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Capitalization of Tangible Assets. Understanding the New IRS Regulations and What [client name] needs to do in Response. Presented by xxxxxxx CPAs and Consultants xxxxxxxxxx, CPA and xxxxxxx, CPA Month Day, 2014. Put Client Logo Here. Meeting’s Discussion Topics.
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Capitalization of Tangible Assets Understanding the New IRS Regulations and What [client name] needs to do in Response Presented by xxxxxxx CPAs and Consultants xxxxxxxxxx, CPA and xxxxxxx, CPA Month Day, 2014 Put Client Logo Here
Meeting’s Discussion Topics • Materials and supplies—definitions of materials and supplies • Discussion of the new de minimis safe harbor rules and annual elections • Repairs—deductions for amounts paid to repair and maintain property not required to be capitalized under 263(a) • The expenditures required to be capitalized • Betterments, Restorations, New Use • Building or component dispositions • Introduction on how to change accounting methods
Today’s Learning Objectives • Understand the tangible property regulations (TPRs) that the IRS has changed related to: • Write offs: • Repairs and maintenance • Materials and supplies • Capitalization Issues: • Improvements to property verses R & M • Acquisitions • What you need to follow up on (changes in accounting methods related to these regulations) • What is the impact of these TPRs to you (both tax and financial statement)
10,000-Feet TPR Observations • Few objective rules • What you have done to date (asset groupings, cost segregation, depreciation choices) matter • Cost segregation still relevant and needed • Multiple Code Sections changed, not just 263(a) [capitalization], but also Sections 162 [ordinary and necessary business expenses], 168 [depreciation] • Every taxpayer (TP) is affected, just about every TP will have to file several 3115s (potentially 4 to 5 IRS form for Change in Accounting Method, Form #3115) • We will need a lot of old facts/data from you
Depreciation Allowable or Taken – this issue is “huge”. Points: (1) Suggest that you use the spring and summer of 2014 to correct any errors in prior year depreciation, and note that(2) section 1.1016-3 is part of the TPRs for a reason – that is the “scary” part – the IRS will use this in their future audits of TPs to deny depreciation deductions or items that could have been written off as R & M in prior years
§1.1016-3 Exhaustion, Wear and Tear, Obsolescence, Amortization, and Depletion • Determination of the amount properly allowable for exhaustion, wear and tear, obsolescence, amortization, and depletion must be made on the basis of facts reasonably known to exist at the end of the taxable year. • A TP is not permitted to take advantage in a later year of the TP's prior failure to take any such allowance or the TP's taking an allowance plainly inadequate under the known facts in prior years. • Caution: In the case of depr., if in prior years the TP has consistently taken proper deductions under one method, the amount allowable for such prior years must not be increased even though a greater amount would have been allowable under another proper method.
Warnings for Taxpayers (TP)…if • (1) a TP does not identify all of the tangible property issue(s), • (2) a TP does not implement the rules correctly, AND • (3) file all of the necessary 3115s under the correct new method(s), • the TPs could have certain current and future tax depreciation denied and/or miss the potential write-off on previously capitalized assets. • This exposure is greatest for errors asset class lives, in bonus depreciation, and for building issues, since that is where the greatest dollar amounts exist. • Your exposure for errors is great and the time to execute is limited.
“Errors” (are impermissible methods) in Depreciation Deductions • Must correct most issues/impermissible methods (class life or bonus errors) by filing a 3115. • Unless the issues/methods were done only in the prior tax years, the TP is not permitted to make these corrections with an amended return • Cannot fix depreciation errors by “catching up” on prior year errors
What TPs Need to Do • Depreciation Schedules: fix them before the IRS disallows “missed” depreciation • Fix based upon the new TPR capitalization criteria – not why it was done when it was added to the depreciation schedule • Assess conformity of your current policies and procedures with these TPRs • Capitalization policies verses R & M • Minimum capitalization thresholds ($500, $1,000, more?) • Routine maintenance expenditures • Internal tracking and capturing data • Do Your Current method(s) conform to TPRs? • Unless you just went into business, there is no way they can, so we need to file 3115s
Depreciation Error Process • Find out what ‘activity’ the business is in by reviewing Rev. Proc. 87-56 • This will instruct us what the asset guideline class lives should be, O/T asset classes 00.11 to 00.4. 00.11 to 00.4 are the “common” class lives. • Based on the business’ “activity” we may have class lives that are different from the common class lives. • 00.11 to 00.4 state the following: office equipment is 7 years; computers =5, copiers=5, cars and trucks=5, land improvements=15 • But if an activity such as 33.3, land improvements are 7 years; if 57.0 (distributive trades and services) equipment assets are 5 years, unless they fit into 00.11 to 00.4.
