Because the current tax rules don’t clearly address the issue of whether expenditures should be deducted (e.g., as repairs or as materials and supplies), or capitalized, the Internal Revenue Service recently attempted to resolve the controversy by issuing new regulations. The IRS’s long-awaited expanded regulations govern whether certain expenditures made by a waste contractor or landfill operator are currently deductible as repair expenses, or whether they must be capitalized and deducted over the life of the underlying business asset.
The new regulations are the IRS’s third attempt to provide comprehensive guidance under the repair or capitalize rules. They attempt to answer such questions as how to treat rotatable spare parts used in repairs. A new rule requires a waste services firm to capitalize repair-type expenses made to assets before they are placed in service. Another significant change will allow a private contracting firm, independent plant or recycling business to deduct “retirement” losses for building components.
If, for example, the waste services operation replaces the roof on its transfer station and disposes of the old roof, it now has the option taking a retirement loss for the old roof. Of course, the replacement must be capitalized, but at least a retirement loss can be claimed.
The new regulations also specify how repairs made simultaneously with improvements are to be treated. The new rules are required reading for landlords and tenants that must capitalize expenses related to leased buildings. And, because these rules were issued in “temporary” form, every business will feel the impact immediately.
Since the Reconstruction Era Income Tax Act of 1870, taxpayers have been prohibited from deducting amounts paid for new buildings, permanent improvements or betterments made to increase the value of property. While this concept has been recognized as part of tax law almost from its inception, exactly what must be capitalized and what may be currently deducted as an expense has been at issue ever since.
According to the IRS, expenditures are currently deductible as a repair expense if they are incidental in nature and neither materially add to the value of the property nor appreciably prolong its useful life. Expenditures are also currently deductible if they are for materials and supplies consumed during the year.
On the other hand, expenses must be capitalized and written off over a number of years if they are for permanent improvements or betterments that increase the value of the property, restore its value or use, substantially prolong its useful life or adapt it to a new or different use.
At times, replacement parts or components are added to business property. For example, a truck’s engine is worn out and replaced. This replacement returns the truck back to its condition prior to the deterioration of the part. It would be logical to consider this replacement as an increase in the truck’s value requiring capitalization. Conversely, it would also make sense to say that by returning the truck back to its prior condition, it had been repaired. Under this theory, all repairs would be deductible, no matter how substantial they might be.
Unfortunately, the above interpretation renders meaningless any distinction between a deductible business expense and a capital expenditure. Thus, it is oftentimes insufficient to merely look at increased value as the determing factor for characterizing the replacement of a part or component.
Obviously, the old rules don’t clearly address the issue of whether expenses should be deducted currently (e.g., as repairs or as materials or supplies) or capitalized. Although the timing of the deduction remains the same under the new regulations, there are new rules where an engine used with a large truck chassis may be treated as a separate asset.
There is also a new definition for “materials and supplies.” Now materials and supplies encompass everything from components acquired to maintain, repair or improve business property; fuel, lubricants, water and similar items expected to be consumed in 12 months or less; and property with an economic useful life of 12 months or less or with a cost of less than $100.
A so-called “de minimis” rule allows waste services businesses to expense the cost of some assets that otherwise would have to be capitalized. That is, the amounts do not have to be capitalized under the new, elective “de minimis” rule if the waste services operation has an applicable financial statement (AFS), such as one required by the Securities and Exchange Commission, or a certified audited financial statement, written accounting procedures in place for treating the amounts as expenses on its AFS, and if the amounts paid and not capitalized are less than a) 0.1 percent of gross receipts; or b) 2 percent of the total depreciation expense as determined in its AFS.
The recently issued “repairs versus improvements” regulations represent the IRS’s attempt to include the large body of court decisions and create all-encompassing guidelines on what constitutes an improvement, namely an expenditure that betters or restores a unit of property, or adapts it to a new and different use. They also adopt a maintenance safe harbor that will be useful for many contracting firms and businesses.
Typically, if a repair cost is not deductible in the year incurred, it would be capitalized and depreciated. If, for example, a refuse contractor had equipment or a machine and performed a capitalizable repair on it, that additional repair cost would be capitalized and depreciated over the appropriate recovery period for tax purposes. If it’s a deducible repair cost, obviously the refuse operation would benefit from a deduction up front in the tax year incurred.
Whether the changes required under the new regulations will be treated as automatic accounting method changes, or whether affected waste services businesses will be required to obtain the IRS’s approval, are as yet unknown at this time. However, the sheer volume and complexity of the new rules on deduction versus capitalization of tangible property costs will also require professional assistance as the waste collection, recycling or landfill operation begins looking at their repair and maintenance costs for 2012.
Mark E. Battersby is an Ardmore, Pa.-based freelance writer who has specialized in taxes and finance for the last 25 years. He currently writes for publications in a variety of fields, syndicates two weekly columns that appear in over 65 publications and has written four books.