SPECIAL REPORT: Navigating the Final Regs on Deduction vs. Capitalization of Tangible Property Costs

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1 SPECIAL REPORT: Navigating the Final Regs on Deduction vs. Capitalization of Tangible Property Costs This Special Report provides an overview of the most widely applicable rules in the new regs and how they are to be applied in practice. Earlier this year, IRS issued long-awaited final regs providing guidance on the application of Code 162(a) and Code 263(a) to amounts paid to acquire, produce, or improve tangible property. These important new regs will affect virtually all taxpayers that acquire, produce, or improve tangible property. There is much for businesses to be pleased with in the final regs. For example, a substantially revised and expanded de minimis safe harbor election effectively a book-tax conformity election will allow many businesses to currently deduct their outlays for lower-cost assets, materials, and supplies. Building owners will be able to use a new safe harbor election allowing a current deduction for routine maintenance. And certain owners of smaller properties get their own per-building safe harbor election for maintenance expenses. Overview of the New Capitalization Regs The new final regs cover the application of Code 162(a) and Code 263(a) to amounts paid to acquire, produce, or improve tangible property. The project was long overdue, as prior final regs didn t clearly address the issue of whether expenses should be deducted currently (e.g., as repairs or as materials or supplies) or capitalized. As a result, over the years, the issue has figured prominently in many court cases and has been the subject of many rulings, dealing with questions as diverse as how to treat environmental remediation expenses, restaurant flatware expenses, renovation of the facade of a historic hotel, and rotable spare parts used in repairs. The final regs are IRS s fourth attempt to provide comprehensive guidance. Proposed regs were issued in 2006 and then modified in Temporary regs were issued late in 2011, building on the concepts introduced in the 2008 regs, but making many changes along the way in response to commentators. Now the temporary regs have been replaced with final regs that resemble the overall approach of the temporary regs but make a number of critically important large and small liberalizations. In particular, the final regs widen some safe harbors found in the temporary regs and create several new ones as well. IRS aimed to provide a comprehensive set of rules on a complex subject and, by and large, it has succeeded. But absorbing and applying these new rules will be a challenge. This Special Report provides an overview of the most widely applicable rules in the new regs and how they are to be applied in practice. Keep in mind that IRS has separately issued new proposed reliance regs that cover dispositions of MACRS property and that intersect with the final capitalization regs. General Capitalization Rule Overall, the new final regs restate in a comprehensive way long-established concepts about which costs must be capitalized in connection with the acquisition or production of real or personal property. Under the new regs, as a general rule, all costs that facilitate the acquisition or production of such property must be capitalized, with exceptions for employee compensation and overhead costs. Investigatory expenses related to the acquisition of realty generally do not have to be capitalized unless the expenses are inherently facilitative. And the final regs require taxpayers to capitalize repairs made to assets before they are placed in service.

2 Under the final regs, unless the expense qualifies as a material or supply, or the de minimis safe harbor election applies, a taxpayer must capitalize amounts paid to acquire or produce a unit of property (UOP), whether real or personal property, including leasehold improvement property, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. Amounts paid to acquire or produce a unit of real or personal property include the invoice price and transaction costs. (Reg 1.263(a)-2(d)) The term unit of property is defined at Reg 1.263(a)-3(e) and explained in detail below. In general, all the components that are functionally interdependent (i.e., where one component s placement in service by the taxpayer is dependent on the placement in service of another component by the taxpayer) comprise a single UOP. (Reg 1.263(a)-3(e)(3)(i)) The taxpayer also must capitalize costs for work performed before the date that the UOP is placed in service by the taxpayer (without regard to any applicable convention under Code Reg 168(d). (Reg 1.263(a)-2(d)(1)) observation: In other words, the actual placed-in-service date is the reference point, regardless of whether for depreciation purposes personal property is treated as placed in service under the half-year or midquarter convention, and regardless of the mid-month convention that applies to all realty. Illustration: In Year 1, Ace Corp. buys a building for use as a business office. Before placing the building in service, Ace incurs costs to repair cement steps, refinish wood floors, patch holes in walls, and paint the building s interior and exterior. In January of Year 2, Ace places the building in service and begins using it as its business office. None of the work was an improvement to the building or its structural components. Nevertheless, the amounts paid must be capitalized as costs of acquiring the building because they were for work performed before Ace placed the building in service. (Reg 1.263(a)-2(d)(2), Ex. 10) observation: As demonstrated by the above illustration, the rule for work performed before the placed-in-service date can transform what would normally be currently deductible repair expenses into capitalized expenses. recommendation: Taxpayers who wish to minimize the amount that must be capitalized should delay making repairs until after they have placed a UOP in service. Defense or perfection of title. Articulating a long-established rule, the final regs say amounts paid to defend or perfect title to real or personal property (e.g., to contest a condemnation) are treated as amounts paid to acquire or produce property and must be capitalized. However, amounts paid to preserve a taxpayer s business activities (e.g., to invalidate a municipal ordinance prohibiting a business from operating) aren t capitalized. (Reg 1.263(a)-2(e)) Facilitative and inherently facilitative costs. Amounts paid to facilitate the acquisition of real or personal property i.e., paid in the process of investigating or otherwise pursuing the acquisition must be capitalized. Facilitative amounts must be included in the basis of property acquired or produced. (Reg 1.263(a)-2(f)(3)(i)) The determination of whether an amount is paid in the process of investigating or otherwise pursuing an acquisition is based on all of the facts and circumstances. The fact that the amount would (or would not) have been paid but for the acquisition is relevant but not determinative. (Reg 1.263(a)-2(f)(2)(i)) observation: This but for standard, along with the concept of inherently facilitative expenses and the carve-out for employee expenses and overhead (discussed below), are paralleled in 2004 final regs dealing with capitalization of costs relating to intangible assets (see Preamble to TD 9107 and Reg 1.263(a)-4). observation: Some facilitative expenses may qualify as amortizable startup expenditures under Code

3 There is much for businesses to be pleased with in the final regs. Facilitative costs include inherently facilitative expenses made up of eleven categories. These include the costs of items such as shipping, moving or appraising property, application fees, sales and transfer taxes, finder s fees, architectural, engineering, environmental or inspection services related to specific properties, brokers or appraisers fees, and services provided by a qualified intermediary in a Code 1031 exchange. (Reg 1.263(a)-2(f)(2)(ii)) Inherently facilitative amounts are capital expenses even if the real or personal property is not acquired. Except for contingency fees, inherently facilitative fees allocable to properties that aren t acquired may be allocated to these properties and recovered as appropriate (e.g., under Code 165, Code 167, or Code 168). (Reg 1.263(a)-2(f)(3)(ii)) Real estate-related whether and which expenses. Costs relating to activities performed in the process of determining whether to acquire real property and which real property to acquire generally aren t facilitative expenses (and therefore may be currently deductible), unless they are inherently facilitative expenses (e.g., the cost of an engineering study or a broker s fee). For example, a retailer wouldn t have to capitalize the cost of hiring a consulting firm to suggest which areas of a city it should expand into (these costs aren t on the inherently facilitative list), but it would have to capitalize the cost of paying an appraiser to determine the value of the properties that the consulting firm recommends (appraisal fees are on the inherently facilitative list). Special allocation rules apply to real and personal property acquired in one transaction. (Reg 1.263(a)-2(f)(2)(iii)), (Reg 1.263(a)-2(f)(4), Ex. 8) Employee compensation or overhead. Amounts paid for employee compensation or overhead are treated as amounts that don t facilitate the acquisition of real or personal property (but under Code 263A may have to be capitalized to property produced by the taxpayer or acquired for resale). However, the taxpayer may elect to capitalize employee compensation or overhead expenses, or both, related to each acquisition. (Reg 1.263(a)-2(f)(2)(iv)) observation: In other words, unless Code 263A applies, amounts paid for employee compensation or overhead while acquiring or deciding to acquire real or personal property are currently deductible (unless the taxpayer makes a capitalization election). The capitalization election (i.e., the election to treat amounts paid for employee compensation or overhead as amounts that facilitate the acquisition of property) is made separately for each acquisition and applies to employee compensation or overhead, or both. The election is made by treating the amounts to which the election applies as amounts that facilitate the acquisition on the taxpayer s timely filed original federal tax return (including extensions) for the tax year during which the amounts are paid. The election can be revoked only by filing a request for a private letter ruling and obtaining IRS s consent to revoke the election. (Reg 1.263(a)-2(f)(2)(iv)) Contingency fees. Such fees (i.e., amounts paid that are contingent on the successful closing of an acquisition) are included in the basis of property acquired. The fees can t be allocated to a property not acquired. (Reg 1.263(a)-2(f)(3)(iii)) Illustration: A restaurant property owner hires a real estate consultant to identify potential property for a new restaurant. The owner pays the consultant when he buys a property. The consultant identifies three likely properties, and the owner decides on one of them and pays the consultant his fee. The consultant s fee is included in the basis of the new property and can t be allocated between properties acquired and not acquired. (Reg 1.263(a)-2(f)(4). Ex. 9) Accounting method change. Except as otherwise provided, a change to comply with Reg 1.263(a)-3 is a change in method of accounting to which Code 446 and Code 481 and the accompanying regs apply. A taxpayer seeking to change to a method of accounting permitted in Reg 1.263(a)-3 must secure IRS consent and follow the administrative procedures in Reg (e)(3)(ii) for obtaining IRS consent to change its accounting method. (Reg 1.263(a)-3(q)) 3

4 Effective date. Three sets of effective date rules are available to taxpayers: (1) The capitalization rules covered above generally apply to tax years beginning on or after Jan. 1, However, the whether and which rules dealing with investigating the acquisition of real property (Reg 1.263(a)-2(f)(2)(iii)), the rules for employee compensation and overhead, including the election to capitalize such expenses (Reg 1.263(a)-2(f)(2)(iv)), and the rules for inherently facilitative expenses (Reg 1.263(a)-2(f)(3)(ii), apply to amounts paid in tax years beginning on or after Jan. 1, (2) A taxpayer may generally choose to apply the capitalization rules covered above to tax years beginning on or after Jan. 1, 2012; a taxpayer may choose to apply Reg 1.263(a)-2(f)(2)(iii), Reg 1.263(a)-2(f)(2)(iv), and Reg 1.263(a)-2(f)(3)(ii), to amounts paid in tax years beginning on or after Jan. 1, A transition rule applies to a taxpayer that (a) wants to elect to capitalize employee compensation and overhead under Reg 1.263(a)-2(f)(2)(iv), for amounts paid in its tax years beginning on or after Jan. 1, 2012, and ending on or before Sept. 19, 2013, but (b) did not make the formal election required by the final regs. The taxpayer can make the necessary election by filing an amended return (including any applicable statements) for the applicable tax year on or before 180 days from the due date, including extensions of the taxpayer s return for the applicable tax year, notwithstanding that the taxpayer may not have extended the due date. (3) A taxpayer may choose to apply Reg (a)-2T of the 2011 temporary regs, as contained in TD 9564, to tax years beginning on or after Jan. 1, 2012, and before Jan. 1, However, the whether and which rules dealing with investigating the acquisition of real property, the rules for employee compensation and overhead, and the rules for inherently facilitative expenses as carried in those temporary regs, may only be applied to amounts paid in tax years beginning on or after Jan. 1, 2012, and before Jan. 1, (Reg 1.263(a)-2(j)) observation: The rules in the temporary regs at Reg (a)-2T were very similar to the rules in Reg 1.263(a)-2. 4

