Are You Ready for the New Tangible Property Rules?

Are You Ready for the New Tangible Property Rules?

by

Eustis Corrigan, CPAManaging Director, CBIZ MHM, LLC

Mike Finnegan, CPAManaging Director, CBIZ MHM, LLC

Steve Henley, CPANational Tax Practice Leader, CBIZ MHM, LLC

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Circular 230 Notice

Any tax advice contained in this program is not intended to be used and cannot be used for the purposes of avoiding any penalties that may be imposed by the Internal Revenue Code.

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• Area under IRS scrutiny for many years• Latest attempt to develop some consistency in

treatment of tangible property transactions– Many favorable changes (i.e. tax deductions available

now)– IRS wants to make method changes as flexible as

possible– This is the new law; tax compliance is required

Introduction

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• IRS has always had interest in the capitalization vs. deduction of costs related to tangible property–Original source: Case law –August 2006: Proposed regulations–March 2008: Re-proposed regulations– IRS issued specific audit guidelines for this issue

History and Background

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• Temporary regulations issued (December 2011)– Transition guidance issued (March 2012)

• Provides 19 new automatic method changes• Scope limitations waived for 2012 and 2013• Required compliance with section 263A

• Large Business & International (LB&I) Directive issued (March 2012)– Stand-down order on most repairs and associated

dispositions issues

History and Background, cont.

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• Final regulations contain the standards for determining whether and when a taxpayer must capitalize costs incurred in acquiring, maintaining, or improving tangible property– Temp regulations (effective for tax years beg on or after 1/1/12)– Final Regulations effective for tax years beg on or after 1/1/14

• May be optionally applied for tax years beginning on or after 1/1/12


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• Proposed Regulations issued 9/19/13 for the Disposition of Tangible Property portion of these rules:– Temporary regulations (currently effective for tax years

beginning on or after 1/1/12):– Final Regulations to be issued later in 2013– Effective for tax years beginning on or after 1/1/14

• Proposed regulations may be optionally applied for tax years beginning on or after 1/1/12


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• Note that these rules are for “Tangible Property”–Not just for tangible personal property– Improvements to and dispositions of real property

are a significant part of the new rules–New rules were not designed for intangible assets

• Focus is on depreciable property, materials & supplies, and repair expenses


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• Compliance with these new rules may require changes in methods of accounting for tax purposes– Transition guidance issued for the Temporary Regulations

• Allows for automatic accounting method changes to get in compliance with these rules

– Transition guidance expected for the Final Regulations

Accounting Method Changes

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• Form 3115 is used to request an Automatic Change– Original Form 3115 is filed as an attachment to the income tax

return and a copy sent to a separate IRS office– Negative adjustments (decrease to income) are deducted in

year of change– Positive adjustments (increase to income) are picked up in

income ratably over 4 years– Transition guidance provides a great deal of flexibility

Accounting Method Changes, cont.

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• As a result of issuing these new rules, the IRS is expecting many Forms 3115 to be filed to get in compliance– IRS stand-down order on audits in this area reflects their

desire to have taxpayers voluntarily make these changes– Expectation is that after the transition period for making these

changes (tax years beginning 1/1/15) the IRS will begin heavy examination activity in this area

• Critical to take advantage of the automatic change provisions now to avoid risk of IRS making changes

• Note that changes in this area may impact other areas and require further changes (UNICAP, Tax Depreciation…)

Accounting Method Changes, cont.

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•2 Primary Subject Areas Covered1) Capitalization and Expensing

• Improvements to Tangible Property• The de minimis safe harbor election• Materials & Supplies

2) Dispositions of Tangible Property • General Asset Account Elections

2 Primary Areas for tax savings and compliance

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• Critical tax compliance area • What is a Capitalized Improvement vs. a Deductible

Expense?

Improvements to tangible property

Improvement

Betterment

Restoration

Adapt to new or different

use

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• Betterment: In general, an expenditure is a Betterment and must be capitalized if it has a “material” impact on the property– Improves a material defect, is for a material addition, or a

material increase in capacity or quality • Restoration: In general, an expenditure is a Restoration

and needs to be capitalized if:– It is for the replacement of a component or returns the property to

its ordinarily efficient operating condition after its class life

• Facts & Circumstances, no bright-line tests but many examples in the Final Regulations

Improvements, cont.

