Implementing the Repair Regulations in your Transportation Business Tiffany Piper, CPA Tax Manager
[email protected] 920-907-2123
For years, taxpayers, along with their accountants, have faced the challenge of distinguishing between capital improvements and repair and maintenance expenses. In 2011 the IRS issued temporary regulations that created guidelines for treatment of these expenditures, along with the proper treatment of materials and supplies. In addition, the regulations covered other issues involving the capitalization of tangible property and also provided the opportunity to write off all or a portion of an asset when disposed of. In September of 2013, the IRS issued the final regulations which are effective for taxpayers with taxable years that start on or after January 1, 2014. The new regulations provide guidance on materials and supplies, capital expenditures, repairs and maintenance, improvements to property and amounts paid to acquire property. On the positive side, we now have some guidance on how to handle these types of costs, but these new regulations are very complex and fact specific with no bright line rules. These regulations will impact almost all taxpayers in any industry, including transportation. Read on for a summary of the new regulations and how they will impact your transportation business.
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Implementing the Repair Regulations in your Transportation Business
Materials and Supplies Materials and supplies are defined as tangible property, excluding inventory, that are used or consumed in operations and is: • A component acquired to maintain, repair or improve a unit of tangible property • Fuel, water, lubricants and similar items that are reasonably expected to be used in 12 months or less • Unit of property whose useful life is 12 months or less • Unit of property with a cost less than $200 The regulations further break down materials and supplies into incidental and nonincidental. What distinguishes incidental and nonincidental is how significant the materials and supplies are to your business. For example, tires and fuel are significant to a transportation company and therefore would be considered nonincidental supplies. Incidental materials and supplies can be deducted when they are purchased assuming there is no record of consumption or physical inventory taken. On the other hand, nonincidental materials and supplies are capitalized and deducted in the year they are used or consumed. Starting in 2014, you will be required to keep a physical inventory or a record of consumption for nonincidental materials and supplies. An exception to this would be if you choose to deduct the material and supply under the de minimis rule, described below. You will need to address how you are accounting for materials and supplies to determine if you are in conformity with the regulations. For instance if you have a shop that houses parts and tires used for repairing tractors and trailers, you will need to assess how you are accounting for these supplies. What supplies are considered incidental and nonincidental? Do you maintain an inventory or track any supplies? When do you expense your supplies? Based on the answers to these questions, you may be required to change your method which will require capitalizing these supplies and accounting for them under the consumption method. Additionally, if you have your tires recapped they are considered rotable parts and are subject to a special set of rules and elections.
you are keeping a physical inventory, and you deduct it as you use it, then you are following the regulations. On the other hand, if you purchase a 3-month supply of fuel and deduct it all upfront, then you may have an issue. Fuel is considered a nonincidental supply and would require that you either keep a physical inventory or a record of consumption.
Capital expenditures The new regulations provide guidance on what expenditures need to be capitalized. You must capitalize any amounts that are paid to improve a unit of property. You make an improvement to a unit of property if you make a betterment, a restoration, or adapt it to a new or different use. This guidance is heavily fact specific with no bright line test so it requires a thorough review of activity performed on tractors and trailers. What is a unit of property? A unit of property consists of a group of functionally interdependent components. In other words, if placing one component in service is dependent on placing another component in service, then they are functionally interdependent and considered one unit of property. For example, a tractor and its components (engine, tires, etc.) would be one unit of property because each of these components needs to be placed in service at the same time in order for the tractor to function. The trailer and its components would be a separate unit of property even though the tractor and the trailer are used together. The regulations separately address what a unit of property is when it comes to buildings. In general, a building and its structural components are one unit of property. Examples of the structural components would be roofs, walls, floors, ceilings and other items that relate to the operation of a building. There are also certain “building systems” that the regulations have defined as separate units of property. These building systems include HVAC systems, plumbing, electrical, escalators, elevators, fire protection, alarm/security and gas distribution. Once unit of property is defined, you then need to determine if amounts paid result in a betterment, restoration or adaption to new/different use.