5 A beneficial de minimis safe harbor election allows taxpayers to elect to currently deduct their outlays for lower-cost business assets that they expense for book purposes under a written policy. De Minimis Safe Harbor Election A beneficial de minimis safe harbor election allows taxpayers to elect to currently deduct their outlays for lower-cost business assets that they expense for book purposes under a written policy. To be eligible for this book tax conformity election, a unit of property can t cost more than $5,000 if a business has an Applicable Financial Statement (AFS) and can t cost more than $500 if the business has no AFS. As an alternative to the general capitalization rule, the final regs permit businesses to elect to expense their outlays for lower-cost business assets. If the taxpayer is eligible for the de minimis safe harbor election, and chooses it, an amount paid to acquire or produce any eligible UOP (or any eligible material or supply) is deducted in the year paid under Code 162 (assuming the item otherwise qualifies as an ordinary business expense), and may not be capitalized or treated as a material or supply. (Reg 1.263(a)-1(f)(1), Reg 1.263(a)-1(f)(3)(iv)) The de minimis safe harbor applies to an amount paid during the tax year to acquire or produce a UOP, or acquire a material or supply, if: (1) The taxpayer has at the beginning of the tax year written accounting procedures treating as an expense for non-tax purposes amounts paid for property (A) costing less than a specified dollar amount; or (B) with an economic useful life of 12 months or less observation: In what may be a drafting error, the requirement that the accounting procedures be written applies only to taxpayers that have an AFS. Since the omission of this requirement for taxpayers that don t have an AFS is likely to be in error, it would seem prudent for taxpayers that don t have an AFS also to have the accounting procedures in writing. (2) The taxpayer treats the amount paid for the property as an expense on its AFS if it has one or on its books and records if it does not in accordance with its accounting procedures; and (3) If the taxpayer has an AFS, the amount paid for the property does not exceed $5,000 per invoice or per item as substantiated by the invoice), or if the taxpayer does not have an AFS, does not exceed $500 per invoice (or per item as substantiated by the invoice), or other amount as identified in published IRS guidance. (Reg 1.263(a)-1(f)(1)(i), Reg 1.263(a)-1(f)(1)(ii)) For purposes of applying the 12-month rule (see item (A)(2) in the list above), the economic useful life of a UOP is not necessarily its inherent useful life, but is the period over which the property may reasonably be expected to be useful to the taxpayer, or if the taxpayer is engaged in a trade or business or income producing activity, the period of time that the property may reasonably be expected to be useful in the trade or business or activity. The factors in Reg 1.167(a)-1(b) (e.g., wear and tear, climatic and other conditions particular to the taxpayer s business) are to be considered in determining this period. (Reg (c)(4)(i)) observation: The examples at Reg 1.263(a)-1(f)(7) make it clear that, at the beginning of its tax year, a taxpayer must have written accounting procedures treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount (or with an economic useful life of 12 months or less), and at that time, the specified dollar amount must be equal to or less than the $5,000 or $500 ceiling amount. recommendation: Companies that don t already have such procedures in place should consider revising accounting procedures before the end of their current year to bring their non-tax expensing limit up to (or down to) the $5,000/$500 limit. 5

6 Revision to conform with $5,000/$500 limit not an accounting method change. The preamble to the final regs makes it clear that if a taxpayer meets the requirements for the safe harbor (including having written accounting procedures in place at the beginning of the tax year and treating amounts paid for property as an expense in accordance with those procedures), then a change in the procedures, by itself, is not a change in accounting method. For example, if a taxpayer s written financial accounting capitalization policy at the beginning of 2014 says amounts paid for property costing less than $200 will be treated as an expense, and the taxpayer changes its written policy as of the beginning of 2015 to treat amounts paid for property costing less that $500 as an expense, the taxpayer is not required to file an application for its 2015 tax year to change its method of accounting for applying the de minimis safe harbor (or determining amounts paid to acquire or produce tangible property under Reg 1.263(a)-1(f)). (Preamble to TD 9636) IRS hints at flexibility in dollar ceilings. The preamble to the final regs says if examining agents and a taxpayer agree that certain amounts in excess of the de minimis safe harbor limits are not material or otherwise should not be subject to review, that agreement should be respected, notwithstanding the requirements of the de minimis safe harbor. However, the preamble makes it clear that a taxpayer seeking a deduction for amounts in excess of the $5,000/$500 amounts allowed by the safe harbor has the burden of showing that such treatment clearly reflects income. (Preamble to TD 9636) AFS defined. Acceptable financial statements for purposes of the de minimis safe harbor election are listed below from highest to lowest priority. An AFS is the taxpayer s financial statement having the highest priority: (1) A financial statement required to be filed with the Securities and Exchange Commission (SEC) (10-K or the Annual Statement to Shareholders). (2) A certified audited financial statement accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional) that is used for: (A) Credit purposes (B) Reporting to shareholders, partners, or similar persons; or (C) Any other substantial non-tax purpose (3) A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or IRS). (Reg 1.263(a)-1(f)(4)) observation: The de minimis safe harbor election probably is the most useful and most widely applicable break for businesses in the final regs, as it allows many businesses to dispense with capitalizing and depreciating (or expensing under Code 179) purchases of many lower-cost assets (e.g., furniture, equipment, computers) needed to run a business. By contrast, the temporary regs issued in late 2011 carried a much more limited de minimis rule for those with an AFS; under the temporary regs, the aggregate of amounts paid and not capitalized for the tax year had to be less than or equal to the greater of (a) 0.1% of gross receipts for tax purposes, or (b) 2% of total depreciation or amortization for the year as determined in the taxpayer s AFS. And businesses without an AFS couldn t make a de minimis election at all under the temporary regs. Illustration: Large Corp has a written accounting policy at the beginning of Year 1, which it follows, to expense amounts paid for property costing $5,000 or less. It also has an AFS. In Year 1, it pays $6,250,000 to buy 1,250 computers at $5,000 each. Large receives an invoice from its supplier indicating the total amount due ($6,250,000) and the price per item ($5,000). Each computer is a UOP and the amounts paid for the computers meet the requirements for the de minimis safe harbor. If Large elects to apply the de minimis safe harbor, it deducts the $6,250,000 in the tax year it is paid, provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business. (Reg 1.263(a)-1(f)(7), Ex. 3) 6

7 Illustration: Able Company does not have an AFS. In Year 1, it buys 10 printers at $250 each for a total cost of $2,500 as indicated by the invoice. Each printer is a UOP, and Able has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500. Able treats the amounts paid for the printers as an expense on its books and records. Able may deduct the $2,500 in the tax year the amounts are paid, provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business. (Reg 1.263(a)-1(f)(7), Ex. 1) caution: An invoice price that s even a few dollars over the $5,000 or $500 threshold will cause the purchased item to be ineligible for the de minimis safe harbor election. An anti-abuse rule prevents taxpayers from circumventing the $5,000/$500 ceiling by, for example, buying components of property separately and receiving separate invoices instead of buying the property as a single UOP as it normally would. (Reg 1.263(a)-1(f)(6)) For example, a taxpayer without an AFS that has accounting procedures in place to expense amounts costing $500 or less, and that buys a used truck for $1,500, can t qualify the truck for the safe harbor by asking the seller to bill it separately for the engine ($500), trailer ($300), cab ($500), and tires ($200). (Reg 1.263(a)-1(f)(7), Ex. 11) Transaction and other additional costs. A taxpayer electing to use the de minimis safe harbor doesn t have to include in the cost of the tangible property the additional costs of acquiring or producing it if these costs are not included in the same invoice as the property. However, the taxpayer must include in the cost of the property all additional costs (for example, delivery fees, installation services, or similar costs) of acquiring or producing the property if these costs are included on the same invoice with the property. Where an invoice includes amounts paid for multiple tangible properties and the invoice includes additional invoice costs related to the properties, then the taxpayer must allocate the additional invoice costs to each property. A taxpayer may use any reasonable method (including, but not limited to: specific identification, pro rata allocation, or a weighted average method based on each property s relative cost). Additional costs consist of the transaction costs (that is, the facilitative costs) of acquiring or producing the property and costs for work performed before the date that the unit of tangible property is placed in service. (Reg 1.263(a)-1(f)(3)(i)) Illustration: ABC Corp has a written accounting policy at the beginning of Year 1 to expense amounts paid for property costing less than $5,000, and it has an AFS. In Year 1, it spends $45,000 to buy and install wireless routers in each of its 10 office locations. Each router is a UOP. The supplier s invoice shows the total amount due ($45,000), including the material price per item ($2,500), and total delivery and installation costs ($20,000). ABC allocates the additional invoice costs on a pro rata basis, bringing the cost of each router to $4,500 ($2,500 materials + $2,000 labor and overhead). If ABC elects to apply the de minimis safe harbor, it may deduct the $45,000 in the tax year the amounts are paid, provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business. (Reg 1.263(a)-1(f)(7), Ex. 5) 7

