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Change to Sales Tax Collection on Sales of Motor Vehicles

Posted 9:00 PM by

The Indiana General Assembly recently enacted a change to the taxability of motor vehicles sold by Indiana dealers to residents of other states. This change became effective on July 1, 2014.

Out-of-state purchasers should now be charged a sales tax rate that is the lesser of their home state’s sales tax rate or the Indiana rate of 7%. Information Bulletin #84 published by the Indiana Department of Revenue discusses the change in detail.

There may be some confusion or practical challenges in the overall implementation of the change including issues involving the monthly sales tax reporting going forward. Members of our Dealership Services Group would be happy to discuss these issues with you and provide assistance as you develop your internal compliance standards.

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IRS Notice 2014-21 on Virtual Currencies

Posted 8:33 PM by

The use of virtual currencies, especially Bitcoin, has increased significantly in recent years. This increased use has raised questions regarding the proper tax treatment of these currencies. In an attempt to clarify many of the uncertainties, the IRS has recently released Notice 2014-21, which provides answers for 16 frequently asked questions surrounding virtual currencies.

The IRS defines virtual currencies as digital representations of value that function as a medium for exchange, a unit of account, and/or a store of value. In other words, the virtual currency acts like “real money” even though it is not legal tender in any country or jurisdiction. A virtual currency is considered to be “convertible” if it has an equivalent value with an established currency, or if it can be easily substituted or exchanged for a legal tender. Bitcoin is probably the most well-known and widely used example of a convertible virtual currency today. Bitcoin can be easily traded and exchanged amongst users and can also be bought or sold for various real currencies, such as U.S. dollars and Euros. The IRS notice deals only with convertible virtual currencies and does not address any virtual currency which is not convertible.

In Notice 2014-21, the IRS starts off by stating that virtual currencies like Bitcoin are considered property, not currency, for tax purposes. Since virtual currencies are considered property, accepting virtual currencies in exchange for goods and services requires the recipient to measure their gross income by using the fair market value of the virtual currency in U.S. dollars as of the date payment was received. Additionally, when virtual currency is used to purchase an item, the taxpayer is required to report gain or loss on the disposition of the virtual currency. In order to do this, the taxpayer must first determine the basis of the virtual currency in U.S. dollars at the time of the exchange. The character of the gain or loss will be determined based on whether the virtual currency is held by the taxpayer as a capital asset. Therefore, if the taxpayer holds the virtual currency as an investment asset then it will be taxed as a capital gain or loss on its disposition. However, if the taxpayer holds the virtual currency as inventory then it will be taxed as ordinary income upon its disposition.

Some virtual currencies, such as Bitcoin, allow people to “mine” the currency. This involves users discovering new Bitcoins by solving complex math problems. When a taxpayer successfully mines virtual currency, the fair market value of the mined currency is includable in the taxpayer’s gross income for the taxable year. Furthermore, if the taxpayer is mining the virtual currency as part of a trade or business, the net earnings from the activity is considered self-employment income and is subject to the self-employment tax. Similarly, if a taxpayer is paid in virtual currency for services rendered as an independent contractor, the fair market value of the virtual currency received is subject to self-employment tax. In the case of an employer-employee relationship, the fair market value of the currency paid as wages to the employee is subject to federal income tax withholding, FICA tax and FUTA tax, and is required to be reported on Form W-2.

The IRS went on to state that when certain property payments which require information reporting to the IRS – such as rent, salaries, wages, premiums, annuities and compensation – are subject to the same information reporting standards when virtual currency is used to complete the payment. Furthermore, when a Form 1099-MISC is used to report payments of virtual currency, it should be reported using the fair market value of the virtual currency as of the date of the payment.

Finally, the IRS dictated that taxpayers who have not treated past virtual currency transactions in a manner that is consistent with Notice 2014-21 may be subject to penalties for failure to comply with tax laws. For example, underpayments attributable to virtual currency transactions and failure to report virtual currency transactions in a correct and timely manner may be subject to accuracy-related and information reporting penalties. However, the IRS does note that penalty relief may be available to taxpayers who can show that the underpayment or failure to properly file information on returns is due to reasonable cause. 

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Standards Updates – 1/28/14

Posted 3:15 PM by

FASB Issues Two Accounting Standards Updates for Private Companies

The Financial Accounting Standards Board (FASB) recently issued two Accounting Standards Updates (ASU) to provide alternatives for private companies on the subsequent accounting for goodwill and interest rate swaps. Both ASUs are consensuses of the Private Company Council and were endorsed by the FASB.

The FASB has defined a private company as the following: “An entity other than a public business entity, a not-for-profit entity, or an employee benefit plan within the scope of Topics 960 through 965 on plan accounting.” They also have defined a public business entity, which includes entities that are required by the SEC to file or furnish financial statements to the SEC and entities that meet various other criteria.

Entities that meet the definition of a private company may elect to adopt the following ASUs. Prior to making the election to adopt, companies should discuss with the users of the financial statements to ensure the users understand any potential impact of each of the ASUs adopted.

The following is a summary of each of the proposed ASUs:

 

ASU 2014-02, Intangibles – Goodwill and Other (Topic 350): Accounting for Goodwill

This ASU permits a private company to amortize goodwill on a straight-line basis over 10 years, or less than 10 years if the entity demonstrates another useful life is more appropriate. A company electing this accounting alternative is required to make an accounting policy election to test goodwill for impairment at the entity level or the reporting unit level.

Under the alternative, goodwill should be tested for impairment when an event or changes in circumstances occurs (a triggering event) that indicates the fair value of the entity (or reporting unit) may be below its carrying amount. Upon such an event or changes in circumstances, a company may assess qualitative factors to determine whether it is more likely than not that the fair value is less than the carrying amount. Further testing is unnecessary when the qualitative assessment indicates it is not more likely than not that goodwill is impaired. Otherwise, a quantitative assessment is required. A company may elect to skip the qualitative assessment and perform the quantitative calculation. A goodwill impairment loss, if any, is recognized for the amount that the carrying amount of the entity (or reporting unit) exceeds the fair value.

Under current guidance, all companies are not allowed to amortize goodwill but are required to test for impairment at least annually. In addition under current guidance if it is determined the carry amount is greater than the fair value, a second step must be completed to determine the amount of the goodwill impairment loss. This second step has been eliminated for private companies adopting this ASU.

By allowing for the amortization of goodwill, the ASU is expected to reduce the likelihood of impairments and require private companies to test goodwill for impairment less frequently.

The ASU applies to all private companies, as defined, and is effective for annual periods beginning after Dec. 15, 2014, with early adoption permitted. If elected, the accounting alternative should be applied prospectively to goodwill existing as of the beginning of the year of adoption, and any new goodwill recognized in periods beginning after Dec. 15, 2014.

