In the past, tax preparers and business owners criticized the IRS capitalization guidelines for being ambiguous, complex, and subjective. There were few quantitative brightline rules. Instead, the appropriate tax treatment was governed by qualitative “betterment” tests and Tax Court cases. The IRS released temporary guidelines in 2011 to clarify how to apply Internal Revenue Code Sections 162 and 263.
Business owners have lots of questions when it comes to deciding whether to expense costs or capitalize fixed assets, such as:
- Can I expense a laptop computer that I purchased for $699 in the current year?
- What qualifies as standby emergency spare parts, and can I capitalize them for tax purposes?
- Can I use the same accounting capitalization policy for book and tax purposes?
- I replaced the roof on my factory, but haven’t yet finished depreciating the original roof. How should I handle the disposition of the old roof?
On September 13, 2013, the final regulations (IRS T.D. 9636) debuted, revealing some significant changes from the 2011 temporary version. Here is an overview of the major changes that will affect your privately held firm.
Materials and Supplies
The new regulations generally allow you to deduct materials and supplies that cost $200 or less to acquire or produce under Section 162.
The final regs also permit an optional election to capitalize rotable, temporary, or standby emergency spare parts that have been acquired to maintain, repair, or improve your property. However, most taxpayers would prefer to expense them in the current period.
Repairs versus Improvements
When it comes to repairs, the final regulations retain most of the guidance issued under the 2011 temporary regulations. Under Section 162, incidental repairs are expensed.
Under Section 263, however, you must generally capitalize improvements that:
- Add to the value or substantially prolong the useful life of your property; or
- Adapt the property to a new or different use.
Betterment test. The final regulations use a modified “betterment” test to determine whether to capitalize costs as improvements. An improvement makes the property better if it materially adds to the asset, restores a major condition or defect, or increases its productivity, efficiency, strength, quality, or output.
An improvement also must be capitalized if it restores the asset by replacing a major component or substantial structural part of the asset, including buildings. The final regulations no longer require you to consider how the expenditure is treated on your financial statements when applying the betterment test.
Routine maintenance safe harbor. The final regulations also allow routine maintenance on fixed assets, including routine building maintenance, to be deducted for tax purposes. Routine maintenance costs are those recurring activities you expect to perform to keep the property in its ordinarily efficient operating condition. Examples include inspection, cleaning, testing, and replacing parts.
To qualify as “routine,” you must expect, at the time the property was placed in service, to perform the activity more than once during its economic useful life. For building improvements to qualify under the routine maintenance safe harbor, you must expect to perform the activity more than once in 10 years.
De Minimis Safe Harbor for Acquisitions
For simplicity’s sake, many business owners prefer to use the same capitalization methods for book and tax purposes. The final regs permit certain taxpayers to deduct tangible property they acquire or produce, if the total cost per item (or invoice) is $5,000 or less. To qualify for this safe harbor, you must:
- Prepare an “applicable financial statement.” That is, a certified audited financial statement or a financial statement filed with a state or local government.
- Possess a written accounting procedure at the beginning of the tax year for expensing property under a specified dollar amount.
- Expense the cost on your applicable financial statement, not just your tax return.
The de minimis safe harbor also applies to property with an economic useful life of 12 months or less as long as the item does not cost more than $5,000 per item (or per invoice).
Many private businesses do not prepare “applicable financial statements.” You might prepare financial statements in-house or have them compiled by a CPA, for example. Taxpayers without applicable financial statements are subject to a $500 capitalization threshold. However, even to qualify for the lesser amount, you must have accounting procedures in place at the beginning of the tax year for expensing property below the threshold.
If you elect to use this safe harbor on your tax return, you must use the de minimis safe harbor for all amounts paid in the taxable year for tangible property, including materials and supplies that meet the requirements. You can only revoke an election to use the de minimis safe harbor by filing an application for change in accounting method.
If you do not currently have a written policy for expensing property under a specified dollar amount, consider drafting one before year end, if you plan to elect the de minimis safe harbor in 2014.
Small Business Safe Harbor
The final regs offer a break to small businesses with gross receipts of $10 million (or less) when it comes to building improvements. For buildings that initially cost $1 million or less, qualifying small taxpayers may elect to deduct the lesser of $10,000 or 2% of the unadjusted basis of the property for repairs, maintenance, improvements, and similar activities each year.
You may elect annually to use the safe harbor for buildings on a building-by-building basis by including a statement on your federal tax return. Amounts to which you correctly apply this safe harbor are not treated as capitalizable building improvements under Section 263. Instead, they are expensed under Section 162.
The final regulations generally apply to taxable years beginning on or after January 1, 2014. However, certain provisions of the final regs only apply to amounts paid or incurred in taxable years beginning on or after January 1, 2014.
You may apply the new regulations to tax years beginning on or after January 1, 2012. Compliance may require you to change your current capitalization procedures and file an IRS form.
The Next Step
The repair regs have been a work-in-progress for many years. The final framework provides much-needed clarity and guidance. But, at more than 200 pages, the final regs are hardly clear and concise. This brief article just scratches the surface of the complex capitalization rules. There are many nuances, exceptions, and safe harbors. The IRS expects to publish additional industry-specific guidelines on capitalizing or expensing tangible property for cable networks, natural gas firms, and retailers in 2014.
If your business owns or leases fixed assets, consult with your tax adviser to determine how these rules affect your accounting practices — and whether they will result in tax savings or unexpected costs.