The IRS issued final tangible property regulations on the deduction and capitalization of expenditures related to tangible property in September 2013 (T.D. 9636) and final tangible property regulations on modified accelerated cost recovery system (MACRS) property dispositions in August 2014 (T.D. 9689). These final regulations are generally effective for tax years beginning on or after Jan. 1, 2014 (or for amounts paid or incurred in tax years beginning on or after Jan. 1, 2014). The final regulations affect all for-profit taxpayers that have expenditures that are classified as either materials and supplies, repairs and maintenance, asset acquisitions, production of assets, or improvements of tangible assets.
Taxpayers were first required to apply the final tangible property regulations to their tax year 2014 filed returns. Those same taxpayers will now need to continue applying the new rules to their tax year 2015 returns.
Under Sec. 263(a), amounts paid to acquire, produce, or improve tangible property must be capitalized and not deducted. Under Sec. 162(a), a taxpayer may deduct all ordinary and necessary business expenses paid or incurred during the tax year in carrying on a trade or business. The tangible property regulations are intended to provide guidance to taxpayers on whether certain expenditures should be capitalized or deductible as a business expense and to provide them with more objective measurements.
The tangible property regulations under Secs. 263(a) and 162(a) are organized as follows:
- Regs. Sec. 1.162-3—Materials and supplies;
- Regs. Sec. 1.162-4—Repairs and maintenance;
- Regs. Sec. 1.263(a)-1—General rules for capital expenditures;
- Regs. Sec. 1.263(a)-2—Amounts paid for acquisition or production of tangible property; and
- Regs. Sec. 1.263(a)-3—Amounts paid for improvement of tangible property.
The final MACRS tangible property regulations addressed, among other matters:
- Regs. Sec. 1.168(i)-1—Dispositions from a general asset account; and
- Regs. Sec. 1.168(i)-8—Dispositions of tangible property other than from a general asset account.
Materials and Supplies: Regs. Sec. 1.162-3
Materials and supplies are defined in Regs. Sec. 1.162-3(c) as:
- A unit of property costing $200 or less;
- A unit of property with an economic useful life of 12 months or less;
- A component to maintain, repair, or improve a unit of property, including rotable, temporary, and standby emergency parts;
- Fuel, lubricants, water, etc., reasonably expected to be consumed in 12 months or less; and
- Any item identified as a material or supply in other IRS guidance.
Under Regs. Sec. 1.162-3(a), amounts paid to acquire or produce incidental materials and supplies are deductible when those amounts are paid. Amounts paid to acquire or produce nonincidental materials and supplies are deductible in the year the materials and supplies are first used or consumed. Rotable and temporary spare parts are treated as used or consumed when a taxpayer disposes of the parts.
Repairs and Maintenance: Regs. Sec. 1.162-4
Under Regs. Sec. 1.162-4(a), a taxpayer may deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized under Regs. Sec. 1.263(a)-3.
General Rules for Capital Expenditures: Regs. Sec. 1.263(a)-1
Under Regs. Sec. 1.263(a)-1(a), no deduction is allowed for any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. No deduction is allowed for any amount paid in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. Examples of capital expenditures on personal tangible property can be found in Regs. Secs. 1.263(a)-2 and 1.263(a)-3.
Amounts Paid for Acquisition or Production of Tangible Property: Regs. Sec. 1.263(a)-2
Regs. Sec. 1.263(a)-2 provides rules for applying Sec. 263(a) to amounts paid to acquire or produce a unit of real or personal property. These rules include 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.
Amounts Paid for Improvement of Tangible Property: Regs. Sec. 1.263(a)-3
The general rule of Regs. Sec. 1.263(a)-3 requires that amounts paid to improve a unit of property must be capitalized. An amount paid is considered an improvement to a unit of property if it results in betterment, restoration, or adaptation to or of the unit of property.
Regs. Sec. 1.263(a)-3(e) defines units of property by reference to (1) buildings and structural components and (2) assets other than buildings and structural components (i.e., all other assets). The unit of property must be established first before an expenditure can be analyzed to determine whether it should be capitalized.
Regs. Sec. 1.263(a)-3(g) gives special rules for determining improvement costs. In general, a taxpayer must capitalize all the direct costs of an improvement and all the indirect costs that directly benefit or are incurred by reason of an improvement. Removal costs are deductible if a taxpayer disposes of a depreciable asset and takes the adjusted basis of the asset or asset component into consideration for purposes of calculating gain or loss.