 

ASU 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps – Simplified Hedge Accounting Approach

Under accounting principles generally accepted in the United States, an interest rate swap is a derivative instrument and recognized on the balance sheet as either an asset or a liability at fair value. Companies may elect hedge accounting if certain requirements are met to reduce income statement volatility due to changes in the swap’s fair value.

This ASU provides an additional accounting alternative to private companies, the “simplified hedge accounting approach,” for certain swaps that are used to economically convert a variable-rate borrowing into a fixed-rate borrowing. Under this approach, an entity may assume no ineffectiveness provided that six criteria, which are specified in the ASU, are met. In addition, the ASU provides entities the option to measure the qualifying swap at settlement value instead of fair value.

Finally, private companies with less than $100 million in assets will not be required to include additional disclosures about the fair value of financial instruments not measured at fair value unless other derivatives are present. All other disclosures related to cash flow hedge accounting and fair value measurements still apply.

The ASU applies to all private companies other than financial institutions, as defined in the FASB Codification, and is effective for annual periods beginning after Dec. 15, 2014, with early adoption permitted. Private companies can elect to apply this approach to an existing qualifying swap, as well as swaps entered into after the date of this ASU, on a swap-by-swap basis.

 

Connect with Ron 
Ron Smith is a partner in Katz, Sapper & Miller's Audit and Assurance Services Department. Ron has extensive experience in, and advises clients and firm members on, accounting, financial reporting, auditing, compliance and internal control matters. He also oversees the firm’s quality control system.

 

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Year-End Trust Distribution Planning

Posted 2:21 PM by

Starting in 2013, trusts, like individuals, are subject to the higher tax rates on qualified dividends and long-term capital gains (i.e., 20% instead of 15%), as well as the Medicare surtax (3.8%). However, unlike individuals, trusts are subject to these rates at a much lower income level:

  • Trusts: $11,950 for both the 20% and 3.8% rates
  • Individuals: 400,000 for single filers or $450,000 for joint filers (20% rate), and $200,000 for single filers or $250,000 for joint filers (3.8% rate)

Further, trusts hit the top rate of 39.6% for ordinary income in excess of $11,950; for individuals, it is $400,000 for single filers or $450,000 for joint filers.

In general, if a trust makes a distribution to a beneficiary, then the beneficiary, not the trust, is taxed on the income. Therefore, it might be desirable for trusts to make distributions to beneficiaries so that the trust income will be taxed to the beneficiaries at their rates instead of the potentially higher trust tax rates. However, it is important to consider whether the trust is authorized to make distributions and whether it is wise to make distributions from a non-tax perspective. For purposes of carrying out 2013 trust income to beneficiaries so that the income can be taxed to beneficiaries at their rates instead of trust rates, trusts have until 65 days after year-end (March 6, 2014) to make a distribution and treat it as a distribution for 2013.

As an example, if a trust has long-term capital gain of $50,000 taxed at the trust's 23.8% rate instead of the individual's 15% rate, then the tax savings of passing the long-term capital gain out to the beneficiary is $4,400 (8.8% x $50,000).

In determining whether trusts should make distributions, keep in mind that if a trust is required to make a distribution (for example, trust accounting income), the distribution is deemed made as of 12/31, even if it is not actually made. However, if the goal is to pass out additional income such as capital gains, the accounting income and capital gains must all be distributed by March 6, 2014.

If you have additional questions, please contact your KSM advisor.

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The Advisor - Issue 2, 2013

Posted 10:16 PM by

In This Issue:

Affordable Care Act Tax Implications of Grouping Activities
With the implementation of the Patient Protection and Affordable Care Act of 2010, also known as the Affordable Care Act (the ACA), there are several new tax provisions that went into effect as of Jan. 1, 2013. Two of the new tax provisions are the High Income Medicare Tax and the Unearned Income Medicare Tax. By Douglas N. Rubenstein, CPA

The Individual Mandate and the Health Insurance Marketplace
Healthcare coverage is set to start on Jan. 1, 2014 for those who would have signed up by Dec. 14, 2013. On the same day the coverage is set to start, so does the Individual Mandate. Due to issues within the marketplace rollout, the time to enroll in a health plan has been extended to March 31, 2014, giving individuals a three-month grace period from the Individual Mandate. By Amber Moore, CPA

Tax Reform: What Does It Mean?
Amid all of the political back-and-forth in Washington that included budget debates and a government shutdown, one topic that continually bubbles to the surface during these conversations is the need for comprehensive tax reform. A major overhaul of the Code has not happened since 1986 and there have been thousands of additions and changes since that time. By Aimee Reavling, CPA

Proposed Changes for Private Company Accounting Standards Continue to Progress
There has been an ongoing debate for years on public versus private company accounting standards (often referred to as big-GAAP versus little-GAAP). As a result of this debate, in 2012 the Financial Accounting Foundation’s Board of Trustees approved the establishment of the Private Company Council (PCC). The PCC was established to improve the process of setting accounting standards for private companies. By Ron L. Smith, CPA

Pass-through Entity Owner Compliance Considerations
Tax season is right around the corner, and that means multistate pass-through entities have decisions to make when it comes to filing and paying taxes for their nonresident owners. Many states require pass-through entities to file withholding and/or composite returns on behalf of their nonresident owners. By Donna L. Niesen, CPA

Survey Sees Hoosier Manufacturers Investing in Growth, Despite Workforce, Regulatory Concerns
The results from Katz, Sapper & Miller's 2013 Indiana Manufacturing Survey: Manufacturing's Renaissance, reveal an often unnoticed but growing renaissance is underway in Hoosier (and American) manufacturing.

Hospital and Health System Survival Strategy
Change has dominated the healthcare arena over the last few years and there is no evidence of a slowdown or calming period in the near future. In attempts to avoid panic with newly released requirement deadlines from the Center for Medicare & Medicaid Services, hospitals and health systems across the country are searching for ideas, strategies and guidance for how to remain relevant, earn a dollar and prosper in the new era of the Affordable Care Act. By KSM's Healthcare Resources Group

 

Katz, Sapper & Miller’s The Advisor is a bi-annual newsletter that focuses on business and tax solutions for today's entrepreneur.

 

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Final Regulations for the Unearned Income Medicare Tax

Posted 8:18 PM by

On Nov. 26, 2013, the Internal Revenue Service (IRS) issued final regulations related to the Unearned Income Medicare Tax*, also known as 3.8 percent Medicare tax. Additionally, the IRS revoked the initial proposed regulations related to the net investment income calculation from the sale of S corporation stock or a partnership interest, and issued a new proposed regulation effective Dec. 2, 2013. The following is a brief summary of the key highlights of the proposed and final regulations, which are much more favorable for taxpayers than the previous rules.

Sale of S Corporation Stock or Partnership Interest

In December 2012, the IRS initially issued Proposed Regulation 1.1411.7 with regards to the sale of an individual’s share of S corporation stock or partnership interest. Under the proposed regulation, the taxpayer was required to go through a five-step process to determine the share of the gain that would be subject to the 3.8 percent Medicare tax. Due to the complexity of the calculation, the IRS revoked the regulation and issued a new proposed regulation that is to simplify the calculation of the gain subject 3.8 percent Medicare tax.

