Texas CPA Group Comments on Proposed 'Repair' Regs

Dear Commissioner Shulman:

The Texas Society of Certified Public Accountants (TSCPA) is a nonprofit, voluntary professional organization representing more than 29,000 CPAs. One of the expressed goals of TSCPA is to speak on behalf of its members when such action is in the best interest of its constituency and serves the cause of CPAs in Texas, as well as the public interest. TSCPA has established a Federal Tax Policy Committee (FTP) to represent those interests on related tax matters. The FTP has been authorized by TSCPA's Board of Directors to submit comments on such matters of interest to committee membership. The views expressed herein, however, have not been submitted for approval by the Board of Directors or Executive Board and, therefore, should not be construed as representing the views or policies of TSCPA.

We appreciate the opportunity to provide comments to the Internal Revenue Service (IRS) on its temporary and proposed regulations that are also referred to as "repairs regulations."

The TSCPA commends the IRS and the Department of the Treasury for issuing the proposed regulations on the capitalization of costs incurred for tangible property. The repair regulations have a significant impact on most industries and corporate taxpayers. We, therefore, appreciate that the IRS has recently issued related Revenue Procedures 2012-19 and 2012-20, as well as an extended deadline for public comments. However, we believe that the issuance of temporary regulations in connection with such far-reaching proposed changes -- changes that would require significant modifications to the accounting systems of many taxpayers -- will create many unanticipated (and unnecessary) problems.

Materials and Supplies

The temporary and proposed regulations (hereinafter "the regulations") provide that a unit of property costing $100 or less can be expensed as a supply. The $100 figure does not reflect the reality of doing business in 2012 and the reduction in the value of a dollar by reason of inflation. For example, at a time when the ink cartridges for two desktop printers will cost more than $100, a deduction of $1,000 or more with provision for inflation adjustment would be more reasonable. Without this higher threshold, businesses will be required to develop and enforce detailed policies as to which supplies can reasonably be expected to be consumed within 12 months of being placed in service.

The regulations offer an election to expense these items as part of the de minimis expense deduction in an attempt to mitigate the capitalization requirement of these items. However, to benefit from the election, taxpayers must implement a process to track items of nominal value that are not currently tabulated. The additional time, effort and expense required to track and accumulate these individual small expenditures to ascertain that they do not cumulatively exceed the de minimis amounts described below will significantly offset the benefit of the availability of the current tax deduction. We suggest a more practical approach to items of relatively minimal value.

De minimis Concept

As drafted in the regulations, in order for a taxpayer to take advantage of the de minimis rule, the taxpayer would have to have an "applicable financial statement" (AFS) and a written deduction policy at the beginning of the year the deduction is claimed. The definition of what qualifies as an AFS is narrowly written to generally include only audited financial statements or financial statements that will be submitted to a governmental agency. The requirement of the AFS will generally limit the availability of this important provision to larger publicly-held businesses. Many, if not most, small businesses will not qualify. The practical effect of this limitation will be to impose significantly greater recordkeeping requirements on businesses that are the least able to afford the time, effort and expense that this requires. Additionally, although these deductions represent timing differences, it will have the effect of imposing a higher effective current tax rate on small businesses than that of identical larger competitors that have financial statements that qualify as AFS. We believe much of this concern could (and should) be addressed by including compilations and reviews in the definition of an AFS. The definition of an AFS should be expanded in other contexts as well. For example, real estate projects are generally required to submit a financial statement to their lender(s) that may not technically constitute a review or compilation. However, because the lender has a vested financial interest in the accuracy of these statements, a financial statement submitted to a lender that holds a lien on the property should also be included in the definition of an AFS.

