Construction Tax Update: Breaking down the Repair Regulations and building up Tax Developments

1. Construction Tax Update:Breaking down the Repair Regulations and building up Tax Developments December 4, 2012

2. Presenters • John Dorn • Partner • Minneapolis, MN • Jon Olson • Partner • Alexandria, MN

3. Learning Objectives • Identify the criteria for determining whether an expenditure relating to tangible property is a deductible expense or must be capitalized. • Identify the “unit of property” used for determining whether an expenditure is deductible or capitalized. • Understand recent Federal income tax changes resulting from rulings, court cases, and Congressional action.

4. The Fight • Determining the line for expenditures relating to tangible property between those required to be capitalized under Section 263(a) and those entitled to deduction under Section 162(a). • Section 263(a) – requires capitalization of amounts paid for new property and improvements or betterments made to increase value of property. • Section 162(a) – allows deduction for all ordinary and necessary business expenses. • Includes repairs (Treas. Reg. 1.162-4T)

5. Temporary and Proposed Regulations • Latest of several sets of regulations issued under the two sections • Issued December 23, 2011 • Purpose – from the Preamble of TD 9564: • “Clarify and expand the standards in the current regulations under sections 162(a) and 263(a) and provide certain bright-linetests for applying these standards.” • IRS hopes to finalize “early” 2013

6. Clarity? Bright Lines? • Most rules based on facts and circumstances • Rules “clarified” through examples • Materials and supplies: 14 examples • De Minimis rules: 4 examples • Unit of Property: 19 examples • Plus 6 more examples on improvement costs • Routine maintenance safe harbor: 10 examples • Betterments: 19 examples • Restorations: 26 examples • Acquired or produced property: 11 examples • Plus 9 more on transaction costs and 3 more on defense of title

7. Unit of property

8. Unit of Property • General rule – All components of real or personal property that are functionally interdependent comprise a single Unit of Property (UOP). • Components are functionally interdependent if the placing in service of one component is dependent on the placing in service of another component. • However, component must be treated as separate UOP if: • Properly treated as within different class of property under Section 168(e); or • Properly depreciated using different method.

9. Unit of Property--Building • General rule – Each building and its structural components is a single UOP • Walls, partitions, floors, ceilings • Permanent coverings • Windows and doors • However, for application of improvement rules to a building, “building systems” are now treated as separate UOPs from the building structure (roof, walls, windows, floors, ceilings) • BIG change from the previous regulations!!

10. Building Systems • HVAC • Plumbing (includes pipes, drains, valves, sinks, bathtubs, toilets, sewer collection) • Electrical systems • All escalators • All elevators • Fire-protection and alarm systems • Security systems • Gas distribution • Other structural components identified by IRS

11. Deductible expenses

12. Materials and Supplies

13. Materials and Supplies • Incidental • No record of consumption • Deduct when purchased • Example: office supplies • Non-incidental • Record of consumption is maintained • Not deductible until used or consumed • Rotable and Temporary Spare Parts • Acquired for installation on a UOP • Default rule is to deduct when disposed of

14. Definition of Materials and Supplies • Tangible personal property • Used or consumed in taxpayer’s operations • Not inventory • One of the following • Component to maintain, repair or improve a UOP that itself is not a UOP • Fuel, lubricants, water, similar items • UOP with economic life ≤ 12 months • UOP with cost ≤ $100, or • Other property identified by IRS as material or supply

15. Elect to Capitalize • Incidental and non-incidental materials and supplies • May elect to capitalize materials and supplies • Election made by capitalizing and depreciating • Timely filed return for year placed in service • Rotable and temporary spare parts • Capitalize and depreciate • Elect to deduct when first installed • Capitalize FMV when removed plus cost of repairs • Deduct again when later installed • Lather, rinse and repeat until disposed of permanently

16. De Minimis Rule

17. De Minimis Rule • Taxpayers can deduct amounts paid to acquire or produce tangible personal property (TPP) • Applies to all TPP except inventory or land • Taxpayer can elect to apply to materials and supplies • To be eligible, taxpayer must: • Have an applicable financial statement (AFS) • F/S filed with SEC, or • CPA audited F/S used for credit or reporting purposes • CPA reviewed F/S does NOT qualify • Have written accounting policy treating amounts as such an expense • Actually treat such amounts as an expense on AFS; and • Total amount of such expensed amounts cannot exceed greater of: • 0.1% of gross receipts for tax purposes • 2% of depreciation and amortization on AFS

