The IRS has released final regulations and removed temporary and proposed regulations governing the application of Code Secs. 162(a) and 263(a) to amounts paid to acquire, produce, or improve tangible property. The new regulations clarify existing regulations under those sections. In addition, final regulations are issued under Code Sec. 167 regarding accounting for and retirement of depreciable property, as well as under Code Sec. 168 regarding accounting for property under the Modified Accelerated Cost Recovery System (MACRS) other than general asset accounts. The final regulations will affect all taxpayers that acquire, produce, or improve tangible property.
Pursuant to Code Sec. 263(a), amounts paid to acquire, produce or improve tangible property must be capitalized and not deducted. Under Code Sec. 162(a), a taxpayer may deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including the costs of certain supplies, repairs, and maintenance.
The final regulations provide a framework for distinguishing capital expenditures from deductible business expenses. Existing standards for determining whether an expense may be deducted as a repair or must be capitalized, which require a facts and circumstances test, have been very controversial due to the subjective nature of the standards. The new regulations take into account various incarnations of temporary and proposed regulations (most recently issued in 2011 (T.D. 9564)), comments received on those regulations, and judicial decisions in an attempt to simplify the rules while achieving results consistent with the case law.
The final regulations follow the format of the 2011 temporary regulations, addressing the following topics:
Reg. §1.162-3 – Rules for materials and supplies;
Reg. §1.162-4 – Repairs and maintenance;
Reg. §1.263(a)-1 – General rules for capital expenditures;
Reg. §1.263(a)-2 – Rules for amounts paid for the acquisition or production of tangible property; and
Reg. §1.263(a)-3 – Rules for amounts paid for the improvement of tangible property.
The final regulations refine and simplify rules contained in the temporary regulations and create a number of new safe harbors.
Comment: The final regulations adopt a revised and simplified de minimis safe harbor under Reg. §1.263(a)-1(f) and extend the safe harbor for routine maintenance under Reg. §1.263(a)-3(i) to buildings. Further, the final regulations add a safe harbor for small taxpayers to the rules governing improvements to tangible property under Reg. §1.263(a)-3. Several of the criteria for defining betterments and restorations to tangible property have also been refined.
The new final regulations also finalize temporary regulations under Code Sec. 167 regarding accounting for and retirement of depreciable property and Code Sec. 168 regarding accounting for MACRS property, other than general asset accounts. Other MACRS regulations relating primarily to dispositions of property are not finalized at this time but are issued concurrently with these regulations as proposed regulations and are discussed separately (TAXDAY, 2013/09/16, I.6).
Materials and Supplies – Reg. §1.162-3
Earlier versions of Reg. §1.162-3 provided, in part, that a taxpayer carrying materials and supplies on hand should include in expenses the charges for materials and supplies only in the amount that was actually consumed and used in operation during the tax year for which the return was made. The earlier regulations did not define “materials and supplies,” but whether property constituted a material or supply (rather than inventory or depreciable property) was addressed in judicial and administrative rulings. Later temporary and proposed regulations provided definitions.
The new final regulations refine the earlier definitions. For example, the final regulations expand the definition of materials and supplies to include property that has an acquisition or production cost of $200 or less (increased from $100 or less), clarify application of the optional method of accounting for rotable and temporary spare parts, and simplify the application of the de minimis safe harbor of Reg. §1.263(a)-1(f) to materials and supplies.
The final regulations also define standby emergency spare parts and limit the application of the election to capitalize materials and supplies to only rotable, temporary, and standby emergency spare parts. A taxpayer that uses the optional method for rotable and temporary spare parts for tax purposes must use the optional method for all of the pools of rotable and temporary spare parts used in the same trade or business for which the optional method is used for the taxpayer’s books and records.
Regulations clarify that a taxpayer may revoke the election to capitalize and depreciate certain material and supplies by requesting a letter ruling to obtain IRS consent to revocation. Also, the de minimis rule applicable to materials and supplies and the general de minimis rule, discussed below, are now more clearly coordinated.
Finally, property identified in previous guidance as materials and supplies remains so classified under the new regulations.
