Hospital Companies Find Repair Regs Fall Short of Goals

A coalition of investor-owned hospital companies (Vanguard Health Systems, Health Management Associates, Inc., HCA Holdings, Inc., Community Health Systems, Inc., LifePoint Hospitals, Inc., and Tenet Healthcare Corporation) ("the Investor-Owned Hospital Company Coalition" or the "Coalition") is writing in response to a Notice of Proposed Rulemaking¹ and Temporary Regulations² (the "2011 Regulations"), which request comments regarding proposed and temporary regulations under sections 162(a), 168, and 263(a) of the Internal Revenue Code of 1986, as amended, relating to the deduction and capitalization of expenditures related to tangible property.

According to the American Hospital Association, investor-owned hospitals account for approximately 17.6 percent of U.S. hospitals.³ It is also important to note that although investor-owned hospitals are not tax-exempt entities, they regularly provide unreimbursed charity care. In fact, according to studies performed by the Congressional Budget Office, investor-owned hospitals provide approximately the same percentage on charity care as tax-exempt nonprofit hospitals.⁴ Coalition members are the nation's leading investor-owned companies operating hospitals offering traditional acute care. They are committed to meeting the health care needs in communities across the country through their ownership of over 400 acute care facilities. Coalition members operate more than 86,000 acute care beds, and employ more than 286,000 employees throughout the United States.

The Coalition's hospitals are located in urban, suburban, and rural communities throughout the country, and as such, serve a diverse population with a range of healthcare needs. In many circumstances, a Coalition hospital is a community's sole hospital. In addition to hospitals, Coalition members operate numerous other healthcare facilities, including outpatient surgery centers, imaging centers and physician practices. Because the majority of costs affected by the 2011 Regulations relate to Coalition members' hospital facilities, the discussions contained herein refer to hospitals. However, the principles applicable to hospital facilities should also apply to other healthcare facilities.

Coalition members are regularly faced with the need to expand their businesses to attract new patients, meet increasing demands in the community for various types of quality healthcare services, and/or expand health care services even though, in many cases, the footprint of their hospital facilities cannot be expanded, either for geographic or economic reasons. Thus, Coalition members routinely repair, refresh, or modify their properties to accommodate changes in healthcare needs and advances in medical practices, to grow in the marketplace, and to satisfy ever changing federal and state regulatory requirements. Coalition members also reconfigure their facilities to provide care in more cost-efficient environments and clinical settings, such as ambulatory care or outpatient surgery/therapy, by converting space previously dedicated to more expensive inpatient care alternatives. The expected proliferation of accountable care organizations under the Patient Protection and Affordable Care Act, Pub. L. No. 118-148, 124 Stat. 119 (2010), will also result in changes to hospital physical plants as they adapt to new models of patient care that encompass the full continuum of care from diagnosis to post-acute care. For all of these reasons, Coalition members are keenly interested in the proper tax treatment of costs associated with tangible property.

The Coalition recognizes that the 2011 Regulations represent a substantial undertaking by the Department of Treasury (the "Treasury") and the Internal Revenue Service (the "IRS" or the "Service"), and appreciates the time and effort invested in the project. In many areas, the 2011 Regulations provide needed guidance regarding the proper tax treatment of costs associated with tangible property. The attached comments articulate issues of particular concern to investor-owned hospital companies. The Coalition appreciates the opportunity to offer input that the Treasury and the IRS may consider as additional guidance in this area is being developed.

Although the preamble to the 2011 Regulations (the "Preamble") indicates that the 2011 Regulations interpret existing authority and include simplifying conventions to reduce taxpayer compliance burdens, the Coalition believes that the rules fall short on both counts. The 2011 Regulations depart from well-established standards set out in long-standing case law and administrative authority. Further, the 2011 Regulations rely on intricate rules and are dependent on each taxpayer's specific facts and circumstances. Too often, the 2011 Regulations fail to provide clear and objective standards. As a result, taxpayers are faced with complicated rules that increase the compliance burden and fail to resolve controversial capitalization issues. Unless the 2011 Regulations are modified substantially when they are finalized, these subjective determinations will necessarily result in increased controversy, which will be costly and time-consuming for both the Service and taxpayers. Significant areas of the tax law, such as the treatment of costs associated with tangible property, should be determined by controlling authority following a clear policy directive. It should not be developed through controversy, which results in inconsistent determinations made on a case-by-case basis.

The Coalition appreciates your consideration of its recommendations, and it welcomes further discussion of its comments. The Coalition believes that these recommended changes will reduce the administrative burden imposed on hospital companies as well as other taxpayers while at the same time not materially altering the effects of the 2011 Regulations.

If you have any questions, please contact me at (202) 220-1589 or mcelroye@pepperlaw.com.

