If you don’t know what Repair Regulations are all about, just mention them to a CPA and watch the look of defeat wash over their face. These new regulations are long, they are complex, they are confusing, and at times they seem to contradict themselves. To launch into a complete and thorough explanation of them would look more like a novel, and honestly, I don’t think anyone out there has a complete understanding of the rules (not even the IRS). That being said, accountants, business owners, controllers, and CFO’s at minimum need to understand the concepts as well as what needs to be done now in order to fall into basic compliance with these new regulations. Let’s dive in…
First, why did these changes come about? For years, the IRS has been battling with taxpayers over their capitalization policies. The IRS has taken numerous taxpayers to court over their assertion that the taxpayer is expensing items that should be capitalized. In these cases, the tax court has overwhelming ruled in favor of the taxpayer. In light of these defeats, the IRS decided to re-write the capitalization rules in order to “build a fence” around these results and come up with a more well-defined definition of what must be capitalized.
Second, the good news. There is now a defined De Minimis Safe Harbor Election, the maximum of which is $5,000 for each unit of property. This means that if it is your company’s policy to expense purchases of $5,000 or less and you buy a computer for $3,200, you can expense that for tax purposes as well and the IRS won’t challenge it. The maximum of $5,000 is automatic for companies who have an audited financial statement or who present financials to a regulatory agency. All other entities can make similar elections, but the maximum amount may be subject to scrutiny by the IRS. Also, you must have written policy in place before the beginning of the tax year in order to meet IRS guidelines.
Additionally, there is a Routine Maintenance Safe Harbor Election available. Per the IRS, routine maintenance is the inspection, cleaning, and testing of property and the replacement of damaged and worn parts with comparable and commercially available and reasonable replacement parts. To be considered routine, the taxpayer needs to reasonably expect to perform the activities more than once during the 10-year period beginning at the time the property is placed in service. There are no dollar limits on this safe harbor. If you have a $1,000,000 piece of manufacturing equipment that breaks down, and it costs $175,000 to replace parts and get it running again, all that cost is an expense, not subject to capitalization. This election must be made annually by the taxpayer.
Finally- the bad, and there’s a lot of it. It’s complex, and it’s mostly facts and circumstances. To start, what must be capitalized? The IRS states that Improvements that are Betterments, Restorations and Adaptations must be capitalized. There is no bright-line test for any of these, and they are all subject to interpretation, so the answer to what is considered a Betterment, Adaption, or Restoration is- it depends. Additionally, the IRS throws around this concept of Unit of Property, and all these tests of whether something is an improvement or not is made at the Unit of property level. For everything other than buildings, a unit of property is defined as a group of functionally interdependent components. A building is considered a unit of property, but within that building there are nine building systems that are considered to be separate units of property. HVAC, Plumbing, Electrical systems, Escalators, Elevators (why aren’t those two combined?), Fire protection and alarm, Security Systems, Gas Distribution and the dreaded other. What that means is if you replace 9 out of 10 air conditioners in a building, that may only be considered a repair if you were looking at the building as the unit of property, but since the HVAC is a separate unit of property the replacement of a combination of items that compose a substantial structural part of a unit of property, it would be considered a Restoration.
More bad news. Since the IRS considers that they have completely changed the way we as taxpayers account for repairs and capitalizations, they consider everyone who has historical fixed assets to now be using an improper method of accounting. What does this mean? It means everyone, according to the IRS, needs to file one or multiple Applications for Change in Accounting Methods. There is some relief from filing an Application for Change in Accounting Method if you have average annual gross receipts of $10,000,000 or less, however it may still be more beneficial for you to file the change even if you fit under this exception.
So what does it all mean? It means the IRS made it harder to figure out if you should capitalize or expense the costs of acquiring tangible property. So let’s get down to your action items as a taxpayer. First, if you have significant fixed assets and you didn’t file a Form 3115 Applications for Change in Accounting Method with your tax return this year, talk to your CPA about whether or not you need to. Also, if you have a robust fixed asset schedule, there may be opportunities to file an accounting method change and actually get a tax benefit. Second, check to see if you made the proper elections with the filing of your return this year. Third, account for fixed asset additions and dispositions as you normally would, but talk to your CPA about it because the treatment may be different this year. Of course, you can always call us at Cornwell Jackson, and we would be glad to sit down and talk you about what you need to do account for and plan around these law changes as well as determine if there are any tax benefits hiding in your depreciation schedule.
If you would like to learn more about how this topic might affect your business, please email or call us at 972.202.8000.
Gary Jackson, CPA, is a tax partner at Cornwell Jackson. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience at Cornwell Jackson and in providing tax planning to individuals and business leaders across North Texas.
Contact him at email@example.com.
This post was originally published on May 15, 2015, and has been updated for content and accuracy.