8 Illustration: Consulting Corp does not have an AFS, but has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500. In Year 1, it pays an interior designer $600 to shop for, evaluate, and make recommendations for new furniture for Consulting s conference room. Following the recommendations, Consulting buys a conference table for $500 and 10 chairs for $300 each. The interior designer submits a $600 invoice for his services and the furniture supplier submits a separate invoice showing a total amount due of $500 for the table and $300 for each chair. For Year 1, Consulting treats the amount paid for the table and each chair as an expense on its books and records, and elects to use the de minimis safe harbor for amounts paid for tangible property that qualify under the safe harbor. The amount paid to the interior designer facilitates the acquisition of the table and chairs but wasn t included in the same invoice as the tangible property. Thus, there s no need to include a pro rata allocation of the designer s cost to determine whether the de minimis safe harbor applies to the table and the chairs. As a result, Consulting may deduct the amounts paid for the table and chairs, and to the interior designer, as ordinary and necessary business expenses under Code 162. (Reg 1.263(a)-1(f)(7), Ex. 6). Property ineligible for de minimis safe harbor election. Amounts paid for any of the following are ineligible for the de minimis safe harbor election: Property that is or is intended to be included in inventory Land Rotable, temporary, and standby emergency spare parts that the taxpayer elects to capitalize and depreciate under Reg (d); and Rotable and temporary spare parts that the taxpayer accounts for under the optional method of accounting for rotable parts under Reg (e). (Reg 1.263(a)-1(f)(2)) Effect of de minimis safe harbor election. A taxpayer that elects to use the de minimis safe harbor for a tax year must apply it to any amount paid to acquire or produce during that year a UOP or material or supply to which the safe harbor applies. Such costs aren t treated as a material or supply and aren t capitalized (unless the UNICAP rules of Code 263(a) apply). When sold or disposed of, property to which the election applies is not treated as a capital asset under Code 1221 or as Code 1231 property. (Reg 1.263(a)-1(f)(1), Reg 1.263(a)-1(f)(3)) observation: Under Code Sec. 179, eligible taxpayers may deduct (in lieu of depreciation) the cost of most tangible personal property, and certain other property, used in the active conduct of a trade or business. For tax years beginning in 2013: (1) the dollar limitation on the expensing deduction is $500,000; and (2) the investment-based reduction in the dollar limitation starts to take effect when property placed in service in the tax year exceeds $2,000,000 (the investment ceiling). For tax years beginning after 2013, the maximum expensing limit is scheduled to drop to $25,000, and the investment ceiling is scheduled to drop to $200,000 (although Congress may not allow the expensing limit and investment ceiling limit to drop this drastically). Under Code 179(d)(1)(A)(i), section 179 property generally is any tangible property to which Code 168 applies. Thus, assets to which the de minimis election applies (and which aren t capitalized and depreciated) should not be counted in determining either the Code 179 maximum expensing limit or the investment ceiling. illustration: MidCorp, a calendar year corporation that has an AFS, has a written accounting policy at the beginning of 2013, which it follows, to expense amounts paid for property costing $5,000 or less. In 2013, it pays $750,000 to buy 500 computers at $1,500 each, and $250,000 to buy 50 high-speed network printers at $5,000 each. Each computer and printer is a UOP, and the amounts paid for them meet the requirements for the de minimis safe harbor. During 2013, MidCorp also spends a total of $1,000,000 on other equipment and business assets that are not eligible for the de minimis safe harbor and instead must be capitalized. MidCorp elects (under the effective date rules explained below), to apply Reg 1.263(A)-1(f) (i.e., the de minimis safe harbor rule) to amounts paid in tax years beginning on or after Jan. 1, Under the final regs, MidCorp should be able to deduct $1.5 million of the total cost of its machinery and equipment purchases during 2013 ($1 million under the de minimis safe harbor, and $500,000 under the Code 179 expensing election). 8

9 How to make the de minimis safe harbor election. The Reg 1.263(a)-1(f) election, which is irrevocable, is made by attaching a statement to the taxpayer s timely filed original Federal tax return (including extensions) for the tax year in which amounts eligible for the election are paid. The statement must be titled Section 1.263(a)-1(f) de minimis safe harbor election and include the taxpayer s name, address, taxpayer identification number (TIN), and a statement that the taxpayer is making the de minimis safe harbor election under Reg 1.263(a)-1(f). The common parent of a consolidated group filing a consolidated income tax return makes the election for each member, and the statement must also include the names and TINs of each member for which the election is made. In the case of an S corporation or a partnership, the election is made by the entity and not by the shareholders or partners. The election can t be made by applying for a change in accounting method or, before obtaining IRS s consent to make a late election, by filing an amended Federal tax return. (Reg 1.263(a)-1(f)(5)) Effective date. Three sets of effective-date rules are available to taxpayers: (1) Reg 1.263(a)-1 generally applies to tax years beginning on or after Jan. 1, 2014, but the de minimis safe harbor election at Reg 1.263(a)-1(f), applies to amounts paid in tax years beginning on or after Jan. 1, (2) A taxpayer may generally apply the rules in Reg 1.263(a)-1, to tax years beginning on or after Jan. 1, 2012; a taxpayer may apply the de minimis safe harbor election at Reg 1.263(a)-1(f), to amounts paid in tax years beginning on or after Jan. 1, A transition rule is available to a taxpayer that (a) wants to apply the de minimis safe harbor election for amounts paid in its tax years beginning on or after Jan. 1, 2012, and ending on or before Sept. 19, 2013, but (b) did not make the formal election required by the final regs (see discussion above). The taxpayer can make the necessary election by filing an amended return (including any applicable statements) for the applicable tax year on or before 180 days from the due date including extensions of the taxpayer s return for the applicable tax year, notwithstanding that the taxpayer may not have extended the due date. (3) A taxpayer may choose to apply Reg (a)-1T of the 2011 temporary regs, as contained in TD 9564, to tax years beginning on or after Jan. 1, 2012, and before Jan. 1, (Reg 1.263(a)-1(h)) observation: It would seem that few taxpayers would choose the third option, as the prior temporary regs, particularly the prior de minimis safe harbor election, were more restrictive than the final regs. 9

10 Much of the guidance in the final capitalization regs revolves around what constitutes the unit of property (UOP) that is being placed in service, repaired, or improved. What is a Unit of Property? Much of the guidance in the final capitalization regs revolves around what constitutes the unit of property (UOP) that is being placed in service, repaired, or improved. The smaller the UOP, the more likely it is that costs incurred in connection with that UOP will have to be capitalized. For example, work on an engine of a vehicle or vessel is more likely to be classified as an expense that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle or vessel, the engine work has a better chance of passing muster as a repair. The new final regs, like the temporary regs that preceded them, carry detailed and complex guidance on what constitutes the UOP, with a separate set of rules for buildings and for property other than buildings. Application of UOP rules. The new UOP rules apply only for purposes of: Code 263(a), generally barring current deductions for new buildings or permanent improvements made to increase the value of any property or estate Reg 1.263(a)-1, explaining which types of expenses must be capitalized Reg 1.263(a)-2, dealing with amounts paid to acquire or produce tangible property Reg 1.263(a)-3, dealing with improvements to tangible property; and Reg , explaining how to handle materials and supplies. (Reg 1.263(a)-3(e)(1)) observation: Thus, for example, treating an asset as part of a larger UOP for capitalization purposes doesn t affect how that asset is treated for depreciation purposes under Code 168. However, as explained below, the reverse isn t true: the way a taxpayer treats an asset for depreciation purposes may affect how the asset is treated for capitalization purposes. caution: The definition of a UOP for capitalization purposes may be the same as, or radically different from, the definition of a UOP for other purposes. For example, the definition of a UOP for non-building assets for capitalization purposes is very similar to the definition of a unit of tangible personal property for UNICAP purposes in Reg 1.263A-10. By contrast, the definition of the UOP for a building is completely different from the definition of a unit of real property for UNICAP purposes in Reg 1.263A-10. Any improvement to a UOP isn t a UOP separate from the UOP improved; special rules apply to leased property. (Reg 1.263(a)-3(e)(4)) UOP for assets other than buildings. In general, for real or personal property that isn t classified as a building by the final regs, all the components that are functionally interdependent comprise a single UOP. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer. (Reg 1.263(a)-3(e)(3)(i)) illustration: A business buys one battery powered golf cart for a foreman s use in negotiating its large warehouse. It buys the cart chassis from one vendor and the battery from another, and then assembles the two components. The UOP is the electric golf cart, since the cart can t be placed in service without the battery. Property aggregated or subject to a general asset account election, or accounted for in a multiple asset account (i.e., pooled), can t be treated as a single UOP. (Reg 1.263(a)-3(e)(1)) UOP for buildings. In general, each building and its structural components are one UO the building. And amounts are treated as paid for an improvement to a building if they improve: (1) the building structure; or (2) any designated building system. 10

11 What is a building structure? A building structure consists of a building and its structural components as defined at Reg (e) (unless the component is a building system (as defined below)). (Reg 1.263(a)-3(e)(2)(ii)) Under Reg (e)(2), the term structural components includes such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling, windows and doors, and other components relating to the operation or maintenance of a building. observation: Thus, if a business improves a building structure by, for example, replacing the entire roof, the expense generally is treated as an improvement to the single UOP consisting of the building. Similarly, if it improves a building system, such as an improvement to the heating, ventilation, and air conditioning (HVAC) system, then the expense constitutes an improvement to the building UOP. What is a building system? This term consists of the following nine structural components. Each of them (including their sub-components) is a building system that is separate from the building structure, and to which the improvement rules must be separately applied (Reg 1.263(a)-3(e)(2)(ii)(B)): (1) HVAC systems (including motors, compressors, boilers, furnace, chillers, pipes, ducts, and radiators); (2) Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste to and from the property line and between buildings and other permanent structures); (3) Electrical systems (including wiring, outlets, junction boxes, lighting fixtures and associated connectors, and site utility equipment used to distribute electricity from the property line to and between buildings and other permanent structures); (4) All escalators; (5) All elevators; (6) Fire-protection and alarm systems (including items such as sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, and alarm control panels); (7) Security systems that protect the building and its occupants (including items such as locks, security cameras, motion detectors, security lighting, and alarm systems); (8) Gas distribution systems (including associated pipes and equipment used to distribute gas to and from the property line and between buildings or permanent structures); and (9) Other structural components identified in published IRS guidance that aren t part of the building structure and are specifically designated as building systems in the regs. (Reg 1.263(a)-3(e)(2)(ii)(B)) Illustration: ABX, Inc. owns a building that it uses in its retail business. The building has two elevator banks in different locations and each elevator bank contains three elevators. ABX must treat the building and its structural components as a single UOP, and all of the elevators, including all their components, comprise a building system. Thus, if ABX pays for an improvement (e.g., a betterment) to the elevator system, it must treat the expense as an improvement to the building. (Reg 1.263(a)-3(e)(6), Ex. (2)) Reg 1.263(a)-3 carries special rules applying the UOP principle to leased property, condominiums and cooperatives. It also provides special rules for determining the UOP for plant property (functionally interdependent machinery or equipment, other than network assets, used to perform an industrial process such as manufacturing). Here, the UOP, as determined under the general UOP rules, is further divided into smaller units comprised of each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment. Additionally, the UOP for network assets (e.g., oil and gas pipelines power transmission and distribution lines) is determined by the taxpayer s particular facts and circumstances, except as otherwise provided in IRS published guidance. 11

