A Letter to Dealers: Deducting or Capitalizing Amounts Paid to Acquire, Produce, or Improve Tangible Property
The letter below was sent to dealers from Dealerships Partner Christopher F. Beaulieu
I'm writing to let you know about an important development that will affect nearly every business, including yours. On December 23, 2011, the IRS issued guidance on whether businesses can deduct or must capitalize amounts they pay to acquire, produce, or improve tangible property. Initially, these new guidelines were to have taken effect for tax years beginning in 2012. However, the IRS has now given taxpayers the option of applying them to tax years beginning in 2013.
The basic premise is that the IRS is taking a much stricter view of what many business owners viewed as repairs (and immediately expensed). These new guidelines will require dealers to reexamine past deductions and current policies to comply with these guidelines and avoid unexpected future adjustments. And therein lies the opportunity. But first, this summary will provide an overview of the new guidelines. You may need more guidance depending on your unique business situation, which is to be expected since the proposed and temporary regulations are complex.
Fixed and current assets
The guidance doesn't just apply to newly acquired assets. For example, if you deducted a major repair on a building in 2010 that under these guidelines should have been capitalized, you may need to reverse the expense and capitalize the repair to claim depreciation. The good news is that the IRS provides incentives to reverse the excess deductions over several years without amending past returns.
Unit of property
One of the key issues is the definition of the "unit of property" (UOP) that is repaired or improved. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized. For example, if a piece of diagnostic equipment includes a car lift, and you view the lift and equipment as one UOP, a repair to the lift may be a deductible repair. If, however, the lift is viewed as a separate UOP, it is more likely that a repair to it will have to be capitalized.
Capitalization or deduction
Amounts paid to improve a UOP must be capitalized. The guidelines specifically describe what constitutes an improvement, that being an expenditure that betters or restores a UOP or adapts it to a new and different use.
A current deduction is allowed for routine maintenance to property. But repair and maintenance expenses are deductible only if not otherwise required to be capitalized.
A current deduction is also allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. Materials and supplies are specifically defined in five categories. For example, a UOP with a useful life of no more than 12 months qualifies as deductible materials and supplies under this rule. Similarly, UOPs that cost $100 or less to acquire or produce qualify as deductible materials and supplies.
Generally each building and its structural components are treated as one UOP. In addition, there is a list of nine specified building systems that are treated as UOPs separate from the building structure. An improvement to the building is defined by its effect on those systems, rather than its effect on the building as a whole. If a taxpayer restores a building structure by replacing the entire roof, the cost is treated as an improvement to the single UOP consisting of the building; capitalization is required. If the taxpayer improves a building system, such as the heating, ventilation, and air conditioning (HVAC) system, capitalization is also required. Remember that improvement includes restoring the UOP to its original use, bettering the UOP, or adapting the UOP to a new use.
Property other than buildings
In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can't be placed in service without the other components. In the prior example, if the lift is only used for the diagnostic equipment, the lift and diagnostic equipment are viewed as one UOP. Even if acquired separately, the lift and the equipment should be capitalized as one. It is also important for your fixed asset schedule to properly detail UOP. This may be an appropriate time to perform a fixed asset review to properly classify property.
Routine maintenance safe harbor
The cost of routine maintenance performed on a UOP that is not a building or a structural component is currently deductible. Routine maintenance refers to the recurring activities a taxpayer expects to perform to keep a UOP in ordinarily efficient operating condition. Examples include inspection, cleaning, testing, and replacing the parts of the UOP with comparable replacement parts. Under the safe harbor, the taxpayer should expect to perform the activities more than once during the class life (under the alternative depreciation rules) of the UOP.
Accounting method changes
A change to conform to the new guidelines is considered a change in accounting method for which an accounting adjustment is required. The IRS has issued procedures under which taxpayers may obtain automatic consent to change the accounting method. This is advantageous because the additional income from such a change is brought into income over four years. Filing for the change in advance of notification of IRS audit protects the taxpayer from the IRS increasing prior year taxable income.
While the new rules are complicated, we have found opportunities to bring dealerships into compliance and at the same time identify opportunities to protect against IRS adjustments on prior years. In some cases, we have found unexpected immediate deductions as we applied these new rules.
For more detail on any of these issues, please contact me or any member of the CliftonLarsonAllen dealership team.
Christopher F. Beaulieu, Dealerships Partner