tax May/June 2012 IMPACT...Tax Tips. The hidden dangers of telecommuting, trusteed IRA helps...

May/June 2012

IMPACTtax

Deduct vs. capitalize

New regs offer guidance

Make the most of real estate losses: Keep good records

How can an estate plan be kept vital after death?

Tax TipsThe hidden dangers of telecommuting, trusteed IRA helps lengthen tax deferral, and more

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When you spend money on tangible business property — such as buildings and equipment — how you classify those expenditures can have a big impact on your tax bill. Maintenance and repair costs, for example, are deductible as cur-rent expenses. Improvement costs, on the other hand, must be capitalized and recovered through depreciation deductions over a period of years.

Unfortunately, it’s not always easy to tell the difference. As the IRS explains in its Capitaliza-tion v Repairs Audit Technique Guide, quoting the Supreme Court’s oft-repeated words from the 1933 case Welch v. Helvering, “the decisive distinctions between current expenses and capital expenditures are those of degree and not of kind.”

Improvement vs. repairIn December 2011, the IRS issued regulations regarding capitalization of amounts paid to acquire, produce or improve tangible property. The regs provide guidelines on the improvement vs. repair question, but the IRS recognizes that the answer depends on a taxpayer’s particular facts and circumstances.

There are a few significant changes, but, over-all, the regulations are consistent with proposed regulations issued in 2008. The latest regs still require taxpayers to capitalize expenditures for “betterments” of property, “restorations” of property or “adaptations” of property “for a new or different use.” Repair and maintenance expenditures, which keep property in efficient operating condition, are deductible.

A betterment enhances a property’s value. It might be a material addi-tion or involve work that remedies

a pre-existing condition or defect. Or it might be a material improvement that increases a prop-erty’s capacity, productivity, efficiency, strength or quality.

Restoration includes rebuilding property to like-new condition after the end of its useful life, returning property to efficient operating condi-tion from a state of disrepair, or replacing a major component or substantial structural part.

The 2008 regs would have established a “bright-line” test (based on cost or size) for what con-stitutes a “major component” or a “substantial structural part.” The new regs discard this test in favor of a facts-and-circumstances approach. Notably, they also permit taxpayers to immedi-ately deduct the unrecovered basis of replaced structural components.

For property adaptations, a new or different use is one that’s “not consistent with the taxpayer’s intended ordinary use” of the property when it was originally placed in service.

To understand the rules, it’s important to study the examples. In some cases, the conclusions may surprise you. (See “Deducting the cost of a build-ing refresh” on page 3.)

Deduct vs. capitalize

New regs offer guidance

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Special rules for buildingsA critical step in distinguishing between improvements and repairs — especially for buildings — is identifying the appropriate “unit of property” (UOP). Suppose that you replace a sub-stantial portion of a building’s roofing materials. If the UOP is the building, you might argue that the work con-stitutes a deductible repair because it keeps the building in efficient operating condition. But if the UOP is the roof, the expenditure should be capitalized as an improvement to the roof.

Under the 2008 proposal, a building and its structural components would have been treated as a single UOP. The new regs retain this rule, but they now treat improvements to the follow-ing target areas as improvements to the building as a whole:

HVAC systems,

Plumbing systems,

Electrical systems,

Escalators and elevators,

Fire protection and alarm systems,

Security systems, and

Gas distribution systems.

So, for example, expenditures for betterment or restoration of a building’s elevator system must be capitalized as an improvement to the building. Special rules are provided for condos, coopera-tives and leased property.

Deductible expensesThe new regs provide a safe harbor for “routine maintenance,” defined as work reasonably expected to be performed more than once during a prop-erty’s useful life. But the safe harbor doesn’t apply to buildings. The IRS was concerned that, given the long life of a building, even major projects

(such as replacing the roof) would qualify for the safe harbor.

The IRS also rejected the “plan of rehabilita-tion” doctrine adopted by some courts. Under that doctrine, the cost of otherwise deductible repairs must be capitalized if they’re part of a “general plan of rehabilitation, modernization, and improvement.” Instead, the regs require tax-payers to capitalize only an improvement’s direct costs plus indirect costs that directly benefit the improvement.