12 Characterization of asset for depreciation purposes overrides UOP rules. Notwithstanding the above UOP rules, a component (or a group of components) of a UOP must be treated as a separate UOP if, when the taxpayer initially placed the UOP in the service, the taxpayer: (1) properly treated the component as being within a different class of property under Code 168(e) for MACRS depreciation purposes than the class of the UOP of which the component is a part; or (2) properly depreciated the component using a different depreciation method than the depreciation method of the UOP of which the component is a part. (Reg 1.263(a)-3(e)(5)(i)) Illustration: XYZ, Inc. transports freight throughout the U.S. and owns a fleet of truck tractors and trailers, each of which is made up of various components including tires. XYZ buys a truck tractor with all of its components, including tires (which have an average useful life to XYZ of more than one year). When XYZ put the tractor in service, it treated the tractor tires as a separate asset for depreciation purposes. It properly treated the tractor (excluding the cost of the tires) as 3-year property and the tractor tires as 5-year property. Under the general UOP rules, XYZ would treat the tractor, including its tires, as a single UOP because the tractor and the tires are functionally interdependent (i.e., the placing in service of the tires is dependent on the placing in service of the tractor). However, because XYZ properly treated the tires as being within a different class of property for depreciation purposes, it must treat the tractor and tires as separate UOPs for capitalization purposes. (Reg 1.263(a)-3(e)(6). Ex (16)) Similarly, notwithstanding the general UOP rules, in any tax year after the taxpayer initially places in service a UOP, if the taxpayer or IRS changes the treatment of that property (or any portion if it) to a proper MACRS class or a proper depreciation method (for example, as a result of a cost segregation study or a change in the use of the property), then the taxpayer must change the UOP determination for that property (or portion of it) to be consistent with the change in treatment for depreciation purposes. Thus, for example, if part of a UOP is properly reclassified to a MACRS class different from the MACRS class of the UOP of which it was previously treated as a part, then the reclassified portion of the property is treated as a separate UOP for capitalization purposes. (Reg 1.263(a)-3(e)(5)(ii)) Illustration: In Year 1, ABC bought and placed in service a building and parking lot for use in its retail operations. It capitalized the cost of the building and the parking lot and began depreciating them as nonresidential real property over 39 years. In Year 3, ABC completes a cost segregation study under which it properly determines that the parking lot qualifies as 15-year property for depreciation purposes, and changes its method of accounting to use a 15-year recovery period and the 150% declining balance method of depreciation for the parking lot. Beginning in Year 3, ABC must treat the parking lot as a UOP separate from the building. (Reg 1.263(a)-3(e)(6), Ex. (18)) observation: Some assets located in a building aren t structural components and don t belong in one of the building systems categories. For example, for depreciation purposes, assets such as decorative canopies, awnings, millwork, and facades have been held to be short-lived Code 1245 property (i.e., personal property) rather than long-lived Code 1250 property. Presumably, these types of assets aren t part of a building or its building systems for capitalization purposes. Similarly, that part of the electrical wiring, plumbing, or fire protection equipment directly associated with non-building equipment (such as a commercial baking oven) has been held to be a short-lived non-building asset. Presumably, these types of assets would be capitalized to the nonbuilding asset with which they are directly associated. Accounting method change. Except as otherwise provided, a change to comply with Reg 1.263(a)-3, is a change in method of accounting to which Code 446 and Code 481 and the accompanying regs apply. A taxpayer seeking to change to a method of accounting permitted by Reg 1.263(a)-3, must secure IRS consent and follow the administrative procedures in Reg (e)(3)(ii), for obtaining IRS consent to change its accounting method. (Reg 1.263(a)-3(q)) 12

13 Effective date. Reg 1.263(a)-3, which carries the UOP rules, generally applies to tax years beginning on or after Jan. 1, 2014, but may be applied at the taxpayer s choice, to tax years beginning on or after Jan. 1, A taxpayer also may choose to apply temporary Reg (a)-3T of the 2011 temporary regs, as contained in TD 9564, to tax years beginning on or after Jan. 1, 2012, and before Jan. 1, (Reg 1.263(a)-3(r)) caution: Certain portions of Reg 1.263(a)-3, involving special elections, carry different effective dates. These are explained in the paragraphs that follow below. Routine Maintenance and Small Building Owner Safe Harbors The temporary regs included a routine maintenance safe harbor only for property other than buildings. The final regs include a routine maintenance safe harbor for buildings as well as for property other than buildings. Either type of routine maintenance is treated as not improving the UOP it involves (and therefore is currently deductible). Additionally, the final regs create a new expensing safe harbor for small building owners. Routine maintenance safe harbor for buildings. Routine maintenance for a UOP that s a building unit consists of the recurring activities that a taxpayer expects to perform as a result of using the property to keep the building structure or each building system in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the building structure or each building system and the replacement of damaged or worn parts with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the building structure or building systems. However, the activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the 10-year period beginning when the building structure or the building system on which the routine maintenance is performed is placed in service by the taxpayer. (Reg 1.263(a)-3(i)(1)(i)) Illustration: In Year 1, Giant, Inc. buys a large retail mall in which it leases space to retailers. The mall contains an escalator system with 40 escalators a building system. When it put the mall in service, Giant reasonably expected that it would need to replace the handrails on the escalators approximately every four years to keep the escalators in ordinarily efficient operating condition. After a routine inspection and test in Year 4, Giant determines that the handrails need to be replaced with comparable and commercially available handrails. Assume that none of the exceptions to the routine maintenance safe harbor (explained below) apply. Because the replacement of the handrails involves recurring activities that Giant expects to perform as a result of its use of the escalator system to keep the escalator system in an ordinarily efficient operating condition, and it reasonably expects to perform these activities more than once during the 10-year period beginning when the escalators were placed in service, the amounts paid for the handrail replacements are within the routine maintenance safe harbor. Thus, the amounts are treated as not improving the building UOP and don t have to be capitalized. (Reg 1.263(a)-3(i)(6), Ex. 13) A taxpayer s expectation won t be deemed unreasonable merely because it does not actually perform the maintenance a second time during the 10-year period, as long as the taxpayer can otherwise substantiate that its expectation was reasonable when it placed the property in service. Factors to be considered in determining whether maintenance is routine and whether a taxpayer s expectation is reasonable include the recurring nature of the activity, industry practice, manufacturers recommendations, and the taxpayer s experience with similar or identical property. For a taxpayer that is a lessor of all or part of a building, its use of the building UOP includes the lessee s use of its UOP. (Reg 1.263(a)-3(i)(1)(i)) 13

14 Non-building routine maintenance safe harbor. Routine maintenance performed on a UOP that isn t a building is the recurring activity a taxpayer expects to perform as a result of its use of the UOP, to keep it in its ordinarily efficient operating condition. Examples include: inspection, cleaning, and testing; and the replacement of parts of the UOP with comparable and commercially available and reasonable replacement parts. In general, amounts paid for routine maintenance also include routine maintenance performed on (and with regard to) rotable and temporary spare parts. (Reg 1.263(a)-3(i)(1)(ii)) Routine maintenance may be performed at any time during the UOP s useful life. However, the safe harbor applies only if, at the time a UOP is placed in service by the taxpayer, it reasonably expects to perform the activities more than once during the class life (under the Code 168 alternative depreciation rules) of the UOP. A taxpayer s expectation will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the class life of the UOP, if the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service. Factors to be considered in determining whether maintenance is routine and whether the taxpayer s expectation is reasonable include the recurring nature of the activity, industry practice, manufacturers recommendations, and the taxpayer s experience with similar or identical property. For a taxpayer that is a lessor of a UOP, its use of the UOP includes the lessee s use of the UOP. (Reg 1.263(a)-3(i)(1)(ii)) Illustration: In January, Year 1, Bee Corp buys a used machine for use in its manufacturing operations. The machine is a UOP that has a class life of 10 years. Bee places the machine in service in January, Year 1, and at that time, expects to perform manufacturer-recommended scheduled maintenance on the machine approximately every three years. The scheduled maintenance includes cleaning and oiling, inspection of parts for defects, and the replacement of minor items (e.g., springs, bearings, and seals). When Bee purchased the machine, it was approaching the end of a three-year scheduled maintenance period. As a result, in February, Year 1, Bee performed the manufacturer-recommended scheduled maintenance. The majority of Bee s costs do not qualify under the routine maintenance safe harbor because the costs were incurred primarily as a result of the prior owner s use of the property and not Bee s use. Bee acquired the machine just before it had received its three-year scheduled maintenance. As a result, the payment for the scheduled maintenance resulted from the prior owner s, and not Bee s, use of the property and must be capitalized if the maintenance results in a betterment, including the amelioration of a material condition or defect, or otherwise results in an improvement of the UOP. (Reg 1.263(a)-3(i)(6), Ex. 5) observation: The preceding example begs the question of what the result would be if the taxpayer bought the used machine one year after its last scheduled maintenance. Would the expenses qualify for the routine maintenance safe harbor since the costs weren t incurred primarily as a result of the prior owner s use? Another example in another section of the regs Reg 1.263(a)-3(j)(3), Ex. 4 seems to say the expenses wouldn t qualify. That example concludes that The routine maintenance safe harbor does not apply to the amounts paid, because the activities performed do not relate solely to the taxpayer s use of the machine. observation: The regs often force taxpayers to perform a multi-tiered analysis to arrive at an answer about an expense. For instance, the above example involving Bee Corp is elaborated upon in another example in another section of the capitalization regs dealing with the issue of whether an expense must be capitalized as a betterment. Reg 1.263(a)-3(j)(3), Ex. 3 adds the additional facts that the scheduled maintenance doesn t include any material additions or materially increase the capacity, productivity, efficiency, strength, quality, or output of the machine, and concludes that although the work performed in the above example doesn t qualify for the routine maintenance safe harbor, it doesn t have be capitalized as a betterment to the machine. Illustration: Assume the same facts as in the above Illustration, except that Bee Corp performs the next scheduled manufacturer recommended maintenance on the machine in Year 4. Here, the expense is eligible for the routine maintenance safe harbor. The maintenance involves the recurring activities that Bee performs as a result of its use of the machine, keeps the machine in an ordinarily efficient operating condition, and consists of maintenance activities that it expects to perform more than once during the 10-year class life of the machine. (Reg 1.263(a)-3(i)(6), Ex. 6) 14

15 Expenses ineligible for routine maintenance safe harbor. Under Reg 1.263(a)-3(i)(3), routine maintenance for safe harbor purposes does not include amounts paid: (1) For a betterment of a UOP. (2) To replace a component of a UOP where the taxpayer has (a) properly deducted a loss for that component (other than a casualty loss under Reg ) or (b) properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component; (3) To restore damage to a UOP for which the taxpayer has taken a basis adjustment as a result of a casualty loss or casualty event under Code 165 (subject to the limit in Reg 1.263(a)-3(k)(4), relating to restoration of damage to a UOP); (4) To return a UOP to its former ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use; (5) To adapt a UOP to a new or different use under the final regs; (6) For repairs, maintenance, or improvement of network assets; or (7) For repairs, maintenance, or improvement of rotable and temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under Reg (e). Tie-in to UNICAP rules. Although amounts paid for routine maintenance generally are deductible currently, they may be subject to capitalization under Code 263A, if the amounts comprise the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale. (Reg 1.263(a)-3(i)(5)) Per-building safe harbor election for qualifying small taxpayers. The final regs add a new safe harbor at Reg 1.263(a)-3(h), permitting qualifying small taxpayers (those with $10 million or less average annual gross receipts in the three preceding tax years) to elect not to treat as capitalized expenses in other words, to currently deduct improvements made to an eligible building property (one with an unadjusted basis of $1 million or less). The new safe harbor election applies only if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2% of the building s unadjusted basis. observation: The $ 1 million per-building limit and the dollar ceiling on eligible expenses assure that the election will be useful only for the smallest property owners. Gross receipts for purposes of the $10 million ceiling include total sales (net of returns and allowances), all amounts received for services, and income from investments and from incidental or outside sources. If there are sales of capital assets or property used in a trade or business, gross receipts are reduced by the taxpayer s adjusted basis in the property. The $1 million unadjusted basis ceiling applies per building, condo, coop, or leased property. (Reg 1.263(a)-3(h)(3)) If the property is leased to the taxpayer, the unadjusted basis of eligible building property is the total amount of (undiscounted) rent paid or expected to be paid by the lessee under the lease for the entire term of the lease. The term of the lease includes renewal periods if all the facts and circumstances in existence during the tax year in which the lease is entered indicate a reasonable expectancy of renewal. (Reg 1.263(a)-3(h)(4), Reg 1.263(a)-3(h)(5)) 15

