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An In-Depth Look: IRS Releases Detailed FAQs Explaining Repair Regulations.

(Parker Tax Publishing March 14, 2015)

Last week, the IRS released a clear and detailed FAQ explaining key aspects of the new tangible property regulations (a.k.a., the "repair regulations"). IRS FAQ - Tangible Property Regulations (3/5/15).

Although the IRS's question-and-answer style guidance covers quite a bit of ground, most falls into four categories:

1. De minimis safe harbor election

2. Rules for the treatment of materials and supplies costs

3. Distinguishing capital improvements from deductible repairs

4. When and how to apply the new regulations

The following are lightly paraphrased excerpts from the IRS FAQ. As is typical for IRS guidance of this type, the FAQ omits citations to the regulations. As a convenience to tax practitioners who wish to dig deeper into the rules, we've provided cites as well as practice aids. For completeness, we've included Parker observations and cautionary warnings where appropriate.

1. De Minimis Safe Harbor Election

Under the final tangible property regulations, taxpayers may elect to apply a de minimis safe harbor to amounts paid to acquire or produce tangible property to the extent such amounts are deducted for financial accounting purposes or in keeping books and records. If a taxpayer has an applicable financial statement (AFS), he or she may use this safe harbor to deduct amounts paid for tangible property up to $5,000 per invoice or item. If a taxpayer does not have an AFS, he or she may use the safe harbor to deduct amounts up to $500 per invoice or item.

Parker Observation: Under the prior regulations, there was no de minimis safe harbor exception to capitalization; taxpayers were required to determine whether each expenditure for tangible property, regardless of amount, was required to be capitalized.

These limitations are for purposes of determining whether particular expenses qualify under the safe harbor; they aren't intended as a ceiling on the amount a taxpayer can deduct as business expenses.

The de minimis safe harbor election eliminates the burden of determining whether every small-dollar expenditure for the acquisition or production of property is properly deductible or capitalizable. If a taxpayer elects to use the de minimis safe harbor, he or she doesn't have to capitalize the cost of qualifying de minimis acquisitions or improvements. However, de minimis amounts paid for tangible property may be subject to capitalization under Code Section 263A, if the amounts include the direct or allocable indirect costs of other property produced or acquired for resale. For example, taxpayers must capitalize all the direct and allocable indirect costs of constructing a new building.

Parker Caution: The de minimis safe harbor does not apply to: (1) amounts paid for property that is or is intended to be included in inventory property; (2) amounts paid for land; (3) amounts paid for rotable, temporary, and standby emergency spare parts that the taxpayer elects to capitalize and depreciate under Reg. Sec. 1.162-3(d); and (4) amounts paid for rotable and temporary spare parts that the taxpayer accounts for under the optional method of accounting for rotable parts pursuant to Reg. Sec. 1.162-3(e).

[Reg. Sec. 1.263(a)-1(f)]

If a taxpayer elects to use the de minimis safe harbor, do they have to capitalize all expenses that exceed the $500 or $5,000 limitations?

No. Amounts paid for the acquisition or production of tangible property that exceed the safe harbor limitations aren't subject to the de minimis safe harbor election. Such amounts are treated under the normal rules that apply. For example, amounts paid for repairs or maintenance are currently deductible (assuming other applicable requirements are met), even if the amounts exceed the $500 or $5,000 limitations.

Are there financial statements other than those required to be filed with the SEC that qualify as an AFS, permitting a taxpayer to apply the $5,000 de minimis limitation?

An AFS includes a financial statement required to be filed with the SEC, as well as other types of certified audited financial statements accompanied by a CPA report, including a financial statement provided for a loan, reporting to shareholders, or for other non-tax purposes. An AFS also includes a financial statement required to be provided to a federal or state government or agency other than the IRS or the SEC. [Reg. Sec. 1.263(a)-1(f)(1)(i)]

What are the requirements for taxpayers without an AFS?

If a taxpayer does not have an AFS, he or she is not required to have written accounting procedures; however, he or she must expense amounts on his or her books and records for the year in accordance with a consistent accounting procedure or policy existing at the beginning of the year to qualify for the de minimis safe harbor election.

