New proposed regs address complex issue–capitalization of tangible assets–Part II
Mike Habib, EA
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 They replace controversial proposed regs that were issued on the same subject in 2006 and that IRS has now withdrawn.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, second in a series, explains how the proposed regs would prescribe new rules for when to deduct or capitalize costs related to the acquisition or production of real or personal property. For an article explaining 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, see the article in yesterday’s Newsstand e-mail. A future article will explain how the proposed regs would differentiate between a repair and an improvement or betterment to property.
Overview. Under the new proposed regs, as a general rule all costs that facilitate the acquisition or production of real or personal property would have to be capitalized, with exceptions for employee compensation and overhead costs. Investigatory expenses related to the acquisition of realty would not have to capitalized unless the expenses are “inherently facilitative.” A complex, but extremely liberal, de minimis rule would allow taxpayers to expense the acquisition of assets that otherwise would have to be capitalized, if the acquisition cost is expensed on the taxpayer’s financial statement and there is no distortion of income. Taxpayers would have the option to capitalize expenses that otherwise would be currently deductible.
General rule for transaction costs. In general, costs would have to be capitalized if they are paid to facilitate the acquisition or production of real or personal property, namely they are paid in the process of investigating or otherwise pursuing the acquisition. A separate subset of 11 costs called “inherently facilitative” costs would be singled out for capitalization whether related to real or personal property, and whether or not the property is actually acquired or produced. These include the costs of shipping, moving or appraising property, application fees, sales and transfer taxes, finder’s fees, and architectural, engineering, environmental or inspection services related to specific properties. (Prop Reg § 1.263(a)-2(d)(3))
Amounts paid for employee compensation or overhead would be treated as amounts that don’t facilitate the acquisition of real or personal property (but under Code Sec. 263A would have to be capitalized to property produced by the taxpayer or acquired for resale). However, the taxpayer could elect to capitalize employee compensation or overhead expenses related to an acquisition. (Prop Reg § 1.263(a)-2(d)(3)(ii)(D))
Observation: In other words, unless Code Sec. 263A applies, amounts paid for employee compensation or overhead while acquiring or deciding to acquire real or personal property would be currently deductible (unless the taxpayer makes a capitalization election). This rule parallels the rule in Reg. § 1.263(a)-4(e)(4)(i) allowing such costs relating to the acquisition of intangible assets to be deducted currently.
Real estate investigatory expenses. Costs relating to activities performed in the process of determining whether to acquire real property and which real property to acquire generally would be deductible pre-decisional costs, unless they are “inherently facilitative” expenses (e.g., the cost of an engineering study or a broker’s fee). For example, a retailer could deduct currently the cost of hiring a consulting firm to suggest which areas of a city it should expand into (these costs aren’t on the “inherently facilitative” list), but it would have to capitalize the cost of paying an appraiser to determine the value of the properties that the consulting firm recommends (appraisal fees are on the “inherently facilitative” list). (Prop Reg § 1.263(a)-2(d)(3)(ii)(C))
Generous de minimis exception. Under a new de minimis exception, taxpayers would be able to currently deduct the cost (including facilitative costs) of acquiring or product a unit of property (see Part I in yesterday’s Newsstand e-mail), if all of these conditions are met:
(1) The taxpayer has 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.
(2) The taxpayer has at the beginning of the tax year, written accounting procedures treating as an expense for non-tax purposes the amounts paid for property costing less than a certain dollar amount.
(3) The taxpayer treats the amounts paid during the taxable year as an expense on its applicable financial statement in accordance with its written accounting procedures.
(4) The total aggregate of amounts paid and not capitalized under the de minimis rules do not distort the taxpayer’s income for the tax year. (Prop Reg § 1.263(a)-2(d)(4)(iii))
The de minimis rule wouldn’t apply to amounts paid to improve property, acquire property for resale, or for land.
