In an effort to resolve the controversy over whether certain expenditures made by optometric professionals and practices are currently deductible as repair expenses or whether they must be capitalized and deducted over the life of the underlying business asset, the Internal Revenue Service has finally released new regulations.
The IRS’s long-awaited expanded regulations for determining whether an expense must be capitalized because it betters or improves tangible business property or equipment, restores it or adapts it to a new and different use will have a significant impact on every optometrist and practice that acquires, produces or improves practice assets, equipment or other property.
In addition to clarifying and expanding the current rules, the new regulations create so-called “bright-line” tests for applying the repair or capitalize standards, provide guidance for accounting for – and disposing of – repaired property as well as clarify other aspects of the repair/capitalize dilemma.
The new regulations specify how repairs made simultaneously with improvements are to be treated and provide a “safe harbor” for routine maintenance expenditures such as those for materials and supplies. The new rules are also must reading for landlords and tenants who must capitalize expenses related to leased buildings. In addition, because the new rules became effective Jan. 1, 2012, every optometrist and his or her practice will feel the impact immediately.
Capitalize or repair expense
Since the Reconstruction Era Income Tax Act of 1870, taxpayers have been prohibited from deducting amounts paid for new buildings, permanent improvements or betterments made to increase the value of property. While this concept has been recognized as part of tax law almost from its inception, exactly what must be capitalized and what may be currently deducted as an expense has been at issue ever since
Mark E. Battersby
According to the IRS, expenditures are currently deductible as a repair expense if they are incidental in nature and neither materially add to the value of the property nor appreciably prolong its useful life. Expenditures are also currently deductible if they are for materials and supplies consumed during the year.
On the other hand, expenses must be capitalized and written-off over a number of years if they are for permanent improvements or betterments that increase the value of the property, restore its value or use, substantially prolong its useful life or adapt it to a new or different use.
Unfortunately, the current rules do not clearly address even the core issue of whether expenses should be deducted currently (e.g., repairs or as materials and supplies) or capitalized.
Under the rules, the cost of work performed to return property to a former condition without extending its useful life is currently deductible as a repair expense, unlike capital improvements that extend its life or increase its usefulness or productivity and must be depreciated.
Similarly the cost of incidental repairs is typically deductible. The regulations state that the cost of incidental repairs that neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient condition, may be deducted as an expense.
New additions are often made to already existing property. These additions are not replacement components nor are they repairs to property, but are instead newly installed components. These additions must still be capitalized.
At other times, replacement parts or components are added to existing equipment or property. For example, a car’s engine is worn out and replaced. This replacement returns the car back to its condition prior to the deterioration of the part. It would be logical to consider this replacement as an increase in the car’s value requiring capitalization. Conversely, it would also make sense to say that by returning the car back to its prior condition, it had been repaired. Under this theory, all repairs would be deductible, no matter how substantial they might be.
Based on this interpretation, it is often not enough to merely look at increased value as the determining factor for characterizing the replacement of a part or component as a deductible business expense or a capital expenditure. An increase in value is only one of many factors that must be considered to determine deductibility or capitalization.
We have changes
The new regulations, the IRS’s third attempt to provide comprehensive guidance under the repair or capitalize rules, try to answer questions such as how to treat environmental remediation expenses and how to treat rotatable spare parts used in repairs. Closer to home, one significant rule change allows an optometry practice to deduct retirement losses for building components.
If, for example, the optometric practice replaces the roof on a building and disposes of the old roof, it now has the option of taking a retirement loss for the old roof. Of course, the replacement must still be capitalized, but at least a retirement loss can be claimed.
Another change involves the “de minimis” expensing rule, a rule that allows an optometric practice to expense or write-off the acquisition cost of property on its books for financial reporting purposes. This immediate write-off is available to any optometric practice or business with a written policy in place to do that, but only up to a threshold or ceiling. The new regulations also include many types of materials and supplies among those eligible for the de minimis expensing rule. Under earlier rules they were not eligible, or only some categories were.
Materials and supplies
As mentioned, under the new rules, the costs of buying or producing materials and supplies remain deductible maintenance expenses in the year they are used or consumed. The cost of incidental materials and supplies, for which no record of consumption is kept, are generally deductible in the tax year in which they are paid.
However, while the timing rules for materials and supplies remain the same, the new rules provide a new definition: Materials and supplies may now be currently deducted as an expense if they are acquired to maintain, repair or improve property owned, leased or serviced by the optometry practice or consist of fuel, lubricants, water and similar items that are reasonably expected to be consumed within 12 months, with an economic useful life of less than 12 months or costing less than $100.
Under an elective de minimis rule, amounts (other than inventory or land), along with amounts paid for any materials and supplies, do not have to be capitalized. That is, the amounts do not have to be capitalized if the optometric practice is one of the few that has an applicable financial statement (AFS), such as one required by the Securities and Exchange Commission, or a certified audited financial statement, written accounting procedures in place for treating the amounts as expenses on its AFS and if the amounts paid and not capitalized are less than 0.1% of gross receipts or 2% of the total depreciation expense as determined in its AFS.
Accounting for repairs and replacements
Every optometric professional should have some way of tracking the practice’s assets used and repair costs on a unit-by-unit basis. After all, increasing repair costs can be a strong indication equipment is coming to the end of its useful life or that the practice has a “lemon” that will continue to suck cash.
Many practices find it useful to maintain a spreadsheet listing the purchase date, identifying the equipment and then listing repair or maintenance costs, along with a brief description of the work performed. It is then easy to determine which equipment or business assets are racking up the costs.
Thanks to the new rules, the principals of many optometric practices may soon discover they will have to modify how they account for expenditures, as well as collect information necessary for determining whether these expenditures are capital or, alternatively, currently deductible in the year that they are incurred.
Typically, if a repair cost is not deductible in the year incurred, it would be capitalized and depreciated. If, for example, an optometric practice performed a capitalizable repair on equipment or even the building housing the operation, that additional repair cost would be capitalized and depreciated over the appropriate recovery period for tax purposes. If it is a deducible repair cost, obviously the optometric practice would benefit from an up-front deduction in the tax year incurred.
While awaiting the IRS’s guidelines for implementing the new regulations, it is already obvious that many optometric professionals will need to implement the changes for the 2012 tax year. Whether the IRS will treat the changes required under the new regulations as automatic accounting method changes and whether affected optometric practices will be required to obtain approval for a change in accounting methods remains an unknown.
The sheer volume of the new rules on deduction vs. capitalization of tangible property costs will obviously require professional assistance. While it is not urgent, now might be a good time to both seek professional help and begin looking at repair and maintenance costs for 2012.
For more information:
- Mark E. Battersby has been reporting on news and developments in the tax and financial arenas for more than 25 years. He can be reached at P.O. Box 527, Ardmore, PA 19003-0527; (610) 789-2480; MEBatt12@earthlink.net.