Opportunity and Risk in the Repair Regulations for your Transportation Business
Opportunity and Risk in the Repair Regulations for your Transportation Business
In September of 2013, the Internal Revenue Service (IRS) issued regulations, effective no later than tax year 2014, that created guidelines for treatment of tangible property expenditures, whether personal or real property. These new tangible property regulations provide guidance on the capitalization and depreciation of capital expenditures, the treatment of materials and supplies, and the opportunity to write off all or a portion of a disposed asset.
The new regulations present new risks and opportunities that affect taxpayers in every industry that owns depreciable capital assets. Transportation companies, for instance, invest heavily in the purchase and upkeep of their tractors, trailers and equipment. Below is a summary of the new regulations and how they will impact your transportation business.
Taxpayers and their accountants have always faced the challenge of differentiating between capital improvements and repair and maintenance expenses as they seek the balance between accurately reflecting business profits verses maximizing tax deductions. The new regulations dictate that expenditures must be written off as repairs if they are not required to be capitalized. As such, an understanding of the capitalization rules is imperative. You must capitalize any amounts that are paid to improve a unit of property or purchased assets. You make an improvement to a unit of property if you make a betterment, a restoration or adapt the property to a new or different use. This guidance is heavily fact‑specific. While there are no bright-line tests, there are now known specific criteria that need to be applied to the expenditures. The new criteria also requires a thorough review of the past and future expenditures on tractors and trailers. That review will determine if prior capitalized expenditures should now be written off and will determine whether future ones will be capitalized.
Units of Property
The foundation of the capitalization rules is in the comparison of the expenditure to the unit of property. What is a unit of property? A unit of property consists of a group of functionally interdependent components. In other words, if placing one component in service is dependent on placing another component in service, then they are functionally interdependent and considered one unit of property. For example, a tractor and its components are one unit of property because each of those components need to be placed in service at the same time in order for the tractor to function.
The regulations have special rules for units of property when it comes to buildings. In general, a building and its structural components are one unit of property. Examples of the structural components would be roofs, walls, floors, ceilings and other items that relate to the operation of a building. There are also certain “building systems” that the regulations have defined as separate units of property. These building systems include heating, ventilation and air conditioning (HVAC) systems, plumbing, electrical, escalators, elevators, fire protection, alarm/security and gas distribution. Even though a building is one unit of property, the capitalization criteria must be applied at the building structure or system level and then even a smaller comparison must be applied for any item that performs a material and discrete function.
Betterment, Restoration or New/Different Use
Once a unit of property is defined, you then need to determine if the amounts paid result in a betterment, restoration or adaption to new/different use, which are defined below:
- Betterment—to correct a material defect/condition that existed prior to the acquisition of a unit of property; the result in a material addition to the unit of property (e.g., enlargement, expansion or extension); or the result in a material increase in capacity, productivity, efficiency, strength, quality or output of the unit of property
- Restoration—returns the unit of property to its ordinarily efficient operating condition if the property was in disrepair and no longer functional; replacement of a component of a unit of property where a gain/loss is recognized on the component; rebuilding the unit of property to a like-new condition after the end of its class life; or the replacement of part(s) that comprise a major component, large physical portion or substantial structural part of the unit of property
- New/different use—adapt a unit of property to a new or different use if the adaption is not consistent with your original intended use of the unit of property when you acquired it
To apply the concepts, let’s look at some examples:
- Assuming you purchased a tractor in 2007, in 2014, you then pay $15,000 to have the engine and transmission rebuilt, and the cab repainted and upholstered. Under the new regulations, this cost would fall under the restoration category discussed above and would be required to be capitalized. The applicable class life of a tractor is four years, and in this example, you are rebuilding the tractor to a like-new condition after the end of its class life.
- If you assume the same facts but the tractor was purchased in 2011. In this case, the class life of the tractor (four years) does not end until 2015, and the expenditures could be deducted.
Routine Maintenance Safe Harbor
The IRS offered some opportunities in the regulations by acknowledging that taxpayers do incur expenditures that assist in keeping a unit of property in its efficient operating condition. As a result, the IRS created the routine maintenance safe harbor that allows taxpayers to expense certain maintenance costs that are routine and reoccur during the use of a unit of property. An activity is reoccurring if you expect to do the maintenance more than once during the applicable class life of the unit of property. This safe harbor rule also applies to buildings and their structural components. In the case of a building and its components, an expenditure can be treated as a repair/maintenance if you reasonably expect to perform it more than once over a 10-year period of time.
With the routine maintenance safe harbor, certain expenditures that relate to maintaining tractors and trailers can be expensed as repairs and maintenance. With a tractor’s applicable class life of four years, any routine maintenance (e.g., oil changes, filters, tune-ups, minor repairs) will be expensed because you expect to do these activities more than once over four years. Another item that can qualify as routine maintenance would be replacement tires. Tires can be replaced a number of times over the class life of tractors (four years) and trailers (six years) and, therefore, can be expensed under this safe harbor when purchased and mounted on the vehicle. On the other hand, activities like rebuilding engines and replacing transmissions typically are not expected to be done more than once over a four-year tractor class life and, therefore, do not qualify under this safe harbor rule but may still be considered repairs if the restoration, betterment or adaption rules are not met.