The new proposed regulation now utilizes a two-step process to determine the taxpayer’s share of gain that would be subject to the 3.8 percent Medicare tax. Step one is to determine the taxpayer’s share of the gain from a deemed asset sale of the company. The second step is to determine the gain from the portion of the assets that would be considered investment income. The amount of the gain subject to the 3.8 percent Medicare tax is the lessor of the seller’s overall gain from the sale of its membership interest “or” the seller’s share of the gain on assets that would be considered net investment income.

Real Estate Professionals

In general, if a taxpayer qualified as a real estate professional, then income from rental real estate activities would be considered non-passive income instead of passive income for income tax purposes. However, under the proposed regulations issued in December 2012, the rental real estate activities would be subject to the 3.8 Medicare tax if the activity was not considered a trade or business. At that time the IRS did not provide a bright line test for when an activity qualifies as a trade or business. Therefore, it was possible for a real estate professional to have some rental real estate income activities subjected to the 3.8 percent Medicare tax.

With the issuance of the final regulations, the IRS issued a safe harbor test that provides if a real estate professional participates in a rental real estate activity for more than 500 hours in the current year or in five of the previous 10 years, then the rental income associated with the activity will be presumed to be derived in the ordinary course of a trade or business. Additionally, if the real estate professional has elected to group their rental real estate activities as one activity under Treasury Regulation Section 1.469-9, then the 500-hour test will apply to the group instead of each individual activity.

Self-Rental Rules and Self-Charged Interest

In general rental real estate activities are considered passive with few exceptions. One of the exceptions relates to the self-rental rule. Treasury Regulation 1.469.2(f)(6) provides that if an individual rents property to an activity in which the individual is a material participant, any net rental income generated from the property is recharacterized as non-passive income. The purpose of this rule was to avoid the taxpayer from manipulating the income from the rental activity and offsetting it against passive losses.

With the issuance of the proposed regulation in December 2012, the IRS did not directly address the self-rental rule issue. The preamble to the proposed regulations stated that in order for a rental real estate activity not to be excluded from net investment income, it needs to be considered a trade or business activity. Additionally, the preamble stated that an allowable grouping of the rental real estate activity with the operating activity would not convert the rental real estate activity into a trade a business activity.

The final regulations issued by the IRS now provide that rental real estate activities subject to the recharacterization rules will be considered non-passive and therefore, not subject to the 3.8 percent Medicare tax. Also, if the rental real estate activity is grouped with an operating activity that qualifies as a trade or business, then the real estate activity will rise to the level of a trade or business activity and therefore, will not be subject to the 3.8 percent Medicare tax.

The regulations also addressed the issue of self-charged interest income treated as investment income. Self-charged interest occurs when an individual makes a loan to a pass-through entity which conducts a trade or business and the individual is a material participant in the entity. Under the proposed regulations, the interest income the individual received from the pass-through entity was considered net investment income and subject to the 3.8 percent Medicare tax. Under the final regulations, the individual is now allowed to offset the self-charged interest income against their share of the entity’s trade or business interest expense related to the loan from the individual. Any excess interest income will be considered investment income and subject to the 3.8 percent Medicare tax rules.

Grouping Rules

Treasury Regulation 1.469-4 allows for the taxpayer to treat two or more business activities or rental activities as a single activity if the activities constitute an appropriate economic unit (“AEU”). The grouping of activities as a single activity is based upon a facts and circumstances test. The grouping rules are important as it allows for the material participation rules to be applied to the group instead of each individual activity. There are certain limitations to the grouping rules and one limitation is a rental activity generally cannot be grouped with a trade or business activity.

With the issuance of the proposed regulations in December 2012, the IRS determined that taxpayers who meet the applicable income thresholds for the Unearned Income Medicare tax should have the opportunity to regroup their activities in the first taxable year beginning after Dec. 31, 2013. The final regulations still allow for the opportunity for eligible taxpayers to reconsider their groupings, but it may only occur during the first tax year beginning after Dec. 31, 2012. For calendar year taxpayers, it would be effective for the Dec. 31, 2013, tax year.

The final regulations also allow for a taxpayer to regroup their activities on an amended return – only if the taxpayer was not previously subjected to the Unearned Income Medicare Tax – but will now be subject to the tax as a result of the amended tax return. This is a one-time opportunity to regroup activities. Once the regrouping is complete, it would apply in all subsequent years.

Treatment of Losses to Offset Gains

Under the proposed regulations issued last December, losses from dispositions of property could only offset property dispositions gains. Losses in excess of gains could not be utilized to offset other investment income. The final regulations provide that in some limited cases excess losses may be available to offset other investment income.

With the issuance of these final regulations, planning opportunities should be taken advantage of prior to year-end. For more information, please contact your advisor.

*The Unearned Income Medicare Income Tax is applicable to taxpayers with investment income and their modified adjusted gross income is in excess of the following threshold amounts:

  • Married Filing Joint or Surviving Spouses - $250,000
  • Single and Head of Household - $200,000
  • Married Filing Separate - $125,000
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IRS Announces Retirement Plan Limitations for 2014

Posted 4:57 PM by

The Internal Revenue Service (IRS) has announced the Cost-of-Living Adjustments (COLA) affecting dollar limitations for retirement plans and other retirement related items for the 2014 tax year. While some of the limitations will remain unchanged, some have increased for 2014 as follows:

 2014 

2013

Social Security Taxable Wage Base

$117,000 

$113,700

Medicare Taxable Wage Base

No Limit

 

No Limit

Compensation (Plan Limit)

$260,000 

$255,000

Compensation (SEP)

$550 

$550

Defined Benefit Limit (415)

$210,000

 

$205,000

Defined Contribution Limit (415)

$52,000 

$51,000

401(k) and 403(b) Contribution Limit

$17,500 

$17,500

401(k) and 403(b) Catch Up Contribution Limit (over age 50)

$5,500 

$5,500

SIMPLE Contribution Limit

$12,000 

$12,000

SIMPLE Catch up Contribution Limit (over age 50)

$2,500 

$2,500

Highly Compensated Employee Definition (prior year)

$115,000 

$115,000

Maximum Deduction (% of Compensation) P/S and SEP Plans

25% 

25%

IRA Contribution Limit (Traditional & Roth)

$5,500 

$5,500

IRA Catch Up Contribution Limit (Over Age 50)

$1,000 

$1,000


Year-End Compliance Reminders

Required Annual Notices

Many defined contribution plans with certain features are required to provide annual notices to plan participants. Generally, these annual notices are in addition to any initial notices the plan administrator may be required to provide on or before an employee’s eligibility date for the plan feature. Plan administrators should ensure that the following annual notices, if applicable, are provided to plan participants on a timely basis.