The requirement that businesses cannot apply the de minimis rule unless they have a written expensing policy at the beginning of the year also presents a practical problem for many taxpayers and is a perfect example of the inappropriateness of these temporary regulations. These lengthy regulations were first made available in late December during the holiday season. It is unlikely that many calendar year companies had sufficient opportunity to digest and understand this requirement in time to draft such a document by the beginning of 2012. A literal reading of the regulation would prohibit such a company from utilizing the de minimis exception this year. We believe the final regulations should make it clear that a company can make the drafting of such a document retroactively effective back to the beginning of 2012 and that policy should be announced immediately by the IRS. In fact, a generous phase-in period for taxpayers to gain an understanding of, and come into compliance with, such a requirement is the fair course of action for the government.

The de minimis rule permits a current year deduction of as much as 0.1 percent of the taxpayer's gross receipts or 2 percent of the taxpayer's total depreciation and amortization for the tax year in which the deduction is claimed. Making the test dependent on factors such as annual income and depreciation that won't be known until the end of the year creates a high level of uncertainty as to the magnitude of repairs that can be expensed. A company that reasonably expected its gross receipts would be at least as high as the prior year, but whose business dropped unexpectedly in the fourth quarter, would be faced with having to go back to reconstruct its records for "repair" expenditures it had expensed earlier in the year.

We fully support the concept of a de minimis rule, but feel the ceiling limitation as currently written undermines the ultimate goal of simplification by adding increased burden to the taxpayer and IRS. It has been a commonly accepted policy for financial accounting purposes to accept a minimum capitalization policy and many taxpayers follow this same policy for tax reporting purposes. Allowing the taxpayer to adopt the capitalization policy used for AFS purposes for tax purposes would greatly reduce the burden on the taxpayer and the IRS, and has the advantage to all of administrative feasibility. Additionally, to the extent that these amounts are subject to financial audit or other attest function and are in accordance with Generally Accepted Accounting Principles (GAAP) we believe this would provide substantial safeguards against distorting income. Furthermore, we suggest that taxpayers be granted the option of electing the above alternative or basing the rule on a 0.1 percent and the 2 percent calculation based on the prior year's figures or even a moving average of the prior two or three years.

Unit of Property

The regulations require that each of eight "systems" (electrical, heating, plumbing, etc.) within a building be considered separately from the building structure in applying the improvement rules. The systems component approach of the regulations will, as the systems are replaced or improved, impose a cost segregation regime on real property counter to longstanding Congressional and IRS policy prohibiting the treatment of these "systems" as separate and distinct assets.¹ Accordingly, building owners generally have not maintained records of cost basis or repair expenditures for these "systems." Such records will be necessary for the implementation of the regulations as drafted and it is essential that the regulations address this issue. Moreover, if cost segregation were to be permitted for these systems, it would certainly demand that the useful life of a heating, ventilation and air conditioning (HVAC) system be less than 39 years.

Furthermore, the regulations specify that a "betterment" of one of these systems not only has to be capitalized, but the capitalization must be depreciated over the modified accelerated cost recovery system (MACRS) life of a similar building regardless of the remaining useful life of the subject matter building. This will impose an unrealistic timing of the deduction in many circumstances. Many, if not most, real property owners expect to replace HVAC systems two or three times during the 39-year MACRS life of a commercial building. These regulations recognize the HVAC system as a separate asset from the building, even though the Internal Revenue Code does not -- with the result that the taxpayer owning the building will be required to deduct the improvement/repair of the HVAC system over a much longer period than its useful life, a most unfair result. A more equitable approach would be to permit depreciation over a shorter period not to exceed the remaining MACRS life of the building.

The effect of this rule is somewhat mitigated by the provision in the regulations that permits the building owner to expense the remaining basis of the "old" system when it is replaced. However, this will pose a difficult challenge for building owners because, as discussed above, in accordance with the historic policy of the IRS, the "systems" and the structure of a building have been treated and documented as a single unit. Accordingly, it has not been necessary to document the cost of these systems separately from the overall cost of the building. Example 5 in the regulations attempts to address this issue by permitting the building owner to "use a reasonable method that is consistently applied to all of the structural components of the building." As a practical matter, however, coming up with a reasonable estimate of the cost of the elevator in the example will be very difficult, especially for buildings that have been in service for many years. Without a commercially reasonable safe harbor or bright line test that can be applied in these circumstances, this will be an area left open to interpretation that is certain to result in frequent controversies between taxpayers and field agents.

Additionally, because it was not necessary in the past, taxpayers owning multiple buildings typically did not maintain records detailing which buildings received the "repairs" under circumstances where the regulations might now require that the "expense" be capitalized. For example, assume an individual owns one rental real estate project consisting of 10 apartment buildings, each of which has 10 units with A/C compressors. The owner has records indicating that 10 of those units have been replaced. If those 10 units were all in one of the buildings, the regulations would mandate capitalization of those replacements. If, on the other hand, the replacements reflected just one unit in each of the 10 buildings, it would seem that could be considered a repair. However, because this level of detail was not deemed necessary in the past, the owner would have had no reason to maintain sufficient records to know which of the scenarios is applicable. One result will be that taxpayers will be required to undertake complex adjustments to their accounting systems for which a phase-in period is appropriate.

Betterments, Adaption and Restoration

The betterment term as used in the regulations specifies circumstances requiring capitalization. For example, retail stores frequently find it necessary to update ("refresh") their facility to attract and maintain their customer base. The regulations take the reasonable position that the cost of cosmetic and layout changes to make merchandise more attractive and accessible to customers is generally currently deductible. However, examples 6 and 8 take the exact opposite position, requiring capitalization of these same expenditures if such activity is undertaken at the same time and "directly benefited or were incurred by reason of" betterments to the store. It does not seem equitable that the exact same expenditures would be deductible by one store but not another just because of the surrounding circumstances. For example, a store may have to close for several days to replace its heating system. Closing the store would be an opportune time to make it more attractive with some cosmetic changes that arguably would not have been done but for the store closing. This presents a subjective decision as to whether those cosmetic changes were "incurred by reason of" the betterment. To avoid this subjective determination, it appears the store owner might be wise to close the store on two different dates to separate the two projects leading to inherently uneconomic behavior forced by arbitrary tax rules. Surely tax regulations can and should avoid this unnecessary regulatory impact on small business.

Similarly, the regulation's examples distinguish between moving a machine from one location to another, which is described as currently deductible, from the situation where the movement of the machine directly benefits, or is done as part of an improvement of the machine. Again, the exact same expense is treated differently if its timing coincides with a "betterment" of the machine in spite of the fact that the "betterment" and the cost of moving the machine may have little relationship to each other. Machines are often moved to improve the efficiency of an assembly line. Coincident with the move, the machine could be placed on a new pad that will decrease the vibrations of the machine. The cost of moving the machine is substantially greater than the cost of the pad. Although the new pad might slightly improve the operation of the machine, it would not have been done but for the move. In this circumstance, it does not seem reasonable to have to capitalize the cost of the move merely because it takes place in the same time frame as the "betterment" of the machine.

Section 1.263(a)-3T(h)(4), examples 6-8 discuss the building "refresh/remodel" concepts. Practically speaking, it will be difficult to determine when the appearance of a store is changed enough to be a betterment as opposed to a refresh. Example 7 states that the plumbing fixtures are replaced with "upgraded" fixtures, therefore resulting in a betterment. Changing to low water flow fixtures might be an upgrade. It would seem reasonable that merely upgrading a fixture with the same efficiency but a more modern look would come within the "refresh" category. Yet in example 20, merely changing the look must be capitalized. In the past, most businesses would have written off the costs in example 20, as they are immaterial compared to the entire plumbing system.

The regulations state that the "restoration" of a unit of property must be capitalized. The regulations define a restoration as any replacement of a "major component" or "substantial structural" part of the unit of property. In effect, this provision gives the IRS the capability to create new components within the established unit of property. Therefore, it is important for the regulations to provide objective guidance, perhaps in the form of specific thresholds, as to what constitutes a "major" component or a "substantial" structural part. Without such objective standards, this is likely to be an area of considerable controversy between taxpayers and examining agents.

