As we prepare for what many in the industry are calling “game changing” rules in the manufacturing of water heaters due to the latest updates to the National Appliance Energy Conservation Act (NAECA), there are similar game changing IRS regulations that have been finalized in the tax code on tangible property that will impact almost all businesses.
On September 13, 2013, the IRS and the Department of the Treasury issued final regulations on tangible property that provide guidance on the tax treatment of costs incurred to acquire, improve or produce tangible property. These regulations are effective for tax years beginning on or after January 1, 2014. Early adoption of these regulations is permitted going back to January 1, 2012. The bottom line is that these regulations are already in effect and impacting your current year tax returns! Unfortunately, like the water heater changes, many professionals have not done a good job in getting the word out on these changes.
So, what are tax regulations? Similar to mechanical code interpretations, tax regulations are official interpretations of the Internal Revenue Code by the Treasury Department. They’re supposed to clarify the tax laws. Before these final regulations, determining whether expenditures could be deducted or had to be capitalized (and depreciated) was a bit of a challenge. All you had to go on were court decisions (facts and circumstances), temporary regulations and limited guidance from the IRS.
A Unit of Property
Guidance in the regulations starts with what establishes a Unit of Property (UOP). Let’s first define “Unit of Property.” For tangible property other than a building, a UOP consists of all components that are functionally interdependent. Functionally interdependent means if the placing in service of one component is dependent on placing in service of other components. For example, a contractor purchases a new service truck. It has several components (cab, service body, engine, tires, etc. The service truck is a UOP. You wouldn’t place a truck into service without an engine or tires.)
Game Changer Alert! The UOP for buildings includes each building and its structural components unless the component is a building system. The following structural components are building systems that are separate from the building structure.
- Heating, ventilating and air conditioning (HVAC) system
- Plumbing system
- Electrical system
- Fire protection system
- Gas distribution system
- Elevators
- And other building systems identified in IRS guidance
An example may help explain how these regulations negatively impact contractors. A building owner has his rooftop air conditioning unit repaired. Under the old regulations, the repair would typically be expensed because it’s not a significant amount compared to the total building cost (i.e., the building is the UOP). Under the new regulations, the UOP is not the building. It’s the HVAC system, which means it’s more likely that the repair will have to be capitalized (and depreciated over the life of the property). The end result of these regulations is to reduce the size of the unit-of-property, which increases the probability that the cost will have to be capitalized as an improvement rather than immediately expensed. (Good for the IRS. Not good for the business owner.)
Generally, a business must capitalize amounts paid to improve a Unit of Property. A UOP is improved if amounts are paid for activities performed by the taxpayer results in:
- A betterment to the UOP
- A restoration of the UOP
- An adaptation of the UOP to a new or different use
Amounts paid that don’t meet any of the above three tests are generally repairs that are deductible.
Amounts paid result in a betterment to the UOP only if:
- It fixes a material condition or defect
- Results in a material addition (physical expansion or enlargement) or
- Results in a material increase in strength, productivity, efficiency, capacity, quality or output
Determining whether an expenditure results in a betterment is made by comparing the UOP’s condition immediately after the expenditure to its condition immediately prior to the expenditure.
Routine maintenance expenditures are still deductible as long as the taxpayer reasonably expects to perform the activity more than once during the property’s life (for buildings and building systems more than once during a 10-year period from when it was placed in service).
Materials & Supplies. These are things that may be expensed. They are tangible property used or consumed in a taxpayer’s business operations that is not inventory and that:
- Is acquired to maintain, repair or improve a unit of property (UOP) owned, leased or serviced by the taxpayer and was not acquired as part of any single unit of tangible property
- Consists of fuel, lubricants, water, and similar items reasonably expected to be consumed in 12 months or less
- Is a UOP with an economic useful life of 12 months or less
- Is a UOP that has an acquisition cost or production cost of $200 or less under these final regulations; or
- Is identified by the IRS in published guidance.
