How Will the New Guidance on Capitalized Expenditures Effect Your Business?
By Aleksandr Gershengorn
August 1, 2011
Recently, IRS has issued Audit Technique Guide (ATG) and instructed its revenue agents and tax auditors to determine which expenditures should be capitalized or deducted. From a taxpayer’s standpoint, it is imperative to understand the position the IRS will likely take with regard to which expenditures should be deducted or capitalized.
Under current rules, any repairs, supplies and/or materials are fully deductible if they do not increase the value or life of an asset. On the other hand, if the expenditures increase the value or life of the property, and are for permanent improvements, they must be capitalized.
Taxpayers should capitalize the expenditure when it:
- Puts the property in a better operating condition;
- Restores the property to a “like new” condition;
- Adds new or replacement components or material sub-components to property;
- Adds upgrades or modifications to property;
- Enhances the value of the property;
- Extends the useful life of the property;
- Improves the efficiency of the property;
- Improves the quality of the property;
- Increases the strength of the property;
- Increases the capacity of the property;
- Improves a material condition or defect; or
- Adapts the property to a new use.
Many companies make capitalization/expense decisions simply based on the dollar amount of the expenditure. For example, a company may deduct an asset which costs less than $1,000, while capitalizing the higher ones. The IRS does not condone or encourage these practices, and will review and determine if the proper accounting and tax treatments were used.
IRS has instructed its revenue agents and tax auditors to consider the following steps when reviewing the costs classified as deductible repairs:
- Improvements that “keep” property in efficient operating condition;
- Restores the property to its previous condition;
- Protects the underlying property through routine maintenance; or
- Incidental repair to property.
By examining and understanding these new factors more clearly, taxpayers may realize that they were incorrectly reporting their expenditures. In many instances, repair and maintenance costs should have been deductible rather than capitalized. In order to properly deduct such costs, taxpayers are required to file Form 3115, Application for Change in Accounting Method, requesting permission from the IRS to change the method of accounting for such costs.
To be prepared for a potential IRS examination, companies who filed Form 3115 or who are thinking about doing so should understand ATG rules and guidelines. Taxpayers should make sure that the proper determination has been made with respect to what is considered a repair and maintenance cost, and should have the proper and meticulous documentation for support.