What After Depreciation Errors? • There are other issues that are not depreciation errors, but rather are TPR issues that are generated from a review of the depreciation schedules. There are: • Repair items that were capitalized. (items that were capitalized but viewed now under the TPRs would have been written off). • Prior building write off issues. (new roof was added but old roof can now be written off • This can be done even if the old roof comes from many years ago (example: old roof was put on in 1995 – there is still many years of depreciation remaining that can be written off as the asset was put on with a 39 year life)
What you need to address first on most of the TPR Issues (after addressing depreciation error corrections):- two items – TPRIssue(s) identification Unit of Property
Issue(s) Identification – “the list” • The actions a TP may need to take under these TRs are not limited to: • Statement to the IRS about, and/or Change in your “unit of property”: What do you want your unit of property to be? Do you have buildings grouped together in the depreciation schedule? (example: multiple buildings in an apartment building)[more on this in a few slides…] • The need to breakout prior costs for property capitalized (i.e. what is the detail in that 39 year asset account where the roof was replaced years ago?) • Write off or capitalize current year expenditures (and if we capitalize, do we have prior to dispose of?
Issue(s) Identification - 2 • If we have to write off prior assets, do they still have basis that can be written off? • If fully depreciated, unless we also want to write off the removal costs of the new asset, we are done with this asset. Just capitalize the current expenditures and depreciate them properly over future years • If we have to write off these prior assets (or removal costs) and they still have basis, we have to determine whether we are going to write those assets off in a 3115 filing under the “cost known” method (such as a cost segregation or being able to recreate the original costs) or under a “reasonable allocation” method (such as a PPI “lookback”)
Issue(s) Identification - 3 • Do we need to correct depreciation errors (i.e. bonus, lives)? Every depreciation schedule will need to be “scrubbed” for errors. These will require 3115 filings in order to take the (typical) negative 481(a) adjustments. We have decided, in general, that this is fall/winter work for 2014 - and that these changes must be done and attached to the 2013 income tax returns. • Adopt new accounting method(s) – (numerous potential methods!!!) • File 3115(s) (separately or together) for what?
Unit of Property (UoP) Is a very important element to these and other regulations Do You first need to change any UoP before you makes a method change under the new TPRs?
Unit of Property (UoP) • UoP is a very important issue, why?: • It is an important criteria in the decision whether a TP can write off an expenditure • Generally: • The smaller the UoP the more likely the expenditure will be required to be capitalized • This issue should almost always be considered in TPR issues, most of the time, early, and affirmative statements made to the IRS on what you want the UoP to be.
Building UoP Examples • Apartment complex with multiple buildings – all listed as one asset on the depreciation schedule: • UoP must be changed to each building (but capitalization considerations on building components and/or system are measured in comparison to that building component that performs a unique function or specifically enumerated system) • Retailer complex with multiple buildings: • UoP is each individual separate building
What the Tangible Property Regulations (TPR) Do • TPRs provide guidance on the application of Sections 162(a) (deduction) and 263(a) (requires capitalization) of the Code to amounts paid to acquire, produce, or improve tangible property. • Regulations aim to clarify the difference between these two opposites • Final regulations were issued in September of 2013 and only give us through tax year 2014 in which to make these new method changes and potential numerous annual elections • Clarify and expand the standards under Sections 162(a) and 263(a) • Provide certain bright-line tests (for example, new de minimis safe harbor rules for certain acquisitions) • Provide guidance under Section 168 regarding the accounting for, and dispositions of, building property
What the ‘Repair’Regulations Do • TR will affect all taxpayers that acquire, produce, or improve tangible property • Regulations are effective on January 1, 2014 or for taxable years that begin after 1-1-2014, but can be applied for tax years 2012 to 2013 (so why not apply the “beneficial” method changes earlier and get a nice tax deduction?)
What the ‘Repair’Regulations Do • Splits the definition of tangible property into two categories: • Buildings • Everything else • For Buildings: a building and its structural components are treated as a single unit of property, but when improving “building systems,” must be separated out
Building and Structural Components 1.263(a)-3(e)(2) (UoP) • General rule that the UoP for a building is comprised of the building and its structural components • Requires that a TP apply the improvement standards separately to the primary components of the building, that is, the building structure or any of the specifically defined building systems. • A cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the specifically enumerated building systems. • Defines the building structure as the building (§1.48-1(e)(1)) and its structural components (§1.48-1(e)(2)) other than the components specifically enumerated as building systems. • A UoP is a method of accounting
Building and Structural Components 1.263(a)-3(e)(2) (UoP) • Defines building systems to include (1) the heating, ventilation, and air conditioning systems (“HVAC”); (2) the plumbing systems; (3) the electrical systems; (4) all escalators; (5) all elevators; (6) the fire protection and alarm systems; (7) the security systems; (8) the gas distribution systems; and (9) any other systems identified in published guidance • These are considered improvements to the building: Replacement of an entire roof, improvement to the HVAC system
Building and Structural Components 1.263(a)-3(e)(2) (UoP) • Old Rule: Taxpayer was required to depreciate building improvements over the life of the original asset (39 years), even if building had been 29 years into its depreciable life; no write off of the replaced component • If one replaced a roof, for example, you depreciated two roofs—the original one and the replaced one, or three roofs, etc. • New Rule: replace a roof, you are able to recover as a loss the remaining basis of the old roof, book the new roof and depreciate it
Background • Section 263(a) (relating to the capitalization requirement) states that no deduction is allowed for: (1) Any amount paid out for new buildings or permanent improvements or betterments made to increase the value of any property, or (2) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance has been made.