As defined above, fuel is considered a material and a supply. If you purchase a 3-month supply of fuel, in which
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Implementing the Repair Regulations in your Transportation Business
Betterment Amounts paid for a unit of property are a betterment if they: • Correct a material defect/condition that existed prior to the acquisition of a unit of property (even if you were not aware of it); • Result in a material addition to the unit of property (i.e. enlargement, expansion or extension); or • Result in a material increase in capacity, productivity, efficiency, strength, quality or output of the unit of property. Restoration A restoration of a unit of property will occur if an amount paid is for: • Returning the unit of property to its ordinarily efficient operating condition if the property was in disrepair and no longer functional; • Replacement of a component of a unit of property where a gain/loss is recognized on the component (including casualty losses); • Rebuilding the unit of property to a like-new condition after the end of its class life; or • The replacement of part(s) that comprise a major component or substantial structural part of the unit of property. New/Different Use Amounts paid that adapt a unit of property to a new or different use if the adaption is not consistent with your original intended use of the unit of property when you acquired it. Let’s apply the concepts to some examples. For example, you purchase a tractor in 2008. In 2014, you pay $30,000 to have the engine rebuilt. Under the new regulations, this cost would fall under the restoration category discussed above and would be required to be capitalized. The class life of a tractor is four years and in this example you are rebuilding the tractor to a like-new condition after the end of its class life. Let’s assume the same facts but the tractor was purchased in 2010. In this case the class life of the tractor (4 years) does not end until 2014. Even though the class life is still in effect, this expenditure would be required to be capitalized because you are replacing a major
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component of the tractor (the engine) which qualifies as a restoration. However, there may be instances where certain rebuilds can be deducted. Inquiry of these types of expenditures will need to be done to determine how they can be deducted. If an amount paid for a unit of property falls under any of the three categories above, then the improvement must be capitalized, but the regulations offer some relief to taxpayers by adding the Routine Maintenance Safe Harbor.
Routine Maintenance Safe Harbor The regulations acknowledged that taxpayers incur expenditures that assist in keeping a unit of property in its efficient operating condition. As a result, the IRS created a safe harbor that allows taxpayers to expense certain maintenance costs that are routine and reoccur during the use of a unit of property. An activity is reoccurring if you expect to do it more than once during the class life (not the depreciable life) of the unit of property. This safe harbor rule also applies to buildings and their structural components. In the case of a building and its components, an expenditure can be treated as a repair/ maintenance if you reasonably expect to perform it more than once over a 10 year period of time. With the routine maintenance safe harbor, certain expenditures that relate to maintaining tractors and trailers can be expensed as repairs and maintenance. With a tractor’s class life of four years, any routine maintenance (i.e. oil changes, filters, tune ups, minor repairs) will be expensed because you expect to do these activities more than once over four years. Another item that can qualify as routine maintenance would be replacement tires. Tires can be replaced a number of times over the class life of tractors (4 years) and trailers (6 years) and therefore can be expensed under this safe harbor when purchased and used immediately. On the other hand, activities like rebuilding engines and replacing transmissions are not expected to be done more than once over a four year tractor class life and therefore do not qualify under this safe harbor rule.
De Minimis Safe Harbor to acquire property In general, when you purchase a unit of property, you
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Implementing the Repair Regulations in your Transportation Business
are required to capitalize it. With the new regulations the IRS provided some relief for this general rule by creating a de minimis exception. This exception allows a taxpayer to immediately deduct amounts they pay to acquire or improve property. Taxpayers who have an applicable financial statement (AFS) can deduct up to $5,000 of the cost of an item of property (per invoice). For purposes of the regulations, an AFS is one that is audited or filed with the SEC. For those who do not have an AFS, the $5,000 limit is reduced to $500. Another requirement that needs to be in place before applying the safe harbor is that you need to have a written book capitalization policy in place by the start of 2014. This policy must specify that you will expense a certain dollar amount (up to $5,000 or $500). An example of a capitalization policy is included. To illustrate how the de minimis safe harbor works, let’s look at an example. Assume that a taxpayer does not have an AFS and has a written policy in place that states they will expense property that costs $500 or less. They purchase 20 office chairs that cost $400 each and pay $8,400. Since the taxpayer has a written policy in place and each office chairs (unit of property) is $500 or less, the taxpayer could expense the full $8,400 paid for the office chairs. Although the regulations state the $5,000/$500 limits, your capitalization policy can be set to an appropriate level for your business. In the case of an IRS audit, it would be the taxpayer who has the burden of proving to the IRS that the amount paid was reasonable and it clearly reflected income. Although the de minimis safe harbor now allows the taxpayer to make these immediate deductions, this may be challenging to the transportation industry as it relates to tires. As we stated earlier, if you are purchasing replacement tires and are using them right away, these would be expensed under the routine maintenance safe harbor. But, what if you purchase extra tires that will be used at a later date? We can first apply the de minimis safe harbor rules to determine if we can deduct them. On average, let’s say that a new tire cost approximately $550. If you have an AFS, this should not be an issue and you can expense it under the de minimis safe harbor.