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• Key Concept is the Unit-of-Property (“UOP”)• Taxpayers need to apply the Improvement

Standards to an expenditure made to the UOP and capitalize the expenditure if it results in a:– A Betterment to the UOP;– A Restoration to the UOP;– Adapts the UOP to a new or different use

Improvements – Unit of Property

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• Regulations attempt to make the UOP as small as possible and splits the UOP into 2 main parts:1. For property other than buildings -- adopts the functional

interdependence standard• Plant property further broken out based on “discreet and

major function”

2. For Buildings and its Structural Components -- defines the UOP as the building structure but further breaks the structure into specified building systems which are separate UOP’s

• Building systems are a new concept under these rules

Improvements – Unit of Property, cont.

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• Building Systems are the following building structures:– (1) HVAC– (2) Plumbing systems– (3) Electrical systems– (4) Escalators– (5) Elevators– (6) Fire protection and alarm systems– (7) Security systems– (8) Gas distribution systems– (9) Other structural components identified in published

guidance

What is a Building System?

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• To determine if an expenditure must be capitalized as an improvement to a building look at whether the expenditure improves a building system, if not, then whether it improves the building and its structural components– Building systems are simply building structural components

that need to be considered independently in determining if an expenditure needs to be capitalized as an “improvement”

– Effectively results in a smaller “unit-of-property”– Taxpayer may have difficulty breaking out the appropriate

“building system” from its records if only the total building cost is recorded

Improvements to Buildings

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• Example of applying the improvement standards to the roof of a building:– A building structure is a single unit of property: whether the

replacement of certain roof components constitutes a capitalized improvement is determined by considering the effect on the building structure, rather than the effect on the roof

– The roof is part of the building structure, it is not a building system, therefore the entire building structure is the appropriate UOP to apply the improvement standards

Example: Improvements to a Building - Roof

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• Example of applying the improvement standards to an elevator in the building:– If a taxpayer performs maintenance on one or more of the

building's elevators, whether those costs are deductible repairs or capital improvements depends on the expenditures' effect on the building's elevator system, not on their effect on the entire building

– The elevator system is a building system, therefore the elevator system is the appropriate UOP to apply the improvement standards

Example: Improvements to a Building - Elevator

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• The safe harbor election is for building property held by taxpayers with gross receipts of $10 million or less

• A qualifying small taxpayer can elect to not apply the improvement rules to an eligible building property (basis of $1 million or less) if the total amount paid during the taxable year for repairs, maintenance, improvements, etc. does not exceed the lesser of:– $10,000 or – 2 percent of the unadjusted basis of the building

Safe harbor for small taxpayers

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• The safe harbor is elected annually on a building-by-building basis by including a statement on the taxpayer’s timely filed original Federal tax return for the year the costs are incurred for the building

• Amounts paid by the taxpayer to which the taxpayer elects the safe harbor are not treated as improvements to the building, provided the amounts otherwise qualify for deduction

• Should prove a popular election with rental properties

Safe harbor for small taxpayers, cont.

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• The Safe Harbor for Routine Maintenance applies to expenditures to keep the property in its ordinary and efficient operating condition (i.e. does not result in a betterment)• Applies to personal property and buildings• Qualifying expenditures can be deducted currently

• A Routine Maintenance expenditure qualifies as routine if the taxpayer reasonably expects to perform the activities:

• For personal property more than once during the life of the property

• For buildings, more than once over a 10 year period from when the building is placed in service

Safe Harbor for Routine Maintenance

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• Apply the new UOP rules to existing capitalized assets– There is a method change to write off prior capitalized

assets that would not need to be capitalized under these new rules

– Note: for open tax years need to consider whether expenditures that were deducted should have been capitalized (method change is available to capitalize)

• Consider if the safe harbor for small taxpayers will apply– This is new to the Final Regulations so we need to see the

transitional guidance to see how this is implemented– May require an accounting method change

Improvements: Tax savings opportunities

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• For capitalized maintenance expenditures to personal property and buildings, consider if the Routine Maintenance Safe Harbor would apply– Look at Restoration-type expenditures– There is a method change to write off prior capitalized assets

that would not need to be capitalized under these new rules• Final Regulations added an election to capitalize otherwise

deductible repairs & maintenance– New to the Final Regulations; need to see the transitional

guidance

Improvements: Tax savings opportunities, cont.

