First in a series of articles addressing the recent changes to Section 263(a)
You may be hearing about the new temporary “repair regulations” issued by the IRS. These regulations provide guidance for when taxpayers can treat expenditures as deductible repairs and when they must capitalize them as a fixed asset. All businesses may potentially be impacted by these new regulations, and you may have to file a change in accounting method to conform to the new rules, which are generally effective for tax years beginning on or after January 1, 2012.
The new regulations have moved away from “bright line” tests that were included in previous proposed guidance. Instead, the regulations require a “facts-and-circumstance” approach, which provides less certainty for taxpayers and their advisers.
While commonly referred to as repair regulations, these rules cover much more than whether an expenditure is a repair. They also address:
- when expenditures for materials and supplies need to be capitalized
- the treatment of costs incurred on rotable parts
- transaction costs that need to be capitalized with the acquisition of a unit of property
- the deduction of the adjusted basis of a disposed building component
- costs that need to be capitalized as improvements to a unit of property (betterment, restoration, adaption)
While the concept of unit of property (UOP) will be covered in more detail in a subsequent article, here’s a general understanding of how UOP is defined. The UOP is the level at which activity must be analyzed to determine if it results in an improvement to the UOP or if it results in a deductible repair.
There are different UOP rules for different types of property. For example, a building structure(excluding building systems) and each building system (HVAC, plumbing, electrical, etc.) are now each considered a UOP. A machine that performs a “major and discreet” function in an industrial process is considered plant property. However, all other personal property with functionally integrated components (such as cars, trucks, or locomotives) is considered a UOP.
Because the subject matter covered in the regulations is so broad, we’ll be breaking the discussion down into a series of shorter articles to be covered in upcoming issues of our e-News. This first article will address the rules relating to materials and supplies.
Under the regulations, incidental materials and supplies can be deducted when purchased, assuming the deduction results in a clear reflection of income. Alternatively, non-incidental supplies must be capitalized and deducted when consumed by the taxpayer.
A supply is considered to be incidental if it is carried on hand and no physical inventory is taken or no record of consumption is kept.
Defining “materials and supplies”
The regulations define materials and supplies as an item of tangible personal property that is not included in inventory, and is one of the following:
- A component (such as a spare part) acquired to maintain, repair or improve a unit of property. These components cannot be acquired as part of a unit of property.
- Fuel, lubricants, water and other similar items that are reasonably expected to be consumed within 12 months or less, beginning when used by taxpayer.
- A UOP that has a economic useful life of 12 months or less, beginning when used by the taxpayer.
- A UOP with an acquisition price of $100 or less.
Rotable and temporary spare parts
Also included in “supplies” are rotable and spare parts. A rotable spare part is a material or supply that is acquired for installation on a unit of property, removable from that unit of property, and either reinstalled on the same unit of property or stored for later installation on a different unit of property. Common examples of rotable spare parts are jet engines for airplanes and diesel engines for over-the-road trucks.
A temporary spare part, as the name would imply, is a material/supply that is used temporarily until a new or repaired part can be installed. After the new part is installed, the temporary spare is removed and stored for later use.
The regulations provide a complex set of rules for accounting for the costs of rotable and temporary spare parts. If you use rotable or temporary spare parts in your business, please contact your Schenck advisor for more details.
You can elect to deduct supplies under the de minimis rule
As discussed above, the general rule for a taxpayer who has non-incidental supplies is to capitalize the cost of these supplies until they are consumed in the taxpayer’s trade or business. Alternatively, the taxpayer may elect to deduct the non-incidental supplies under the de minimis exception. If you are eligible for the de minimis rule, you can currently deduct the cost of supplies up to a ceiling amount.
The ceiling amount is the greater of the following: 1) .1% of gross receipts for income tax purposes or 2) 2% of book depreciation and amortization.
The taxpayer must meet the following four criteria in order to qualify for de minimis treatment:
- The taxpayer has an applicable financial statement. An applicable financial statement is either an audited financial statement or a financial statement used for regulatory reporting (HUD, FERC, etc.).
- The taxpayer has at the beginning of the year a written accounting policy for the expensing of property below a certain dollar amount.
- The taxpayer deducts in its applicable financial statement the amounts in number two above.
- The amount deducted does not exceed the ceiling amount described above.
Electing to capitalize and depreciate supplies
Taxpayers may also elect to capitalize the cost of supplies (incidental and non-incidental) and to depreciate them. A taxpayer would make this election by capitalizing the costs of the non-incidental supplies and depreciating them. The supplies would be treated as placed in service in the year acquired and would be eligible for bonus depreciation, if applicable.
The above rules relating to supplies are best illustrated by the following example:
Company X owns a fleet of aircraft that it operates in its business. In Year 1, Company X purchases a stock of spare parts, which it uses to maintain and repair its aircraft. Company X keeps a record of consumption of these spare parts. In Year 2, Company X uses the spare parts for the repair and maintenance of one of its aircraft. The spare parts are considered supplies since they are components acquired to maintain, repair or improve a unit of property. And, since Company X maintains a record of consumption of these parts, the parts are considered non-incidental supplies and can only be deducted when consumed. As a result the costs of the spare parts cannot be deducted until year 2 when the parts are used to repair the airplane.
If Company X deducted the purchase of spare parts as of January 1, 2012, the effective rate of the regulations, a change in accounting method to conform to the regulations would be required.
Alternatively, Company X could elect to deduct these spare parts under the de minimis exception (discussed below).
Company X could also elect to capitalize and depreciate these spare parts. This alternative would only make sense if the recovery period of the parts used for depreciation purposes is less than the period of time it would take Company X to use these parts in its operation.
Company X may be able to change the classification of the spare parts from non-incidental to incidental if they would no longer maintain a record of consumption. The benefit of currently deducting the supplies would have to be weighed against business factors such as not being able to track the amount of spare parts on hand.
The new repair regulations may dramatically affect the way you are required to account for supplies, especially if you maintain a record of consumption of the supplies or if you maintain an inventory of the supplies. You should review your current accounting treatment of supplies with your Schenck adviser to determine if a change in accounting method is required.
Wondering how your business will be affected by these changes? Want to learn how to identify opportunities for deductions as well as items that you have historically expensed that now need to be capitalized? View our webinar on the repair regulations here.
Joe Schirger, CPA, MT, tax manager, has over twenty years of experience providing tax consulting and tax compliance solutions for businesses and individuals.