has a capitalization policy (formal or informal) by which it immediately writes off expenditures under a certain cost threshold. The IRS has never officially condoned such a business practice — until now (within limits). Any taxpayer with an audited financial statement and a written capitalization policy in effect as of the first day of the year can elect to immediately deduct expenditures under that book policy up to a limit of $5,000 per item or invoice. A taxpayer without an audited financial statement can elect to deduct expenditures under its accounting procedures (which are not required to be written) up to a limit of $500 per item or invoice. For some taxpayers, making the de minimis safe harbor election simply protects from audit scrutiny the amounts they had been previously deducting. For taxpayers without a capitalization policy, or that had policies with thresholds below the $500/$5,000 limits, the de minimis safe harbor election provides an opportunity to increase tax deductions if they modify their accounting practices accordingly.
Routine Maintenance Safe Harbor — Some taxpayers may have historically capitalized routine maintenance activities, perhaps because of the size of the expenditures. Taxpayers that adopt the routine maintenance safe harbor accounting method can deduct certain maintenance activities, such as cleaning, testing, inspecting and replacing worn parts, as long as the activities are expected to be performed more than once during the asset's depreciable class life (or within a 10 year period in the case of a building). The routine maintenance safe harbor may simply provide peace of mind upon examination, or, for taxpayers who have been too conservative in their capitalization practices, it may generate additional deductions by allowing them to write off the unrecovered cost of routine maintenance activities that were capitalized in prior years.
Small Taxpayer Safe Harbor Election— In an attempt to simplify small taxpayers' compliance with the rules pertaining to capitalization of building improvements, the final tangible property rules add a new safe harbor for taxpayers with gross receipts of $10 million or less. Qualifying small taxpayers can elect not to capitalize improvements to a building with an unadjusted cost basis of $1 million or less if the total amount paid during the year for repairs, maintenance and improvements does not exceed the lesser of $10,000 or 2% of the unadjusted cost basis of the building. The safe harbor is elected annually on a building-by-building basis. As with the de minimis safe harbor election, the small taxpayer safe harbor election may generate additional tax deductions for some taxpayers, while simply protecting from scrutiny amounts already deducted by other taxpayers.
Obligations under the Tangible Property Regulations
Unfortunately, not every aspect of the new tangible property regulations will yield increased tax deductions upon adoption. Some could produce either more deductions or the recapture of previously taken deductions, depending on prior accounting practices. Others may not impact current deductions significantly, but nonetheless are required to be implemented and thus will require some analysis and some additional disclosures with the taxpayer's 2014 tax return.
Materials and Supplies— The basic rules governing materials and supplies have not substantially changed — non-incidental materials and supplies must be deducted in the year consumed while incidental materials and supplies (for which no inventory is maintained) are deducted in the year purchased. What has changed is how materials and supplies are defined — expanded to include property with an acquisition cost of $200 or less. Since this definition did not exist under the old rules, generally all taxpayers will need to adopt an accounting method change to conform to the new definition of materials and supplies. Even if the taxpayer has adopted the de minimis safe harbor, which includes materials and supplies, the taxpayer should still adopt the new materials and supplies definition as a protective measure, given that the de minimis safe harbor is an annual election. Fortunately, the accounting method change to adopt the materials and supplies definition is applied on a going forward basis so the taxpayer does not need to assess whether materials and supplies incurred in prior years have been treated appropriately under the new definition.
Improvements— At the heart of the final tangible property regulations are rules to determine whether an expenditure constitutes an "improvement" to an asset (which would then need to be capitalized) because it resulted in a betterment, restoration or adaptation of the property. Since these standards did not exist previously, the requirement to follow the new standards necessitates adopting an accounting method change. Unlike the method change for materials and supplies, the new improvement standards must be applied retroactively. This means that the taxpayer will need to review expenditures in prior years to evaluate whether their treatment conforms to the new standards. A decision to deduct expenditures in a prior year, where the improvement standards suggest capitalization, would require the taxpayer to recapture some of that deduction. Conversely, a decision to capitalize expenditures in a prior year, where the improvement standards suggest deducting, would enable the taxpayer to write off the undepreciated cost of those expenditures. Even if all prior year decisions happen to comply with the new standard, an accounting method change to adopt the new standard is required, given that it didn't previously exist (even if no additional deductions or income recapture would result).
As complicated as these new rules seem, this discussion only contemplates the most common issues that taxpayers will face as they implement the new tangible property regulations. With time running out, taxpayers should act quickly to assess the actions required to comply with the rules. For more information on the tangible property regulations and how they impact your business, consult your local CBIZ MHM tax advisor. Also, see the links below to previous CBIZ MHM articles for additional information.
•Updated Tangible Property Rules Expand Safe Harbors, Disposition Rules
•IRS Issues Implementation Guidance on Tangible Property Regulations
•New Tangible Property Guidance Allows Late Partial Disposition Elections
Copyright © 2014, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that—unless specifically indicated otherwise—any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC and other Financial Services subsidiaries of CBIZ, Inc. (NYSE: CBZ) that provide tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies.