The new IRS tangible asset regulations
How they will impact your construction business – and your customers
CONSTRUCTION QUARTERLY UPDATES |
Recently issued final (and proposed) income tax regulations addressing the treatment of tangible property and repairs will directly affect how contractors conduct their business — from the supplies and equipment used in construction to the finished product constructed for their customers. The final regulations are complicated — over 200 pages, and require time and resources to digest, analyze and implement. They are also mandatory, with a general effective date for tax years beginning on or after Jan. 1, 2014. Taxpayers who choose to ignore these regulations bear the risks of noncompliance, which may include IRS audit exposure and potential interest and penalties. The good news is that contractors who invest the time, effort and resources to understand and comply with these regulations can mitigate these risks, and possibly gain some tax advantages through the early adoption of selected provisions.[i]
As discussed in more detail below, the regulations directly affect the tax treatment of the tangible property and equipment a contractor uses (and produces) in its business — from the initial acquisition, to repairs and maintenance, major restorations and reconfigurations, and dispositions. The scope of the regulations is broad and includes the acquisition or production of all tangible property, including real property (such as buildings and plants) and personal property (such as motor vehicles, equipment, tools, and materials and supplies). From a construction business perspective, these regulations may also affect the after-tax cost of the completed structure or building delivered to the contractor's ultimate customer. Contractors who plan for this may gain a competitive advantage with their ultimate customers.
Many contractors involved with commercial property construction or multifamily rental construction are familiar with cost segregation studies. The concept behind a cost segregation study is clear — taxes should be considered in determining the ultimate cost of a structure. A tax efficient structure will have a lower after-tax cost, because proper tax planning provides greater tax benefits to the building's owner. Historically, cost segregation studies have helped to provide this benefit. These studies have been around for many years and continue to be used today.[ii] The regulations add a new layer of tax rules that all parties involved in construction projects should consider when allocating costs to constructed assets.
These new regulations will have a direct impact on both the contractor's after-tax cost of doing business and its ultimate customer's after-tax building acquisition costs. Unlike many industries, this "double impact" creates an incentive for contractors to proactively plan for these regulations, and apply them effectively. For many contractors, ignorance or "passive compliance" of these new regulations may not make good business sense, and may create cost disadvantages when compared to more proactive competitors.
Background – The tangible asset regulations were initially issued in December 2011 in temporary form.[iii] These regulations were intended to provide guidance for taxpayers applying Internal Revenue Code sections 162, 168 and 263(a), which sets forth the general rules for the treatment of materials and supplies and capital expenditures.[iv] The final regulations were issued in September 2013. The effective date of the regulations, originally set at Jan. 1, 2012 in the temporary regulations, has been deferred to taxable years (or amounts paid or incurred in taxable years) beginning on or after Jan. 1, 2014, with provisions allowing for early adoption (discussed below). The IRS has also issued guidance that puts a moratorium on its examination of most repair versus improvement issues until tax years beginning on or after Jan. 1, 2014. Accordingly, unless the IRS issues guidance indicating otherwise, taxpayers should plan to comply with these regulations by their first tax year beginning in 2014.
To comply with these regulations, contractors should consider the following:
1. Tax accounting method changes. With respect to tangible assets, most contractors will need to change one or more of their historical tax accounting methods to ones acceptable under the regulations. In 2012, the IRS issued two revenue procedures incorporating 19 automatic accounting method changes that taxpayers may use in early adopting the temporary regulations.[v] With respect to the final regulations, the IRS plans to issue similar transition guidance (also in the form of two revenue procedures) later this year on accounting method changes needed to adopt various portions of the final regulations.[vi] The number of required accounting method changes will vary depending upon the nature and complexity of the contractor's business, types of assets involved and other factors. It is anticipated that most changes will require the filing of a Form 3115 (discussed below) and the computation of a section 481(a) adjustment to account for the cumulative effect of adopting a new accounting method. However, not all potential changes will result in a section 481(a) adjustment (generally these will include method changes to adopt provisions that apply to amounts paid or incurred in tax years beginning on or after Jan. 1, 2014). Finally, the final regulations provided for many annual elections that do not require or permit the filing of a Form 3115 to use such provisions (and will not include section 481(a) adjustment(s)).