Repairs – Reg. §1.162-4
Amounts paid for repairs and maintenance to tangible property are deductible if the amounts paid are not required to be capitalized under Reg. §1.263(a)-3 . This rule has been retained unchanged from prior versions of the regulations.
De Minimis Safe Harbor – Reg. §§1.162-3(f) and 1.263(a)-1(f)
Taxpayers are generally required to capitalize amounts paid to acquire or produce a unit of real or personal property. Under prior temporary regulations, a de minimis exception allowed a taxpayer to deduct certain amounts paid for tangible property if the taxpayer had an applicable financial statement, had written accounting procedures for expensing amounts paid for such property under specified dollar amounts, and treated those amounts as expenses on its applicable financial statement. The ceiling applicable to this exception was the greater of (1) 0.1 percent of the taxpayer’s gross receipts for the tax year as determined for tax purposes; or (2) 2 percent of the taxpayer’s total depreciation and amortization expense for the tax year as determined on the taxpayer’s applicable financial statement.
Under the final regulations, the ceiling in the de minimis rule has been eliminated and replaced with a new safe harbor determined at the invoice or item level and based on the policies used by the taxpayer for its financial accounting books and records. A taxpayer with an applicable financial statement may rely on the de minimis safe harbor under Reg. §1.263(a)-1(f) only if the amount paid for property does not exceed $5,000 per invoice, or per item as substantiated by the invoice. This amount is subject to change by the IRS in future guidance. The de minimis safe harbor has been expanded to include amounts paid for property having an economic useful life of less than 12 months, provided the amount per invoice or item does not exceed $5,000.
A de minimis rule is also included for taxpayers without an applicable financial statement, provided that accounting procedures are in place to deduct amounts paid for property costing less than a specified amount, or amounts paid for property with an economic useful life of 12 months or less. The specified amount for taxpayers in this category is $500. If the cost exceeds $500 per invoice (or item), then no portion of the cost of the property will fall within the safe harbor.
Regardless of whether or not the taxpayer has an applicable financial statement, the de minimis safe harbor does not preclude a taxpayer from reaching an agreement with the IRS that the IRS examining agents will not review certain items. Examining agents do not need to revise their materiality thresholds in accordance with the safe harbor limitations.
The de minimis safe harbor is elected annually by including a statement on the taxpayer’s tax return for the year elected. An election to use the safe harbor may not be made through the filing of an application for change in accounting method.
Temporary regulations required that, to use the de minimis safe harbor, a taxpayer had to have written accounting procedures in place at the beginning of the tax year treating the amounts paid for property costing less than a certain dollar amount as an expense for financial accounting purposes. It was suggested that transition guidance be issued for taxpayers that did not have written accounting procedures in place at the beginning of 2012. The final regulations do not adopt these suggestions for transition relief, since they are not applicable until tax years beginning on or after January 1, 2014. Taxpayers without written accounting procedures that choose to elect the de minimis safe harbor for their 2014 tax years should have sufficient time to consider and draft appropriate procedures prior to the applicability date of the final regulations.
In the case of affiliated corporations filing a consolidated return, the regulations provide that, if a taxpayer’s financial results are reported on the applicable financial statement for a group of entities, then the group’s applicable financial statement may be treated as the applicable financial statement of the taxpayer.
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 the property if these costs are not included on the same invoice as the tangible property. However, a taxpayer electing to apply the de minimis safe harbor must include in the cost of the property all additional costs (for example, delivery fees, installation services, or similar costs) of acquiring or producing the property if these costs are included on the same invoice with the tangible property.
If an invoice includes amounts paid for multiple tangible properties and the invoice includes additional invoice costs related to the multiple properties, then the taxpayer must allocate the additional invoice costs to each property using a reasonable method (e.g., specific identification, pro rata allocation, or weighted average method based on each property’s relative cost). Additional costs consist of the transaction costs of acquiring or producing the property and the costs for work performed prior to the date that the unit of tangible property was placed in service.
The de minimis safe harbor must be applied to all eligible materials and supplies (other than rotable, temporary, and standby emergency spare parts subject to the election to capitalize or rotable and temporary spare parts subject to the optional method of accounting for such parts) if the taxpayer elects the de minimis safe harbor under Reg. §1.263(a)-1(f) . Taxpayers that do not elect the de minimis safe harbor must treat amounts paid for materials and supplies in accordance with Reg. §1.162-3 .
