In 2014, the IRS issued final guidance on the treatment of costs for tangible property under the sweeping “repair” regulations that impact most businesses. Since that time, there has been much conversation about the final regulations since their implementation became mandatory. Most recently, the Internal Revenue Service (IRS) released guidance pertaining to two areas in which business taxpayers must determine whether to capitalize or deduct certain costs. The areas are as follows: (1) The de minimis safe harbor for certain capital items and (2) the so-called “remodel-refresh” safe harbor applicable to taxpayers operating a retail establishment or restaurant. Each of these areas is discussed in further detail below.
According to previously released IRS regulations, business taxpayers can deduct, rather than capitalize, certain capital items up to a specified dollar amount based largely upon one key factor. That factor is whether or not the taxpayer has an Applicable Financial Statement (AFS). An AFS is a financial statement that is (1) audited, (2) filed with the SEC or (3) filed with another government agency. Taxpayers with an AFS, if they also have a written accounting policy as of the beginning of the year in question, are entitled to deduct, rather than capitalize, certain capital items up to $5,000 per item. Taxpayers without an AFS, until recently, were entitled to deduct certain capital items only up to $500 per item, regardless of whether or not the accounting policy governing this decision was in writing.
On November 24, 2015, the IRS released Notice 2015-82 increasing the de minimis safe harbor threshold for taxpayers without an AFS from $500 per item up to $2,500 per item. The amount which can be deducted remains up to $5,000 per item for taxpayers with an AFS. The IRS released this guidance after receiving numerous comments from small business owners that the $500 limit was too low to effectively reduce the administrative burden of remaining in compliance with current capitalization regulations. At the same time, the $500 limitation differed from the financial accounting policies of many small businesses, which often permit the deduction of amounts spent on certain capital items in excess of $500. The increased $2,500 per item limit for taxpayers without an AFS is effective for tax years beginning on or after January 1, 2016. This should serve to reduce the administrative burden faced by small business taxpayers.
Taxpayers operating in the retail and restaurant industries regularly incur expenditures to remodel or refresh the buildings used in the course of their customer-focused business. These expenditures often consist of altering the physical appearance and layout of the building. According to longstanding tax law, taxpayers are permitted to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including the cost of repairs and maintenance. At the same time, taxpayers are generally required to capitalize amounts paid to improve tangible property. Due to the fact that remodel-refresh projects vary so much in frequency, quality and degree, taxpayers and the IRS frequently encounter questions pertaining to whether the costs should be deducted as repairs and maintenance, or capitalized as an improvement to the building. Both taxpayers and the IRS have had to expend significant resources to resolve such questions.
On November 19, 2015, the IRS released Rev. Proc. 2015-56, under which qualified taxpayers may determine the portion of their remodel-refresh costs which may be deducted and the portion which must be capitalized and recovered through depreciation. Rev. Proc. 2015-56 is effective for tax years beginning on or after January 1, 2014. Under the safe harbor provided, a qualified taxpayer may treat 75% of its qualified costs incurred as deductible, and must treat the remaining 25% of its qualified costs as improvements and capitalize the costs.
In order to qualify for this safe harbor a taxpayer must have an AFS and be in the trade or business of selling merchandise to customers at retail or in the trade or business of preparing and selling meals, snacks or beverages to customers for immediate on-premises and/or off-premises consumption. A building owner who leases to a qualified taxpayer may also be eligible. Automotive dealers and hotels, among other taxpayers, are specifically excluded from the definition of qualified taxpayer.
The IRS defines qualifying remodel-refresh project costs and qualified buildings for the purpose of this safe harbor and provides numerous examples. The IRS also provides procedures for obtaining IRS consent to change to this safe harbor method of accounting. Taxpayers that want to use this safe harbor will need to file an accounting method change and examine how they have previously accounted for qualified costs.
We will continue to keep you updated as developments and guidance are released from the IRS regarding tangible property regulations.
If you have any questions, please contact Andrew Lattimer at firstname.lastname@example.org or (860) 570.6327.
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