A tax accounting method change typically requires the filing of IRS Form 3115, Application for Change in Accounting Method. Generally, each method change requires its own Form 3115; however, the pending transition guidance may permit the filing of one Form 3115 that contains more than one accounting method change. Should this occur, all the information required for each method change will likely be required to be submitted with the single completed Form 3115.
Contractors will need to determine which method changes under the final regulations will apply to their business(es), and develop a plan to file the required Form(s) 3115. While the full details of accounting method change applications and procedures is beyond the scope of this article, taxpayers can often file automatic Form(s) 3115 by the tax return due date applicable to the year of change. For example, if a calendar year corporate taxpayer wishes to change an accounting method for 2013, the applicable Form 3115 would be due on or before Sept. 15, 2014, the extended due date of its 2013 corporate income tax return.[vii]
Finally, taxpayers should note that many provisions of the final regulations are adopted and applied through annual elections and not through accounting method changes (e.g., the de minimis safe harbor election and the election to capitalize repair or maintenance costs to conform with book treatment, both discussed below). The final regulations provide guidance on which provisions must be applied through annual elections and also generally provide a special transition rule for taxpayers that wish to make a late election to apply a certain provision to tax years beginning on or after Jan. 1, 2012 and ending on or before Sept. 19, 2013. The elections provided in the final regulations are also generally irrevocable (or require a private letter ruling requests to revoke) and cannot be made or revoked through the filing of a Form 3115.
2. Asset capitalization policies. Many contractors will need to update their existing asset capitalization policy, or create a policy by the first day of their tax year that begins in 2014. Contractors in more than one line of business may need a capitalization policy for each line of business.
3. Tax compliance changes. To implement the changes required by these regulations, contractors may need to review their recent (and not so recent) tax returns, asset depreciation schedules and other tax history to determine what changes to make. Contractors may also need to review historical information for equipment purchases and repairs. Those contractors that own buildings and other structures may need to analyze their building's cost history, along with the structural components, to make "unit of property" determinations required by the regulations (discussed below).
4. Future application. Applying these regulations and changes going forward may provide an opportunity for your contracting business. You can structure your tax accounting to take advantage of what the new regulations have to offer for your contracting business directly, and possibly for your ultimate customers who acquire the property you construct.
Applying the new regulations
The regulations provide guidance in four primary areas:
Materials and supplies (collectively supplies)
Capital expenditures (including a de minimis safe harbor)
Costs to acquire or produce tangible property
Costs to improve tangible property (including a routine maintenance safe harbor, a small taxpayer safe harbor, and election to capitalize repair or maintenance costs to conform with book treatment)
Dispositions of tangible property, specifically MACRS assets[viii] (including partial assets) and general asset accounts (GAAs)[ix]
Each of these areas is described in more detail below.
Supplies – The regulations define supplies as tangible property used or consumed in a taxpayer's operations that is not considered inventory and that meets one of the following requirements:
A component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer, that is not acquired as part of any single unit of property
Fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12months or less, beginning when used in the taxpayer's operations
A unit of property that has an economic useful life of 12 months or less, beginning with the date the property is used or consumed in the taxpayer's operations (e.g., drill bits, saw blades, paint, tape, etc.)
A unit of property costing $200 or less
A rotable or temporary spare part (collectively rotables) or standby emergency spare part
Is identified in published guidance as supplies[x]
Consistent with longstanding rules, taxpayers may continue to deduct incidental supplies when purchased, and nonincidental supplies when first used or consumed in operations. Incidental supplies include noninventoried supplies with no record of consumption (e.g., small office supplies or cleaning materials). Nonincidental supplies are typically accounted for as consumed and are usually subject to physical inventory (e.g., fuel, motor oil, drill bits, saw blades, toner cartridges and small engine parts such as air filters, spark plugs, etc., for which usage is tracked). Rotables are generally deductible when disposed of and include removable items (such as rotors, pumps, engines, compressors and motors) which are stored and used to replace similar items in use when they wear out or break, and generally repaired and reused.
