The Tax Treatment of Repairs and Maintenance Expenditures:
A Practical Guide to Mitigating Tax Compliance Issues while Maximizing Tax Consulting Opportunities Under New Capitalization Regs.
(Parker's Federal Tax Bulletin: December 21, 2012)

By Contributing Authors: Julio Gonzalez, Peter J. Scalise, & Veronica Marino

Introduction

On December 23, 2011, the IRS issued temporary regulations that govern when costs are required to be capitalized or deducted as repair and maintenance costs. The new regulations replace the previously issued proposed regulations issued in March 2008.The proposed regulations were binding only on the IRS and not taxpayers.

Originally, the temporary regulations were binding on both the IRS and taxpayers and applied to tax years beginning on and after January 1, 2012. On December 17, 2012, in T.D. 9564, the IRS amended the applicability date for the temporary regulations. See related discussion in the Highlights section of this Bulletin. The temporary regulations now apply to tax years beginning on or after January 1, 2014. However, taxpayers may choose to apply the temporary regulations for tax years beginning on or after January 1, 2012. Practitioners should ascertain the impact of the regulations on sustaining strong tax return filing positions (i.e., "Will", "Should", "More-Likely-Than-Not" and "Substantial Authority").

As a reminder, the following standards for the applicable levels of opinion should be meticulously analyzed when assessing a client's tax return filing position:

(1) Will" Standard: Generally, a 95 percent or greater probability of success if challenged by the IRS. A "Will" opinion generally represents the highest level of assurance that can be provided by an opinion.

(2) "Should" Standard: Generally, a 70 percent or greater probability of success if challenged by the IRS. A "Should" opinion provides a lower level of assurance than is provided by a "Will" opinion, but a higher level of assurance than is provided by a "More-Likely-Than- Not" opinion.

(3) "More-Likely-Than-Not" Standard: A greater than 50 percent probability of success if challenged by the IRS. The "More-Likely-Than-Not" standard is the highest level of accuracy required for purposes of avoiding the accuracy-related penalties under Code Sec. 6662A.

(4) "Substantial Authority" Standard: Typically, greater than the "Realistic Possibility of Success" standard and lower than the "More-Likely-Than-Not" standard (i.e., 40 percent probability of success).

(5) "Realistic Possibility of Success" Standard: Approximately a one-in-three or greater possibility of success if challenged by the IRS.

(6) "Reasonable Basis" Standard: Significantly higher than the "Non Frivolous" standard (i.e., not deliberately improper) and lower than the "Realistic Possibility of Success" standard. The position must be reasonable based on at least one tax authority that can be cited as valid legal authority.

(7) "Non-Frivolous" Standard: Approximately a 10 percent chance of being upheld upon examination by the IRS and accordingly under no circumstance should a tax professional ever render services with this level of comfort.

(8) "Frivolous" Standard: Approximately less than a 10 percent chance of being upheld upon examination by the IRS and accordingly under no circumstances should a tax professional ever render services with this level of comfort.

It should be noted that each of the aforementioned standards has a relevant meaning to both the taxpayers and tax professionals when evaluating a tax position and the related disclosure requirements. Note that the percentages listed for "More-Likely-Than-Not" and "Realistic Possibility of Success" are specifically provided for and discussed in the treasury regulations. In contrast, the percentages for "Substantial Authority," "Reasonable Basis," "Non-Frivolous" and "Frivolous" have been developed based on their relative importance in the hierarchy of standards of opinion as primarily provided for in congressional committee reports. Moreover, while not intrinsically quantitatively calculable, the percentages are still practical in demonstrating the relative strength of one level as opposed to another level.

This article will focus on a practical engineering guide to mitigating tax compliance issues while maximizing tax consulting opportunities in connection with repair and maintenance expenditures.

Tangible Property Scope Synopsis

The line where deductible repairs under Code Sec. 162 ends and capitalized improvements under Code Sec. 263 begins has always been far from patently clear and has led to much controversy between taxpayers and the IRS.

The new regulations do little to clarify this matter (i.e., generally avoiding bright-line tests for facts-and-circumstances analysis). However, they do make substantive changes to the location of the linesome taxpayer favorable and some government favorable. Moreover, this line can be considerably clarified when taking an engineering approach resulting in a more sustainable tax return filing position. For example, having a structural engineer opine upon whether a repair to a building rooftop is a deductible repair or a repair that must be capitalized makes more business sense than having an accountant or attorney make this determination without consulting a qualified engineer. This is no different than having structural engineers render cost segregation services as opposed to accountants and attorneys who have not earned degrees in engineering and are not qualified to read and interpret blueprints and engineering concepts. It is always optimal to have a joint-collaborative effort between licensed engineers and accountants to ensure a sustainable tax return filing position, from both a qualitative and quantitative standpoint, when rendering any engineering-based tax advisory service offering (i.e., cost segregation, construction tax planning, energy tax incentives, research tax incentives, etc.).

