A Practical Guide to Interpreting the New Temporary Regulations on Tangible Property and its Impact on Tax Return Filing Positions
The IRS has issued new Temporary Treasury Regulations on December 23, 2011 that governs when costs are required to be capitalized or deducted as repair and maintenance costs. The new regulations replace the previously issued Proposed Treasury Regulations that were issued in March of 2008. To be clear, Proposed Treasury Regulations are binding only on the IRS and not the taxpayers. In contrast, Temporary and Final Treasury Regulations are binding on both the IRS and the taxpayers. To that end, with this latest issuance of Temporary Treasury Regulations the onus has been shifted onto taxpayers to ensure compliance as these regulations have the force and effect of law. To that end, taxpayers must now adhere to these new Temporary Treasury Regulations for taxable years beginning on and after January 1, 2012 and ascertain its impact on sustaining strong tax return filing positions (i.e., “Will”; “Should”,“More-Likely-Than-Not”,“Substantial Authority”).
As a reminder, the subsequent standards of the applicable levels of opinions should be meticulously analyzed when assessing a client’s tax return filing position:
- “Will” Standard: Generally, a 95% or greater probability of success if challenged by the IRS. A “Will” opinion generally represents the highest level of assurance that can be provided by an opinion;
- “Should” Standard: Generally, a 70% or greater probability of success if challenged by the IRS. A “Should” opinion provides a lower level of assurance than is provided by a “Will” opinion, but a higher level of assurance than is provided by a “More-Likely-Than- Not” opinion;
- “More-Likely- Than- Not” Standard: A greater than 50% probability of success if challenged by the IRS. The “More-Likely-Than-Not” standard is the highest level of accuracy required for purposes of avoiding the accuracy-related penalties under I.R.C. 6662A;
- “Substantial Authority” Standard: Typically, greater than a “Realistic Possibility of Success” standard and lower than “More-Likely-Than-Not” standard (i.e., 40% probability of success);
- “Realistic Possibility of Success” Standard: Approximately a one-in-three or greater possibility of success if challenged by the Service;
- “Reasonable Basis” Standard: Significantly higher than the “Not Frivolous” standard (i.e., that is, not deliberately improper) and lower than the “Realistic Possibility of Success” standard. The position must be reasonable based on at least one tax authority that can be cited as valid legal authority;
- “Non-Frivolous” Standard: Approximately a 10% chance of being upheld upon examination by the Service and accordingly under no circumstance should a tax professional ever render services with this level of comfort; and
- “Frivolous” Standard: Approximately a percentage less than a 10% chance of being upheld upon examination by the Service and accordingly under no circumstances should a tax professional ever render services with this level of comfort.
It should be duly noted that each of the aforementioned standards above has a relevant meaning to both the taxpayers and tax professionals when evaluating a tax position and the related disclosure requirements. Noting, the percentages listed for “More-Likely-Than-Not” and “Realistic Possibility of Success” are specifically provided for and discussed in the treasury regulations. In contrast, the percentages for “Substantial Authority”, “Reasonable Basis”, “Non-Frivolous”, “Frivolous” have been developed based upon their relative importance in the hierarchy of standards of opinion as primarily provided for in congressional committee reports. Moreover, while not intrinsically quantitatively calculable, the percentages are still practical in demonstrating the relative strength of one level as opposed to another level.
Tangible Property Scope Synopsis
The line where deductible repairs under I.R.C. § 162 ends and capitalized improvements under I.R.C. § 263 begins has always been far from patently clear and has led to much controversy between taxpayers and the IRS. The new regulations do little to clarify this matter (generally avoiding bright-line tests for facts and circumstances analysis). However, they do make some substantive changes to the location of the line—some taxpayer favorable and some government favorable.
Complying with the new regulations generally requires a change in accounting methods. Taxpayers wanting to change to an allowable method must get the IRS’s consent. On March 7, 2012, the IRS issued two companion revenue procedures detailing how taxpayers may obtain IRS automatic consent to the accounting method changes required by the rules.
Rev. Proc. 2012-19 addresses repair and maintenance, materials and supplies, and related method changes resulting from the temporary regulations. Whereas, Rev. Proc. 2012-20 addresses depreciation, disposition, and related method changes resulting from the temporary regulations.