Standby emergency spare parts include items that meet the definition of supplies and that: (1) are acquired when a particular machinery or equipment is acquired; (2) are set aside for use as replacements; (3) are located at or near the site of the installed related machinery or equipment; (4) directly related to the particular machinery or equipment they serve; (5) are normally expensive; (6) are only available on special order; (7) are not subject to normal periodic replacement; (8) are not interchangeable in other machines or equipment; (9) are not acquired in quantity; and (10) are not repaired and reused.[xi]
The new regulations give taxpayers the option of capitalizing and depreciating rotables and standby emergency spare parts; however, taxpayers may not elect to capitalize and depreciate other supplies. The final regulations also allow taxpayers to elect a de minimis safe harbor (discussed below) that, if elected, must be applied to all supplies that fall within the de minimis requirements (except for rotables and standby emergency spare parts for which the taxpayer elected to capitalize and depreciate or rotables for which the taxpayer applies the optional method (discussed below)).[xii] A special optional method is available for rotables that allow for faster recognition of the cost of rotables but also requires income inclusions under specified circumstances, special tracking, and must be applied to all pools within a trade or business for which the taxpayer uses such method for book purposes. Additionally, if the taxpayer applies the optional method to a pool of rotables for which the taxpayer does not use the method for book purposes, the taxpayer must apply the optional method to all pools of rotables in its trade or business.[xiii]
Taxpayers should note that even if otherwise deductible, supplies may still be subject to capitalization under other provisions of the Internal Revenue Code and Treasury regulations, such as Reg. section 1.263(a)-2 (requiring capitalization of amounts paid to improve tangible property) and section 263A (uniform capitalization rules).
Every contractor should review its existing tax accounting practices to determine which available method(s) for supplies makes the most sense from a tax accounting and operational perspective.
Small asset purchases and the de minimis safe harbor – Many taxpayers have historically deducted asset purchases where the individual assets purchased are priced at or below a small threshold amount. For example, a contractor may follow a policy of deducting purchases of small tools costing $250 or less per tool. This practice is commonly used to reduce the administrative burden of tracking and accounting for many small assets. Both the temporary and final regulations include de minimis rules that set limits on this practice. The temporary regulations' de minimis rule was controversial and potentially problematic. As discussed below, the final regulations incorporate a revised and simplified de minimis safe harbor that is predictable, practical and easy to implement.
The de minimis safe harbor allows taxpayers the ability to deduct purchases based on a per invoice or per item basis up to a specified threshold. The safe harbor is available to taxpayers both with and without an applicable financial statement (AFS). The applicable threshold varies depending on whether the taxpayer has an AFS.[xiv]
Taxpayers with an AFS – To use the de minimis safe harbor, taxpayers with an AFS must have (and follow for AFS purposes) a written capitalization policy for nontax purposes that is in place as of the beginning of the tax year that requires the deduction of amounts paid for property costing less than a specified dollar amount or property with a useful life of 12 months or less. If these requirements are met, the taxpayer may expense amounts paid for property if such amounts do not exceed $5,000, in accordance with its AFS policy.[xv]
Taxpayers without an AFS – To use the de minimis safe harbor, taxpayers without an AFS must have (and follow for book purposes) an accounting procedure for nontax purposes that is in place as of the beginning of the tax year that requires the deduction of amounts paid for property costing less than a specified dollar amount or property with a useful life of 12 months or less. If these requirements are met, the taxpayer may expense amounts paid for property that costs $500 or less, in accordance with its accounting procedure.[xvi]
The de minimis safe harbor, if elected, requires taxpayers to follow their written accounting procedures, but only up to the safe harbor limits. A taxpayer must establish a written policy (or accounting procedure for non-AFS taxpayers) as of the beginning of the tax year of election, and must elect to use the safe harbor annually by including an election statement with its timely filed annual income tax return.[xvii]
Items with costs exceeding the de minimis limits will fall outside of the de minimis safe harbor, even if the taxpayer's book de minimis policy allows for the expensing of such items. However, a taxpayer may be able to support the deduction of such items under its de minimis policy if it can demonstrate the treatment clearly reflects income and reaches an agreement with its IRS examining agent allowing for the treatment of such items as de minimis (the burden will be on the taxpayer to establish the propriety of such treatment).
