Posted by: Howard Kass, CPA, AEP®
We are writing this to alert you to recent changes in federal tax law that will likely affect you significantly. The changes I am going to explain will affect the way you are required to deduct expenses related to the ownership of tangible property (for example: buildings, land, furniture, equipment, materials & supplies, etc.) . These changes are a direct result of recently issued regulations (“regs”) from the IRS, addressing the tax treatment of amounts paid to acquire, produce, or improve tangible property. The regs impose complex rulesgoverning when such payments can be deducted and when they must be capitalized and depreciated over time. The new rules must be adhered to for tax years beginning on orafter January 1, 2014 and may entail significant time and effort to adopt and comply with.
What does this mean to you, the business owner?
For many businesses that own tangible property, there could be one or more additional tax forms to be included with your return (form 3115), requesting required changes in accounting methods for certain aspects of property ownership, as well as a variety of elections that will have to be made with your return.
Certain “small businesses” (less than $10 million in assets or $10 million in average gross receipt for the preceding three years) will have the option of not filing form 3115, and, instead, only applying the required changes prospectively. Please note that, simply because a business qualifies to not file form 3115 doesn’t mean that is the best decision for their business. There will be circumstances where it will be advantageous for a business to file the extra form.
Regardless of whether or not a business files form 3115, all businesses are still required to comply with the accounting changes going forward and may have elections to file with their 2014 income tax returns. For some businesses, the additional time required to comply with these new regs could be as little as one hour, while for other businesses, particularly those that own real estate, the additional time of compliance could amount to numerous hours.
What businesses are subject to these regs?
Any business that acquires or owns tangible property. Whether or not you are required to file form 3115, you will need to follow the other steps mentioned above to comply with the regs. This doesn’t just apply to businesses that file their own, separate income tax returns. If you are self-employed and file a schedule C, you will need to comply with the regs. If you own real estate, either in your business or for rental purposes, you will, without question, have to comply with the regs.
The important point in this notice is that compliance with these regs is not optional, it is mandatory. Failure to do so can dramatically increase the likelihood that your business will be audited by the IRS. Further, those businesses who opt not to file form 3115, do not receive any audit protection for tax years beginning prior to January 1, 2014.
So, what has changed in the way we may treat tangible property for tax purposes? Following is a brief summary that will be helpful in understanding the far-reaching nature of these regs.
Capitalize or deduct? Generally, amounts paid to improve a “unit of property” (see following) must be capitalized. An improvement is an expenditure that betters a unit of property, restores it, or adapts it to a new and different use. In contrast, a current deduction is allowed for repairs and maintenance to property.
Unit of property (UOP). This is a new term that identifies the item being improved or repaired. Generally, the lower the cost of a UOP, the more likely it is that money expended on it will have to be capitalized, and not deducted.
- Property other than buildings. In general, a single UOP consists of all components that are functionally interdependent, such that one component can't be placed in service without the other components. Assume a business needs a battery-powered golf cart for its warehouse. If it buys the chassis from one vendor, the battery from another, and then assembles them, the cart is the UOP, since the chassis can't be placed in service without the battery.
- Buildings. When it comes to buildings, there is much more to pay attention to in the new regs! Each building and its structural components comprises one UOP. In addition, each of the following building systems comprises a separate UOP from the building structure: HVAC, Plumbing and Electrical systems, Escalators/Elevators, Fire/Alarm/Security Systems, and Gas Distribution Systems.
Deducting materials and supplies. A deduction is allowed for amounts paid to produce and acquire materials and supplies that have a useful life of a year or less, and are consumed during the year. Moreover, UOPs that cost $200 or less qualify as deductible materials and supplies.
There are a couple of safe-harbors you need to be aware of.
- De minimis safe harbor. The regs allow a deduction for limited amounts paid for tangible property that are expensed for financial accounting purposes. Taxpayers with an “Applicable Financial Statement” (generally an audited financial statement) may rely on this safe harbor to deduct expenditures of up to $5,000 if they have a written accounting policy in place permitting this. For businesses without an Applicable Financial Statement, the maximum amount is currently $500. Again, an accounting policy must be in place permitting this but, in this case, it doesn’t have to be written. What happens if you don’t have a policy in place? Your ability to deduct expenditures – of any amount – that an IRS agent believes to be unreasonable could be in jeopardy!
- Routine maintenance safe harbor. Certain expenditures for routine maintenance may be deducted, rather than capitalized. Routine maintenance includes activities that keep business property in ordinarily efficient operating condition (as opposed to putting it in ordinarily efficient operating condition), such as inspection, cleaning, testing, and replacement of damaged or worn parts. Additional rules apply to building structures.
The bottom line, here, is that, because of the significant record-keeping required and additional forms that may have to be filed this year, tax returns for most businesses and lessors of real property will take significantly longer to complete. The result? Tax returns for businesses and those involved in any rental activity will, in most cases, involve significantly more documentation that they did previously, whether or not form 3115 is filed, and will likely cost more to prepare. Rest assured that we will do our utmost to make the tax preparation process as efficient as possible and to minimize related fee increases.
A final note: Be forewarned that failure to comply with these new tangible property regs can result in disallowed deductions, as well as penalties and interest.
If you have questions on this, or any other tax or business related issue, please contact the experts at Zinner & Co.