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• With the change in the tax rules for what is capitalized, will the book accounting policies need to be changed?– Will the write-off of prior capitalized amounts also be reflected on

the books?– Will the Routine Maintenance Safe Harbor be followed for book

purposes?– Increased scrutiny of repairs & maintenance expenses is required

• The Improvement rules are the new tax law in this area and future expenditures need to be applied to the appropriate UOP to determine if there is a capitalized improvement or a deductible expense– Taxpayers must have a methodology for breaking out the “building

system” in order to apply the improvement standards

Improvements: compliance considerations

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• The Code or Regulations have never condoned the use of a de minimis rule for expensing costs that were otherwise required to be capitalized

• Most taxpayers relied on agreements from prior IRS audits

• The new de minimis safe harbor applies to:– Amounts paid to acquire or produce a unit of real or

personal property– Materials & supplies (discussed later)

The De minimis safe harbor election

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• De minimis safe harbor -- an annual election that permits a taxpayer to currently deduct otherwise capital expenditures (including materials & supplies) if the taxpayer:– (1) has an “accounting policy” (at the beginning of the tax

year) that requires expensing of items that cost no more than a specified dollar amount for book purposes, and

– (2) consistently applies that policy for book purposes.• Critical that book and tax treatment of small dollar items be

understood

De minimis safe harbor, cont.

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• Both requirements must be satisfied to deduct amounts otherwise required to be capitalized

• The ceiling for the de minimis safe harbor depends on whether the taxpayer has an Applicable Financial Statement “AFS”– AFS is an Audited statement– AFS is also a financial statement required to be

provided to the Federal or State government or their agencies (consider bonding agencies for contractors????)


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• The de minimis safe harbor uses an invoice test:• Taxpayers with an AFS: A taxpayer may rely on the de

minimis safe harbor only if the amount paid for property does not exceed $5,000 per invoice or per item as substantiated by the invoice;– Note accounting policy must be written

• Taxpayers without an AFS: A taxpayer may rely on the de minimis safe harbor only if the amount paid for property does not exceed $500 per invoice or per item as substantiated by the invoice;– Note accounting policy just needs to “exist”


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• Under the Temporary Regulations, the de minimis rule required an accounting method change

• Under the final regulations, it is an annual election• The implementation guidance will let us know if a method

change is required• Since the de minimis rule requires the policy to be in

existence at the beginning of the tax year, to utilize this rule the policy needs to be prepared in 2013 for 2014 tax years– For an AFS and the $5,000 ceiling it must be written– Without an AFS and the $500 ceiling it just must be in place


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• Elect the de minimis safe harbor– Will provide some protection during an IRS exam for the

deduction taken on small dollar items– Can still deduct amounts above the safe harbor ceiling

amount, but will not have the same protections – Book ceiling can be larger than allowed for tax, but the

safe harbor protection is limited to the ceiling provided in the Regulations

– Annual election to be attached to return

De minimis safe harbor: Tax savings opportunities

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• Use of the de minimis safe harbor requires that the taxpayer have an accounting policy (at the beginning of the tax year) that requires expensing of items that cost no more than a specified dollar amount for book purposes and that it is followed consistently (written policy for an AFS)

• Need to be aware of the various P&L general ledger accounts (including materials & supplies) that are impacted by the de minimis safe harbor to ensure all applicable expenditures are considered

• Note that the book policy of deducting amounts below the policy ceiling needs to be followed consistently

De minimis safe harbor: compliance considerations

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• Same distinction must still be made:– Non-incidental materials and supplies

• deductible in the taxable year in which the materials and supplies are used or consumed in the taxpayer's operations

– Incidental materials and supplies • no record of consumption or physical inventory kept • deductible in the taxable year in which these amounts are paid,

provided taxable income is clearly reflected

• Materials & supplies generally must be treated as non-incidental, unless they are “incidental”

Materials & Supplies

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• The regulations have provided a specific definition of materials & supplies– The regulations do not provide a definition of incidental or

non-incidental• Taxpayers can use this definition to avoid capitalizing and

depreciating as a UOP– Under the Final Regulations, cannot elect to capitalize and

depreciate materials & supplies• Records must be kept to determine year of consumption

(i.e. the year deductible)– Year of deduction may be impacted by UNICAP

Materials & Supplies, cont.

