ARDMORE, Pa. — In an effort to resolve the controversy over whether certain expenditures made by a drycleaning business are currently deductible as repair expenses, or whether they must be capitalized and deducted over the life of the underlying business asset, the Internal Revenue Service has finally released new regulations.
The IRS’s long-awaited expanded regulations for determining whether an expense must be capitalized because it betters or improves tangible business property or equipment, restores it, or adapts it to a new and different use, will have a significant impact on every drycleaning business that acquires, produces, or improves its tangible property.
In addition to clarifying and expanding the current rules, the new regulations create “bright-line” tests for applying the repair-or-capitalize standards, provides guidance for accounting for—and disposing of—repaired property, as well as clarifying other aspects of the repair/capitalize dilemma.
The new regulations specify how repairs made simultaneously with improvements are to be treated, and provide a “safe harbor” for routine maintenance expenses such as materials and supplies. The new rules are also must reading for landlords and tenants that must capitalize expenses related to leased buildings. And, because the new rules were issued in “temporary” form, every drycleaning plant owner and operator will feel the impact immediately.
MATERIAL AND SUPPLIES
As mentioned, under the new rules the costs of buying or producing materials and supplies remain deductible maintenance expenses in the year they are used or consumed. The cost of incidental materials and supplies, for which no record of consumption is kept, are generally deductible in the tax year in which they are paid.
However, while the timing rules for materials and supplies remain the same, the new rules provide a new definition. Materials and supplies may now be currently deducted as an expense if they are acquired to maintain, repair or improve business property owned, leased, or serviced by the drycleaning business, consist of fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12 months, with an economic useful life of less than 12 months or costing less than $100.
Under an elective “de minimis” rule, amounts (other than inventory or land), along with amounts paid for any materials and supplies are not required to be capitalized. That is, the amounts do not have to be capitalized if the drycleaning operation has an applicable financial statement (such as one required by the Securities and Exchange Commission), 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 (1) 0.1% of gross receipts or (2) 2% of the total depreciation expense as determined in its AFS.
ACCOUNTING FOR REPAIRS AND REPLACEMENTS
Every drycleaning business should have some way of tracking the equipment and other assets used in the business and their repair costs on a unit-by-unit basis. It’s unlikely that those repair costs can be tracked mentally. Increasing repair costs can be a strong indication that equipment is coming to the end of its useful life, or that the operation has a “lemon” that will continue to suck cash.
Generally, it is useful to maintain a spreadsheet listing the purchase date, identifying the equipment and then listing repair or maintenance costs, along with a brief description of the work performed. It becomes easy to then determine which units or models are racking up the costs.
Thanks to the new rules, the owners and operators of many drycleaning businesses may discover that they will have to modify how they account for expenditures, as well as collecting information necessary to determine whether these expenditures are capital or alternatively currently deductible in the year that they are incurred.
Typically, if a repair cost is not deductible in the year incurred, it would be capitalized and depreciated. If, for example, a drycleaning plant owner or operator 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 deductible repair cost, obviously the drycleaning operation would benefit from a deduction up front in the tax year incurred.
While awaiting the IRS’ guidelines for implementing the new regulations, it is already obvious that many plant owners and operators will need to implement the changes for the 2012 tax year. Whether the IRS will treat the changes required under the new regulations as automatic accounting method changes, and whether affected drycleaning businesses will be required to obtain approval for a change in accounting methods, are, as yet, unknown.
The sheer volume of the new rules on deduction vs. capitalization of tangible property costs will obviously require professional assistance. Now is a good time to seek such help. While it’s not urgent, now might be a good time to begin looking at repair and maintenance costs for 2012.
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult a tax adviser for advice regarding your particular situation.