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Construction Tax Update:
Breaking down the Repair
Regulations and building up
Tax Developments
December 4, 2012
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Presenters
• John Dorn
• Jon Olson
– Partner
– Minneapolis, MN
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– Partner
– Alexandria, MN
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Learning Objectives
• Identify the criteria for determining whether an
expenditure relating to tangible property is a
deductible expense or must be capitalized.
• Identify the “unit of property” used for determining
whether an expenditure is deductible or capitalized.
• Understand recent Federal income tax changes
resulting from rulings, court cases, and Congressional
action.
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The Fight
• Determining the line for expenditures relating to
tangible property between those required to be
capitalized under Section 263(a) and those entitled
to deduction under Section 162(a).
• Section 263(a) – requires capitalization of amounts
paid for new property and improvements or
betterments made to increase value of property.
• Section 162(a) – allows deduction for all ordinary
and necessary business expenses.
– Includes repairs (Treas. Reg. 1.162-4T)
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Temporary and Proposed Regulations
• Latest of several sets of regulations issued under the
two sections
• Issued December 23, 2011
• Purpose – from the Preamble of TD 9564:
– “Clarify and expand the standards in the current
regulations under sections 162(a) and 263(a) and provide
certain bright-line tests for applying these standards.”
• IRS hopes to finalize “early” 2013
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Clarity? Bright Lines?
• Most rules based on facts and circumstances
• Rules “clarified” through examples
– Materials and supplies: 14 examples
– De Minimis rules: 4 examples
– Unit of Property: 19 examples
◊ Plus 6 more examples on improvement costs
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Routine maintenance safe harbor: 10 examples
Betterments: 19 examples
Restorations: 26 examples
Acquired or produced property: 11 examples
◊ Plus 9 more on transaction costs and 3 more on defense of title
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UNIT OF PROPERTY
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Unit of Property
• General rule – All components of real or personal
property that are functionally interdependent
comprise a single Unit of Property (UOP).
• Components are functionally interdependent if the
placing in service of one component is dependent on
the placing in service of another component.
• However, component must be treated as separate
UOP if:
– Properly treated as within different class of property
under Section 168(e); or
– Properly depreciated using different method.
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Unit of Property--Building
• General rule – Each building and its structural
components is a single UOP
– Walls, partitions, floors, ceilings
– Permanent coverings
– Windows and doors
• However, for application of improvement rules to a
building, “building systems” are now treated as
separate UOPs from the building structure (roof,
walls, windows, floors, ceilings)
• BIG change from the previous regulations!!
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Building Systems
• HVAC
• Plumbing (includes pipes, drains, valves, sinks,
bathtubs, toilets, sewer collection)
• Electrical systems
• All escalators
• All elevators
• Fire-protection and alarm systems
• Security systems
• Gas distribution
• Other structural components identified by IRS
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DEDUCTIBLE EXPENSES
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Materials and Supplies
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Materials and Supplies
• Incidental
– No record of consumption
– Deduct when purchased
– Example: office supplies
• Non-incidental
– Record of consumption is maintained
– Not deductible until used or consumed
• Rotable and Temporary Spare Parts
– Acquired for installation on a UOP
– Default rule is to deduct when disposed of
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Definition of Materials and Supplies
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•
•
•
Tangible personal property
Used or consumed in taxpayer’s operations
Not inventory
One of the following
– Component to maintain, repair or improve a UOP that
itself is not a UOP
– Fuel, lubricants, water, similar items
– UOP with economic life ≤ 12 months
– UOP with cost ≤ $100, or
– Other property identified by IRS as material or supply
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Elect to Capitalize
• Incidental and non-incidental materials and supplies
– May elect to capitalize materials and supplies
– Election made by capitalizing and depreciating
– Timely filed return for year placed in service
• Rotable and temporary spare parts
– Capitalize and depreciate
– Elect to deduct when first installed
◊ Capitalize FMV when removed plus cost of repairs
◊ Deduct again when later installed
◊ Lather, rinse and repeat until disposed of permanently
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De Minimis Rule
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De Minimis Rule
• Taxpayers can deduct amounts paid to acquire or produce
tangible personal property (TPP)
– Applies to all TPP except inventory or land
– Taxpayer can elect to apply to materials and supplies
• To be eligible, taxpayer must:
– Have an applicable financial statement (AFS)
◊ F/S filed with SEC, or
◊ CPA audited F/S used for credit or reporting purposes
◊ CPA reviewed F/S does NOT qualify
– Have written accounting policy treating amounts as such an expense
– Actually treat such amounts as an expense on AFS; and
– Total amount of such expensed amounts cannot exceed greater of:
◊ 0.1% of gross receipts for tax purposes
◊ 2% of depreciation and amortization on AFS
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De Minimis Rule Election
• Made by deducting such amounts in the year paid
• Timely filed return
• May elect not to treat an otherwise eligible amount
so as to come under the 0.1% gross receipts or 2% of
depreciation expense tests
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De Minimis Rule – Preamble
• Rule is not intended to prevent a taxpayer from
reaching an agreement with the IRS revenue agents
that, as an administrative matter, based upon risk
analysis or materiality, the agents will not review
certain items.