If a taxpayer does not have an AFS, but has a policy for his or her books and records of deducting amounts more than $500, the taxpayer may properly deduct these amounts for federal tax purposes, as long as he or she can show that the reporting policy clearly reflects income.

In these situations, taxpayers may want to elect the de minimis safe harbor for items costing $500 or less to assure that the deduction of the items costing $500 or less will not be questioned by the IRS.

How do taxpayers elect to use the de minimis safe harbor?

Taxpayers should attach a statement titled "Section 1.263(a)-1(f) de minimis safe harbor election" to the timely filed original federal tax return including extensions for the year in which the de minimis amounts are paid. The statement should include the name, address, and Taxpayer Identification Number of the taxpayer, as well as a statement that the taxpayer is making the de minimis safe harbor election. Under the election, taxpayers must apply the de minimis safe harbor to all expenditures meeting the criteria for the election in that year. [Reg. Sec. 1.263(a)-1(f)(5)]

Parker Practice Aid: See Parker's sample de minimis safe harbor election statement.

An annual election is not a change in method of accounting. Therefore, taxpayers should not file Form 3115, Application for Change in Method of Accounting, to use the de minimis safe harbor for a particular tax year, and should not file a Form 3115 to change the amount deducted under the taxpayer's book policy. Similarly, taxpayers should not file a Form 3115 to stop applying the de minimis safe harbor for a subsequent tax year.

How does the de minimis safe harbor affect the deductions typically taken for materials and supplies or repairs and maintenance?

In general, when a taxpayer elects the de minimis safe harbor, materials and supplies that also qualify under the de minimis safe harbor are treated as de minimis costs and are not treated as materials and supplies. However, the de minimis safe harbor doesn't change a taxpayer's ability to deduct costs for materials and supplies, incidental or nonincidental, that don't qualify under the de minimis safe harbor.

Similarly, the de minimis safe harbor doesn't change a taxpayer's ability to deduct repair and maintenance costs that don't qualify under the de minimis safe harbor, e.g., costs that exceed the safe harbor threshold. Therefore, for costs that don't qualify under the de minimis safe harbor, taxpayers apply the general rules for identifying and deducting repair and maintenance costs, incidental supplies, and nonincidental materials and supplies.

[Reg. Sec. 1.263(a)-1(f)(3)(iv)]

2. Rules for Treatment of Materials and Supplies Costs

What is included in the definition of materials and supplies?

Materials and supplies are tangible, non-inventory property used and consumed in a taxpayer's operations including:

Acquired components - Costs of components acquired to maintain, repair, or improve tangible property owned, leased, or serviced by the taxpayer and that's not acquired as part of a larger item of tangible property;

Consumables - Costs of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in operations;

12 month property - Costs of tangible property that has an economic useful life of 12 months or less, beginning when the property is used or consumed;

$200 property - Costs of tangible property that has an acquisition cost or production cost of $200 or less.

The property need only fit into one of the above categories to qualify as a material or supply.

[Reg. Sec. 1.162-3(c)(1)]

When can a taxpayer deduct the costs of materials and supplies?

As under prior rules, taxpayers may deduct the costs of incidental and nonincidental materials and supplies in the following manner:

Incidental materials and supplies - If the materials and supplies are incidental, i.e., of minor or secondary importance, carried on hand without keeping a record of consumption, and no beginning and ending inventories are recorded (e.g., pens, paper, staplers, toner, trash baskets) then taxpayers deduct the materials and supplies costs in the year in which the amounts are paid or incurred, provided taxable income is clearly reflected.

Nonincidental materials and supplies - If the materials and supplies are not incidental, then taxpayers deduct the materials and supplies costs in the year in which the materials and supplies are first used or consumed. For example, a taxpayer could deduct certain expendable spare parts in a trucking business for which records of consumption are kept and inventories are recorded in the year the part is removed from storage and installed in one of the trucks. However, an otherwise deductible material or supply cost could be subject to capitalization under Code Sec. 263(a) if the material or supply is used to improve property, or under Code Sec. 263A if the material or supply is incorporated into property produced or acquired for resale.

