With the advent of enhanced expensing opportunities like 100 percent bonus depreciation and super-high Section 179 limits, businesses may be inclined to pay less attention to capitalization policies. But enhanced expensing opportunities are intended as temporary measures designed to stimulate business activity. When normal depreciation rules return, perhaps as soon as 2012, companies will once again focus on what constitutes a repair-expense deduction and what expenditures create a new asset that must be capitalized and the cost recovered through depreciation deductions.

In the Small Business Jobs Act of 2010 (SBJA), Congress raised the Section 179 deduction amount to $500,000 for tax years beginning in 2010 and 2011. And they also extended 50-percent bonus depreciation to qualified assets placed in service during 2010.

Just three months later, in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, Congress increased the bonus-depreciation percentage to 100 percent for qualifying property acquired and placed in service after September 8, 2010 and before January 1, 2012.

Recent IRS Audit Guide

Amid all the fanfare surrounding the announcement of higher tax write-offs for asset purchases, the Internal Revenue Service (IRS) quietly issued a new Audit Technique Guide (ATG) and instructed its examiners to focus on the issue of whether expenditures should be capitalized or deducted.

Under current rules, repair expenses are currently deductible if they are incidental in nature and neither materially add to the value of the property nor appreciably prolong its useful life. Costs for materials and supplies consumed during the year are also currently deductible.

However, expenditures must be capitalized 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 the property to a new or different use.

The ATG instructs examining agents to consider capitalization when an expenditure:

• Puts the property in a better operating condition, as opposed to keeping the property operating efficiently;
• Restores the property to a like-new condition, rather than restoring the property to its previous condition;
• Adds new or replacement components or subcomponents to the property;
• Upgrades or modifies the property;
• Enhances the value of the property in the nature of a betterment;
• Extends the useful life of the property;
• Improves the efficiency, strength or capacity of the property;
• Ameliorates a material condition or defect; or
• Adapts the property to a new use.

Unit of Property

A key issue in determining whether an expenditure should be capitalized or expensed is the unit of property (UOP). The smaller the UOP, the more likely it is that costs incurred in connection with that UOP will have to be capitalized.

In Ingram Industries, Inc. v. Commissioner, T.C. Memo 2000-323, the Court addressed whether the costs of cleaning, inspecting and repairing towboat engines were capital expenditures. The IRS focused on the engines and argued that the work performed increased the value and prolonged the useful life of the engines. Ingram argued that the appropriate focus was on the towboat. The Court agreed with Ingram, stating that the record did not support a practice (industry or otherwise) to purchase or treat towboat engines separately from the towboats.

The Court reasoned that the towboats and engines, if properly maintained, were both expected to last 40 years, that the towboats were purchased with the engines and that the engines were designed to be maintained without removing them from the boat. The Court also noted that there was no evidence indicating that towboat owners regularly and periodically replaced the towboat engines. The Court held that the expenditures did not increase the value or useful life of the towboat or the engine and could be deducted.

In the ATG, the IRS describes seven factors it will use in determining the appropriate UOP:

1. Whether the property is manufactured, marketed or purchased separately;
2. Whether the property is treated as a separate unit by a regulatory agency, in industry practice or by the company, in its books and records;
3. Whether the property is designed to be easily removed from a larger assembly, is regularly or periodically replaced or is one of a fungible set of interchangeable or rotable assets;
4. Whether the property must be removed from a larger assembly to be fixed or improved;
5. Whether the property has a different economic life than the larger assembly;
6. Whether the property is subject to a separate warranty; and
7. Whether the property serves a discrete purpose or functions independently from a larger assembly.

Capitalization Policies

Many companies make capitalization/expense decisions based on the dollar amount of the expenditure. For example, a business may regularly deduct amounts less than $1,000, while higher expenditures are reviewed to determine the proper accounting and tax treatment.

The new ATG suggests that IRS examiners will take the following steps in reviewing costs classified as repairs:

• Analyze detailed records to determine the reason the work was undertaken. Determine the extent to which costs were treated as a UOP separate from the primary UOP.
• Determine the asset's age, acquisition date and any prior repair work that relates to that asset.
• Determine the purpose of the project and the dates the project began and ended.
• Consider how soon the work will have to be repeated.
• Consider whether expenditures:
• result in new assets;
• improve the property, putting it in a better operating condition;
• add new components or material sub-components;
• add upgrades or modifications;
• enhance the value of the property in the nature of a betterment;
• extend the useful life of the property;
• improve the efficiency, quality, strength or capacity of the property; or
• adapt the property to a new use.

The ATG advises examiners to review the assets identified in any cost-segregation study to determine whether the business is being consistent for purposes of both asset identification/classification and determining whether an expense relating to that asset should be capitalized or treated as a repair deduction. For example, if an item is identified as a tangible asset and treated as personal property for purposes of asset classification and/or depreciation, it should not be treated as a structural component of a building to obtain repair treatment.

Change of Accounting Method

A change from capital/depreciable to current expense treatment for previously capitalized expenditures is a change in accounting method. Businesses that have become less vigilant in identifying repairs during years of enhanced depreciation write-offs may have to consider requesting a change in accounting method.

Companies changing methods must file Form 3115 (PDF), generally using the automatic consent provisions contained in Revenue Procedure 2008–52, as modified by Revenue Procedure 2009–39. Section 2.08 of Rev. Proc. 2009–39 added new Appendix section 3.06 to Rev. Proc. 2008–52, which applies to “Repair and Maintenance Costs.” Appendix section 3.06 provides automatic consent for a business that changes its method of accounting from capitalizing to deducting repair and maintenance costs as ordinary and necessary business expenses. This change also applies to a company that wants to change the UOP it uses to determine the deductibility of repair and maintenance costs.