Background • 263(a) Regulations state that capital expenditures include amounts paid or incurred to: • Add to the value, or substantially prolong the useful life, of property owned by the TP; or, • Adapt the property to a new or different use. • Amounts paid or incurred for incidental repairs and maintenance of property (as defined by 162 and §1.162-4 (relating to the deduction for ordinary and necessary trade or business expenses) are not capital expenditures under §1.263(a)-1.
U.S. Courts onCapitalization Have • Recognized the highly factual nature of determining whether expenditures are for capital improvements or for repairs • Articulated a number of ways to distinguish between deductible repairs and non-deductible capital improvements. • Explained that R and M expenses are incurred for the purpose of keeping property in an ordinarily efficient operating condition over its probable useful life for the uses for which the property was acquired. • Explained that capital expenditures, in contrast, are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use
U.S. Courts onCapitalization Have • Explained that the relevant distinction between capital improvements and repairs is whether the expenditures were made to “put” or “keep” property in efficient operating condition • Stated that if the expenditure merely restores the property to the state it was in before the situation prompting the expenditure arose and does not make the property more valuable, more useful, or longer-lived, then such an expenditure is usually considered a deductible repair. • Concluded that a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property. • Key is that TR have attempted to match or meet these “elements” outlined in those court cases ….
TPR RegulationsDo Not Change • §263(a), which requires TPs to capitalize amounts paid to improve tangible property and • §263A and the regulations under §263A, which require TPs to capitalize the direct and allocable indirect costs, including the cost of materials and supplies, to property produced or to property acquired for resale • §1.471-1, which requires TPs to include in inventory certain materials and supplies
TPR RegulationsDo Adopt and Refine • The definition and treatment of materials and supplies • New de minimis safe harbor rules for the acquisition and production of property and/or material & supplies • An election to capitalize materials and supplies and/or R & M • Safe harbor for routine maintenance for both tangible personal property and buildings • Rules for determining a unit of property • Certain rule revisions for determining whether there has been an improvement to a unit of property • Rules revisions for determining whether an amount is paid for an improvement to a building. • Rule revisions for determining whether an amount is paid for the replacement of a major component or substantial structural part of a unit of property
TPR RegulationsDo Adopt and Refine • Expanded definition of disposition for MACRS to include the retirement of a structural component (loss recognition availability for partial building disposals) • The general rule that incidental materials and supplies (for which no inventories or records of consumption are maintained) are deductible in the year purchased • Statements that non-incidental materials and supplies are not deductible until the year in which they are used or consumed in the TP's operations, unless the new safe harbor de minimis is applied) • New rules for rotable and temporary spare parts • No longer a need for TPs to understand General Asset Groupings • Numerous new and revised examples
Definition ofMaterial and Supplies • TPRs define and expand the definition of materials and supplies as tangible property that is used or consumed in the TP’s operations, not constituting a UoP, not acquired as part of a single UoP, and is not inventory, and that: • Is a component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the TP and that is not acquired as part of any single unit of tangible property; • Consists of fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less, beginning when used in TP's operations; (New Category) • Is a UoP that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the TP's operations;
Definition ofMaterial and Supplies • Is a UoP that has an acquisition cost or production cost (under Section 263A ) of $200 or less (or other amount as identified in published guidance in the Federal Register or in the IRB; or • Is identified in published guidance in the Federal Register or in the IRB as materials and supplies for which treatment is permitted • Also provide an election to treat certain materials and supplies under the de minimis safe harbor rule • Allow a TP to elect to capitalize certain materials and supplies. • Redefine the first category of materials and supplies by further describing the types of components that qualify and by • Eliminating the prior discussion that such property not be a UoP
Definition ofMaterial and Supplies • Specified acquisition or production cost threshold • Final TPRs up the limitation to $200 per item • Add language, however, that gives the IRS and the Treasury Department the flexibility to change the amount of the limitation • A TPR with either applicable financial statements (AFS) or at least a written communicated policy will be permitted to deduct amounts paid for property up to $5,000 and $500 respectively if it complies with the new method change requirements and elects annually to write off on books and tax these amounts. • Adds a new definition for “standby emergency spare parts”
