Beginning with tax years starting on or after January 1, 2014, the IRS has issued a very complex set of Regulations that will require most businesses to keep much better records for repairs, maintenance and supplies expenditures. A business is defined as any taxpayer who files tax returns as a corporation, partnership, LLC, sole proprietor, farmer, rancher, or landlord. There are numerous elections and reporting issues that could become problematic if expenditures are misclassified; and the rules are different for those businesses that issue audited financial statements over those that do not.
We are writing this letter to help our clients understand the need to analyze and appropriately classify these individual items. The filing and disclosure requirements for these expenditures will increase the time to prepare business tax returns; and we may need to spend time scanning your records to identify misclassified expenditures. Compliance will necessitate additional fees when we prepare returns, this year and in the future. If your records segregate these items appropriately, it will help somewhat to mitigate the additional fees, but will not eliminate them. Here is a summary of the new rules and what you will need to do to comply with the new IRS requirements.
General Application Rules
Spending for material, supplies, and repairs to equipment and buildings should be analyzed (tested) to determine whether the expenditure has caused a betterment, restoration or adaptation of the main unit of property.
A unit of property is defined as the inter-related parts composing one larger unit. For example, in the case of equipment or vehicles, a unit of property could be a delivery truck, or machine that is composed of inter-related parts (engine, body, chassis, cutting heads, conveyors, sorters, pickers, cappers, etc.). Therefore, any repairs to the unit must be examined as to whether they made it better or more efficient (betterment), last longer (restoration) or changed what it was used for (adaptation).
For buildings the same three tests apply, and the regulations define as separate units of property any portion of the structure and the following nine sub-systems: HVAC, plumbing, electrical, elevators, escalators, security, fire protection and/or gas distribution systems. Therefore, any repairs to any of the structure or sub-systems must be examined to determine if the expenditure made it better or more efficient (betterment), last longer (restoration) or changed what it was used for (adaptation).
There are some “safe harbor” tests that will apply to expenditures below the thresholds described below, to allow deductibility in the year the cost is incurred. Additionally, businesses that keep records of purchases and usage of materials, supplies, parts, and replacement units (essentially tracking them like inventory) will deduct those items when used, and not when purchased; unless one of the safe harbors applies.
Written policy statements are required in most cases to establish deduction thresholds, especially if you intend to use test levels that are higher than the safe harbors. We suggest that you adopt, and annually monitor the policies at an annual planning meeting with your legal and financial professionals, who can serve as valuable business advisory boards to management; and periodically review expenditures in the categories described below to ensure appropriate treatment under the rules on a consistent basis.
Materials and Supplies
You are now allowed to write off expenditures for any incidental (i.e. those that have no tracking of consumption) individual items costing $200 or less, lasting less than 12 months, or fuel, lubricants or similar items that will be used in 12 months or less (the materials and supplies safe harbor). In addition, you can raise that test level to $500, by making an election to expense all material, supply, and repair costs under that level, as applicable to each unit purchased (see the safe harbor for equipment repairs section in the next paragraph). If that threshold is too low, then a higher expense level can be established, if you do not inventory such items by tracking purchases and withdrawals and using the higher threshold will not materially distort your financial results. A written policy is necessary to define the per unit cost level for annual expensing if you use a higher threshold.
Equipment Repairs and Maintenance
The safe harbor for equipment repairs allows an annual deduction if the expenditure cost is less than $500, by expressly making an annual election on your tax return to expense such items. A larger safe harbor option of $5,000 is available if a business issues audited financial statements to banks, vendors, creditors, municipal agencies, or shareholders. In some cases the test for expensing could be even higher, if you have a written policy and consistently follow it.
Building Repairs & Maintenance
Buildings with an original cost basis of $1,000,000 or less are subject to a special safe harbor rule; building repairs safe harbor. Total expenditures costing the lesser of $10,000 or 2% of the original cost basis, may be annually deducted as a repair. Otherwise, building repair expenditures must be examined individually, at the item or unit level, in accordance with the rules we have described below, to determine if they may be treated as currently deductible expenses or depreciable assets.
Building Expenditures Not Within the Safe Harbor Rules
The IRS rules now call out the character of building and/or leasehold repair expenditures, on a per unit or item basis, if they are outside of the various “safe harbors.” Anything considered a betterment cost, restoration to any part of the component (units) or adaptation under these rules must be categorized appropriately for consideration as depreciable property, otherwise it may be expensed as repairs.
These regulations are extremely complicated and this recap cannot possibly cover all the nuances. While these rules attempt to provide some certainty in an effort to reduce controversies between the IRS and taxpayers, the future of tax planning opportunities lies in reviewing facts and circumstances and understanding the distinctions between repairs, betterments, restorations, and adaptations. You should communicate with us at least annually to review your expenditures to maintain compliance and to improve tax planning opportunities.