When deciding how to handle tangible property costs, businesses generally have two options:
Deduct now. Internal Revenue Code Section 162 allows you to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including the costs of certain supplies, repairs and maintenance.
In addition, businesses can deduct materials and supplies that cost $200 or less to acquire or produce under Section 162, as well as incidental repairs and routine building maintenance, including costs to inspect, clean, test and replace parts.
Capitalize and depreciate later. Section 263 requires you to capitalize amounts paid to acquire, produce or improve tangible property. Capitalized costs are generally not deducted in the current tax year; they're depreciated over their economic useful lives.
Under Section 263, however, you must generally capitalize improvements that:
- Add to the value, or substantially prolong the useful life, of your property, or
- Adapt the property to a new or different use.
The final regs use a modified "betterment" test to determine whether to capitalize costs as improvements. An improvement makes the property better if it materially adds to the asset, restores a major condition or defect or increases its productivity, efficiency, strength, quality or output.
An improvement also must be capitalized if it restores the asset by replacing a major component or substantial structural part of the asset, including buildings. The final regs no longer require you to consider how the expenditure is treated on your financial statements when applying the betterment test.
In general, taxpayers prefer to deduct as many tangible property costs as possible to lower their taxable income in the current period. However, the final regs permit an optional election to capitalize rotable, temporary or standby emergency spare parts that have been acquired to maintain, repair or improve your property.
The decision to expense or capitalize an item is just a matter of timing. You will pay the same taxes over the life of the asset, regardless of how you classify the costs, as long as tax rates and laws remain consistent. If you expect higher tax rates or more restrictive tax laws in the future, you might prefer to capitalize costs to reduce taxable income in future periods.
Some items are easily classified as a deductible business expense (such as a box of staples) or a capital expenditure (such as a new forklift). Others fall in the gray area between Sections 162 and 263. The final repair regulations refine and clarify those gray areas, as well as provide various de minimis "safe harbors."
The new repair regulations are not elective. They are required for business taxpayers who have fixed assets and whose tax year begins on or after January 1, 2014. In order to officially change the various methods of accounting to conform to the new repair regulations, taxpayers must file Form 3115, Application for Change in Accounting Method, with the IRS. Filing this Form alerts the IRS of the Taxpayer's change in accounting method and it provides audit protection if the change is ever audited. Taxpayers have until the filing of their 2014 tax returns (including extensions) to get into compliance with the final repair regulations.
How Have the Procedures Changed for Small Businesses?
At the request of many small business owners and tax professionals, the IRS has made it easier for small businesses to adopt certain parts of the final repair regs. Revenue Procedure 2015-20 allows small businesses to make certain accounting method changes on a prospective basis in tax years beginning on or after January 1, 2014. This modification effectively means that small business taxpayers making these certain changes in accounting method for the first tax year that begins on or after January 1, 2014, may elect to make the change on a cut-off basis.
Qualifying businesses also won't need to complete and file a Form 3115 to use this simplified procedure for 2014. Instead, they can make the change solely through the filing of a federal tax return. However, some small business taxpayers may choose to file a Form 3115 to retain a clear record of a change in method of accounting or to make permissible concurrent automatic changes on the same form.
Taxpayers should explore all their options before making the decision to not file Form 3115 since not doing so may end up costing the business in the future.
What Are the IRS Minimum Thresholds for Expensing Tangible Property Costs?
The final regs permit certain taxpayers to deduct tangible property they acquire or produce, if the total cost per item (or invoice) is $5,000 or less. To qualify for this safe harbor, you must:
- Prepare an "applicable financial statement." That is, a certified audited financial statement or a financial statement filed with a state or local government.
- Possess a written accounting procedure at the beginning of the tax year for expensing property under a specified dollar amount.
- Expense the cost on your applicable financial statement, not just your tax return.
The de minimis safe harbor also applies to property with an economic useful life of 12 months or less as long as the item doesn't cost more than $5,000 per item (or per invoice).
For those small businesses that don't prepare "applicable financial statements" a $500 capitalization threshold is provided in the regulations. Tangible property costs below this amount are generally considered to be ordinary and necessary business expenses and, therefore, not treated as capital expenditures under the final repair regs.
Businesses that don't prepare applicable financial statements may elect to apply the de minimis safe harbor if, among other things, the amount paid for the property subject to the de minimis safe harbor doesn't exceed $500 per invoice (or per item as substantiated by the invoice) or other amount as identified in published guidance issued by IRS.
Revenue Procedure 2015-20 clarifies that the safe harbor doesn't limit a taxpayer's ability to deduct otherwise deductible repair or maintenance costs that exceed $500. The safe harbor merely establishes a minimum threshold below which all qualifying amounts are considered deductible. Consistent with longstanding law, a taxpayer may continue to deduct all otherwise deductible repair or maintenance costs, regardless of amount.
In addition, the existence of the de minimis safe harbor doesn't mean that a taxpayer cannot establish a de minimis deduction threshold in excess of the safe harbor amount, provided the taxpayer can demonstrate that a higher threshold clearly reflects the taxpayer's income.
Revenue Procedure 2015-20 requests comments from small businesses and tax practitioners on whether the $500 safe-harbor threshold for those businesses without an applicable financial statement should be increased in the future.
Where Can Small Businesses Find More on the Repair Regs?
In light of IRS Revenue Procedure 2015-20, it's easier for a qualifying small business to make a change of accounting method under the final repair regulations. Please weigh all your options before making the decision to not file Form 3115, Application for Change in Accounting Method, to comply with the final repair regulations. Not filing may end up costing your business in the long run. Before filing your 2014 federal tax return, review your company's tangible property capitalization policies for potential tax savings opportunities. If your business doesn't currently have a written capitalization policy, consider drafting one in 2015.
At more than 200 pages, the final regs are hardly clear and concise. This brief article just scratches the surface of the complex capitalization rules. There are many nuances, exceptions and safe harbors. Your tax professional can help you evaluate the decision to deduct or capitalize tangible property costs and ensure compliance with the latest IRS regulations and procedures.
Defining "Small Business"
To qualify for the simplified procedures mentioned in Revenue Procedure 2015-20, a small business taxpayer must have:
- Total assets of less than $10 million as of the first day of the tax year that the change in accounting method under the final repair property regs is effective, OR
- Average annual gross receipts of $10 million or less for the prior three tax years.
For more information on Repair Regs for Small Businesses, contact Tim Sturm at firstname.lastname@example.org or call 615-309-2303.