De Minimis Safe Harbor (DMSH) to Acquire Property
When a taxpayer purchases a unit of property, generally capitalization is required; however, the IRS provided some relief under the regulations by creating a DMSH exception. This exception allows taxpayers to immediately deduct amounts they pay to acquire or improve property, if the taxpayer complies with all of the DMSH rules. The DMSH rules can be applied by all taxpayers if the rules are met. First, they must have a capitalization policy in place before the tax year starts. This policy must specify that you will expense a certain dollar amount (e.g., $1,000 and under). Under the regulations, taxpayers who have an applicable financial statement (AFS) audited or filed with the Securities and Exchange Commission (SEC) are granted a safe harbor to deduct up to $5,000 of the cost of an item of property (per invoice). For those who do not have an AFS, the $5,000 safe harbor is reduced to $500 per item. Although the regulations state the $5,000/$500 as safe harbor limits, the capitalization policy should be set to an appropriate level for your business. During an IRS audit, the taxpayer has the burden of proving to the IRS that the amount paid in excess of the safe harbor was reasonable and clearly reflects income.
As an example, assume that a taxpayer does not have an AFS and has a written policy in place that states they will expense property that costs $500 or less. They purchase 25 desks that cost $400 each and pay $10,000. Since the taxpayer has a written policy in place and each office chair (unit of property) is $500 or less, the taxpayer could expense the full $10,000 paid for the desks.
Another transportation industry example relates to tires. Purchasing replacement tires and using them right away results in an immediate expense. However, when purchasing additional tires that will be used at a later date, you could first apply the DMSH rules to determine if you can deduct them, but amounts in excess of your DMSH must be deferred until those tires are put into service. For example, if a new tire costs $600 and a taxpayer has a DMSH policy of $500, that new tire would have be deferred until placed into service.
The regulations also allow taxpayers the opportunity to partially dispose of duplicate portions of property, including buildings and their structural components. Historically, for example, if you replaced a roof on a building, the cost of the new roof was capitalized, but taxpayers were not allowed to dispose of the prior roof. Under the new regulations, a taxpayer can elect to dispose of the prior roof. These partial asset dispositions provide an opportunity to write off duplicable assets for tax years prior to 2014 and are only available through the filing of the 2014 tax returns.
Materials and Supplies
Materials and supplies are defined as tangible property, excluding inventory, which is used or consumed in operations and is:
- A component acquired to maintain, repair or improve a unit of tangible property, or
- Fuel, water, lubricants and similar items that are reasonable expected to be used in 12 months or less, or
- A unit of property whose useful life is 12 months or less, or
- A unit of property with a cost less than $200
Once an item is determined to be material and supplies, the regulations require a taxpayer to divide these materials and supplies into either the incidental or nonincidental categories. Incidental materials and supplies can be deducted when they are purchased, assuming there is no record of consumption or physical inventory taken. On the other hand, nonincidental materials and supplies are required to be deferred and deducted in the year they are used or consumed. No later than tax year 2014, taxpayers are required to defer and keep a physical inventory or a record of consumption for their nonincidental materials and supplies. This rule is trumped if a taxpayer chooses to, and is able to, deduct the material and supply under the DMSH rule as described above.
Taxpayers must review and adapt their accounting for materials and supplies by tax year 2014 to conform the treatment of material and supplies to the regulations. For instance, a shop that houses parts and tires used for repairing or maintaining tractors and trailers will need to evaluate and potentially revise its accounting for these supplies and determine if those items are either incidental or nonincidental under the regulations. If the taxpayer maintains an inventory, tracks those items or those items that are significant to the taxpayer, then those items are, by the IRS definition, nonincidental. If the taxpayer currently expenses those supplies as they are purchased, then the taxpayer will be required to change their accounting method from deducting those items when purchased to deferring those supplies until used or consumed by tax year 2014.
As an additional consideration, fuel is considered a nonincidental supply, as defined in the regulations, and requires the maintenance of either a physical inventory or a record of consumption. Therefore, if a taxpayer purchases a three-month supply of fuel, keeps a physical inventory of it and only deducts it as it is consumed, then the regulations are being followed. A full deduction at the time of purchase is not allowed.
Transportation companies invest heavily in the purchase and upkeep of their tractors and trailers. While the new regulations are complex, understanding how they impact your transportation business is critical to maximizing tax deductions while maintaining tax compliance. Past decisions regarding the material and supply expenditures, as well as the capitalization or write-off of their repairs to tractors and trailers, must be reviewed to determine what changes are necessary under the new regulations. These changes will require the filing of certain IRS tax forms no later than tax year 2014, while other changes are either new annual elections or choices. Your Boyer & Ritter LLC advisor has the resources to assist you in determining how these new regulations will affect your business.