Over the last several years, the IRS has published a series of regulations and rulings that dramatically change how taxpayers must account for the costs of acquiring, repairing, improving and even disposing of tangible property. These new rules represent some of the most significant changes in tax law since the Tax Reform Act of 1986 and they must be adopted no later than the tax year beginning on or after January 1, 2014. While these rules are intended to minimize confusion in determining which expenditures related to tangible property are allowable as immediate deductions and which expenditures must be capitalized and depreciated, there are still many complicated considerations in their application. Furthermore, because most of these new standards are being implemented as changes in accounting methods, the mandatory adoption requires the analysis of expenditures made in prior years, possibly extending 30 or more years into the past. Business owners who have not already begun this process should seek the advice of their CPA or tax advisors immediately in order to have time to properly plan for the implementation of the new rules.
How are the new rules adopted?
All businesses purchase tangible property. Tangible property includes materials, supplies, machinery, equipment, furniture, leasehold improvements and real property. Every business will need to change their accounting methods in order to reflect the final tangible property regulations. Unfortunately, this change, in most instances, cannot be applied simply by changing the way new expenditures are expensed or capitalized. In order to make a change in accounting method, the impact of the new rules on prior years must be determined and the resulting income or deduction must be included in taxable income in the year the accounting method is changed.
For example, suppose that a business made repairs in 2005 to the roof of a building that they own. At the time, the business determined that the cost of these repairs should be capitalized and depreciated over 39 years. Under the new rules, because the scope of the repairs was not a restoration, a betterment, an improvement, or an adaptation to a new use of the property, the costs are deductible in the year incurred. As such, the business is entitled to deduct the remaining undepreciated cost of the roof repairs in the current year as part of the change in accounting method.
Unfortunately, not all changes will result in deductions. Where a business expensed costs in prior years, under the new rules they must be capitalized and depreciated. The difference between the prior expense and the depreciation allowable up to the date of the adoption of the new regulation must be taken into income. Fortunately, the IRS allows income recognized from a change in accounting method to be spread over four taxable years.
While it may be tempting to continue business as usual and not make the required changes in accounting method to adopt the final tangible property regulations, this decision could be very detrimental. Failure to properly implement the new rules and calculate the impact of the change in accounting method may result in the loss of current and future tax depreciation or the potential write-off of previously capitalized expenses.
Reconsider the example of the roof repair previously capitalized, which is a deductible expense under the new regulations. If the business in this situation does not make the change in accounting method and claim the deduction it is entitled to, it may forfeit future depreciation deductions. If the business is audited by the IRS in a year past the statute of limitation for the year of the expenditure (generally three years), the IRS could disallow the depreciation deductions for the year under exam, all future years, and all years not closed by the statute of limitations. Because the original expenditure was made in a year beyond the statute of limitations for amending the return, a properly filed change of accounting method is the only way to claim the additional deduction for the undepreciated cost of the repairs. While many tax practitioners have become accustomed to almost benign neglect from the IRS with respect to the examination of fixed assets and depreciation in recent years, the IRS has clearly indicated that with the advent of the final tangible property regulations they plan to make these areas a significant part of examinations.
Making a change in accounting method requires that a taxpayer request permission from the IRS to make the change. This request is made by filing Form 3115. In some instances, permission must be received from the IRS before the change in accounting method can be adopted. Luckily, the IRS has provided automatic consent for the implementation of the new tangible property regulations. However, taxpayers must still file Form 3115 for each accounting method change and each activity. Most businesses will be required to file multiple 3115’s in the year they adopt the new regulations. For example, if a business owns three different rental properties reported as separate activities, a separate 3115 must be filed for each change of accounting method for each of the separate rental property activities.
Performing the analysis to determine the impact of a change in accounting method and accumulating the necessary support and documentation is a time consuming process. Due to the complications of the new regulations, a qualified CPA or tax professional should be engaged to assist the business with the process of implementation. Even with outside professional assistance, businesses should anticipate that a significant investment of internal time and resources will still be required to complete the project.
So what’s the good news?
Despite the burden that implementing the new tangible property regulations places on businesses, they also present some potential tax saving opportunities.
- De Minimis Safe Harbor Election – It is common practice for most businesses to expense items that fall under a certain cost threshold. Until now, there was no support for this practice under the tax law. The final tangible property regulations now provide a “de minimis safe harbor election” which allows taxpayers to follow this capitalization policy for tax as well as “book” accounting. Any taxpayer that prepares a “qualified audited financial statement” can deduct expenses for tax as well as book up to a limit of $5,000 per item or invoice, provided that they have a written capitalization policy in place to that effect as of the first day of the fiscal year. Taxpayers without an audited financial statement can elect to deduct expenditures up to $500 per item or invoice. In order to take advantage of the $5,000/$500 safe harbor, the taxpayer must apply the same policy for both tax and book purposes and file an annual election with their tax return. In addition to these safe harbor amounts, the regulations also address taxpayers utilizing a capitalization policy that deducts expenditures greater than the safe harbor amounts. The regulations indicate that such policies will be allowable provided they do not materially misstate income. The caveat for this expanded deduction is that upon examination, the burden lies with the taxpayer to prove to an examining agent that the deductions are not excessive.
- Partial Asset Disposition Election – In the past, when a taxpayer replaced a significant component of an asset such as a roof, an HVAC unit, or the flooring in a building, they added the cost of the replacement as a new depreciable asset and began claiming depreciation deductions. The cost of the component that was replaced remained as part of the capitalized cost of the asset and continued to be depreciated over the remaining useful life of the asset. The final tangible property regulations provide that when a taxpayer capitalizes the cost for the replacement of a component of an asset, they can elect to write-off the remaining undepreciated cost of the replaced property. If the taxpayer cannot specifically identify the cost of the replaced component, the regulations go on to provide the taxpayer may utilize a reasonable method to allocate cost, such as rollback of the cost of the replacement using the Producer Price Index for the year the original asset was placed in service. The IRS allows taxpayers to make late partial asset disposition to claim deductions for components replaced in prior taxable years. However, the window for late partial asset disposition elections closes with the filing of the tax return for tax years beginning on or after January 1, 2014.
- Routine Maintenance Safe Harbor – In the past, many taxpayers capitalized the cost of routine maintenance activities because of the size of the expenditure. Under the final tangible property regulations, taxpayers may adopt a routine maintenance safe harbor. The cost of cleaning, testing, inspecting and replacing worn components can be expensed provided the activities are expected to be performed more than once during the asset’s depreciable class life, or within 10 years for buildings and their systems. Taxpayers can write-off the remaining undepreciated cost of routine maintenance capitalized in prior years as part of their change in accounting method.
The final tangible property regulations represent a seed change in the tax law that has far-reaching impact. Every business owner needs to be aware of this change and work with competent professional advisors to determine the impact of the new rules. The implementation process will be time-consuming and possibly involve additional costs, but with effective planning, may yield substantial tax saving opportunities. Whatever the impact of the new rules may be, good or bad, they must be properly addressed by all taxpayers before a tax return is filed for tax year 2014.