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• Definition -- Tangible property (other than inventory) used or consumed in a taxpayers operations and that:– Are components acquired to maintain, repair, or improve a UOP;– Consists of fuel, lubricants, water, and similar items, that are

reasonably expected to be consumed in 12 months or less, beginning when used in taxpayer's operations;

– Is a UOP that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer's operations;

– Is a UOP that has an acquisition cost or production cost of $200 or less; or

– Is identified in published guidance as materials and supplies for which treatment is permitted under this section


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• Coordination with the de minimis safe harbor:–The final regulations require that the de minimis

safe harbor be applied to all eligible materials and supplies if the taxpayer elects the de minimis safe harbor

–Exception for rotable, temporary, and standby emergency spare parts that are subject to a separate election to capitalize


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• Automatic accounting method changes are available to change the treatment of materials and supplies to incidental from non-incidental, and vice-versa

• If the de minimis safe harbor is elected – beneficial if taxpayer treats all materials & supplies as incidental

Materials & Supplies: Tax savings opportunities

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• IRS will utilize the definition of materials and supplies and may determine incidental supplies are non-incidental (issue if de minimis safe harbor is not elected)

• Consumption records need to be kept for non-incidental supplies

• Tax accounting treatment may differ from book accounting• Coordination with UNICAP is needed since materials and

supplies generally are subject to UNICAP• Recordkeeping considerations if materials & supplies are

included in the de minimis safe harbor

Materials & Supplies: compliance considerations

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•2 Primary Subject Areas Covered1) Capitalization and Expensing

• Improvements to Tangible Property• The de minimis safe harbor• Materials & Supplies

2) Dispositions of Tangible Property • General Asset Account Elections

2 Primary Areas for tax savings and compliance

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• There are new proposed regulations and older temporary regulations that deal with this area

• The proposed regulations appear to be similar to the temporary regulations

• Issue: there is not any form of implementation guidance for the proposed regulations

• Taxpayers can rely on the proposed regulations starting in tax years beginning 1/1/12

• The Final Regulations may be issued by the end of the year

Dispositions of tangible property

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• *** This is the biggest opportunity for tax savings***• The Proposed Regulations define a disposition similar to the

Temporary Regulations but include a concept called a “Partial Disposition”

• There is an election that can be made where the loss on the partial disposition is taken and the replacement expenditure is capitalized

• The loss is allowed on: 1. A structural component (or a portion thereof) of a building, or

2. The disposition of a major component (or a portion thereof) of any other asset

Dispositions of tangible property, cont.

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• There are many examples in the proposed regulations illustrating the impact of the Partial Disposition Election– Included in the examples are the replacement of an

elevator, the replacement of aircraft engines and the replacement of truck engines.

• The Partial Disposition Election is made on the taxpayer’s timely filed original Federal tax return, including extensions, for the taxable year in which the portion of the asset is disposed of by the taxpayer


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• If the partial disposition election is not made, the original component continues to be depreciated– The replacement expenditure needs to be reviewed under

the betterment and restoration improvement standards to determine if it needs to be capitalized

– Under the temporary regulations, the original, replaced component cannot continue to have depreciation taken

• In no case can a taxpayer take the loss on the component disposition and also deduct the replacement expenditure• In effect, cannot take a repair expense and a disposition loss


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• How is the adjusted basis of the disposed component determined? – Typically, taxpayers include only a single asset in their fixed

asset systems for a building and for most personal property assets leaving them with no way to determine the cost basis of a certain component of those assets

– The Temporary Regulations provided that, if the taxpayer cannot determine the unadjusted depreciable basis from its books and records, the taxpayer may use any reasonable method that is consistently applied


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• The Proposed Regulations provide more guidance on reasonable methods:– A study (including a “cost-seg”) allocating the cost of the asset

to its individual components; – Discounting the cost of the replacement asset to its placed-in-

service year cost using the Consumer Price Index; and– A pro rata allocation of the unadjusted depreciable basis of the

general asset account or multiple asset account, as applicable, based on the replacement cost of the disposed asset and the replacement cost of all of the assets in the general asset account or multiple asset account, as applicable


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• The Temporary Regulations had the individual building structures as the asset for disposition purposes

• Under the Proposed Regulations, the building is the asset for disposition purposes– This has the same practical impact as the GAA election

had from the Temporary Regulations in that it allows for disposed structures to continue to be depreciated;

• Therefore the GAA election is likely not needed under the proposed regulations

General asset accounts (“GAA”)

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• Opportunity: The implementation guidance issued for the Temporary Regulations, allowed for accounting method changes to be filed to write off prior year building structure dispositions– This would be consistent with the goal of stopping the

depreciation of an asset and its replacement– The temporary regulations only apply to building structures

• There will likely not be implementation guidance issued for the proposed regulations, so it is unclear how the final regulations will treat prior year dispositions, but conceptually this should be allowed

Prior year dispositions of building structures

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• To take advantage of this opportunity under the temporary regulations, an analysis must be made of the real property assets on the tax depreciation schedule to determine if there was a prior year disposition of a building component– If so, figure out the loss or stop depreciating– In most cases, taking the loss deduction is preferable

to losing depreciation

Dispositions in prior years, cont.

