Capitalizing on equipment repairs

Once again, every owner of an aggregate operation is facing this question: When is a repair a capital expenditure? Properly classifying repair, maintenance and improvement expenses is important because improvements to business property must usually be depreciated over many years – as many as 39 years for some business properties.

No matter how much they cost, repairs to business property are currently deductible in a single year. If, for example, an aggregate producer spends $1,000 to repair a business vehicle, it can deduct the entire amount in one year. Yet if the $1,000 amount is to improve the vehicle, it must be deducted a little at a time over five years. Obviously, it is preferable for expenditures to be classified as repairs rather than as improvements with the entire amount deductible in one year.

Unfortunately, distinguishing between repairs and improvements has not always been easy despite the fact that the “final” guidelines governing the deductibility of repairs and improvements to business property went into effect Jan. 1, 2014. Recent changes to those repair regulations haven’t helped.

Ever-changing guidelines

Section 263(a) of our basic tax laws requires amounts paid to acquire, produce or improve tangible property be capitalized. A crushed stone, sand or gravel business generally recovers those capital costs over time through depreciation or amortization deductions. It can also recover those costs when the property is disposed of, a much slower rate of recovering any expenditure. Alternatively, Section 162(a) allows the deduction of ordinary and necessary business expenses incurred during the taxable year, including the cost of repairs and maintenance.

The gist of the repair regulations is that the aggregate business must depreciate any expense incurred to:
◾ Make a long-term asset much better than it was before;
◾ Restore it to operating condition; or
◾ Adapt it to a new use.

In other words, expenses that are not for betterments, restorations or adaptations are currently deductible repairs.

De minimis safe harbor

The repair rules contain a unique expensing “safe harbor” that allows a business to deduct the cost of materials and supplies. The new guidelines increase the de minimis safe harbor per item expensing limits for those aggregate operations without a so-called “applicable financial statement” (AFS).

An AFS is a certified, audited financial statement such as those statements required to be filed with the Securities and Exchange Commission (SEC) or other certified audited financial statements accompanied by a CPA report, including financial statements provided for a loan, reporting to shareholders or for other non-tax purposes. An AFS can also include a financial statement required by a federal or state government other than the IRS or the SEC.

For those aggregate businesses without an AFS or a written accounting procedure, amounts must be expensed on the operation’s books under a consistent accounting procedure or policy that existed at the beginning of the taxable year. Even with an AFS, the operation must have the accounting procedures in writing in order to qualify for the de minimis safe harbor.

Under the final regulations for tangible assets, an aggregate producer can choose to apply a de minimis safe harbor to the amounts paid to acquire or produce tangible property to the extent those amounts are deducted on the operation’s books and records. With an AFS, this safe harbor can be used to deduct amounts paid for tangible property up to $5,000 per invoice or item (as substantiated by an invoice). Without an AFS, the safe harbor may be used to deduct amounts only up to $2,500 ($500 prior to Jan. 1, 2016) per invoice or item.

These limitations are for determining whether particular expenses qualify under the safe harbor and are not intended as a ceiling on the amount that can be deducted.

Materials and supplies

The final tangibles regulations don’t change the rules for deducting materials and supplies. They merely incorporate the already existing definitions and treatments while adding safe harbors.

As the new guidelines define them, materials and supplies are tangible, non-inventory property that are used and consumed in sand, gravel or crushed stone operations, including:
◾ Acquired components – The cost of components acquired to maintain, repair or improve property owned, leased or serviced by the operation and that was not acquired as part of a larger item of tangible property;
◾ Consumables – Costs for fuel, lubricants, water and similar items that might reasonably be expected to be consumed in 12 months or less;
◾ 12-month property – The cost of tangible property with an economic useful life of 12 months or less, beginning when the property is used or consumed in the operation; or
◾ $200 property – Tangible property with an acquisition cost or production cost of $200 or less.
The final regulations also provide guidance for those using “rotable” spare parts. Rotable spare parts are materials and supplies acquired for installation on a “unit of property,” removable from that unit of property, generally repaired or improved, and either reinstalled on the same property or stored for later installation.

Smaller taxpayers

A “small” operation is not required to capitalize as an improvement, and therefore may be permitted to deduct the costs of work performed on owned or leased buildings (such as repairs, maintenance, improvements or similar costs) thanks to a unique safe harbor. To qualify for the small taxpayer safe harbor, the aggregate mining operation must have:
◾ Average annual gross receipts of $10 million or less; and
◾ Own or lease property with an unadjusted basis of less than $1 million; and
◾ The total amount paid during the taxable year for repairs, maintenance, improvements or similar activities performed on such property can’t exceed the lesser of 2 percent of the unadjusted basis of the eligible building property or $10,000.

Fortunately, an annual election is not a change in a method of accounting. Therefore, it is not necessary to file Form 3115, Application for Change in Accounting Method, to make this election or to stop applying the safe harbor in a subsequent year.

When it comes to routine maintenance, the aggregate operation is not required to capitalize costs and can deduct amounts that meet all of the following criteria:
◾ Amounts paid for recurring activities that are expected to be performed;
◾ Expenditures resulting from use of the property in the aggregate operation;
◾ The cost of keeping the property in its ordinarily efficient operating condition; and
◾ For building structures and building systems expenditures for work done more than once during the 10-year period beginning when placed in service or for property other than buildings, more than once during the class life of the unit of property.

If the amount doesn’t meet all of these requirements for the routine maintenance safe harbor, the operation may still deduct the expenditure so long as it is not an improvement.

Changing accounting horses

Although all businesses other than “small qualifying taxpayers” with total assets of less than $10 million and annual average gross receipts of less than $10 million should already have filed for an accounting method change (using Form 3115, Application for Change in Accounting Method) to comply with the new rules, changes can still be made for any tax year by any producer not being audited.

When the method of accounting is changed, the aggregate producer figures out how much higher or lower its income would have been if it had always used the new method. If income would have been higher, it can generally spread that income over four years. If the operation’s income would have been lower, it takes a whopping big deduction in the year of the change.

The repair regulations

The latest version of the repair regulations contains few clear “bright-line rules” to explain exactly how much an asset must be altered in order to constitute an improvement. Instead, all of the “facts and circumstances” must be reviewed before making a judgment call. Fortunately, the final regulations do provide several benefits to the average aggregate mining operation. For example, under the new regulations:
◾ Items costing $200 or less are considered supplies and are currently deductible in a single year;
◾ A special “de minimis safe harbor” allows businesses to immediately write off items costing $500 or less (businesses with a CFS can write off items costing up to $5,000);
◾ The cost of “routine maintenance” is currently deductible; and
◾ Aggregate producers can deduct the unrecovered basis (cost) of business property that is replaced when performing improvements – for example, the unrecovered cost of an old roof can be deducted when a new roof is installed.

The “final” tangible property regulations were issued to provide guidance designed to help every aggregate producer distinguish between a currently deductible repair and an expenditure that must be capitalized. Obviously, professional guidance may be necessary in order to ensure that repairs will remain repairs in the eyes of the ever-vigilant IRS.

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Mark E. Battersby is a freelance writer who has specialized in taxes and finance for the last 25 years.