16 Under this safe harbor, qualifying small taxpayers include amounts not capitalized as a result of the de minimis safe harbor election of Reg 1.263(a)-1(f) and not capitalized as a result of the routine maintenance safe harbor for buildings (discussed earlier in this paragraph) to determine the annual amount paid for repairs, maintenance, improvements, and similar activities performed on the building. If the amount paid for repairs, maintenance, improvements, and similar activities performed on a building UOP exceeds the per-eligible-building threshold (lesser of $10,000 or 2% of unadjusted basis) for a tax year, then the safe harbor doesn t apply to any amounts spent during the tax year. Here, the taxpayer must apply the general rules for determining improvements, including the routine maintenance safe harbor for buildings. (Reg 1.263(a)-3(h)(2), Reg 1.263(a)-3(h)(8)) The taxpayer may elect to apply the de minimis safe harbor under Reg 1.263(a)-1(f) to amounts qualifying under the de minimis safe harbor, regardless of the application of the per-building safe harbor for small taxpayers. (Reg 1.263(a)-3(h)(8)) The safe harbor for building property held by small taxpayers may be elected annually on a buildingby-building basis by including a statement on the taxpayer s timely filed original Federal tax return, including extensions, for the year the costs are incurred for the building. (Reg 1.263(a)-3(h)(6)) Amounts paid by the taxpayer to which it properly applies and elects the safe harbor are not treated as improvements to the building under Reg 1.263(a)-3, and may be deducted (if they otherwise qualify) under Reg or Reg , as applicable. An election to apply the safe harbor for small taxpayers can t be revoked. (Reg 1.263(a)-3(h)(7)) Accounting method change. Except as otherwise provided, a change to comply with Reg 1.263(a)-3, which includes the routine maintenance safe harbors, is a change in method of accounting to which Code 446 and Code 481 and the accompanying regs apply. A taxpayer seeking to change to a method of accounting permitted in Reg 1.263(a)-3, must secure IRS consent and follow the follow the administrative procedures in Reg (e)(3)(ii), for obtaining IRS consent to change its accounting method. (Reg 1.263(a)-3(q)) Effective date. Three choices apply: Reg 1.263(a)-3, generally applies to tax years beginning on or after Jan. 1, 2014, but the Reg 1.263(a)-3(h) per-building safe harbor for small taxpayers applies to amounts paid in tax years beginning on or after Jan. 1, A taxpayer may generally apply Reg 1.263(a)-3, to tax years beginning on or after Jan. 1, 2012; a taxpayer may choose to apply the Reg 1.263(a)-3(h) per-building safe harbor for small taxpayers to amounts paid in tax years beginning on or after Jan. 1, A transition rule applies to a taxpayer that (a) wants to elect the per-building safe harbor for small taxpayers for amounts paid in its tax years beginning on or after Jan. 1, 2012, and ending on or before Sept. 19, 2013, but (b) did not make the formal election required by the final regs. These taxpayers can make the necessary election by filing an amended return (including any applicable statements) for the applicable tax year on or before 180 days from the due date including extensions of the taxpayer s return for the applicable tax year, notwithstanding that the taxpayer may not have extended the due date. A taxpayer may choose to apply Reg (a)-3T of the 2011 temporary regs, as contained in TD 9564, to tax years beginning on or after Jan. 1, 2012, and before Jan. 1, (Reg 1.263(a)-3(r)) observation: The temporary regs didn t carry either the routine maintenance safe harbor for buildings, or the per-building safe harbor for small taxpayers. 16

17 The IRS aimed to provide a comprehensive set of rules on a complex subject and, by and large, it has succeeded. Capitalization of Betterments, Restorations, and Adaptations of Property to a New or Different Use Historically, costs have been held to be currently deductible as a repair expense under Code 162 if they are incidental in nature, and neither materially add to the value of the property nor appreciably prolong its useful life. Costs have been held to be capitalized expenses under Code 263 if they are for permanent improvements or betterments that increase the value of the property, restore its value or use, substantially prolong its useful life, or adapt it to a new or different use. Prior final regs didn t clearly address the repairs vs capitalization issue, and, as a result, over the years it spawned a host of sometimes conflicting cases and rulings. The new final regs, like the temporary regs before them, are an attempt by IRS to deal with the issue in a systematic manner. Repair (as well as maintenance) expenses are now treated as deductible if they are not otherwise required to be capitalized, or if the taxpayer does not elect to capitalize them (explained below). (Reg (a)) The major categories of capitalized expenses i.e., those that better or improve a UOP, restore it, or adapt it to a new and different use are retained, but now a taxpayer will have to work through detailed, highly structured rules for each category to determine if an expense must be capitalized under Code 263. Next, a taxpayer will have to wade through a number of examples, over 60 in just this area, to see if there s one that s similar to its situation. The final regs retain the basic structure carried in the temporary regs, but make many large and small changes and add many new examples in an attempt to clarify the rules. Capitalizing betterment costs. Under the final regs, taxpayers must capitalize amounts paid for betterment of a UOP. An amount is treated as being for a betterment only if it: (1) Ameliorates a material condition or defect that either existed before the taxpayer acquired the UOP or arose during its production, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production; (2) Results in a material addition (including a physical enlargement, expansion, extension, or addition of a major component) to the UOP, or results in a material increase in the capacity, including additional cubic or linear space of the UOP; or (3) Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the UOP. (Reg 1.263(a)-3(j)(1)) Application of qualitative and quantitative factors. The final regs clarify that the applicability of the qualitative and quantitative factors in (2) and (3) in the list above depends on the nature of the UOP. If an addition or increase in a particular factor can t be measured in the context of a specific type of property, then that factor isn t relevant in determining whether there has been a betterment to the property. (Reg 1.263(a)-3(j)(2)) Thus, for example, while payments for work on an office building or a retail building may clearly comprise a physical enlargement or increase the capacity, efficiency, strength, or quality of such building, it is unclear how to measure whether work performed on a building increases its productivity or output. Thus, the productivity and output factors would not generally apply to buildings. On the other hand, it is appropriate to evaluate many items of manufacturing equipment in terms of output or productivity as well as size, capacity, efficiency, strength, and quality. (Preamble to TD 9636) If a part can t be replaced with the same part (e.g., due to technological advancements or product enhancements), replacing it with an improved but comparable part doesn t, by itself, result in a betterment. (Reg 1.263(a)-3(j)(2)(ii)) Property s before and after condition. The need for an expense may be triggered by normal wear and tear, or damage, that occurred during the taxpayer s use of the property. Here, the determination of whether the expense results in a betterment is made by comparing the condition of the UOP immediately after the expense with its condition immediately before the circumstances necessitating the expense. (Reg 1.263(a)-3(j)(2)(iv)(A)) 17

18 For normal wear and tear, when determining the property s before and after condition, the condition of the property immediately before the circumstances necessitating the expenditure is: Its condition after the last time the taxpayer corrected the effects of normal wear and tear (whether the amounts paid were for maintenance or improvements), or; If the taxpayer has not previously corrected the effects of normal wear and tear, the condition of the property when placed in service by the taxpayer. (Reg 1.263(a)-3(j)(2)(iv)(B)) If the expense corrects damage to a UOP that occurred during the taxpayer s use of the property, the condition of the property immediately before the circumstances necessitating the expenditure is the condition of the property immediately before the damage. (Reg 1.263(a)-3(j)(2)(iv)(C)) observation: Taxpayers trying to determine whether an expense is a betterment often will be reduced to comparing or analogizing the facts of their situation to the facts in one of the numerous examples in the regs. A summary of some of the betterment examples follows. Cleaning up contamination caused by leaking of underground storage tanks installed by prior owner of property results in a betterment to the land. (Reg 1.263(a)-3(j)(3), Ex. 1) observation: The facts and the holding in the above example essentially mirror those in United Dairy Farmers, Inc., (CA 6, 10/3/2001) 88 AFTR 2d Removal and replacement of asbestos installed by a taxpayer in a building before its health hazards were known doesn t result in a betterment to the structure. (Reg 1.263(a)-3(j)(3), Ex. 2) observation: The facts and holding in Example 2 essentially mirror those in Cinergy Corp v. U.S., (Ct Fed Cl 3/10/2003) 91 AFTR 2d Amounts paid to bring an assisted living facility up to a higher standard (e.g. repair of damaged drywall, repainting and rewallpapering, repairing and replacing windows, doors and roof, and replacement of furniture, window treatments and cabinets) result in a betterment to the facility. (Reg 1.263(a)-3(j)(3)) Periodic refresh of retail stores in a nationwide chain (cosmetic and layout changes, repair and general maintenance, moving a wall to allow reconfiguration of retail space, new painting, etc.) keeps the stores in an ordinarily efficient condition and don t result in a betterment. However, the replacement of Code 1245 property (display tables and racks) would have to be capitalized. (Reg 1.263(a)-3(j)(3)) If the refresh was made at the same time as limited improvements (increasing storage space, adding loading dock and second overhead door, upgrades to electric system) that don t affect and aren t otherwise related to the refresh, then only the limited improvements must be capitalized as betterments. The refresh costs (other than the Code 1245 costs) don t result in a betterment. (Reg 1.263(a)-3(j)(3)) The substantial remodeling of retail stores to upgrade them in order to reach higher-end customers (e.g., replacing large part of walls with windows, replacing escalators, adding elevators, rebuilding facades) would be a betterment. (Reg 1.263(a)-3(j)(3)) Amounts paid by a building to meet new city earthquake standards (addition of expansion bolts to foundation) are betterments because the expense materially increases the building s strength. (Reg 1.263(a)-3(j)(3)) 18