  • 401(k) Safe Harbor Notice: All eligible participants in a safe harbor 401(k) plan must receive an annual notice that describes the safe harbor contribution allocation formula and certain other plan features. The notice must be given by December 1 for a calendar year plan, and not fewer than 30 days or more than 90 days before the first day of the plan year for a non-calendar year plan.
     
  • 401(k) Automatic Enrollment Notice: If the plan provides that employees will be automatically enrolled, the plan administrator must give eligible employees an annual notice that describes the circumstances in which eligible employees are automatically enrolled and pay will be automatically contributed to the plan. The notice must be given by December 1 for a calendar year plan and not fewer than 30 days before the first day of the plan year for a non-calendar year plan. Depending on the plan’s auto-enrollment features, the notice may be referred to as a QACA (Qualified Automatic Contribution Arrangement), an EACA (Eligible Automatic Contribution Arrangement) or an ACA (Automatic Contribution Arrangement) notice.
     
  • Qualified Default Investment Alternative (QDIA) Notice: A plan that permits participants to direct the investment of their account balances may provide that if the participant does not provide an affirmative investment direction election, the portion of the account balance for which an affirmative election was not given will be invested in a qualified default investment alternative. Plan administrators must give the annual notice by December 1 for a calendar year plan and at least 30 days prior to the beginning of the plan year for a non-calendar year plan.

It should be noted that a safe harbor 401(k) plan may incorporate two or more of the above notices into a single notice.

Plan Forfeitures

Many defined contribution plans require participants to complete a period of service before becoming fully vested in employer matching or non-elective (profit sharing) contributions. If a participant terminates prior to completing the service requirement for full vesting, the non-vested account may be forfeited and placed into a plan forfeiture suspense account. Some plan administrators allow the plan’s forfeiture suspense account to accumulate over several years.  The Internal Revenue Code does not allow this practice. 

The plan’s document or adoption agreement should contain provisions detailing how and when to utilize the plan’s forfeiture suspense account and may provide several options on the use of the forfeitures. A plan’s failure to utilize forfeitures in a timely manner denies plan participants additional benefits or reduced plan expenses. Generally, a plan administrator will have the following options related to the plan’s forfeiture suspense account under the terms of the plan document:

  • Forfeitures may be used for eligible plan expenses (including administration, recordkeeping and audit fees)
  • Forfeitures may be added to any employer matching or non-elective (profit sharing) contributions and allocated to eligible participants in the same manner
  • Forfeitures may be used to reduce any employer matching or non-elective (profit sharing) contributions

Fidelity Bond

The Employee Retirement Income Security Act of 1974 (ERISA) requires all persons who handle assets of employee benefit plans to be bonded through an ERISA fidelity bond. This requirement protects plans against losses sustained due to acts of fraud or dishonesty by those persons whose positions require them to come in direct contact with or exercise discretion over plan assets. 

At the beginning of each plan year, the plan administrator or other fiduciary must assure that the bond continues to satisfy the ERISA requirements. The fiduciary should make appropriate adjustments or add additional protection to make sure the bond is in compliance for the new plan year. The bond must provide coverage for persons handling plan funds in an amount no less than 10% of the amount of funds handled in the previous year. The minimum bond amount cannot be less than $1,000 and does not need to be more than $500,000 per plan (or $1 million for plans that hold employer securities). The bond does not need to state a specific dollar amount, but instead can provide that at least 10% of funds handled, per plan are covered. The fiduciary could purchase an inflation guard provision that automatically increases the amount of coverage under the bond to equal the amount required under ERISA, if not already in place.

 
For questions regarding your retirement plan, please contact any of the members of our Employee Benefit Plan Services Group.
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The Final “Repair and Maintenance” Regulations – Explaining the Impact on Business (Part II)

Posted 3:57 PM by

Summary – The following is Part II of a multi-part series discussing the impact of new regulations governing when taxpayers deduct or capitalize expenditures related to tangible property. (View Part I.) With the effective date of Jan. 1, 2014, quickly approaching, taxpayers should give immediate attention to these new rules, as commentators agree that nearly all taxpayers will be affected. The new rules may require significant changes to a taxpayer’s practices with respect to the capitalization or deduction of certain expenditures.

On Sept. 13, 2013, the Internal Revenue Service (IRS) released final rules concerning when taxpayers must capitalize and when they may deduct an expenditure related to acquiring, producing, maintaining or repairing tangible property. The final rules replace and remove previously issued temporary regulations under Internal Revenue Code (Code) Sec. 263(a) and 162(a). These new regulations must be followed by all taxpayers for tax years beginning Jan. 1, 2014. At a taxpayer’s choosing, these rules may be followed by taxpayers for tax years beginning Jan. 1, 2012. 

Code Sec. 263(a) requires the capitalization of amounts paid to acquire, produce or improve tangible property. A taxpayer generally recovers capital costs over time through depreciation or amortization deductions, or at the time of disposition, an inherently slower rate of recovery of any expenditure.  Alternatively, Code Sec. 162(a) allows the deduction of ordinary and necessary business expenses incurred during the taxable year, including the cost of supplies, repairs and maintenance. 

The new regulations attempt to provide guidance for distinguishing between deductible supplies, repairs, and maintenance, and capital expenditures. The new rules also discuss the disposition of depreciable property under Code Sec. 167 and 168. The final regulations cover five major topics:

  • Capital expenditures (Reg. 1.263(a)-1)
  • Amounts paid for acquisition or production of tangible property (Reg. 1.263(a)-2)
  • Amounts paid for improvements to tangible property (Reg. 1.263(a)-3)
  • Repairs and maintenance (Reg. 1.162-4)
  • Materials and supplies (Reg 1.162-3)

Part II of this series discusses final rules related to amounts paid to acquire, produce, improve, repair or maintain tangible property.

Amounts Paid to Acquire or Produce Tangible Property

Under final regulations, §1.263(a)-2 requires that, except as allowed by rules relating to materials and supplies (Reg. 1.162-3) and de minimis expenditures (Reg. 1.2639(a)-1(f)), all amounts paid to acquire or produce tangible real or personal property must be capitalized. As compared to Reg. 1.263(a)-3, which primarily addresses expenditures made with respect to tangible property previously acquired by taxpayers, Reg. 1.263(a)-2 primarily addresses expenditures incurred to obtain or create an item of property not previously owned.

For purposes of analyzing expenditures under the final regulations, and for purposes of identifying the type of property to which an expenditure applies, the final 263(a) regulations refer to regulations under Code Section 48. “Tangible personal property” means any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including structural components of such buildings or structures). Tangible personal property includes all property (other than structural components) which is contained in or attached to a building.

Real property is defined as land and improvements to land, including buildings and other inherently permanent structures. The term “building” generally means any structure enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display or sales space. For purposes of Reg. 1.263(a)-2, real property also includes other tangible property as defined by Reg. 1.48-1(d). The act of producing real or personal property is defined broadly and includes the acts of constructing, building, installing, manufacturing, developing, creating, raising or growing tangible property.