² T.D. 9564, 76 Fed. Reg. 81080 - 81127 (Dec. 27, 2011), 2012-14 I.R.B. 614, available at http://www.gpo.gov/fdsys/pkg/FR-2011-12-27/pdf/2011-32024.pdf.

³ American Hospital Association, Fast Facts on U.S. Hospitals, available at http://www.aha.org/research/rc/stat-studies/fast-facts.shtml

⁴ The Congress of the United States, Congressional Budget Office, Nonprofit Hospitals and the Provision of Community Benefits (2006); United States Government Accountability Office, Nonprofit, For-Profit, and Government Hospitals: Uncompensated Care and Other Community Benefits (2005).

Set forth below are the comments submitted on behalf of the Investor-Owned Hospital Company Coalition (the "Coalition"). These comments are being made with respect to the proposed regulations under sections 162(a), 168, and 263(a) in response to a Notice of Proposed Rulemaking by cross-reference to temporary regulations (REG-168745-03 and TD 9564, referred throughout as the "2011 Regulations") pertaining to the deduction and capitalization of expenditures related to tangible property.

The Coalition commends the Treasury and the Service for their continued efforts to provide capitalization guidance. The Coalition appreciates the opportunity to submit comments and to work with the Treasury and the IRS to develop guidance that is administrable and will reduce future controversy involving costs associated with tangible property.

A primary concern for the Coalition is the treatment of buildings under the 2011 Regulations. Although the 2011 Regulations explicitly conclude that a building and its structural components are considered a single unit of property, the rules effectively componentize buildings into the building structure and eight separate building systems (the HVAC system, plumbing system, electrical system, escalators, elevators, fire protection and alarm system, security system, and gas distribution system).¹ Instead of applying the betterment and restoration standards to the building as a single unit of property, which is the approach used throughout the 2011 Regulations for other complex tangible property, the 2011 Regulations impose a requirement that improvements be measured against the structure and systems. Separating buildings into a structure and various buildings systems is counter to controlling authority, at odds with the underlying business operations within the hospital industry, and inconsistent with the depreciation rules. More importantly, this standard imposes a costly and time-consuming recordkeeping burden on hospital companies without any apparent policy rationale.

Generally, the 2011 Regulations apply the "functional interdependence" standard set forth in proposed tangible property regulations issued in 2008² (the "2008 Proposed Regulations") to determine a unit of property. Under this standard, all components that are functionally interdependent are considered a single unit of property.³ The functional interdependence standard is drawn from several decisions, including Fed Ex Corp. v. U.S., in which the court addressed the unit of property standard in a case involving the proper treatment of repair expenses.⁴ In Fed Ex, the court found that an airframe, engine, and auxiliary power sources were a single unit of property.⁵

However, while the 2011 Regulations acknowledge this authority for other complex tangible property, they are not applied to buildings.⁶ Rather, the 2011 Regulations include a requirement that for purposes of betterments and restorations of buildings, these tests are measured against building structures and systems. In this regard, buildings are componentized while other complex tangible property (e.g., aircraft, trucks, and towboats) is not. Applying this standard to buildings is not only counter to controlling authority, which supports the functional interdependence standard, but also at odds with the inherent nature of hospitals, for which the building is the heart and soul of the business. The Coalition requests that you consider applying this authority to buildings when the 2011 Regulations are finalized.

Additionally, the componentization of a hospital building creates an inconsistency with the depreciation rules. Following implementation of the Accelerated Cost Recovery System in 1981, taxpayers generally are not allowed to componentize a building for depreciation purposes.⁷ Hospital companies are further disadvantaged because their largest assets are buildings, which are depreciable over a 39-year recovery period. For the most part, investor-owned hospital companies cannot even take advantage of the temporary 15-year period for qualified leasehold improvements ("QLHI"). As a result, the hospital industry is at a distinct disadvantage because the 2011 Regulations require capitalization of improvement costs attributable to hospital structures or building systems while the Internal Revenue Code of 1986, as amended (the "Code"), precludes depreciation on a component-by-component basis.

Finally, this provision imposes a substantial recordkeeping burden on hospital companies. For newly acquired hospital buildings, capturing the required costs on a separate component basis means costly and time-consuming changes because existing accounting systems do not capture the eight new categories enumerated in the 2011 Regulations. For older buildings, this new requirement will be extremely difficult, if not impossible, to implement. In many cases, records may not exist, and thus, information cannot be reconstructed to ensure accurate implementation of the 2011 Regulations. Even though certain factors may be established through appraisals, valuation, or estimation techniques, these services will also be burdensome, expensive, and time-consuming for taxpayers and will likely result in disputes with the Service. Because these requirements are disproportionately imposed on businesses with significant real estate holdings, like the hospital industry, it is difficult to understand the policy rationale for treating buildings differently from other complex tangible property. Further, we are unaware of any case law developments necessitating componentizing a building.

