Capitalization of Tangible Assets

1. Capitalization of Tangible Assets Understanding the New IRS Regulations and What ___________ needs to do in Response Presented by xxxxxxx CPAs and Consultants xxxxxxxxxx, CPA and xxxxxxx, CPA August xx, 2013 Put Client Logo Here

2. Today’s Discussion Topics • Materials and supplies—definitions of materials and supplies • Discussion of de minimis rule under Reg. Sec. 1.263(a)-2T • Repairs—deductions for amounts paid to repair and maintain property not required to be capitalized under 263(a) • The expenditures required to be capitalized • Betterments, Restorations, New Use • Building or component dispositions • Introduction on how to change accounting methods

3. Today’s Learning Objectives • Understand what has Changed from the Temporary Regulations (TR) to: • Write offs: • Repairs and maintenance • Materials and supplies • Capitalization Issues: • Improvements to property • Acquisitions • What you need to follow up on (changes in accounting methods related to these regulations) • What is the impact of these TR to you (both tax and financial statement)

4. 10,000-Feet Observations • Few objective rules • What you have done to date (asset groupings, cost segregation, depreciation choices) matter • Cost segregation still relevant and needed(for write off of old when new improvements are made) and still important for other issues (ability to depreciate different classes) • Multiple Code Sections changed, not just 263(a), but also Sections 162, 168 • Every taxpayer (TP) is affected, just about every TP will have to file a 3115 or two

5. Comments on the Regulations from Others • Affects virtually all businesses • AICPA says about the TRs: • Too few bright-line tests, too complex • Have an AFS discriminates against smaller TPs • Accounting method RPs should have examples • Need to define “gross receipts” • TPs do not currently track “capitalization threshold ceiling” • Changes are not clear: change to book capitalization? Not have a written policy in place? “should” verses “must” used in the change RPs—which one is it?

6. Depreciation Allowable or Taken – this issue is “huge”. Points: (1) Suggest that you use this summer (2013) to correct any errors in prior year depreciation, and note that(2) section 1.1016-3T is part of the TPRs for a reason – that is the “scary” part – the IRS will use this in their audits of TPs to deny depreciation deductions

7. §1.1016-3T Exhaustion, Wear and Tear, Obsolescence, Amortization, and Depletion • Determination of the amount properly allowable for exhaustion, wear and tear, obsolescence, amortization, and depletion must be made on the basis of facts reasonably known to exist at the end of the taxable year. • A TP is not permitted to take advantage in a later year of the TP's prior failure to take any such allowance or the TP's taking an allowance plainly inadequate under the known facts in prior years. • Caution: In the case of depr., if in prior years the TP has consistently taken proper deductions under one method, the amount allowable for such prior years must not be increased even though a greater amount would have been allowable under another proper method.

8. Warnings for Taxpayers…if • (1) a TP does not identify all of the tangible property issue(s), • (2) a TP does not implement the rules correctly, AND • (3) file all of the necessary 3115s under the correct new method(s), • the TPs could have certain current and future tax depreciation denied and/or miss the potential write-off on previously capitalized assets. • This exposure is greatest for errors in bonus depreciation and for building issues, since that is where the greatest dollar amounts exist. • Your exposure for errors is great and the time to execute is limited.

9. Errors in Depreciation Deductions • Correct by filing an amended return for that year(s) (for certain errors) • If TP is not permitted to make the correction with an amended return, may be able to change accounting method to correct the amount of depreciation (with a 3115 filing) • Cannot fix depreciation errors by “catching up” on prior year errors

10. What TPs Need to Do • Depreciation Schedules: fix them before the IRS disallows missed depreciation • Fix based upon the new TPR viewpoints – not why it was done when it was added to the depreciation schedule • Assess conformity of your current policies and procedures with these TPRs • Capitalization policies • Minimum capitalization thresholds • Routine maintenance expenditures • Internal tracking and capturing data • Current method(s) conform to TPRs? • If not, need to file 3115s

