May 20, 2008
Dear Client,
We are writing to inform you about certain IRS proposed regulations that may affect your decisions regarding purchases of business assets. Earlier this year, the IRS issued a second set of proposed regulations to help taxpayers differentiate between a deductible repair and an item requiring capitalization. The new proposed regulations (2008 Proposed Regulations) are much more restrictive and conservative in nature than the previous proposed regulations, and include a "de minimis" expensing rule. In this letter we will cover some of the more significant provisions of the new regulations and discuss several tax planning opportunities and recommendations for you to consider.
Background
The issue of whether a repair should be capitalized or expensed is an ill-defined and subjective area of tax law. In 2006 the IRS issued Proposed Regulations (NPRM REG-168745-03, 8/21/06) in an effort to make it easier to distinguish between repairs and capital improvements. The 2006 Proposed Regulations included a 12-month rule whereby an amount paid for the acquisition or production of a "unit of property" with an "economic useful life" of 12 months or less was not considered a capital expenditure. Furthermore, the 2006 proposed regulations stated that "an amount must be capitalized if it (1) adds to the value or substantially prolongs the useful life of the property owned by the taxpayer, or (2) adapts the property to a new or different use."
2008 Proposed Regulations
The 2008 Proposed Regulations (REG-168745-03, 3/10/08) retain the same basic conservative approach of the 2006 Proposed Regulations, but provide additional rules that were not included in the first set of regulations. The new proposed regulations include a three-part test to be used in determining whether an expenditure is a deductible repair expense or a capital improvement. According to the new rules, an expenditure would need to be capitalized if the expenditure results in (1) a betterment to the property, (2) restoration to the property, or (3) adapts the property to a new or different use.
The new proposed regulations also provide a definition of materials and supplies for distinguishing fixed assets from supplies. This distinction is important because fixed assets with a useful life of more than one year are generally depreciable, while materials and supplies are currently deductible. The proposed rules define a material and supply as tangible property that is used or consumed in the taxpayer's operations and that (1) is not a unit of property, (2) is a unit of property with an economic useful life of 12 months or less, or (3) is a unit of property that costs $100 or less.
Another major change included in the 2008 Proposed Regulations is a provision for "de minimis" costs and routine maintenance activity. Historically, there has never been any legislative or regulatory authority permitting the expensing of personal property under a minimum threshold amount. Under the new proposed regulations, a business is allowed to apply a de mininis threshold for amounts paid to acquire or produce a unit of personal property if the taxpayer (1) has an applicable financial statement, (2) has a written accounting procedure in place at the beginning of the tax year which specifies the maximum dollar amount for expensing property, and (3) actually applies that accounting procedure in its financial statements. An applicable financial statement is defined as (1) a financial statement required to be filed with the SEC, (2) an audited financial statement certified by a CPA, or (3) a financial statement required to be provided to a federal or state agency (other than the SEC or the IRS).
Unfortunately for the taxpayer, the proposed regulations also include a safe harbor provision that strictly limits the total amount that can be expensed in any given year under the de minimis rule. According to the new regulations, the total aggregate of amounts paid and not capitalized for the year may not distort the taxpayer's income for the year. For this purpose, the total aggregate amount the taxpayer expenses as materials and supplies for the year must be less than or equal to the lesser of "0.1 percent of the taxpayer?s gross receipts for the tax year, or 2 percent of the business?s total depreciation and amortization expense for the tax year as determined in its financial statement." For example, a business with $1 million of gross receipts and at least $50,000 of depreciation expense could only deduct up to $1,000 without distorting income.
On the plus side, the 2008 Proposed Regulations added an explicit safe harbor for routine maintenance under which qualifying activities would not be considered capital improvements. Under this safe harbor, routine maintenance activities include "recurring activities that a taxpayer expects to perform more than once over the class life of a unit of property" and which "keep the unit of property in its ordinarily efficient operating condition." For example, the inspection, cleaning and testing of a unit of property and the replacement of its parts with the same or comparable parts are activities that are generally not required to be capitalized.
Planning Ideas
It appears that the 2008 Internal Revenue Service Proposed Regulations will become final by the end of the year. As such, we strongly recommend that you establish a written "capitalization policy" approved by the board of directors of your business or the partners/members of your business, even if you do not have an applicable financial statement as defined above. The capitalization policy should clearly specify a minimum expenditure amount for items before such items are capitalized as an asset. Expenditures below the stated amount would be expensed and deducted in the year of acquisition. Keep in mind that the threshold of expenditures for such a policy cannot distort income (see above for example). Please contact us if you would like our assistance in establishing a written capitalization policy for your business.
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The safe harbor de mininis rule explained above does not specifically define depreciation and amortization expense. It is our firm's position that the safe harbor extends to depreciation and amortization on intangible and tangible property. Including these items in depreciation and amortization expense may result in an increased safe harbor level, or an increased amount that can be expensed.
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The safe harbor for routine maintenance described above appears to offer some tax planning opportunities. For example, based upon one of many scenarios included in the new regulations, a roof replacement may not require capitalization as long as the cost of the new roof (1) did not comprise 50% or more of the physical structure of the building, and (2) did not comprise 50% or more of the cost to acquire a new building. Additionally, replacing carpet with the same or comparable carpet may not require capitalization, nor would replacing a furnace unit with a similar furnace unit. However, replacing carpet with ceramic tile would result in a material increase in the quality and useful life of the flooring, and would therefore need to be capitalized since the expenditure would result in a betterment to the building. Similarly, replacing a furnace with a solar heating panel would presumably result in a material increase in energy efficiency, and would thus be a betterment and not eligible for expensing.
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In applying the aforementioned rules, be aware that in 2008 Congress has passed laws which allow for immediate depreciation (expensing) of $250,000 of equipment if the business?s total asset purchases do not exceed $800,000. Therefore, for 2008 the new stricter capitalization rules may not be as onerous as they will be in future years.
Once finalized, the 2008 Proposed Regulations will affect any taxpayer who incurs repairs and maintenance-type expenses with respect to tangible property. If you have not already done so, be sure to have a written capitalization policy in effect by the end of the year that specifies a maximum dollar level for expensing asset purchases. Also, be sure to actually apply that policy when recording all transactions in your financial statements.
If you have any questions regarding expensing and/or capitalizing your business expenditures, please contact us at your convenience.
Very truly yours,
SOUKUP, BUSH & ASSOCIATES, P.C.
