IRS CODE SECTION 263 FINAL REPAIR/CAPITALIZATION REGULATIONS

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1 IRS CODE SECTION 263 FINAL REPAIR/CAPITALIZATION REGULATIONS Presenting the Top 10 Things You Must Know PRESENTED BY: JOHN MARTELLINI, CPA, MST LGC&D, LLP

2 These seminar materials are intended to provide the seminar participants with guidance in tangible asset regulation matters. The materials do not constitute, and should not be treated as professional advice regarding the use of any particular tangible asset treatment or the consequences associated with any technique. Every effort has been made to assure the accuracy of these materials. LGC&D, LLP and the author do not assume responsibility for any individual's reliance upon the written or oral information provided during the seminar. Seminar participants should independently verify all statements made before applying them to a particular fact situation, and should independently determine the impact of any particular tax planning technique before recommending the technique to a client or implementing it on the client's behalf. 2

3 Compliance Annual Election Statements Form 3115 s Capitalization Policy Systems to Capture Necessary Information Opportunities De Minimis Rule Routine Maintenance Dispositions BAR Tests Small Taxpayer Exception 3

4 IRS issued proposed & temporary regulations 12/ pages long and 155 examples. Eight years in the making. Effective 1/1/12. Final regulations issued 9/13/13. Effective 1/1/14 or can be applied to 1/1/12 if certain conditions are met. Revised rules and updated examples 4

5 Per IRS repair = deduct; renovation = capitalize; betterment = capitalize; adaptation = capitalize. Need to focus on items acquired, not total invoice amount. Different methodology. 5

6 New expensing provisions helps to replace reduced depreciation benefits. Bonus was 100% in Bonus now at 50% for 2012 and No bonus expected for Section 179 was $500k in Section 179 reduced to $25k for

7 General rule = capitalize Commissions, transaction costs, loan costs, legal, transportation, title costs, appraisals, inspections. Costs incurred before property in service = capitalize. Employee compensation and overhead costs generally are not treated as amounts that facilitate the acquisition of property = expense. 7

8 Lease term is not the appropriate life. Lessee spends separate unit of property. Lessor spends not separate unit of property. Exception for short leases of one year and normal replacement. Refreshing painting and carpeting = expense 8

9 # 10 Compliance Reporting Unfortunately the IRS has not issued final instructions on filing form 3115 change in accounting method. Should be issued before year end? Change in method of accounting. De minimis elections. 9

10 # 9 Prior Period Adjustments Potential to correct prior year data for incorrect depreciation lives or items that should have been expensed. Caution also need to review for items that were previously expensed that should have been capitalized. 10

11 # 8 BAR Tests BAR tests regarding Betterments Adaptations Restorations 11

12 Betterment = capitalize. Adaptation = capitalize. Restore exhausted property = capitalize. 12

13 Improvement Restoration Betterment Adaptation Betterment Ameliorates a material condition or defect at acquisition or production Material addition or expansion Reasonably expected to materially increase the productivity, efficiency, strength, quality, or output Restoration Adaptation New or different use if the adaptation is inconsistent with the taxpayer s intended, ordinary use of the UOP at the time it was originally placed in service Return to former operating condition no longer functioning Rebuild the property to like-new condition after class life Replacement of a major component/substantial 13 structural part

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17 #7 Small Taxpayer Exception A qualifying taxpayer (less than $10m of gross receipts) may elect to expense expenditures related to an eligible building (unadjusted basis of $1m or less) if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the eligible building property does not exceed the lesser of: 2 percent of the unadjusted basis of the eligible building property; or $10,000 17

18 #6 Industry Exceptions Class life not always applicable. Economic useful life as applicable to taxpayer can be used. Recurring activities that a taxpayer expects to perform as a result of the taxpayer s use of the asset to keep it in ordinarily efficient operating condition. 18

19 Example rental real estate replacement of small appliances and carpeting. Period of lease < one year = expense. Needs to be consistent with f/s. 19

20 The aircraft is the unit of property. Therefore routine engine work = expense. Rotables and spares. Engine swap to avoid downtime for repairs = capitalize is general rule. 20

21 Can expense maintenance if expected to be done more than once over the assets useful life. Plane engine overhauls. Functionally interdependent equipment is one unit of property. Not the whole assembly line or laundry facility. Depends on each taxpayer s facts and circumstances. Separate unit of property aircraft, locomotive, computer, printer, semi-truck. 21

22 Recurring activities that a taxpayer expects to perform as a result of the taxpayer s use of the building to keep the building structure or system in its ordinarily efficient operating condition. The taxpayer must reasonably expect to perform the activities more than once during a 10year period beginning at the time the building structure or building system is placed in service.

