Don’t Blame the Messenger Capitalization Regulations Affordable Care Act Capitalization Regulations • Effective Date: January 1, 2014 • Issue: Where is the line between current deduction and an expense that must be capitalized • Materials and Supplies Expense or Capitalization • Repair or Capitalization • History: Fedex vs Commissioner • Unravels 40 years of court precedence (meaning there is more gray area than ever before and thus more court cases to come) 2 Safe Harbors • The regulations provide two safe harbors to “simplify” the regulations. They do actually help to a degree. • De Minimis rule safe harbor • Routine Mainenance Safe Harbor De Minimis Rule Safe Harbor • Amounts $500 or under are expensed in the year of purchase • Must have a written policy in place at the beginning of the year • An annual election must be made on your timely filed tax return, if no election the amount is -0• The $500 limit is per item as listed on invoice • Delivery fees and installation are NOT included in the $500 limit IF they are not included on the same invoice as the item purchased. • If the additional costs are listed on the same invoice they are included in the $500 limit. • The $500 limit DOES include sales tax • Anti-Abuse Rules: Can’t purchase a car with each items separately stated with a value under $500! BE REASONABLE! Routine Maintenance Safe Harbor • You expect to perform the activity more than once over the property’s ADS class life (most farm machinery 10 years) • The maintenance keeps (rather than puts) the property in an ordinary efficient operating condition • The need for the maintenance results from the taxpayer’s own use of the property (rather than existing wear and tear from a prior owner’s use) • Buildings – Allows a deduction for items of maintenance that are expected to last less than ten years. Deducible Materials & Supplies Non-Farm • Is not inventory and meets on of the following criteria • Consists of fuel, lubricants, water, and similar items, reasonably expected to be consumed in 12 months or less • Is a unit of property that has an economic useful life of 12 months or less. • Is a unit of property that has an acquisition cost of $200 or less (unless safe harbor election is used) • Rotable, Temporary and Standby Emergency Parts • Generally deductible when used • Example: Entity keeps a truck engine on hand to be used when another engine fails. When this engine is placed in service, either the old engine is rebuilt or a new one is purchased and ready to be used as a replacement. • Generally Expensive • If you have these talk to use afterwards! Materials & Supplies - Farmers • For farmers, the deduction for materials and supplies is limited to such items actually used or consumed during the next tax year. • There is no change for farmers on materials and supplies! (enjoy the good news because it ends here) Repairs vs Capitalization • Under the new regulations, improvements, which must be capitalized, fall into three categories: • Betterments • Restorations • Adaptations to a new or different use Betterments: • Repairs a material condition or defect that existed prior to you acquiring the unit of property; or • Is for a material addition to the unit of property, including a physical enlargement, expansion, or extension of that unit; or • Results in a material increase in capacity, productivity, efficiency, strength, or quality of the unit of property, or the output of the unit of property Restoration: • Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended purpose; • Results in the rebuilding of the unit of property to a like-new condition after the end of its class life (ADS) • Is for the replacement of a part or a combination of parts that constitutes a major component or a substantial structural part of a unit of property…. This is the big one! • A major component is a part or combination of parts that perform a discrete and critical function in the operation of the unit of property. Example (Restoration): • Replacement of major component or substantial structural part; personal property. G is a common carrier that owns a fleet of petroleum hauling trucks. G pays amounts to replace the existing engine, cab, and petroleum tank with a new engine, cab, and tank. Assume the tractor of the truck (which includes the cab and the engine) is a single unit of property and that the trailer (which contains the petroleum tank) is a separate unit of property. The new engine and the cab each constitute a part or combination of parts that comprise a major component of G's tractor, because they perform a discrete and critical function in the operation of the tractor. In addition, the cab constitutes a part or combination of parts that comprise a substantial structural part of G's tractor. Therefore, the amounts paid for the replacement of the engine and the cab must be capitalized under paragraph (k)(1)(vi) of this section. Moreover, the new petroleum tank constitutes a part or combination of parts that comprise a major component and a substantial structural part of the trailer. Accordingly, the amounts paid for the replacement of the tank also must be capitalized under paragraph (k)(1)(vi) of this section. Example (Not a Restoration) • Not replacement of major component; incidental. J owns a machine shop in which it makes dies used by manufacturers. In Year 1, J purchased a drill press for use in its production process. In Year 3, J discovers that the power switch assembly, which controls the supply of electric power to the drill press, has become damaged and cannot operate. To correct this problem, J pays amounts to replace the power switch assembly with comparable and commercially available replacement parts. Assume that the drill press is a unit of property under paragraph (e) of this section and the power switch assembly is a small component of the drill press that may be removed and installed with relative ease. The power switch assembly is not a major component of the unit of property under paragraph (k)(6)(i)(A) of this section because, although the power assembly may affect the function of J's drill press by controlling the supply of electric power, the power assembly is an incidental component of the drill press. In addition, the power assembly is not a substantial structural part of J's drill press under paragraph (k)(6)(i)(B) of this section. Therefore, J is not required to capitalize the costs to replace the power switch assembly under paragraph (k)(1)(vi) of this section. Adaptations: • You must generally capitalize as an improvement an amount paid to adapt a unit of property to a new or different use. Repair vs Capitalization – Buildings • Buildings and their structural components are considered a single unit of property. However under the new rules the distinction between capitalization and repair is made after breaking the building into the