The first step in rendering a repairs and maintenance analysis is to start with a complete review of the fixed asset schedule and a list of repairs and maintenance expenditures. Based on the sheer volume of capitalized assets and repairs and maintenance line items, one must decide on the sampling methodology to be used to identify which line items must be reviewed from a qualitative standpoint to get to the substance of the transaction. In addition, it is necessary to review why this capitalization or expenditure was incurred in order to identify if the expenditure was tantamount to an expense incurred to maintain the ordinary useful life of the asset, in which case the expense can deducted, or if the expense was incurred to appreciably prolong the useful life, in which case it is categorized as a betterment, restoration, and /or adaptation and must be capitalized.

As a background, there are two basic categories of samples: statistical samples and professional judgment samples. Each category of sampling methodology is subject to different treatment in connection to tax matters. Statistical samples are based on mathematical principles and use the laws of probability to measure sampling risk. The prominent feature of statistical sampling is its ability to measure risk. The measurement instrument is the confidence interval, which gives a calculated range of values for the estimated amount of misstatement in a population. The measurability of statistical sampling distinguishes it from so-called professional judgment sampling, where the decision as to the items selected for examination is left to the professional judgment of the tax professional. Statistical sampling is a measurement tool. When applied in a substantive test of details, it measures misstatement in an account or class of transactions. Its ability to measure arises from the selection method used, which is similar to probability sampling. As a Best Practice Rule, for engagements with a large number of transactions to be reviewed (i.e., thousands of transactions vs. dozens of transactions), it is only practicable to utilize statistical sampling, as other methods would not be feasible due to the large-scale volume and time needed to vet the thousands of transactions. As a caveat, should the IRS take exception to how a statistical sample was prepared during the course of an examination, the IRS has the right to disallow both the statistical sample and the entire claim. Similar to transfer pricing analysis, statistical sampling should always be prepared by qualified professionals and, again, not prepared in a vacuum by accountants and attorneys. It is critical when designing and implementing methodologies for specialty tax incentives that only true subject matter experts be engaged with appropriate educational backgrounds and subject matter expertise as applicable (i.e., accountants working collaboratively with engineers, economists, and other professionals).

Once the sample of capitalized assets and repairs and maintenance expenditures has been identified to be interviewed on, it is imperative to have a truly joint collaborative effort between qualified and licensed engineers and accountants to vet each and every line item that has been selected for examination. The subsequent practical guide will enable a tax professional to understand the necessary inquires required to properly opine upon whether an expense should be deducted or capitalized under the new temporary regulations.

Deductible Expenses under the New Temporary Regulations

Materials and Supplies

The temporary regulations indicate that incidental materials and supplies may be deducted when purchased as long as no record of consumption is kept and expensing such items does not distort income. Non-incidental materials and supplies, however, are not expensed until they are used or consumed.

Items considered materials and supplies are:

(1) Components acquired to maintain or repair property;

(2) Fuel, lubricants, water and similar items;

(3) Property with an economically useful life of 12 months or less;

(4) Property with an acquisition or production cost of $100 or less; and

(5) Other property identified by the IRS.

De Minimis Rule

The de minimis rule provides another deduction opportunity for amounts paid to acquire or produce tangible property. To be eligible, however, a taxpayer must:

(1) Have an Applicable Financial Statement (AFS), which is generally an audited financial statement;

(2) Have a written accounting policy at the beginning of the tax year for deducting property costing less than a certain dollar amount for non-tax purposes; and

(3) Follow its written accounting policy.

The total amount of such expensed items cannot exceed the greater of 0.1 percent of the taxpayer's gross receipts for the tax year as determined for federal income tax purposes or 2 percent of the taxpayer's total depreciation and amortization expense for such year as determined in its AFS. As a caveat, many small to middle market privately held companies will not be able to take advantage of the de minimis rule because they don't have an AFS.

PRACTICE TIP: While many small businesses do not have an AFS and thus cannot avail themselves of the de minimis rule, the rule may subsequently be broadened to apply to smaller businesses. Alternatively, a business may grow to the point where it does have an AFS and can take advantage of the de minimis rule. In either case, to avail themselves of this rule, taxpayers must have in place written accounting procedures treating as an expense for nontax purposes the amounts paid for property costing less than a certain dollar amount. Thus, practitioners should advise clients to put into place, as soon as possible, the written accounting procedures necessary to take advantage of the de minimis rule should they otherwise be able to. For example, if a calendar-year business otherwise qualifies for the de minimis rule in 2013, it must have the written accounting procedures in place by the end of 2012. Often, these written policies will just be written clarification of procedures the taxpayer already has in place.