19 observation: Example 11 of Reg 1.263(a)-3(j)(3), and Reg 1.263(a)-3(g)(4), makes it clear that the fact that work is undertaken to satisfy a regulatory requirement is not relevant in determining whether the amount is paid to improve a property. This is the same result prescribed by the courts before the final regs were issued. Replacement of 2 of the 10 roof mounted HVAC units on a building to solve a climate control problem isn t a betterment even if the replacement units are 10% more energy efficient than the units they replaced. The small efficiency increase doesn t amount to a material increase in the efficiency, output, etc., of the HVAC system. (Reg 1.263(a)-3(j)(3)) Capitalizing restoration costs. Costs to restore a UOP, including making good the exhaustion for which an allowance is made, must be capitalized. An amount is treated as a restoration cost only if it falls in one of five categories: (1) Category 1 replaces a component of a UOP where the taxpayer has (1) properly deducted a loss for that component (other than a casualty loss under Reg ) or (2) properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component. However, this rule doesn t apply if the UOP is fully depreciated and the loss is attributable only to remaining salvage value for federal tax purposes. (Reg 1.263(a)-3(k)(1)(i), Reg 1.263(a)-3(k)(1)(ii)) Illustration: A taxpayer replaces inoperable components of a walk-in freezer that s Code 1245 property and isn t part of the building structure or HVAC system, and either abandons the old components and claims a loss or sells the old components and recognizes a loss. The cost of buying and installing the new components must be capitalized. (Reg 1.263(a)-3(k)(7), Exs. 1 and 2) (2) Category 2 restores damage to a UOP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or casualty event under Code 165. (Reg 1.263(a)-3(k)(1)(iii)) Illustration: The owner of an office building with an adjusted basis of $500,000 spends $50,000 to repair storm damage (repair roof, remove storm debris) and reduces its basis in the building to $450,000. The $50,000 must be capitalized as an improvement. If the owner is compensated for the $50,000 loss by insurance, but makes the necessary basis adjustment to $450,000, it still must capitalize the $50,000 as an improvement since it properly took a basis adjustment on account of a Code 165 casualty event. (Reg 1.263(a)-3(k)(7), Exs. 3 and 4) (3) Category 3 returns the UOP to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use. (Reg 1.263(a)-3(k)(1)(iv)) Illustration: A farm s outbuilding, formerly used for storage, falls into a state of disrepair and isn t structurally sound. The farm owner has the outbuilding s walls shored up and its siding replaced. The amounts are treated as restoring the outbuilding and must be capitalized as an improvement. (Reg 1.263(a)-3(k)(7)) (4) Category 4 results in the rebuilding of the UOP to a like-new condition (i.e., it is brought to the status of a new, rebuilt, remanufactured, or similar status under federal regulatory guidelines or manufacturer s original specifications) after the end of its class life under Code 168 for alternative depreciation system (ADS) purposes. Generally, a comprehensive maintenance program, although substantial, doesn t return a UOP to a like-new condition. 19

20 Illustration: Fifteen years after it buys a plane with a class life of 12 years, XYZ, a commercial airline, performs the second heavy maintenance visit required by the FAA. This involves disassembling the airframe, removing key parts and performing certain tasks to prevent deterioration of the airframe (lubrication and service, operational and visual checks, inspection and functional checks, reconditioning of minor parts and components, and removal, discard, and replacement of certain life-limited single cell parts, such as cartridges, canisters, cylinders, and disks). Reconditioning of parts includes burnishing corrosion, repairing cracks, dents, gouges, punctures, tightening or replacing loose or missing fasteners, replacing damaged seals, gaskets, or valves, and similar activities. Other work involves adding structural reinforcements and replacing skin panels on a small section of the fuselage. However, the heavy maintenance does not include the replacement of any major components or substantial structural parts of the aircraft with new components, and doesn t bring the aircraft to the status of new, rebuilt, remanufactured, or a similar status under FAA guidelines or the manufacturer s original specifications. After the heavy maintenance, the aircraft is reassembled. Although the heavy maintenance is performed after the end of the class life of the aircraft, XYZ is not required to treat the heavy maintenance as a restoration and improvement of the plane because, although extensive, the amounts paid do not restore the aircraft to like-new condition. The safe harbor for routine maintenance also may apply. (Reg 1.263(a)-3(k)(7), Ex. 9) observation: In Rev Rul , CB 295, IRS held that heavy maintenance costs of inspecting, repairing, and reconditioning airframe parts and components were currently deductible repairs, because the work did not appreciably increase or prolong the airframe s value or life expectancy, or adapt it to a new or different use. But IRS said replacement of skin panels on the fuselage had to be capitalized because they improved the airframe and materially added to its value. Similarly, installation of fire detection, ground proximity warning, and air phone systems would have to be capitalized. (5) Category 5 replaces a part or a combination of parts that comprise a major component or a substantial structural part of a UOP. (Reg 1.263(a)-3T(i)) All the facts and circumstances are to be considering in determining whether a cost falls in Category 5, above. These facts and circumstances include the quantitative or qualitative significance of the part or combination of parts in relation to the UOP. A major component is a part or combination of parts that performs a discrete and critical function in the operation of the UOP. However, an incidental component of the UOP, even though that component performs a discrete and critical function in the UOP s operation, will not generally, by itself, constitute a major component. A substantial structural part is a part or combination of parts that makes up a large portion of the UOP s physical structure. (Reg 1.263(a)-3(k)(6)) Special rule for restoration of damage. For purposes of restoration costs in Category 2 above, the capitalized amount paid to restore damage is limited to the excess (if any) of (a) the adjusted basis under Reg of the single, identifiable property for determining the loss allowable on account of the casualty, over (b) the amount paid to restore the damage to the UOP that also constitutes an improvement under any other restoration categories (Categories 1, 3, 4, and 5). The amounts over any excess are treated under otherwise applicable rules (e.g., as repairs and maintenance, costs to acquire or produce UOPs, or costs to improve UOPs). Illustration: ABC Corp s business headquarters suffer storm damage when the building has an adjusted basis of $500,000. The cost of restoring the building is $750,000, and ABC claims a Code 165 casualty loss of $500,000 (its basis) and reduces the building s basis to zero. It pays $350,000 to a contractor to replace the entire roof, and $400,000 to pump water out, clear debris, and replace damaged drywall and flooring. The latter costs don t directly benefit and aren t incurred because of the roof replacement. ABC must capitalize the $350,000 roof replacement cost under the restoration rule in Category 5, above the roof that s replaced is a major component and a substantial structural component of the building. Thus, ABC must treat as a restoration $150,000 ($500,000 adjusted basis $350,000 capitalized under the major component replacement rule) of the $400,000 paid to repair and clean the building structure. As a result, in addition to the $350,000 to replace the roof structure, ABC must also capitalize the $150,000 as an improvement to the building UOP. ABC is not required to capitalize the remaining $250,000 repair and cleaning costs. (Reg 1.263(a)-3(k)(7), Ex. 5) 20

21 Capitalizing amounts to adapt property to a new or different use. Under this rule, the cost of adapting a UOP to a new or different use must be capitalized. In general, a new or different use means a situation where the adaptation isn t consistent with the taxpayer s intended ordinary use of the property when he placed it in service. (Reg 1.263(a)-3(l)) For example, the cost of converting a company s manufacturing facility into a showroom facility must be capitalized. (Reg 1.263(a)-3(l)(3)) However, if the owner of a building consisting of 20 retail spaces converts three spaces into one larger space for an existing tenant by knocking down walls, the cost of the conversion isn t treated as a new or different use because the combination of spaces is consistent with the owner s intended, ordinary use of the building. (Reg 1.263(a)-3(l)(3), Ex. 2) caution: The cost of converting the three spaces into one might be a betterment if, for example, if it is found to have made the UOP more efficient, or if the remodelled space serves a higher-end class of consumers. Reg 1.263(a)-3(l)(3), illustrates how closely a company will have to scrutinize its expenditures. It deals with a manufacturer that polluted its land, remediated the pollution, then regraded the land to develop it for residential use. The cost of remediating the land to make it suitable for residential use does not adapt it to a new and different use and does not have to be capitalized under Reg 1.263(a)-3(l), but the cost of regrading the land must be capitalized as improvements to the land under Reg 1.263(a)-3(d)(3) and Reg 1.263(a)-3(l), because it adapts the land to a use different than the one the company intended when it put the land in service. Optional regulatory accounting method. This optional method allows certain regulated taxpayers to follow the method of accounting they are required to follow by the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB), as applicable, in determining whether an amount paid improves property. For purposes of the optional method, a taxpayer in a regulated industry is one subject to the regulatory accounting rules of the FERC, FCC, or STB. A taxpayer that uses the regulatory accounting method does not apply the rules under Code 162, Code 212, or Code 263(a), in determining whether amounts paid to repair, maintain, or improve property are capital expenditures or deductible expenses. However, the UNICAP rules of Code 263A continue to apply to costs required to be capitalized to property produced by the taxpayer or to property acquired for resale. The regulatory accounting method is a method of accounting under Code 446(a). (Reg 1.263(a)-3(m)) Election to capitalize repair and maintenance costs. The final regs include an election that allows taxpayers to treat amounts paid during the tax year for repair and maintenance to tangible property as amounts paid to improve that property and as an asset subject to the allowance for depreciation. The election can be made only for amounts (a) incurred in carrying on a trade or business, and (b) treated as capital expenditures on the taxpayer s books and records regularly used for regularly computing income. (Reg 1.263(a)-3(n)(1)) A taxpayer that makes the irrevocable capitalization election must (a) apply it to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its books and records in that tax year; and (b) begin to depreciate the cost of such improvements when they are placed in service by the taxpayer under the applicable provisions of the Code and regs. The election is made by attaching a statement to the taxpayer s timely filed original federal tax return (including extensions) for the tax year in which the improvement is placed in service. (Reg 1.263(a)-3(n)(2)) The capitalization election doesn t apply to amounts paid for repairs or maintenance of rotable or temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under Reg (e). (Reg 1.263(a)-3(n)(3)) 21

22 Repairs undertaken contemporaneously with improvements. Under the judicially developed plan of rehabilitation doctrine, a taxpayer must capitalize otherwise deductible repair costs if they are incurred as part of a general plan of renovation or rehabilitation. The final regs modify this doctrine. They specifically provide that indirect costs made at the same time as an improvement, but that do not directly benefit or are not incurred by reason of the improvement, don t have to be capitalized under Code 263(a). (Reg 1.263(a)-3(g)) illustration: A company takes a truck out of service to overhaul its engine. During the overhaul, the truck s broken taillights are replaced and tears in the driver s seat are mended. These expenses are deductible as repairs. However, a taxpayer still must capitalize under Code 263A all the direct costs of an improvement and all indirect costs (such as otherwise deductible repair or component removal costs) that directly benefit or are incurred by reason of an improvement. (Reg 1.263(a)-3(g)) Illustration: A trucking company replaces the existing engine, cab, and petroleum tank of one of its trucks with a new engine, cab, and tank. At the same time, it paints the new cab with its company logo. The paint job must be capitalized along with the cost of the new engine, cab, and tank, since the need to paint the logo arose from the replacement of the cab with a new cab. The paint expense directly benefits and is incurred by reason of the replacement of the major components of the truck. (Reg 1.263(a)-3(j)(3)) Accounting method changes. Except as otherwise indicated, a change to comply with Reg 1.263(a)-3, is a change in method of accounting to which Code 446 and Code 481 apply. Taxpayers that want to change to a method of accounting allowed in Reg 1.263(a)-3, must get IRS s consent. (Reg 1.263(a)-3(q)) Effective date. Three sets of effective-date choices are available to taxpayers: (1) Reg 1.263(a)-3, which contains the rules discussed in this paragraph, generally apply to amounts paid in tax years beginning on or after Jan. 1, 2014, but the optional regulatory accounting method (Reg 1.263(a)-3(m)), and the election to capitalize repair and maintenance costs (Reg 1.263(a)-3(n)), apply to amounts paid in tax years beginning on or after Jan. 1, (2) A taxpayer generally may choose to apply the rules in Reg 1.263(a)-3, to tax years beginning on or after Jan. 1, A taxpayer may choose to apply the optional regulatory accounting method (Reg 1.263(a)-3(m)), and the election to capitalize repair and maintenance costs (Reg 1.263(a)-3(n)), to amounts paid in tax years beginning on or after Jan. 1, A transition rule applies to a taxpayer that (a) wants to apply the election to capitalize repair and maintenance costs (Reg 1.263(a)-3(n)) for amounts paid in its tax year beginning on or after Jan. 1, 2012, and ending on or before Sept. 19, 2013, but (b) did not make the formal election required by the final regs (see discussion above). Such a taxpayer can make the necessary election by filing an amended return for the applicable tax year on or before 180 days from the due date including extensions of the taxpayer s return for the applicable tax year, notwithstanding that the taxpayer may not have extended the due date. (3) A taxpayer may choose to apply Reg (a)-3T of the 2011 temporary regs, as contained in TD 9564, to tax years beginning on or after Jan. 1, 2012, and before Jan. 1, (Reg 1.263(a)-3(r)) 22

