Deduct or Capitalize - Newer New Rules for Repair Costs
By Mark E. Battersby
Since the inception of the Internal Revenue Code, the IRS and car wash operators and other business owners have been at odds over whether expenditures 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.
The IRS has also released a long-awaited Revenue Procedure that details the procedures necessary to obtain the “automatic” consent of the IRS to change 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 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 currently deducted as an expense has been at issue ever since.
The IRS’s newly released regulations provide guidance on a number of difficultquestions, 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 car wash operator rebuilds a conveyor system’s motor, the IRS usually considers that expenditure to be a capital expense. In the IRS’s view, rebuilding a motor increases the value of the conveyor (the unit of property) and prolongs its economic useful life. By comparison, the IRS views regularly scheduled maintenance repairs as currently deductible, since they do not materially increase the conveyor’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 amounts 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 car wash operator 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 includes 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
• 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 kept and where immediately deducting or expensing them will not distort the car wash 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 rotatable and other spare parts is deducted only when they are disposed of.
• Spare parts are capitalized and depreciated.
• 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.
STAYING SAFE WITH SAFE HARBORS
Safe Harbors can best be compared to legitimate “loopholes” designed by our 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 car wash businesses might benefit from Safe Harbors such as the following:
De Minimis Safe Harbor Election
A car wash 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).
Small Taxpayer Safe Harbor
The regulations add a new safe harbor for car care 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 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. 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 car washes, there is another safe harbor. Routine maintenance includes the inspection, cleaning, and testing of the property, machinery, or equipment and replacement with comparable, commercially available, and reasonable replacement parts.
Unfortunately, in order to be considered “routine” maintenance, the car wash operator has to expect to perform these services more than once during the class life (generally the same as for depreciation) of the property.
THE ELECTION TO CAPITALIZE
The final regulations include an entirely new provision that allows a car wash operator to treat amounts paid for repairs and maintenance to tangible property as amounts paid to improve that property. Thus, if the operator 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 operation’s books and records.
Another significant change in the new regulations allows a car wash to take “retirement losses” on components. If, for example, a building’s roof is replaced and the old roof disposed of, the operation now has the option of taking a retirement loss for the old roof. Of course, the replacement roof must be capitalized, but the retirement loss can be claimed on the roof replaced.
Much of the 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 as a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.
ACCOUNTING METHOD CHANGES
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 car wash operation’s annual tax return. Unfortunately, since the IRS considers many of the provisions to be accounting methods, operators must file not one, but numerous Form 3115s, Application for Change in Accounting Method.
A business seeking to change to a method of accounting permitted under the final regulations must get the 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 business’s timely filed tax return 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).
The 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 car wash operators who 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 pose considerable compliance risks for every car wash. However, because many car wash operators will soon discover they need to elect new tax strategies that require an application for an accounting method change, professional assistance is almost mandatory.
Mark E. Battersby is an Ardmore, PA-based freelance writer, specializing in finance and tax issues.