Back in June 2014 I blogged about the new IRS Regulations governing tangible personal property. These regulations prompted a vigorous debate over the last 7 months between the most astute students of the US Tax Code as to what constitutes the need to file IRS Form 3115 - Change in Accounting Method for our business clients as a direct result of these new governing regulations.
Many practitioners make compelling points supporting the position that most ALL businesses MUST file IRS Form 3115 simply because the new regulations have changed so dramatically that most every business large and small alike will be impacted. Others still are of the opinion that simply electing the new de minimus safe harbor in and of itself necessitates filing the form.
Understanding whether your business needs to file a change in accounting method for 2014 income tax purposes is a profoundly significant matter that you must absolutely discuss with your tax practitioner for 2014 forward. Fortunately the following IRS Revenue Procedures were released Friday 1/16/2015 - just in the nick of time - and should help bring clarity.
As per the IRS announcement of :
"Revenue Procedure 2015-13 updates and revises the general procedures under § 446(e) of the Internal Revenue Code and § 1.446-1(e) of the Income Tax Regulations to obtain the consent of the Commissioner of Internal Revenue (Commissioner) to change a method of accounting for federal income tax purposes. Specifically, this revenue procedure provides the general procedures to obtain the advance (non-automatic) consent of the Commissioner to change a method of accounting and provides the procedures to obtain the automatic consent of the Commissioner to change a method of accounting described in Rev. Proc. 2015-14, 2015-5 I.R.B., (or successor) (List of Automatic Changes).
Revenue Procedure 2015-14 provides the List of Automatic Changes to which the automatic change procedures in Rev. Proc. 2015-13, 2015-5 I.R.B., (or successor) apply. The definitions in section 3 of Rev. Proc. 2015-13 apply to this revenue procedure."
Here's the rub!
Beginning tax year 2014, the IRS issued what are called the “Final Tangible Property Regulations,” or TPR for short. These regulations affecting all businesses; Schedule C, Schedule E, Schedule F, Partnerships, S Corporations, or Corporations.
This final TPR governs the deduction and capitalization of costs incurred to acquire, maintain or improve tangible property, and also provides new rules regarding materials and supplies and the disposition of property. These regulations require that you keep adequate records for purchases, repairs and maintenance, materials and supplies, and require you to specifically analyze each of these items costing over $500.
Affected by the new include expenditures that are made to acquire, maintain or improve property as well as materials and supplies but not general businesses expenses. The below summary is to help you understand how to analyze these items and classify them appropriately for all tax years going forward.
Materials and Supplies (M&S):
Part of these new regulations is guidance on deducting materials and supplies (M&S). The issue is whether or not a taxpayer can immediately deduct these cost of the M&S or if they must be capitalized and expensed when used or consumed. The treatment of M&S depends on whether they are incidental or non-incidental.
The IRS has specifically defined a material and supply (M&S) as:
- Costing $200 or less, or
- A component purchased to maintain, repair, or improve a unit of property, lasting less than 12 months, or
- Fuel, lubricants or similar bulk items
Tax treatment of M&S:
- Incidental M&S are those where you do not keep a record of consumption. These are deducted when purchased. As a practical matter, these items will not necessarily need to be analyzed.
- Non-incidental M&S are those where a record of consumption are kept. These are deducted when used or consumed. The non-incidental M&S rule is applicable to both cash and accrual basis of accounting. For non-incidentals, if you do not use or consume an item, you must put the items you don’t use/consume on the balance sheet. For example, if you buy 10 widgets that qualify as non-incidental M&S for $100 each and you use/consume 8 in the tax year, you will expense $800 on the Income Statement and show the remaining $200 as an asset on the Balance Sheet in an account called “Non-incidental M&S.”
De Minimis Safe Harbor (DMSH):
The De Minimis Safe Harbor (DMSH) is a very taxpayer friendly provision of these new Regulations that state if you follow the rules, as outlined below, you can deduct up to $500 for any item. In order to qualify for this $500 Safe Harbor, a taxpayer must:
- Not have audited financials – (reviews, compilations, and other books reviews are ok)
- Have a capitalization policy effective 1/1/2014 and
- Treat all qualifying expenses on the books in accordance with the capitalization policy
This DMSH applies to all parts of the new Regulations, including materials and supplies, repairs, maintenance, and items purchased under the $500 threshold. Said another way, if you buy, repair, or improve an asset and it costs < $500, you can expense that item as long as you meet the above criteria.
