The IRS and the capitalization of tangible assets

New proposed regs address complex issue–capitalization of tangible assets

Mike Habib, EA
myIRSTaxRelief.com

IRS has issued new comprehensive proposed regs on when amounts are treated as paid to acquire, produce, or improve tangible property. They replace controversial proposed regs that were issued on the same subject in 2006 and that IRS has now withdrawn. The new proposed regs would be effective for tax years beginning on or after the date that they are finalized.

This article explains how the proposed regs would define materials and supplies that are deductible under Code Sec. 162, and prescribe new rules for when the deduction for these items may be claimed. Future articles will explain other key aspects of the new proposed regs, such as how to treat amounts paid to sell property, transaction costs related to acquisitions, and what constitutes a repair versus an improvement or betterment to property.

Background: Costs are currently deductible as a repair expense under Code Sec. 162 if they are incidental in nature, and neither materially add to the value of the property nor appreciably prolong its useful life. Costs also are currently deductible if they are for materials and supplies consumed during the year. Expenses must be capitalized under Code Sec. 263 if they are for permanent improvements or betterments that increase the value of the property, restore its value or use, substantially prolong its useful life, or adapt it to a new or different use.

Observation: Current regs don’t clearly address the issue of whether expenses should be deducted currently (e.g., as repairs or as materials or supplies) or capitalized. As a result, the issue has been central in many court cases over the years, dealing with questions such as how to treat environmental remediation expenses, and how to treat rotable spare parts used in repairs. The proposed regs issued in 2006 were an ambitious attempt to rectify the lack of guidance but were roundly criticized by practitioners. In the new proposed regs, IRS takes another crack at this ambitious project.

Overview of proposed regs. The new proposed regs include many of the provisions contained in the 2006 proposed regs, but also provide many additional rules that were not included in the 2006 proposed regs. For example, the new proposed regs would define “materials and supplies” (including a special 12-month rule and a $100 de minimis rule), and include: a book conformity de minimis rule for acquisitions of units of property; a safe harbor for routine maintenance; and an optional simplified method for regulated taxpayers. The new proposed regs also would make significant changes to the rules relating to unit of property and restorations, and allow for industry-specific repair allowance methods in future published guidance.

Materials and supplies. Current Reg. § 1.162-3, only a few sentences long, generally provides that charges for materials and supplies are deductible as expenses only in the amount that are actually consumed and used in operation during the year. The cost of incidental materials and supplies purchased during the year is deductible if no record of their consumption is kept and no physical inventory of them is taken at the beginning and end of the year. However, this method may be used only if it clearly reflects income.

IRS decided to revise Reg. § 1.162-3 , to provide clear and consistent treatment for those items that traditionally have been considered to be materials and supplies and to provide distinct, but coordinated, treatment for those items that should governed by Code Sec. 263(a) .

Observation: The revised rules for materials and supplies are brand-new; the subject wasn’t covered in the withdrawn 2006 proposed regs.

Timing of deduction for materials and supplies. The cost of buying or producing non-incidental materials and supplies would be deductible in the tax year in which the materials and supplies are used or consumed in the taxpayer’s operations. By contrast, the cost of buying or producing incidental materials and supplies that are carried on hand and for which no record of consumption is kept or physical inventories at the beginning and end of the year are not taken, would be deductible in the tax year in which these amounts are paid, provided taxable income is clearly reflected. (Prop Reg § 1.162-3(a))

For purposes of the deduction timing rule, rotable spare parts and temporary spare parts would be treated as used or consumed in the tax year in which the taxpayer disposes of the parts. In general, rotable spare parts are parts for machinery or equipment that can be reserviced or repaired when they malfunction and can be used repeatedly. Temporary spare parts are parts used temporarily until they can be replaced with new or repaired parts (and then the temporary parts are set aside to be reused). (Prop Reg § 1.162-3(b))