The first alternative is that taxpayers be permitted accelerated recovery periods for building components. When hospitals place structural components into service, they understand that the components will almost certainly have to be replaced before the 39-year class life expires to make way for modifications to the hospital, including as a result of advances in treatments and changes made to better serve patients. The Code acknowledges this phenomenon by providing that high technology medical equipment may be depreciated over a 5-year period, but it does not resolve the issues remaining for building structural components.⁹ As a result, hospital companies are not able to depreciate the structural components in a manner that accurately reflects their actual life. Rather, hospital companies may deduct the remaining bases of the components only when they dispose of the components, as discussed below. To more accurately reflect the actual lives of the structural components, and thus, match expenses with revenues, the Coalition recommends that hospitals be permitted accelerated recovery periods for structural components. The Coalition proposes that the accelerated recovery period for all structural components be ratable over 15 years using the straight line method of depreciation. However, the Coalition also proposes that hospital buildings continue to have a recovery period of 39 years.

The Coalition also recommends an accelerated recovery period for hospital interiors. The Code and Treasury Regulations permit shortened recovery periods in certain cases to take into account the shorter lives of certain assets. For instance, Section 168(e)(3)(D)(i) permits a 10-year recovery period for any single purpose agricultural or horticultural structure. In addition, Section 168(e)(3)(E)(iii), permits a 15-year recovery period for gas station convenience stores and similar structures. With regard to gas station convenience stores and similar structures, the Committee on Finance stated that it permitted an accelerated recovery period for such property to "clarify (and restore) the treatment of such property" because it believed that the IRS had taken a position "contrary to the historical treatment of such property" in determining that such structures had a 39-year recovery period.¹⁰ The Treasury permitted a shorter, 15-year recovery period in Treas. Reg. Section 1.263(a)-4, for intangibles that do not have a specifically enumerated recovery period. In that case, the shorter life was provided to more accurately reflect the actual life of certain intangible assets. This suggestion could be implemented with a change to Rev. Proc. 87-56,¹¹ which already provides specialized recovery for costs associated with particular assets and industries.¹²

The Coalition believes that the 2011 Regulations take a position contrary to the historic treatment of hospital components by requiring that they be componentized. Thus, unless the unit of property standards for buildings that are included in the 2011 Regulations are returned to the standards in the 2008 Proposed Regulations, the Coalition recommends an accelerated recovery period for hospital interiors that is ratable over 10 years using the straight line method of depreciation. Like single purpose agricultural or horticultural structure and gas station convenience stores and similar structures, the 2011 Regulations should be revised to more accurately reflect the true life of such property. We cannot glean an underlying policy rationale for permitting accelerated recovery for single purpose agricultural or horticultural structure and gas station convenience stores while failing to provide accelerated recovery for hospital interiors. Hospital buildings are analogous to such structures in that their unique use mandates accelerated recovery to reflect the frequent refresh projects required for operation.

Finally, the Coalition suggests a simplified methodology to address the complexities and to reduce potential controversy for these issues. As a result of the rapid technology changes in healthcare delivery, a significant portion of the capital invested in hospital buildings is classified as Section 1245 property (e.g., wiring, flooring, and other interior elements excluding machinery and equipment).¹³ Due to the complexities and administrative burden associated with segregating Section 1245 costs from the Section 1250 costs inherent in the vast majority of hospital projects, the Coalition believes that it would be in the best interest of both taxpayers and the Service to provide a simplifying convention to reduce the administrative burden and inherent controversy associated with delineating Section 1245 costs from Section 1250 costs. Therefore, the Coalition recommends an elective simplifying convention whereby taxpayers are given the option of recovering all interior and structural component costs (i.e., all Section 1245 and 1250 costs exclusive of separate units of property for machinery and equipment) ratably over ten years using the straight line method of depreciation in lieu of claiming bonus and accelerated depreciation on Section 1245 costs. Accelerated recovery could be applied on a project-by-project basis and could be effected by simply classifying all interior and structural component costs. Such simplification would reduce the burden of both the industry and the Service. As noted above, such simplification could be accomplished by amending Rev. Proc. 87-56.

II. Capitalization Standards

The long-standing approach under Sections 162 and 263 provided a consistent approach for evaluating costs as deductible or capitalizable. Treas. Reg. § 1.162-4 provided that "[t]he cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinary efficient operating condition, may be deducted as an expense." Further, the predecessor version of Treas. Reg. § 1.263(a)-1(b) set forth an understandable approach addressing capitalization, providing that costs were required to be capitalized if they: "(1) . . . add to the value, or substantially prolong the useful life, of property owned by the taxpayer . . . or (2) . . . adapt property to a new or different use."

