The Tangible Property "Repair" Regulations for Manufacturers, DistributorsAugust 10, 2012
Crystal A. Germanese, CPA
On December 23, 2011, the IRS released 200 plus pages of regulations regarding the deduction and capitalization of tangible asset costs in temporary and proposed form. In other words, temporary regulatory measures have been put in place while the proposed permanent forms are deliberated upon and implemented. The Temporary Regulations apply to tax years beginning on or after January 1, 2012 or to amounts paid or incurred in tax years beginning on or after January 1, 2012, as applicable, and will affect every taxpayer that acquires, produces or improves tangible property.
Below we have highlighted some of the areas of the new regulations that will have the greatest impact on a significant majority of taxpayers in order to help you understand the rules and how they will be implemented. For a full review of the regulations, we have compiled a series of articles here.
De Minimis Rule
In general, a taxpayer must capitalize amounts paid to acquire or produce a unit of property. Temporary Regulation 1.263(a)-2T provides an exception through the de minimis rule.
In order for a taxpayer to apply the de minimis rule, the taxpayer must have an applicable financial statement, have a written capitalization threshold at the beginning of the taxable year and treat the amount as an expense on its financial statements. The total amount expensed for the taxable year must be less than or equal to the greater of:
- 0.1% of the taxpayer’s gross receipts for federal income tax purposes; or
- 2% of the taxpayer's total depreciation or amortization expense.
Many commentators have expressed that the ceiling should be increased. For example, taxpayers with gross receipts of $50 million will only be allowed to deduct acquisitions up to $50,000 based on the first threshold. Taxpayers may have traditionally deducted more than the newly defined de minimis amount using their existing capitalization thresholds. Also, many taxpayers will need to revise their current procedures to track the total amount of what they are currently expensing to ensure they are not exceeding the threshold. This tracking may be cumbersome to taxpayers that do a lot of acquiring.
Another concern with the de minimis rule is that it only applies to taxpayers with an applicable financial statement. For this purpose, an applicable financial statement is defined as an audited financial statement or a financial statement required to be filed with the SEC or a federal or state government agency. Taxpayers with reviewed or compiled statements will not have the ability to apply the de minimis rule, requiring them to capitalize all of their acquisitions without regard to any capitalization threshold.
Commentary surrounding this rule also includes concern that the threshold cannot be determined until after a taxpayer's gross receipts and depreciation and amortization expense for the tax year are known. This will be unknown to taxpayers during the year making it more difficult to estimate the treatment of their acquisitions throughout the year. Also, consolidated groups are required to calculate the de minimis ceiling separately for each member of the consolidated group.
Many are anticipating some changes to the de minimis rule when the final regulations are issued, but as of now the current de minimis rule applies to tax years beginning on or after January 1, 2012.
Materials and Supplies
The rules under Temporary Regulation 1.162-3T also provide guidance for the treatment of materials and supplies and rotable and temporary spare parts. If an acquisition is not deductible under the de minimis rule, it may still be deductible as a material or supply. Under the temporary regulations, amounts paid to acquire or produce materials and supplies are deductible in the taxable year in which the materials and supplies are used or consumed in the taxpayer’s operations.
Materials and supplies are defined to include tangible property that is determined to have an economic useful life to the taxpayer of 12 months or less, beginning when first used or consumed in the taxpayer’s operations, or that has an acquisition or production cost of $100 or less. The bright-line test of $100 or less will catch many taxpayers by surprise. In some cases, taxpayers may have been using a higher threshold in considering what are materials and supplies.
Rotable and temporary spare parts are deducted when used or consumed; however, a taxpayer may elect to capitalize and depreciate rotables or elect an optional method treatment. Under the optional method, the taxpayer deducts its basis in the rotable in the year it is placed in service, recognizes income when the rotable is removed, capitalizes costs to fix the rotable and then claims a deduction for such basis when the rotable is once again placed in service. Rotable and temporary spare parts are defined as acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved and either reinstalled on the same or other property or stored for later installation.
The temporary regulations generally provide that amounts paid to improve a unit of property are capitalized. Aunit of property is considered to improve the property if it:
- Results in a betterment to the unit of property;
- Restores the unit of property;or
- Adapts the unit of property to a new or different use.
In order to determine if an amount is paid to improve a unit of property, taxpayers need to understand how a unit of property is defined. In the case of a building, an improvement is made if the building structure, or one of the defined building systems, is improved. The building sub-systems as broken out in the temporary regulations are HVAC, plumbing, electrical, elevators, escalators, fire protection and alarm, security and gas distribution systems.
For property other than buildings, the unit of property is determined using a functional interdependence standard, under which the placing in service of one component by the taxpayer depends on the placing in service of the other component by the taxpayer. Plant property, however, must be further divided into smaller units based on a component or a group of components that perform a discrete and major function or operation. Plant property is defined as functionally interdependent machinery or equipment used to perform an industrial process, such as manufacturing, generation, warehousing, distribution, automated materials handling in service industries or similar activities.