However, many taxpayers in the transportation industry will face the $500 limit. As a result, the purchase of new tires may exceed this limit and you would no longer be eligible for safe harbor treatment. Even though the safe harbor is not available, you could still deduct the tires by increasing the limit in your capitalization policy. But as stated above, the burden would be on you to demonstrate to the IRS that such a deduction clearly reflects income under your facts and circumstances. Alternatively, you could capitalize the tires and deduct them as consumed. An example of a capitalization policy (which you should print onto your corporate letterhead) is included. For an electronic version of the capitalization policy, visit www.schencksc.com/truckingrepairregs.
Disposals The regulations allow taxpayers the opportunity to partially dispose of duplicate portions of property, including buildings and there structural components. For example, in the past if you replaced a roof on a building, the cost of the new roof was capitalized but you were not allowed to dispose of the prior roof. With the new regulations, you can elect to dispose of the prior roof. The regulations illustrate reasonable methods that taxpayers can use to identify the disposed asset. Generally, when you have to replace a component of a tractor, trailer or even a building you will capitalize the new item but elect to dispose of the replaced component. Transportation companies typically face major expenditures in the upkeep of their tractors and trailers. In the past, some taxpayers may have been aggressive in expensing the majority of their repairs to tractors and trailers. However starting in 2014, these expenditures must be revisited to determine what changes are necessary to adopt the new regulations. It is important that you review your repair and supply expenditures and make sure capitalization policies are in place. Overall the new regulations are very complex, but they can provide benefits to your business if implemented correctly. It will be vital for you to meet with your Schenck advisor to address how these new regulations will affect your business. 800-236-2246 • schencksc.com Appleton • Fond du Lac • Green Bay • Manitowoc Milwaukee • Oshkosh • Sheboygan • Wausau © Schenck sc 2014 10.14
Capitalization Policy
This document sets forth the capitalization/expensing policy of ___________________________ for financial accounting purposes with respect to amounts paid to acquire or produce tangible property, including property used to repair, maintain, or improve other tangible property.
Tangible Property defined All tangible personal and real property acquired or produced by the company for use in carrying on its trade or business, including machinery, equipment, furniture, fixtures, computers, vehicles, tools, materials, supplies, land, buildings, leasehold improvements, and other real property.
Capitalization threshold and procedure ___________________________ will treat as a current expense for financial accounting purposes, except as provided below, amounts paid for the acquisition or production of: • Each item of tangible property costing $___________ or less; and • Tangible property with an economic useful life of 12 months or less regardless of cost. The cost of an asset shall be determined on a per item, per invoice basis. Costs of items shall be recorded at historical cost as of the acquisition or production date. Amounts spent on repairs, additions, and improvements to land, buildings, other real property, and personal property may be expensed under this policy unless an alternative treatment is required under the company’s applicable financial standard.
Capital Asset Defined and Amounts A “Capital Asset” is defined as a unit of property that: (1) has an economic useful life that extends beyond 12 months; and (2) is acquired or produced for a cost of more than $___________. Capital Assets must be capitalized and depreciated for financial accounting purposes.
Other This policy does not apply to inventory items and items includible in inventory.
Effective Date: January 1, 2014 Signed _______________________________________