23 Among the factors to be considered in determining whether a taxpayer is performing routine maintenance are the recurring nature of the activity; industry practice; manufacturers' recommendations; and the taxpayer's experience. 23

24 #5 Dispositions Taxpayers may take a loss on the disposition of a structural component of a building or a portion of a structural component of a building. Loss must be recognized in the tax year of the disposition. 24

25 This PARTIAL DISPOSITION RULE is designed to minimize situations where multiple versions of the same asset (e.g., building structural component) are on the books and being depreciated simultaneously. Election is made by the due date (including extensions) of the original return for the tax year of the disposition. Election is made by reporting the gain or loss on the timely filed original return for the year of the disposition. 25

26 The taxpayer may use any reasonable method for purposes of determining the unadjusted depreciable basis of the disposed portion of the asset. Examples of a reasonable method include, but are not limited to: A pro rata allocation of the unadjusted depreciable basis of the asset based on the replacement cost of the disposed portion of the asset and the replacement cost of the asset, and A study allocating the cost of the asset to its individual components. 26

27 #4 Unit of Property Building is not the unit of property. Generally can expense if expenditure does not exceed 30-40% of the building component or particular item, example windows. 27

28 Each component (or group of components) that performs a discrete and major function or operation within the machinery or equipment. 28

29 Fire Protection & Alarms Electrical Systems 29

30 Building & Structural Components: A unit of property (UOP) for a building is comprised of the building and its structural components. However, taxpayers must apply improvement standards separately to the building structure and to each specifically defined building system. 30

31 Routine maintenance = expense. Inspection, cleaning, testing, replacement of small parts = expense. Scheduled maintenance = expense unless also provides a betterment. If in disrepair, need to capitalize costs. Routine maintenance related to prior owner s use = capitalize - assumed that purchase price was lower due to work needing to be done. 31

32 Facts and circumstances. Improved but comparable part ok to expense. If betterment capitalize. Routine maintenance and refreshing expense. Remodel costs capitalize. Identical replacement not available, ok to expense if not betterment. 32

33 Performs a discrete and critical function: Roof Furnaces Chillers Roof Mounted HVAC units Sprinkler system Building wiring Toilets or Sinks Windows Floors 33

34 Constitutes a major component capitalize: Whole roof; All chiller units; Whole sprinkler system; Whole building wiring; All toilets or sinks; 200 of 300 windows; and 40% of floors 34

35 Does not constitute major components - expense: Rubber roof membrane; 1 of 3 furnaces; 3 of 10 roof mounted HVAC units; 30% of building wiring; 8 of 20 (40%) sinks; 100 of 300 windows; 10% of floors; 1 of 4 elevators; 35

36 #3 De Minimis Rules - Capitalization Policy If no accounting policy, general rule is any item over $200 must be capitalized if expected to last more than one year. If accounting policy and no audited financial statements, any item up to $500 can be expensed. If accounting policy and audited financial statements, any item up to $5,000 can be expensed. 36

37 Allows taxpayer to substitute its threshold for capitalization for a specified dollar amount. Generally deducted in the taxable year the amount is paid or incurred. Exception to the normal placed in service rule. 37

38 Planning opportunity. A taxpayer electing to apply the de minimis safe harbor is not required to include in the cost of the tangible property the additional costs of acquiring or producing such property (for example, delivery fees, installation services, or similar costs) if these costs are not included in the same invoice as the tangible property. 38

39 TEMP. REGULATIONS Less than $100 = expense. Useful life < year = expense. Materials and supplies = expense if used in one year. Written capitalization policy, consistent with f/s. What is considered reasonable for expensing? $100?, $500, $1,000? FINAL REGULATIONS Less than $200 = expense. Useful life < year = exp. Materials and supplies = expense if used in one year. Written capitalization policy, consistent with f/s. Can change 1/1 of each tax year. If no audited f/s, can expense up to $500 / item. If audited f/s, can expense up to $5,000 / item. Need to attach election to tax return each year.

40 TEMP. REGULATIONS Limited to greater of.1% gross receipts or 2% of f/s depreciation and amortization. If over these limits can elect to capitalize the excess. Additional work to maintain records. When was policy established? If not 1/1/12, not eligible for FINAL REGULATIONS All limits removed. Very taxpayer friendly, especially for businesses with low gross receipts like real estate entities. Need capitalization policy in effect on the first day of the tax year. Additional work to maintain records. When was policy established? If not 1/1/13, not eligible for 2013.

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42 #2 Consistency with F/S Capitalization policy needs to be consistent with financial statement presentation. Beware of effect of policy on loan covenants etc. 42

43 An applicable financial statement includes: a financial statement required to be filed with the SEC; a certified audited financial statement that is accompanied by the report of an independent certified public accountant; or a financial statement (other than a tax return) required to be provided to the federal or state government or any federal or state agency (other than the IRS). 43

44 #1 Time is of the Essence! Need to have accounting policy in place on January 1st of the tax year. Need written and dated policy. Accounting policy needs to be attached to tax return each year. 44

45 A taxpayer makes the election by attaching a statement to the taxpayer s timely filed original Federal tax return (including extensions) for the taxable year in which these amounts are paid. The statement must be titled Section 1.263(a)1(f) de minimis safe harbor election and include the taxpayer's name, address, identification number, and a statement that the taxpayer is making the de minimis safe harbor election under 1.263(a)-1(f). The safe harbor must be applied to all amounts expensed under the book policy including materials and supplies. 45

46 The written accounting procedures provided for the group and utilized for the group's audited financial statements may be treated as the written accounting procedures of each of the taxpayers. 46

47 In the case of a consolidated group filing a consolidated income tax return, the election is made for each member of the consolidated group by the common parent, and the statement must also include the names and taxpayer identification numbers of each member for which the election is made. In the case of an S corporation or a partnership, the election is made by the S corporation or the partnership and not by the shareholders or partners. 47

48 We are here to assist you! Capitalization policy. Assistance with Invoices. Providing specific examples from the Regulations. Assets that are repairs and do not have to be capitalized. Assets that have an incorrect recovery period assigned. 48

49 Items that have been capitalized that could create a disposition deduction. Items expensed in prior years that should have been capitalized. Form 3115 Review. 49

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