New Capitalization Regulations
ACTION ITEM: Business taxpayers must have written accounting policies in place on the first day of the tax year (January 1, 2014 for calendar year taxpayers) to deduct the de minimis amounts provided under safe harbor provision.
Recently, the Internal Revenue Service issued final tangible property capitalization regulations. These regulations provide clarity to a complex area of tax law for business taxpayers who acquire tangible property or who own tangible property which they improve, maintain or repair. The final regulations address the proper characterization and tax treatment of expenditures related to these acquisitions, improvement, maintenance, and repair activities.
Generally, under IRC Section 263(a), amounts paid to acquire, produce or improve tangible property must be capitalized. However, taxpayers are permitted to deduct ordinary and necessary business expenses, including the costs of certain supplies, repairs and maintenance under IRC § 162(a). It is often difficult to distinguish (1) between assets that must be capitalized and property that is a material or supply, and (2) between improvement costs and repair or maintenance costs. The finalized regulations attempt to clarify when such payments may be deducted and when they must be capitalized.
De Minimis Safe Harbor Election
A key provision in the final regulations is a revised safe harbor election that permits a deduction for de minimis amounts paid for tangible property. Under the safe harbor election, a taxpayer may elect to not capitalize (in other words, to currently deduct) specified amounts paid in the tax year to acquire or produce tangible property, provided the amounts don’t exceed applicable thresholds. The amount of the threshold depends on whether the taxpayer has written accounting procedures in place and, if so, whether the taxpayer has an applicable financial statement.[i]
Taxpayers with an Applicable Financial Statement and Written Accounting Procedures
A taxpayer with an applicable financial statement may rely on the final regulations’ safe harbor to expense an item in accordance with the taxpayer’s written accounting policies it utilized in preparing its financial statements, provided the amount paid for tangible property does not exceed $5,000 per item. In addition, the safe harbor also applies to a financial accounting policy that expenses amounts paid for property with an economic useful life of 12 months or less, provided the costs don’t exceed the $5,000 threshold.
Taxpayers without an Applicable Financial Statement
A taxpayer lacking an applicable financial statement, but with a written accounting policy in place calling for (1) expensing amounts paid for property less than a specified amount and/or (2) expensing payments for property with an economic life of 12 months or less, may rely on the de minimis safe harbor as long as the costs do not exceed $500 per item.
Taxpayers without either an Applicable Financial Statement or Written Accounting Procedures
The final regulations increase the ceiling for characterizing tangible property as materials or supplies to $200 (formerly $100). Thus, taxpayers who do not have an applicable financial statement or written accounting procedures in place as of the beginning of the tax year may still deduct expenditures for tangible property costing $200 or less.
Making the Election
In order to use the safe harbor, businesses must have accounting procedures in place on the first day of the tax year. The accounting procedures must treat as an expense amounts paid for property that cost less than a specified dollar amount or have an economic useful life of 12 months or less. Failure to timely establish written accounting procedures may result in having to capitalize amounts that might otherwise have been expensed. In addition, the taxpayer’s timely filed original tax return must include an annual election to expense items addressed by the safe harbor provision. The annual election is irrevocable and generally applies to all tangible property including materials and supplies purchased during the tax year.
The regulations apply to tax years beginning on or after January 1, 2014; however, taxpayers can choose to apply the final regulations to tax years beginning on or after January 1, 2012, or apply the 2011 temporary regulations to tax years beginning on or after January 1, 2012, and before January 1, 2014. The final regulations may be applied retroactively, but many taxpayers will only be able to use the safe harbor in future tax filings because the de minimis safe harbor provision requires written accounting policies in place on the first day of the applicable tax year.
Although the final regulations provide some clarity, transitioning to these new rules might prove challenging. Please let us know if you would like to discuss these regulations or take steps to obtain tax benefits available from these regulations.
SAMPLE CAPITALIZATION POLICY
This accounting policy establishes the minimum cost (capitalization amount) that shall be used to determine the capital assets to be recorded in <business entity>’s books and financial statements.
2. Capital Asset Definition and Thresholds
A “Capital Asset” is a unit of property with a useful life exceeding one year and a per unit acquisition cost exceeding <specify amount>. Capital assets will be capitalized and depreciated over their useful lives. <Business entity> will expense the full acquisition cost of tangible personal property below these thresholds in the year purchased.
3. Capitalization Method and Procedure
All Capital Assets are recorded at historical cost as of the date acquired.
Tangible assets costing below the aforementioned threshold amount are recorded as an expense for <business entity>’s annual financial statements (or books). In addition, assets with an economic useful life of 12 months or less must be expensed for both book and financial reporting purposes.
Invoices substantiating the acquisition cost of each unit of property are to be retained for a minimum of <number> (<#>) years.
Tax Capitalization Threshold: The permissible ceiling for deducting otherwise capitalizable expenditures is <specify amount> when our business has applicable financial statements. The threshold is limited to <specify amount> in the absence of applicable financial statements.