Unfortunately, the 2011 Regulations modify rather than clarify or codify these capitalization standards. In many ways, the 2011 Regulations complicate the determination of whether costs are deductible repair costs or capital expenditures. The 2011 Regulations provide that amounts resulting in an improvement of property must be capitalized if the expenditure results in a "betterment" or "restoration" of property or if the expenditure adapts property to a new or different use.¹⁴ The Coalition requests that the Treasury and IRS consider whether such extraordinary changes should be finalized. Of particular concern are changes made with respect to betterments, restorations, adaptations, and the routine maintenance safe harbor.

Hospital companies routinely complete refresh projects to keep their buildings appealing to their patient population. Examples include ongoing maintenance of wards, which involves repair and renovation of patient rooms and nurse stations. These activities may relate to the appearance of the hospital and may include costs for painting, wall patching, flooring repair and ceiling renovations, as well as plumbing costs. These repair costs may also include costs the hospital incurs to perform HVAC repair or electrical maintenance to ensure continuous electricity and energy efficiency (e.g., electrical rewiring or retrofitting interior light fixtures, or moving toward more "green" buildings). Accordingly, hospital companies routinely complete refresh projects to keep their buildings appealing to their patient population.

The 2011 Regulations provide that an amount results in a capitalizable betterment if it is paid for one of the following with respect to a unit of property: (i) ameliorating a material condition or defect; (ii) resulting in a material addition to the property; or (iii) resulting in a material increase in capacity, productivity, efficiency, strength, or quality of the property.¹⁵ The betterment test in the 2011 Regulations supplants the previous standard which required capitalization of costs that materially increase the value of property. The new standard incorporates a facts and circumstances review; there are no bright lines or objective measurements of a betterment and no definition of what is considered "material."

As discussed above, the overriding goal for refresh projects is to ensure that the hospitals improve patient care. As a result, changes are made regularly to facilitate patient care, including changes in the types of care, treatment preferences, and technology. In this regard, hospital refresh costs are in many ways similar to the costs at issue in the revenue ruling addressing ISO 9000 certification, and the Service's analysis and conclusions therein are instructive.¹⁶ The ruling notes that costs incurred to improve the overall quality or attractiveness of a taxpayer's business operations, provide an advantage and differentiate the taxpayer, enabling the taxpayer to retain existing customers and expand its business to new markets and new customers. Although the ruling recognizes that the ISO 9000 certification costs "may yield future benefits . . . these future benefits are incidental to the primary benefit of current sales. Expenditures that primarily benefit current operations generally are deductible."¹⁷ Hospital companies incur refresh costs for a singular purpose: to improve patient care, thereby making their facilities more appealing to prior, current and new patients, including by adding new healthcare offerings or by expanding existing services. Many hospital refresh projects are influenced by external factors, including changes in population health, treatment protocols, federal and state regulations, or technology enhancements or advancements. Hospitals also make changes to their physical plants to increase efficiency and reduce the cost of care, while preserving or improving quality (e.g., by migrating from more costly inpatient care to less costly ambulatory care). Although hospital refresh projects may yield some future benefit, as with ISO 9000 costs, the primary purpose of hospital refresh projects is to improve the patient care experience and quality of patient outcomes. Consequently, such costs were previously characterized as deductible and should retain that treatment.

The Coalition appreciates the three refresh examples included in the 2011 Regulations; however, the proper treatment of routine refresh projects within the confines of a hospital building, without expanding the building's square footage, remains ambiguous, and it is impossible to glean with certainty how the betterment standard should be applied.¹⁸ Consistent with suggestions previously made by others, the Coalition suggests that when the 2011 Regulations are finalized, the betterment discussion be revised.¹⁹

In particular, the Coalition recommends that future guidance set forth more objective standards to provide greater clarity regarding application. To this end, the Coalition suggests that future guidance include the following examples.

Further, taxpayers will benefit from clarification regarding the application of Section 263A when the 2011 Regulations are finalized. Although applying the "directly benefits or incurred by reason of" standard achieves the goal of replacing the uncertain, court-created "plan of rehabilitation" doctrine with a more uniform standard, absent clarification to the betterment standard and accompanying examples, it may appear that Section 263A is being used to achieve the same result as would occur if the plan of rehabilitation doctrine were applied to various fact patterns. On its face, the "directly benefits or incurred by reason of standard requires that an expenditure "directly benefit" or be "incurred by reason of" the improvement activity in question, and the Preamble states that the standard is not invoked merely because the repairs and maintenance are performed at the same time as an improvement. However, the fact that costs of many of the refresh activities described in the examples were deductible when addressed separately, but capitalizable under Section 263A in another example, suggests that certain costs were capitalized simply because they were incurred at the same time as the remodel. The examples in the 2011 Regulations confuse whether and when Section 263A should be applied. Future regulations should clarify how and when the Section 263A standard should be applied in the context of a building refresh.

The Coalition also asks that when the 2011 Regulations are revised, additional guidance be included regarding the interaction between the tangible regulations and the application of Sections 1245 and 1250, such as Example 3 above. Many routine maintenance costs are properly treated as deductible repair expenses. It is important to note that these routine maintenance costs may include costs for cosmetic alterations, updates, and reconfigurations, provided there is no increase in the property's capacity, strength, or quality. Of course, costs to acquire and install Section 1245 property added as part of these projects must be capitalized. The three refresh examples included in the 2011 Regulations, imply that any Section 1245 and any Section 1250 costs must be analyzed to determine whether they result in a betterment of the Section 1245 unit of property or one of the Section 1250 building systems. The 2011 Regulations indicate that when Section 1250 property results in a betterment, then its costs must be capitalized, and if not, such costs are currently deductible. However, no example in the 2011 Regulations fully demonstrates or explains the interaction of Section 1245 and Section 1250 in determining what costs result in a betterment.

The 2011 Regulations eliminate the 50-percent threshold test and replace it with a facts and circumstances approach for determining when the replacement of a "major component" requires capitalization. According to the Preamble, the test was removed because there were concerns that the 50-percent threshold would "lead to results that are drastically different from the results reached in the case law and rulings in this area."²⁴ However, by virtue of eliminating the 50-percent threshold test, all replacements of a major part or substantial structural component of a unit of property must be capitalized, without regard to the timing of the replacement and without an objective standard for measuring whether a part is a major or substantial structural component of a unit of property. Consequently, this change creates significant uncertainty for taxpayers attempting to evaluate whether a replacement is a major part or a substantial structural component of a unit of property. The Coalition agrees with other commentators who have suggested that the 50-percent threshold should be restored.²⁵

Unfortunately, the 2011 Regulations restrict activities relating to buildings and the structural components of a building from qualifying for the safe harbor.²⁸ The Coalition maintains that the exclusion of the buildings and structural components from the safe harbor is inequitable. Hospitals are subject to continuous wear and tear as a result of use by the public and also subject to maintenance requirements established by state and federal regulators, both of which necessitate ongoing routine maintenance. It is unquestionable that hospital companies must perform ongoing maintenance of the type specified in the routine maintenance safe harbor and that such maintenance is expected to be undertaken more than once in the life of a hospital building and its structural components.

By excluding buildings and structural components from the routine maintenance safe harbor, hospital companies are required to apply the complex facts and circumstances analysis to determine whether such costs may be deducted. In addition to increasing the compliance burden for these companies, this approach will likely lead to disputes with the Service and the resolution of such controversies will result in disparate treatment of similarly situated taxpayers. There is no apparent policy rationale for allowing certain industries to take full advantage of the routine maintenance safe harbor while excluding others, like the hospital industry, altogether from the routine maintenance safe harbor. For these reasons, the Coalition requests that the Treasury and the Service explicitly provide that repair and maintenance cost associated with buildings qualify for the routine maintenance safe harbor.

III. Dispositions

The 2011 Regulations provide new rules relating to dispositions of MACRS assets.²⁹ In particular, the definition of a disposition is expanded to include the retirement of structural components. As a result, taxpayers that place a structural component in a general asset account may elect to recognize a loss for the remaining adjusted basis attributable to the component when that component is removed from service. The Preamble states that these changes are intended to be taxpayer-friendly; however, this fails to acknowledge the disadvantageous elements of the new rules.

Specifically, if a taxpayer deducts the remaining adjusted basis attributable to the component when it is removed from service, then the taxpayer must capitalize the cost of the replacement property. Allowing greater flexibility with dispositions is generally beneficial. Unfortunately, however, the 2011 Regulations leave unanswered many questions regarding application of this provision. Moreover, the disposition provisions add complexity. This complexity will be difficult for taxpayers to apply, and for examiners to review, at a time when both are facing compelling resource constraints.

For example, many taxpayers will have difficulty determining the remaining adjusted basis of a structural component that they replace when they make an election to deduct such amount. Accordingly, the Coalition asks that a simplified method for calculating the replaced component's remaining adjusted basis be adopted based on either a discount value of the replaced structural component or the square footage of the components replaced. Further, for those situations in which taxpayers do not have sufficient information to accurately determine a replaced structural component's remaining adjusted basis, the Coalition requests that taxpayers be permitted to determine the remaining adjusted basis of a replaced structural component based solely on a formula utilizing the cost of the replacement component. Finally, given that these elections are complex and can be burdensome, the Coalition requests that a taxpayer be permitted to elect, rather than mandated, to treat the retirement of a structural component as a disposition. If, however, the provisions are not changed when the 2011 Regulations are finalized, the Coalition requests that a general asset account election be the default provision.