Under a safe harbor, an amount deducted currently under the AFS de minimis rule for the tax year would be treated as not distorting income if that amount, added to the amounts deducted in the tax year as materials and supplies for units of property costing $100 or less (see Part I in yesterday’s Newsstand e-mail), is less than or equal to the lesser of:
(a) 0.1% of the taxpayer’s gross receipts for the tax year, or
(b) 2% of the taxpayer’s total depreciation and amortization for the tax year as determined in its AFS. (Prop Reg § 1.263(a)-2(d)(4)(iii))
Illustration: X buys 10 printers at $200 each for a total cost of $2,000. Each printer is a separate unit of property. X has an applicable financial statement and a written policy at the beginning of the tax year to expense amounts paid for property costing less than $500. X treats the amounts paid for the printers as an expense on its applicable financial statement. Assuming the total aggregate amounts not capitalized under the de minimis rule for the tax year do not distort the taxpayer’s income, X would not be required to capitalize the amounts paid for the printers. (Prop Reg § 1.263(a)-2(d)(3)(iv), Ex. 1)
Property to which a taxpayer applies the de minimis rule would not be treated upon sale or disposition as a capital asset under Code Sec. 1221 or as property used in the trade or business under Code Sec. 1231, and such property would not be treated as a material or supply. The cost of property to which the de minimis rule applies wouldn’t have to be capitalized under Code Sec. 263A, to a separate unit of property, but may have to be capitalized as a cost of other property if incurred by reason of the production of the other property. (Prop Reg § 1.263(a)-2(d)(4)(iv))
Election out of de minimis exception. A taxpayer would be allowed to elect out of the de minimis exception for any unit of property during the tax year to which the de minimis exception would otherwise apply. The election would be made by treating the amount paid as a capital expense in its timely filed original Federal income tax return (including extensions) for the tax year in which the amount is paid. (Prop Reg § 1.263(a)-2(d)(3)(v))
Observation: The proposed regs make it clear that a taxpayer would be able to “elect out” of just enough of its acquisition costs to fall within the “non-distortion” safe harbor.
Illustration: Y is a member of an affiliated group that files a consolidated return. In 2008, Y buys 300 computers at $400 each for a total cost of $120,000. Each computer is a unit of property. Y has a written policy at the beginning of the taxable year to expense amounts paid for property costing less than $500, and treats the amounts paid for the computers as an expense on its applicable financial statement. In addition, in 2008 Y buys 300 desk chairs for $50 each for a total cost of $15,000. Y intends to deduct the amounts paid for the desk chairs when used or consumed as non-incidental materials and supplies because they are units of property costing less than $100 (see Part I in yesterday’s Newsstand e-mail). For its 2008 tax year, Y has gross receipts of $125 million and reports $7 million of depreciation and amortization on its AFS. Thus, in order to meet the de minimis rule safe harbor for 2008, the sum of the amounts not required to be capitalized under the de minimis rule for 2008 ($120,000) plus the amounts Y intends to deduct as materials and supplies for 2008 ($15,000), must be less than or equal to $125,000 (0.1% of Y’s total gross receipts of $125 million, which is less than $140,000 (2% of Y’s total deprecation and amortization of $7 million). Since $135,000 ($120,000 + $15,000) exceeds $125,000, Y wouldn’t meet the de minimis rule safe harbor for its 2008 tax year. As a result, to apply the de minimis rule to the $120,000 paid to acquire the computers, it would have to otherwise establish that this amount does not distort its taxable income in 2008.
However, if Y makes an election to capitalize the $10,000 paid to acquire 25 of the 300 computers at $400 each, Y would not have to capitalize the $110,000 paid to acquire the remaining 275 computers because this amount, when added to the $15,000 that Y intends to deduct in 2008 as materials and supplies, would not exceed the de minimis rule safe harbor of $125,000 for 2008. (Prop Reg § 1.263(a)-2(d)(3)(iv), Exs. 2 and 3.)