11. Depreciation Error Process • Find out what ‘activity’ the business is in by reviewing Rev. Proc. 87-56 • This will instruct us what the asset guideline class lives should be, O/T asset classes 00.11 to 00.4. 00.11 to 00.4 are the “common” class lives. • Based on the business’ “activity” we may have class lives that are different from the common class lives. • 00.11 to 00.4 state the following: office equipment is 7 years; computers =5, copiers=5, cars and trucks=5, land improvements=15 • But if an activity such as 33.3, land improvements are 7 years (which is client); if 57.0 (distributive trades and services) assets are 5 years, unless they fit into 00.11 to 00.4.

12. What After Depreciation Errors? • There are other issues that are not depreciation errors, but rather are TPR issues that are generated from a review of the depreciation schedules. There are: • Repair items that were capitalized. (items that were capitalized but viewed now under the TPRs would have been written off). • Prior building write off issues. (new roof was added but old roof should have been written off

13. What you need to address first on most of the TR Issues (after addressing depreciation error corrections):- two items – TPRIssue(s) identification Unit of Property

14. Issue(s) Identification – “the list” • The actions a TP may need to take under these TRs are not limited to: • Change in unit of property: do we have buildings grouped together in the depreciation schedule? (example: multiple buildings in a car dealership) • The need to breakout prior costs for property capitalized (i.e. what is the detail in that 39 year asset account where the roof was replaced years ago?) • Write off or capitalize current year expenditures (and if we capitalize, do we have prior to dispose of?

15. Issue(s) Identification - 2 • If we have to write off prior assets, do they still have basis that can be written off? • If fully depreciated, we are done with this asset. Just capitalize the current expenditures and depreciate them properly over future years • If we have to write off these prior assets and they still have basis, we have to determine whether we are going to write those assets off in a 3115 filing under the “cost known” method (such as a cost segregation or being able to recreate the original costs) or under a “reasonable allocation” method (such as a CPI “lookback”)

16. Issue(s) Identification - 3 • Do we need to correct depreciation errors (i.e. methods, lives)? Every client’s depreciation schedule will need to be “scrubbed” for errors. These will require 3115 filings in order to take the (typical) negative 481(a) adjustments. We have decided, in general, that this is summer work for 2013 and that these changes will be attached to the 2013 income tax returns. • Change asset groupings (i.e. building from SAA to GAA?) • Adopt new accounting method(s) – (numerous potential methods!!!) • File 3115(s) (separately or together) for what?

17. Unit of Property (UoP) Is a very important element to these and other regulations Does the client first need to change its UoP before it makes a method change under the new Tangible Property Regs.?

18. Unit of Property (UoP) - 1 • UoP is a very important issue, why?: • It is an important criteria in the decision whether a TP can write off an expenditure • Generally: • The smaller the UoP the more likely the expenditure will be required to be capitalized • This issue should almost always be considered in TR issues, most of the time, early. If it is a problem, it must be changed and 3115 filed. If not, move on.

19. Building UoP Examples - 2 • Dealer with multiple floors in one building: • UoP is the building (but capitalization considerations on building components and/or system are measured in comparison to that building component that performs a unique function or specifically enumerated system) • Dealer complex with multiple buildings: • UoP is each individual separate building

20. Review of the Temporary Tangible Property Regulations Main Standards

21. What the Tangible Property Regulations (TPR) Do • Temporary TPRs provide guidance on the application of Sections 162(a) (deduction) and 263(a) (requires capitalization) of the Code to amounts paid to acquire, produce, or improve tangible property. • Regulations aim to clarify the difference between these two opposites • Temporary regulations = one that is current law and has to be followed until the final regulations are issued • Final expected to be issued in 2013 • Clarify and expand the standards in the current regulations under Sections 162(a) and 263(a) • Provide certain bright-line tests (for example, a de minimis rule for certain acquisitions) • Provide guidance under Section 168 regarding the accounting for, and dispositions of, property

22. What the ‘Repair’Regulations Do • Amend the general asset account (GAA) regulations. • TR will affect all taxpayers that acquire, produce, or improve tangible property • Regulations are effective on January 1, 2014 or for taxable years that begin after 1-1-2014, but can be applied for tax years 2012 to 2013 (so why not apply the “beneficial” ones earlier?)

