After nearly a decade in the making, the IRS finally issued the much-anticipated Final Tangible Asset Regulations (more commonly known as the Repair Regulations) last September.
These regulations will significantly impact how organizations treat the amounts paid to acquire, produce, or improve tangible property — including plants, machinery, buildings, plus more — in the manufacturing industry. The good news for manufacturing firms is that more companies will now be eligible for tax benefits under the simplified regulations. However, the challenging part of these new regulations is that achieving compliance under the new rules and adjusting practices to reap the potential benefits will require some additional effort and resources.
The regulations will have two significant impacts to manufacturing firms’ business:
1. Costs to improve tangible property
Whether taxpayers should capitalize or deduct (expense) repairs or improvements has been a murky topic over the past years and has led many companies to adopt a “capitalize all repairs” policy to avoid disputes with the IRS. The repair regulations provide clear guidance as to how one should “test” a repair to see if that repair meets the criteria for capitalization. The regulations also provide several safe harbors that will allow taxpayers to safely choose to deduct certain repair expenses.
Central to the concept of repairs or improvements is the determination of exactly what constitutes the repaired or improved asset. The IRS terms this delineation of the repaired asset as the Unit of Property (UOP) and has several rules regarding how UOP is defined.
The basic definition of UOP is components or assets that are functionally interdependent, but special rules apply for:
- Buildings, where the IRS defines nine separate structures and subsystems, or
- Manufacturing lines where the IRS defines each separate function on the line as its own UOP.
Once the UOP has been determined, taxpayers then have to apply a 3-step test to see if the repair should be capitalized. Those steps are:
1. Betterment. Is the repair reasonably expected to result in a material
increase in the strength or capacity of the UOP? E.g., installing a stronger
engine on a machine that allows the machine to handle more capacity.
2. Restoration. Does the repair restore the UOP to original working order?
E.g., replacement of a building roof damaged in a storm.
3. Adaptation. Does the repair adapt the UOP to a different use? E.g.,
conversion of a warehouse space to be used as a showroom.
If the repair falls into any of the three categories above, the IRS mandates that the repair should be expensed. Unless… the repair also falls into one of these safe harbors:
- De Minimis. With proper documentation and an applicable financial statement (AFS), repair line items or invoices up to $5,000 may be deducted. If lacking an AFS, repair line items or invoices up to $500 may be deducted.
- Routine Maintenance. Taxpayers that document routine maintenance policies and reasonably expect to perform such maintenance more than once in a 10-year period may be able to deduct costs for such maintenance.
The two safe harbors represent an opportunity for manufacturers to potentially find tax savings in items that may have otherwise been capitalized.
2. Partial Dispositions
One item that has long been a sticking point for taxpayers is the treatment of portions of tangible property that are lost due to casualty or replaced as part of a repair. Prior to the new regulations, taxpayers were not allowed to recognize a loss in such events. For instance, if the roof of a manufacturing facility was damaged by a storm and then subsequently replaced, the taxpayer was obligated to keep the value of the roof on the books and continue to depreciate the property (over a 39 year life). Under the new rules, taxpayers can elect to perform a partial disposition and recognize a loss on the value of the lost / replaced property (the roof in this example).
While the new repair regulations bring helpful clarity and order to the treatment of tangible property, there’s a good chance that most organizations’ existing tax accounting practices – and in particular their fixed assets systems – are no longer fully compliant with the new regulations or beneficial. This is why it’s necessary manufacturing firms conduct a thorough assessment of how they currently treat their tangible property in order to make this transition painless and even advantageous for them. Accommodating the new regulations can seem time-consuming and stressful, but by starting to transition your processes to account for the new regulations you’ll be able to avoid many headaches down the road.
About The Author
Dean Sonderegger is the executive director of product management, Bloomberg BNA, Software Segment. Bloomberg BNA is a wholly owned subsidiary of Bloomberg, which is a leading source of legal, regulatory, and business information for professionals.
Dean Sonderegger has more than 20 years of experience in the development and delivery of tax and accounting software solutions, with a specific focus on large enterprise clients. During that time, he has helped some of the largest publicly traded corporations in the world select and implement BNA Fixed Assets™ in order to strengthen accounting controls and gain significant efficiencies.