Deciphering the New Rules for Repair Costs
The IRS has issued final regulations addressing whether a cost is a deductible repair or a capital expenditure.
Since the very inception of the Internal Revenue Code, the IRS and businesses – including print service providers – have been at odds over whether expenditures made are currently deductible, or whether they must be capitalized and recovered through depreciation over time. Now, 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.
In addition, the IRS has released a long-awaited Revenue Procedure detailing the procedures for obtaining the “automatic” consent of the IRS to change accounting methods, as required by these 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 business property. While this concept has been recognized as part of US tax law almost from its inception, exactly what must be capitalized and what can be currently deducted as an expense has been at issue ever since.
The IRS’s newly released regulations, however, serve to provide guidance on a number of 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 capital in nature.
If, for example, a print shop rebuilds the motor on an in-house machine, the IRS usually considers that expenditure to be a capital expense. In the IRS view, rebuilding a motor increases the value of the machine (the unit of property) and prolongs its economic useful life. By comparison, the IRS deems regularly scheduled maintenance repairs as currently deductible – since they don’t materially increase the asset’s value or appreciably prolong its useful life.
In general, the new regulations distinguish between amounts paid to acquire or produce business property, equipment, or machinery, and those amounts that are paid to improve existing property. When it comes to “improvements” to business property, capitalization is required if the expenditure is a betterment, restoration, or adaptation of the unit of property.
A print shop must generally capitalize amounts paid to acquire or produce tangible property, unless the 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 is used or consumed in the taxpayer’s operations. This can include: fuel, lubricants, water, or 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; and a component acquired to maintain, repair, or improve a unit of tangible property that’s not acquired as part of another unit of property. These are items for which records of consumption are not kept and where immediately deducting or expensing them will not distort the print shop’s income. Materials and supplies that do not fit these definitions are deducted when used or consumed.
Rotatable and temporary spare parts: This category is a subset of materials and supplies. Several alternative methods are allowed:
• The cost of rotatable 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 you should record income at its fair market value when the part is removed (continuing that process until claiming a final loss at disposition).
Staying safe with Safe Harbors
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, you might benefit from Safe Harbors in the following examples:
* De Minimis Safe Harbor election: A print shop may elect a “de minimis” Safe Harbor to deduct amounts paid to acquire or produce property, up to a dollar threshold of $5000 per invoice (or per item in some cases), but only $500 for those without.
* Small taxpayer Safe Harbor: The regulations add a new Safe Harbor for businesses with gross receipts of $10 million or less. The Safe Harbor is intended to simplify small taxpayers' compliance with the rules requiring capitalization of building improvements. Qualifying businesses 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. The Safe Harbor is elected annually on a building-by-building basis.
* Routine maintenance Safe Harbor: When it comes to expeditures for the routine maintenance performed by so many printing businesses, there’s 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. Unfortunately, in order for something to be considered “routine” maintenance, the shop has to expect to perform these services more than once during the class life (generally the same as for depreciation) of the property.
Electing to capitalize
The final regulations include an entirely new provision allowing a business to treat amounts paid for repairs and maintenance to tangible property as amounts paid to improve that property. Hence, if the print shop chooses, the amounts paid as property improvements become assets subject to depreciation – as long as the expenditures are business-related and the amounts are treated as capital expenditures on the shop’s books.
Another significant change in the new regulations allows a shop to take “retirement losses” on components. If, for example, a building’s roof is replaced and the old roof is disposed of, the company now has the option of taking a retirement loss for the old roof. Of course, the replacement roof must be capitalized; and the retirement loss can be claimed on the roof that’s been replaced.
Property units and accounting-method changes
Much of the new guidance provided by the IRS revolves around what constitutes a “unit of property” (UOP). In general, the smaller the UOP being placed in service, repaired, or improved, the more likely that the UOP’s cost will have to be capitalized. For example, work on an engine of a vehicle is more likely to be classified as an expense that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.
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 regulation’s Safe Harbors and elections can be implemented on a print operation’s annual tax return. Unfortunately, since the IRS considers many of the provisions to be accounting methods, many shops must file numerous Form 3115s, Application for Change in Accounting Method.
A shop seeking to change to a method of accounting permitted under the final regulations must get IRS 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 company’s timely filed tax return for the year of change (with extensions). A signed copy must also be sent to the IRS’s national office.
Keep in mind that the tax strategies and methods you’ve used in the past may no longer be either feasible or advisable. Yes, the newly created “Safe Harbors” and other taxpayer-favorable features will provide tax-planning opportunities – and potential tax savings – for print service providers and businesses.
But while the new repair regulations bring some helpful clarity and order to the treatment of tangible property – and they go a long way to answering the question of what is a repair and what is an expenditure to be capitalized and depreciated – they also pose considerable compliance risks for every business. Many print shops will discover they need to take on new tax strategies requiring an accounting method change, and I suggest seeking out professional tax assistance rather than going it alone here.
Mark Battersby is a freelance writer who has specialized in taxes and finance for the last 25 years.