New Regs Rewrite Rules on Deduction vs Capitalization of Tangible Property Costs

1/6/2012 -

The IRS has issued temp regs providing guidance on the application of Code Sec. 162(a)and Code Sec. 263(a)to amounts paid to acquire, produce, or improve tangible property. These important new regs will affect virtually all taxpayers that acquire, produce, or improve tangible property. Among other things, they clarify and expand the standards in the current regs; provide certain new bright-line tests for applying these standards; provide guidance under Code Sec. 168 regarding the accounting for, and dispositions of, property subject to that section; and amend the general asset account regs. The text of the temp regs also serves as the text of the proposed regs.

This article, first in a series examining the complex new temp regs, explains how they define materials and supplies, as well as rotable and temporary spare parts, and prescribe new rules and elective de minimis and optional methods for handling their cost.

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.

Materials and supplies.Current Reg. § 1.162-3generally provides that charges for materials and supplies are deductible as expenses only in the amount actually consumed and used in operation during the year. The cost of incidental materials and supplies purchased during the year is deductible in the year purchased 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.

Timing of deduction for materials and supplies.Under the new temp regs, the costs of buying or producing:

• non-incidentalmaterials and supplies are deductible in the tax year in which the materials and supplies are used or consumed in the taxpayer's operations; and
• incidentalmaterials 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, generally are deductible in the tax year in which they are paid, provided taxable income is clearly reflected. (Reg. § 1.162-3T(a))

Thus, the timing rules for materials and supplies generally are the same as under current regs.

New definition of materials and supplies.The temp regs define the term “materials and supplies” as tangible property used or consumed in the taxpayer's business operations that is not inventory and that falls within any of the following categories:

(1) It is a component acquired to maintain, repair, or improve a unit of tangible property (see below) owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property; or

(2) It consists of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in taxpayer's operations; or

(3) It is a unit of property with an economic useful life (see below) of 12 months or less, beginning when the property is used or consumed in the taxpayer's operations; or

(4) It is a unit of property with an acquisition cost or production cost (as determined under Code Sec. 263A) of $100 or less (or other amount identified in published guidance); or

(5) It is identified in published IRS guidance as materials and supplies eligible for the rules in Reg. § 1.162-3T. (Reg. § 1.162-3T(c))

IRS says that the temp regs do not supersede, obsolete, or replace earlier revenue procedures to the extent they deem certain property to constitute materials and supplies under Reg. § 1.162-3. For example, Rev Proc 2002-12, 2002-1 CB 374, allows a taxpayer to treat smallwares (a restaurant's glassware, flatware, etc.) as materials and supplies that are not incidental under Reg. § 1.162-3. IRS says such property continues to qualify as materials and supplies under the temp regs because it is identified in published guidance as materials and supplies (category (5), above). (Preamble to TD9564, )

Unit of property defined.The term “unit of property” is a central theme in the temp regs and its complex definition is carried in Reg. § 1.263(a)-3T(e). For purposes of this article, 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. (Reg. § 1.263(a)-3T(e)(3)(i)) (Reg. § 1.263(a)-3T(e)(6), Example 9)

What is economic useful life?For purposes of applying the 12-month rule (see category (3) in the list above), the temp regs generally provide that the economic useful life of a unit of property is not necessarily its inherent useful life, but is the period over which the property may reasonably be expected to be useful to the taxpayer. The factors in Reg. § 1.167(a)-1(b) (e.g., wear and tear, climatic and other conditions particular to the taxpayer's business) are to be considered in determining this period. (Reg. § 1.263(a)-3T(c)(3)(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, solely for purposes of the 12-month economic useful life test (see category (3) in the list above), the taxpayer determines economic useful life in a way that's consistent with the economic useful life used for purposes of determining depreciation (regardless of any salvage value) in the books and records supporting the AFS. But the general rule for determining economic useful life applies if a taxpayer treats amounts paid for a unit of property as an expense in its AFS on a basis other than useful life or if a taxpayer does not depreciate the unit of property on its AFS. For example, if a taxpayer treats as an expense on its AFS amounts paid for a unit of property costing less than a certain dollar amount, the economic useful life of that unit of property must be determined under the general rule. (Reg. § 1.263(a)-3T(c)(3)(ii))

Elective de minimis rule.A taxpayer may elect to apply the de minimis rule in Reg. § 1.263(a)-2T(g) to any material or supply as defined above, and any material or supply for which the election is made that is not treated as a material or supply under Reg. § 1.162-3T. (Reg. § 1.162-3T(f)(1))

The election may be made whether the material or supply is incidental or non-incidental.