In order to apply the Safe Harbor, you will need to have a signed capitalization policy on file, ideally as part of your copy of the federal tax return. The election will be made every year on your tax return, unless the IRS changes the rules.
Repairs and Maintenance: Equipment
A repair is anything that is not considered a restoration, adaptation, betterment, or improvement, (the R.A.B.I. rules) and may be deducted. Said another way, anything that passes the RABI rules must be capitalized and anything that fails the RABI rules must be expensed.
If you perform recurring activities to keep non-building property in ordinarily efficient operating condition, those expenses can be written off as long as the recurring maintenance is expected to be performed more than once during its useful life. Building rules are discussed below.
We suggest entering individual items costing $500 or less into your repairs account because of the DMSH rule, but refraining from adding any items above that cost to this account. Items costing more than the $500 will generally be required to be individually analyzed under the RABI rules below to determine if they can be written off or must be capitalized.
Repairs & Maintenance: Buildings
If you have average annual gross receipts for the prior three tax years of $10 million or less and your unadjusted basis in your building is less than $1,000,000, there is a special rule. These taxpayers may elect to not capitalize any amount if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the building does not exceed the lesser of: (i) $10,000; or (ii) 2 percent of the unadjusted basis of the building. This rule is called the Safe Harbor for Small Taxpayers (SHST), and is very beneficial if you qualify because it can turn items that generally must be capitalized into an immediate deduction. This election will be done annually on the tax return.
If you perform recurring activities to keep building property in ordinarily efficient operating condition, those items can be written off as long as the routine maintenance is expected to be performed more than once in a 10 year period.
Amounts paid to improve tangible property (RABI rules)
The most complex, yet most rule based part of these new Regulations, is determining if an amount paid to improve a unit of property should be expensed or capitalized. To do so, the IRS now requires you to examine each expenditure on each unit of property, outside of the above limits, to determine if there has been a betterment, restoration or adaptation to that unit of property (for short, the R.A.B.I tests). If the improvement is determined to be a betterment, restoration or adaption, then it must be capitalized. If not, it must be written off. There is no dollar amount, or threshold, to these categories either.
A unit of property is now defined as the inter-related parts composing one larger unit. For example, a car is one unit of property, a machine and all its parts are one unit of property, a building, its structure and the building systems are all one unit of property. For buildings, you must apply the rules first to the building itself, then to the building systems, such as HVAC, plumbing, electrical, elevators, security, fire protection or gas distribution. Anything that meets the RABI rules must be capitalized, otherwise it may be written off.
A Betterment results in fixing a condition that existed prior to your purchase or results in a material increase in capacity, productivity, efficiency, or quality. An example would be improving a machine with a part that materially increases its capacity/output.
A Restoration generally results in returning a non-functional asset to use, the cost of rebuilding an asset after the end of its depreciable life, replacing a major component of the unit of property, or comprises a large physical portion of the property. An example would be replacing the entire engine in a machine or truck.
Finally, Adaptation costs are amounts paid to change the piece of property that was not consistent with the intended ordinary use of the property when it was originally placed in service. Best example of this would be costs incurred to convert a warehouse to condo units.
As a practical matter, there will be few costs that are classified as adaptation costs. The main focus should be on whether or not the costs fall into the betterment or restoration categories.
If you have a question about any of the above use a Suspense account in your bookkeeping software that can be reviewed with your tax practitioner for proper classification as part of preparing your business' 2014 income taxes. These new regulations will affect every tax year going forward, so it’s important to know them and apply them correctly.
The take away from this post is that if you are filing IRS Form 3115, IMHO most all taxpayers should consider checking the (b) "other" box on Part 1 Line 1 of IRS Form 3115 and as a "description" write "ALL CODES 184-193 PER NEW REGULATIONS"