Application with de minimis safe harbor - If a taxpayer elects to use the de minimis safe harbor and any materials and supplies also qualify for the safe harbor, taxpayers must deduct amounts paid for these materials or supplies under the safe harbor in the year the amounts are paid or incurred. Such amounts are not treated as amounts paid for materials and supplies and may be deducted as business expenses in the year they are paid or incurred.

[Reg. Secs. 1.162-3(a)]

What must taxpayers do to apply the final regulations to materials and supplies?

Because the final regulations governing the treatment of materials and supplies are based primarily on prior law, taxpayers previously in compliance with the rules generally will still be in compliance and generally no action will be required to continue to apply these rules on a prospective basis.

3. Distinguishing Capital Improvements from Deductible Repairs

Have the final regulations changed the rules for determining whether an expenditure is a deductible repair or a capital improvement?

The final regulations synthesize existing case law and prior administrative rules into a framework to help taxpayers determine whether a cost is deductible as a repair and maintenance expense or must be capitalized because it's an improvement. If the amounts are not paid or incurred for an improvement to tangible property as determined under the final regulations, then the amounts generally are deductible as repairs and maintenance.

Whether a cost is for repair or an improvement will always require reviewing facts and circumstances, as required under prior rules. This facts and circumstances analysis is described in more detail below. The final regulations do not eliminate the requirements of Code Sec. 263(a), which generally provides that taxpayers must capitalize the direct and allocable indirect costs of producing real or tangible personal property and acquiring property for resale.

In addition, the final regulations provide several simplifying safe harbors and elections to ease compliance with these rules.

[T.D. 9636]

Two-Step Facts and Circumstances Analysis for Distinguishing Capital Improvements from Deductible Repairs

Step 1 - What is the unit of property?

For buildings, the unit of property is generally the entire building including its structural components. However, under the final regulations and for these purposes only, the improvement analysis applies to the building structure and each of the key building systems. The key building systems are the plumbing system, electrical system, HVAC system, elevator system, escalator system, fire protection and alarm system, gas distribution system, and the security system. Lessees of portions of buildings apply the analysis to the portion of the building structure and portion of each building system subject to the lease. Lessors of an entire building apply the improvement rules to the entire building structure and each of the key building systems.

For non-buildings, the unit of property is, and the analysis applies to, all components that are functionally interdependent. Components of property are functionally interdependent if taxpayers cannot place in service one component of property without placing in service another component of property.

For plant property (e.g. a manufacturing plant, generation plant, etc.), the unit of property is, and the analysis applies to, each component or group of components within the plant that performs a discrete and major function or operation.

For network assets (e.g., railroad track, oil and gas pipelines, etc.), the particular facts and circumstances or industry guidance from the IRS determines the unit of property and the application of the improvement analysis.

Step 2 - Is there an improvement to the unit of property identified in Step 1?

A unit of tangible property is improved only if the amounts paid are:

(1) For a betterment to the unit of property; or

(2) To restore the unit of property; or

(3) To adapt the unit of property to a new or different use.

What is a betterment?

Betterments include:

- Amounts paid to fix a material condition or material defect that existed before the acquisition or arose during production of the unit of property; or

- Amounts paid for a material addition, including a physical enlargement, expansion, extension, or addition of a major component, to the property or a material increase in capacity, including additional cubic or linear space, of the unit of property; or

- Amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property where applicable.

Parker Observation: In recognition of the fact that taxpayers may apply different standards for capitalizing amounts on their applicable financial statements and such standards may not be controlling for whether the activities are betterments for federal tax purposes, the final regulations do not include the taxpayer's treatment of the expenditure on its financial statement as a factor to be considered in performing a betterment analysis.

[Reg. Sec. 1.263(a)-3(j)]

What are amounts to restore a unit of property?

Restorations include:

Replacement of a major component or substantial structural part - Amounts paid for the replacement of a part or combination of parts that make up a major component or a substantial structural part of the unit of property; or

Recognition of gains or losses and basis adjustments - Taxpayer has taken into account or adjusted the basis of the unit of property or component of the unit of property, including: (a) deducted loss; (b) sale or exchange; or (c) casualty loss or event

Deterioration to state of disrepair - Amount paid to return the unit of property to its ordinarily efficient operating condition, if the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use; or

Rebuilding to like-new condition - Amounts paid for the rebuilding of the unit of property to a like-new condition after the end of its class life.

