Complex Regulations on Deducting or Capitalizing Repairs Now in Effect

As if constantly changing tax laws weren't complex enough, the IRS has also been issuing new forms, rulings, and regulations.  On December 23, 2011, temporary regulations were issued changing the tax rules (effective for tax years beginning on or after January 1, 2012) regarding whether costs incurred for tangible property must be capitalized as an asset or may be expensed as a repair.  Since all businesses own or lease tangible property, all businesses are affected by these regulations.  In some cases, businesses will need to change their method of tax accounting to comply with the new regulations.  Changing a tax accounting method is complex and often involves a cumulative adjustment to taxable income to change from the effects of the prior method.

The length and complexity of the regulations prohibit a full analysis.  Some of the highlights are:

1. New rules are set forth for deducting or capitalizing materials and supplies.
2. Several methods of accounting are provided for rotable and temporary spare parts.
3. Rules are provided for moving and reinstalling property.
4. To determine whether a cost incurred for property is an "improvement" requiring capitalization, it is necessary to refer to what is called a "unit of property."  A "unit of property" is somewhat subjective as demonstrated by numerous examples in the regulations.  Generally, the larger the unit of property the more likely the cost can be deducted as a repair.
5. For buildings, the IRS has identified eight component systems as "units of property" making improvements to these components (e.g., HVAC, plumbing, electricity, elevators, etc.) more likely to be capital expenditures (requiring lengthy depreciation) rather than repairs (permitting current deductions).
6. Leasehold improvements are a separate unit of property.
7. For machinery and equipment, a unit of property is one that performs a discrete and major function or operation.
8. While a "unit of property" is considered in accounting for repairs or improvements, the concept is not used for purposes of determining the property's depreciation period.
9. Improvements are required to be capitalized.  An improvement means that a unit of property has been bettered.  For example, a material defect prior to acquisition has been fixed, a material addition has been added, capacity has been increased, the unit of property has been restored, or the unit of property has been adapted to a new or different use.
10. Routine maintenance such as cleaning, testing, and reasonable replacement of parts is not considered an improvement and may be deducted as a repair.
11. The retirement of a structural component of a building may now be treated as a disposition separate from the overall building and a loss claimed for the adjusted tax basis.

The complexity and cost of complying with these regulations just to determine whether an expenditure is a repair or is a capital asset certainly won't make American business any more competitive in the global marketplace.  Taxpayers have been making these decisions for decades, and now the IRS comes along with new rules changing long-held accounting practices.  The increased intrusion of government regulators into normal business accounting practices drives up the cost of business.  These rules are currently in effect and must be dealt with in your accounting systems.

Proposal Would Dramatically Change Rules for Inherited IRAs

On February 7th, Max Baucus, the Senate Finance Committee Chairman, proposed dramatic changes to the distribution rules for beneficiaries of inherited IRAs, 401(k)'s, and other qualified plan accounts (all termed "IRAs" in this post), for deaths after 2012.  The proposal raises $4.6 billion over 10 years and is part of a highway funding bill.  The change would require beneficiaries to completely distribute the inherited accounts within five years.  Exceptions would be provided for certain beneficiaries:  disabled or chronically ill individuals, surviving spouses, children who had not attained the age of majority, and beneficiaries who are not more than 10 years younger than the deceased account owner.  Once these beneficiaries die, the five-year rule applies to their beneficiaries.  Furthermore, when a beneficiary-child reaches the age of majority, the five-year rule commences.  Senator Baucus justifies his proposal by stating that IRAs are intended for retirement, but some taxpayers are using them to give tax-free benefits to second, third, and maybe fourth generations.  He further stated that if this proposal doesn't pass now, perhaps it will as part of tax reform.

Current rules permit beneficiaries to stretch-out distributions from inherited IRAs over their life expectancies.  The younger the beneficiary, the longer the stretch-out period.  In the early years, the IRA can continue to grow in value as the required distribution amounts will generally be less than the IRA earnings.  Distributions from traditional IRAs are subject to income tax.  A 50% penalty applies to any shortfall in the required minimum distribution amount.  Accelerating the required distribution amounts eliminates the financial benefits of compounding IRA earnings on a tax-deferred basis.  The proposed change will have a major detrimental financial impact upon families that have used retirement accounts to save for the future.  Larger required distributions will likely cause the beneficiary to pay income tax on the benefits at a higher tax rate, and will tempt beneficiaries to spend their inheritances instead of preserving the IRA benefits for their own retirements.  Furthermore, once the assets are outside of the IRA, the beneficiary loses whatever asset protection benefits were afforded by the IRA.

The proposed change goes even further and can apply to IRA accounts of owners who have died or will die before 2013.  Once the primary IRA beneficiary (who may use the current stretch-out rules) dies, those who succeed to the primary beneficiary's benefits will be subject to the new five-year payout rule!

Many commentators do not believe this proposal will become law at this time.  If it does become law, proactive planning will be necessary to reduce the resulting financial loss on families.  This proposal will upend the financial planning of many families, and seems to be a short-sighted grab for tax revenue to fund one-time government expenditures.

Voluntary Offshore Disclosure Program, Round Three

The IRS has had a major focus on finding and penalizing taxpayers who have foreign financial accounts and who have not made proper disclosure of those accounts and have not paid U.S. income tax on earnings in those accounts.  Two temporary, voluntary disclosure programs in 2009 and 2011 were established to encourage delinquent taxpayers to come forward and clear up the matter.  About 33,000 disclosures were made and $4.4 billion was collected.  The new program started in January 2012 and has no end date.  However, the IRS cautions that it could end or modify the program at any time, and so taxpayers should come forward expeditiously.  The IRS also warns of severe civil (criminal penalties are also a possibility) penalties if they find a taxpayer with delinquent foreign accounts before such taxpayer makes a voluntary disclosure.  The IRS also states that "quiet disclosures," whereby taxpayers amend past tax returns to disclose foreign financial accounts and pay back taxes, will not avoid the full extent of penalties that the IRS will assert if the quiet disclosure is discovered.  Taxpayers must come under the new voluntary disclosure program to reduce penalties.

The new program is not inexpensive.  The program requires up to eight years of corrected back tax returns, with added taxes, interest, and the addition of the accuracy-related and/or delinquency penalty.  In addition, the taxpayer must pay a penalty of 27.5% of the highest aggregate balance in foreign financial accounts during the eight full years prior to the date of disclosure.  This is an increase from the 25% penalty under the 2011 program.  The penalty might be reduced to 12.5% if foreign accounts and assets total $75,000 or less.  There is also a penalty reduction to 5% for certain restrictive situations.

Taxpayers who have yet to make full disclosure of their foreign accounts and to pay U.S. income tax on foreign earnings should use this program to come clean.  The risks of coming clean with quiet disclosure in order to avoid the settlement penalties are too high.  More information about the program can be found on the IRS website at http://www.irs.gov/newsroom/article/0,,id=252162,00.html.