The Coalition makes a number of suggestions to address these concerns, which are discussed more fully below.

The Coalition recommends that simplifying conventions be adopted to facilitate compliance. One approach recommended by other commentators and supported by the Coalition would be to permit a taxpayer to determine the remaining adjusted basis of a structural component using a discounted value method under which the taxpayer would, using either the Consumer Price Index or Producer Price Index, discount the current value of the replaced structural component back to the date it was either placed in service, for de novo facilities, or purchased, for acquired facilities.³² The taxpayer could then reduce the discounted cost of the component by the amount of the component's cumulative depreciation from the time the component was placed in service to arrive at the remaining adjusted basis of the replaced structural component that is deductible.

When several structural components are replaced, such as in a major hospital refresh project, the discount method could be onerous to apply. Thus, in such cases, the Coalition recommends that a taxpayer be permitted to determine its deduction based on a square footage method. Under the square footage method, the taxpayer would determine the percentage of square feet renovated by calculating the total square feet renovated and dividing that amount by the total square feet of the structure. The taxpayer would then reduce the square foot percentage by 20 percent to take into account permanent structural components that are not removed during the renovation. The taxpayer would then reduce its adjusted basis in the structure by the final square foot percentage.

To reduce these complexities, the Coalition agrees with the comments made by the American Institute of CPAs that the 2011 Regulations should permit taxpayers to elect to treat dispositions of structural components as dispositions of MACRS property, rather than making such treatment mandatory. Further, because the new rules for general asset accounts allow companies to elect either to continue depreciation or to discontinue depreciation and recognize gain or loss on dispositions from the general asset account, it appears that taxpayers will generally choose the election for a building. For this reason, the general asset account election should be the default for buildings, and companies should only be required to make an election if they wish to opt out of the rules. If this approach is not adopted, then the Coalition alternatively recommends that the 2011 Regulations adopt the recommendation from Ivins, Phillips & Barker that whenever a taxpayer is required to capitalize a replacement part or component of a unit of property for "whatever reason, and at whatever the point in time in the tax administration process that occurs, the taxpayer is entitled to claim an offsetting deduction for the adjusted basis of the replaced part or component, if the taxpayer so desires."³⁶

IV. De Minimis Rule and the Treatment of Materials and Supplies

Treas. Reg. § 1.162-3T(c)(1) provides a new definition of materials and supplies. Under the regulation, generally, items that have a life of less than 12 months or cost less than $100 are deductible when used or consumed in a taxpayer's business.³⁷ With respect to these items, many taxpayers would have considered such items as de minimis property for financial accounting purposes and expensed them. The 2011 Regulations provide a simplifying convention that allows immediate deduction for such items for tax purpose as well. Treas. Reg. § 1.162-3T(f) permits an election to apply the de minimis property election of Treas. Reg. § 1.263(a)-2T(g) to non-incidental materials and supplies. However, to comply with the ceiling rule of the de minimis election, taxpayers will be required to institute burdensome processes to account for property costing as little as $100 per item (or less in case of non-incidental materials and supplies).

The Coalition appreciates the clarification of the treatment of materials and supplies. Nonetheless, the Coalition has several recommendations for changes to the de minimis rule to simplify administration. Simplifying the administration of the de minimis rule would reduce controversy, which benefits both the Service and taxpayers.

The Preamble indicates that the Threshold Amount was intended to be an administrable limit on a taxpayer's total de minimis expense deduction.⁴⁶ However, application of the de minimis rule on a member-by-member basis will result in a significant administrative burden for consolidated taxpayers because financial data for an AFS is not always collected on a separate member basis. Thus, the intention of the de minimis rule would be thwarted if applied on a member-by-member basis. In addition, application of the de minimis rule on a member-by-member basis may create distortions when a member of the consolidated group (1) has a disproportionate amount of group's gross receipts, (2) holds a disproportionate amount of the group's depreciable or amortizable property, or (3) incurs a disproportionate amount of the group's de minimis expenses. Therefore, for administrative convenience and to limit controversies, the Coalition recommends that the Threshold Amount be calculated based on the amounts in the AFS of the consolidated group. Further, the Coalition recommends that, for purposes of determining the Threshold Amount, partnerships are considered to be group members because they are generally included in a consolidated taxpayer's AFS. Thus, the determination should be based on the consolidated group for book purposes, for example, including partnerships that satisfy the financial reporting requirements for inclusion of their operational results in the taxpayer's consolidated AFS. Any limitation calculated on a consolidated basis would need to be allocated to the members of the consolidated group and such an allocation could be made using an approach similar to the one set forth in Treas. Reg. § 1502-21(b)(2)(iv).

