The Internal Revenue Service has released final regulations for repairs of tangible property, providing some benefits for small businesses that were not in the earlier temporary regulations, but also perhaps shutting them out from breaks available to larger companies.
The long-awaited repair regulations in TD 9636 that were released last Friday provide guidance on the deduction and capitalization of expenditures related to capital property (see IRS Releases Final Tangible Property Repair Regulations). They aim to clarify and expand the standards in the current regulations, as well as replace and remove temporary regulations that were issued in 2011 (see IRS Issues Regulations on Tangible Property Repairs).
“In a number of different areas you can elect to follow your book capitalization policy,” said Eric Lucas, a principal at KPMG’s Washington National Tax Office. “You don’t have to dig in and analyze the fact-based tests that are in the tax standards. The de minimis expensing rule goes to whether a company can follow its policy in expensing items that fall below a certain threshold. In the tax rule, the final regs create a $5,000 safe harbor. Most companies have a book policy that’s $5,000 or less, so some companies will be able to elect and use the safe harbor, which I think they’ll find helpful. For those companies that have a policy that exceeds $5,000, they can still follow that policy, but it’s up to the examining agent to determine whether it’s a clear reflection of income.”
There is also some help in the final regulations with deductible capital improvements.
“Similarly in determining whether you have a deductible repair or a capital improvement, the final regs allow you to elect to follow your book policy, which I think is helpful, because there are a number of companies out there that don’t want to have to dig in and apply the fact-based tests with the regs, and would rather just follow their book capitalization policies each year,” Lucas explained. “If they make an election each year to do that, they can follow their book policy. I think that’s helpful. And then lastly, the final regs retain the ability to take a partial disposition on building property, and they have made some changes that make it a bit easier practically to implement that than what existed under the temp regs.”
The de minimis expensing rule can also help businesses that need to deduct expenses such as laptop computers.
“That’s the tax rule that tells you whether you can follow your book minimum capitalization threshold,” said Lucas. “Most companies have a sort of materiality threshold. If they buy property like a laptop or a phone, and the cost of those individual units falls below a certain threshold, then they’ll just expense it on their books and records. The tax rule goes to whether you can just follow that same policy for tax purposes because financial reporting and tax operate under different rules. The tax rule in the final regs makes it easier to just follow your book policy as long as your book policy is $5,000 or less.”
For small businesses, however, the IRS is limiting the rule to some extent. “Generally to follow that rule, you have to have an applicable financial statement, which is a financial statement that’s filed with the SEC,” said Lucas. “It is a certified audited financial statement, or it’s a financial statement that is filed with a state or local government. If you don’t have those types of financial statements—and many small businesses don’t—you’re not able to use the $5,000 safe harbor and you’re limited to a $500 threshold. So you have a lower threshold because you don’t have the backstop of having an independent audited financial statement that you can rely on. The government is concerned with abuse. If there’s no independent audited financial statement, then that can lead to abusive situations where companies start deducting the cost of these items for tax purposes. That’s why you have the lower $500 threshold.”
Lucas pointed out that KPMG does not work extensively with smaller business, but he said he is interested to hear what their reaction will be on the $500 threshold. “I expect there will be some comments if small business is not pleased with that,” he said.
Other changes may be of advantage to small taxpayers, but that too is open to debate. The final regulations permit a qualifying small taxpayer to elect to not apply the improvement rules to an eligible building property if the total amount paid during the taxable year for repairs, maintenance, improvements and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2 percent of the unadjusted basis of the building. The eligible building property includes a building unit of property that is owned or leased by the qualifying taxpayer, provided the unadjusted basis of the building unit of property is $1 million or less.
“It seems somewhat low to me,” said Lucas. “Because if it’s the lesser of $10,000 or 2 percent of adjusted basis, that ends up being a low number. A lot of companies are going to spend a lot more than $10,000 on building repairs each year, so they wouldn’t be able to use the safe harbor. I’m interested in the reaction from the small business community as well on whether that threshold is helpful. But at least there is something out there for small business that they can rely on. In the temporary regulations there were no provisions for small business.”
The final regulations also cut back somewhat on flexibility for many materials and supplies, except for temporary spare parts.
“In the temporary regulations, you could elect to capitalize and depreciate any material and supply,” said Lucas. “I think they were concerned with some abuses there where you have a material and supply, it really should have a shorter life, and you end up capitalizing and depreciating it over, let’s say, a 20- or 15-year period. I think the government was concerned that if you use something in your trade or business and it gets consumed right away, and then you’re going to depreciate it over a much longer life, that really doesn’t clearly reflect the cost of that item or one that should be taken into account. They cut back on that and said, no, for materials and supplies, they’re deducible when they’re used and consumed unless they’re a rotable, a temporary or emergency standby spare part. For rotable spare parts, there’s some case law out there. A number of companies do want to capitalize and depreciate them, and there are some rulings that say yes, you can capitalize and depreciate rotable spare parts. So the rule in the final regs just follows those results. It probably gets you closer to the right answer, but it does take away some of the flexibility that existed in the temp regs.”
The IRS plans to issue further guidance for specific industry sectors, including cable networks, natural gas firms and retailers. “There are probably going to be revenue procedures that are going to be industry specific and they will be issued under the various industry resolution programs where the industry gets together with the IRS and Treasury and they craft a safe harbor,” said Lucas. “It’s kind of an add-on to the rules and regulations that’s more industry specific. There are a number of those currently ongoing that we expect to be released in the next year.”
The final repair regulations generally provide some positive benefits for businesses and tax practitioners, according to Lucas. “I think the expansion of the routine maintenance safe harbor in the building property is helpful, although they used a 10-year period to apply the test, which may be somewhat limiting, but overall it’s more than what existed under the temporary regulations,” he said. “Just overall I would say the rules are more user friendly in allowing companies to follow their book policy, so I think many companies and practitioners will find that helpful.”
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