The Intersection Between State and Federal Law: Sales Tax and the New IRS Tangible Property Regulations

It seems I can’t get through a work day lately without some tax alert, webinar invite, article, or tweet addressing the new IRS tangible property regulations. These new rules have caused quite the uproar in the tax community, as outlined by articles here, here, here, and here. These regulations are aimed at questions as to whether expenditures on tangible property are currently deductible, or whether they must be capitalized and recovered through depreciation over time. And the principal question that the final regulations address is whether expenditures relating to the maintenance and alteration of tangible property, including buildings and other fixed assets, are properly treated as repairs, which are currently deductible, or are required to be capitalized as an improvement to the property. That distinction—between deductible repairs and capital improvements—has been mostly developed through judicial decisions, based on facts and circumstances. But in 2003, the IRS issued Notice 2004-6 , announcing that it intended to propose regulations in this area. And with the expediency and speed we have come to expect from our government, final regulations were issued in September 2014, and more recently the IRS announced simplified procedures offering relied to certain small businesses.    

But this post is not intended to provide a detailed analysis of these rules. You can get that by clicking through all the various hyperlinks above. Indeed, my focus is in the state and local tax area, and this is not an issue I’ve come across with any regularity yet, at least on the state income tax side. But recently questions have been posed to me on the sales-tax side of this. Specifically, I’m being asked whether the changes here could affect the capital improvement distinctions that are often made for state sales tax purposes. More specifically, if a company is allowed by virtue of these new regulations to treat capital expenditures as repairs, for instance, does that also mean that the sales tax status as a capital improvement also has to change? 

The short answer is no. I don’t think that anything in these regulations should change the way a sales tax auditor determines whether or not work qualifies as a capital improvement. Those rules, especially in New York, are spelled out in specific detail in Tax Law § 1105(c)(5). And under these rules, the term “capital improvement” is defined as any “addition or alternation” to real property that:

(i) substantially adds to the value of or appreciably prolongs the useful life of the real property;

(ii) becomes part of the real property or is permanently affixed to the real property so that removal would cause damage to the property or article itself; and

(iii) is intended to become a permanent installation. 

Those tests are based largely on concepts from the law of fixtures, which governs when a person (that is, a tenant) surrenders items of property by making them a permanent part of the real property. For sales tax purposes, a contractor completing a capital improvement is not viewed as selling individual items of tangible personal property to its customer along with the labor to install them; rather, the contractor is viewed as selling the end result of its services; that is, new real property, something that falls outside the scope of the sales tax. More on New York’s test can be found in this great article by two of my favorite lawyers.

The IRS also has somewhat of a three-part “improvement” test, but it’s not the same test. The final regulations generally require a taxpayer to capitalize its expenditures to "improve" a pre-existing unit of property. For this purpose, a unit of property is improved if the expenditures result in 1) a betterment to or 2) restoration of the unit of property, or 3) adapt the unit of property to a new or different use. 

To some extent, the IRS rules are broader, meaning that it might be easier for work to qualify as a capital improvement for federal purposes than it would be for state sales tax purposes. But let’s not concern ourselves with such mental exercises. When faced with the question of whether or not something is a repair or a capital expenditure in a sales tax audit, taxpayers and their practitioners need to be focusing on the sales tax rules only. Believe me, it’s hard enough dealing with those rules, since they don't work all that well anyway! So it doesn’t matter that for federal tax purposes under the new regulations a different answer might be had. We still need to turn the focus to the sales tax rules only to make a proper determination as to capital improvement status for sales tax purposes. 

Still, however, I certainly can envision confusion on audit since often a sales tax auditor will look to depreciation schedules to determine the distinction between capital assets and expenses. And if a company takes a position for sales tax purposes that a certain project is a capital improvement but is required for federal tax purposes to treat such project as a repair, certainly this will at least require a conversation with a sales tax auditor as to the nuanced distinction between federal and state tax rules. I don’t look forward to such a conversation, and it’s certainly possible that a state sales tax auditor could take a different view if it resulted in more sales tax revenue. But I really think that this is a practical problem, not a legal issue. For substantive legal purposes, when determining whether or not a project qualifies as a capital improvement, we must look to the state and sales tax rules to make that determination.  

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