Parker Observation: A taxpayer does not have to treat as a restoration amounts paid under restoration standard (1) or (2) above if the unit of property has been fully depreciated and the loss is attributable only to remaining salvage value as computed for federal income tax purposes.

[Reg. Sec. 1.263(a)-3(k)]

What adapts a unit of property to a new or different use?

In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.

[Reg. Sec. 1.263(a)-3(l)]

Alternatives to Facts and Circumstances Analysis: Elections and Safe Harbors

Simplifying alternatives to the facts and circumstances analysis include:

(1) Safe Harbor Election for Small Taxpayers;

(2) Safe Harbor for Routine Maintenance; and

(3) Election to Capitalize Repair and Maintenance Costs.

Safe Harbor Election for Small Taxpayers

Taxpayers are not required to capitalize as an improvement, and therefore may deduct, the costs of work performed on owned or leased buildings, e.g., repairs, maintenance, improvements or similar costs, that fall into the safe harbor election for small taxpayers. The requirements of the safe harbor election for small taxpayers are:

(1) Average annual gross receipts less than $10 million; and

(2) Owns or leases building property with an unadjusted basis of less than $1 million; and

(3) The total amount paid during the year for repairs, maintenance, improvements, or similar activities performed on such building property doesn't exceed the lesser of: (a) two percent of the unadjusted basis of the eligible building property; or (b) $10,000.

Taxpayers make the election to use the safe harbor for each year in which qualifying amounts are incurred. The election is made by attaching a statement to the taxpayer's income tax return for the year.

Practice Aid: See Parker's sample small taxpayer safe harbor election statement.

An annual election is not a change in method of accounting. Therefore, taxpayers shouldn't file Form 3115, Application for Change in Method of Accounting, to make this election or to stop applying the safe harbor in a subsequent year.

[Reg. Sec. 1.263(a)-3(h)]

Safe Harbor for Routine Maintenance

Taxpayers are not required to capitalize as an improvement, and therefore may deduct, amounts that meet all of the following criteria:

(1) Amounts paid for recurring activities that the taxpayer expects to perform;

(2) As a result of the use of the property in a trade or business;

(3) To keep the property in its ordinarily efficient operating condition; and

(4) The taxpayers reasonably expects, at the time the property is placed in service, to perform the activities: (a) For building structures and building systems, more than once during the 10-year period beginning when placed in service, or (b) For property other than buildings, more than once during the class life of the unit of property.

If the amount doesn't meet all of the requirements for the routine maintenance safe harbor, the taxpayer may still deduct the amount if the amount is not for an improvement under the facts and circumstances analysis.

Parker Observation: Unlike the small taxpayer safe harbor (discussed above), the safe harbor for routine maintenance does not require filing an election statement.

The routine maintenance safe harbor DOES NOT apply to amounts paid for betterments. However, it DOES apply to certain restorations that would otherwise be improvements, including when a taxpayer pay amounts to replace a major component or substantial structural part of a unit of property.

Because the final regulations are based primarily on prior law, taxpayers who were previously in compliance with the rules generally will be in compliance with the final regulations and generally no action is required. If a taxpayer is not in compliance or otherwise wants to change his or her method of accounting to use the safe harbor for routine maintenance, the taxpayer should file Form 3115, Application for Change in Accounting Method, and compute a Code Sec. 481(a) adjustment.

[Reg. Sec. 1.263(a)-3(i)]

Election to Capitalize Repair and Maintenance Costs

To reduce the difficulty with applying the facts and circumstances analysis to identify the tax treatment of costs and to recognize simpler administration by permitting taxpayers to follow financial accounting policies for federal tax purposes, the final regulations include an election to capitalize repair and maintenance expenses as improvements, if the taxpayer treats such costs as capital expenditures for financial accounting purposes.