structure and eight specific subsystems. What this means is that each expenditure must be analyzed by whether it is a repair or improvement of the subsystem. • Major Subsystems: • • • • • • • • • Building Structure HVAC Plumbing System Electrical System Escalators Elevators Fire Protection Security Gas Distribution Repair vs Capitalization – Buildings Cont. • But that is not enough: • Now you have to break each Subsystems into Major Components defined earlier. • A major component is a part or combination of parts that perform a discrete and critical function in the operation of the Subsystems. • This breakdown has the effect of forcing more expenditures to be capitalized and does nothing but confuse the situation… Example • Replacement of major component or substantial structural part; roof. K owns a manufacturing building. K discovers several leaks in the roof of the building and hires a contractor to inspect and fix the roof. The contractor discovers that a major portion of the decking has rotted and recommends the replacement of the entire roof. K pays the contractor to replace the entire roof, including the decking, insulation, asphalt, and various coatings. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The roof is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Because the entire roof performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure under paragraph (k)(6)(ii)(A) of this section. In addition, because the roof comprises a large portion of the physical structure of the building structure, the roof comprises a substantial structural part of the building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, under either analysis, K must treat the amount paid to replace the roof as a restoration of the building under paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the amount paid as an improvement under paragraph (d)(2) of this section. Example • Not replacement of major component or substantial structural part; roof membrane. L owns a building in which it conducts its retail business. The roof decking over L's building is covered with a waterproof rubber membrane. Over time, the rubber membrane begins to wear, and L begins to experience leaks into its retail premises. However, the building is still functioning in L's business. To eliminate the problems, a contractor recommends that L replace the membrane on the roof with a new rubber membrane. Accordingly, L pays the contractor to strip the original membrane and replace it with a new rubber membrane. The new membrane is comparable to the original membrane but corrects the leakage problems. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount is paid to restore the building structure or any building system. The roof, including the membrane, is part of the building structure as defined under paragraph (e)(2)(ii)(A) of this section. Because the entire roof performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure under paragraph (k)(6)(ii)(A) of this section. Although the replacement membrane may aid in the function of the building structure, it does not, by itself, comprise a significant portion of the roof major component under paragraph (k)(6)(ii)(A) of this section. In addition, the replacement membrane does not comprise a substantial structural part of L's building structure under paragraph (k)(6)(ii)(B) of this section. Therefore, L is not required to capitalize the amount paid to replace the membrane as a restoration of the building under paragraph (k)(1)(vi) of this section. Safe Harbor for Buildings for Qualifying Small Taxpayers • Eligible building had an unadjusted basis of $1 million or less • The total amount spent during the taxable year on repairs, maintenance, improvements and similar activities on the building does not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building • Qualifying Small Taxpayer is one whose average annual gross receipts for the three preceding tax years do not exceed $10 million • Election must be made Potential Need for Form 3115 • Form 3115 is used for changing accounting methods. • Some experts suggest that, to be safe, all businesses that acquire or maintain tangible property must now file Form 3115. • Form 3115 is very costly to produce • Our opinion: Unless you have had a clear accounting method that you used in the past that differs from what we have just talked about you may not need to file Form 3115 (Most of you don’t have formal accounting methods in place) • If your previous accounting procedures or treatment of property on tax returns differ materially from those under the new regulation, a change to comply with the new regulations requires filing Form 3115 • We could be wrong on this and the only way to know is when the courts get this in their hands. • So, If you are concerned or you know you have a change in accounting method we may need to file Form 3115 Bookkeeping for Repairs/Supplies • 1 repair account for those repairs you are confident are repairs • New repair account with a ? for those repairs you are unsure of • 1 supply account for those supplies you are confident are supplies • New supply account with a ? for those supplies you are unsure of Section 179 Update • Currently at $25,000. Repair Reg Steps: • Step 1 – Adopt current year De Minimis Policy • Step 2 – Personal Property Rules; Apply De Minimis and safe harbor maintenance rules to materials, supplies, equipment and repairs as follows: • a. Expense supplies and maintenance items lasting < 12 months (Farmers expense supplies and maintenance expected to be used in the next tax year) • b. Expense repairs and acquisitions costing <$500 per maintenance policy • c. Expense repairs that are expected to be replaced more than once during the asset life Repair Reg Steps Cont: • Step 3: Real Property Rules; Apply safe harbor maintenance rules to buildings • a. Expense items replaced or expected to be replaced within a 10 year period, • b. Determine if qualifies small business revenues <$10,000,000 • c. Determine if building original cost is <$1,000,000 • d. If bosth b and c are met determine if total maintenance costs including other current year expense items are less than $10,000 per building • e. If d is met expense the amounts, Otherwise life as you know it has ended and apply the capitalization rules below. Repair Reg Steps Cont: • Step 4: Apply the 3 Betterment tests to each item whose individual cost is >$500, if no betterment test applies go to Step 5, if any capitalize • Step 5: Apply the restoration test to each item whose individual cost is >$500, if no restoration test applies go to step 6, if any capitalize • Step 6: Apply the adaptation tests to each item whose individual cost is >$500, if any adaptation test applies capitalize • Step 7: Go and enjoy a beverage of your choice because clearly that is what the authors of this regulation were doing!