As we approach year-end, many of our clients are in the midst of preparing to close the year, of which tax planning is always an important consideration. Historically, government contractors have maintained “2 sets of books.” The first on a GAAP accrual basis, which is required as a component of an adequate accounting system per the SF1408 PreAward Accounting System Survey for all contractors working with flexibly-priced contracts, and the second set of books maintained on a tax basis. There are a variety of factors that create differences between the two sets of books, such as the IRS 50% rule for business meals vs. FAR 31 allowability/allocability considerations for the same category of expense. Further, DCAA is not tasked with assessing tax compliance, and as an agency income tax treatment has no impact to the audits performed by the agency. This year, however, a new IRS regulation concerning the capitalization of assets is creating confusion for some government contractors and could impact cost accounting for government contracts.
In September of 2013, the IRS issued final regulations concerning the capitalization of tangible property costs. As a firm, Redstone GCI does not prepare tax returns or provide tax advice, so the purpose of this discussion is not to comment on the application of the regulation for tax purposes, but rather to describe some aspects of the rule that may bleed into other areas of cost accounting for Government contracts, such as the incurred cost submission.
In brief, the new IRS regulation sets a de minimis threshold of $500 for capitalization of tangible personal property, unless the property has a useful life of less than twelve months or the company meets specific financial statement requirements. Specifically, if the company has audited financial statements (AFS) or has filed financial statements other than their tax return to another state or federal agency, then they can elect to expense property that costs up to $5,000 if in accordance with their written capitalization policy.
The rule immediately begs the question: what if anything will DCAA do in regard to this new regulation?
- Theoretically they should do nothing, as noted previously the IRS regulation has not historically been used by DCAA (rightfully so) due to no connection of the IRS Code to FAR Part 31 Cost Principles.
- FAR 31.201-2(a) denotes the requirements for allowability of a cost, and while it does reference GAAP, there is not mention of IRS Tax Code with regard to the allowability of a cost claimed under a U.S. Government contract or proposal.
- Further FAR Part 31 denotes an entire cost principle to the topic of Depreciation (FAR 31.205-11), and again no mention of the IRS Tax Code.
- Whew! Well not so fast…
- The first standard for allowability under FAR 31.201 is reasonableness, so digging a little deeper, reasonableness is defined under FAR 31.201-3, which describes ordinary and necessary expenses and generally accepted business practices in accordance with Federal and State laws and regulations. While quite a reach, DCAA could look to the capitalization policy established for tax purposes under the veil of reasonableness.
- For contractors subject to CAS, in this case CAS 409, there is a reference to IRS guidelines, but only in the context of asset service lives and only temporarily (until a contractor develops its asset service lives based upon contractor-specific experience).
There is always the potential for the DCAA to broaden regulation, and as an agency they have a long-running practice of implementing audit practices far more broad than the specific regulatory requirements, so it isn’t without possibility that the DCAA may attempt to use the new IRS thresholds in the course of audit. However, we see this as unlikely, as that approach would be a very slippery slope. If the DCAA attempts to impose arbitrary reasonableness threshold based on the Company’s accounting for cost for tax purposes, then should the contractor be able to use other tax-methods in accounting for cost for government contracts, like Section 179 accelerated depreciation (potentially expiring soon as well) or less stringent IRS requirements to support reasonableness of other categories of cost?
As has historically been the case, the presence of a consistently applied written capitalization policy is key to supporting the capitalization practices of a company in the course of a DCAA audit. The IRS has stated, within their new regulation that this is a priority for their agency as well. If a company (not subject to CAS 409) elects to use a different capitalization policy for tax vs. government cost accounting, we recommend that they both be clearly documented as to their applicability. Said simply, if you are going to use a different threshold for book vs. tax, then make sure you have two separate written policies with their stated applicability (tax or GAAP-basis), and that you consistently apply the threshold under both scenarios. In our experience, problems in audit related to asset capitalization have almost always been tied to a company “picking and choosing” when to enforce their capitalization policy, or a lack of a written policy.
Finally, one other item of passing interest for many of our small business clients is the language allowing adoption of a higher capitalization policy (up to $5,000) if the company has filed required financial statements (other than a tax return) to any other State or Federal Agency. The IRS rule did not clarify this statement in any way, but it begs the question of what specific filings could qualify a government contractor for the exemption. Things that come to mind as potential options for government contractors are as follows:
- Annual financial statement filings required for company’s participating in the 8(a) program
- Annual financial statement filings for licensure (such as contractor’s license)
Another option could include your annual incurred cost submission (if required by contract). FAR 52.216-7(d)(2)(iv)(F) denotes that “Certified financial statements and other financial data” is considered supplemental information not required for adequacy, but may be required during the audit process. We would recommend that companies who may consider this as an option consult with their tax provider.