A taxpayer may elect to treat repair and maintenance costs paid during the year as amounts paid to improve property if he or she:

(1) Pays these amounts in carrying on a trade or business;

(2) Treats these amounts as capital expenditures on his or her books and records regularly used in computing income; and

(3) Makes the election to capitalize for each year in which qualifying amounts are incurred by attaching a statement to a timely filed original federal tax return including extensions for the year that the amounts are paid.

If a taxpayer makes the election to capitalize repair and maintenance expenses, he or she must apply the election to all amounts paid for repair and maintenance that are treated as capital expenditures on the books and records in that year.

Practice Aid: See Parker's sample election statement that can be used when electing to capitalize repair and maintenance costs.

An annual election is not a change in method of accounting. Therefore, taxpayers shouldn't file Form 3115, Application for Change in Method of Accounting, to make this election or to stop capitalizing repairs and maintenance costs for a subsequent year.

[Reg. Sec. 1.263(a)-3(n)]

4. When and How to Apply the New Regulations

What is the effective date?

Generally, the final regulations apply to years beginning on or after Jan. 1, 2014, or in certain circumstances, apply to costs paid or incurred in years beginning on or after Jan. 1, 2014. [Reg. Sec. 1.263(a)-2(j)(1)].

How do the repair regulations coordinate with other Code provisions?

Nothing in the final repair regulations changes the treatment of any amount that is specifically provided for under any provision of the IRC or the Treasury regulations other than section 162(a) or section 212. For example, the final regulations do not eliminate the requirements of section 263(a), which generally provides that taxpayers must capitalize the direct and allocable indirect costs of producing real or tangible personal property and acquiring property for resale.

How does a taxpayer change a method of accounting to use the final regulations?

Under the Code, a change in method of accounting includes a change in the treatment of an item affecting the timing for including the item in income or taking the item as a deduction. For example, a change in a method of accounting occurs if a taxpayer has been capitalizing certain amounts that were characterized as improvements and would like to currently deduct the amounts as repairs and maintenance costs pursuant to the final regulations.

Taxpayers must get consent from the IRS to change a current accounting method to a new accounting method. The IRS provides automatic consent procedures for those who want to change to a method of accounting permitted under the final regulations.

Generally, taxpayers receive automatic consent to change a method of accounting by completing and filing Form 3115, Application for Change in Accounting Method, and including it with a timely filed original federal tax return for the year of change. Taxpayers also mail a duplicate copy of the Form 3115 to Ogden, Utah. The Form 3115 will identify the taxpayer, describe the methods that are being changed, identify the type of property involved in the change, and include a Code Sec. 481(a) adjustment, if applicable.

The Code Sec. 481(a) adjustment takes into account how taxpayers treated certain expenditures in years before the effective date of the final regulations to avoid duplication or omission of amounts in taxable income. For detailed instructions for filing applications for changes in methods of accounting under the tangibles regulations, see Rev. Proc. 2015-13, and sections 6.37-6.40 and 10.11 of Rev. Proc. 2015-14.

[Reg. Sec. 1.263(a)-1(g); Rev. Proc. 2015-14]

Simplified Procedures for Small Business Taxpayers (RP 2015-20 Relief)

The final section of the IRS's FAQ is devoted to a lengthy discussion of relief granted to small business taxpayers under Rev. Proc. 2015-20.

In a nutshell: the revenue procedure waives the requirement for small businesses to file a Form 3115, Application for Change in Accounting Method, and instead allows them to opt for a simplified procedure for changing accounting methods under the final repair regulations. Such changes can be made on a prospective basis for tax years beginning in 2014 (a.k.a. "the cut-off method"), thereby eliminating the need to make a Code Sec. 481(a) adjustment with respect to prior tax years. For purposes of Rev. Proc. 2015-20, a "small business" is defined as one with total assets of less than $10 million or average annual gross receipts of $10 million or less for the prior three tax years.

For an article on the simplified procedures for small business taxpayers covering the same ground as the IRS's FAQ, see the February 27, 2015 issue of Parker's Federal Tax Bulletin. For a quick reference guide, see Parker ¶360,240; for in-depth analysis, see ¶241,591. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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