On December 23, 2011, the IRS issued simultaneous proposed and temporary regulations to clarify and expand regulations under Code Sections 162(a) and 263(a) and provide guidance related to property dispositions under Section 168. The regulations are generally effective for tax years beginning on or after January 1, 2012 and will apply to all taxpayers that acquire, produce or improve tangible property.
There has been a long-running dispute between the IRS and taxpayers on whether property expenditures are 1) improvements that must be capitalized and recovered through depreciation or 2) repair and maintenance costs that can be currently deductible as an ordinary expense. Existing IRS regulations and guidance, and court cases all set out tests for making the determination, but much uncertainty among taxpayers still existed. In response to this uncertainty, the IRS released proposed regulations in 2006 and revised proposed regulations in 2008. The new temporary regulations were issued in response to comments on the proposed regulations.
All taxpayers will need to review the new rules and determine what changes, if any, will need to be made under the new regulations. Taxpayers whose current method of expensing or capitalizing costs is contrary to the new regulations, most likely will need to change their method of accounting on Form 3115 and make a Section 481(a) tax adjustment. The 481(a) adjustment means that a business will have to apply the new rules to costs incurred both prior to and after the effective date of the regulations. This adjustment could reverse some prior benefits for changes made under the former proposed regulations. Two revenue procedures will be forthcoming to provide transition rules for businesses changing their method of accounting, including the granting of automatic consent to make the change.
Highlights of the Temporary Regulations
The temporary regulations contain many of the same rules as the 2008 proposed regulations; however, there are some noted changes.
Building Improvements – The temporary regulations keep the proposed regulation’s definition of “unit of property”, however, make significant modification to the “improvement” standards. Under prior law, taxpayers generally could look at the building “unit of property” as a whole to see if an improvement was made. If the expenditure to a part of the building did not result in an improvement to the whole building, the expenditure did not have to be capitalized, and thus, could be expensed currently as a repair. Under the temporary regulations, the building can still be considered a unit of property; however, the tests for whether or not there is an improvement (betterment, restoration/replacement, adaptation) to the building must be made by looking at specific building component systems – the heating and air conditioning system, plumbing system, electrical system, escalators and elevators, fire and alarm system, security system and gas distribution system. Now, if an expenditure results in an improvement to any of these systems, it is considered an improvement to the building, thus requiring capitalization.
Of particular interest to auto dealers, commentators on the proposed regulations had requested an exception to the improvement betterment rules for retail store reimaging costs. Despite requests, the temporary regulations do not provide an exception, but instead state that the determination of whether reimaging expenditures result in an improvement or repair is based on a facts and circumstances test. The temporary regulations provide three examples of common retail reimaging scenarios to illustrate the application of the new rules. One example is for a non capitalized retail refresh with no structural/system improvements; a second partly capitalized retail refresh with minor structural/system improvements; and a third fully capitalized refresh with substantial structural/system improvements.
The new improvement rules and examples indicate that repair treatment for building upgrades with substantial improvements to a building structure or structural systems will be more difficult than in the past.
Dispositions – The temporary regulation’s definition of “dispositions” now includes the retirement of structural components. If a taxpayer replaces a structural component of the building, for example an HVAC system, an expense is allowed for the remaining cost of the old HVAC system. This is a good change from the old rules that required the simultaneous depreciation of the new property along with the remaining basis of the old property. Additionally, if taxpayers find themselves capitalizing more property costs under the new “improvement” rules, this new expensing rule should help alleviate some of the pain.
De Minimus Rule – The temporary regulations now allow taxpayers to deduct certain amounts paid for tangible property if 1) the taxpayer has an applicable financial statement, 2) has a written accounting policy for deducting de minimus amounts, and 3) such amounts are expensed on its financial statement in accordance with the written policy. The aggregate of amounts expensed under the new de minimus rule for the tax year must be less than or equal to the greater of:
- 0.1% of the taxpayer’s gross receipts for the year; or
- 2% of the taxpayer’s total depreciation and amortization expense for the tax year on its applicable financial statements.
Taxpayers that do not have applicable financial statements may not use the de minimus rule, but must instead rely on a separate, temporary regulation to deduct material and supplies that cost under $100.
The temporary regulations are very new and very comprehensive. Stay tuned because Schneider Downs will be producing more articles and web discussion to communicate the full impact of these regulations on taxpayers.
Katie Myers, Tax Manager, also contributed to this Insight.
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