– Burden on taxpayer that treatment clearly reflects income
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IRS Update on De Minimis Rule
• Recognition of administrative burden on some
companies due to failure to track amounts which
would be subject to de minimis limitations
– Not much sympathy from IRS Office of Chief Counsel, in
that taxpayers previously were required to capitalize such
costs
• One of the topics identified in Notice 2012-73
– “may be revised in a manner that might affect, and in
certain cases simplify, taxpayers’ implementation of the
rules when the regulations are issued in final form.”
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Dispositions
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Dispositions
• Occurs when ownership of an asset is transferred or
when an asset is permanently withdrawn from use
– Includes sale, retirement, physical abandonment of asset
• Disposition requires recognition of gain or loss
• What is the “asset” disposed of?
– Cannot be larger than UOP
– Structural components (including all components thereof)
of a building
– Improvements or additions
• Does not include a component of personal property
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Dispositions - Consequences
• Depreciation ends at time of asset’s disposition
• If asset disposed of is component of larger asset:
– Must reduce basis and depreciation reserve of larger asset
by amount of basis and reserve allocated to component
– Allocate basis to component using any reasonable method
• Gain or loss must be recognized
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Dispositions – Problem with Buildings
• What happens if taxpayer believes the amounts paid to
replace a component are a deductible repair expense?
– Disposition rules state that depreciation of old component must
stop and allocated basis is removed from larger asset
– Repair rules state that loss cannot be recognized
◊ If loss is recognized must capitalize new component as restoration
• Solution – Make a General Asset Account (GAA) election
– Disposition of a component of the building does not cause the
recognition of a loss or a basis reduction
– Result – Depreciate old component and deduct new component
– Regulations also provide flexibility to elect out of GAA when
taxpayer wants to recognize loss on disposition
◊ When “repair” must be capitalized as an improvement
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IRS Update on Dispositions
• One of the topics identified in Notice 2012-73
– May be revised and simplified
• IRS possibly making current GAA treatment for
buildings the default treatment for buildings.
– Not wanting a 3115 from every taxpayer that owns a
building in a trade or business.
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DEDUCTIBLE REPAIRS
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Repairs
• General rule – Taxpayer can deduct amounts not
otherwise required to be capitalized.
• Routine maintenance safe harbor
– Inspection, cleaning, testing, replacing of parts with
comparable parts of a UOP
– Taxpayer reasonably expects such activities will be
performed more than once during the asset’s class life
– Includes such activities even when performed after the
expiration of the asset’s class life
– Caution: safe harbor no longer applies to buildings or
structural components of buildings
– Also a topic identified in Notice 2012-73
◊ Revised? Simplified?
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CAPITAL EXPENDITURES
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Acquisitions
• General rule – Must capitalize amounts paid to
acquire or produce real or personal property.
• General rule does not affect exceptions
– Materials and supplies
– De minimis rule
• Amounts paid to acquire or produce include:
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–
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Invoice price
Transaction costs
Costs incurred prior to UOP being placed in service
Defense or perfection of title
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Betterments
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Betterments
• Corrects a material condition or defect existing prior to
acquisition or during the production of a UOP
– Applies even if taxpayer was unaware of the condition or defect
• Results in a material addition to the UOP
– Enlargement
– Expansion
– Extension
• Results in material increase in capacity, productivity,
efficiency, strength, or quality of UOP or output.
• Buildings – An amount results in a betterment to the
UOP if it results in a betterment to either the building
structure or any of the nine building systems.
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Betterments - Considerations
• “Appropriate” to consider all the facts and
circumstances including:
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Purpose of the expenditure;
Physical nature of the work performed;
Effect of the expenditure on the UOP; and
Taxpayer’s treatment of expenditure on its AFS
• If same replacement part is not available, then
replacement with “comparable” part is not, by itself,
a betterment to UOP
– Technological advancement or product enhancements
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Standard of Comparison
• Condition of property before and after expenditure
– Compare to condition of property before particular event
necessitating expenditure
◊ Example: storm damaging a roof
• Normal wear and tear excepted
• Take into account condition of property when placed
in service by taxpayer
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Restorations
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Restorations
• An amount paid restores a UOP if it:
– Replaces a component of a UOP and taxpayer recognized gain
or loss on old component (disposition)
– Repairs damage to a UOP for which taxpayer has taken casualty
loss
– Returns UOP to ordinary operating condition after deteriorating
to state where it is no longer functional
– Rebuilds UOP to like-new condition after end of class life
– Replaces a major component or substantial structural part of
the UOP
• Buildings – An amount results in a restoration to the
UOP if it results in a restoration to either the building
structure or any of the nine building systems.
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Restorations (cont.)
• “Major component” or a “substantial structural part”
– Must consider all the facts and circumstances including the
quantitative or qualitative significance of the part or
combination of parts in relation to the UOP
– Includes a part or combination of parts that:
◊ Comprise a large portion of the physical structure of UOP; or
◊ Perform a discrete and critical function in the operation of UOP
• Replacement of a minor component
– Even if it affects the function of the UOP, is not supposed
to constitute a major component or substantial structural
part (i.e., require capitalization).
