ARDMORE, Pa. — Since the inception of the Internal Revenue Code, the IRS and drycleaning businesses have been at odds over whether expenditures made are currently deductible or whether they must be capitalized and recovered through depreciation over time.
Now, after seven years of drafts and proposed rules, the IRS has issued final regulations addressing whether a cost is a deductible repair or a capital expenditure.
The IRS has also released a long-awaited Revenue Procedure that details the procedures for obtaining the “automatic” consent of the IRS to change accounting methods as required by the new repair regulations.
REPAIR OR IMPROVEMENT
Since the Reconstruction Era Income Tax Act of 1870, taxpayers have been prohibited from deducting amounts paid for new buildings, permanent improvements, or “betterments” to business property made to increase the value of business property. While this concept has been recognized as part of U.S. tax law almost from its inception, exactly what must be capitalized and what can be currently deducted as an expense has been at issue ever since.
The newly released IRS regulations provide guidance on a number of difficult questions, such as whether replacing a component of a building is a current deduction or whether it must be depreciated over 39 years. Expenditures that restore property to its operating state are, according to the IRS, a deductible repair. However, expenditures that provide a more permanent increment in longevity, utility, or worth of the property are more likely capital in nature.
If, for example, a dry cleaner rebuilds a van or truck’s engine, the IRS usually considers that expenditure to be a capital expense. In the agency’s view, rebuilding an engine increases the value of the vehicle (the unit of property) and prolongs its economic useful life. By comparison, the IRS views regularly scheduled maintenance repairs as currently deductible, since they do not materially increase the vehicle’s value or appreciably prolong its useful life.
In general, the new regulations distinguish between amounts paid to acquire or produce business property, equipment or machinery and amounts paid to improve existing property. When it comes to “improvements” to business property, capitalization is required if the expenditure is a betterment, restoration, or adaptation of the unit of property.
A drycleaning business must generally capitalize amounts paid to acquire or produce tangible property unless the property falls into the category of materials and supplies, or qualifies for the so-called “de minimis” safe harbor. The new guidelines cover the following:
- Materials and Supplies — Incidental materials and supplies may be deducted when purchased. Tax-deductible materials or supplies are tangible personal property, other than inventory, that is used or consumed in the taxpayer’s operations. This includes fuel, lubricants, water, or similar items that can be reasonably expected to be consumed in 12 months or less.
It also includes:
Other property with an economic useful life of 12 months or less
An item with an acquisition or production cost of $200 or less
A component acquired to maintain, repair, or improve a unit of tangible property that is not acquired as part of another unit of property
These are items for which records of consumption are not kept and where immediately deducting or expensing them will not distort the drycleaning operation’s income. Materials and supplies that do not fit these definitions are deducted when used or consumed.
- Rotatable and Temporary Spare Parts — A subset of materials and supplies, several alternative methods are allowed for spare and substitute parts:
The cost of rotatable and other spare parts is deducted only when they are disposed of,
Spare parts are capitalized and depreciated, or
The cost of spare parts can be deducted when first installed but record income at fair market value when removed, continuing that process until claiming a final loss at disposition.
STAYING SAFE WITH SAFE HARBORS
“Safe harbors” can best be compared to legitimate “loopholes” designed by our lawmakers to limit the full impact of a tax law or provision that might be harmful to a particular group of taxpayers. Under the repair regulations, some dry cleaners might benefit from safe harbors such as the following:
- De Minimis Safe Harbor Election — A drycleaning business may elect a “de minimis” safe harbor to deduct amounts paid to acquire or produce property up to a dollar threshold of $5,000 per invoice (or per item in some cases, but only $500 for those not invoiced separately from a major asset).
- Small Taxpayer Safe Harbor — The regulations add a new safe harbor for drycleaning businesses with gross receipts of $10 million or less. The safe harbor is intended to simplify small taxpayers’ compliance with the rules requiring capitalization of building improvements. Qualifying small taxpayers can elect not to capitalize building improvements with an unadjusted cost basis of $1 million or less if the total amount paid during the year for repairs, maintenance and improvements does not exceed the lesser of $10,000 or 2% of the unadjusted cost basis of the building. The safe harbor is elected annually on a building-by-building basis.
- Routine Maintenance Safe Harbor — When it comes to expenditures for the routine maintenance performed by so many drycleaning businesses, there is another safe harbor. Routine maintenance includes the inspection, cleaning, and testing of the property, machinery or equipment and replacement with comparable and commercially available and reasonable replacement parts.
Unfortunately, in order to be considered “routine” maintenance, the dry cleaner has to expect to perform these services more than once during the class life (generally the same as for depreciation) of the property.
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an attorney or tax adviser for advice regarding your particular situation.
Check back Tuesday for the conclusion!
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