Amounts paid for tangible property eligible for the de minimis safe harbor may be subject to capitalization under Code Sec. 263A if these amounts constitute the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale.
Amounts Paid to Acquire or Produce Tangible Property – Reg. §1.263(a)-2
Temporary regulations provided rules for applying Code Sec. 263(a) to amounts paid to acquire or produce a unit of real or personal property. These rules are generally retained in the final regulations, including general requirements to capitalize amounts paid to acquire or produce a unit of real or personal property, requirements to capitalize amounts paid to defend or perfect title to real or personal property, and rules for determining the extent to which taxpayers must capitalize transaction costs related to the acquisition of property. The de minimis safe harbor has been moved to Reg. §1.263(a)-1(f) to reflect its broader application to amounts paid for tangible property, including amounts paid for improvements and materials and supplies, except as otherwise provided under Code Sec. 263A .
Amounts Paid to Improve Property – Reg. §1.263(a)-3
The final regulations generally retain earlier rules for determining whether an amount improves, betters, or restores property, including the unit of property. A building is generally defined as a unit of property. These regulations continue to apply the improvement rules separately to the building structure and each building system.
The final regulations do not provide quantitative bright lines for determining the materiality of an addition to a unit of property or an increase in capacity, productivity, efficiency, strength, quality, or output of a unit of property, despite comments requesting such bright lines. The regulations rely on qualitative factors to provide fair and equitable treatment for all taxpayers in determining whether a particular cost constitutes a betterment.
Temporary regulations required consideration of all facts and circumstances in determining if a betterment of property existed, including treatment of the expenditures on a taxpayer’s applicable financial statement. The final regulations remove the taxpayer’s treatment of the expenditure on its financial statement as a factor to be considered in performing a betterment analysis. In addition, the determination of whether amounts are paid for a betterment of the taxpayer’s property no longer includes consideration of the taxpayer’s facts and circumstances.
With respect to retail store refresh or remodel projects, commenters requested quantitative bright lines and additional details in the given examples. Although bright lines were not adopted, additional details were added to examples, illustrating distinctions between betterments and maintenance activities when a taxpayer undertakes multiple simultaneous activities on a building.
The final regulations also provide rules for determining the unit of property for leased property and for leasehold improvements, as well as special rules for determining improvement costs (including costs incurred during an improvement and removal costs).
Final regulations include a safe harbor for small taxpayers to assist them in applying the general rules for improvements to buildings. A safe harbor election is provided for building property held by taxpayers with gross receipts of $10 million or less (a “qualifying small taxpayer” ). Such a taxpayer can elect to not apply the improvement rules to an eligible building property if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2 percent of the unadjusted basis of the building. Eligible building property includes a building unit of property that is owned or leased by the qualifying taxpayer, provided the unadjusted basis of the building unit of property is $1,000,000 or less.
The safe harbor for building property held by small taxpayers may be elected annually on a building-by-building basis by including a statement on the taxpayer’s timely filed tax return, including extensions, for the year the costs are incurred for the building. Amounts paid by the taxpayer to which the taxpayer properly applies and elects the safe harbor are not treated as improvements to the building under Reg. §1.263(a)-3 and may be deducted under Reg. §§1.162-1 or 1.212-1 , as applicable, in the tax year that the amounts are paid or incurred, provided the amounts otherwise qualify for deduction under those sections. A taxpayer may not revoke an election to apply the safe harbor for small taxpayers.
A safe harbor for routine maintenance activities for property other than a building or its structural components, applicable under temporary regulations, has been expanded to apply to routine maintenance for buildings. The inclusion of a routine maintenance safe harbor for buildings is expected to alleviate some of the difficulties that could arise in applying the improvement standards for certain restorations to building structures and building systems.
The final regulations use 10 years as the period of time in which a taxpayer must reasonably expect to perform the relevant activities more than once. However, amounts incurred for activities falling outside the routine maintenance safe harbor are not necessarily expenditures required to be capitalized under Reg. §1.263(a)-3 . Amounts incurred for activities that do not meet the routine maintenance safe harbor are subject to analysis under the general rules for improvements.
