Accounting Methods Update: Repair Regulations and Transition Guidance Baltimore DC Tax Executives Institute

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1 Accounting Methods Update: Repair Regulations and Transition Guidance Baltimore DC Tax Executives Institute Ellen McElroy and Todd Reinstein June 7, 2012

2 AGENDA Overview of Tangible Regulations Unit of Property Improvement/Betterment Restoration/Adaptation Routine Maintenance Loss on Disposition Acquisitions Transition Rules

3 Tangible Regulations Overview Section 263(a) Requires capitalization for amounts: Paid for new buildings, permanent improvements, or betterments made to increase the value of any property Paid in restoring property or in making good the exhaustion for which an allowance has been made Section 162 Permits a deduction for amounts that are paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized. Regulations aim to clarify the distinction between these standards

4 Tangible Regulations Overview On December 23, 2011, the Treasury and IRS issued a comprehensive regulatory package (the 2011 Regulations) to address the deductibility and capitalization of amounts paid for repairs, maintenance, and improvements of tangible property T.D. 9564; 2011 IRB LEXIS 843 The 2011 Regulations are both temporary and proposed and are therefore immediately effective

5 Tangible Regulations Overview The IRS sought to provide rules of general legal application and provide a unified approach regarding the treatment of costs associated with tangible assets Rules are intended to reflect, synthesize, and codify existing law Regulations make several significant changes: to the definition to unit of property in capitalization standard by adding safe harbors and simplifying conventions

6 Tangible Regulations Unit of Property Critical to the determination of whether an amount is deducted or capitalized, it is important to identify the unit of property to which the cost relates Earlier guidance required highly factual determination

7 Tangible Regulations Unit of Property General Rule: Regulations adopt the functional interdependence standard All components that are functionally interdependent make up a single unit of property Components are functionally interdependent if both must be placed in service simultaneously to perform intended function Several important exceptions: building improvements, plant property, network assets, and leased property

8 Tangible Regulations Unit of Property For all property other than buildings, the 2011 Regulations reject the plan of rehabilitation doctrine and adopt a functional interdependence test A building and its structural components are treated as a single unit of property But when applying the improvement standard, the taxpayer must analyze whether any one of several building systems are affected, and if so, capitalization is required

9 Tangible Regulations Unit of Property Building systems include: Heating, ventilation, and air conditioning (HVAC); Plumbing; Electrical; Escalators; Elevators; Fire protection and alarms; Security systems; Gas distribution; and Other components identified in published guidance

10 Tangible Regulations Unit of Property Plant property means functionally interdependent machinery or equipment, other than network assets, used to perform an industrial process Property has to be divided into components that perform discrete and major functions Building, boiler, turbine, and generator are separate units of property

11 Tangible Regulations Unit of Property Network assets: Functional interdependence test does not apply Determination is based on facts and circumstances and published guidance

12 Tangible Regulations Unit of Property Leased property: For the lessor, the UOP is the building and its structural components For the lessee, the UOP is the structural components associated with the leased portion Lessee improvements are treated as an acquisition of a UOP separate from the unit of leased property Lessee renovations are not treated as a separate UOP

13 Tangible Regulations Improvement Standards After determining the UOP, taxpayers must apply the improvement standard An expenditure is an improvement if it results in or causes a: Betterment; Restoration; or Adaptation to a new or different Use

14 Tangible Regulations Betterments A betterment arises when costs are incurred to: Ameliorates a material condition or defect; Materially adds to the property; or Materially increases the capacity, productivity, or efficiency of the unit of property

15 Tangible Regulations Betterment Spectrum A basic refresh will not rise to the level of a betterment general repairs maintenance other cosmetic changes A refresh that also involves work to a building system may result in both a betterment and deductible expenses Determining at what point along the spectrum a refresh becomes a betterment is the most difficult and important question

16 Tangible Regulations Betterment Replaces increase in value standard For major components and substantial structural parts, all the facts and circumstances are considered, including: qualitative and quantitative significance of the parts; whether the parts comprise a large portion of the physical structure; and whether the parts perform a discrete and critical function in operating the property

17 Tangible Regulations Restoration Replaces increase in useful life standard A restoration occurs when the taxpayer has paid an amount to restore a UOP, including amounts paid in making good the exhaustion for which an allowance is or has been made

18 Tangible Regulations Restoration A restoration occurs when: a component of a UOP is replaced and the TP has deducted a loss for the component; a component of a UOP is replaced and the TP has taken AB in gain/loss on the sale or exchange of the component; UOP is repaired and the TP has taken basis adjustment as a result of a casualty loss under Section 165; UOP is returned from a state of disrepair to operating condition; UOP is rebuilt to a like-new condition after its class life; or a major component or substantial structural part of a UOP is replaced

19 Tangible Regulations Restoration Restores property to a new, rebuilt, remanufactured status per federal guidelines or manufacturer s specs Determined based on facts and circumstances, rejecting the 50% standard in the 2008 regulations Major component or substantial structural part include large part of physical structure of the UOP or that perform a discrete and critical function in the operation of that UOP

20 Tangible Regulations Repairs Following Casualties 2011 regulations adopt government position from 2006 and 2008 proposed regulations Capitalization is required for any costs incurred to address damage caused by a casualty event More importantly, rules require method change requiring positive Section 481(a) adjustment What effect Exam settlement? What effect Closing Agreement?

21 Tangible Regulations Adaptation Amounts paid to adapt property to a new or different use must be capitalized Such expenditures include adaptations that are not consistent with the taxpayer s intended ordinary use of the unit of property at the time originally placed in service by the taxpayer

22 Tangible Regulations Routine Maintenance One beneficial rule for taxpayers is the safe harbor for routine maintenance Routine maintenance includes recurring activities that the taxpayer expects to perform to keep the property in its ordinary efficient operating condition Routine maintenance is deemed not to improve a unit of property and may be deducted

23 Tangible Regulations Loss on Disposition Rules Under the 2011 Regulations, when a taxpayer takes a loss (e.g., on a building component), any subsequent repairs must be capitalized Also, regulations allow a loss for worn or damaged components when discarded TP using a single asset account faces a tough decision between taking the casualty loss and capitalizing repairs, or foregoing the casualty loss to deduct repair costs; continuing to depreciate assets that have been abandoned or disposed of

24 Tangible Regulations Loss on Disposition Rules The general asset account (GAA) solves this problem and provides TPs with greatest flexibility Allows loss upon the disposition of assets and structural components Allows optional election to claim loss or continue depreciation RP permits late elections for GAA and allows method change and Section 481(a) adjustment

25 Tangible Regulations Loss on Disposition Rules Prior rules: TP required to depreciate the capitalized costs of an improvement over the life of the original asset; no basis recovery of replaced component Replace a roof, depreciate two roofs, or three roofs, etc. New rules: Replace a roof, recover as a loss remaining basis of the roof and depreciate the new roof only

26 Tangible Regulations Disposition Rules Assets depreciated under the same method, with the same recovery period, with the same convention, and placed in service the same year may be placed in a single GAA for depreciation purposes

27 Tangible Regulations Loss on Disposition Rules Regulations expand the definition of disposition to include the retirement of a structural components of a building Regulations also amend the GAA rules to allow TPs option to recognize gain or loss on dispositions of structural components

28 Tangible Regulations Amounts Paid to Acquire or Produce: Materials and Supplies Materials and Supplies: tangible property that is used or consumed in the TPs operations that is not inventory and that: Is a component acquired to maintain, repair or improve a UOP; Consists of fuel, lubricants, water, or similar items expected to be consumed within 12 months; UOP with an acquisition/production cost of $100 or less; or Is identified in published guidance

29 Tangible Regulations General Rules for Materials and Supplies Incidental Materials and Supplies are deductible as paid or incurred No consumption records or inventories are maintained Must clearly reflect income Non-incidental Materials and Supplies are deductible as used or consumed Rotables are generally deductible on final disposition

30 Tangible Regulations Range of Treatment for Materials and Supplies Follow the general rules for Materials and Supplies Elect to capitalize and amortize Follow the De Minimis rule Election is also available for Optional Method for Rotables and Temporary Spare Parts

31 Tangible Regulations Amounts Paid to Acquire or Produce: De Minimis Rule De Minimis Rule allows taxpayers to treat de minimis acquisitions as materials and supplies By properly defining true materials and supplies, a taxpayer can utilize the de minimis rule (subject to the ceiling) to qualify longer lived assets for immediate deduction

32 Tangible Regulations Amounts Paid to Acquire or Produce: De Minimis Rule To qualify for the de minimis rule, the taxpayer must: Have an applicable financial statement; Have written accounting procedures treating items costing less than a certain dollar amount as expenses for non-tax purposes; Treat such amounts as expenses in its applicable financial statement; and Meet a threshold test

33 Tangible Regulations Amounts Paid to Acquire or Produce: De Minimis Rule Under the threshold test, the amount deducted immediately must be less than or equal to the greater of 0.1 percent of gross receipts (for tax purposes) or 2 percent of total depreciation and amortization expense The Threshold Amount is an overall ceiling; if costs exceed the Threshold Amount, all the expenditures must be capitalized

34 Tangible Regulations Transition Rules In general, a method change with a full 481(a) adjustment is required to implement changes resulting from the new regulations Section 481(a) adjustment prevents duplication or omission of amounts upon change from old to new method and is computed notwithstanding period of limitations

35 Tangible Regulations Transition Rules On March 7, 2012, the IRS issued transition rules for applying the new repair regulations Rev. Proc Rev. Proc Revenue procedures provide the procedural rules for taxpayers to change methods of accounting to comply with the new rules Method changes include a range of requirements with respect to Section 481(a) adjustments

36 Tangible Regulations Transition Rules Rev. Proc Method changes for costs to maintain, improve, acquire, or produce tangible property Transaction costs De Minimis rule Materials and supplies Generally allows for automatic change procedures and audit Scope limitations have been waived for the 1st two tax years beginning after 12/31/2011

37 Tangible Regulations Transition Rules Rev. Proc Method changes for MACRS property, GAA and dispositions It is anticipated that all TPs that own or lease will want to make a GAA election for previous and future years Generally allows for automatic change procedures and audit protection Scope limitations have been waived for the 1st two tax years beginning after 12/31/2011

38 Tangible Regulations Transition Rules LB&I Directive (3/15/2012) All exam activity should cease, no new activity Exam should withdraw all IDRs and NOPAs

39 Questions & Answers

40 For more information, visit Ellen McElroy Todd Reinstein

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