Finally, taxpayers should note that otherwise de minimis amounts might still need to be capitalized under section 263A if the amounts constitute direct or allocable indirect costs of other property produced by the taxpayer or acquired by the taxpayer for resale.[xviii]
Costs to acquire or produce tangible property – Taxpayers are required to capitalize most expenditures incurred to acquire or produce tangible property (unless they fall under the de minimis safe harbor election, as discussed above). This includes facilitative costs, which are defined as costs paid or incurred to facilitate or complete a tangible property acquisition. However, employee compensation and overhead are excluded from the facilitative cost definition and need not be capitalized under the regulations, unless the taxpayer elects to do so.[xix] Taxpayers should also be mindful that while certain costs may not have to be capitalized under the final regulations, capitalization may be required under other Internal Revenue Code provisions, most notably the uniform capitalization rules under section 263A.
The final regulations also include special rules for real property acquisitions. Investigative and pursuit related costs are not required to be capitalized if they are incurred in the process of determining whether to acquire real property, and which real property to acquire.[xx] However, as noted above, taxpayers must still address whether section 263A or other tax law provisions could require capitalization of these costs.
The final regulations are also important for the ultimate owner of the structure or building under construction. Good record keeping and invoicing can help general contractors and building owners to lower their after-tax costs, and construct more tax efficient structures. Accurate and responsive project accounting may also assist building owners to accumulate the information they need to properly cost and classify their constructed assets under these new regulations. Contractors who have an understanding and appreciation of the regulations' requirements will be better equipped to serve their general contractor (where applicable) and the ultimate building owner.
Costs to improve tangible property—improvement and repair rules – The final regulations contain rules for determining which property costs must be capitalized as improvement costs, and which costs may be deducted as repairs. To apply these rules, the regulations provide guidelines for determining the "unit of property." A unit of property is defined as the item of property against which improvement costs are measured. Generally, the larger the unit of property, the more likely it is that the activities performed after the property is placed in service by the taxpayer will constitute deductible repairs. Special unit of property determination rules exist for the following asset types:
- Building structures
- Building systems (e.g., HVAC, plumbing, elevators, etc.)[xxi]
- Leased property
- Plant property (such as an integrated factory or manufacturing facility)
- Network assets (such as electric lines, pipelines or railroad tracks)[xxii]
Taxpayers are required to analyze improvement costs against their units of property to determine which costs must be capitalized under the new regulations. Improvements that fall within one of the three categories below are generally required to be capitalized.[xxiii]
Betterment – A material addition or increase in capacity or is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the unit of property.
Restoration – Restores deteriorated nonfunctioning property to a working condition, replaces a major component or substantial structural part, or other comparable improvement.
Adaptation – Adapts the property to a new or different use.
The final regulations include a safe harbor election for building property held by taxpayers with average annual gross receipts (for the prior three tax years) of $10 million or less (a qualifying small taxpayer).[xxiv] The final regulations permit a qualifying small taxpayer to elect not to apply the improvement rules to "eligible building property" if the total amount paid or incurred during the tax year for repairs, maintenance, improvements, and similar activities does not exceed the lesser of $10,000 or 2 percent of the unadjusted basis of the building. For this safe harbor, "eligible building property" is defined as a building unit of property that is owned or leased by the taxpayer, where the unadjusted basis of the property is $1 million or less. A qualifying taxpayer elects to use the safe harbor on an annual and eligible–by-eligible building basis by filing a statement with its timely filed tax return for the year of election.[xxv]
Finally, the final regulations include an election to capitalize repair and maintenance costs to the extent such costs are capitalized for book purposes.[xxvi] If the election is made, the repair and maintenance costs are treated as improvement costs and are capitalized and depreciated when they are placed in service under the applicable provisions of the Internal Revenue Code. This election is made on an annual basis by filing a statement with the timely filed tax return.[xxvii]
Repairs — deductibility and safe harbor – Expenditures that do not fall under one of the above categories may be deductible as repairs.[xxviii] Taxpayers should be cautious however, since deductibility versus capitalization determinations are often a facts and circumstances exercise. Taxpayers should always retain technical tax and factual support for larger repair expenditures, as they are common targets for IRS audit inquiries.
