Expenses & Deductions
Taxpayers are generally allowed to deduct the cost of making incidental repairs to their property under Sec. 162 and Regs. Sec. 1.162-4. However, in order to be deductible currently, a repair’s cost must not be subject to capitalization under Sec. 263(a). Specifically, Regs. Sec. 1.263(a)-1(a) provides that no deduction will be allowed for:
- Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or
- Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made in the form of a deduction for depreciation, amortization, or depletion.
Regs. Sec. 1.263(a)-1(b) goes on to provide that capital expenditures include amounts paid or incurred to (1) add to the value, or substantially prolong the useful life, of property owned by the taxpayer or (2) adapt property to a new or different use. Therefore, the determination of whether a cost falls within the scope of the regulations under Secs. 263(a) or 162 is extremely important.
In an effort to provide clarity in this area, the IRS and Treasury published proposed regulations in 2006 and reproposed regulations in 2008 (REG-168745-03). The IRS and Treasury are expected to release a regulations package in the near future that will include final regulations, temporary regulations, and proposed regulations covering numerous issues in this area. However, notwithstanding the pending guidance, the IRS Large Business and International Division recently released an audit technique guide (ATG) that provides a framework for an examining agent to follow when examining this issue.
This item briefly describes some important cases in this area and the proposed regulations before discussing the recently released ATG.
There are numerous cases discussing whether a cost is a deductible repair cost or a capital expenditure. The IRS provided guidance on what constitutes a deductible repair expense and what constitutes a capital expenditure in Rev. Rul. 2001-4. In that ruling, the IRS favorably cites Plainfield-Union Water Co., 39 T.C. 333 (1962), in which the Tax Court held that the proper test to determine whether a cost is a capital expenditure is “whether the expenditure materially enhances the value, use, life expectancy, strength, or capacity as compared with the status of the asset prior to the condition necessitating the expense.” The revenue ruling also cites the decision in Illinois Merchants Trust Co., 4 B.T.A. 103 (1926), which applied a “put vs. keep” standard. Applying that standard, taxpayers would deduct repair costs incurred to keep the property in an ordinarily efficient operating condition, whereas costs incurred to put the property in an efficient operating condition would be considered capital expenditures.
The revenue ruling also addresses replacement costs, providing that if a major component or substantial structural part of the asset is replaced and, as a result, the asset as a whole has increased in value, life expectancy, or use, the costs of the replacement must be capitalized. However, replacements of a part or parts that are a relatively minor portion of the asset’s physical structure would be deductible as repair or maintenance expenses.
Maintenance costs are often incurred by taxpayers to keep equipment from breaking down and needing to be repaired. Certain businesses are also required to incur costs to maintain property in an attractive or accommodating condition in order to attract customers and facilitate the sale of goods or services. Rev. Rul. 2001-4 addresses equipment maintenance, providing that such costs are properly deductible under Sec. 162. Similarly, in Moss, 831 F.2d 833, 842 (9th Cir. 1987), the court held that certain costs incurred in remodeling, such as repainting and repapering, were deductible as repair and maintenance costs under Sec. 162.
One important part of applying the above rules is determining the proper unit of property to which the rules should be applied. Typically, the larger the unit of property, the less likely it is that a particular cost will require capitalization. The question becomes how a taxpayer determines the proper unit of property. While courts have looked at various factors in order to determine the proper unit of property, the court in FedEx Corp., 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6th Cir. 2005), provided the most detailed analysis. The factors examined include whether the taxpayer and the industry treat the component part as part of a larger unit of property for regulatory or management purposes, whether the economic useful life of the component is the same as the economic useful life of the larger unit of property, whether the larger unit of property and the smaller unit of property can function independently, and whether the component part can be maintained while affixed to the larger unit of property.
Recent IRS Directives
With the release of the proposed and re-proposed regulations, taxpayers began to take a closer look at their treatment of repair and maintenance type costs incurred for their property. Many found that they were improperly capitalizing (and depreciating) costs that should have been treated as deductible repair and maintenance costs when applying the current standards. In order to properly deduct such costs, taxpayers are required to file a Form 3115, Application for Change in Accounting Method, requesting permission from the IRS to change the method of accounting for such costs. Prior to August 27, 2009, these changes required advance consent. Rev. Proc. 2009-39, which modified and clarified Rev. Proc. 2008-52 relating to automatic consent changes, added a change to properly deduct repair and maintenance costs under Regs. Sec. 1.162-4 to the list of changes that could be made under the automatic procedures.
With the increased number of method changes being filed and taxpayer focus in the area, in an industry director directive (LMSB-4-0110-001) the IRS designated situations in which a taxpayer changes its method of accounting to recharacterize previously capitalized costs under Sec. 263(a) as deductible repair and maintenance costs under Sec. 162 as a Tier I issue. This was the first of two industry director directives focusing on the issue. The second directive (LMSB-4-0110-002) emphasizes that consent granted for a method change to deduct previously capitalized costs does not preclude the IRS from examining the issue of whether certain expenses are deductible repair costs or costs that should be capitalized.