The regs also include a “de minimis rule,” allow-ing taxpayers that meet certain requirements the option of deducting rather than capitalizing expenditures that fall below specified thresholds.

Review your accounting methodsAll businesses should review these new regs — particularly the examples — and evaluate their impact on the tax treatment of tangible property costs. Many will need to change their accounting methods to ensure they report these costs cor-rectly on their tax returns.

Deducting the cost of a building refreshIn the recently issued IRS regulations for deducting vs. capitalizing tangible business property expenditures, one example involves a national retailer that periodically “refreshes” the appearance and layout of its stores to make the stores more attractive and the merchandise more accessible to customers.

Examples of the work performed include replacing and reconfiguring display tables and racks, relocating lighting, moving walls, repairing and repainting walls and floors, and power washing building exteriors.

The retailer is permitted to deduct these expenses because the work keeps the building “in the ordinary efficient operating condition that is necessary for [it] to continue to attract customers to its stores.” Some or all of the cost would have to be capitalized, however, if the work involves structural improvements or upgrades or it rises to the level of a “substantial remodel.”

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It’s often said that the three most important things in real estate are “location, location, location.” But from a tax perspective, you might revise that to read “documentation, documentation, docu-mentation.” The passive activity loss (PAL) rules make it difficult for rental real estate owners to deduct their losses unless they qualify as real estate professionals. And that demands accurate timekeeping records.

The rulesThe PAL rules generally prohibit taxpayers from deducting net losses generated by “passive” business activities — including rental real estate losses — from nonpassive income, such as wages or investment income. Disallowed losses may be carried forward and deducted against passive income in later years or recovered when the pas-sive business activity is sold.

There are two exceptions, however:

1. Rental real estate owners may deduct up to $25,000 in losses from properties in which they “actively” participate. (The deduction is phased out for taxpayers whose modified adjusted gross income exceeds $100,000 and is eliminated once it reaches $150,000.)

2. Real estate professionals may deduct their rental losses from nonpassive income without limitation.

“Real estate professionals” are individuals who, during the tax year, spend at least 750 hours (and more than half their total hours) working on real estate businesses in which they materially participate.

No ballpark guesstimatesTo qualify as a real estate professional, you must document your participation by “any reasonable means.” Ideally, you should keep contemporane-ous daily time reports or logs. Alternatively, you may be able to establish your approximate time commitment with appointment books, calendars or narrative summaries. But, as the U.S. Tax Court explained in Vandegrift v. Commissioner, you can’t rely on an after-the-fact “ballpark guesstimate.”

In Vandegrift, the taxpayer earned $120,000 during the year as a salesman. He also owned nine real estate properties, six of which were actively rented. He acquired the other three as rental properties, but a quick sale turned out to be more advantageous.

On his tax return, Vandegrift deducted a net loss on the six rental properties from his short-term capital gains on the properties he’d sold. He claimed to be a real estate professional, but

Make the most of real estate losses: Keep good records

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When a loved one passes away, you might think that the options for his or her estate plan have also been laid to rest. But that isn’t the case. There are postmortem tactics the deceased’s executor (or per-sonal representative), spouse and beneficiaries can employ to help keep his or her estate plan on track.

The QTIP electionA qualified terminable interest property (QTIP) trust can be a great way to use the marital deduc-tion to minimize estate tax at the first spouse’s death and limit the surviving spouse’s access to the trust principal. For the transfer of property to the trust to qualify for the deduction, a QTIP election must be made on the estate tax return.

QTIP assets ultimately are subject to tax as part of the surviving spouse’s estate. In some cases, including more assets in the estate of the first spouse to die can minimize the overall estate tax. In such a situation, the deceased spouse’s execu-tor may decide not to make the QTIP election or to make a partial QTIP election.