23. What the ‘Repair’Regulations Do • Splits the definition of tangible property into two categories: • Buildings • Everything else • For Buildings: a building and its structural components are treated as a single unit of property, but when improving “building systems,” can be separated out

24. Building and Structural Components 1.263(a)-3T(e)(2) (UoP) • General rule that the UoP for a building is comprised of the building and its structural components • Requires that a TP apply the improvement standards separately to the primary components of the building, that is, the building structure or any of the specifically defined building systems. • A cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the specifically enumerated building systems. • Defines the building structure as the building (§1.48-1(e)(1)) and its structural components (§1.48-1(e)(2)) other than the components specifically enumerated as building systems. • A UoP is a method of accounting

25. Building and Structural Components 1.263(a)-3T(e)(2) (UoP) • Defines building systems to include (1) the heating, ventilation, and air conditioning systems (“HVAC”); (2) the plumbing systems; (3) the electrical systems; (4) all escalators; (5) all elevators; (6) the fire protection and alarm systems; (7) the security systems; (8) the gas distribution systems; and (9) any other systems identified in published guidance • These are considered improvements to the building: Replacement of an entire roof, improvement to the HVAC system

26. Building and Structural Components 1.263(a)-3T(e)(2) (UoP) • Old Rule: Taxpayer was required to depreciate building improvements over the life of the original asset (39 years), even if building had been 29 years into its depreciable life; no write off of the replaced component • If one replaced a roof, for example, you depreciated two roofs—the original one and the replaced one, or three roofs, etc. • New Rule: replace a roof, recover as a loss the remaining basis of the old roof, book the new roof and depreciate it

27. Major Regulation Sections and Subjects

28. Background • Section 263(a) (relating to the capitalization requirement) states that no deduction is allowed for: (1) Any amount paid out for new buildings or permanent improvements or betterments made to increase the value of any property, or (2) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance has been made.

29. Background • 263(a) Regulations state that capital expenditures include amounts paid or incurred to: • Add to the value, or substantially prolong the useful life, of property owned by the TP; or, • Adapt the property to a new or different use. • Amounts paid or incurred for incidental repairs and maintenance of property (as defined by 162 and §1.162-4 (relating to the deduction for ordinary and necessary trade or business expenses) are not capital expenditures under §1.263(a)-1.

30. U.S. Courts onCapitalization Have • Recognized the highly factual nature of determining whether expenditures are for capital improvements or for repairs • Articulated a number of ways to distinguish between deductible repairs and non-deductible capital improvements. • Explained that R and M expenses are incurred for the purpose of keeping property in an ordinarily efficient operating condition over its probable useful life for the uses for which the property was acquired. • Explained that capital expenditures, in contrast, are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use

31. U.S. Courts onCapitalization Have • Explained that the relevant distinction between capital improvements and repairs is whether the expenditures were made to “put” or “keep” property in efficient operating condition • Stated that if the expenditure merely restores the property to the state it was in before the situation prompting the expenditure arose and does not make the property more valuable, more useful, or longer-lived, then such an expenditure is usually considered a deductible repair. • Concluded that a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property. • Key is that TR have attempted to match or meet these “elements” outlined in those court cases ….

