Taxpayers and the taxing authorities have long locked horns over the tax treatment of repair and maintenance costs. For instance, should a business immediately deduct these costs, or should it capitalize and depreciate them over a number of years? After a 10- year odyssey in which it drafted and issued (and redrafted and re-issued) rules related to these issues, the IRS finally settled on a lengthy, complex, and controversial set of regulations.
These rules address repairs and maintenance issues and have become known as the “repair regulations.” However, they also address the tax treatment of smaller property purchases and property disposals. The rules, which went into effect at the beginning of 2014, were designed to reduce complexity, but have in many ways created more confusion for companies across industries. However, they are here to stay, and distributors must work to understand them, comply with them, and address their impact.
While sorting through the rules can be time-consuming and burdensome, distributors may be able to realize tax benefits — and more. Once a distributor understands the rules and the impact on its business, it can impart that knowledge to its customers. While the distributor can’t and shouldn’t be a full-fledged tax adviser for its customers, it can equip customer relations managers and sales personnel with a basic understanding of the effect of the new rules on its customers’ businesses. This can help the distributor add significant value to customer engagements.
Learn How To Live Under New Rules
The IRS’ goal in the final “repair regulations” was to simplify key issues involving the tax treatment of various expenditures related to tangible property. For example, the IRS:
- Adopted a revised de minimis safe harbor for smaller property purchases that allows companies to directly expense – and not capitalize – up to $5,000 per item (a $500 per item limit applies to smaller companies). The regulations also include several other safe harbor methods.
- Revised several of the provisions for determining what constitutes an improvement to property (improvements must be capitalized). The rules further define an improvement with detailed definitions of whether an expenditure represents a “betterment,” an “adaptation” or a “restoration” to tangible property.
- Altered the rules governing dispositions of tangible property. In particular, the IRS adopted new provisions for partial dispositions of assets, which were generally not permitted previously.
These regulations force a distributor to examine all its property expenditures. This could include all its fixed asset purchases (capital expenditures), materials and supplies, repairs and maintenance costs, renovations and improvements, and property disposals. A distributor’s fixed assets are often concentrated in its building, which is usually a warehouse-type facility. Within this facility, a distributor may use various equipment and vehicles to sort, move, pull, and ship inventory. A manufacturer will likely have even more sizeable investments in machinery and equipment.
While they are tedious, and the various components impact distributors in different ways, the rules, especially de minimis safe harbor, can offer distributors immediate tax benefits. For example, say a distributor buys 50 small pieces of material handling equipment which cost just under $5,000 each. In the past, the distributor may have capitalized that cost. Now, it can elect to expense and deduct the approximately $250,000 total cost immediately.
However, distributors must keep in mind that under de minimis safe harbor, they need to synchronize their financial statements with their tax returns. So, if a distributor expenses the $250,000 for tax purposes, it must do the same on its financial statements. This could impact the reporting on its financial statements and create issues with debt covenants with creditors.
Help Your Customers
A distributor’s work may have a direct impact on how “repair regulations” affect its customers. For example, a distributor of industrial equipment, material handling equipment or the smaller components of larger pieces of equipment work with products that may fall under the regulations for a customer.
Take a $50,000 muffle within a $500,000 furnace used in a heat treating facility. While the company only needs to replace the furnace every decade, it must replace the muffle every few years. Though whether the muffle is treated as a separate “unit of property” (another new definition within the “repair regulations” with its own subset of rules) or not will impact the tax treatment, the company may be able to expense it as it is replaced.
Therefore, the company could be in a position to currently deduct the cost of the muffle and realize a tax benefit in the year of the purchase instead of capitalizing it and seeing smaller deductions over several years. The distributor of the muffle can add value by alerting the customer to these potential tax savings.
Similarly, if a distributor is working with HVAC units, roofing materials, windows, or other parts of a building, it has an opportunity to educate customers on their ability to expense costs that they may have previously capitalized.
Under the new regulations, a building is broken down into various systems, such as the HVAC system, plumbing system, and electrical system. The regulations require taxpayers to evaluate any expenditure they make in relation to the impact on these building systems. As a result, the cost of these expenditures does not necessarily determine whether a taxpayer capitalizes the spending as an improvement or treats it as an expense.
The IRS offers an example in the regulations of an office building with 300 windows, which comprise a quarter of the building’s surface area. If the company replaces 100 of the windows, it may qualify as a repair under the rules, and the company could deduct the cost. However, replacing 200 of the windows would likely qualify as an improvement that must be capitalized.
Further, since the roof is considered part of a whole building in the rules, replacing the roof’s membrane could be considered a repair which a company can expense. In the past, this would have been a cost it often capitalized as an improvement.
It’s important to note that this part of the regulations, which deals with whether to capitalize or expense an item, does not require conformity between a company’s tax statements and financial statements. Thus, a company could deduct the cost of replacing windows for tax purposes but capitalize the cost for financial statement purposes.
An Opportunity For Distributors
Distributors are still engaged in the tedious process of understanding how the IRS’ “repair regulations” impact their businesses. Still, the “repair regulations” are a reality distributors have to face. And the distributors that put in the extra work and time needed to fully educate their teams will put themselves in a position to enjoy added tax benefits as well as a competitive edge with their customers.
James Wagner, CPA, is partner-in-charge of the manufacturing and distribution practice at Sikich LLP. James Brandenburg, CPA, is a tax partner at Sikich LLP. Sikich LLP is a professional services firm specializing in accounting, technology, investment banking and advisory services.