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New Capitalization Rules: Opportunities and Traps
(Parker's Federal Tax Bulletin: November 26, 2012)

On November 7, at the AICPA Federal Tax Conference in Washington, D.C., two members of the AICPA Tangible Property Task Force reviewed the temporary regulations on capitalization issued at the end of 2011. David Strong, Director at Crowe Horwath LLP, and Natalie Tucker of the Washington D.C. National Tax Office of McGladrey LLP, emphasized certain year-end strategies practitioners must consider in dealing with the new capitalization rules, as well as opportunities for mitigating some of its more onerous provisions.

On December 27, 2011, the IRS issued temporary regulations (T.D. 9564) aimed at assisting taxpayers in determining whether amounts paid to acquire, produce, or improve tangible property must be capitalized. The temporary regulations are generally effective for amounts paid after 2011. The regulations clarify and expand prior proposed regulations, which had been issued in 2008.

Taxpayers Have Two Years for Automatic Consent Method Changes to Comply with the New Rules

In the wake of the revised capitalization rules, the IRS issued Rev. Proc. 2012-19 and Rev. Proc. 2012-20 to help taxpayers in obtaining automatic IRS consent to change to methods of accounting provided in the capitalization rules. These revenue procedures modify Rev. Proc. 2011-14.

To encourage taxpayers to adopt the methods contained in the regulations, Rev. Proc. 2012-19 and 2012-20 favorably waive the scope limitations under Rev. Proc. 2011-14 (i.e., the limitations that preclude certain taxpayers from eligibility for the automatic consent procedures) for accounting method changes filed for a taxpayer's first or second tax year beginning after December 31, 2011. The method changes provided by Rev. Proc. 2012-19 and 2012-20 will still be automatic after this two-year period, but the normal scope limitations will apply, which could limit a taxpayer's ability to file an automatic Form 3115 (e.g., if it is under exam, has changed its method of accounting for the item within the last five years, etc.).

Rev. Proc. 2012-19 deals with accounting method changes relating to the treatment of tangible property and covers changes to the methods of accounting relating to materials and supplies, relating to repairs and maintenance, general capitalization rules, relating to amounts paid or incurred for acquisition and production of tangible property, and relating to amounts paid or incurred for the improvement of tangible property. Rev. Proc. 2012-20 deals with changes relating to dispositions and depreciation.

A taxpayer that properly files a Form 3115 under Rev. Proc. 2012-19 or 2012-20 generally receives back year audit protection for the item for which the change is being made. Furthermore, the IRS Large Business and International (LB&I) Section issued Directive LB&I-4-0312-004 that applies to exam activity relating to positions taken on original returns relating to the following issues: (1) whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Code Sec. 263(a); and (2) any correlative issues involving the disposition of structural components of a building or dispositions of tangible depreciable assets. LB&I-4-0312-004 indicates that the IRS will not assert penalties arising from a taxpayer's noncompliance with the temporary regulations for the taxpayer's first tax year beginning after December 31, 2011, provided the taxpayer complies for its second tax year ending after December 31, 2011.

CAUTION: Because Rev. Proc. 2012-19 and Rev. Proc. 2012-20 waive the scope limitations under Rev. Proc. 2011-14 only for the two tax years after 2011, any taxpayer that undergoes a reorganization or any other transaction that cuts its year in half or creates a short year must be especially careful. Such transactions will accelerate the timeframe in which the taxpayer has to avail itself of the favorable provisions relating to the waiver of scope limitations.

Most of the changes under these revenue procedures involve taking into account a Code Sec. 481(a) adjustment based on comparing what the adjustment would be under the new rules compared to the old rules. However, some changes relating to depreciation and dispositions involve applying a cut-off method.

One key point specific to these revenue procedures, Mr. Strong noted, is the ability to use statistical sampling to determine the Code Sec. 481(a) adjustment. This is particularly helpful to taxpayers that have mass amounts of information in their repair and maintenance accounts that they can't look at by transaction. By using statistical sampling, they can look at a sample size and then extrapolate across the population, thus simplifying the Code Sec. 481(a) computation.

One of the things these procedures allow is the ability to file for multiple accounting method changes within one Form 3115. There are 19 different accounting method changes associated with the temporary regulations, and practitioners must consider if their clients need to file any number of them.

CAUTION: To implement these regulations for 2013, there are some things taxpayers must do this year. First, to obtain automatic IRS consent under Rev. Proc. 2012-19 or Rev. Proc. 2012-20 to change to one of the methods in the new capitalization rules, a taxpayer must currently be using a Code Sec. 263A methodology. If a taxpayer is not currently in compliance with Code Sec. 263A, the taxpayer must first file a Form 3115 requesting an accounting method change to bring the taxpayer into compliance with Code Sec. 263A before the taxpayer can file a Form 3115 to take advantage of the automatic accounting method changes in Rev. Proc. 2012-19 or Rev. Proc. 2012-20. So practitioners with clients on a facts-and-circumstances methodology should be considering whether this is appropriate for their client. Additionally, practitioners need to understand how these method changes and the resulting Code Sec. 481(a) adjustment will affect the client's inventory calculations.

As Ms. Tucker noted, there is no statute of limitations for accounting method changes. In computing a Code Sec. 481 adjustment, the taxpayer must calculate what a particular expenditure would have been as if the taxpayer had always used the new method and compare that to what the taxpayer actually did under method the taxpayer is changing from, and the difference is the Code Sec. 481 adjustment. She noted that the statute of limitations comes into play when there is an error, but there is no statute of limitations with respect to accounting method changes. Thus, taxpayers may have to go back three or four years or 15 years or more to calculate the cumulative effect of how an expenditure was treated compared to how it would have been treated under the new rules. Taxpayers who do not do this to come into compliance with the new rules could be subject to the IRS doing the calculation and making the taxpayer take the adjustment into income in one year as opposed to four years for adjustments calculated by the taxpayer. Thus, one of the benefits of doing the voluntary method changes under Rev. Proc. 2012-19 and Rev. Proc. 2012-20 is that if its an unfavorable adjustment, the taxpayer can spread it over four years and there are no penalties and interest. Otherwise, if the IRS does it under exam, the adjustment must be taken into income in one year with interest and penalties.

