When it comes to your business’ tax return, you do not have any room to gamble. One wrong move and you can increase your business’ chances of having its tax return selected for Internal Revenue Service (“IRS”) review; a process that you want to avoid at all costs. So what should your business do to stay in compliance with the tax laws?
Determining whether to expense or capitalize certain repair and maintenance expenditures for tax purposes can be quite daunting. Prior to 2014, the decision to expense or capitalize repair and maintenance expenditures was governed by IRS temporary regulations that were regarded as complex and not taxpayer-friendly. Thankfully, in late 2013, the IRS issued final regulations T.D. 9636 that replaced the temporary regulations. T.D. 9636 became effective January 1, 2014. In reality, the final regulations are still fairly complex, but they do include several new provisions that benefit taxpayers. Among the benefits are revised safe harbor thresholds and clarified guidance in dealing with the treatment of materials, supplies, and maintenance expenses.
Under the new regulations, materials and supplies are allowed to be deducted as expenses in the year that they are first used or consumed. Materials and supplies are defined in the regulations as non-inventory items that are generally below $200 in value and are used or consumed in the normal course of the taxpayer’s business. Additionally, incidental materials and supplies, or those that are carried on hand with no records of consumption, are deductible as expenses in the year that they are purchased. Essentially, this means that your business can expense small maintenance items under $200, such as light bulbs and cleaning supplies.
The clarification and expansion of several safe harbors in the temporary regulations was another integral part of the final regulations. The first of these, the de minimis safe harbor, is an election that establishes a threshold for businesses to follow in determining whether or not to capitalize a repair or maintenance expenditure. The election, once made, allows your business to expense repair and maintenance expenditures under the applicable threshold amount with a less likelihood of IRS review. The dollar amount of the threshold is either $500 or $5,000 depending on whether your business has an Applicable Financial Statement (“AFS.”) An AFS is a financial statement required to be filed with the Securities and Exchange Commission, a financial statement audited by an independent accounting firm, or any financial statement other than a tax return required to be filed with a government agency. For businesses without an AFS, the threshold amount is $500 and for businesses with an AFS the threshold is $5,000. To demonstrate the safe harbor, let’s say your business has a $3,500 expense for A/C repair. If your business has an AFS and you make the election, you can safely deduct the full amount as an expense. A business without an AFS, however, will have no choice but to capitalize the full cost of the repair for tax purposes, or risk an IRS review.
The routine maintenance safe harbor was also changed under the new regulations. Previously, routine maintenance was only deductible as an expense if it was performed on tangible personal property. The new regulations expand the safe harbor to also include routine maintenance performed on buildings. Per the regulations, routine maintenance is any activity expected to be performed at least once that is undertaken to keep the property in its ordinarily efficient operating condition. There is no election required in order to take advantage of the routine maintenance safe harbor.
In addition to the other changes and clarifications, a new safe harbor election was added to the final regulations for small taxpayers with average gross receipts in the past three years under $10,000,000. This new safe harbor allows small businesses to expense any building improvements made during a tax year, if the total amount of repairs, maintenance, and improvements for the year do not exceed the lesser of $10,000 or 2% of the original cost of the building. To apply this safe harbor, let’s say your small business installs new floors at a cost of $5,000 in a building that they originally purchased for $1,000,000. In this case, $10,000 is less than 2% of the original cost of the building, which is $20,000 ($1,000,000 x 2%). Therefore, we will utilize the $10,000 threshold. If other maintenance, repair, and improvements for the year are greater than $5,000, then your business must capitalize the new floors. However, if other maintenance, repairs, and improvements are less than $5,000 for the year, then your business does not need to capitalize the new floors.
Please keep in mind that the specific regulations discussed herein have been greatly simplified for this article and additional rules and nuances exist in the actual regulations. Before making any tax decisions regarding the capitalization of repair and maintenance expenses, we highly recommend that you seek the advice of a tax professional.
Jacob Lutz, CPA
Jacob joined Cerini & Associates in January of 2013 and has been actively providing tax, compliance, and business advisory services to a wide variety of both for-profit and non-profit clients.