Election to CapitalizeMaterial and Supplies • A TP may elect to treat as a capital expenditure and to treat as an asset, subject to depreciation, the cost of any M and S • Election applies to amounts paid during the taxable year to acquire or produce any M or S. Any asset for which this election is made shall not be treated as a M or S. • Exceptions. A TP may not elect to capitalize • Any amount paid to acquire or produce a M or S if: • The M or S is intended to be used as a component of a unit of property and • The TP has not elected to capitalize and depreciate that unit of property; or • Any amount paid to acquire or produce a rotable or temporary spare part if the TP has applied its optional method of accounting
Election to CapitalizeMaterial and Supplies • A TP makes the election by capitalizing the amounts in the taxable year the amounts are paid and by beginning to depreciate them • If a pass-through entity, the election is made at the entity level • A TP must apply the de minimis safe harbor to amounts paid for all M & S, except for those M & S that the TP elects to capitalize and depreciate
DMSH • Final - (can apply to 2012 and 2013 but must apply 2014 and after) de minimis safe harbor: • There is no ceiling as to the amount that can be deducted if it fits in the DMSH amounts • Must make an annual election on the tax return • Safe harbor determined at invoice item level, but same on policies for books and records • If you have an audit, TP may rely on DMSH only if the amount paid for property does not exceed $5,000 per invoice, or per item as substantiated by the invoice. • If no audited financials, generally DMSH is $500 per invoice/items 40
DMSH • The de minimis safe harbor has been expanded to include amounts paid for property having an economic useful life of less than 12 months. • A $500 per item de minimis rule is also included for taxpayers without an AFS, but still have to have accounting procedures in place to deduct amounts paid for property costing less than a specified amount, or amounts paid for property with a life of 12 months or less • If cost exceeds $500 per invoice, no portion will qualify for the safe harbor 41
DMSH • The de minimis safe harbor does not preclude a TP from reaching an agreement with the IRS that the IRS examining agents will not review certain items. • Examining agents do not need to revise their materiality thresholds in accordance with the safe harbor limitations. • The DMSH is elected annually by including a statement on the TP's tax return for the year elected. • An election to use the safe harbor may not be made through the filing of an application for change in accounting method, it must be made on the return when filed 42
DMSH • If an invoice includes amounts paid for multiple tangible properties and the invoice includes additional invoice costs related to the multiple properties, then the taxpayer must allocate the additional invoice costs to each property using a reasonable method • The DMSH must be applied to all eligible M & S (other than rotable, temporary, and standby emergency spare parts subject to the election to capitalize or to rotable and temporary spare parts subject to the optional method of accounting for such parts) if the TP elects the DMSH 43
DMSH • TPs that do not elect the de minimis safe harbor must treat amounts paid for materials and supplies in accordance with Reg. §1.162-3. • TPs subject to 263A can not avoid those provisions by using the DMSH • Safe harbor does not apply to inventory, land, items it capitalizes, and the optional method of rotable parts • Safe harbor is deducted as ordinary and necessary expense 44
De minimis Rule Election Details … of the de minimis safe harbor election: • Note that the TPRs do not state that the “election” of the safe harbor de minimis rule is a method of accounting • That means that a TP can elect to apply the de minimis rule in one year and not the next
Applicable Financial Statements • Defined as: TP’s FS that has the highest priority. • The FS are, in descending priority: • A FS required to be filed with the SEC; • A certified audited FS that is accompanied by the report of an independent CPA, that is used for: • Credit purposes; • Reporting to shareholders, partners, or similar persons; or • Any other substantial non-tax purpose; or • A FS (other than a tax return) required to be provided to the federal or a state government or any federal or state agencies (other than the SEC or the Internal Revenue Service).
Amounts Paid to Improve Tangible Property - Reg. §1.263(a)-3(d) Requirement to capitalize amounts paid for improvements • A TP generally must capitalize the related amounts paid to improve a unit of property owned by the TP. • For purposes of this section, a unit of property is improved if the amounts paid for activities performed after the property is placed in service by the TP-- • (1) Are for a betterment to the unit of property • (2) Restore the unit of property or • (3) Adapt the unit of property to a new or different use 48
Special rules for determining improvement costs— Reg. §1.263(a)-3(g) Removal Costs— • If a TP disposes of a depreciable asset, including a partial disposition under Prop. Reg. §1.168(i)-1(e)(2)(ix), and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, then the costs of removing the asset or component are not required to be capitalized • If the taxpayer wants to deduct removal costs, it must file a new 3115 for this method 49
Special rules for determining improvement costs— Reg. §1.263(a)-3(g) Removal Costs— • If a TP disposes of a component of a unit of property, but the disposal of the component is not a disposition, then the TP must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property. 50