18. De Minimis Rule Election • Made by deducting such amounts in the year paid • Timely filed return • May elect not to treat an otherwise eligible amount so as to come under the 0.1% gross receipts or 2% of depreciation expense tests

19. De Minimis Rule – Preamble • Rule is not intended to prevent a taxpayer from reaching an agreement with the IRS revenue agents that, as an administrative matter, based upon risk analysis or materiality, the agents will not review certain items. • Burden on taxpayer that treatment clearly reflects income

20. IRS Update on De Minimis Rule • Recognition of administrative burden on some companies due to failure to track amounts which would be subject to de minimis limitations • Not much sympathy from IRS Office of Chief Counsel, in that taxpayers previously were required to capitalize such costs • One of the topics identified in Notice 2012-73 • “may be revised in a manner that might affect, and in certain cases simplify, taxpayers’ implementation of the rules when the regulations are issued in final form.”

21. Dispositions

22. Dispositions • Occurs when ownership of an asset is transferred or when an asset is permanently withdrawn from use • Includes sale, retirement, physical abandonment of asset • Disposition requires recognition of gain or loss • What is the “asset” disposed of? • Cannot be larger than UOP • Structural components (including all components thereof) of a building • Improvements or additions • Does not include a component of personal property

23. Dispositions - Consequences • Depreciation ends at time of asset’s disposition • If asset disposed of is component of larger asset: • Must reduce basis and depreciation reserve of larger asset by amount of basis and reserve allocated to component • Allocate basis to component using any reasonable method • Gain or loss must be recognized

24. Dispositions – Problem with Buildings • What happens if taxpayer believes the amounts paid to replace a component are a deductible repair expense? • Disposition rules state that depreciation of old component must stop and allocated basis is removed from larger asset • Repair rules state that loss cannot be recognized • If loss is recognized must capitalize new component as restoration • Solution – Make a General Asset Account (GAA) election • Disposition of a component of the building does not cause the recognition of a loss or a basis reduction • Result – Depreciate old component and deduct new component • Regulations also provide flexibility to elect out of GAA when taxpayer wants to recognize loss on disposition • When “repair” must be capitalized as an improvement

25. IRS Update on Dispositions • One of the topics identified in Notice 2012-73 • May be revised and simplified • IRS possibly making current GAA treatment for buildings the default treatment for buildings. • Not wanting a 3115 from every taxpayer that owns a building in a trade or business.

26. Deductible Repairs

27. Repairs • General rule – Taxpayer can deduct amounts not otherwise required to be capitalized. • Routine maintenance safe harbor • Inspection, cleaning, testing, replacing of parts with comparable parts of a UOP • Taxpayer reasonably expects such activities will be performed more than once during the asset’s class life • Includes such activities even when performed after the expiration of the asset’s class life • Caution: safe harbor no longer applies to buildings or structural components of buildings • Also a topic identified in Notice 2012-73 • Revised? Simplified?

28. Capital Expenditures

29. Acquisitions • General rule – Must capitalize amounts paid to acquire or produce real or personal property. • General rule does not affect exceptions • Materials and supplies • De minimis rule • Amounts paid to acquire or produce include: • Invoice price • Transaction costs • Costs incurred prior to UOP being placed in service • Defense or perfection of title

30. Betterments

31. Betterments • Corrects a material condition or defect existing prior to acquisition or during the production of a UOP • Applies even if taxpayer was unaware of the condition or defect • Results in a material addition to the UOP • Enlargement • Expansion • Extension • Results in material increase in capacity, productivity, efficiency, strength, or quality of UOP or output. • Buildings – An amount results in a betterment to the UOP if it results in a betterment to either the building structure or any of the nine building systems.

32. Betterments - Considerations • “Appropriate” to consider all the facts and circumstances including: • Purpose of the expenditure; • Physical nature of the work performed; • Effect of the expenditure on the UOP; and • Taxpayer’s treatment of expenditure on its AFS • If same replacement part is not available, then replacement with “comparable” part is not, by itself, a betterment to UOP • Technological advancement or product enhancements

33. Standard of Comparison • Condition of property before and after expenditure • Compare to condition of property before particular event necessitating expenditure • Example: storm damaging a roof • Normal wear and tear excepted • Take into account condition of property when placed in service by taxpayer

34. Restorations

35. Restorations • An amount paid restores a UOP if it: • Replaces a component of a UOP and taxpayer recognized gain or loss on old component (disposition) • Repairs damage to a UOP for which taxpayer has taken casualty loss • Returns UOP to ordinary operating condition after deteriorating to state where it is no longer functional • Rebuilds UOP to like-new condition after end of class life • Replaces a major component or substantial structural part of the UOP • Buildings – An amount results in a restoration to the UOP if it results in a restoration to either the building structure or any of the nine building systems.