IRS explains that the rotable and temporary spare parts rule prevents taxpayers from prematurely deducting the cost of a unit of property by systematically replacing components with rotable spare parts. It anticipates that taxpayers with rotable or temporary spare parts that are not discarded after their original use generally will prefer to capitalize their costs under a new election in the proposed regs (see below) and treat those parts as depreciable assets. (Preamble to Prop Reg 03/07/2008)

IRS cautions taxpayers to recognize that the used or consumed standard for non-incidental materials and supplies generally is met later than the placed in service standard used for depreciation purposes. Additionally, they are reminded that after a material or supply is used or consumed, capitalization of the material or supply cost to another property may be required. For example, the cost of materials and supplies used in the production of inventory or a self-constructed asset generally must be capitalized under Code Sec. 263A . Similarly, the cost of producing materials and supplies generally must be capitalized as part of the production costs of the materials and supplies. The new proposed regs aren’t intended to change this treatment. (Preamble to Prop Reg 03/07/2008)

New definition. The term materials and supplies would be defined as tangible property used or consumed in the taxpayer’s business operations and that meets any of the following tests:

(1) it is not a unit of property (see below) and is not acquired as part of a single unit of property; or
(2) it is a unit of property with an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations; or

(3) it is a unit of property with an acquisition cost or production cost (as determined under Code Sec. 263A) of $100 or less; or

(4) it is identified in published IRS guidance as materials and supplies eligible for the rules in Reg. § 1.162-3. (Prop Reg § 1.162-3(d))

Under Prop Reg § 1.263(a)-3(d)(2), for property other than buildings, property used in plants such as manufacturing facilities, and network assets (e.g., railroads), all the components that are functionally interdependent (i.e., one component’s placement in service by the taxpayer is dependent on the placement in service of another component by the taxpayer) comprise a single unit of property. However, one component or a group of them would have to be treated as a separate unit of property if (a) for book purposes the taxpayer uses an economic life different from that assigned to the unit of property of which the component is a part, or (b) for depreciation purposes the component is treated as being in a different MACRS class than the property of which it is a component, or written off using a different depreciation method than the property of which it is a component.

For example, a computer and printer are two different units of property. A truck trailer and its wheels generally would be treated as one unit of property, but if the taxpayer for book purposes uses a different economic useful life for the tires than for the trailer, the tires would have to be treated as separate units of property. (Prop Reg § 1.263(a)-3(d)(2)(iv), Exs. 7 & 8)

What is economic useful life? For purposes of applying the 12-month rule (see the second item in the list above), the new proposed regs generally would adopt the economic useful life definition in Reg. § 1.167(a)-1(b) and would provide that, the measurement period for economic useful life begins when the item is first used or consumed in the taxpayer’s trade or business. The time prior to when an item is used or consumed would not be taken into consideration in determining the economic useful life of the asset, even though the item may have been placed in service (ready and available for its intended use) for depreciation purposes. (Prop Reg § 1.162-3(d)(2)(i))

However, a special rule applies to taxpayers with an applicable financial statement (AFS), such as one required to be filed with the Securities and Exchange Commission, or a certified audited financial statement accompanied by an independent CPA’s report and used for credit or reporting purposes. Here, for purposes of the 12-month economic useful life test, the taxpayer must determine economic useful life in a way that’s consistent with the economic useful life used for purposes of determining depreciation in the books and records supporting the AFS. An exception applies if a taxpayer does not assign a useful life to certain property in its AFS (e.g., the item is currently expensed in the taxpayer’s AFS because it is considered de minimis). (Prop Reg § 1.162-3(d)(2)(ii))

Election to capitalize materials or supplies. Taxpayers would be given the option to elect to treat the cost of a material and supply as a capital expenditure. In general, the election would be made separately for each material and supply and would be revocable only with the IRS’s consent. The election would be made by capitalizing the cost of the material and supply in the year the cost is incurred and beginning depreciation of the item in the year it is placed in service. (Prop Reg § 1.162-3(e))