Repairs

The general rule is that a taxpayer may deduct amounts paid for repairs and maintenance to tangible property as long as the amounts are not otherwise required to be capitalized. Although the general rule is not very helpful, the regulations do allow a safe harbor deduction for routine maintenance.

Routine Maintenance Safe Harbor

Routine maintenance is the set of recurring activities that keep a unit of property in its ordinary operating condition. This includes the inspection, cleaning, testing, and replacing of parts. Activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the class life of the property. The routine maintenance safe harbor applies to all property other than buildings.

Expenditures Required to be Capitalized

Amounts paid for tangible property that need to be capitalized fall into two general buckets: (1) amounts paid to acquire or produce tangible property, and (2) amounts paid to improve it. Taxpayers must generally capitalize amounts paid to acquire or produce a unit of real or personal property, including leasehold improvement property. This includes the invoice price, transaction costs, and costs for work performed before the date the property is placed in service by the taxpayer. Additionally, a taxpayer must capitalize amounts paid to improve property. Property is improved if the amounts paid result in betterment to the property, restore the property, or adapt the property to a new or different use.

Betterments

A betterment is an amount paid to correct a material condition or defect of the property, which results in either a material addition to the property (physical enlargement, expansion, or extension) or a material increase in capacity, productivity, efficiency, strength or quality of the property or the output of the property.

Restorations

An amount is paid to restore property if:

(1) It is for the replacement of a component of the property and the taxpayer recognized gain or loss on the sale or exchange of the component or deducted a loss for the component;

(2) The taxpayer returns the property to its ordinary efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional;

(3) It results in the rebuilding of the property to a like-new condition after the end of its class life; or

(4) It replaces a part or a combination of parts that comprise a major component or substantial structural part of the unit of property.

Adaptations

An amount is paid to adapt property to a new or different use if the adaptation is not consistent with the taxpayer's intended ordinary use of the property at the time the property was originally placed in service by the taxpayer.

The IRS included 19 examples in the regulations to illustrate what is and what is not a betterment, and 26 examples to illustrate what is and what is not a restoration. The number of examples demonstrates the difficulty in determining the fine line between a deductible expense and a capitalized item.

Unit of Property

Determining the relevant unit of property also plays a large role in shaping whether an amount paid is properly deducted as a repairor must be capitalized as an improvement to the property. The larger the unit of property, the more likely the amount paid will be considered a deductible repair.

For real and personal property (except buildings), a unit of property is comprised of all components that are functionally interdependent (i.e., the placing in service of one component is dependent on the placing in service of the other component).

A new twist in these regulations is the unit of property determination for buildings. A building and its structural components are a single unit of property. For application of the improvement rules, however, "building systems" constitute separate units of property from the building structure. Consequently, for purposes of the improvement analysis, the units of a building property are the building structure (exterior walls, roof, windows, doors, etc.) and the building systems (HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm systems, security systems, gas distribution systems, and other structural components identified as building systems by the IRS).

This componentizing of a building into several units of property is a significant change from the prior proposed regulations. Accordingly, taxpayers that deducted repairs in prior years relating to any of these building systems will need to determine whether such treatment is still appropriate. If not, it may be necessary to request a change in accounting method.

Conclusion

The optimal way to mitigate or eliminate risk and render a precise tax return filing position under a Code Sec. 263(a) study would be to apply engineering-based analysis of the fixed assets and expenditures for repairs and maintenance. When rendering any engineering-based tax advisory service (the tax treatment of repairs and maintenance expenditures, cost segregation services, construction tax planning, energy tax incentives, research tax incentives, etc.) it is imperative to have a joint collaborative effort between highly qualified and licensed engineers and accountants to properly opine upon the tax return filing position from both a qualitative and quantitative perspective. Be sure to engage a true subject matter expert to best ensure sustainable tax return filing positions without any negative impacts on financial statement reporting in connection to both US GAAP and IFRS.

ABOUT THE AUTHORS

Julio P. Gonzalez is the Founding President and CEO of Engineered Tax Services. Julio is a noted thought leader amongst engineering based tax advisory services and a nationally renowned AICPA and AIA Keynote Speaker on specialty tax incentives.

Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is also a highly distinguished member of both the Board of Directors and Board of Editors for The American Society of Tax Professionals and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an Operating Division of ASTP. Peter is a nationally acclaimed AICPA, ABA, ASTP, TEI and AIA Keynote Speaker on specialty tax incentives.

Veronica Marino serves as a Senior Associate for Engineered Tax Services where she renders specialty tax incentives. Veronica joined Engineered Tax Services with approximately five years of leading public accounting experience and is a graduate of Florida State University where she earned her Bachelor of Science Degree in Accounting.

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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