The final regulations capture and require the capitalization of both direct and indirect expenditures that result in the production or acquisition of property. In general, the amount paid to acquire or produce a unit of property (UOP) includes the invoice price (the cost of the item of property itself), transaction costs (referred to as “inherently facilitative costs” in the final rules), and amounts paid for work incurred prior to the date the subject property is placed in service. In an effort to minimize controversy with taxpayers regarding costs it considers to be facilitative, the IRS provides Reg. 1.263(a)-2(f). This section contains an extensive list of inherently facilitative costs that must be capitalized, including:

  • Transportation costs;
  • Appraisals or valuations;
  • Costs of negotiation;
  • Certain contingent fees (e.g., contingent broker commissions);
  • Application fees and permits;
  • Transfer taxes and other conveyance fees;
  • Architectural, engineering and similar design fees; and
  • Costs related to like kind exchanges

Taxpayers should be aware that certain indirect expenditures are expressly identified as not subject to capitalization under Reg. 1.263(a)-2:

Certain investigative and decision-making expenditures. Amounts paid by taxpayers in the process of investigating or evaluating the acquisition of real property are deductible, if the amount paid relates to activities performed in the process of determining whether to acquire real property and/or which real property to acquire (sometimes called the “whether or which rule”). This rule applies only to real property; amounts paid to evaluate personal property must be capitalized. It should be noted that expenditures that result in the acquisition of personal property together with real property (for example, the purchase of a building plus furniture contained therein) must be allocated between items of personal and real property, and the amount allocated to personal property must be capitalized into the basis of the subject personal property.

Amounts paid for employee compensation and overhead. Amounts related to employee compensation or overhead are not required to be capitalized. Taxpayers may elect to treat expenditures paid for employee compensation or overhead as facilitative costs, and therefore may capitalize those costs. The election is made by capitalizing the subject costs on the taxpayer’s timely filed original Federal tax return.

Amounts Paid to Improve, Repair or Maintain Tangible Property

The Unit of Property and Functional Interdependence Concepts

Few areas of the 263(a) regulations generate as much controversy between taxpayers and the IRS as do the rules under Reg. 1.263(a)-3. The ever-present dilemma for taxpayers is how to determine when an asset has been improved versus when it has merely been maintained or repaired. How does one discern when an asset has increased in value or had its useful life extended? What constitutes an “incidental” repair? What is “maintenance”? While taxpayers were hoping for bright line tests to answer these and similar questions, the final regulations still rely on analysis of facts and circumstances to determine how to treat such expenditures. The application of the new regulations to amounts paid will likely remain a source of contention between taxpayers and the IRS, but the final rules provide numerous examples of typical transactions and their treatment to help guide taxpayers. Central to any analysis under Reg. 1.263(a)-3 is understanding the concept of the “unit of property” and “functional interdependence.”

The general rule of Reg. 1.263(a)-3 requires that amounts paid to improve a unit of property must be capitalized. An amount paid is considered an improvement to a UOP if it results in one of the following three outcomes:

  • Results in a betterment to the UOP;
  • Restores the UOP; or
  • Adapts the UOP to a new or different use.

The regulations generally define units of property by reference to: (1) buildings and structural components, and (2) assets other than buildings and structural components (i.e., everything else). Because the accurate application of the final regulations is dependent upon defining the asset (i.e., the unit of property) with respect to which an expenditure is made, it is important for taxpayers to understand the conceptual framework of functional interdependence and units of property.

In the case of buildings, the overall UOP is the building itself (as defined in Reg. 1.48-1(e)(1)) plus all structural components (as defined in Reg. 1.48-1(e)(2)). The IRS, in an effort to insure uniform application of the final rules to all types of buildings, further distinguish between elements of the building structure and certain specifically identified functional systems of a building. This further delineation establishes subsets of building components that must be analyzed as separate units of property. Under the new regulations, the units of property associated with buildings are:

  • The building structure and structural components, except for those systems defined in items 2 through 9 hereunder
  • Heating, ventilation and air conditioning systems (including motors, compressors, boilers, furnaces, chillers, pipes, ducts and radiators)
  • Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste to and from the property line and between buildings and permanent structures)
  • Electrical systems (including wiring, outlets, junction boxes, lighting fixtures, and site utility equipment used to distribute electricity from the property line to and between buildings and other permanent structures)
  • All escalators
  • All elevators
  • Fire protection and alarm systems (including sensors, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm controls panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment such as extinguishers and hoses)
  • Security systems for protection of the building and its occupants (including window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit)
  • Gas distribution system (including associated pipes and equipment used to distribute gas to and from the property line and between buildings or permanent structures)

Taxpayers should understand that this is a significant change from previously issued proposed regulations, given that under prior guidance taxpayers treated the entire building, inclusive of the now separately identified systems, as a single unit of property. For example, under prior guidance expenditures related to heating, ventilation, and air conditioning (HVAC) systems may have been deducted based on the analysis that the UOP, the building, was not improved. Under final 263(a) rules the analysis must look at only the HVAC system as the UOP.

Rule for lessees. In the case of lessees of buildings, the unit of property is each building and its structural components where the lessee leases the entire building. Where the lessee leases a portion of a building (e.g., an office, a floor, or certain square footage), the unit of property is that portion of each building, and the structural components associated with that portion of each building, subject to the lease. With regard to the classification of an amount paid as a leasehold improvement, it should be noted that an expenditure related to work previously performed on a leased building (e.g., a change to a prior renovation) is analyzed with respect to its relation to the entire building, not the prior renovation.

In the case of property other than buildings (typically equipment and processing systems), all of the components that are functionally interdependent comprise a single unit of property. Functionally interdependent components are those where the placing in service of one component is dependent upon the placing in service of one or more other components, where such components together form a complete system. The final regulations discuss three basic classes of property other than buildings:

  1. “Plant property”, which means functionally interdependent machinery or equipment (other than network assets) used to perform an industrial process
  2. “Network assets”, which means railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines; and
  3. General purpose systems that are not plant property or network assets.

The final rules extend the analysis of functional interdependence to distinguish between separate components of plant property that perform discrete or major functions within the functionally interdependent system. Because understanding and defining the unit of property is critical to determining whether an amount is deductible or capital, manufacturers, utility operators and similar taxpayers should give particular attention to understanding the analysis of discrete or major functions in connection with the concept of functional interdependence.

See IRS Examples: Building Systems and Plant Property

After establishing the unit of property to which an expenditure relates, taxpayers must determine whether the expenditure constitutes:

  • A betterment of the unit of property;
  • Restoration of the unit of property; or
  • An adaptation of the unit of property to a different use.

If the character of an expenditure is determined to align with any of the aforementioned categories of improvements, that expenditure must be capitalized. Before undertaking an analysis of whether an amount must be capitalized under §1.263(a)-3, taxpayers should take note of the following special rules.