A safe harbor for routine maintenance is available under Regs. Sec. 1.263(a)-3(i). An amount paid for routine maintenance on a unit of tangible personal property, a building, or a major system of a building is not considered an improvement and therefore can be deducted. An amount is considered routine maintenance on a building only if the taxpayer expects to perform the maintenance more than once during the 10-year period beginning when the building structure or system was put into service by the taxpayer. An amount is considered routine maintenance on a unit of tangible personal property if the taxpayer expects to perform the maintenance more than once during the class life of the unit of property.
Dispositions From a General Asset Account: Regs. Sec. 1.168(i)-1
Regs. Sec. 1.168(i)-1 provides rules for general asset accounting under Sec. 168(i)(4). The provisions of this section apply only to assets for which a taxpayer has made an election under Regs. Sec. 1.168(i)-1(l). Regs. Sec. 1.168(i)-1 gives rules for establishing, determining depreciation allowances for, and making dispositions from a general asset account.
Dispositions of Tangible Property Other Than a General Asset Account: Regs. Sec. 1.168(i)-8
Regs. Sec. 1.168(i)-8 provides rules for dispositions of MACRS property. A building, condominium, or cooperative unit (all including their structural components) is the asset for tax disposition purposes. A taxpayer desiring to claim a loss on a retired structural component is now required to make a partial disposition election.
The partial asset disposition rule is generally elective, but the rule must be applied to:
- A disposition of a portion of an asset as a result of a casualty event described in Sec. 165;
- A disposition of a portion of an asset for which gain (determined without regard to Sec. 1245 or 1250) is not recognized in whole or in part under Sec. 1031 or Sec. 1033;
- A transfer of a portion of an asset in a "step-in-the-shoes" transaction described in Sec. 168(i)(7)(B); or
- A sale of a portion of an asset.
A taxpayer makes the partial disposition election on its timely filed federal tax return for the tax year in which the taxpayer disposed of the portion of the asset.
A taxpayer can make several elections for tax year 2015 to take advantage of the tangible property regulations. Below are the most common ones:
De minimis safe-harbor election: Regs. Sec. 1.263(a)-1(f) allows a de minimis safe-harbor election for amounts a taxpayer paid to acquire or produce tangible property, to the extent the taxpayer deducted such amounts for financial accounting purposes or in keeping its books and records. Taxpayers will need to make the de minimis safe-harbor election on their 2015 tax return if they want to be able to expense amounts paid for a unit of property costing $5,000 or less for a taxpayer with an applicable financial statement (AFS) and costing $500 or less for a taxpayer without an AFS. The taxpayer will still need to have a book capitalization policy in place, as it did in 2014. The taxpayer will need to attach an election statement to its filed 2015 tax return.
The IRS requested comments on whether it is appropriate to increase the de minimis safe-harbor limit for a taxpayer without an AFS. Currently, the amount is still $500 or less, but the IRS could increase it in the future.
Election to capitalize employee compensation and/or overhead: If a taxpayer acquires real or personal property in 2015, it can elect to capitalize on an acquisition-by-acquisition basis employee compensation and/or overhead amounts paid to facilitate the acquisition. No election statement is required. The taxpayer just needs to capitalize those amounts on its timely filed original 2015 tax return.
Small taxpayer safe-harbor election: A safe harbor is available under Regs. Sec. 1.263(a)-3(h) that allows small taxpayers to elect to currently deduct amounts paid to improve eligible building property, up to the lesser of $10,000 or 2% of the eligible building property's unadjusted basis. A small taxpayer is one with less than $10 million in average annual gross receipts for the preceding three tax years. Eligible building property must have an unadjusted basis of $1 million or less. The taxpayer will need to include an election statement with its timely filed 2015 tax return.
Election to capitalize repair and maintenance costs: An election is available under Regs. Sec. 1.263(a)-3(n) to capitalize repair and maintenance costs. A taxpayer can make this election on its 2015 tax return if it capitalized the costs for book purposes in 2015. The taxpayer will need to include an election statement with its timely filed 2015 tax return.