23 How to Handle Materials and Supplies Under the Final Capitalization Regs Under prior final regs, the cost of materials and supplies wasn t capitalized (although the timing of the deduction depended on whether or not the materials and supplies were incidental ), but the regs made no attempt to define material or supply. The final regs (as did the prior temporary regs) provide a new and detailed definition of these costs, and require eligible materials and supplies to be expensed under the de minimis safe harbor election if the taxpayer chooses this book-tax conformity election for other eligible costs. Timing of deduction for materials and supplies. Under the new final regs, the costs of buying or producing: Non-incidental materials and supplies generally are deductible in the tax year in which the materials and supplies are first used or consumed in the taxpayer s operations; and Incidental materials and supplies that are carried on hand, and for which no record of consumption is kept or physical inventories at the beginning and end of the year are not taken, generally are deductible in the tax year in which they are paid, provided taxable income is clearly reflected. (Reg (a)) observation: The timing rules for materials and supplies generally are the same as they were under prior final regs. Revised, detailed definition of materials and supplies. The final regs define the term materials and supplies as tangible property used or consumed in the taxpayer s business operations that is not inventory and that falls within any of the following categories: (1) It is a component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property. Illustration: Aircorp owns a fleet of aircraft that it operates in its business. In Year 1, it buys a stock of spare parts to maintain and repair its aircraft and keeps a record of consumption of these spare parts. In Year 2, Aircorp uses the spare parts for the repair and maintenance of one of its aircraft. The repair and maintenance activities do not improve the aircraft and the parts aren t rotable spare parts. The amounts that Aircorp paid for the spare parts in Year 1 are deductible in Year 2, the tax year in which the spare parts are first used to repair and maintain the aircraft. (Reg (h), Ex. 1) (2) It 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. Illustration: Cee Corp operates a fleet of aircraft that carries freight for its customers, and maintains several jet-fuel storage tanks on its premises. Once jet fuel is placed in an aircraft, it is reasonably expected to be consumed within 12 months or less. On Dec. 31, Year 1, Cee Corp buys a two-year supply of jet fuel, and in Year 2, it uses a portion of the jet fuel bought on Dec. 31, Year 1, to fuel the aircraft used in its business. Cee Corp may deduct in Year 2 the amounts paid for the portion of jet fuel used in the operation of its aircraft in Year 2. (Reg (h). Ex. 5) (3) It is a unit of property (UOP) with an economic useful life (see below) of 12 months or less, beginning when it is used or consumed in the taxpayer s operations. (4) It is a UOP with an acquisition cost or production cost (as determined under Code 263A) of $200 or less (or other amount identified in published guidance). 23

24 Illustration: In Year 1, Consulting Corp pays $500 for one box of ten toner cartridges for its printers; each toner cartridge is a separate $50 UOP. In Year 1, Consulting s employees place eight of the toner cartridges in printers, and store the remaining two cartridges for use in a later tax year. The toner cartridges are materials and, although purchased in one box costing more than $200, the allocable cost of each UOP is $50. As a result, the $400 paid by Consulting for eight of the cartridges is deductible in Year 1, the tax year in which it first uses each of those cartridges; the amounts paid for the remaining two cartridges ($50 each) are deductible in the tax year in which each cartridge is first used in its business. (Reg (h), Ex. 9) observation: The dollar limit in the temporary regs was $100 or less. (5) It is identified in published IRS guidance as materials and supplies eligible for the rules in Reg (Reg (c)(1)) In the preamble to the final regs, IRS says that the rules on materials and supplies do not supersede, obsolete, or replace earlier revenue procedures to the extent they treat certain property as materials and supplies under Reg For example, Rev Proc , CB 374, allows a taxpayer to treat smallwares (a restaurant s glassware, flatware, etc.) as materials and supplies that are not incidental under Reg And Rev Proc , CB 374, permits a qualifying small business taxpayer to treat certain inventoriable items in the same way as materials and supplies that are not incidental under Reg IRS says such property continues to qualify as materials and supplies under the final regs because it is identified in published guidance as materials and supplies (category (5), above). (Preamble to TD 9636) observation: This illustrates one of the practical difficulties in implementing the final regs. Although the guidance in the regs generally is effective in tax years beginning after Dec. 31, 2013 (with elective early application, as explained below), taxpayers and their advisers still must determine the extent to which prior IRS guidance continues to apply. What is economic useful life? For purposes of applying the 12-month rule (see category (3) in the list above), the final regs generally provide that the economic useful life of a UOP is not necessarily its inherent useful life, but is the period over which the property may reasonably be expected to be useful to the taxpayer, or if it is engaged in a trade or business or income producing activity, the period of time that the property may reasonably we expected to be useful in the trade or business or activity. The factors in Reg 1.167(a)-1(b) (e.g., wear and tear, climatic and other conditions particular to the taxpayer s business) are to be considered in determining this period. (Reg 1.263(a)-3(c)(4)(i)) However, a special rule applies to taxpayers with an applicable financial statement (AFS), such as one required to be filed with the Securities and Exchange Commission, or a certified audited financial statement accompanied by an independent CPA s report and used for credit or reporting purposes. Here, solely for purposes of the 12-month economic useful life test (see category (3) in the list of materials and supplies, above), the taxpayer determines economic useful life in a way that s consistent with the economic useful life used for purposes of determining depreciation (regardless of any salvage value) in the books and records supporting the AFS. But the general rule for determining economic useful life applies if a taxpayer treats amounts paid for a UOP as an expense in its AFS on a basis other than useful life or if a taxpayer does not depreciate the UOP on its AFS. For example, if a taxpayer treats as an expense on its AFS, amounts paid for a UOP costing less than a certain dollar amount, notwithstanding that its useful life exceeds one year, the economic useful life of that UOP must be determined under the general rule for materials and supplies. (Reg 1.263(a)-3(c)(3)(ii)) 24

25 Application of elective de minimis safe harbor to materials and supplies. The final regs permit businesses to elect to expense their outlays for lower-cost business assets. Specifically, if a taxpayer makes the de minimis safe harbor election, any amount paid to acquire or produce a UOP or for a material or supply that falls within the safe harbor rules generally is deducted in the year paid as an ordinary business expense under Code 162, and may not be capitalized or treated as a material or supply. (Reg 1.263(a)-1(f)(1), Reg 1.263(A)-1(f)(3)(iv)) observation: By contrast, the much more limited elective de minimis rule in the temporary regs (Reg T(f)(1)) could be applied selectively to any material or supply. As explained in more detail below, the de minimis safe harbor applies to an amount paid during the tax year to acquire or produce a UOP, or acquire a material or supply, if the taxpayer: (1) has at the beginning of the tax year written accounting procedures treating as an expense for non-tax purposes amounts paid for property (a) costing less than a specified dollar amount, or (b) with an economic useful life of 12 months or less; (2) treats the amount paid for the property as an expense on its applicable financial statement (AFS) if it has one or on its books and records if it does not in accordance with its accounting procedures; and (3) the amount paid for the property does not exceed $5,000 per invoice (or per item as substantiated by the invoice) if the taxpayer has an AFS, or $500 per invoice (or per item as substantiated by the invoice), if the taxpayer does not have an AFS, or other amount as identified in published IRS guidance. (Reg 1.263(a)-1(f)(1)(i), Reg 1.263(A)-1(f)(1)(ii)) observation: The de minimis safe harbor may have the effect of accelerating the taxpayer s deduction for eligible materials and supplies. Illustration: ABX Corp provides billing services to its customers. In Year 1, it buys 50 scanners costing $195 each to be used by its employees. In Year 1, ABX s employees begin using 35 of the scanners, and it stores the remaining 15 scanners for use in a later tax year. The scanners are materials and supplies (because each costs no more than $200), and, under the general rule for material and supplies, ABX would deduct in Year 1 the amounts it paid for 35 of the scanners (i.e., the deduction occurs in the year in which the scanners are first used). The amounts paid for the remaining 15 scanners would be deductible in the tax year in which each machine is first used in ABX s business. Assume that ABX s scanners qualify for the de minimis safe harbor, and ABX properly elects to apply it to amounts paid in Year 1. ABX must apply the de minimis safe harbor to amounts paid for all the scanners, and as a result may deduct the amounts paid for all 50 scanners under as an ordinary and necessary business expense in the tax year the amounts are paid. (Reg (h), Exs. 7 and 8) observation: Under the temporary regs (Reg T(d)), with certain exceptions, a taxpayer could elect to capitalize and depreciate the cost of any material or supply. Under the final regs, this capitalization election is available only for rotable, temporary, or emergency spare parts. Other rules. When materials and supplies are sold or otherwise disposed of, they generally aren t treated as Code 1221 capital assets or as property used in the trade or business under Code (Reg (g)) Additionally, nothing in Reg changes the treatment of any amount provided for in the Code (except for Code 162 and Code 212), such as the Code 263A rules requiring taxpayers to capitalize the direct and allocable indirect costs, including the cost of materials and supplies, to property produced or acquired for resale, or the rules in Reg 1.263(a)-3, requiring taxpayers to capitalize amounts paid to improve tangible property. (Reg (b)) 25