Repairs and maintenance completed simultaneously with improvements are deductible. Under previous temporary regulations, the rehabilitation doctrine required that a taxpayer capitalize all costs (including, for example, otherwise deductible repair costs) incurred at the same time as an improvement. For example, if a taxpayer requested a paving contractor to patch potholes in an existing parking lot at the same time as the contractor was paving a new, expanded parking area, the patching work would be required to be capitalized. This treatment was required even though the patching work would otherwise be a deductible repair. Final regulations under 1.263(a) allow qualifying costs to be deducted as repairs or maintenance regardless whether such expenditures are incurred at the same time as an improvement project.

Removal costs may be deductible. If a taxpayer disposes of a depreciable asset and takes the adjusted basis of the asset or asset component into consideration for purposes of calculating gain or loss, then the costs to remove the asset or asset component are deductible.

Safe harbor for small taxpayers. Under certain circumstances, a small taxpayer may not have to capitalize an amount determined to be an improvement. A small taxpayer is one with: (1) less than $10 million in average gross receipts for the preceding three years; and (2) unadjusted basis in the building to which an expenditure relates of $1 million or less. If an eligible small taxpayer, then the taxpayer may annually deduct the lesser of $10,000 or 2 percent of the unadjusted building basis. In calculating total deductions related to tangible property the taxpayer must include all expenditures for repairs, maintenance, improvements and similar activities. A small taxpayer elects to deduct amounts paid for improvements by attaching a statement to the taxpayer’s timely filed original Federal tax return.

Safe harbor for routine maintenance. Any amount paid for routine maintenance on a unit of tangible personal property, a building, or a major system of a building, is not considered an improvement to that unit of property. Therefore, the amount paid may be deducted. In the case of buildings, maintenance activities can only be considered routine if the taxpayer reasonably expects to perform the activities more than once during the 10-year period beginning when the subject building structure or system is placed in service. In the case of property other than buildings, maintenance activities can only be considered routine if the taxpayer expects to perform the activities more than once during the class life of the unit of property.

Optional election to capitalize repair and maintenance costs. Taxpayers may treat maintenance expenditures differently for purposes of tax reporting versus financial statement reporting. If desired, taxpayers may elect to capitalize amounts otherwise deductible for tax purposes. This election allows taxpayers to align the tax treatment of an expenditure with the treatment for purposes of financial statements. It also relieves the administrative and reporting burden of tracking book-tax differences. The election is made annually by attaching a statement to the taxpayer’s timely filed original tax return.

Betterments

An expenditure constitutes a betterment of a UOP if the expenditure:

  • Ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;
  • Is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component to the unit of property or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or
  • Is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the unit of property.

Certain caveats to the requirement to capitalize costs exist under betterment rules, although an expenditure may be required to be capitalized under another provision of Internal Revenue Code. Specifically:

Changes in technology and replacement parts not a betterment. If an expenditure is made to replace a part of a unit of property, and a comparable replacement part is not available (e.g. due to technological changes or product enhancements), a betterment does not necessarily occur merely because the replacement part is improved over the part being replaced. Through this rule, a taxpayer is not deemed to have bettered a unit of property merely because a better quality component has succeeded a prior component as the standard replacement part to be used in the unit of property.

Correcting normal wear, tear and/or damage not a betterment. In cases where an expenditure is made to relieve the effects of normal wear, tear and/or damage occurring during a taxpayer’s use of the unit of property, the determination of whether a betterment has occurred is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the time period when the property incurred the normal wear, tear and/or damage. The result of this rule is that returning a unit of property to its condition immediately prior to use by the taxpayer does not, of itself, constitute a betterment.

See IRS Examples: Betterments

Restorations

Under the final regulations, taxpayers must capitalize amounts paid to restore a unit of property. An expenditure restores a unit of property if it:

  • Is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component, other than a casualty loss under Reg. 1.165-7;
  • Is for the replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
  • Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under Code Section 165, or relating to a casualty event described in Code Section 165;
  • Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
  • Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; and
  • Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property

Restorations typically involve events that trigger recognition of a loss, as opposed to activities that generate ordinary deductions. As such, it is likely that the requirement to capitalize expenditures due to application of the restoration rules will be uncommon. Taxpayers should note that, in general, a comprehensive maintenance program, even if substantial, does not typically return a unit of property to like new condition.

Special rule related to casualty losses. Previous temporary regulations required the capitalization of the entire expenditure related to restorations of casualty losses. This created unfavorable results for taxpayers owning property with a high fair market value but low adjusted basis, where such property was destroyed by a casualty event. The final regulations limit the amount of restoration expenditures required to be capitalized to the taxpayer’s adjusted basis in the damaged property prior to the event. Expenditures in excess of the adjusted basis in the property may be deducted.

See IRS Examples: Restorations

Adaptation to different use

The rules of 1.263(a)-3(l) govern the capitalization of amounts paid to adapt a unit of property to a new or different use. An amount is deemed paid to adapt a UOP to a different use if the adaptation is inconsistent with the taxpayer’s ordinary use of the UOP at the time it was placed in service.

See IRS Examples: Different Use

The IRS has provided numerous examples in the final regulations to illustrate the concepts discussed above. Taxpayers are encouraged to review those examples as guidance for determining the treatment of expenditures made in the course of operating their business.

Please look for more information regarding the final repair and maintenance regulations in upcoming segments from this series. Please contact your KSM advisor with questions about new rules under Reg. 1.263(a).

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The Final “Repair and Maintenance” Regulations – Explaining the Impact on Business (Part I)

Posted 3:53 PM by

Summary – The following is Part I of a multi-part series discussing the impact of new regulations governing when taxpayers deduct or capitalize expenditures related to tangible property. (View Part II.) With the effective date of Jan. 1, 2014, quickly approaching, taxpayers should give immediate attention to these new rules, as commentators agree that nearly all taxpayers will be affected. The new rules may require significant changes to a taxpayer’s practices with respect to the capitalization or deduction of certain expenditures.

On Sept. 13, 2013, the Internal Revenue Service (IRS) released final rules concerning when taxpayers must capitalize and when they may deduct an expenditure related to acquiring, producing, maintaining or repairing tangible property. The final rules replace and remove previously issued temporary regulations under Internal Revenue Code (Code) Sec. 263(a) and 162(a). These new regulations must be followed by all taxpayers for tax years beginning Jan. 1, 2014. At a taxpayer’s choosing, these rules may be followed by taxpayers for tax years beginning Jan. 1, 2012. 

Code Sec. 263(a) requires the capitalization of amounts paid to acquire, produce or improve tangible property. A taxpayer generally recovers capital costs over time through depreciation or amortization deductions, or at the time of disposition, an inherently slower rate of recovery of any expenditure.  Alternatively, Code Sec. 162(a) allows the deduction of ordinary and necessary business expenses incurred during the taxable year, including the cost of supplies, repairs and maintenance. 