Election to treat a partial disposition of an asset as a disposition: A taxpayer that is not required to dispose of a partial asset can elect to make a partial asset disposition in 2015. To make the election, the taxpayer completes Form 4797, Sales of Business Property, for the partial asset disposition and includes the form with its timely filed 2015 tax return. No election statement is needed.
Accounting Method Changes
Many accounting method changes were required for the 2014 tax year to comply with the tangible property regulations. Other accounting method changes were optional for taxpayers in 2014. Some of those same required and optional accounting method changes are available to taxpayers in 2015. Rev. Procs. 2015-13 and 2015-14 provide guidance on accounting method changes related to the tangible property regulations.
The draft Form 3115, Application for Change in Accounting Method, that taxpayers will use for an accounting method change in tax year 2015 has been made available by the IRS. The IRS plans to release the final form and instructions prior to the 2016 (2015 tax year) tax season. Taxpayers will need to use the new Form 3115 for all tax year 2015 accounting method changes.
Below are the most common accounting method changes related to the tangible property regulations:
DCN 184, 186, 187, or 192: Designated automatic accounting method change number (DCN) 184, 186, 187, or 192 was required to be filed on a Form 3115 in tax year 2014 for all applicable taxpayers. DCN 184, 186, 187, or 192 allowed taxpayers to comply with the final regulations for their repair and maintenance costs, units of property, materials and supplies, and acquisition and production costs.
If a taxpayer did not file DCN 184, 186, 187, or 192 for tax year 2014, it can file these method changes for tax year 2015, as long as the IRS has not notified it of, or it is not under, an audit. Filing the method change in 2015 will allow a taxpayer to take advantage of a potential negative Sec. 481(a) adjustment and to provide audit protection.
DCN 21: This DCN applies when a taxpayer wants to change its method of accounting for removal costs in disposal of a depreciable asset, including a partial disposition. The taxpayer can currently deduct removal costs if it has filed a DCN 21. A taxpayer may make this method change for tax year 2015 if it has removal costs in the year that it would like to currently expense. A taxpayer can still decide to capitalize removal costs even if it filed a DCN 21.
DCN 7: This DCN applies to a taxpayer that is changing its depreciation from an impermissible method to a permissible one. The taxpayer will have either a positive or negative Sec. 481(a) adjustment included on Form 3115. A taxpayer may file this method change in tax year 2015 if it needs to correct an impermissible depreciation method from any year prior to 2015.
DCN 205/206: DCN 205 applies to a taxpayer that has disposed of a building or structural component, and DCN 206 applies to dispositions of other tangible depreciable assets, including land improvements. A taxpayer that has a depreciable asset (separately broken out) on its fixed-asset listing more than once can file a DCN 205 or 206 to remove the depreciable asset that had been disposed of in the past but was not written off the fixed-asset listing. The taxpayer can file this method change with its timely filed 2015 tax return to remove the prior disposed-of asset from its fixed-asset listing. The Sec. 481(a) adjustment will be the remaining tax basis of the asset that the taxpayer is removing.
DCN 196: This DCN applied to a taxpayer that was making a late partial disposition election. DCN 196 afforded taxpayers the ability to take into account the remaining basis of the portion of the asset in the year of change. Unfortunately, this method change was allowed only for a tax year beginning on or after Jan. 1, 2012, and before Jan. 1, 2015. A taxpayer cannot make this method change for tax year 2015.
Rev. Proc. 2015-20
Rev. Proc. 2015-20 provides small business taxpayers a simplified procedure to implement the final regulations. A small business taxpayer must meet the following criteria to be able to use the procedures under Rev. Proc. 2015-20:
- It has total assets of less than $10 million on the first day of the tax year for which an accounting method change under the final tangible property regulations is effective; or
- It has average annual gross receipts of $10 million or less for the prior three tax years.
A small business taxpayer that meets one of these two criteria can choose to change to certain methods of accounting under the final regulations by taking into account only amounts paid or incurred in tax years beginning on or after Jan. 1, 2014. The taxpayer will not have a Sec. 481(a) adjustment for the first tax year beginning in 2014 and will not be required to file a Form 3115 for that year (other than for certain concurrent changes). The taxpayer will be implementing the tangible property regulations prospectively. The taxpayer will only need to file its 2014 federal tax return to comply with the final tangible property regulations under Rev. Proc. 2015-20. If a taxpayer chooses these procedures, it will not receive audit protection for prior-year tangible property regulations issues.