The Coalition appreciates the opportunity to comment on the 2011 Regulations. It is hoped that Treasury and the Service will incorporate these suggested changes in future guidance.

² 73 Fed. Reg. 12838 (Mar. 10, 2008).

³ Treas. Reg. § 1.263(a)-3T(e)(3)(i).

⁴ 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff'd 412 F.3d 617 (6th Cir. 2005) (the court weighed several factors in determining that engines and auxiliary power units were not separate units of property from the airframe of an airplane and, as a result, the repair regulations under then Treas. Reg. §§ 1.162-4 and 1.263(a)-1(b) should apply to the airframe). The court in Fed Ex noted the following:

⁵Id.

⁶See e.g., Treas. Reg. § 1.263(a)-3T(g)(5), Exs. 1 (aircraft as a single unit of property) and 8 (same for towboats).

⁷ See former Section 168(f), added by the Economic Tax Recovery Act of 1981, Pub. L. No. 97-34, 95 Stat. 172 (1981). See also AmeriSouth XXXII, Ltd. v. Comm'r, T.C. Memo 2012-67 (Mar. 12, 2012) (citing to Rev. Proc. 87-56, 1987-2 C.B. 674 and Treas. Reg. § 1.48-1(e) for the definition of buildings and structural components; holding that structural components are depreciated over the life of the residential real property). See also Comment Letter from Retail Industry Leaders Association, Guidance Regarding Deduction and Capitalization of Expenditures Relating to Tangible Property -- IRS REG-168745-03 (Mar. 26, 2012) which summarizes this provision.

⁸ Comment Letter from Best Buy Co., Inc., Comments on Temporary Regulations under Section 263(a) -- Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (Apr. 17, 2012); Comment Letter from Ivins, Phillips & Barker, Comments on Temporary and Proposed Regulations -- Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (Apr. 9, 2012); Comment Letter from Retail Industry Leaders Association, supra note 7.

⁹ Section 168(e)(3)(B)(iv); Section 168(i)(2).

¹⁰ Section 1120 of the Small Business Job Protection Act of 1996, Pub. L. No. 104-188, 110 Stat. 1755 (1996).

¹¹ 1987-2 CB 674.

¹² For example, in Rev. Proc. 87-56, class life 40.2 provides a shorter recovery period for railroad structures, class life 48.11 allows a shorter recovery period for telephone central office buildings, and class life 80.0 allows a shorter recovery period for some buildings associated with theme and amusement parks.

¹³See Hospital Corp. of America v. Comm'r, 109 TC 21 (1997) (where the Tax Court permitted Hospital Corp. of America, a member of the Coalition, to use cost segregation for a "multitude" of improvements).

¹⁴ Treas. Reg. § 1.263(a)-3T(d).

¹⁵ Treas. Reg. § 1.263(a)-3T(h)(1).

¹⁶ Rev. Rul. 2000-4, 2000-1 C.B. 331, which found that that costs associated with securing ISO 9000 certification were deductible.

¹⁷Id. at 337.

¹⁸ Treas. Reg. § 1.263(a)-3T(h)(4), Exs. 6(i), 7, and 8. Example 6 concludes that cosmetic and layout changes do not "better" a retail store when the changes merely make the store more attractive and make the merchandise more accessible to customers. The example correctly notes that refresh projects are an ordinary and necessary occurrence to remain competitive. However, Example 8 requires capitalization with virtually identical costs merely because the building refresh occurs simultaneously with other significant changes. The example concludes, without analysis, that the costs are capitalized as a result of Section 263A, and that the costs "directly benefitted or were incurred by reason of other improvements to the store and its electrical system. Example 7 falls between the examples; a current deduction is permitted for the "refresh" costs when such costs are incurred at the same time as, but lack sufficient connection, to the other activities.

¹⁹See, e.g., Comment Letter from the American Institute of CPAs, Comments on Proposed and Temporary Regulations under Sections 162(a), 168, and 263(a) Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (REG-168745-03 and TD 9564) and Revenue Procedures 2012-19 and 2012-20 (Jul. 16, 2012); Comment Letter from Best Buy Co., Inc., supra note 8; Comment Letter from the Tax Executives Institute, Inc., Proposed Regulations on Capitalization of Expenditures Related to Tangible Property (Apr. 24, 2012).

