Taxpayers are generally allowed to deduct the cost of making incidental repairs to their property used in carrying on any trade or business under IRC § 162 and Treas. Reg. § 1.162-4. However, to be deductible currently, a repair cost must not be subject to capitalization under IRC § 263(a). Specifically, no deduction is allowed for (1) any amount paid for new buildings or for permanent improvements that increase the value of the property or (2) any amount spent restoring property or in making good the exhaustion of property for which a depreciation allowance has been made. Treas. Reg. § 1.263(a)-1(b) specifies that capital expenditures include amounts paid or incurred to (1) add to the value or substantially prolong the useful life of property owned by the taxpayer or (2) adapt property to a new or different use.
The IRS Large Business & International Division recently released an audit technique guide (ATG) that provides a framework for IRS examining agents to follow when examining this issue. It provides useful insights into how the IRS will determine whether certain costs are deductible repair costs or capital expenditures. While the ATG does not provide any conclusions on substantive issues, such as unit-of-property determinations, it does provide procedures for agents to follow while examining taxpayers who have filed a change in accounting method related to recharacterizing previously capitalized costs.
The ATG states that whether a cost qualifies as a deductible repair cost is a factual determination for which the burden of proof rests with the taxpayer. Taxpayers are required to keep sufficient contemporaneous records to support their determination that an expense qualifies as a deductible repair and maintenance cost.
The main body of the ATG provides suggestions for IRS agents to follow in planning and conducting their examinations of repair costs. Specifically, it encourages agents to review taxpayer applications for a change in accounting method related to repair costs/unit of property, cost segregation and disposal of property; to review the taxpayer’s repair cost studies, including any presentation materials, correspondence and engagement letters; to review the taxpayer’s SEC 10-K forms and its policies related to fixed assets; and to conduct interviews and site visits.
The body of the ATG contains a list of 46 potential information document request (IDR) items. Taxpayers and their service providers should review the list of IDR items to make sure that they have on record adequate documentation related to the determination that an expense is a deductible repair and maintenance expense.
The ATG also includes six appendices that discuss case law and other authority that may be relevant in determining whether certain costs should be treated as repair and maintenance costs.
Taxpayers considering or who have implemented a change in accounting method to recharacterize capital expenditures as deductible repair and maintenance costs should be aware of the guidance in the ATG. To be prepared for a potential IRS examination, taxpayers should ensure that the proper determination has been made with respect to their unit-of-property definition and what is considered a repair and maintenance cost, as well as have the proper documentation to support the determination.
For a detailed discussion of the issues in this area, see “New IRS Audit Technique Guide for Examination of Repair and Maintenance Costs,” by Ellen Fitzpatrick, CPA, in the February 2011 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser