Deducting and Capitalizing Business Expenses (IRS Final Capitalization Regulations)

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1 February 14, 2015 To Sullivan Strategic Clients and Friends of the Firm RE: Deducting and Capitalizing Business Expenses (IRS Final Capitalization Regulations) Dear Client: I'm writing to let you know about an important development that will affect every business, including yours. The IRS has issued long-awaited regulations (the regs ) on the tax treatment of amounts paid to acquire, produce, or improve tangible property. The regs are lengthy and complex. The summary below is intended to give an overview of how they treat issues of deduction and capitalization. Executive Summary Business taxpayers must have written accounting policies in place on the first day of the tax year (January 1, 2014 for calendar year taxpayers) to deduct the de minimis amounts provided under safe harbor provision. Attached to this memo is a sample capitalization policy which we suggest you consider and return to us for inclusion with the 2014 tax returns we prepare on your behalf. Background Recently, the Internal Revenue Service issued final tangible property capitalization regulations. These regulations provide clarity to a complex area of tax law for business taxpayers who acquire tangible property or who own tangible property which they improve, maintain or repair. The final regulations address the proper characterization and tax treatment of expenditures related to these acquisitions, improvement, maintenance and repair activities. Generally, under IRC Section 263(a), amounts paid to acquire, produce or improve tangible property must be capitalized. However, taxpayers are permitted to deduct ordinary and necessary business expenses, including the costs of certain supplies, repairs and maintenance under IRC 162(a). It is often difficult to distinguish (1) between assets that must be capitalized and property that is a material or supply, and (2) between improvement costs and repair or maintenance costs. The finalized regulations attempt to clarify when such payments may be deducted and when they must be capitalized.

2 De Minimis Safe Harbor Election A key provision in the final regulations is a revised safe harbor election that permits a deduction for de minimis amounts paid for tangible property. Under the safe harbor election, a taxpayer may elect to not capitalize (in other words, to currently deduct) specified amounts paid in the tax year to acquire or produce tangible property, provided the amounts don t exceed applicable thresholds. The amount of the threshold depends on whether the taxpayer has written accounting procedures in place and, if so, whether the taxpayer has an applicable financial statement (typically this is an AUDITED FINANCIAL STATEMENT OR A FINANCIAL STATEMENT PROVIDED TO GOVERNMENT ENTITIES). Most of you will not have an applicable financial statement, but please ask us for clarification. Applicable Financial Statement Requirement and Written Accounting Procedures A taxpayer with an applicable financial statement may rely on the final regulations safe harbor to expense an item in accordance with the taxpayer s written accounting policies it utilized in preparing its financial statements, provided the amount paid for tangible property does not exceed $5,000 per item. In addition, the safe harbor also applies to a financial accounting policy that expenses amounts paid for property with an economic useful life of 12 months or less, provided the costs don t exceed the $5,000 threshold. Even though you lack this applicable financial statement standard, there is hope. If you have a written accounting policy in place calling for (1) expensing amounts paid for property less than a specified amount and/or (2) expensing payments for property with an economic life of 12 months or less, they may rely on the de minimis safe harbor as long as costs don t exceed $500 per item. Taxpayers without an Applicable Financial Statement or Written Accounting Procedures The final regulations increase the ceiling for characterizing tangible property as materials or supplies to $200 (formerly $100). Thus, taxpayers who do not have an applicable financial statement or written accounting procedures in place as of the beginning of the tax year may still deduct expenditures for tangible property costing $200 or less. Making the Election In order to use the safe harbor, businesses must have accounting procedures in place on the first day of the tax year. The accounting procedures must treat as an expense amounts paid for property that cost less than a specified dollar amount or have an economic useful life of 12 months or less. Failure to timely establi sh written accounting procedures may result in having to capitalize amounts that might otherwise have been expensed. In addition, the taxpayer s timely filed original tax return must include an annual election to expense items addressed by the safe harbor provision. The annual election is irrevocable and generally applies to all tangible property including materials and supplies purchased during the tax year.

3 Making the Election (continued) The regulations apply to tax years beginning on or after January 1, 2014; however, taxpayers can choose to apply the final regulations to tax years beginning on or after January 1, 2012, or apply the 2011 temporary regulations to tax years beginning on or after January 1, 2012, and before January 1, The final regulations may be applied retroactively, but many taxpayers will only be able to use the safe harbor in future tax filings because the de minimis safe harbor provision requires written accounting policies in place on the first day of the applicable tax year. Change in Accounting Method If your business was in existence before 2014 and you didn t have a policy in place of currently deducting items that qualify as materials and supplies that exactly matched the requirements of the new IRS regulations (which you likely didn t), your adoption of the rule in 2014 and later is considered to be a change in your method of accounting. Prior to February 13, 2015, you were required to obtain the IRS s permission to make such a change which could be obtained automatically by filing IRS FORM 3115 APPLICATION FOR CHANGE IN ACCOUNTING METHOD. Fortunately, on February 13, 2015, the IRS released Rev. Proc which permits small businesses to use a simplified procedure to do this. Small businesses, including sole proprietors, for purpose of this are considered if they have assets totaling less than $10 million or average annual gross receipts totaling $10 million or less. Please let me know if you would like to discuss this further. Sincerely yours, John P. Sullivan, CPA/ABV, CVA * Founder Sullivan Strategic LLC

4 Other Concepts from the Regulations Unit of property. One key concept in the regs is the "unit of property" (UOP) that is being improved or repaired. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized. For example, work on an engine of a vehicle 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, the engine work has a better chance of passing muster as a repair. Property other than buildings. In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can't be placed in service without the other components. Say that a business buys a battery-powered golf cart for its foreman to use in getting around a large warehouse. It buys the chassis from one vendor and the battery from another, and then assembles the two components. Here, the cart is the UOP, since the chassis can't be placed in service without the battery. Buildings. When it comes to buildings, the regs generally treat each building and its structural components as one UOP-the "building." The regs also list nine specific building systems that are treated as separate from the building structure. An improvement to the building is defined by its effect on those systems, rather than on the building as a whole. If a taxpayer restores a building structure, such as by replacing the entire roof, the expense is treated as an improvement to the single UOP consisting of the building. If the taxpayer makes an improvement to a building system, such as the heating, ventilation, and air conditioning (HVAC) system, that expense is also an improvement to the building UOP. Deducting materials and supplies. A deduction is allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. Materials and supplies are defined to include five specific categories of property used or consumed in the business operations. UOPs with an economic useful life of no more than 12 months qualify as materials and supplies under this rule. Likewise, certain inexpensive items qualify as materials and supplies. Under the final regs, this rule applies to UOPs that cost $200 or less to acquire or produce, an increase from the $100 threshold in the 2011 temporary regs.

5 Other Concepts from the Regulations (Continued) Routine maintenance safe harbor. The regs include a safe harbor that allows certain expenses of routine maintenance to be deducted rather than capitalized. Routine maintenance means recurring activities that keep business property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts. Under the 2011 temporary regs, this safe harbor wasn't available for building maintenance. The final regs expand the safe harbor to cover buildings as well. For a building structure or system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, the taxpayer must reasonably expect to perform the activities more than once during the property's class life for depreciation purposes. Per-building safe harbor for qualifying small taxpayers. The final regs add a new safe harbor that allows qualifying small taxpayers-those with average annual gross receipts of $10 million or less in the three preceding tax years-to deduct improvements made to a building property with an unadjusted basis of $1 million or less. This safe harbor applies only if the total amount paid during the tax year for repairs, maintenance, and improvements to the building doesn't exceed the lesser of $10,000 or 2% of the building's unadjusted basis. This safe harbor may be elected annually on a building-by-building basis. It is elected by including a statement on the tax return for the year the costs are incurred for the building. I can help you to take advantage of this rule by filing the necessary election.

6 CAPITALIZATION POLICY Purpose This accounting policy establishes the minimum cost (capitalization amount) that shall be used to determine the capital assets to be recorded in our books and financial statements. Capital Asset Definition and Thresholds A Capital Asset is a unit of property with a useful life exceeding one year and a per unit acquisition cost exceeding $500. Capital assets will be capitalized and depreciated over their useful lives. We will expense the full acquisition cost of tangible personal property below these thresholds in the year purchased. Capitalization Method and Procedure All Capital Assets are recorded at historical cost as of the date acquired. Tangible assets costing below the aforementioned threshold amount are recorded as an expense for our annual financial statements (or books). In addition, assets with an economic useful life of 12 months or less must be expensed for both book and financial reporting purposes. Documentation Invoices substantiating the acquisition cost of each unit of property are to be retained for a minimum of seven (7) years.