36. Restorations (cont.) • “Major component” or a “substantial structural part” • Must consider all the facts and circumstances including the quantitative or qualitative significance of the part or combination of parts in relation to the UOP • Includes a part or combination of parts that: • Comprise a large portion of the physical structure of UOP; or • Perform a discrete and critical function in the operation of UOP • Replacement of a minor component • Even if it affects the function of the UOP, is not supposed to constitute a major component or substantial structural part (i.e., require capitalization).

37. Adaptations

38. Adaptations • An amount paid adapts a UOP to a new or different use if the adaptation is not consistent with the taxpayer’s intended use of the property at the time the property was originally placed in service. • For buildings, the analysis applied to the building structure and each of the nine building systems.

39. Implementation

40. Effective Dates • T.D. 9564 • Tax years beginning after 2011 • However, most rules require full 481 adjustments • Possibly going back as far as 1987 • Exceptions, effective for amounts paid after 2011: • Materials and supplies • Costs to acquire real property • De minimis rule • Notice 2012-73 • Regs delayed until tax years beginning after 2013 • However, taxpayers permitted to apply to 2011 and after • Notified taxpayers of expected changes to de minimis rule, dispositions, and routine maintenance safe harbor.

41. Changes in Accounting Method • Accounting method changes • Section 481 adjustment • Positive changes spread over 4 years • Negative changes recognized in year of change • Always open to IRS adjustment • Filing method change provides audit protection • And spreads positive changes over 4 years • Conclusion – File necessary method changes to be compliant with the new regs! • Guidance arrived March 7, 2012 • Rev. Proc. 2012-19 for materials and supplies, repairs • Rev. Proc. 2012-20 for depreciation changes • New Form 3115 codes for automatic consents (162-180)

42. 2012 Federal Income Tax Update

43. Domestic Production Activities Deduction • Regs allow Section 199 deduction for activities to erect or substantially renovate real property. • Tax Court allows bridge and road renovation as eligible for Section 199 (Gibson & Assoc.)

44. Gibson & Assoc. • Issues in case • Definition of Item or Unit. • IRS argued whole road system was the “unit of item”. The bridge was just one little component of the total road system • Classifications and descriptions in documents. • Painting vs surface restoration • Authority. • IRS argued that contained to just Section 199. Taxpayer successfully used Section 263(a) and other relevant case law.

45. Investment Income Tax in 2013 • 3.8% surtax on net investment income of individuals effective in 2013, computed as the lesser of: • Net investment income, or • Excess of modified AGI over $200K single/$250K jt. • Example • Definition of net investment income • Interest, div., annuities, royalties, rents • Passive business income and trading • Gains from property (except active business) 15

46. High Earner Medicare Tax • Present employee FICA payroll tax: 6.2% OASDI on first $110,100; 1.45% Medicare tax on all earnings • Effective in 2013, Medicare tax up .9% to 2.35% on higher income earners [IRC Sec. 3101(b)(2)]: • Single earned income over $200,000 • Joint earned income over $250,000 • Assessed on employee share only, but employer withholds • If W/H inadequate, remit in 1040 • Income tax deduction for ½ SE tax remains the same 18

47. Accrual of Bonuses • 2009 CCA: No deduction if some employees ineligible because terminate before payment date • All events test not met • Rev. Rul. 2011-29: OK to accrue if terminated employee amounts reallocated to other employees • Automatic consent accounting method change 19

48. Section 179 Provisions Sec. 179 Asset Addn. Tax yr. beginning inLimitPhase-out Range 2009 $250,000 $800K - $1.05M 2010 $500,000 $2M - $2.5M 2011 $500,000 $2M - $2.5M 2012 $139,000 $560K - $699K 2013 $25,000 $200K - $225K

49. Bonus Depreciation Acquired & Placed in Service Bonus % 1/1/10 – 9/8/10 50% 9/9/10 – 12/31/11 100% 1/1/12 – 12/31/12 50% 1/1/13 and after 0% • Tax year of taxpayer not relevant 28

50. Bonus Depreciation • Overview of eligibility • Original use with taxpayer (i.e., new not used) • Qualified property (< 20 yr. recovery period) • Acquired & placed in service in eligible period • Ordering: Sec. 179 first; 50% bonus second 29