The IRS has issued final regulations: Is it a deductible repair or a capital expenditure?
By Mark E. Battersby
Since the inception of the Internal Revenue Code, the IRS and specialty fabric professionals have often been at odds over whether expenditures made are currently deductible as repair costs, or whether they must be capitalized and recovered through depreciation over time. After seven years of drafts and proposed rules, the IRS has issued final regulations addressing whether a cost is a deductible repair or a capital expenditure.
The IRS has also released a long-awaited Revenue Procedure that details the procedures for obtaining its “automatic” consent for changing accounting methods as required by the new repair regulations.
Repair or improvement?
Since the Reconstruction Era Income Tax Act of 1870, taxpayers have been prohibited from deducting amounts paid for new buildings, permanent improvements or “betterments” to business property made to increase the value of that business property. While this concept has been recognized as part of U.S. tax law almost from its inception, exactly what must be capitalized and what can be deducted as an expense has been at issue ever since.
The IRS’s newly released regulations provide guidance on a number of difficult questions, such as whether replacing a component of a building is a current deduction or whether it must be depreciated over 39 years. Expenditures that restore property to its operating state are, according to the IRS, a deductible repair. However, expenditures that provide a more permanent increment in longevity, utility, or worth of the property are more likely to be considered capital in nature.
For example, if a textile products operation rebuilds the electric motor on an automated cutting machine, the IRS usually considers that expenditure to be a capital expense. Rebuilding a motor increases the value of the equipment (the unit of property) and prolongs its economic useful life. By comparison, the IRS views regularly scheduled maintenance repairs as currently deductible because they do not materially increase the cutter’s value nor appreciably prolong its useful life.
In general, the new regulations distinguish between amounts paid to acquire or produce business property, equipment or machinery and the amounts paid to improve existing property. When it comes to “improvements,” capitalization is required if the expenditure is a betterment, restoration or adaptation of the unit of property.
Generally, a business must capitalize amounts paid to acquire or produce tangible property unless that property falls into the category of materials and supplies, or qualifies for the so-called “de minimis” safe harbor. The new guidelines cover the following:
Materials and supplies. Incidental materials and supplies may be deducted when purchased. Tax-deductible materials or supplies are tangible personal property, other than inventory, that are used or consumed in the taxpayer’s operations. This includes fuel, lubricants, water and similar items that can be reasonably expected to be consumed in 12 months or less. It also includes:
- Other property with an economic useful life of 12 months or less;
- An item with an acquisition or production cost of $200 or less;
- A component acquired to maintain, repair or improve a unit of tangible property that is not acquired as part of another unit of property.
These are items for which records of consumption are not necessary and where immediately deducting or expensing them will not distort the operation’s income. Materials and supplies that do not fit these definitions are deducted when used or consumed.
Rotable and temporary spare parts. This category is a subset of materials and supplies. Several alternative methods are allowed:
- The cost of rotable and other spare parts is deducted only when they are disposed of,
- Spare parts are capitalized and depreciated; or
- The cost of spare parts can be deducted when first installed, but record income at its fair market value when the part is removed, continuing that process until claiming a final loss at disposition.
Safe harbors can best be compared to legitimate loopholes designed by lawmakers to limit the full impact of a tax law or provision that might be harmful to a particular group of taxpayers. Under the repair regulations, some industrial textile products businesses might benefit from safe harbors such as the following:
De minimis safe harbor election. Specialty fabrics professionals may elect a “de minimis” safe harbor to deduct amounts paid to acquire or produce property up to a dollar threshold of $5,000 per invoice (or per item in some cases), but only $500 for those without the required written accounting procedure.
Small taxpayer safe harbor. Regulations add a new safe harbor for businesses with gross receipts of $10 million or less, intended to simplify small taxpayers’ compliance with the rules requiring capitalization of building improvements. Qualifying small taxpayers can elect not to capitalize building improvements with an unadjusted cost basis of $1 million or less if the total amount paid during the year for repairs, maintenance and improvements does not exceed the lesser of $10,000 or 2 percent of the unadjusted cost basis of the building. This is elected annually on a building-by-building basis.
Routine maintenance safe harbor. When it comes to expeditures for routine maintenance performed, there is another safe harbor. Routine maintenance includes the inspection, cleaning and testing of the property, machinery or equipment, and replacement with comparable and commercially available and reasonable replacement parts.
To be considered “routine” maintenance, however, a business manager must expect to perform these services more than once during the class life (generally the same as for depreciation) of the property.
Choosing to capitalize
The final regulations include a new provision that allows a business to treat amounts paid for repairs and maintenance to tangible property as amounts paid to improve that property. If the business person chooses, amounts paid as property improvements become assets subject to depreciation—as long as the expenditures are business-related and are treated as capital expenditures on the operation’s books and records.
Another significant change in the new regulations allows a business to take “retirement losses” on components. If a building’s roof is replaced and the old roof is disposed of, for example, the business now has the option of taking a retirement loss for the old roof. The replacement roof must be capitalized, but the retirement loss can be claimed on the roof replaced.
The new repair regulations have been described as the most comprehensive changes to the issues of capitalization and write-off in more than 20 years. Some of the new regulations’ safe harbors and elections can be implemented on the business’s annual tax return. Because the IRS considers many of the provisions to be accounting methods, however, businesses must file not one, but numerous, Form 3115s, Application for Change in Accounting Method.
Any business seeking to change to a method of accounting permitted under the final regulations must get the IRS’s consent before implementing that new method. Under the automatic consent procedures, the IRS will consent when a Form 3115, Application for Change in Accounting Method, is attached to the business’s tax return (filed on time) for the year of change (with extensions). A signed copy must also be sent to the IRS national office.
The question of capitalization versus expensing of business property has long boiled down to a question of whether the expenditures maintain or restore property in or to its ordinarily efficient operating condition (expense) or appreciably prolong its life, materially increase its value, or adapt it to a different use (capitalization).
Tax strategies and methods used in the past may no longer be either feasible or advisable. Through newly created safe harbors and other taxpayer-favorable features, the new regulations will provide tax planning opportunities—and potential tax savings—for specialty fabric products businesses that will face fewer disputes with the IRS.
While the new repair regulations bring helpful clarity and order to the treatment of tangible property and go a long way to answering the question of what is a repair and what is an expenditure that must be capitalized and depreciated, they also pose considerable compliance risks. Because many business owners will soon discover they need to elect new tax strategies that require an application for an accounting method change, finding professional assistance is, as always, a good business strategy. Check with your accountant for more information.