Enterprises planning to purchase machinery and equipment during the remainder of this year or early next year should try to accelerate their buying plans, if doing so makes sound business sense. This is the second installment of a 3-part Special Study on how businesses may be able to lock in accelerated deductions by buying qualifying assets this year and placing them in service before year-end. It explains an expensing safe harbor under the capitalization regs that has been liberalized for smaller businesses. The first installment explained how generous expensing under Code Sec. 179 can boost year-end deductions. The third installment will show how to use 50% bonus depreciation to bulk up first-year deductions for those eligible new assets that can’t be expensed under Code Sec. 179 or the regs’ safe harbor.
How Expensing Safe Harbor in Capitalization Regs can Boost Year-End Deductions
Under the tangible property recovery regs, a taxpayer generally must capitalize amounts paid to acquire or produce property, whether real or personal, including assets such as land and land improvements, buildings, machinery and equipment, and furniture and fixtures. Fortunately, the tangible property capitalization regs contain an exception to the general capitalization requirement, allowing businesses to elect to expense certain lower-cost business assets.
Many businesses may be able to use this exception, the “de minimis safe harbor election”, to expense certain business assets well in excess of the Code Sec. 179 expensing dollar limit or to save use of the Code Sec. 179 allowance for assets that don’t qualify for the de minimis safe harbor. The “de minimis safe harbor election” may be particularly useful when it comes to year-end planning, as it is available for qualifying assets even if they are bought and placed in service near the close of the taxpayer’s tax year.
The safe harbor is essentially an election to treat certain outlays for lower-cost assets, materials and supplies in the same manner for tax purposes as for book purposes—so-called book-tax conformity. If the conditions of the election are met, costs that a business would otherwise have to capitalize and depreciate over a number of years for tax purposes can instead be deducted in the year of purchase, assuming they otherwise qualify as ordinary business expenses, and assuming the costs don’t have to be capitalized under the UNICAP rules of Code Sec. 263A. And unlike the Code Sec. 179 expensing election, there is no aggregate annual dollar limit on the amount that can be deducted under the de minimis safe harbor election.
The safe harbor applies to amounts paid during the tax year to acquire or produce what the regs call a “unit of property” (UOP), or acquire a material or supply, if:
- At the beginning of the tax year, the taxpayer has written accounting procedures treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount, or with an economic useful life of 12 months or less;
- The taxpayer treats the amount paid for the property as an expense on its “applicable financial statement” (AFS, defined below), if it has one, or on its books and records if it does not, in accordance with its accounting procedures; and
- The amount paid for the UOP doesn’t exceed $5,000 per item (as substantiated by invoice) if the taxpayer has an AFS, or $2,500 if the taxpayer doesn’t have one.
Note that the dollar limit per item of UOP used to be $500 for taxpayers that don’t have an AFS, but in Notice 2015-82, the IRS increased the dollar limit for these taxpayers from $500 to $2,500. This increase is effective for costs incurred during tax years beginning on or after Jan. 1, 2016, but IRS said use of the new threshold won’t be challenged in tax years prior to 2016.
In general, an AFS is:
- A financial statement required to be filed with the SEC;
- A certified audited financial statement along with the report of an independent CPA used for credit purposes, reporting to shareholders, partners, etc., or any other substantial nontax purpose; or
- A financial statement (other than a tax return) required to be provided to the federal or a state government or agency other than the SEC or the IRS.
If the de minimis safe harbor election is made for a tax year (by attaching a statement to a timely filed—including extensions—original Federal income tax return), it applies to all expenses that qualify for the safe harbor for that year.
Illustration 1: Large Corp has a written accounting policy at the beginning of 2016, which it follows, to expense amounts paid for property costing $5,000 or less. It also has an AFS. In 2016, it pays $6.25 million to buy 1,250 machines at $5,000 each. Large Corp receives an invoice from its supplier indicating the total amount due ($6.25 million) and the price per item ($5,000). Each machine is a UOP, and the amounts paid for them meet the requirements for the de minimis safe harbor. If Large Corp, which isn’t subject to the UNICAP rules of Code Sec. 263A, elects to apply the de minimis safe harbor, it deducts the $6.25 million in 2016, provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.
Observation: Under Code Sec. 179(d)(1)(A)(i), “section 179 property” generally is any tangible property to which Code Sec. 168 applies. Thus, assets to which the de minimis election applies (and which aren’t capitalized and depreciated) should not be counted in determining either the Code Sec. 179 maximum expensing limit or the investment ceiling.
Illustration 2: The facts are the same as in the previous illustration except that Large Corp also spends a total of $1 million on other equipment and business assets that are not eligible for the de minimis safe harbor and instead must be capitalized. Large Corp elects to apply the de minimis safe harbor rule. Since the $6.25 million that’s deducted under the safe harbor rule will not count for purposes of the rule phasing out Code Sec. 179 expensing if the Code Sec. 179 investment ceiling ($2,010,000, for 2016) is exceeded, Large Corp should be able to expense, under Code Sec. 179, $500,000 of the equipment and business assets that are not eligible for the de minimis safe harbor.
As the above illustration shows, the benefits of the election are evident for companies with an AFS. Since many smaller companies don’t have an AFS, however, any safe harbor election they make generally will be limited to items costing no more than $2,500. Even so, they will benefit because amounts expensed under the safe harbor won’t eat into their $500,000 Code Sec. 179 expensing limit.
Note this key distinction. Although amounts expensed under the de minimis safe harbor election aren’t subject to capitalization under Code Sec. 263(a), they may have to be capitalized under Code Sec. 263A if the UNICAP rules apply to the taxpayer. (Reg. § 1.263(a)-1(f)(1), Reg. § 1.263(a)-1(f)(3)(v)) By contrast, under Reg. § 1.263A-1(e)(3)(iii), amounts expensed under Code Sec. 179 are indirect costs that are not required to be capitalized under Code Sec. 263A.
For more information about expensing safe harbor items, contact Larson & Company today.