In general, under Reg. § 1.263(a)-2T(d)(1), amounts paid to acquire or produce a unit of real or personal property must be capitalized. However, under the elective de minimis rule, such amounts (but not inventory or land), along with amounts paid for any material or supply, don't have to be capitalized if:

• The taxpayer has an AFS, has written accounting procedures in place at the beginning of the tax year for expensing amounts paid for such property under certain dollar amounts, and treats such amounts as expenses on its AFS in accordance with such written accounting procedures; and
• The aggregate of amounts paid and not capitalized under the de minimis rule for the tax year are less than or equal to the greater of (1) 0.1% of the taxpayer's gross receipts for the tax year as determined for federal income tax purposes; or (2) 2% of the taxpayer's total depreciation and amortization expense for the tax year as determined in its AFS. (Reg. § 1.263(a)-2T(g))

The election for materials and supplies is made by deducting the amounts paid to acquire or produce a material or supply in the tax year that the amounts are paid and by complying with Reg. § 1.263(a)-2T(g). The election is made on the timely filed return for the year that amounts are paid for the material or supply. (Reg. § 1.162-3T(f)(2))

Dollar ceilings aren't rigid.In the preamble to the temp regs, IRS says that the de minimis rule is not intended to prevent a taxpayer from reaching an agreement with IRS examining agents that, as an administrative matter, based on risk analysis or materiality, the agents will not review certain items. Thus, if examining agents and a taxpayer 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 temp regs' de minimis rule. However, a taxpayer that seeks a deduction for amounts in excess of the amount allowed by this rule or by agreement with IRS examining agents will have the burden of showing that such treatment clearly reflects income. (Preamble to TD9564)

Election to capitalize.Under Reg. § 1.162-3T(d), with certain exceptions, a taxpayer may elect to capitalize and depreciate the cost of any material or supply. The election is made by capitalizing the amount paid in the tax year it is paid, and by beginning to depreciate the cost in that year. The election is made on the timely filed return for the year the asset is placed in service by the taxpayer for depreciation purposes.

General rule for rotable and temporary spare parts.Under Reg. § 1.162-3T(a)(3), the general rule for rotable spare parts and temporary spare parts is that for purposes of the rule for non-incidental materials and supplies, they are treated as used or consumed in the tax year in which the taxpayer disposes of the parts.

Rotable spare parts are materials and supplies acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation. Temporary spare parts are materials and supplies that are used temporarily until a new or repaired part can be installed and then are removed and stored for later (emergency or temporary) installation. (Reg. § 1.162-3T(c)(2))

Optional method for rotable and temporary spare parts.Reg. § 1.162-3T(d), allows a taxpayer to use the following optional method for all of its rotable and temporary spare parts in the same trade or business:

(A) Deduct the amount paid to buy or produce the part in the tax year that the part is first installed on a unit of property for use in the taxpayer's operations. (Installation costs also are deductible.)

(B) When the part is removed from the unit of property, include in gross income the part's fair market value (FMV).

(C) Include in the basis of the part (i) its FMV when removed, and (ii) the amount paid to remove the part from the unit of property.

(D) Include in the basis of the part any amounts paid to maintain, repair, or improve the part in the tax year these amounts are paid.

(E) In the tax year the part is reinstalled, deduct the amounts paid to reinstall the part and those amounts included in the basis of the part under (C) and (D), above, to the extent that those amounts have not been previously deducted upon reinstallation.

(F) In the tax year the part is disposed of, deduct the amounts included in the basis of the part under (C) and (D), to the extent that those amounts have not been previously deducted upon reinstallation. (Reg. § 1.162-3T(e)(2))

A taxpayer also may elect to capitalize and depreciate the cost of rotable spare parts or apply the de minimis rule of Reg. § 1.263(a)-2T(g), to such parts. (Reg. § 1.162-3T(a)(3), T.D. 9564)

Other rules.Unless the taxpayer elects to capitalize and depreciate their cost, when materials and supplies are sold or otherwise disposed of, they aren't treated as Code Sec. 1221 capital assets or as property used in the trade or business under Code Sec. 1231 . (Reg. § 1.162-3T(g)) Additionally, nothing in Reg. § 1.162-3T changes the treatment of any amount provided for in the Code (except for Code Sec. 162 and Code Sec. 212 ), such as the Code Sec. 263A rules requiring taxpayers to capitalize the direct and allocable indirect costs, including the cost of materials and supplies, to property produced or to property acquired for resale. (Reg. § 1.162-3T(b))

Finally, a change to comply with Reg. § 1.162-3T is a change in method of accounting to which Code Sec. 446 and Code Sec. 481 apply. Taxpayers that want to change to a method of accounting allowed in Reg. § 1.162-3T, must get IRS's consent. (Reg. § 1.162-3T(h))

Effective date.The above rules generally apply to amounts paid or incurred (to acquire or produce property) in tax years beginning after Dec. 31, 2011, but a taxpayer may apply the optional method of accounting for rotable and temporary spare parts to tax years beginning after Dec. 31, 2011. (Reg. § 1.162-3T(h))