Rev. Proc. 2012-19 separates the accounting method changes into the following categories:
- Deducting repair and maintenance costs (Temp. Regs. Sec. 1.162-4T) and changing the definition of units of property for purposes of determining whether amounts have been expended to improve a unit of property under Temp. Regs. Sec. 1.263(a)-3T(a)(3).
- Applying the regulatory accounting method for regulated taxpayers (Temp. Regs. Sec. 1.263(a)-3T(k)).
- Deducting non-incidental materials and supplies when used or consumed (Temp. Regs. Secs. 1.162-3T(a)(1) and (c)(1)).
- Deducting incidental materials and supplies when paid or incurred (Temp. Regs. Secs. 1.162-3T(a)(2) and (c)(1)).
- Deducting non-incidental rotable and temporary spare parts when disposed of (Temp. Regs. Sec. 1.162-3T(a)(3)).
- Deducting rotable and temporary spare parts under the optional method (Temp. Regs. Sec. 1.162-3T(e)).
- Deducting dealer expenses that facilitate the sale of property (Temp. Regs. Sec. 1.263(a)-1T(d)(1)).
- Deducting de minimis amounts (Temp. Regs. Sec. 1.263(a)-2T(g) and Temp. Regs. Sec. 1.263(a)-1T(b)(14)).
- Deducting certain costs for investigating and pursuing the acquisition of real property (Temp. Regs. Sec. 1.263(a)-2T(f)(2)).
- Deducting amounts paid for routine maintenance on property other than buildings (Temp. Regs. Sec. 1.263(a)-3T(g)).
- Capitalizing costs to facilitate the sale of property by non-dealers (Temp. Regs. Sec. 1.263(a)-1T(d)(1)).
- Capitalizing acquisition or production costs (Temp. Regs. Secs. 1.263(a)-2T(e) and (f)).
- Capitalizing improvements to tangible property (Temp. Regs. Sec. 1.263(a)-1T and Temp. Regs. Sec. 1.263(a)-3T).
Rev. Proc. 2012-20 establishes new automatic accounting method changes for:
- Depreciation of leasehold improvements;
- Changing from a permissible to another permissible method of accounting for depreciation of MACRS property;
- Disposition of a building or structural component;
- Dispositions of tangible depreciable assets (other than a building or its structural components);
- Dispositions of tangible depreciable assets in a general asset account; and
- General asset account elections.
Each of the above accounting method changes has separate detailed rules for implementing it. The changes share the requirement that the Form 3115, Application for Change in Accounting Method, be sent to the Ogden, Utah, office instead of the national office and the requirement to use a single form when making a concurrent automatic change. These aforementioned revenue procedures are effective for tax years beginning on or after Jan. 1, 2012.
Deductible Expenses under the New Temporary Regulations
Materials and Supplies
The new regulations indicate that incidental materials and supplies may be deducted when purchased as long as no record of consumption is kept and expensing such items does not distort income. Non-incidental materials and supplies, however, are not expensed until they are used or consumed.
Items considered materials and supplies are:
- Components acquired to maintain or repair property
- Fuel, lubricants, water, and similar items
- Property with an economically useful life of 12 months or less
- Property with an acquisition or production cost of $100 or less
- Other property identified by the IRS
De Minimis Rule
The de minimis rule provides another deduction opportunity on amounts paid to acquire or produce tangible property. To be eligible, however, a taxpayer must: have an Applicable Financial Statement (AFS—which is generally an audited financial statement); have a written accounting policy for deducting property costing less than a certain dollar amount for non-tax purposes; and follow its written accounting policy.
The total amount of such expensed items cannot exceed the greater of:
- 0.1 percent of the taxpayer’s gross receipts for the tax year as determined for federal income tax purposes; or
- 2 percent of the taxpayer’s total depreciation and amortization expense for such year as determined in its AFS.
As a caveat, many small to middle market privately held companies will not be able to take advantage of the de minimis rule because they don’t have an AFS.
The general rule is that a taxpayer may deduct amounts paid for repairs and maintenance to tangible property as long as the amounts are not otherwise required to be capitalized. Although the general rule is not very helpful, the regulations do, however, allow a safe harbor deduction for routine maintenance.