The final regulations also include a safe harbor that allows deductibility of certain routine maintenance expenditures applicable to buildings and other properties (the routine maintenance safe harbor).[xxix] This safe harbor applies to costs incurred for recurring activities that a taxpayer expects to perform to keep a unit of property in ordinary efficient working condition. It applies if the taxpayer reasonably expects to perform the activities more than once during the alternative depreciation system (ADS) class life of a unit of property (for nonbuilding property) or within 10 years of placing a building unit of property (the applicable building system or building structure) into service (for building property). Use of the routine maintenance safe harbor is an accounting method and is not adopted or used through an annual election. Additionally, even if costs otherwise fall within the safe harbor, they may still be subject to capitalization under section 263A.[xxx]
Improvement and repair rules—impact on contractors – The improvement and repair rules affect contractors with their own business operations, and in the after-tax costs of their ultimate customers. Contractors frequently invest substantial sums into their equipment, including acquisitions, upgrades, overhauls and repairs. Under the regulations, the tax treatment of these costs (capitalization or deduction) may depend on the purpose and type of expenditures, the cost and complexity of the equipment, and other factors.
The improvement and repair rules also impact the contractor's ultimate customer, the building owner. The regulations should be carefully considered prior to committing any major expenditure to an existing structure. While the new regulations provide important guidance, the tax treatment of such expenditures is also dependent on the underlying facts and circumstances. Proper planning and documentation can often provide a more advantageous tax result for a building owner. Contractors should be mindful of this, and assist their customers by providing proper documentation and support when requested, which may allow for a more tax efficient structure.
Property dispositions – The IRS has also issued proposed regulations under section 168 that address asset sales and other dispositions. These proposed regulations were issued concurrently with the final tangible asset regulations issued under sections 162 and 263(a). The disposition regulations clarify that with respect to buildings, the building and its structural components are the asset.[xxxi] The disposition regulations allow taxpayers to deduct a loss on the disposition of a structural component of a building, such as an elevator or HVAC system, but only if a partial disposition election is made. The partial disposition election may be made annually with any MACRS property,[xxxii] and is required for certain types of transactions.[xxxiii] The disposition regulations also contain a special rule addressing IRS adjustments to treat costs as improvements where the taxpayer originally treated them as repairs.[xxxiv]
Early adoption – Taxpayers may early adopt selected provisions of the final regulations for tax years beginning on or after Jan. 1, 2012. Additionally, while proposed, the property disposition regulations were issued as reliance guidance, meaning taxpayers may rely on them for tax years beginning on or after Jan. 1, 2012 (and before they become final). The early adoption option gives contractors the flexibility to adopt the favorable parts of the final and proposed regulations before the 2014 tax year, or in stages. This provides a great opportunity for contractors to optimally plan for compliance with the final regulations by their tax years that begin in 2014.
Begin planning now – A full discussion addressing all the details of implementing these new regulations, including tax accounting method changes, adoption of capitalization policies and future tax compliance, is beyond the scope of this article. Contractors, like many other taxpayers, should appreciate the potential impact of these regulations, and begin planning now for their implementation. An important first step is evaluating current tax and accounting policies and identifying accounting methods that must be implemented by the first day of the 2014 tax year. As noted above, unlike most businesses, contractors should focus on how these regulations affect their business and the operations of their ultimate customer — the building owner. Cost is a driving factor in the construction business, and for most businesses, income taxes are an important cost component. Creating tax efficiencies in your own operations and for your customers can help your contracting business stand out, win more projects and be more successful.