For the 2015 tax year, a small business taxpayer will need to continue applying the tangible property regulations to its repairs and maintenance, asset acquisitions, materials and supplies, capital expenditures, and asset disposals.
Many taxpayers met the criteria for the simplified procedures under Rev. Proc. 2015-20 and did not file any Forms 3115 related to the tangible property regulations in 2014. These taxpayers might now want to file those accounting method changes in tax year 2015 to take advantage of a prior-year negative Sec. 481(a) adjustment or to get audit protection for years prior to 2015.
Some tax practitioners believe that a taxpayer that "defaults" to accepting relief under Rev. Proc. 2015-20 automatically forfeits any opportunity to correct expenditures that it could have expensed in years prior to 2014. This is not true. As long as a taxpayer has not violated the eligibility rules of filing automatic method changes of Rev. Proc. 2015-13, it has not forfeited its ability to file tangible property regulations method changes in tax years after 2014.
The confusion comes in where the IRS states in its tangible property regulations frequently asked questions (FAQs; available at www.irs.gov) that if a small business taxpayer chooses the procedures under Rev. Proc. 2015-20, any Sec. 481(a) adjustment on a Form 3115 cannot take into account amounts prior to 2014. But what if a taxpayer did not explicitly choose the procedures under Rev. Proc. 2015-20 and just "defaulted" to employing the revenue procedure because it did not file any Forms 3115?
The FAQs say a taxpayer is not required to but should consider including a statement with its 2014 tax return indicating that its qualifying trade or business is not applying the simplified procedure under Rev. Proc. 2015-20 if it wants to be able to file Forms 3115 in the future for tax years prior to 2014.
However, the IRS then conducted a webinar on July 15, 2015, in which it addressed the tangible property regulations (available at www.irsvideos.gov). During this webinar, the IRS spoke on Rev. Proc. 2015-20. The Service stated that if a taxpayer plans to file the Forms 3115 in tax year 2015 and wants to include items in prior tax years, it must include a statement with its 2014 tax return stating that it is not following Rev. Proc. 2015-20.
So the IRS has now taken two positions on this situation (neither authoritative). Currently, it is uncertain whether a small business taxpayer can include items from prior years in a Form 3115 filing if it did not include a statement with its 2014 tax return opting out of the Rev. Proc. 2015-20 procedures. Small business taxpayers should wait until there is more clarification from the IRS before deciding whether to file those Forms 3115. One thing that is clear is that a taxpayer cannot file a DCN 196 in tax year 2015, even if the taxpayer explicitly opted out of Rev. Proc. 2015-20.
The tangible property regulations affected most business taxpayers for tax year 2014. They put a burden on taxpayers to file accounting method changes, make elections, and implement new procedures for their tangible assets. Small business taxpayers gained some reprieve from filing accounting method changes, but they still needed to implement the new tangible asset procedures.
Now that tax year 2015 is here and the 2016 filing season is right around the corner, taxpayers need to start addressing how they are going to handle the tangible property regulations this year. Taxpayers will need to continue using the tangible asset procedures they implemented in 2014, and they will need to include election statements with their tax year 2015 returns to take advantage of the de minimis safe harbor, small taxpayer safe harbor, or the election to capitalize repair and maintenance costs. Taxpayers can also make elections to capitalize employee compensation and/or overhead and to treat a partial disposition of an asset as a disposition.
Large business taxpayers (taxpayers not eligible under Rev. Proc. 2015-20) that did not file Forms 3115 related to the tangible property regulations with their 2014 tax returns should file Forms 3115 with their 2015 tax returns. This would include DCN 184, 186, 187, or 192; DCN 7; DCN 21; or DCN 205/206. Taxpayers cannot file DCN 196 in any tax year after 2014. Small business taxpayers are not required to file any Forms 3115 related to the tangible property regulations for tax year 2015, but some are still eligible to do so. Small business taxpayers that explicitly opted out of Rev. Proc. 2015-20 can file most Forms 3115 related to the tangible property regulations in 2015. Taxpayers that did not explicitly opt out of Rev. Proc. 2015-20 should wait until the IRS clarifies its position on filing Forms 3115 related to the tangible property regulations for tax year 2015 before filing them.
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.