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​The IRS Gets Specific with Tangible Property Guidance
by Ariana Warren, Senior II and Aaron Fox, Senior Manager
 
In an effort to address a long-standing area of disagreement with taxpayers, the Internal Revenue Service (the Service) has been devoting special attention to the depreciation deduction and the application of MACRS. In September 2013 the Service released IRS Bulletin 2013-43 (T.D. 9636) addressing capitalization policies, their application, and providing examples which include definitions of terminology used to describe some tangible property. The effective date is September 19, and is required for all fiscal years that begin on or after January 1, 2014. The guidance provides final regulations under sections 167 and 168, but do not remove the temporary guidance under section 168. These regulations impact all organizations that acquire, produce, or improve tangible property. Accordingly, it is important that tax-exempt organizations understand and properly implement these new requirements to ensure and maintain their compliance with the tax code.
 
The Service originally embarked on this goal in 2006, working alongside the Treasury to propose amendments to regulations under section 263(a) relating to amounts paid to acquire, produce, or improve tangible property. After seven years of development, this has produced regulations which are cumbersome, but which must be carefully and strategically implemented, and require any updates to an organization’s depreciation policy be in writing as of the beginning of the year.
 
Requirements under the new regulations 
 
The new regulations establish a framework for determining how to categorize supplies, repairs, maintenance or other deductible business expenses. It also defines when repairs can be expensed instead of being capitalized. The guidance is very detailed and attempts to capture all types of tangible property expenses, ranging from examining the treatment of brake pads for your car, to repairs made for a building.  Tax-exempt organizations will need to review their current policy for compliance with the Services’ outline.
 
Capitalization, depreciation and expenses under the new regulations can be summarized as follows:  
 
  • Generally, all tangible property that is not inventory should be capitalized and depreciated unless there is an exception.
  • Amounts paid to acquire or produce tangible property must be capitalized.
  • Items that qualify as materials and supplies can be expensed if they cost $200 or less, or have a useful life of 12 months or less under the de minimis rules under Section 1.263(a)-1(f). If a taxpayer has audited financial statements and a capitalization policy in place, on an annual basis they can elect to expense up to $5K; without audited financial statements, the limit is $500. The written capitalization policy must exist at the beginning of the tax year.
  • If a taxpayer’s financial results are reported within a financial statement for a group of entities, then the group’s applicable financial statement may be treated as the applicable financial statement of the taxpayer. Furthermore, in this situation, the written accounting procedures provided for the group and utilized for the group’s applicable financial statements may be treated as the written accounting procedures of the taxpayer.
  • Expenditures to improve property must be capitalized. You must also capitalize costs to adapt or restore the unit. This must be performed for each unit of property. A unit is defined as consisting of components that are functionally independent. Note that if you treat related components as having a different useful life and use a different depreciation method, then each item becomes separate from the original unit. For example, consider a boat. If you capitalize the mast and the hull using separately distinct useful lives, then these items are no longer treated as one singular boat, but rather a mast and a hull.
  • Taxpayers must now recognize a gain or loss when assets are permanently withdrawn, unless the asset is converted to personal use, in which case there is no recognition of a gain or loss. Taxpayers are still required to capitalize expenses to restore casualty losses for which the taxpayer has a basis. There are applicable limitations which are dependant upon the basis.
  • Under the routine maintenance safe harbor rule, if an expense is for routine maintenance, it does not have to be capitalized and may be deducted so long as these expenses are reasonable and will occur more than once during the asset’s life, e.g. changing the air filter on your furnace. These safe harbor rules extend to building maintenance. Also, small taxpayers can expense items incurred that are related to real property using the property’s basis as a metric. You may expense the lower of 2% of the unadjusted basis or $10K if the building has a basis of $1M or less.
  • Finally, the regulations state that a change to comply with these regulations is a change in method of accounting. However, separate procedures will be provided allowing automatic consent for tax years starting on or after January 1, 2012 to an accounting method within the regulations.
 
Implications for Exempt Organizations
 
The regulations effect every organization with tangible personal property and any such organization should have a good capitalization policy in place which will safeguard and ensure they are compliant with Section 263(a).   Tax-exempt organizations that deduct depreciation on their Form 990-T should also make an extra effort to update their capitalization policy to be consistent with these procedures. Existing policies should be scrutinized for compliance and updated as necessary, giving special attention to the facts and circumstances that could lead to the use of any exclusions or safe harbors.  An assessment should be made with careful consideration for each asset class, units and components.   Doing so may be tedious and will likely require a great deal of time.  It is recommended that organizations undergo this assessment early within the year as opposed to when reporting will be required at the end of the year.

As always, Raffa is available to help consult and provide guidance during this process as needed. For any questions, please contact Raffa Tax Partner, Frank Smith at 202-955-6735 or fsmith@raffa.com.

This article contributed by Ariana Warren, Senior II and Aaron Fox, Senior Manager in Raffa's Nonprofit Tax practice.