Routine Maintenance Safe Harbor
Routine maintenance is the recurring activities that keep a unit of property in its ordinary operating condition. This includes the inspection, cleaning, testing, and replacing of parts. Activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the class life of the property. The routine maintenance safe harbor applies to all property other than buildings.
Expenditures Required to be Capitalized
Amounts paid for tangible property that needs to be capitalized fall into two general buckets: amounts paid to acquire or produce tangible property, and amounts paid to improve it.
- Taxpayers must generally capitalize amounts paid to acquire or produce a unit of real or personal property, including leasehold improvement property. This includes the invoice price, transaction costs, and costs for work performed prior to the date the property is placed in service by the taxpayer.
- A taxpayer must capitalize amounts paid to improve property. Property is improved if the amounts paid result in betterment to the property, restore the property, or adapt the property to a new or different use.
A betterment is an amount paid to correct a material condition or defect of the property, which results in either:
- A material addition to the property (physical enlargement, expansion, or extension), or
- A material increase in capacity, productivity, efficiency, strength, or quality of the property or the output of the property.
An amount is paid to restore property if:
- It is for the replacement of a component of the property and the taxpayer recognized gain or loss on the sale or exchange of the component or deducted a loss for the component;
- The taxpayer returns the property to its ordinary efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional;
- It results in the rebuilding of the property to a like-new condition after the end of its class life; or
- It replaces a part or a combination of parts that comprise a major component or substantial structural part of the unit of property.
An amount is paid to adapt property to a new or different use if the adaptation is not consistent with the taxpayer’s intended ordinary use of the property at the time the property was originally placed in service by the taxpayer.
The IRS included 19 examples in the regulations to illustrate what is and what is not a betterment, and 26 examples to illustrate what is and what is not a restoration. The number of examples demonstrates the difficulty of determining the fine line between a deductible expense and a capitalized item.
Unit of Property
Determining the relevant unit of property also plays a large role in shaping whether an amount paid is properly deducted as a repair—or must be capitalized as an improvement to the property.
It should be duly noted that the larger the unit of property, the more likely the amount paid will be considered a deductible repair.
For real and personal property (except buildings), a unit of property is comprised of all components that are functionally interdependent (i.e., the placing in service of one component is dependent on the placing in service of the other component.)
A new twist in the new regulations is the unit of property determination for buildings. A building and its structural components are a single unit of property. For application of the improvement rules, however, “building systems” constitute separate units of property from the building structure. Consequently, for purposes of the improvement analysis the units of a building property are:
- The building structure (exterior walls, roof, windows, doors, etc.)
- The building systems (HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm systems, security systems, gas distribution systems, and other structural components identified as building systems by the IRS
This componentizing of a building into several units of property is a significant change from the prior proposed regulations. Accordingly, taxpayers that deducted repairs in prior years relating to any of these building systems will need to determine whether such treatment is still appropriate. If not, it may be necessary to request a change in accounting method.
On March 7, 2012, the IRS released administrative guidance in the forms of Revenue Procedure 2012-19 and Revenue Procedure 2012-20, which in essence provide transition rules relating to the temporary regulations regarding deduction and capitalization of expenditures in connection to tangible property issued on December 23, 2011. The temporary regulations are effective for tax years beginning on or after January 1, 2012, and affect alltaxpayers that acquire, produce, or improve tangible property. The transition rules address repair and maintenance, materials and supplies, depreciation, disposition, and related tax accounting method changes. The guidance also provides the procedures by which taxpayers may obtain the automatic consent of the Commissioner of Internal Revenue to change to the methods of accounting for tax years beginning on or after January 1, 2012.
The revised procedures shift the frame of reference for determining whether a repair is expensed or capitalized from the entire building to structural components of the building. It is now likely that certain repairs that were previously treated as expenses will now be required to be capitalized. However, owners now have the opportunity to write-off the under appreciated portion of the building components replaced or the tenant improvements removed during the retrofitting.
About the Author
Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is also a highly distinguished member of both the Board of Directors and Board of Editors for The American Society of Tax Professionals and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an Operating Division of ASTP.
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