32. Temporary RegulationsDo Not Change • §1.263(a), which requires TPs to capitalize amounts paid to improve tangible property and • §263A and the regulations under §263A, which require TPs to capitalize the direct and allocable indirect costs, including the cost of materials and supplies, to property produced or to property acquired for resale • §1.471-1, which requires TPs to include in inventory certain materials and supplies

33. Temporary RegulationsDo Adopt and Refine • The definition and treatment of materials and supplies • The de minimis rule for the acquisition and production of property under §1.263(a)-2T , • An election to capitalize materials and supplies • Safe harbor for routine maintenance under §1.263(a)-3T • Rules for determining a unit of property (§1.263(a)-3T(e)) • Certain rule revisions for determining whether there has been an improvement to a unit of property under §1.263(a)-3T • Rules revisions for determining whether an amount is paid for an improvement to a building. • Rule revisions for determining whether an amount is paid for the replacement of a major component or substantial structural part of a unit of property

34. Temporary RegulationsDo Adopt and Refine • Expanded definition of disposition for MACRS to include the retirement of a structural component (loss recognition) • The general rule that incidental materials and supplies (for which no inventories or records of consumption are maintained) are deductible in the year purchased • Statements that non-incidental materials and supplies are not deductible until the year in which they are used or consumed in the TP's operations • New rules for rotable and temporary spare parts • A need for TPs to understand General Asset Groupings • Numerous new and revised examples

35. Temporary RegulationsMake New Rules • Under §1.263(a)-3T(f) for the treatment of amounts paid to improve leased property • Under §1.168(i)-8T that revise the definition of disposition for property subject to Section 168 to include the retirement of a structural component of a building

36. Temporary RegulationsHave Hundreds of Examples • Examples of 1.161-3T (Materials and Supplies) • Examples of 1.168(i)-1T (General Asset Accounts) • Examples of 1.168(i)-1T(e)(2) (General Asset Accounts Disposed of) • Examples of 1.168(i)-1T(e)(3)(ii) (General Asset Accounts Disposed of) • Examples of 1.168(i)-1T(e)(3)(iii) (General Asset Accounts Disposed of)

37. Temporary RegulationsHave Hundreds of Examples • Examples of 1.168(i)-8T (Dispositions of MACRS property) • Examples of Amounts Paid to Sell Property (1.263(a)-1T) • Examples of Amounts Paid to Acquire or Produce Tangible Property Under §1.263(a)-2T • Examples of Amounts Paid for Defense or Perfection of Title to Tangible Property Under §1.263(a)-2T(e) • Examples of Transaction costs (1.263(a)-2T(f)

38. Temporary RegulationsHave Hundreds of Examples • Example of Elections to deduct materials and supplies under the de minimis rule (1.263(a)-2T(g)) • Examples of Units of Property and Improvements Under 1.263(a)-3T(e) • Examples of Improvements to Leased Property: Leasehold Improvements 1.263(a)-3T(f) • Examples Under Safe harbor for Routine Maintenance 1.263(a)-3T(g) • Examples of Betterments 1.263(a)-3T(h)

39. Temporary RegulationsHave Hundreds of Examples • Examples of Capitalization of Restorations 1.263(a)-3T(i) • Examples of Capitalization of Amounts to Adapt Property to a New or Different Use 1.263(a)-3T(j) • Examples of Capitalization or Expensing Under the Optional Regulatory Accounting Method 1.263(a)-3T(k) • Example of §1.1016-3T Exhaustion, Wear and Tear, Obsolescence, Amortization, and Depletion

40. Material and Supplies

41. Definition ofMaterial and Supplies • TR define and expand the definition of (the first category of) materials and supplies as tangible property that is used or consumed in the TP’s operations, not constituting a UoP, not acquired as part of a single UoP, and is not inventory, and that: • Is a component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the TP and that is not acquired as part of any single unit of tangible property; • Consists of fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less, beginning when used in TP's operations; (New Category) • Is a UoP that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the TP's operations;