²⁰ Comment Letter from the Tax Executives Institute, Inc., supra note 19. The letter proposed a sliding scale presumption for more accurately classifying betterments. According to the proposal, expenditures in excess of $50,000 relating to, or affecting more than 50 percent of the physical structure of a unit of, property costing up to $100,000 are presumed to be betterments. If the property costs between $100,000 and $1,000,000, then any expenditures in excess of 35 percent, or affecting more than 35 percent of the physical structure of the unit of property, are presumed to be betterments. The rate decreases to 20 percent when the cost of the property is between $1,000,000 and $5,000,000 and to 10 percent when the property cost $5,000,000 or more.

²¹ Treas. Reg. § 1.263(a)-3T(j)(1). For buildings, this standard is applied to both building structures and building systems. The examples relating to retail facilities suggest that as long as the building adaptations do not deviate from the building's original purpose of retail sales, it will not constitute a new or different use. Treas. Reg. § 1.263(a)-3T(j)(3), Exs. 2, 3.

²² Capitalization is required for amounts paid to restore a unit of property, including amounts paid in making good the exhaustion for which an allowance has been made. Treas. Reg. § 1.263(a)-3T(i).

²³ Under former Proposed Treas. Reg. § 1.263(a)-3(g), an improvement replaced a major component or substantial structural component if either (1) the replacement cost comprised 50 percent or more of the replacement cost of the entire unit of property, or (2) the replacement parts comprised 50 percent or more of the physical structure of the unit of property ("the 50-percent threshold").

²⁴ 76 Fed. Reg. at 81075.

²⁵See, e.g., Comment Letter from Ivins, Phillips & Barker, supra note 8; Comment Letter from the Tax Executives Institute, Inc., supra note 19; Comment Letter from KPMG, Comments on Proposed Regulations under Section 263(a) -- Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (Apr. 17, 2012).

²⁶ Treas. Reg. § 1.263(a)-3T(g).

²⁷Id.

²⁸Id. ("An amount paid for routine maintenance performed on a unit of property other than a building or a structural component of a building is deemed not to improve that unit of property" (emphasis added)).

²⁹ Treas. Reg. § 1.168(i)-8T(a) through (i).

³⁰ 76 Fed. Reg. at 81078.

³¹Id.

³²See, e.g., Comment Letter from Best Buy Co., Inc., supra note 8; Comment Letter from the American Institute of CPAs, supra note 19.

³³ These include taxable stock acquisitions, partnership contributions under Section 721, and various tax-free reorganizations under Section 368. All of these result in the taxpayer stepping into the shoes of the acquired hospital with respect to basis and depreciation.

³⁴See Publication 946 (Mar. 22, 2012) for details regarding calculating depreciation.

³⁵ A taxpayer that makes a general asset account election and that does not elect to deduct the remaining basis of a disposed structural component will have to continue depreciating the amounts allocable to the disposed component. 2012-14 I.R.B. 614, 621 (Apr. 2, 2012).

³⁶ Comment Letter from the Tax Executives Institute, Inc., supra note 19; Comment Letter from Ivins, Phillips & Barker, supra note 8.

³⁷ The rules generally provide that materials and supplies include property that is: (1) not inventory and (2) falls into one of the following categories: (i) components acquired to maintain, repair, or improve a unit of tangible property; (ii) fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less; (iii) has an economic useful life of 12 months or less; (iv) has an acquisition or production cost of $100 or less (or other amount identified in future IRS guidance); or (v) is identified in future IRS guidance as materials and supplies.

³⁸ Treas. Reg. § 1.263(a)-2T(g)(1).

³⁹ Comment Letter from the Tax Executives Institute, Inc., supra note 19; Comment Letter from Ivins, Phillips & Barker, supra note 8.

⁴⁰Id.

⁴¹ Comment Letter from Ivins, Phillips & Barker, supra note 8; Comment Letter from the Tax Executives Institute, Inc., supra note 19.

⁴² Comment Letter from Best Buy Co., Inc., supra note 8; Comment Letter from Retail Industry Leaders Association, supra note 7; Comment Letter from the Tax Executives Institute, Inc., supra note 19; Comment Letter from the American Institute of CPAs, supra note 19; Comment Letter from KPMG, supra note 25.

⁴³ Treas. Reg. § 1.263(a)-2T(g)(7).

⁴⁴ Treas. Reg. § 1.263(a)-2T(g)(7), (8) Exs. 2, 3.

⁴⁵ 76 Fed. Reg. at 81064.

⁴⁶Id.

⁴⁷ Comment Letter from Best Buy Co., Inc., supra note 8; Comment Letter from Ivins, Phillips & Barker, supra note 8.

⁴⁸See, e.g., Treas. Reg. § 1.263(a)-2T(g)(8), Ex. 2.

⁴⁹See, e.g., Treas. Reg. § 1.263(a)-2T(g)(8), Ex. 3, 4.

⁵⁰ 2002-1 C.B. 374 (Jan. 7, 2002).