The qualified disclaimerA qualified disclaimer is an irrevocable refusal to accept an interest in property from a will or liv-ing trust. Under the right circumstances, a quali-fied disclaimer can be used to redirect property to other beneficiaries in a tax-efficient manner.

To qualify, a disclaimer must be in writing and delivered to the appropriate representative. Gen-erally this must occur within nine months after the transfer is made and before the disclaimant accepts the property or any of its benefits.

How can an estate plan be kept vital after death?

the court disagreed, finding his subjective esti-mate (without contemporaneous verification) to be insufficient. Nevertheless, the court permitted Vandegrift to deduct his rental losses. Even though

the sold properties were never rented, the court accepted Vandegrift’s testimony that he’d pur-chased the properties with the intent to rent them. Thus, all nine properties were part of the same rental real estate business, and it was appropriate to net the rental losses against the sale gains.

Track your timeIn Vandegrift, the taxpayer was fortunate that his income from passive business activities was sufficient to allow him to deduct his passive losses. But the case also illustrates the impor-tance of good record keeping for taxpayers who wish to qualify as real estate professionals.

QTIP assets ultimately are subject to tax as part of the surviving spouse’s estate. In some cases, including more assets in the estate of the first spouse to die can minimize the overall estate tax.

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The disclaimant has no power to determine who’ll receive the property. Rather, it must pass to the transferor’s spouse or to someone other than the disclaimant, according to the terms of the underlying document making the transfer — such as a will, a living or testamentary trust or a beneficiary form.

Exemption portabilityOne provision of the 2010 Tax act was to create a mechanism for spouses to take advantage of the unused estate tax exemption amount that other-wise could have gone to waste at the first death. This exemption “portability” allows the survivor to use his or her spouse’s unused amount.

There are caveats with these rules, however. For example, under current law, portability won’t apply after 2012. Further, to take advan-tage of the first spouse’s remaining exemption, you’d have to file an estate tax return to elect portability even if an estate tax return wouldn’t otherwise be required. And, if portability isn’t extended, the surviving spouse would have to die or use the exemption to make gifts before 2013.

The spouse’s right of election To discourage people from disinheriting their spouses, most states’ laws give surviving spouses a right of election that allows them to circum-vent the will and take an elective share of certain property. The share varies from state to state, so check your state law.

Because a spouse’s elective share of property qualifies for the marital deduction, exercising the election can help reduce estate taxes. Keep in mind, however, that this strategy can have a neg-ative effect on other estate planning strategies.

Protecting the family businessIf a large portion of the estate consists of real prop-erty used in a family business or farm, a special-use valuation may reduce estate taxes. The executor can elect to value the property based on its actual use, rather than its “highest and best use.”

There are several strict requirements to follow. For example, “qualified heirs” must materially partici-pate in the operation of the business or farm for at least 10 years after the deceased’s death.

For closely held businesses, if the deceased’s interest exceeds 35% of his or her adjusted gross estate and certain other requirements are met, the executor can elect to defer estate taxes attrib-utable to that business for five years (paying only interest for the first four years) and then pay the tax in 10 annual installments, with interest.

The alternate valuation dateProperty typically is valued as of the date of death for estate tax purposes. But an executor may elect to use the alternate valuation date, which is six months later. This date can be used only when it results in a lower estate tax bill, so it’s typically elected when the value of property has declined.

The election is irrevocable and can’t be applied selectively to certain property. Once the election is made, it applies to all of the estate’s property (except for property disposed of during the six-month period).

Keep on trackFollowing the death of a loved one, there are steps that can be taken to keep his or her estate plan on the right track toward accomplishing his or her goals. To help ensure your loved one’s plan isn’t derailed, consult your tax advisor.

The hidden dangers of telecommutingIf you allow employees to telecommute, be sure to consider the potential tax implications. Hir-ing someone in another state, for example, might create sufficient nexus to expose your company to that state’s income, sales and use, franchise, withholding, or unemployment taxes. And the employee might be subject to double taxation if both states attempt to tax his or her income.