The new regulations attempt to provide guidance for distinguishing between deductible supplies, repairs, and maintenance, and capital expenditures. The new rules also discuss the disposition of depreciable property under Code Sec. 167 and 168. The final regulations cover five major topics:

  • Capital expenditures (Reg. 1.263(a)-1)
  • Amounts paid for acquisition or production of tangible property (Reg. 1.263(a)-2)
  • Amounts paid for improvements to tangible property (Reg. 1.263(a)-3)
  • Repairs and maintenance (Reg. 1.162-4)
  • Materials and supplies (Reg 1.162-3)

Part I of this series covers final rules related to capital expenditures.

Reg. 1.263(a)-1 provides that no deduction is allowed for: 1) any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or 2) any amount paid in restoring property or in making good the exhaustion thereof for which a depreciation or amortization deduction has been taken. The ongoing dilemma for taxpayers has been the application of these rules to business activity. What constitutes an “incidental” repair? What is “maintenance?” How does one discern when an asset has increased in value or had its useful life extended? Can amounts that are capital in nature be deducted even though they are  small in cost and do not distort income in the current or future taxable years?

Although Code states that no deduction is allowed for capital items, in practice taxpayers of all sizes frequently follow an expensing policy whereby expenditures under a certain cost threshold, whether capital or deductible, are deducted in the current taxable year. Such expensing policies were not previously addressed in Code or Regulations, except to the extent of rules requiring that methods of accounting not materially distort income in any taxable year. In an attempt to reduce controversy regarding expensing policies and promote consistency among taxpayers, the IRS has created rules to address expensing policies. 

Called the “de minimis rules,” the final rules under Reg. 1.263(a)-1 establish safe harbors under which companies may deduct expenditures with a cost below certain thresholds. The first safe harbor provision allows taxpayers to deduct in the current taxable year amounts paid to acquire or produce tangible property, or for materials or supplies, equal to or less than $5,000 per invoice, or per item reported on an invoice.

This $5,000 safe harbor is not available to all taxpayers. In order to qualify, a taxpayer must prepare:

  • A financial statement (the 10-K or the Annual Statement to Shareholders) required to be filed with the Securities and Exchange Commission (SEC)
  • A certified audited financial statement that is accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional) that is issued for:
  • Credit purposes;
  • Reporting to shareholders, partners, or similar persons; or
  • Any other substantial non-tax purpose
  • A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the IRS).

In addition to preparing one of the above reports (called “applicable financial statements”), taxpayers must:

  • Have, at the beginning of the taxable year, a written accounting procedure treating as an expense for non-tax (i.e., book) purposes:
  • Amounts paid for property costing less than a specified dollar amount; or
  • Amounts paid for property with an economic useful life (defined under Reg. 1.162-3(c)(3)) of 12 months or less;
  • Treat the amount paid for the property as an expense on its applicable financial statement in accordance with its written accounting procedure
  • Limit the application of the policy to amounts paid for property that does not exceed $5,000 per invoice, or per item as reported and charged per invoice.

Example: De minimis safe harbor; taxpayer with applicable financial statement. Company C reports its financial results on an applicable financial statement. C has a written accounting policy at the beginning of Year 1, which is followed by C, to expense amounts paid for property costing $5,000 or less. In Year 1, C pays $6,250,000 to purchase 1,250 computers at $5,000 each. C receives an invoice from its supplier indicating the total amount due ($6,250,000) and the price per item ($5,000). Assume that each computer is a unit of property under §1.263(a)-3(e). The amounts paid for the computers meet the requirements for the de minimis safe harbor. If C elects to apply the de minimis safe harbor, C may not capitalize the amounts paid for the 1,250 computers or any other amounts meeting the criteria for the de minimis safe harbor. Instead, C may deduct these amounts under §1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.

For companies who do not qualify for the $5,000 de minimis safe harbor, Reg. 1.263(a)-1 provides a similar safe harbor with a lower cost limit. Under this lower safe harbor, taxpayers may deduct in the current taxable year amounts paid to acquire or produce tangible property, or for materials or supplies, equal to or less than $500 per invoice, or per item reported on an invoice. In order to qualify for this safe harbor, a taxpayer must:

  • Not prepare an applicable financial statement
  • Have at the beginning of the taxable year a written accounting procedure treating as an expense for non-tax (i.e. book) purposes –
  • Amounts paid for property costing less than a specified dollar amount; or
  • Amounts paid for property with an economic useful life (defined under Reg. 1.162-3(c)(3)) of 12 months or less
  • Treat the amount paid for the property as an expense on its books and records in accordance with its written accounting procedure
  • Limit the application of the policy to amounts paid for property that does not exceed $500 per invoice, or per item as reported and charged per invoice.

Example: De minimis safe harbor; taxpayer without applicable financial statement. In Year 1, Company B purchases 10 printers at $250 each for a total cost of $2,500, as indicated by the invoice. Assume that each printer is a unit of property under Section 1.263(a)-3(e). B does not have an applicable financial statement. B has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $500, and B treats the amounts paid for the printers as an expense on its books and records. The amounts paid for the printers meet the requirements for the de minimis safe harbor under Section 1.263(a)-1. If B elects to apply the de minimis safe harbor under this paragraph (f) in Year 1, B may not capitalize the amounts paid for the 10 printers or any other amounts meeting the criteria for the de minimis safe harbor. Instead, B may deduct these amounts under Section 1.162-1 in the taxable year the amounts are paid provided the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business.

In addition to the above requirements of the de minimis rules, taxpayers should be aware of several other elements of the final regulations:

The de minimis safe harbor is elective. Taxpayers relying upon the de minimis safe harbor must, in each taxable year in which amounts are deducted under the safe harbor, attach to their timely filed original federal tax return a statement title “Section 1.263(a)-1(f) de minimis safe harbor election.” The statement must include the taxpayer’s name, address, taxpayer identification number, and a statement that the taxpayer is making the de minimis safe harbor election under Reg. Section 1.263(a)-1(f).

Soft costs of tangible property not considered. For property deducted under the de minimis safe harbor, “soft costs” associated with acquisition or production of such property are not included in applying the $5,000 or $500 limits if the costs are not included on the same invoice as the tangible property. Soft costs might include, for example, delivery fees, installation services or similar costs necessary to put the property into service. If multiple items of property are billed on one invoice, along with soft costs that apply to some or all of the items of property, the taxpayer must allocate the soft costs to each item using a reasonable method. Reasonable methods may include, but are not limited to, specific identification, pro rata allocation, or weighted average based on the property’s relative cost.

Materials and supplies must be deducted. If a taxpayer elects to use the de minimis safe harbor, the taxpayer must also apply the safe harbor toward materials and supplies (as defined under Reg. 1.162-3).

Section 263A rules still apply. Amounts otherwise deductible under the de minimis safe harbor may be subject to the capitalization requirements of Code Sec. 263A. Code Sec. 263A governs direct or indirect costs allocable to property produced or acquired by the taxpayer for resale.

