The tangible property regulations made final by Treasury Decision 9636 (78 FR 57686, September 19, 2013, and corrected at 79 FR 42189, July 21, 2014) are the culmination of an IRS effort to provide clearer and simpler rules for accounting for tangible property. The regulations provide a de minimis safe harbor for expensing certain capital items. Treas. Reg. §1.263(a)-1(f)(1) allows the deduction of capital items that are beneath certain thresholds. Taxpayers with audited financial statements may adopt a policy of expensing all items with an invoiced amount of less than $5,000. Smaller businesses with a written accounting procedure for capitalization may expense items with an invoiced amount of $2,500 or less (Notice 2015-82).
The safe harbor can also be used to expense repairs and improvements whose total cost is beneath the thresholds. For expenditures that exceed the threshold, the new regulations provide guidelines for making the distinction between repairs that must be capitalized and those that can be expensed. This distinction has frequently been a difficult one. Although the regulations state that “incidental repairs” are deductible, this provision is limited to expenses that “are not otherwise required to be capitalized” [Treas. Reg. §1.162-4(a)]. The capitalization requirements of IRC §263(a) prohibit deductions for “betterments made to increase the value of any property or estate,” and the relevant regulations indicate the capitalization rules apply to amounts that would otherwise be deductible under §162. The new regulations provide a two-step process for determining whether expenditures must be capitalized or can be expensed. The first step involves identifying the correct unit of property, and the second applies the distinction between repairs and improvements [Treas. Reg. §263(a)-3].
UNIT OF PROPERTY
In Fedex Corporation v. U.S. (92 AFTR 2d 2003-5986), the District Court rejected the IRS position that expenses for jet engine maintenance programs should be capitalized. Because the engine and the aircraft couldn’t “function without each other,” the Court concluded that the relevant unit of property was the aircraft. This functional interdependence standard is applied by the new regulations. Treas. Reg. §1.263(a)-3(e)(3) declares that “components that are functionally interdependent comprise a single unit of property.”
Expenditures that improve a unit of property must be capitalized [Treas. Reg. §1.263(a)-3(d)]. But routine maintenance to keep a unit of property in “efficient operating condition” is an expense. A unit of property is improved if a taxpayer’s expenditures result in betterments, restorations, or adaptations. Consequently, once the relevant unit of property has been identified, analysis should determine whether an expenditure results in a betterment, restoration, or adaptation.
Betterments are expenditures that result in material additions or increases in productivity. Correcting defects that existed prior to the acquisition of a unit of property is also considered a betterment [Treas. Reg. §§1.263(a)-3(j)(1)(i-iii)]. Although expenditures to correct defects and make property functional are capitalized when the defects existed prior to the property’s acquisition, similar expenditures made to correct defects arising as a result of normal wear and tear are expensed. Determining whether the expenditures result in repairs or betterments involves “comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the circumstances necessitating the expenditure” [Treas. Reg. §1.263(a)-3(j)(2)(iv)(A)].
Restorations are amounts spent to return a unit of property to a functional condition after it deteriorated to the point where it was no longer functional. A restoration also takes place when equipment that has been used beyond the extent of its class life is restored to “like-new condition” [Treas. Reg. §1.263(a)-3(k)(1)(iv-v)]. Restoration expenditures are different from periodic maintenance to keep equipment in efficient operating condition, which is an ordinary and necessary expense. Routine maintenance often involves the replacement of worn-out or defective parts. Normally, these replacements are expensed. But the replacement of parts that constitute “a major component or a substantial structural part of a unit of property” must be capitalized [Treas. Reg. §1.263(a)-3(k)(1)(vi)]. A major component is “a part or combination of parts that performs a discrete and critical function in the operation of the unit of property.” Substantial structural parts are those that constitute “a large portion of the physical structure of the unit of property” [Treas. Reg. §1.263(a)-3(k)(6)(i)(A-B)].
Determining whether replacement parts constitute major components or substantial structural parts is a matter of facts and circumstances. The regulations don’t provide a clear distinction between incidental replacement parts that can be expensed and those that must be capitalized. They indicate that the facts and circumstances involved in making this determination should include “the quantitative and qualitative significance of the part or combination of parts in relation to the unit of property” [Treas. Reg. §1.263(a)-3(k)(6)(i)].
A facts and circumstances test involving both quantitative and qualitative factors requires the exercise of professional judgment. Treas. Reg. §1.263(a)-3 provides some examples that may be instructive. Providing a new engine, cab, and petroleum tank for a petroleum hauling truck would be capitalized because it involves the replacement of major components of the vehicle. On the other hand, although a power switch assembly for a drill press is essential to operate the equipment, its replacement shouldn’t be capitalized because it’s an incidental component. These examples distinguish replacements that are clearly major components from those that are clearly incidental. Between these extremes, there will be many situations requiring the exercise of professional judgment.
Adaptations are defined as “amount[s] paid to adapt a unit of property to a new or different use.” A “new or different use” is the application to a use that is “not consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in service by the taxpayer” [Treas. Reg. §1.263(a)-3(l)(1)].
The examples of adaptations provided in the regulations involve buildings, which are frequently adapted to different uses. But machinery and equipment also can be adapted to uses that are different from their use when they were placed in service. For example, a van that was originally purchased to transport people could be modified to deliver goods. Amounts spent on such a conversion should be capitalized as improvements.
Determining the correct accounting for equipment maintenance expenditures will continue to require professional judgment. Nevertheless, the new regulations provide structure to the decision-making process. Moreover, the concept of relevant units of property and the distinction between improvements and routine repairs and maintenance are defined with enough precision to provide guidance to decision makers.
© 2018 A.P. Curatola