The rules vary by state and also by type of tax — and become even more complicated for international telecommuters. So it’s a good idea to review the rules before you approve a cross-border telecommuting arrangement.

Consider a cost segregation study before an asset acquisitionA recent U.S. Tax Court case, Peco Foods v. Com-missioner, highlights the importance of conducting a cost segregation study before certain asset acqui-sitions. Peco Foods acquired two food processing plants in an “applicable asset acquisition” pursu-ant to Internal Revenue Code Section 1060, under which the buyer’s basis in the assets is determined wholly by reference to the consideration paid.

Peco and the seller agreed to an allocation of the purchase price among various assets (including certain buildings), which they reported to the IRS on Form 8594, Asset Acquisition Statement. Sec. 1060 provides that such an agreed-upon allocation is binding unless the IRS concludes that the allocation or fair market value is inappropri-ate. Peco later conducted a cost segregation study and tried to reallocate portions of the amounts allocated to buildings to shorter-lived building

components in an effort to accelerate depreciation deductions. The Tax Court rejected this strategy, however, finding that the parties’ allocation sched-ules were binding and couldn’t be adjusted after the fact. Had Peco conducted the study before the acquisition and prepared the allocation schedules accordingly, the tax consequences might have been more favorable.

Trusteed IRA helps lengthen tax deferralIRA beneficiaries can stretch out required mini-mum distributions (RMDs) over their life expec-tancies. Designating a young person as beneficiary, therefore, can allow your IRA to grow on a tax-deferred basis over a potentially very long period. One drawback, however, is that there’s nothing stopping him or her from draining the account.

A potential solution is a trusteed IRA. Some-times called an “individual retirement trust,” a trusteed IRA allows you to restrict distributions to the beneficiary (other than RMDs) as you see fit. You can also name a contingent beneficiary to receive the IRA balance if the primary benefi-ciary dies before the account is exhausted.

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TIPStax

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. ©2012 TXImj12

James E. Stroh, CPA : 216-274-3220

Jim is the firm’s President. He focuses his practice on providing small business consulting and tax planning. His areas of concentration include manufacturing, construction and personal

service corporations. Mr. Stroh has assisted clients in mergers and acquisitions, restructuring for tax planning purposes and small business generational planning. [email protected]

Daniel S. Gibel, CPA : 216-274-3230

Dan focuses his area of practice in performing small business advisory and assurance services. He devotes time to both closely held businesses and tax-exempt organizations. He has over twenty years experience in consulting with privately held businesses and their owners on issues related to profitability and tax planning. [email protected]

Robert E. Goll, CPA : 216-274-3227

Bob’s experience is in attest and management services for medium to large corporations. He has advised national and international clients concerning methods of improving corporate systems and profits, including maximizing corporate tax savings. He has served as an advisor in mergers, acquisitions, and emerging business situations. [email protected]

Thomas C. Kaminsky, CPA : 216-274-3222

Tom specializes in small business advisory services. His areas of concentration are manufacturing, construction, law firms and other personal service companies. In addition to assisting clients with accounting and management services, Tom helps clients prepare business plans and financial projections for internal purposes and to assist in obtaining financing. [email protected]

Leonard Sott, Jr., CPA : 216-274-3224

Len has diverse experience in taxation and accounting procedures of closely held and professional corporations. He has extensive experience in both individual and

corporate client representation before the Internal Revenue Service. Len is also the director of the firm’s Tax-Exempt Organization Practice Group. [email protected]

Arthur P. Ward, Jr., CPA, MT : 216-274-3228

Art is the firm’s tax director. Art’s philosophy is to be proactive with his clients and guide them through the complexities of the tax code. He serves as a trusted business advisor to his

clients who consult him regularly as a source of creative tax-saving strategies, research, and general business counsel. [email protected]



Card, Palmer, Sibbison & Co. has

been serving as a trusted advisor and management con-

sultant to owners and businesses in Northeast Ohio since 1920. We have expertise in both the privately held company and not-for-profit area. As certified public accountants we per-form the traditional financial and

tax services but also provide a wide array of other

business services.

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