John Wright

In response to previous court decisions, the IRS has proposed regulations that significantly change the basic test for distinguishing capital expenditures from currently deductible repairs for property, plant and equipment. However, these regulations may not be cited or relied upon until they are finalized. Also, these regulations do not change the treatment of an item specifically provided for under another provision or regulation of the Internal Revenue Code. For example, they do not change the treatment of amounts under Section 263A, which requires taxpayers to capitalize certain costs related to production or resale activities, including allocable repair and maintenance costs.

Under applicable legal authority and the proposed regulations, the tests for distinguishing capital expenditures from current deductible expenses are based on the “unit of property.” In general, if expenditures do not extend the useful life or change the character or nature of the unit of property, the expenditure is currently deductible.

For example, a company owns a factory building, discovers a leak in the roof and hires a contractor to inspect and fix the roof. The contractor discovers a major portion of the sheathing and rafters has rotted and recommends replacing the entire roof. The company pays the contractor to replace the roof. Assume the building and its structural components are the unit of property and the roof does not comprise 50 percent or more of the physical structure of the building. Also assume the cost of the roof does not comprise 50 percent or more of the cost to acquire a new building. Under applicable legal authority and the proposed regulations, the new roof is not a major component or substantial structural part of the building. Therefore, the company is not required to capitalize the amounts paid to replace the roof and may deduct the expenditure as a currently deductible repair.

What if the company had incurred these costs for the new roof several years ago, had capitalized them and now wants to change its method of accounting to currently deduct them?

The IRS has added this method change to its procedures to allow a taxpayer to obtain automatic consent to change to this method of accounting. This procedure applies to taxpayers who want to change their method of accounting from capitalizing costs paid or incurred to repair and maintain tangible property to treating the repair and maintenance costs as ordinary and necessary business expenses that are currently deductible. This change also applies to a taxpayer who wants to change the unit of property it uses to determine the deductibility of repair and maintenance costs to a unit of property that is permissible under applicable legal authority. Pursuant to this procedure, if final regulations are adopted with positions inconsistent with the method of accounting implemented by the taxpayer, that method will no longer be regarded as proper. In such events, the taxpayer will be required to follow any instructions in the final regulations or other guidance published concerning methods of accounting for the repair, maintenance or improvement of tangible property for future taxable years.

While taxpayers may not change a method of accounting in reliance upon the rules contained in the proposed regulations, companies should review depreciation schedules to identify previously capitalized items that qualify as deductible repairs under applicable legal authority. By implementing an automatic change in accounting method for these items, a company has an opportunity to lower its current tax expense and improve cash flow.

Contact your BKD advisor for assistance in applying these rules to your specific situation.