Under the new capitalization rules, the definition of a disposition is expanded to take into account a structural component of a building (e.g., a roof). Thus, Ms. Tucker noted, under the new rules, when doing a method change, if the taxpayer had two roofs on a building, the taxpayer could write off the basis in the first one and capitalize the second one and depreciate it over 39 years under the new method. So if a taxpayer had three roofs, the taxpayer could use the method change to write off the bases of the first two roofs and then depreciate the third so the taxpayer would do the disposition method change to write off the first two roofs. Previously, if it was a structural component, the taxpayer had to depreciate both roofs.

If the taxpayer previously deducted a replacement as a repair, the taxpayer has to look at whether, under the new rules, it should have been deducted as a repair. If it should not have, the taxpayer has to go back and capitalize and depreciate it.

Deduction Opportunities under the Restoration Rules

Ms. Tucker then presented some options for mitigating the effects of the new restoration rules. Under Reg. Sec. 1.263(a)-3T, a taxpayer must capitalize amounts paid to restore a unit of property, including amounts paid in making good the exhaustion for which an allowance is or has been made. An amount is paid to restore a unit of property where it:

(1) is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss);
(2) is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
(3) is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss;
(4) returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
(5) results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or
(6) is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.

Thus, under (1), above, the replacement of a structural component of a building is capitalized where a loss is deducted for that component. Ms. Tucker gave as an example a company that has a broken window that must be replaced. It's appropriate for the taxpayer to take a loss on the broken window and then the replacement window qualifies as a structural component of the building. By taking the loss, the taxpayer kicks the replacement window into the restoration rules, thus requiring the capitalization of the replacement window.

However, as Mr. Strong pointed out, taxpayers can get around such treatment by electing to use the general asset account (GAA) rules, not taking the loss, and instead deducting the new window as a repair and maintenance cost. The purpose of the GAA rules is to mitigate the more onerous aspects of the disposition rules. Under the GAA rules, assets that are subject to the election are grouped into one or more general asset accounts. Assets that are eligible to be grouped into a single general asset account may be divided into more than one general asset account. Each general asset account must include only assets that (i) have the same applicable depreciation method; (ii) have the same applicable recovery period; (iii) have the same applicable convention; and (iv) are placed in service by the taxpayer in the same tax year. Mr. Strong stated that, especially with respect to real property, it is generally beneficial to make the GAA election.

Thus, the taxpayer in the example above could put the entire building in one general asset account. In that case, the taxpayer would not deduct the broken window, but instead would take a repair and maintenance deduction for the new window and just continue depreciating the broken window in the building group under the GAA rules.

Ms. Tucker noted there is also an opportunity to deduct rather than capitalize the restoration of property described under (5) and (6) above (i.e., the rebuilding of a unit of property to a like-new condition after the end of its class life, or replacing a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property) by using the safe harbor for routine maintenance as provided in Reg. Sec. 1.263(a)-3T(g)(1).

Observation: As the routine maintenance safe harbor rule is currently written, it applies only to tangible personal property

Under the routine maintenance safe harbor rule, an amount paid for routine maintenance performed on a unit of property other than a building or a structural component of a building is deemed not to improve that unit of property and thus may be deducted. Routine maintenance is the recurring activities a taxpayer expects to perform as a result of the taxpayer's use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the unit of property, and the replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts. The activities are routine only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life of the unit of property. 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, the taxpayer's experience, and the taxpayer's treatment of the activity on its applicable financial statement.

Planning for the De Minimis Rule

One of the highlights of the new capitalization provisions is the de minimis rule. A taxpayer is not required to capitalize amounts paid for the acquisition or production of a unit of property (excluding inventory and land) if the taxpayer meets the following requirements:

(1) the taxpayer has applicable financial statements (AFS);
(2) the taxpayer has at the beginning of the tax year written accounting procedures treating as an expense for nontax purposes the amounts paid for property costing less than a certain dollar amount;
(3) the taxpayer treats the amounts paid during the tax year as an expense on the AFS in accordance with its written accounting procedures; and
(4) the total aggregate of amounts paid and not capitalized for the tax year are less than or equal to the greater of (i) 0.1 percent of the taxpayer's gross receipts for the tax year as determined for federal income tax purposes; or (ii) 2 percent of the taxpayer's total depreciation and amortization expense for the tax year as determined in its AFS.

Taxpayers may also elect to apply this rule to materials and supplies. Ms. Tucker noted that, while many small businesses do not have applicable financial statements and thus cannot avail themselves of the de minimis rule, the rule may subsequently be broadened to apply to smaller businesses. Alternatively, a business may grow to the point where it does have applicable financial statements and can take advantage of the de minimis rule. In either case, to avail themselves of this rule, taxpayers must have in place written accounting procedures treating as an expense for nontax purposes the amounts paid for property costing less than a certain dollar amount.

Thus, practitioners should advise clients to put into place, as soon as possible, these written accounting procedures so they can take advantage of the de minimis rule should they otherwise be able to. For example, if a calendar-year business otherwise qualifies for the de minimis rule in 2013, it must have the written accounting procedures in place by the end of 2012. Often, these written policies will just be written clarification of procedures the taxpayer already has in place.

(Staff Editor at 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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