Overview of the Final Repair and Capitalization Regulations Sorting - PDF document

2/17/2015 Overview of the Final Repair and Capitalization Regulations Sorting Out the Confusion and the Myths – The Final Treasury Regulations on Repairs and Capitalization Roger A. McEowen Director, Center For Agricultural Law and Taxation, Ames, Iowa & Paul G. Neiffer Principal, CliftonLarsonAllen, LLP, Kennewick & Yakima, WA Contact Information Roger A. McEowen • – mceowen@iastate.edu – (515) 294 ‐ 4076 – www.calt.iastate.edu – @CALT_IowaState Paul G. Neiffer • – paul.neiffer@claconnect.com – (509) 823 ‐ 2920 – www.claconnect.com – @FarmCPA TaxPlace • Note: – Today’s presentation will be archived on TaxPlace where it will be available for viewing by subscribers • No CE credit offered for viewing after today’s live presentation 1

2/17/2015 Learning Objectives At the end of this session you will be able to:  Define a unit of property  Recognize opportunities to deduct expenditures as materials and supplies  Understand tests for requirements on capitalization due to improvements, renovations and restorations  Understand the practical application of the regulations to client situations 2 Final Repair Regulations Final and proposed regulations were issued on Sept. 13, 2013. • – Generally finalize the temp. and proposed regs. issued on 12/23/11 – Regs. issued under I.R.C. §168 (GAA and dispositions) again issued as proposed Generally effective for tax years beginning on or after Jan. 1, 2014 • – At the earliest, IRS can’t impose the changes established by the regulations until examining return for 2014 tax year – Taxpayers do have the option to early adopt the regulations for tax years beginning on or after Jan. 1, 2012. – Contain some taxpayer ‐ favorable changes • De minimis safe harbor • Routine maintenance safe harbor New Repair Regulations • What’s the issue? – I.R.C. §162(a) allows deduction for ordinary and necessary expenses paid or incurred during tax year in carrying on trade or business, including amounts paid for incidental repairs – I.R.C. §263(a) denies a deduction for any amount paid for new property or for permanent improvements or betterments that increase value of any property, or amounts spent to restore property 2

2/17/2015 Materials and Supplies • Separate into incidental and non ‐ incidental supplies – Incidental – deducted when purchased as long as no record of consumption kept and expensing would not distort income. Reg. 1.162 ‐ 3(a)(2) – Non ‐ incidental materials and supplies are not expensed until used or consumed. Reg. 1.162 ‐ 3(a)(1) Material and Supplies What is a deductible material or supply? • – Tangible personal property, other than inventory, used or consumed in taxpayer’s business that is… • A component acquired to maintain, repair or improve a unit of tangible property and that is not acquired as part of any single unit of tangible property; • Fuel, lubricants, water or similar items reasonably expected to be consumed in 12 months or less • A unit of property with economic useful life of 12 months or less • Item with acquisition cost or production cost of $200 or less • Property identified in the Fed. Reg. or in the IRB as materials and supplies Example Alexco provides billing services to its customers. It purchases 50 • scanners to be used by its employees. Each scanner costs $150. In the first year, Alexco’s employees begin using 35 of the scanners and stores the remaining scanners for use in a later year – The scanners are materials and supplies under 1.162 ‐ 3(c)(1)(iv) • Alexco may deduct the cost of the 35 scanners used in the first year (if they are non ‐ incidental) • The remaining scanners are deductible in the year first used in Alexco’s trade or business. 1.162 ‐ 3(h), Example 7 – Note: If Alexco had treated all 50 scanners as incidental, then all 50 scanners are deductible at time of purchase 3

2/17/2015 Final Repair Regulations What about materials and supplies (e.g., tangible • personal property that is used in the taxpayer’s trade or business and is not inventory)? – Can be deducted when purchased if no record of consumption kept and expensing does not distort income (otherwise deduct when used or consumed) – Query: • Does the creation of a GAAP financial statement deny the ability to deduct prepaid farm supplies because it constitutes a record? Final Repair Regulations – The Big Picture Distinguish between amounts paid to acquire or • produce tangible property and amounts paid to improve existing property – Always capitalize amounts paid to acquire or produce tangible property, unless… • It qualifies as materials and supplies, or • It qualifies under the de minimis safe harbor and conforms to the taxpayer’s annual safe harbor election – Capitalize amounts paid to improve existing property if the expenditure is a betterment, restoration or adaptation • Everything else is a deductible repair §1.162 ‐ 3 (Materials and Supplies) §1.162 ‐ 12 (Expenses of Farmers) • Both regs. originated in 1958 – 1.162 ‐ 3 has always required that the deduction for non ‐ incidental materials and supplies be limited to those actually used or consumed during the tax year • The final regulations did nothing to change this rule – 1.162 ‐ 12 • Farmers can deduct from gross income as necessary expenses “all amounts actually expended” in carrying on the business of farming 4

2/17/2015 Materials and Supplies ‐ Farmers However, the treatment of materials and supplies for • farmers has been guided by Reg. 1.162 ‐ 12(a) which allows full deductibility for all amounts actually expended in carrying on the business of farming including, e.g., gasoline “if used wholly in the business of farming.” – Both Reg. 1.162 ‐ 3 and Reg. 1.162 ‐ 12 originated in 1958. Reg. 1.162 ‐ 3 has always required that the deduction for non ‐ incidental materials and supplies be limited to those actually used or consumed during the tax year. – Thus, it does not appear that the provisions in the new Reg. 1.162 ‐ 3 distinguishing between incidental and non ‐ incidental materials or supplies will be applicable to farmers. Materials and Supplies Example: • – Pete (cash method farmer) filled his 4,000 gallon diesel fuel tank on December 30. He expects to use the fuel in the next 12 months • Pete can currently deduct the expense – Listed as a supply inventory on financial statement – Keeps record of consumption – Can deduct the expense as necessary to conduct farming business. Treas. Reg. 1.162 ‐ 12(a) Note: The same analysis applies to the purchase • of tires to be consumed in next 12 months Final Repair Regulations Rotable and temporary spare parts are a subset of materials and • supplies, but are not immediately deductible. – What are they? • RSP ‐ acquired for installation on a UoP; removable from that UoP; generally repaired or improved; either installed on the same or other property or stored for later installation • TSP – parts used temporarily until a new or repaired part can be installed and then are removed and stored for later emergency or temporary installation Options for handling: • – Deduct cost when disposed of (default rule) – Capitalize and depreciate over recovery period; – Deduct when first installed, but record income at FMV when removed with FMV becoming tax basis in the part, and continue that process until ultimately disposed of and any remaining basis is deducted 5

2/17/2015 De Minimis Safe Harbor Election Can elect safe harbor to deduct amounts paid to • acquire or produce tangible personal property up to threshold of $5,000/invoice (or per item if taxpayer has an AFS) – Must have, at the beginning of the tax year, written accounting procedures treating amounts: • Paid as an expense for non ‐ tax purposes, or • Amounts paid for property costing less than a specified dollar amount, or • Amounts paid for property with an economic useful life of 12 months or less What is an AFS? • A 10 ‐ K filed with the SEC • A certified audited financial statement prepared by an independent CPA • Financial statement required for federal or state governmental entity – Non ‐ audited FS required for government backed loans (SBA, Farmer ‐ Mac, etc.) are not AFS For Taxpayers With No AFS • Safe harbor is $500 – IRS considering increasing the $500 threshold • Rev. Proc. 2015 ‐ 20 • May not be applicable in time for timely filed 2014 tax returns – Accounting policy to expense need not be in writing 6