Since 2003 the IRS has been working to revamp how businesses should account for money spent on buying, making, improving and repairing tangible property. The final regulations were announced in 2014 with an important update made in 2015. Why would such a seemingly arcane tax accounting topic take a decade to finalize? The changes affect over $17 trillion in tangible assets owned by U.S. businesses and may require accounting changes for virtually every company in the country.
The new regulations address whether or not expenditures on tangible assets should be deducted or capitalized. This has been a point of contention between businesses and the IRS for decades leading to numerous Tax Court proceedings. The general consensus under the old regulations was that disagreements could only be resolved individually using the particular facts and circumstances of the case. The new regulations provide more specific (and more complex) guidance with a goal of clarifying when expenditures should be capitalized or expensed.
Deduct or capitalize?
If a restaurant spends $30,000 on a new pizza oven it’s considered a capital expenditure meaning that the oven becomes an asset of the company and its value depreciates little by little over its useful life. For tax purposes the depreciation each year increases the company’s overall expenses, reduces its profits and lowers its tax bill.
If that same restaurant spends $1,000 repairing a broken sensor, the full amount can be treated as an expense in the year it was incurred which also increases the company’s overall expenses, reduces its profits and lowers its tax bill.
But what if the restaurant spends $4,000 replacing the doors on the oven with new ones that contain the company logo? Are those new doors a repair and maintenance expense which can be claimed as a deduction and lowers profits by $4,000? Or are they an improvement which extends the useful life of the oven requiring that the cost be amortized over time, reducing profits by a fraction of the $4,000 every year over many years? Making the wrong choice can lead to additional taxes, penalties, an audit or even a case in tax court which has basically said that the decision to expense or capitalize comes down to the “facts and circumstances” of each case.
Companies almost always prefer expensing because it reduces tax profits and income taxes due in the short-term by a larger amount. The IRS prefers capitalization which reduces income taxes due in the short-term by a smaller amount over multiple years, minimizing the negative impact to IRS revenues in the short-term.
The new regulations
The new regulations establish the following framework for the accounting treatment of tangible property:
Default position
The new regulations start from the default position that all expenditures on tangible property should be capitalized unless the expenditure falls into one of the many categories of exceptions.
Units of property
All tangible assets are to be organized into individual units of property (“UoP”). A unit of property is comprised of all of the “functionally interdependent” parts of an asset. A company with a fleet of 10 delivery vans would treat each van as a UoP. Generally all of the components of a given van (the engine, doors, etc.) are functionally interdependent and therefore no further UoP breakdown is required. The only exception would be if the business applies a different depreciation schedule to part of the van. If a company depreciates the shelving in the back of the van differently than the rest of the van then there would be two UoPs: The shelving and the van excluding the shelving. The Industry Issue Resolution Program from the IRS provides guidance on how to treat specific assets.
Classifying expenditures
For each UoP, the business must review all related expenditures. Expenditures must be capitalized if they result in a betterment, adaptation or restoration of the UoP. The IRS classifies them as follows:
- Betterments “ameliorate a material condition or defect” that was present before purchase; or results in “a material addition to the unit of property” or result in a “material increase in the capacity, productivity, efficiency, strength, or quality” of the UoP.
- Adaptations change a UoP so that its new use is “inconsistent with the taxpayer’s intended ordinary use at the time the property was originally placed in service”.
- Restorations of a UoP include: replacing a component or repairing damage that impacts the tax basis of the UoP, returning a UoP to a functional state of degrading to a state of disrepair, rebuilding the UoP to like-new condition after the end of its depreciation useful life, or replacing a major component or structural element.
Materials and supplies
The new regulations define “materials and supplies” as expenditures on tangible property that cost less than $200 or have a useful life of 12 months or less. Materials and supplies can be expensed; they do not need to be capitalized. Companies have the option to set a higher dollar value for classifying materials and supplies. The maximum is either $500 or $5,000 with the latter being available to companies that have audited financial statements and a capitalization policy in place at the beginning of the year.
The new regulation also includes additional provisions for dealing with the sale or disposition of tangible property, acquisition costs and special UoPs like buildings.
Waiving filing requirements for small businesses
Millions of businesses account for tangible property-related expenditures differently and will need to change their accounting to comply. The IRS considers the steps taken by companies to adapt to these new regulations to be changes to the company’s accounting method. Any time a company changes their accounting method they must file form 3115 Application for Change in Accounting Method. The form must be submitted with a tax return and the IRS must approve the changes. Filing out this form correctly can be onerous, especially for small businesses with limited resources.
To address the voluminous feedback received from small business owners regarding Form 3115 the IRS recently published Revenue Procedure 2015-20 which waives the requirement that small business file Form 3115 along with their tax returns. The requirement is waived for tax years beginning on January 1, 2014 and covers companies with less than $10 million in assets or less than $10 million a year in revenue calculated as the average revenue over the past 3 years. This reduces the burden on small business owners at the time of preparing and filing tax returns.
More information
Business owners with further questions should speak to their tax and accounting advisors. While small businesses don’t need to file Form 3115 there are still many decisions that need to be made regarding tangible property accounting that require specific tax accounting expertise.
You may also call the following contacts provided by the IRS. They had direct responsibility for authoring the relevant Revenue Procedures:
- Patrick Clinton of the Office of Associate Chief Counsel at the IRS: (202) 317-7005
- Merrill Feldstein of the Office of the Associate Chief Counsel at the IRS: (202) 317-5100
- Alan S. Williams of the Office of the Associate Chief Counsel at the IRS: at (202) 317-5100
