Last September, the IRS issued the long-awaited Final Tangible Asset Regulations (more commonly known as the Repair Regulations). The new regulations will drastically impact how manufacturing companies treat the amounts paid to purchase, produce, or improve tangible property, like plants, buildings, machines, and much more. While the simplified regulations allow for more manufacturing firms to qualify for tax benefits, they also introduce many compliance challenges. Firms will need to look at their tax practices with a new set of eyes to ensure they not only meet the regulations, but also reap the full potential benefits.
The regulations will have two significant impacts to manufacturing firms’ business:
No. 1. - Tax treatment of repairs or improvements to tangible property
Prior to the repair regulations, there was little guidance on whether manufacturing firms should capitalize or deduct (expense) repairs or improvements. As a result, many companies adopted a “capitalize all repairs” policy to avoid any disputes with the IRS. Luckily, the new regulations eliminate any gray areas and provide clear guidelines for how a company can “test” a repair and determine if it should be capitalized or not. The regulations also include multiple safe harbors that will allow taxpayers to safely choose to deduct certain repair expenses.
A key component of determining whether a cost is a repair or improvement is first determining exactly what constitutes the asset being repaired or improved. The IRS coins this delineation of the repaired asset as the Unit of Property (UOP) and has several rules regarding how UOP is defined.
At its most basic level, UOP is components or assets that are functionally interdependent, but special rules apply for:
- Buildings, where the IRS defines nine separate structures and subsystems
- Manufacturing lines, where each separate function on the line is its own UOP
After the UOP is identified, there’s then a series of three tests taxpayers must apply to see if the repair should be capitalized:
1. Betterment — Is the repair reasonably expected to result in a material increase in the strength or capacity of the UOP? For instance, 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? For instance, replacement of a building roof damaged in a storm.
3. Adaptation — Does the repair adapt the UOP to a different use? For example, conversion of a warehouse space to be used as a showroom.
If after doing the test, the company finds that the repair falls into any of the three categories above, the IRS requires that the repair be capitalized. However, if the repair also falls into one of these safe harbors, then it doesn’t have to be capitalized.
- 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.
These two safe harbors offer manufacturers an opportunity for potential tax savings in items that may have otherwise been capitalized.
No. 2. - Deduction of portions of an asset disposed of during a repair/improvement (Partial dispositions)
A long-time frustration for taxpayers has been the treatment of portions of tangible property that are lost due to casualty or replaced as part of a repair. Before the repair regulations, companies were not allowed to record a loss for these cases. For instance, if facility’s roof was damaged during a story and then replaced, the firm had to the keep the value of the roof on the books as is and continue to depreciate the property (over a 39 year life). Now, however, companies can elect to perform a partial disposition and recognize a loss on the value of the lost or replaced property.
The new repair regulations certainly bring clarity to how companies should treat their tangible property, but there’s a strong chance that most firms’ existing tax accounting practices — and specifically their fixed asset management systems — are not compliance the with the regulations or even beneficial. It’s for this reason manufacturing firms need to reevaluate how they currently treat their tangible property to ensure the transition to the new regulations is as painless and advantageous as possible.
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.