Anti-abuse rule. If a taxpayer acts to manipulate a transaction with the intent of circumventing the $5,000 or $500 expensing limits, the IRS will make the necessary adjustments to carry out the purposes of 1.263(a)-1. For example, if a taxpayer acquires an item of property and attempts to divide the acquisition cost of the item between multiple invoices, each of which are below the $5,000 or $500 expensing limits, the transaction may be recharacterized. Taxpayers must consider the complete and total expenditure for an item of property when applying the de minimis rules.

Please look for more information regarding the final repair and maintenance regulations in upcoming segments from this series. If you have questions about the de minimis safe harbor provisions, please contact your KSM advisor.

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Q&A on Affordable Care Act’s Individual Mandate

Posted 4:32 PM by

How does it affect individuals?

While Congress recently delayed employers’ responsibilities under the Affordable Care Act until 2015, the deadline for the Act’s Individual Mandate is still Jan. 1, 2014. The Mandate requires most individuals to have minimum essential health insurance coverage for themselves and their dependents. Those who do not comply will be subject to monthly penalties calculated on Form 1040 and paid as part of their federal income tax. Some individuals will be exempt from the Individual Mandate and others may receive financial assistance.

Who is exempt from the coverage rules?

The following individuals can qualify as exempt:

  • Members of recognized religious sects
  • Members of healthcare sharing ministries
  • Nonresident aliens and illegal aliens; incarcerated individuals
  • American Indian tribe members
  • Those who have a short coverage gap (less than three months; only one permitted per year)
  • Those who do not have to file a personal income tax return
  • Individuals who cannot afford coverage (the coverage contribution would exceed eight percent of adjusted household income)
  • Individuals with a hardship exemption certificate

Exemptions are granted either through a state marketplace or by the Internal Revenue Service (IRS) through the income tax filing process. If an individual’s status changes during the year from exempt to nonexempt, the taxpayer would be responsible for having minimum essential health insurance for the remaining calendar months or would owe the penalty for those months. Coverage for one day of a month counts for the entire month.

What is the minimum essential coverage?

Generally, individuals will obtain the required minimum essential coverage through: an eligible employer-sponsored plan; an individual plan purchased through a state insurance marketplace; or, in states that have chosen not to establish a marketplace, a federal exchange. Individuals qualifying for Medicare Part A, Medicaid or certain other government-sponsored programs are considered to have the minimum essential coverage.

What is a state insurance marketplace?

State health insurance marketplaces, or Exchanges, will help individuals purchase affordable coverage. Exchanges will be supervised and provide access to Qualified Health Plans (QHPs) but will not issue insurance. Additionally, each Exchange will have a Small Business Health Options Program (SHOP) so certain small employers can offer their employees health insurance at an affordable rate. To purchase coverage through the Exchange, an individual will have to complete an application. The per-month cost of plans in Indiana is expected to range from under $100 for catastrophic coverage for individuals to almost $1,000 for premium coverage for a family of four. See Health Insurance Marketplace Premiums for 2014 for more detail on plan cost.

What does not qualify as minimum essential coverage?

Certain specialized coverage and limited scope insurance will not qualify. Examples of these types of nonqualifying plans include: workers’ compensation or similar insurance; dental or vision benefits; coverage where the medical benefits are secondary or incidental to the policy’s other insurance benefits; and coverage for only a specified disease or illness.

How does this affect U.S. citizens or nationals residing outside the U.S.?

Those who live outside of the U.S. and meet either the bona fide residence test or the physical presence test for any month after Dec. 31, 2013, are considered to have met the coverage requirement for that month. In addition, individuals who are a bona fide resident of any U.S. possession for any month after Dec. 31, 2013, are deemed to meet the minimum essential coverage requirement for that month.

What about the Individual Shared Responsibility Penalty?

For every month that a nonexempt individual or the individual’s nonexempt dependent lacks minimum essential coverage, a penalty will be imposed. According to the Congressional Budget Office, less than two percent of Americans will owe this penalty. Note: An individual is subject to the penalty only if he or she is alive for the entire month. Therefore, for example, a child born April 3 could not be subject to the penalty until May.

How is the penalty calculated?

The individual shared responsibility penalty is: 1) the lesser of the sum of the monthly penalty amounts for each individual claimed on Form 1040; or 2) the sum of the monthly national average premium for bronze-level qualified health plans that provide coverage for the applicable shared responsibility family. Note: Generally, a bronze plan is one that pays for 60 percent of all healthcare costs for an average person. The individual is responsible for the other 40 percent of costs.

The monthly penalty amount is an amount equal to one-twelfth of the greater of a flat dollar amount or an excess income amount that is based on a percentage of income. The flat dollar amount is the lesser of the sum of the applicable amounts for all individuals included in the taxpayer's shared responsibility family, or 300 percent of the applicable amount for the calendar year in which the tax year ends. For nonexempt individuals who are at least age 18, the applicable dollar amount is $95 for 2014, $325 for 2015, and $695 for 2016. The dollar amount for individuals who are under 18 on the first day of a month is half of the previously listed amounts. Note: When an individual turns 18 during the year, separate calculations must be performed to determine any penalty applicable for the months in the year before the birthday and the months after.

The excess income amount is the excess of the taxpayer's household income for the tax year over a threshold gross income amount multiplied by the income percentage. The threshold gross income amount is the amount of income required for an individual to file an income tax return for a particular year. The income percentage is 1 percent for tax years beginning in 2013 and 2014; 2 percent for tax years beginning in 2015; and 2.5 percent for tax years beginning in 2016 and later years.

Example: Steven and Vanessa are a married couple with one dependent child, Micah, who is five years old in 2014. No member of the family has minimum essential coverage. Assume their annual household income is $119,500. Additionally, assume the filing threshold for a married couple is $19,500 for 2014 and continues to apply for tax years 2015 and 2016. For the applicable years, assume that the annual national average bronze plan premium for a family of three (two adults, one child) is $12,000.

Steven and Vanessa’s excess income each year is $100,000 ($119,500−$19,500). The flat dollar amount for 2014 would be $237.50 ($95 X 2.5). Since their decline coverage in 2014, they would pay a $1,000 penalty (one percent of their excess income). If they had coverage for only two months, the penalty would decrease to $833 ($1,000/12 X 10). The penalty amount for a full year of noncoverage would rise to $2,000 in 2015 and $2,500 in 2016.

How is the penalty reported and enforced?

The individual shared responsibility penalty will be reported on an individual’s income tax return. The IRS has indicated new forms will be developed that taxpayers will use to calculate the penalty. The penalty will be assessed and collected in the same manner as other penalties and is due upon notice and demand by the IRS. A taxpayer who fails to pay the penalty when filing a Form 1040 will receive a notice from the IRS. If the taxpayer still does not pay the penalty, the IRS can collect the penalty by reducing any future income tax refunds or offsetting credits the taxpayer may be due.

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