The final regulations retain earlier rules regarding restoration, but with revisions to the major component rule (clarification of some definitions) and the casualty loss rule. Temporary regulations provided that an amount is paid to restore a unit of property if it is for the repair of damage to the unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under Code Sec. 165 , or relating to a casualty event described in that section. Capitalization of restoration costs is required under the casualty loss rule, even when the amounts paid for the repair exceed the adjusted basis remaining in the property and regardless of whether the amounts may otherwise qualify as repair costs.
The final regulations revise the casualty loss rule to permit a deduction for amounts spent in excess of the adjusted basis of the property damaged in a casualty event. A taxpayer is still required to capitalize amounts paid to restore damage to property for which the taxpayer has properly recorded a basis adjustment, but the costs required to be capitalized under the casualty loss rule are limited to the excess of: (1) the taxpayer’s basis adjustments resulting from the casualty event, over (2) the amount paid for restoration of damage to the unit of property that also constitutes a restoration under the other criteria of Reg. §1.263(a)-3(k)(1) (excluding the casualty loss rule). Casualty-related expenditures in excess of this limitation are not treated as restoration costs under Reg. §1.263(a)-3(k)(1)(iii) and may be properly deducted if they otherwise constitute ordinary and necessary business expenses (for example, repair and maintenance expenses) under Code Sec. 162.
Election to Capitalize Repair and Maintenance Costs
The final regulations include a new provision that allows a taxpayer to elect to treat amounts paid during the tax year for repair and maintenance to tangible property as amounts paid to improve that property and as an asset subject to the allowance for depreciation, as long as the taxpayer incurs the amounts in carrying on a trade or business and the taxpayer treats the amounts as capital expenditures on its books and records used for regularly computing income.
A taxpayer that elects this treatment must apply the election to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its books and records in that tax year. A taxpayer making the election must begin to depreciate the cost of such improvements when the improvements are placed in service by the taxpayer under the applicable provisions of the code and regulations. The election is made by attaching a statement to the taxpayer’s timely filed original tax return (including extensions) for the tax year in which the improvement is placed in service. Once made, the election may not be revoked.
Change in Method of Accounting
Separate procedures will be provided under which taxpayers may obtain automatic consent for a tax year beginning on or after January 1, 2012, to change to a method of accounting provided in the final regulations. Although a taxpayer seeking a change in method of accounting to comply with these regulations generally must take into account a full adjustment under Code Sec. 481(a) , it is expected that, for the specific situation where a taxpayer seeks to change to a method of accounting that is applicable only to amounts paid or incurred in tax years beginning on or after January 1, 2014, a limited Code Sec. 481(a) adjustment will apply, taking into account only amounts paid or incurred in tax years beginning on or after January 1, 2014, or at a taxpayer’s option, amounts paid or incurred in tax years beginning on or after January 1, 2012.
The final regulations are effective September 19, 2013, and apply to tax years beginning on or after January 1, 2014. Some provisions only apply to amounts paid or incurred in tax years beginning on or after January 1, 2013. Taxpayers may apply the new regulations to tax years beginning on or after January 1, 2012.
T.D. 9636, 2013FED ¶47,036
Code Sec. 162
CCH Reference – 2013FED ¶8600
CCH Reference – 2013FED ¶8620
CCH Reference – 2013FED ¶8753
Code Sec. 165
CCH Reference – 2013FED ¶9901
Code Sec. 167
CCH Reference – 2013FED ¶11,010
CCH Reference – 2013FED ¶11,018
CCH Reference – 2013FED ¶11,020
Code Sec. 168
CCH Reference – 2013FED ¶11,276P
Code Sec. 263
CCH Reference – 2013FED ¶13,700C
CCH Reference – 2013FED ¶13,701
CCH Reference – 2013FED ¶13,703
CCH Reference – 2013FED ¶13,704
CCH Reference – 2013FED ¶13,704K
Code Sec. 263A
CCH Reference – 2013FED ¶13,809
CCH Reference – 2013FED ¶13,811
Code Sec. 1016
CCH Reference – 2013FED ¶29,414
Tax Research Consultant
CCH Reference – TRC BUSEXP: 9,080