[i] The information contained in this article is general in nature and is based on authorities that are subject to change. Please consult with your tax advisor to determine how the information in this article might apply to your particular situation.
[ii] Some building owners are tax-exempt entities, such as governments, charities and religious organizations. Tax-exempt entities are not usually motivated by tax efficiencies, so tax planning with their benefits in mind will produce limited benefits at best.
[iii] For income tax compliance purposes, temporary regulations carry the same weight as final regulations.
[iv] All "section" and "Reg. section" references refer to the Internal Revenue Code of 1986, as amended and the Treasury regulations thereunder.
[v] Rev. Procs. 2012-19 and 2012-20.
[vi] It is expected that the two revenue procedures will supersede the revenue procedures issued under the temporary regulations (i.e., they will include procedures for adopting both the temporary and final regulations). As of the time of release of this article, it is expected that this guidance will be released in November 2013.
[vii] This assumes that the change in method can be made automatically and that the taxpayer does not timely file its 2013 tax return until Sept. 15, 2014. Automatic Forms 3115 must not be filed any later than the timely filing of the tax return for the year of change.
[viii] The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system applied by the Internal Revenue Code.
[ix] The General Asset Account (GAA) election allows taxpayers to group and depreciate certain MACRS property categories. The GAA election often makes MACRS tax depreciation calculations simpler and less burdensome, especially for larger groups of similar assets. A discussion of GAAs is beyond the scope of this article; however, taxpayers should be aware that recognitions of dispositions of assets (or partial assets) included in GAAs are only allowed under specified circumstances (see Prop. Reg. section 1.168(i)-1).
[x] See Reg. section 1.162-3(c).
[xi] Reg. section 1.162-3(c)(3).
[xii] See generally Reg. section 1.162-3.
[xiii] Reg. section 1.162-3(e).
[xiv] Reg. section 1.263(a)-1(f).
[xv] Reg. section 1.263(a)-1(f)(1)(i).
[xvi] Reg. section 1.263(a)-1(f)(ii).
[xvii] Reg. section 1.263(a)-1(f)(5). If elected, the safe harbor must be applied to all property falling within its scope. The safe harbor does not apply to inventory, land, rotables and standby emergency spare parts that the taxpayer has elected to capitalize and depreciate, and rotables accounted for under the optional method. See Reg. section 1.263(a)-1(f)(2).
[xviii] Reg. section 1.263(a)-1(f)(3)(v).
[xix] Reg. section 1.263(a)-2(f)(2).
[xx] However, inherently facilitative amounts, as defined in Reg. section 1.263(a)-2(f)(2), are treated as facilitative costs regardless of whether they are incurred in the investigation of whether and which real property to acquire.
[xxi] See Reg. section 1.263(a)-3(e)(2). The building, including its structural components and systems, is considered one unit of property. However, the improvement rules must be applied separately to each defined building system or the building structure, as applicable. Thus, if an amount is incurred to improve a building system or the building structure, it will be treated as an improvement cost to the building as a whole.
[xxii] See Reg. section 1.263(a)-3(e).
[xxiii] See generally Reg. section 1.263(a)-3.
[xxiv] See generally Reg. section 1.263(a)-3(h).
[xxv] Reg. section 1.263(a)-3(h)(6).
[xxvi] See generally Reg. section 1.263(a)-3(n).
[xxvii] Reg. section 1.263(a)-3(n)(2).
[xxviii] See Reg. section 1.162-4.
[xxix] See generally Reg. section 1.263(a)-3(i).
[xxx] See generally Reg. section 1.263(a)-3(i). Additionally, Reg. section 1.263(a)-3(i)(3) provides several exclusions from the routine maintenance safe harbor.
[xxxi] See Prop. Reg. section 1.168(i)-8(c)(4) for a discussion on determining assets for purposes of the disposition rules.
[xxxii] This assumes that the MACRS property was not subject to a GAA election.
[xxxiii] See Prop. Reg. section 1.168(i)-8(d)(2) for a discussion of the partial disposition election.
[xxxiv] Reg. section 1.168(i)-8(d)(2)(iii).