26 Effective date. Reg generally applies to amounts paid or incurred in tax years beginning on or after Jan. 1, 2014; but taxpayers may choose to apply the reg to amounts paid or incurred in tax years beginning on or after Jan. 1, They also may choose to apply the provisions of temporary Reg T, as contained in TD 9564, to amounts paid or incurred (to acquire or produce property) in tax years beginning on or after Jan. 1, 2012, and before Jan. 1, See below for the effective date and transition rule provisions applicable to rotable and temporary spare parts and the effective date of the de minimis safe harbor election (i.e., the book-tax conformity election). Final Capitalization Regs Give Taxpayers Four Ways to Handle Rotable Spare Parts The property tax treatment of rotable and temporary spare parts has stirred some controversy over the years. In the wake of two key court cases, IRS agreed that, under certain circumstances, rotable spare parts could be capitalized and depreciated rather than treated as inventory. However, IRS didn t issue comprehensive guidance on this subject until it issued the proposed, temporary, and now final, capitalization regs. In essence, the final regs, continuing the approach adopted in the temporary regs, approve four methods of dealing with rotable and temporary spare parts: treating them as non-incidental materials and supplies; using a new optional method; deducting the cost currently under the de minimis safe harbor election; or capitalizing the cost of such parts. The final regs also create a brand new category of costs called standby emergency spare parts and provide that three of the four methods that apply to other spare parts apply to this new category as well. Rotable spare parts are materials and supplies acquired for installation on a unit of property (UOP), removable from that UOP, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation. Temporary spare parts are materials and supplies that are used temporarily until a new or repaired part can be installed and then are removed and stored for later (emergency or temporary) installation. (Reg (c)(2)) Standby emergency spare parts are materials and supplies that are: (1) Acquired when particular machinery or equipment is acquired (or later acquired and set aside for use in particular machinery or equipment) and directly related to that particular machinery or piece of equipment; (2) Set aside for use as replacements to avoid substantial operational time loss caused by emergencies due to particular machinery or equipment failure; (3) Located at or near the site of the installed related machinery or equipment to be readily available when needed; (4) Normally expensive, only available on special order, not readily available from a vendor or manufacturer, and not subject to normal periodic replacement; (5) Not interchangeable in other machines or equipment; (6) Not acquired in quantity (generally, only one is on hand for each piece of machinery or equipment); and (7) Not repaired and reused. (Reg (c)(3)) General rule for rotable, temporary and standby emergency spare parts. Under Reg (a)(3), the general rule for rotable spare parts and temporary spare parts is that they are subject to the same treatment as non-incidental materials and supplies namely, they are treated as used or consumed in the tax year in which the taxpayer disposes of the parts. observation: Thus, under the general rule, the deduction for rotable spare parts is deferred until they are disposed of. observation: Unless the parts in question have a short life cycle the default general rule (i.e., deferral of the deduction) seems the least tax-attractive. 26

27 Optional method for rotable and temporary spare parts. Reg (e), allows a taxpayer to use the following optional accounting method for its rotable and temporary spare parts: (A) Deduct the amount paid to buy or produce the part in the tax year that the part is first installed on a UOP for use in the taxpayer s operations. (Installation costs also are deductible.) (B) When the part is removed from the UOP, include in gross income the part s fair market value (FMV). (C) Include in the basis of the part (i) its FMV when removed (since tax has been paid on that FMV), and (ii) the amount paid to remove the part from the UOP. (D) Include in the basis of the part any amounts paid to maintain, repair, or improve the part in the tax year these amounts are paid. (E) In the tax year the part is reinstalled, deduct the amounts paid to reinstall the part and those amounts included in the basis of the part under (C) and (D), above, to the extent that those amounts have not been previously deducted upon reinstallation. (F) In the tax year the part is disposed of, deduct the amounts included in the basis of the part under (C) and (D), to the extent that those amounts have not been previously deducted upon reinstallation. (Reg (e)(2)) Illustration: Transport Inc. operates a fleet of tanker trucks, each of which is a UOP. When it acquires a new type of truck, Transport also buys a substantial number of rotable spare parts that it will keep on hand to quickly replace similar parts in trucks as those parts break down or wear out. These rotable parts are removable from the trucks and are repaired so that they can be reinstalled on the same or similar trucks. Transport uses the optional method of accounting for all its rotable and temporary spare parts. In 2014, it acquires several vehicles and a number of rotable spare parts to be used as replacement parts in these trucks. Each of these rotable parts costs $1,000. In 2015, Transport repairs Truck A and uses a rotable to replace a worn or damaged part. It costs $150 to install the part. For 2015, Transport deducts $1,150 (i.e., the cost of the rotable part reducing its basis to zero) plus the cost of installing it on Truck A. In 2016, Transport pays $50 to remove the rotable from Truck A. At that time, the rotable has a $300 FMV. Transport must include $300 in its gross income (i.e., the FMV of the removed rotable). Also in that year, Transport includes in the basis of the rotable its $300 FMV and the $50 paid to remove it from Truck A. Thus, the basis of the rotable rises to $350. In 2017, Transport pays $400 to maintain, repair, or improve the rotable. For that year, Transport includes $400 in the basis of the rotable (i.e., the amount paid to maintain, repair, or improve it). Thus, the basis of the rotable rises to $750 ($350 from 2016, plus $400 repair cost). In 2018, Transport pays $150 to reinstall the rotable on Truck B. It deducts the $150 reinstallation cost and the total $750 amount previously included in the basis of the rotable part. After the deduction, the basis of the rotable is zero. In 2021, Transport spends $50 to remove the rotable from Truck B, and it sets it aside for possible later use. At that time, the rotable is worth $250. For 2021, Transport includes in income the part s $250 FMV. In addition, in that year, Transport includes in the basis of the part $50 paid to remove the rotable from Truck B. Thus the part s basis in 2021 is $300. In 2022, Transport disposes of the rotable its value is zero. For 2022, Transport may deduct the part s remaining basis of $300. (Example adapted from Reg (h), Ex. 3) 27

28 Conditions on use of optional method. A taxpayer that chooses to use the optional method for rotable and temporary spare parts must apply it to each rotable or temporary spare part upon the taxpayer s initial installation, removal, repair, maintenance or improvement, reinstallation, and disposal of each part. The optional method may be used for all of the taxpayer s pools of rotable and temporary spare parts used in the same trade or business and for which it uses this method for its books and records. If a taxpayer uses the optional method for pools of rotable or temporary spare parts for which it does not use the optional method for its book and records, then the taxpayer must use the optional method for all its pools of rotable spare parts in the same trade or business. The optional method for rotable parts is a method of accounting under Code 446(a). (Reg (e)(1)) Deducting the cost of rotables under the de minimis safe harbor election. A taxpayer that makes the de minimis safe harbor election under Reg 1.263(a)-1(f), generally must apply the election to all eligible material and supplies, which includes all eligible rotable and temporary spare parts, as well as standby emergency spare parts. (Reg (c)(2) and Reg (c)(3)) However, the de minimis safe harbor election can t be made for those materials or supplies for which the taxpayer elects to use the optional method of accounting (see directly above) or capitalize (see below). (Reg (f)) Illustration: ABX Corp., a calendar year corporation, has a written accounting policy at the beginning of Year 1, which it follows, to expense amounts paid for property costing $5,000 or less. It also has an applicable financial statement (AFS). In Year 1, it pays $1 million to buy 1,000 rotable spare parts that cost $1,000 each. ABX elects to apply Reg 1.263(A)-1(f) (i.e., the de minimis safe harbor rule) to eligible amounts paid in Year 1. ABX must in Year 1 currently deduct its $1 million outlay on rotable spare parts, unless it elects to use the optional method of accounting, or elects to capitalize part or all of these costs. Election to capitalize rotables, temporary spare parts or standby emergency parts. Under Reg (d), a taxpayer also may elect to capitalize and depreciate the cost of any rotable spare parts, temporary spare parts, or standby emergency parts. The election generally applies to amounts paid during the tax year to acquire or produce any rotable, temporary, or standby emergency spare part. However, the capitalization election can t be made if: The rotable, temporary, or standby emergency part is intended to be used as a component of a UOP with a economic useful life of 12 months or less, or a UOP costing $200 or less; The rotable, temporary, or standby emergency spare part is intended to be used as a component of a property, and the taxpayer cannot or has not elected to capitalize and depreciate that property under Reg (d); or The amount is paid to acquire or produce a rotable or temporary spare part, and the taxpayer uses the optional method of accounting for rotable and temporary spare parts (explained above). (Reg (d)(2)) illustration: Assume the same facts as in the previous example. Under the regs, ABX apparently may elect to capitalize and depreciate part of its rotables purchases in Year 1 and currently deduct the balance of the rotables cost. 28

29 How to make the capitalization election. A taxpayer makes the election by capitalizing the amounts paid to acquire or produce each qualifying rotable, temporary, or standby emergency spare part in the tax year the amounts are paid and by beginning to recover the costs when it places the asset in service for purposes of determining depreciation. The election must be made on a timely filed original federal tax return (including extensions) for the tax year the asset is placed in service by the taxpayer for purposes of determining depreciation. In the case of an S corporation or a partnership, the election is made by the entity and not by the shareholders or partners. The election is revocable only if a private letter ruling request is made and IRS consents. An election may not be made or revoked through the filing of an application for change in accounting method or, before obtaining IRS s consent to make the late election or to revoke the election, by filing an amended federal tax return. (Reg (d)(3)) Other rules. When materials and supplies are sold or otherwise disposed of, they generally aren t treated as Code 1221 capital assets or as property used in the trade or business under Code (Reg (g)) However, rotables, temporary, or standby emergency spare parts that the taxpayer elects to capitalize and depreciate aren t treated as a material or supply, and the recognition and character of the gain or loss upon a disposition of such assets is determined under other applicable Code provisions. Additionally, nothing in Reg changes the treatment of any amount provided for in the Code (except for Code 162 and Code 212), such as the Code 263A rules requiring taxpayers to capitalize the direct and allocable indirect costs, including the cost of materials and supplies, to property produced or acquired for resale, or the rules in Reg 1.263(a)-3, requiring taxpayers to capitalize amounts paid to improve tangible property. (Reg (b)) Finally, except as otherwise provided, a change to comply with Reg is a change in method of accounting to which Code 446 and Code 481 apply. Taxpayers that want to change to a method of accounting allowed in Reg must get IRS s consent. (Reg T(i)) Effective date. There are three sets of effective date choices: (1) Reg generally applies to amounts paid or incurred in tax years beginning on or after Jan. 1, 2014, but taxpayers may apply the optional method of accounting for rotable and temporary spare parts in Reg (e), to tax years beginning on or after Jan. 1, (2) A taxpayer generally may choose to apply the rules in Reg , to amounts paid or incurred in tax years beginning on or after Jan. 1, A taxpayer may choose to apply the optional method of accounting for rotable and temporary spare parts in Reg (e), to tax years beginning on or after Jan. 1, A transition rule applies to a taxpayer that (a) wants to apply the election to capitalize and depreciate rotable parts, temporary spare parts, and standby emergency spare parts under Reg (d), for its tax year beginning on or after Jan. 1, 2012, and ending on or before Sept. 19, 2013, but (b) did not make the formal election required by the final regs (see discussion above). Such a taxpayer can make the necessary election by filing an amended return for the applicable tax year on or before 180 days from the due date including extensions of the taxpayer s return for the applicable tax year, notwithstanding that the taxpayer may not have extended the due date. (3) A taxpayer may choose to apply Reg (a)-3T of the 2011 temporary regs, as contained in TD 9564, to tax years beginning on or after Jan. 1, 2012, and before Jan. 1, (Reg (j)) 29