Audit Techniques Guide
The IRS followed up the two directives with the recent release of an ATG (LB&I-4-0910-023) that is to be used by examining agents to help them determine whether certain costs are deductible repair costs or capital expenditures. While the ATG does not provide any conclusions on substantive issues, such as unit of property determinations, it does provide procedures for agents to follow while examining taxpayers who have filed a change in accounting method related to recharacterization of previously capitalized costs. The ATG states that whether a cost qualifies as a deductible repair cost is a factual determination for which the burden of proof rests with the taxpayer. Taxpayers are required to keep sufficient contemporaneous records to support their determination that an expense qualifies as a deductible repair and maintenance cost.
The main body of the ATG provides suggestions for IRS agents to follow in planning and conducting their examinations of repair costs. Specifically, it encourages agents to do the following—among other things—in order to discover relevant information:
- Review Forms 3115 related to repair costs/unit of property, cost segregation, and disposal of property. In reviewing the forms, the agents are told to “identify the legal authority the taxpayer is using to support their change in accounting method.” Agents are told to determine the amount of the Sec. 481(a) adjustment on the tax return and compare it with the Sec. 481(a) adjustment on the Form 3115. If there is a difference between the Sec. 481(a) on the Form 3115 and the Sec. 481(a) on the tax return, the agent is instructed to ask about the difference.
- Review repair cost studies, including any presentation materials, correspondence, and engagement letters. In reviewing the repair cost study, correspondence, and engagement letter, agents are told to look for information in those documents that would indicate the “depth, accuracy, and methodology of the study.” Specifically, if sampling was used, the agents are instructed to determine how that was accomplished (e.g., statistical sampling, modeling, or judgment sampling).
- Review documents examined as part of the repair cost study, including invoices, blueprints, and contracts with construction contractors, architects, etc.
- Review the taxpayer’s Form 10-K and its policies related to fixed assets.
- Conduct interviews with relevant personnel.
- Conduct site visits.
The ATG also instructs agents to apply the law to the taxpayer’s facts and circumstances, consider the tax treatment of any related issues (such as Secs. 199 or 263A), and discuss the agent’s findings with the taxpayer. As highlighted in the industry director directives, taxpayers cannot rely on the proposed regulations until they are issued in final format. Until that time, taxpayers and revenue agents should determine whether the expenditures included in the taxpayer’s Sec. 481(a) adjustment are deductible using current law.
The body of the ATG contains a list of 46 potential information document request (IDR) items. The 46 IDR items are organized into the following groupings: (1) general items; (2) Forms 3115; (3) repair study and related documentation; (4) unit of property; (5) computations; (6) remodels; and (7) additional items. This is a standard IDR request that has been seen in practice and gives taxpayers knowledge of what the IRS will be examining with regard to these method changes. Taxpayers and their service providers should review the list of IDR items to make sure that they have on record adequate documentation related to the determination that an expense is a deductible repair and maintenance expense.
Also included in the ATG are six appendices that discuss case law and other authority that may be relevant in determining whether certain costs should be treated as repair and maintenance costs. Appendix A discusses accounting method procedures relating to the various types of fixed-asset method changes (cost segregation, repairs, unit of property, dispositions). Appendix B reviews various factors the courts have looked at in deciding whether costs are deductible repair costs or capitalizable expenditures. Specifically, costs incurred to do the following would be considered capital expenditures costs: put the property in a better operating condition; restore the property to a “like new” condition; add new or replacement components or material sub-components to property; add upgrades or modifications to property; enhance the value of the property in the nature of a betterment; extend the useful life of the property; improve the efficiency, quality, strength, or capacity of the property; ameliorate a material condition; adapt the property to a new or different use; or carry out a general rehabilitation plan. A shorter list of situations is also provided that would result in a deductible repair cost. These are costs that keep property in efficient operating condition, restore the property to its previous condition, protect the underlying property through routine maintenance, or are incidental repairs to property.
Appendix C discusses the unit of property issue as it relates to personal property, plant property, and real property. The ATG lists seven factors that may be used to determine the proper unit of property for personal or plant property. The factors listed in FedEx are included, plus three additional factors: whether the property is manufactured, marketed, or purchased separately; whether the property is designed to be easily removed from the larger unit of property, is regularly replaced, or is one of a set of interchangeable or rotatable parts; and whether the property is subject to a separate warranty. As it relates to buildings, the ATG states that the determination of the unit of property for a building or its structural components must be based on the taxpayer’s facts and circumstances.
Appendix D discusses issues that arise out of the disposition of property. Appendix E covers related issues and instructs IRS agents to consider the effect of the Sec. 481(a) adjustment on a taxpayer’s Sec. 199 deduction. Finally, Appendix F discusses the use of computer audit support specialists for examination of repair and maintenance method changes.
Taxpayers who are considering or who have implemented a change in accounting method to recharacterize previously considered capital expenditures to deductible repair and maintenance costs should be aware of the issues in the ATG guide. To be prepared for a potential IRS examination, taxpayers should ensure that the proper determination has been made with respect to unit of property and what is considered a repair and maintenance cost and should have the proper documentation to support the determination.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.