By Tanya LaCosse, CPA
Johnson Jacobson Wilcox CPAs
The new tangible property regulations from the IRS are some of the of the most dramatic tax law changes to affect businesses since the 1986 Internal Revenue Code overhaul.
The IRS created these new rules to provide clearer guidelines for how to treat repairs and improvements of a business’s tangible property (furniture, equipment, buildings, etc.) on tax forms.
But even though the intent is to clarify, any IRS rule change comes with a learning curve. And for business owners that learning curve begins right now. Initially published as “Proposed Regulations” in 2006, the new rules are now “Temporary Regulations,” which means all businesses that own tangible property are required to follow them.
With the new rules, the IRS is looking to resolve conflicts with taxpayers over which expenditures related to tangible property are direct write-offs versus capitalization and depreciation expenditures.
The new rules provide "bright-line" tests and "safe-harbors" intended to minimize confusion. But there still may be some confusion in instances, for example, where a repair to tangible property that was treated as an immediate write off in the past is now required to be capitalized and depreciated over a period of time, and vice versa. Business owners should seek the advice of a CPA to learn how to handle these situations.
A silver lining?
There may also be potential write off opportunities, or tax savings, for businesses. Business owners may be able to expense greater amounts for certain repairs, materials and supplies than they had in the past.
For example, roof costs that were previously capitalized may now be written off if a roof improvement is subsequently made.
Also, some previously capitalized items may now be considered “repairs” and thus currently deductible. And items that had previously been capitalized may be eligible under the new rules for a current write-off of the un-depreciated balance of the original cost.
Complying with the new rules in order to see these tax savings opportunities will be burdensome. Most businesses will have to modify internal processes that will require accounting method changes.
Here's the kicker – These accounting method changes cannot be done without requesting the change from the IRS. This will force most businesses to file with the IRS one or more applications for an accounting method change (IRS Form 3115).
In fact, we anticipate that most business taxpayers will have to file multiple 3115s. What's worse, not only will these taxpayers be required to file for each accounting method change, a filing will also be needed for each separate entity, or trade or business.
For example, an individual filing a Form 1040 that owns three rental properties held in separate LLCs will be required to file three (or more) separate 3115s.
It does not matter what form a business operates under; a “C” corporation, an “S” corporation, a partnership, an LLC, a sole proprietorship (Schedule C on individual return), or a rental (Schedule E on individual return); these new rules and requirements apply.
Failure to follow these new rules could cause taxpayers to LOSE current and future tax depreciation or the potential write-off of previously capitalized expenses.
Here's an example: A business had previously capitalized and is depreciating an expenditure that is now defined as a repair that should have been expensed in the year paid.
The business does not file a 3115 form to change its accounting method for this item, which would allow a current deduction for the remaining un-depreciated amount, and instead continues the depreciation.
If the business is audited by the IRS in a year past the statute of limitations (typically three years) for the year of the expenditure, the IRS could deny depreciation deductions for future years and all prior years not closed by the statute of limitations. It could also remove the un-depreciated amount without a current deduction.
The IRS rationale could be that the cost should never have been capitalized and can't be corrected because it occurred in a year closed by the statute of limitations.
Simply put, filing all the required 3115 forms is critical for tax savings, and planning for these changes is imperative.
We anticipate that the final version of these regulations (due out later this summer) will permit taxpayers to “pick and choose” which accounting method changes to adopt in any of the tax years 2012, 2013, or 2014.
Taxpayers will want to adopt those methods first that provide the greatest write off and defer methods that require taxable income increases.
It goes without saying that these new rules are extremely complicated. The unique circumstances of each business will need to be analyzed to determine the best accounting methods that will maximize tax savings.
Frequently Asked Questions:
Can a taxpayer just change the method of accounting for repairs vs. capitalization without filing a Form 3115 with the IRS?
No! What is commonly misunderstood is that any change in accounting for a significant item must be requested of the IRS, even if it is to correct an improper method of accounting.
What is an example of an expenditure under the new rules that may be changing from write off to capitalization, or vice versa?
An expenditure to re-roof a building by adding a new roof material over the existing roof could be considered a replacement of the original roof "component" of the building, requiring capitalization of the cost of the new roof and write-off of the original un-depreciated cost of the "old" roof.
The trick here is identifying the cost of the original roof; how many building owners know the breakout of the cost of just the roof on a building they purchased or built years ago?
Is there a certain cost minimum required for something to be considered tangible property?
Maybe. The rules currently contain "de minimis" provisions that may be available to some, but certainly not all, businesses. Basically, a business that issues an audited financial statement will qualify for the de minimis rule. We expect the IRS to broaden the scope of eligibility for the de minimis rule when it issues the final regulations.
Isn’t this something that tax software will “catch” and generate a Form 3115 for me?
No. While tax preparation software will calculate and prepare a tax return, it is not designed to apply judgment to determine each business' unique circumstances and apply all the complex options of these rules.
Tanya LaCosse is a shareholder with Johnson Jacobson Wilcox CPAs. For more information about the firm, visit http://www.jjwcpa.com or call 702-304-0404.