The larger the unit of property, the more likely an expenditure will be considered a repair rather than an improvement. The breaking down of the building structure and subsystems and the division of plant property into smaller components will lead to fewer amounts of deductible repair expenditures.
For example, a taxpayer uses many different machines in an assembly line-like process to treat, launder and prepare linens. Because this equipment is plant property used in an industrial process, each sorter, boiler, washer, dryer, ironer and folder must be treated as a separate unit of property. If a taxpayer was considering the assembly line as the unit of property and it replaced a major component in one of the sorters, it may have been considered a deductible repair as compared to the entire assembly line. However, since each sorter is a separate unit of property and it was a major component of that one sorter, it would be required to be capitalized.
A routine maintenance safe harbor is provided as an exception to capitalization for amounts paid for recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the property. 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. An activity is not considered routine and recurring if it results in a betterment or adaptation, is performed on property where a taxpayer has taken into account the adjusted basis of the property (e.g. by claiming a loss), or if the property is in a state of nonfunctional disrepair prior to the expenditure.
Dispositions and General Asset Accounting
The Temporary Regulations provide that the facts and circumstances of each disposition are considered in determining the appropriate asset disposed. A taxpayer may generally use any reasonable, consistent method to treat each of an asset’s components as the asset for disposition purposes, unless specifically described otherwise. A big change in the temporary regulations is that a disposition includes a disposition of a structural component of a building. Under prior law, a taxpayer was precluded from recovering basis on the disposal of a component of the building, yet was required to capitalize the cost of the new replacement component if it was not considered a deductible repair.
An alternative to the general rule of depreciation is the election to use the general asset accounts. Each general asset account is effectively treated as the asset. Each general asset account must include only assets that have the same depreciation method, recovery period, convention and placed-in-service year. A taxpayer is allowed to establish as many accounts for assets as the taxpayer wants.
No loss is realized upon the disposition of an asset in a general asset account until there is a complete disposition of the assets in the account. A taxpayer, however, can elect to terminate general asset accounting treatment for an asset in the account when the taxpayer disposes of the asset in a qualifying disposition. The Temporary Regulations expand a qualifying disposition to generally include any disposition, including a structural component of a building.
Taxpayers may want to consider making a general asset accounting election to reduce the administrative burden and protect its ability to deduct repairs. For example, a taxpayer replaces a portion of the roof of its building. Assume the replacement would be considered a repair. However, since the taxpayer is required to dispose of a structural component of its building, it must dispose of the portion of the roof that was replaced and reduce its basis in its original building. Once a taxpayer has recognized a basis adjustment or loss, the replacement is automatically considered a restoration and must be capitalized. If the taxpayer made a general asset in the year it placed its building into service, it would not be required to dispose of the portion of the roof and would have the ability to expense the current expenditures as a repair.
In the example above, without the general asset accounting election in place, the taxpayer is forced to make the disposition. This is not a choice and, if not done, the future depreciation and/or disposal of the building must be treated as if the disposition was correctly done.
Taxpayers should consider whether general asset accounting elections would be appropriate and, under the transition guidance issued by the IRS, can make late general asset accounting elections for assets placed into service before January 1, 2012 during the two taxable years following December 31, 2011.
Change in accounting method
On March 7, 2012, the IRS issued Revenue Procedures 2012-19 and 2012-20 which provide procedures for a taxpayer to obtain automatic consent of the Commissioner to comply with the temporary regulations. Taxpayers have two years after December 31, 2011 to adopt the method changes provided in the temporary regulations and will generally have to calculate a 481(a) catch up adjustment. However, some of the changes, such as the de minimis rule and materials and supplies, are only taken into account for amounts after January 1, 2012. Taxpayers will recognize an unfavorable 481(a) adjustment over four years starting with the year of change.
The Revenue Procedures also expressly authorize the use of statistical sampling to compute the 481(a) adjustments for some items such as repairs. Revenue Procedure 2011-42 provides guidance on the sampling plan standards, documentation and technical formulas. The calculation of the 481(a) adjustment to comply with the temporary regulations may be burdensome to many taxpayers. Taxpayers will have to retrospectively review their prior period acquisitions, improvements, repairs and dispositions to determine if the treatment is consistent with the new accounting method being adopted.
Given that the new regulations apply to every taxpayer that “acquires, produces or improves tangible property,” it’s almost guaranteed that there will be an impact on the majority of businesses. Taxpayers should review their current acquisition, expensing and disposition procedures to assess their compliance with the new rules. As always, please contact us if you have any questions regarding the proper means of applying the new measures to your business.
Crystal A. Germanese is a manager at BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in Connecticut and Massachusetts. The firm, with nearly 300 professionals and staff, offers a diversity of services which includes auditing, accounting, tax and business advisory services. In addition, BlumShapiro provides a variety of specialized consulting services such as succession and estate planning, business technology services, employee benefit plans, litigation support and valuation and financial staffing. The firm serves a wide range of privately held companies, government and non-profit organizations and provides non-audit services for publicly traded companies.