Repairs versus Improvements: New Rules for Deductibility
For many business taxpayers, one of the biggest tax quandaries they face is trying to decide when an expenditure is one that must be capitalized as an asset (with the cost deducted over time through depreciation) versus simply taking an immediate deduction for repairs and maintenance expense, supplies, etc.
Theoretically speaking, any expenditure for property with a useful life of more than 12 months is required to be capitalized and depreciated. This rule also applies to an expenditure that is an improvement, i.e., one that betters or restores a unit of property or adapts it to a new and different use.
However, with the theoretical also comes the practical, and the two sometimes are in conflict. For instance, let's say you buy a $5 stapler. It obviously (most likely) will be around more than 12 months; unless of course you have a temper! Seriously though, while that stapler may technically have to be capitalized and depreciated, doing so makes no practical sense.
Because of this tension between the technical and the practical, not to mention the subjective opinion about when something "improves" property as opposed to simply "repairing" or "maintaining" it, confusion often abounds.
The IRS and Treasury consequently have issued long-awaited, comprehensive regulations on the capitalization of amounts paid to acquire, produce or improve tangible property.
The regulations, released at the end of 2011 and effective immediately for most taxpayers provide the standards that businesses must now apply to determine whether expenditures can be deducted as repairs or supplies, or must be capitalized and then recovered over a period of years.
The regulations are broad and far-reaching and will apply to most every business taxpayer that uses tangible property, whether owned or leased, regardless of the form of entity that operates the business, and regardless of the entity's foreign or domestic status. They apply to manufacturers, wholesalers, distributors, and retailers.
The new regulations generally apply to amounts paid or incurred in tax years beginning on or after January 1, 2012. Thus, for calendar year taxpayers, the rules already apply.
Some of the rules build upon rules already in place; other requirements, however, are completely new.
The regulations are generally beneficial to most businesses, but they also add complexity. They provide a more defined framework for determining capital expenditures, along with some clarifications of the law and some simplifying conventions.
The regulations make significant and substantial changes to the previous proposed regulations issued by the government in 2008. In many cases, the tax treatment of an expenditure will vary from its treatment for book purposes, putting an additional burden on taxpayers to apply new tax accounting systems to track and collect data.
These new regulations will require many decisions by taxpayers in determining the appropriate tax treatment. In some cases, taxpayers are given an explicit election to decide what type of tax treatment to follow. In other cases, taxpayers must make a de facto election.
In either case, once a particular method of accounting is adopted for particular assets, you must continue to follow that method of accounting, and will not be able to change it without the IRS's permission.
There will be more guidance from the IRS. Many businesses will need to change their method of accounting to comply with the new regulations. The IRS has promised to issue revenue procedures that provide transition rules changing a method of accounting.
The regulations require that taxpayers make so-called Code Section 481(a) adjustments to prevent duplicated or omitted tax benefits. Because of this requirement, taxpayers will in effect have to apply the new rules to costs incurred prior to the effective date of the regulations.
As a result, some taxpayers may have to capitalize amounts they previously deducted, and recognize income based on the difference in treatment. Conversely, other taxpayers may be able to deduct amounts previously capitalized, and take a deduction for the difference.
The IRS is taking comments and considering further changes, so any plans set forth to respond to these new regulations must themselves be ready for fine tuning.
There has been much criticism of the regulations as being far too complex, especially for small businesses. The AICPA, for instance, has submitted strong comment and testimony about the overbearing and complex nature of the new rules, so further changes (and hopefully simplification) may be in the offing.