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Adaptations
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Adaptations
• An amount paid adapts a UOP to a new or different
use if the adaptation is not consistent with the
taxpayer’s intended use of the property at the time
the property was originally placed in service.
• For buildings, the analysis applied to the building
structure and each of the nine building systems.
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IMPLEMENTATION
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Effective Dates
• T.D. 9564
– Tax years beginning after 2011
– However, most rules require full 481 adjustments
◊ Possibly going back as far as 1987
– Exceptions, effective for amounts paid after 2011:
◊ Materials and supplies
◊ Costs to acquire real property
◊ De minimis rule
• Notice 2012-73
– Regs delayed until tax years beginning after 2013
– However, taxpayers permitted to apply to 2011 and after
– Notified taxpayers of expected changes to de minimis rule,
dispositions, and routine maintenance safe harbor.
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Changes in Accounting Method
• Accounting method changes
– Section 481 adjustment
◊ Positive changes spread over 4 years
◊ Negative changes recognized in year of change
– Always open to IRS adjustment
– Filing method change provides audit protection
◊ And spreads positive changes over 4 years
– Conclusion – File necessary method changes to be
compliant with the new regs!
• Guidance arrived March 7, 2012
– Rev. Proc. 2012-19 for materials and supplies, repairs
– Rev. Proc. 2012-20 for depreciation changes
– New Form 3115 codes for automatic consents (162-180)
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2012 Federal Income Tax
Update
Domestic Production Activities Deduction
• Regs allow Section 199 deduction for activities to
erect or substantially renovate real property.
• Tax Court allows bridge and road renovation as
eligible for Section 199 (Gibson & Assoc.)
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Gibson & Assoc.
• Issues in case
– Definition of Item or Unit.
◊ IRS argued whole road system was the “unit of item”. The bridge
was just one little component of the total road system
– Classifications and descriptions in documents.
◊ Painting vs surface restoration
– Authority.
◊ IRS argued that contained to just Section 199. Taxpayer
successfully used Section 263(a) and other relevant case law.
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Investment Income Tax in 2013
• 3.8% surtax on net investment income of individuals
effective in 2013, computed as the lesser of:
– Net investment income, or
– Excess of modified AGI over $200K single/$250K jt.
– Example
• Definition of net investment income
– Interest, div., annuities, royalties, rents
– Passive business income and trading
– Gains from property (except active business)
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High Earner Medicare Tax
• Present employee FICA payroll tax: 6.2% OASDI on
first $110,100; 1.45% Medicare tax on all earnings
• Effective in 2013, Medicare tax up .9% to 2.35% on
higher income earners [IRC Sec. 3101(b)(2)]:
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Single earned income over $200,000
Joint earned income over $250,000
Assessed on employee share only, but employer withholds
If W/H inadequate, remit in 1040
Income tax deduction for ½ SE tax remains the same
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Accrual of Bonuses
• 2009 CCA: No deduction if some employees ineligible
because terminate before payment date
– All events test not met
• Rev. Rul. 2011-29: OK to accrue if terminated
employee amounts reallocated to other employees
– Automatic consent accounting method change
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Section 179 Provisions
Tax yr. beginning in
2009
2010
2011
2012
2013
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Sec. 179
Limit
$250,000
$500,000
$500,000
$139,000
$25,000
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Asset Addn.
Phase-out Range
$800K - $1.05M
$2M - $2.5M
$2M - $2.5M
$560K - $699K
$200K - $225K
Bonus Depreciation
Acquired & Placed in Service
1/1/10 – 9/8/10
9/9/10 – 12/31/11
1/1/12 – 12/31/12
1/1/13 and after
Bonus %
50%
100%
50%
0%
• Tax year of taxpayer not relevant
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Bonus Depreciation
• Overview of eligibility
– Original use with taxpayer (i.e., new not used)
– Qualified property (< 20 yr. recovery period)
– Acquired & placed in service in eligible period
• Ordering: Sec. 179 first; 50% bonus second
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WOTC Veteran Hires
• WOTC generally 40% of first $6,000 of wages =
$2,400 credit
• An extender: Expired 12-31-11
• Certification: Prescreening notice (Form 8850) within
28 days of employment
• Veteran-hire WOTC extended thru 2012
– Expanded categories and credit amts. if hired after
11-21-11
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WOTC for Hiring Qualified Veterans
Maximum credit:
Qual. Vet. category
1. Food stamp family
2. Disabled and
- w/in 1 yr. of active duty
- unempl. >6 mo. of last 12
3. Unempl. >4 wks. prior 12 mo.
4. Unempl. >6 mo. prior 12 mo.
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Old
$2,400
New
$2,400
$4,800
$4,800
-
$4,800
$9,600
$2,400
$5,600
WOTC for Hiring Qualified Veterans
• Veteran: > 180 days active duty
– 4 of 5 categories do not require recent active duty
• Tax-exempt employers: Credit allowed, limited to
employer’s 6.2% Soc. Sec. tax on all employees for
12 mos. after hire
– Credit at 26%, not 40% of wages
– Lower maximums (65% of for-profit)
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Questions?
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Thank You
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