481 Adjustments

The regulations provide specific guidance applicable to a taxpayer that had expensed as a repair in a prior year an expenditure that, under these regulations, should have been capitalized. In such a circumstance, the taxpayer would be required to utilize a change in accounting method under Code section 481 to reverse the expense and capitalize the expenditure. We believe these regulations should be applied using the "cut off" method for several reasons. First, going through the process of a change in accounting method is unnecessarily complex and will result in a significant expenditure of time, effort and funds to accomplish.

Secondly, simply because the taxpayer considered the expenditure to be currently deductible at the time it was incurred, it is unlikely that there will be adequate records to support the details necessary to make such a change accurate. Further, the regulations as drafted would require the taxpayer to determine whether the repair was done during the class life of the asset, thereby allowing it to be expensed, or after the class life expired, requiring capitalization. Finally, for items that typically are replaced several times during the class life cycle of the asset, the regulations would also require the taxpayer have the records enabling them to trace each "repair" item through the next replacement. For example, portions of a building's roof may have to be repaired on several occasions over the MACRS life of the building. Few, if any, building owners would have historical records in sufficient detail to know whether any of the later repairs were to portions of the roof that had been previously repaired. We suggest that the final regulations clarify that reasonable estimates such as those provided in Treas. Reg. section 1.263A-7 are permitted where more accurate information is not available. Requiring such a change for events that might have taken place several years prior is counter to both the longstanding policy supporting the statute of limitations and the prohibition on the retroactive application of substantive changes in the IRS administration of the tax law.

Relief Proposal

Many taxpayers may now find that the new regulations require them to capitalize items that they previously expensed, and they now face the trouble and expense of mastering 200 pages of regulations, identifying items that need to be changed, and going through a section 481 adjustment. As discussed above, many taxpayers may not have the detailed records necessary for items that were expensed years ago to be able to capitalize these items under the regulations. We propose that the IRS provide relief from the retroactive application of the regulations for the many businesses that had not exceeded the limits of section 179 for the year in question and could have immediately deducted these capital costs by electing section 179 treatment. Further, we urge generous transition time for taxpayers to deal with the massive amount of work to comply with these proposals.

In addition to our general concerns, we have some questions related to specific examples that should be modified and/or clarified:

• Section 1.162-3T(h) Examples 5, 8 and 14 -- De minimis rule

• These examples significantly expand what most businesses would consider "non-incidental" materials or supplies. To include items such as glass held to replace broken windows, fax machines, briefcases and inexpensive office chairs in the non-incidental category raises the issue of what could possibly qualify for a current deduction and is contrary to common sense.

• Section 1.168(i)-8T(d)(2) -- Nonrecourse debt

• This section states that if an asset is subject to nonrecourse indebtedness, its disposition is subject to section 1231 rather than an abandonment loss under section 165. Unlike an abandonment loss, a section 1231 loss may not be ordinary if you have 1231 gains. Section 1.168(i)-8T(h), example 5(iii), illustrates this. Note that example 5 does not say it is subject to nonrecourse debt, but that is presumably why section 1231 applies. Section 1231 should not apply at all -- the disposition has no effect on the nonrecourse debt. The component which replaces the retired one is subject to the nonrecourse debt in lieu of the retired component, so a taxpayer would be subject to section 1231 twice with respect to the same building component.

• Section 1.263(a)-3T(h)(4) -- Roof repairs/replacements

• See the attached list of cases where the courts reached decisions favorable to taxpayers that are counter to the conclusions in examples 12-15. Additionally, more guidance or examples are needed as to what is a significant part.

• Section 1.263(a)-3T(i)(5) Example 16 -- HVAC system

• The chiller unit is replaced with a more energy efficient one and is a betterment. However, the result does not appear to turn on that; it turns on the fact that the chiller performs a discrete and critical function. The example mentioning that it was a betterment raises the question of whether it would be deductible as a repair if it were not a betterment. In example 15, the furnace is not a betterment but does have to be capitalized.