Managing the IRS Repair Regulations and the Ongoing Challenges Presented After Initial Implementation
The IRS final “repair regulations,” effective January 1, 2014, completely revamped the way taxpayers evaluate expenditures in order to determine whether certain costs represent immediately deductible repair expenses, or capital improvements that must be depreciated over time. In addition, regulations issued in Section 1.162-3 provide new guidance on when a taxpayer may deduct costs incurred to acquire materials, supplies, repairs, and maintenance. The repair regulations present new risks and opportunities for taxpayers, and the challenge now involves integration of a significant tax rule into your financial reporting function.
For both public and private organizations that issue financial statements and have a tax provision, the administrative burden may seem daunting, requiring you to make multiple accounting method changes. In many cases, businesses will need to devise new collection procedures to capture the necessary data to implement these regulations. The volumes of required recordkeeping may quickly make an impact on your finance department resources.
AAFCPAs has provided a summary of important provisions contained in the final regulations and key operational considerations clients must examine in order to minimize internal disruption and stay in compliance with these new regulations.
Fixed Asset Tracking for GAAP vs. Tax Purposes
Historically, there has been minimal difference in fixed asset cost for financial statements and tax purposes. Exceptions related mostly to property (a) acquired via like-kind exchange, (b) self-developed assets, mostly software, where book/tax divergence was already allowed, or (c) the sale of a company in a stock transaction where an election to step up assets under IRC 338 or 338(h)(10) was either unavailable or inadvisable.
The new repair regulations require items formerly capitalized as ‘improvements’ to be currently deducted, which will increase the physical number of assets tracked for financial, but not tax purposes. The additional requirement of new rules relating to partial dispositions in certain cases also adds complexity.
Impact on Deferred Tax Calculations
Historically, computation of the deferred tax calculation applicable to depreciable property has been a relatively straightforward exercise. Timing differences resulting from the application of accelerated tax depreciation methods (Section 179 Expense, bonus depreciation, etc.) create a deferred tax liability. Companies with significant investments in real property (owned and leased) frequently depreciate these items over longer periods for tax than required under GAAP, which creates a deferred tax asset. As noted in the preceding paragraph, complexity was reduced by the similarity of gross cost figures for both financial and tax accounting. This allowed for the use of net book value as the starting point in computing the net deferred tax asset or liability.
Under the repair regulations, the financial and tax similarity of gross costs can no longer be treated as a given. Many items capitalized for financial accounting purposes are now required to be deducted for income tax purposes. This adds significant complexity to the task of tracking fixed assets for purposes of the deferred tax calculation, as many of the differences will now be caused by variances in gross cost as opposed to net book value.
As an additional note, where the repair regulations have the force and effect of law, compliance must be reviewed in conjunction with Uncertain Tax Position disclosures required by ASC 740.
Fixed Asset Sales Recapture
The final repair regulations present a potential benefit for individuals, trusts, and owners of flow through entities. With a lower gross cost, gains previously taxed at ordinary tax rates or the 25% recapture rate for real property will be converted to 20% capital gain.
However, as the number of individual fixed assets increase, and the recordkeeping for some span multiple years, the ability to continually track will become increasingly complex. For example, in the past, replacement of HVAC units on a building may have been capitalized on your financial statements and tax returns. Now, under the new regulations, these must get deducted for tax purposes as repairs, significantly increasing the complexity of accounting.
Ongoing recordkeeping burden on taxpayers
The dramatic increase in complexity of IRS regulations will significantly increase the costs and administrative burdens of taxpayers as they struggle to comply with their duty to pay tax.
Given the breadth and diversity of the assets involved, the impact of the repair regulations has been most significant for those industries that regularly incur large capital expenditures, e.g., manufacturing & distribution, energy, telecommunications, transportation, high tech & technology, healthcare, construction, and businesses with substantial real estate holdings.
AAFCPAs has the resources and expertise to ensure you are accurately tracking fixed assets, particularly as the financial and tax aspects of accounting methods become more divergent. In addition, we are able to assess your methods of accounting, determine the need for a formal cost segregation or repair/capitalization study, review whether disposals should generate current deductions, and ensure proper reporting and classification.
If you have any questions about the implementation of the repair regulations, please contact your AAFCPA partner, or Richard Weiner, CPA, MST at 774.512.4078, firstname.lastname@example.org.