De Minimis Safe-Harbor Election. This allows a business to elect to expense qualifying expenditures such as amounts paid to acquire or produce a unit of property or eligible materials and supplies. To be eligible for the de minimis safe-harbor election, the business must meet the following three requirements:
- At the beginning of the year, the business has written accounting procedures opting to expense for non-tax purposes (i.e., financial accounting) amounts paid for property costing less than a specified dollar amount or items with an economic useful life of 12 months or less.
- The business treats the amount paid for the property as an expense on its applicable financial statements (AFSs) if it has AFSs or on its books and records if it does not.
- The business has an AFS and the amount paid for the property does not exceed the safe-harbor amount of $5,000 per invoice. If no AFS, then the amount can’t exceed $500. (NOTE: The $500 safe-harbor is one specific part of the regulations that the American Institute of Certified Public Accountants [AICPA] is lobbying to get significantly increased. Fortunately, the IRS is open to comments regarding the viability of the $500 limit.)
Applicable Financial Statement (AFS). It is a financial statement required to be filed with the Securities and Exchange Commission (SEC), a certified audited financial statement with a report of an independent CPA or a financial statement required to be provided to a federal or state government or agency not including the IRS or SEC.
This de minimis safe-harbor is an annual election. It does not apply to amounts paid for inventory, land or rotable, temporary and standby emergency spare parts. If you don’t have an applicable financial statement or written accounting procedures in place, you can’t use this de minimis safe-harbor. A written statement must be attached to the timely filed federal tax return including extensions. This election may not be revoked for that tax year once it’s made.
Safe Harbor Elections
Another safe harbor election is available to small businesses (average annual gross receipts for three preceding years of less than or equal to $10 million). This one relates to electing to expense amounts paid during the year for repairs, maintenance and improvements to an eligible building property. The total amount paid cannot exceed the lesser of $10,000 or 2% of the unadjusted basis of the eligible building property.
Eligible building properties are those buildings whose unadjusted basis is $1 million or less. If your expenses exceed $10,000 per building or the building’s unadjusted basis is in excess of $1 million, this election is not available to you. This safe-harbor also requires a statement be attached to the timely filed federal tax return including extensions. This is also an annual election and may not be revoked once it’s made.
One of the reasons that CPAs are so concerned about these final regulations on tangible property is that a business can be caught in a tax trap. How so? A business making a change to comply with the regulations is considered to be making a change in accounting method. This requires consent from the IRS, which means that a Form 3115 must be filed. This means more work for the both the business and the CPA, which means increased costs to the business.
These are far-reaching regulations that will impact virtually every business. How it impacts each business will most often be different so your guidance should come from your CPA not a fellow business owner. If your CPA has not discussed these regulations with you yet, I encourage you to reach out to him or her and ask about them. There are aspects of these regulations that impact not just your tax return but also your financial accounting processes and system. An innocuous accounting policy or procedure performed or changed by someone in the office can cause significant tax problems for the business. Therefore, it’s important that you understand what impact these tangible property regulations will have on your business.
UPDATE: On February 13th, the IRS issued a new procedure that makes it easier for small business owners to comply with these tangible property repair regulations. This procedure allows small businesses (those businesses with assets totaling less than $10 million or average annual gross receipts totaling $10 million or less) to change a method of accounting under these regulations on a prospective (going forward) basis for the first taxable year beginning on or after January 1, 2014. The IRS is also waiving the requirement to complete and file a Form 3115 for small businesses that choose to use this simplified procedure for 2014.
This article is not intended to be comprehensive in nature and competent professional tax advice should be sought in determining the issues that impact your specific situation.
Michael A. Bohinc is a certified public accountant in Cleveland, Ohio. He is the Chief Financial Officer of Norhio Plumbing Inc. in Aurora, Ohio. He currently serves as the Interim Director for the Service Nation Alliance – Plumbing Group and is a consultant and Coach Partner for the Service Roundtable. He has 26 years’ experience working on business management and tax issues in the plumbing-heating-cooling industry. He can be reached at 440/708-2583, or via e-mail at [email protected].