42. Definition ofMaterial and Supplies • Is a UoP that has an acquisition cost or production cost (under Section 263A ) of $100 or less (or other amount as identified in published guidance in the Federal Register or in the IRB; or • Is identified in published guidance in the Federal Register or in the IRB as materials and supplies for which treatment is permitted • Also provide an election to treat certain materials and supplies under the de minimis rule of §1.263(a)-2T, and • Allow a TP to elect to capitalize certain materials and supplies. • Redefine the first category of materials and supplies by further describing the types of components that qualify and by • Eliminating the requirement that such property not be a UoP under Section §1.263(a)-3T(d)(2)

43. Definition ofMaterial and Supplies • Specified acquisition or production cost threshold • TR retains the $100 limitation • Add language, however, that gives the IRS and the Treasury Department the flexibility to change the amount of the limitation • A TP with applicable financial statements (AFS) will be permitted to deduct amounts paid for property up to higher thresholds if it complies with the requirements set out in the de minimis rule provided in §1.263(a)-2T . • Designated (smallwares under Rev. Proc. 2002-12, or 2002-28 for certain inventoriable items in the same manner as materials and supplies that are not incidental under §1.162-3) property continues to qualify as materials and supplies under the TR because the property is identified in published guidance as materials and supplies.

44. Election to CapitalizeMaterial and Supplies • A TP may elect to treat as a capital expenditure and to treat as an asset, subject to depreciation, the cost of any M and S • Election applies to amounts paid during the taxable year to acquire or produce any M or S. Any asset for which this election is made shall not be treated as a M or S. • Exceptions. A TP may not elect to capitalize • Any amount paid to acquire or produce a M or S if: • The M or S is intended to be used as a component of a unit of property and • The TP has not elected to capitalize and depreciate that unit of property; or • Any amount paid to acquire or produce a rotable or temporary spare part if the TP has applied its optional method of accounting

45. Election to CapitalizeMaterial and Supplies • A TP makes the election by capitalizing the amounts in the taxable year the amounts are paid and by beginning to depreciate them • If a pass-through entity, the election is made at the entity level

46. De minimisUnits of Property

47. De minimis RuleUnder §1.263(a)-2T TP is not required to capitalize amounts paid for the acquisition or production (including any amounts paid to facilitate the acquisition or production) of a UoP if… • TP had an AFS (as defined in the regulations); • TP had, at the beginning of the taxable year, written accounting procedures treating as an expense for non-tax purposes the amounts paid for property costing less than a certain dollar amount; • TP treated the amounts paid during the taxable year as an expense on its AFS in accordance with its written accounting procedures; and • Total aggregate of amounts paid and not capitalized under the de minimis rule for the taxable year must be < or = to the greater of: • 0.1 percent of the TP’s gross receipts for the taxable year as determined for Federal income tax purposes; or • 2.0 percent of the TP’s total depreciation and amortization expense for the taxable year as determined in its AFS.

48. De minimis RuleUnder §1.263(a)-2T TP is not required to capitalize amounts paid for the acquisition or production (including any amounts paid to facilitate the acquisition or production) of a UoP if… • The de minimis rule does not apply to amounts paid for labor and overhead incurred in repairing or improving property. • Permits a member to utilize the written accounting procedures provided on the AFS of its affiliated group. • If examining agents and a TP agree that certain amounts in excess of the de minimis rule ceiling are immaterial and should not be subject to review, that agreement should be respected, notwithstanding the requirements of the de minimis rule in the TR.

49. De minimis Rule Election Details … of the de minimis material and supplies: • TP makes the election by deducting the amounts paid to acquire or produce a material or supply in the taxable year that the amounts are paid in its timely filed original federal income tax return (including extensions) for the taxable year that amounts are paid for the material or supply • May revoke an election only by filing a request for a private letter ruling • Election may not be made or revoked through the filing of an application for change in accounting method or by filing an amended federal income tax return.

50. De minimis Rule Election Details … of the de minimis material and supplies: • Note that the TR do not state that the “election” of the de minimis rule is a method of accounting • That means that a TP can elect to apply the de minimis rule in one year and not the next, and/or apply it to certain assets and not to others. • Note, however, that electing a UoP is a method of accounting …