By Mark Battersby, Contributing Editor
Since the inception of the Internal Revenue Code, the Internal Revenue Service (IRS) and convenience store 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” made to a business property to increase its value. 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 IRS’s newly released 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 a property to its operating state are, according to the IRS, deductible repairs. 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 c-store business rebuilds a cooler’s compressor, the IRS usually considers that expenditure to be a capital expense. In the IRS’s view, rebuilding a compressor increases the value of the cooler (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 cold vault’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 c-store 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:
1. Other property with an economic useful life of 12 months or less;
2. An item with an acquisition or production cost of $200 or less; and
3. 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 c-store operation’s income. Materials and supplies that do not fit these definitions are deducted when used or consumed.
• Rotable and Temporary Spare Parts. This category is a subset of materials and supplies. Several alternative methods are allowed:
1. The cost rotatable and other spare parts are deducted only when they are disposed of;
2. Spare parts are capitalized and depreciated; or
3. The cost of spare parts can be deducted when first installed, but record income at their fair market value when the parts are removed, continuing that process until claiming a final loss at disposition.
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 c-store businesses might benefit from safe harbors, such as the following:
• De Minimis Safe Harbor Election. A c-store 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 without).
• Small Taxpayer Safe Harbor. The regulations add a new safe harbor for c-store 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 c-store 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 c-store operator has to expect to perform these services more than once during the class life (generally the same as for depreciation) of the property.
Election to Capitalize
The final regulations include an entirely new provision that allows a c-store business to treat the amounts paid for repairs and maintenance to tangible property as amounts paid to improve that property. Thus, if the c-store operator chooses, the amounts paid as property improvements become assets subject to depreciation—as long as the expenditures are business-related and the amounts are treated as capital expenditures on the operation’s books and records.
Another significant change in the new regulations allows c-stores to take “retirement losses” on components. If, for example, a building’s roof is replaced and the old roof disposed of, the operation now has the option of taking a retirement loss for the old roof. Of course, the replacement roof must still be capitalized, but the retirement loss now can be claimed on the roof replaced for tax purposes.
The question of capitalization versus expensing of business property has long boiled down to a question of whether the expenditures maintain or restore property in, or to, its ordinarily efficient operating condition (an expense) or appreciably prolong its life, materially increase its value, or adapt it to a different use (capitalization).
Unfortunately, the tax strategies and methods used in the past may no longer be either feasible or advisable. However, through the newly created “safe harbors” and other taxpayer-favorable features, the new regulations will provide tax planning opportunities—and potential tax savings—for c-store businesses that should face fewer disputes with the IRS.
While the new repair regulations bring helpful clarity and order to the treatment of tangible property, and go a long way to answering the question of what is a repair and what is an expenditure that must be capitalized and depreciated, they pose considerable compliance risks for every c-store.
Because many operators will soon discover they need to elect new tax strategies that require an application for an accounting method change, professional assistance is almost mandatory.