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• Dispositions of prior year building structures under the temporary regulations:– Review tax depreciation records for clients with multiple

year 27.5-year or 39-year real property additions• Could be evidence of a replacement of a structural

component and a loss can be taken (or depreciation must be stopped)

– Also, look for multiple year 15-year land improvement additions• Could be evidence of a replaced land improvement and a

loss can be taken (or depreciation must be stopped)

Dispositions: Tax savings opportunities

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• Since the partial disposition removes that part of the depreciable asset from the tax depreciation records, an opportunity for future tax savings exists:– The accumulated depreciation of the disposed asset is

no longer on the tax depreciation schedule;– In a future sale of the property at a gain, this will

remove some future potential depreciation recapture (§1250 or §1245) and more of the gain could be taxed at the more favorable long-term capital gains rate

• This could be very valuable to pass-through entity owners

Dispositions: Tax savings opportunities, cont.

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• Remember that these disposition rules apply to many types of businesses, as well as individuals that own rental properties– This could be an instance where individual taxpayers

file an accounting method change with their personal return (i.e. an individual that has rental properties)

• These rules apply to capitalized leasehold improvements if you do not own the building

Dispositions: Tax savings opportunities, cont.

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• With the change in the tax rules allowing for building structure and significant component dispositions, will the book accounting policies need to be changed?– How will the tax law change to “componentizing” fixed

assets be treated under GAAP– Will the write-off of prior year building structure

dispositions also be reflected on the books?• Need to come up with the adjusted basis of the asset

disposed under the partial disposition election

Dispositions: compliance considerations

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Closing

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• In order to be compliant with these new rules a review of the following is required– Tax Depreciation records– Repair & maintenance account detail– Materials & supplies expense detail– Book capitalization policy– UNICAP calculations– Prior 3115’s impacting the above– Prior cost-segregation studies

Taxpayer records to be reviewed

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• Section 263A UNICAP conformity requirement• Optional application of temp/final/proposed rules

– 2012, 2013, 2014• Repairs studies have been a Tier 1 issue; will continue to

receive IRS exam focus• Prior repairs studies need to be evaluated• IRS will continue to address industry-specific issues via

Industry Issue Resolution (“IIR”) process

Priority Considerations

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• Impact on DPAD deduction• For individuals, deduction may decrease passive income

or increase passive losses (3.8% tax to be considered)• Fixed assets/cost segregation• State and Local Tax

– Apportionment factors– Personal property taxes

• Impact on systems and processes– G/L accounts– Coding

Other Collateral Considerations

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• Tax savings are a likely result• Effective for years beginning on or after 1/1/14, but early adoption is

possible• 2 Primary Subject Areas

1. Capitalization and Deduction:• Improvements to Tangible Property (incl. Routine maintenance safe

harbor)• The de minimis safe harbor• Materials & Supplies

2. Disposition of Tangible Property• Automatic method changes available to assist in getting compliant

with these rules

Recap

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Summary/Key Takeaways

• Be aggressive in applying these rules:– Tax savings opportunities -- Many changes will result in a

reduction to income– Compliance and Risk Management – Taxpayers need to be

aware of tax return positions and risks– Always consider UNICAP impact

• Learn the rules – the changes required are fact-based so taxpayers and practitioners will need to be well versed in order to apply them

• Understand the impact these rules will have on accounting systems – most tax accounting follows book accounting where capitalization is concerned– These rules may change a taxpayer’s book accounting or cause a

book versus tax difference

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QUESTIONS?

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Upcoming Webinars – Save the Date

Eye on Washington: Quarterly Business Tax Update (3rd Quarter) on Wednesday, October 30th from 2:00 – 3:00 ET

Registration will be available closer to webinar date.

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CBIZ MHM, LLC Contact Information

Eustis CorriganManaging Director 901.842.2876 [email protected]

Mike FinneganManaging Director 602.650.6205 [email protected] Steve HenleyNational Tax Practice Leader 770.858.4443 [email protected]

mailto:[email protected]



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Thank You