The IRS’s recent Audit Techniques Guide for the Tangible Property Regulations can help business taxpayers avoid problems with IRS examiners in interpreting the 2014 regulations on how to treat expenses incurred for materials, supplies, repairs and maintenance.

Most taxpayers have finalized implementation of the Tangible Property Regulations over a year ago. These regulations covered how to determine when an expenditure is capital versus when an expenditure can be treated as an expense. In most situations, the implementation of these regulations is considered to be taxpayer favorable. Most taxpayers who correctly implement these regulations will find that more items can be expensed as compared to the old rules.

During the implementation process, many taxpayers were required to file a Change in Accounting Method, also known as a Form 3115. Due to the number of these forms and the new changes related to the Tangible Property Regulations, the IRS issued an Audit Techniques Guide on Sept. 14, 2016, detailing how auditors are to deal with these new changes.

While an Audit Techniques Guide does not set precedent, it does provide valuable insight into how the IRS interprets the new regulations. Most of the guidance offered in this manual follows closely how most tax preparers were implementing these rules. However, it is important to highlight a few areas in this new guidance.

Safe Harbor Expensing Limits
Under the new regulations, the IRS has set a safe harbor under which acquired items do not need to be capitalized. This safe harbor is $5,000 for taxpayers with an audited financial statement or $2,500 for taxpayers without an audited financial statement. Many taxpayers have questioned how to go about arguing for a higher limit if a higher safe harbor would more clearly reflect income for their business.

Under this guidance the IRS specifically states, “Examiners should not negotiate with taxpayers to set de minimis thresholds beyond the safe harbor limits. A taxpayer that seeks a deduction for amounts in excess of the amount allowed by the safe harbor or by agreement with IRS examining agents will have the burden of showing that such treatment clearly reflects income.”

This statement clearly puts the burden of proof on the taxpayer in the cases where a higher threshold is desired. The IRS does not state how that burden can be proven; however, it is clear that in the cases where a higher threshold is desired, the taxpayer needs to be prepared to clearly demonstrate that this methodology is an accurate representation of their income.

Additionally, the IRS reinforced the fact that transactional costs need to be included when determining if property qualifies for safe harbor treatment. This means that if a taxpayer acquires a desk for $2,500 and the invoice includes a delivery charge of $100, the cost would be $2,600 for analysis under the safe harbor. However, the IRS does not require separately invoiced costs to be included. In the example above, if company A sold the desk for $2,500 and company B delivers the desk for $100, and both invoice separately, the costs do not need to be combined for determination of the safe harbor. However, the IRS does have an anti-abuse rule that would preclude a taxpayer from manipulating the transaction to achieve a tax benefit under the safe harbor.

Major Component
On page 66 of the Audit Techniques Guide, the IRS discusses the determination of whether an asset is a major or minor component. Specifically, it discusses an example of a building with three furnaces and three air conditioning units. In the example, a furnace breaks and needs to be replaced. If all three furnaces work together, one furnace is not a major portion of the HVAC system. The argument is that if one furnace fails, the other two furnaces can continue to heat the building but are not as efficient as all three working together.

The IRS then goes on to provide a separate example. In the second example the building has three wings, each with its own furnace and air conditioning unit. In this case, each furnace heats a specific wing of the building. If one furnace needs to be replaced, it is a significant portion of the HVAC system for that wing of the building and must be capitalized.

This adds complexity to the analysis of building systems as it relates to the regulations. If a taxpayer replaces one of the three units, it might be capital and it might be an expense. The key issue will be what function that specific unit contributes to the building as a whole and to the area that the HVAC unit feeds. Many buildings have multiple HVAC units feeding different floors or specific areas. In order to determine if a replacement is capital, a more detailed analysis must take place moving forward.

Leased Property
This is one area that has created a large amount of confusion as it relates to the new regulations. Under the regulations, a lessee of a building looks at the expenditures in relation to the portion of a building subject to their lease. However, a lessor of a building gets to look at the building as a whole. This differentiation caused many taxpayers to assume that many leasehold improvements paid for by the landlord could be treated as an expense. The argument is that in a building with 10 equal spaces, the improvements to one space would never be a major part of the unit of property. Unfortunately, this oversimplifies the situation and can lead to some errors.

The IRS confirms that when a lessor makes improvements to a space, it is required to capitalize the amounts paid if Section 110 applies to the construction allowance. The IRS goes on to state that “qualified long-term real property constructed or improved with any amount excluded from a lessee’s gross income by reason of §110(a) must be treated as non-residential property of the lessor for purposes of depreciation and determining gain or loss.”

Cost Segregation
Finally, the IRS confirmed the value of cost segregation studies under the new regulations. Under this guidance the IRS states, “In many cases, taxpayers who previously decided not to conduct cost segregation studies for depreciation purposes are hiring specialists with engineering expertise to determine units of property for purposes of applying the improvement rules. Even taxpayers that conducted these studies in the past are once again hiring specialty firms, or CPAs, to take another look at their units of property and associated costs.

“Cost segregation studies now serve additional purposes. For example, not only do these studies reclassify a building’s components into assets with shorter class lives, but they also identify building systems for purposes of applying the improvement rules. These studies are also used to identify functionally interdependent plant property and to determine individual components or groups of components that perform a discrete and critical function.”

By making this statement the IRS is confirming that the cost segregation study is more valuable than ever. At the same time the qualifications of the preparer are more critical than ever. A cost segregation professional not only needs to identify the personal property, but also must look at the individual units of property to determine how they interact. Additionally, the preparer has to understand the engineering side of the study and have a mastery of depreciation law and the Tangible Property Regulations.

The full text of the new guidance can be found on the IRS’s website.

David McGuire is director of the Cost Segregation Practice at McGuire Sponsel. His expertise includes fixed assets, cost segregation, and depreciation law. His background includes consulting on repair and maintenance studies under the 263(a) regulations and reviewing corporate capitalization policies. He is a frequent speaker on the topic of the repair regulations for various accounting training seminars nationwide. Additionally, he has a thorough knowledge in bonus deprecation, which includes step up in basis, Section 108, and passive loss limitations.