As we head into the 2014 filing season we wanted to make you aware of important IRS changes that may impact your business. The IRS has laid out new rules regarding the tax treatment of amounts paid to acquire, produce, or improve tangible property. The IRS rules explain when those payments can be deducted for an immediate tax benefit, and when they must be capitalized. These rules are effective for 2014; however, additional questions have been raised so there has been ongoing guidance as to how these rules should be implemented.
Capitalization or deduction – The rules set forth the general rule that amounts paid to improve a unit of property must be capitalized. An improvement is defined as an expenditure that betters a unit of property, restores it, or adapts it to a new and different use.
On the other hand, the rules allow a current deduction for repairs and maintenance to property. Deductible repair and maintenance expenses are defined in a negative way—they are deductible if not otherwise required to be capitalized.
Unit of property – One key concept in the rules is the “unit of property” (UOP) that is being improved or repaired. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized.
For example, work on an engine of a vehicle is more likely to be classified as an expense that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.
For this reason will need a very detailed break out of asset additions by line item for IRS reporting purposes and can no longer lump assets together for purposes of reporting on the tax returns.
Tangible Property – A single UOP consists of all components that are functionally interdependent, such that one component can’t be placed in service without the other components.
Say that a business buys computer and a printer. Here, the computer is a separate unit of property from the printer as it is not interdependent on the printer to work.
Building- The new rules treat each building and its structural components as one UOP—the “building.” An improvement to the building is defined by its effect on those systems, rather than on the building as a whole.
If a taxpayer restores a building structure, such as by replacing the entire roof, the expense is treated as an improvement to the single UOP consisting of the building. If the taxpayer makes an improvement to a building system, such as the heating, ventilation, and air conditioning (HVAC) system, that expense is also an improvement to the building UOP.
Materials and supplies- A deduction is allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. Materials and supplies are defined to include specific categories of property used or consumed in the business operations.
UOPs with an economic useful life of no more than 12 months qualify as materials and supplies under this rule. Likewise, certain inexpensive items (with cost of $200 or less) will qualify as a deductible expense.
De minimis safe harbor- The rules allow a taxpayer to deduct certain limited amounts paid for tangible property that are expensed for financial accounting purposes. This de minimis safe harbor amounts (up to $5,000) are available to taxpayers that have audited financial statement (AFS). Businesses without an AFS can only use the de minimis safe harbor up to $500.
A taxpayer with an AFS may rely on the de minimis safe harbor if no more than $5,000 per invoice, or per item as substantiated by the invoice, was paid for the property. Again, for businesses without an AFS, the maximum figure is $500 rather than $5,000.
To use the safe harbor, the business must have accounting procedures in place at the beginning of the tax year that treat as an expense amounts paid for property that costs less than a specified dollar amount or has an economic useful life of 12 months or less. We can assist you in making sure that your business meets these requirements.
Routine maintenance safe harbor – Certain expenses of routine maintenance can be deducted rather than capitalized. Routine maintenance means recurring activities that keep business property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.
For a building structure or system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, the taxpayer must reasonably expect to perform the activities more than once during the property’s class life for depreciation purposes.
Per-building safe harbor for qualifying small taxpayers- The final rules add a new safe harbor that allows qualifying small taxpayers—those with average annual gross receipts of $10 million or less in the three preceding tax years—to deduct improvements made to a building property with an unadjusted basis of $1 million or less. This safe harbor applies only if the total amount paid during the tax year for repairs, maintenance, and improvements to the building doesn’t exceed the lesser of $10,000 or 2% of the building’s unadjusted basis.
This safe harbor may be elected annually on a building-by-building basis. It is elected by including a statement on the tax return for the year the costs are incurred for the building. We can help you to take advantage of this rule by filing the necessary election.
Accounting method changes – A change to conform to these rules is considered a change in accounting method, for which an IRS accounting method adjustment is required. We recommend filing tax Form 3115 to incorporate these IRS tax law changes.
Please give us a call to discuss your options as it relates to these tax law changes.
See a sample capitalization policy.