The De Minimis Safe Harbor (DMSH) of section 1.263(a)-1(f) provides a relatively straightforward way for taxpayers to avoid capitalizing assets and improvements under section 263(a). However, one obvious question is whether the De Minimis Safe Harbor may be applied to new construction. When dealing with newly constructed buildings, the simple rules can become incredibly complex. Below is an outline that discusses some of the most common issues with the DMSH and new construction.
- Accounting Procedure: Under section 1.263(a)-1(f)(1)(ii)(B) & (B)(1), the taxpayer must have an accounting procedure as of the beginning of the year under which they treat as an expense for non-tax purposes items under a specified dollar amount.
- Please note that this specified dollar amount could be set at any level, but it must be for non-tax purposes such as financial or managerial accounting.
- Please also note that this beginning of the year requirement may be difficult or impossible to meet for a new entity.
- Start-up Issue: Under 1.263(a)-1(f)(3)(iv), amounts not capitalized under a DMSH election are deducted under section 162 only if they are ordinary and necessary expenses incurred in carrying on a trade or business. When dealing with new construction in a new entity, the taxpayer often falls under the rules for start-up expenditures found in section 195. In that situation, electing the DMSH may turn five-year assets into 15-year amortizable, start-up expenditures.
- Book Expensing: Under section 1.263(a)-1 (f)(1)(ii)(C), the taxpayer must treat the amount paid for the property as an expense on its books and records. When combining this requirement with the accounting procedure requirement, it appears that expensing treatment in books or journal entries prepared solely for income tax return filing purposes would not meet the requirements of the DMSH.
- Tax Dollar Limit: Under section 1.263(a)-1 (f)(1)(ii)(D) as updated by Notice 2015-82, the amount paid for the property must be $2500 or less per invoice or per invoice item.
- UNICAP Conformity: Under section 1.263(a)-1 (f)(3)(v), items that would otherwise be expensed under the DMSH may be capitalized under section 263A “if the amounts paid for tangible property comprise the direct or allocable indirect costs of other property produced by the taxpayer[.]”
- Please note that this UNICAP conformity rule applies to the cost of “other property produced by the taxpayer.” Even if a single door, for example, is broken out on an invoice and otherwise meets the requirements of the DMSH, it would still be capitalized as part of the direct costs of producing the building Unit of Property.
- Though the regulations do not provide a clear answer, capitalization under section 263A would presumably not apply beyond the level of a single UoP. For example, the purchase of a refrigerator that otherwise meets the requirements of the DMSH would not be capitalized under UNICAP as a direct or indirect cost of constructing a building.
- Anti-abuse rule: Under section 1.263(a)-1(f)(6), taxpayers cannot manipulate transactions so that property falls under the DMSH. Abuse is presumed when the taxpayer creates invoices to componentize an item generally acquired as a single unit that would exceed any of the DMSH dollar limits, both book and tax. This may create complications when dealing with new construction.
- When dealing with a contractor, ordinary payment applications may show very limited details, so that the amounts invoiced do not substantiate the actual cost of an item. By asking for greater componentization from the contractor, the taxpayer may run afoul of the anti-abuse rule.
- Frequently, an operating entity constructs a building and then sells it to a related entity; or, more often, distributes the property to its shareholders who then contribute it to a new entity. The latter often involves only entries on the book and the former often uses lump-sum purchase prices with marginal descriptions. The taxpayer changing its business practices to componentize a property in this case may run afoul of the anti-abuse rule.
So where does this leave us on using the DMSH for new construction? The taxpayer needs to make sure the most important, threshold requirements for the DMSH are met: 1) book expensing policy as of year-beginning; 2) actual expensing on the books, and 3) invoice-based substantiation. The taxpayer also needs to avoid using the DMSH prior to the active trade or business commencing under section 195. Once these obstacles are bypassed, the taxpayer will generally find that the DMSH election is restricted to the same items that would be cost segregated: section 1245 tangible personal property and some land improvements.
For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting. For more information, please call 800.806.7626 or visit www.sourcehovtax.com.
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