The new repair regulations - some things to consider.

• Author: Mersereau, Dwight N.

All taxpayers that acquire, produce, or improve tangible property will need to evaluate whether to change their methods of accounting (1) to comply with income tax regulations that were recently issued by the Internal Revenue Service and the U.S. Department of the Treasury. Commonly referred to as "the repair regulations," the new rules generally became effective on January 1, 2012. (2) The repair regulations are a marked departure from prior law (as well as earlier proposed regulations). In many respects, they require taxpayers to capitalize more costs than they were required to capitalize under prior law (and what they would have been required to capitalize under the earlier proposed regulations). In addition, the repair regulations provide several new, optional safe-harbor methods of accounting and elections for taxpayers to consider. This article discusses some of the changes in law the repair regulations make as well as some of the optional methods and elections that taxpayers need to consider.

Costs of Materials and Supplies

Under prior law, taxpayers generally were permitted to account for the costs of their materials and supplies as a deferred expense (i.e., not as inventory nor as depreciable property). Under the deferred expense method, taxpayers generally could deduct the cost of their non-incidental materials and supplies when they used and consumed them in operations, and could deduct the cost of their incidental materials and supplies when they purchased them, so long as they did not track their use of the materials and supplies and deducting them currently clearly reflected their income. (3)

The repair regulations retain that general framework. Additionally, the repair regulations define what are materials and supplies, provide an optional method of accounting for rotable and temporary spare parts, provide an optional election to account for materials and supplies under a de minimis rule, and provide an optional election to capitalize and depreciate the otherwise deductible cost of materials and supplies.

1. Materials and Supplies Defined

   The repair regulations define materials and supplies as tangible property that is used or consumed in the taxpayer's operations that is not inventory (4) and that:

   (1) is a component acquired to maintain, repair, or improve a unit of tangible property (5) owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;

   (2) consists of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in the taxpayer's operations;

   (3) is a unit of property that has an economic useful life of 12 months or less, (6) beginning when the property is used or consumed in the taxpayer's operations;

   (4) is a unit of property that has an acquisition or production cost of $100 or less; or

   (5) is identified in guidance published in the Federal Register or Internal Revenue Bulletin as materials and supplies for which treatment is permitted under Treas. Reg. [section] 1.162-3. (7)

   Property that is otherwise described above, but that a taxpayer acquires and uses to improve tangible property, is not a material and supply. Such property is instead subject to the capitalization rules under section 263(a), which are discussed below. (8)

2. Rotable and Temporary Spare Parts

   Rotable spare parts are materials and supplies under number (1) in the foregoing list that a taxpayer acquires for installation on a unit of property with the intention to later remove them from that unit of property, repair or improve them, and then either reinstall them on the same or other property or stores them for later installation. (9)

   Temporary spare parts are materials and supplies under number (1) that a taxpayer uses temporarily (until it can install new or repaired parts) and then removes and stores them for later emergency or temporary installation. (10)

   Under the repair regulations, a taxpayer generally can consider its rotable and temporary spare parts as used or consumed in its operations--and thus, their cost deductible--only when it disposes of them. In some cases, this treatment is less favorable than capitalizing and depreciating the cost of the spare parts, particularly where the taxpayer will not dispose of the spare parts for many years. (11) In such cases, a taxpayer can elect to treat the spare parts as depreciable property. (12) This election, which is also available for other materials and supplies, is discussed below.

   Alternatively, a taxpayer may use the "optional method for rotables" to account for its rotable and temporary spare parts, but only if the taxpayer uses the optional method for all of the rotable and temporary spare parts in its trade or business. (13) Under the optional method, the taxpayer deducts the cost of a rotable or temporary spare part when the taxpayer first installs it. When the taxpayer removes the spare part, however, the taxpayer must include its fair market value in income. That amount--together with the taxpayer's costs of removing the spare part and any costs of maintaining, repairing, and improving it--will be the basis of the spare part. The taxpayer then can deduct the basis in the spare part, and any installation costs, when the taxpayer reinstalls it. When it disposes of a spare part, the taxpayer can deduct any remaining basis in the spare part. (14)

   Finally a taxpayer can elect to deduct the cost of its rotable and temporary spare parts under the de minimis rule, which is discussed below.

   To summarize, a taxpayer may account for the cost of rotable and temporary spare parts using the following methods:

   * Deduct the cost when the taxpayer disposes of them;

   * Capitalize and depreciate the cost over the applicable recovery period;

   * Elect the optional method for rotables; or

   * Deduct the cost under the de minimis rule.

   If a taxpayer elects the optional method for rotables, it must use the method for all rotable and temporary spare parts within a trade or business, but it may selectively apply the de minimis rule. In contrast, if a taxpayer does not elect the optional method for rotables, it may use the deferral method, and selectively apply both the de minimis rule and the capitalization method.

3. The De Minimis Rule Election

   Rather than deducting the cost of non-incidental materials and supplies when it uses or consumes them in the operations of the business, a taxpayer can elect to deduct the cost of non-incidental materials and supplies (including rotable and temporary spare parts) in the year in which it produces or acquires them, to the extent such a deduction qualifies under the de minimis rule of Temp. Reg. [section] 1.263(a)-2T(g). (15) Under the de minimis rule, a taxpayer can deduct the cost of non-incidental materials and supplies if the taxpayer (i) as of the beginning of the year, has a written accounting policy to expense property costing less than a certain threshold, and (ii) did in fact expense the cost of the property on its AFS (16) in accordance with that policy. (17) The total aggregate deduction under the de minimis rule, including deductions for the cost of property other than materials and supplies, (18) however, must be less than or equal to the greater of, (i) 0.1 percent of the taxpayer's gross receipts for the year, or (ii) two percent of the taxpayer's total financial accounting depreciation expense for the year. (19)

   A taxpayer makes the election simply by deducting the cost of the materials and supplies in its timely-filed (including extensions) original federal income tax return for the year the taxpayer acquires or produces the materials and supplies. (20) A taxpayer may revoke the election only by showing good cause for the revocation. (21) A taxpayer may make the election with respect to each material and supply that it acquires or produces. (22) Thus, to maximize the benefit under the election, a taxpayer that is approaching the limit on the deduction can apply the de minimis rule to the materials and supplies that will be used or consumed over the longest period of time.

4. Election to Capitalize and Depreciate

   Alternatively, a taxpayer can selectively elect to capitalize and depreciate the cost of any material and supply. (23) A taxpayer may choose to do so, for example, if the length of time it takes the taxpayer to use and consume the particular material and supply is significant compared to the recovery period. A taxpayer makes the election by capitalizing the cost of the materials and supplies subject to the election (i.e., by not deducting it) and beginning to depreciate it in the taxpayer's timely-filed (including extensions), original federal income tax return for the year the taxpayer places the materials and supplies in service. (24) A taxpayer may revoke the election only by showing good cause for the revocation. (25) If it elects to use the optional method for rotables, a taxpayer cannot make the election to capitalize the cost of any rotable and temporary spare parts. (26)

   Costs to Acquire or Produce Tangible Property

   The repair regulations retain the longstanding rule that taxpayers must capitalize the costs of acquiring and producing tangible property. (27) Additionally, the repair regulations clarify both that taxpayers must capitalize transaction costs and when a taxpayer must account for moving and reinstallation costs of property that the taxpayer previously placed into service. The repair regulations also provide a de minimis rule. Each of these issues is now discussed. (28)

1. Transaction Costs

   Just as the regulations with respect to intangible property require, (29) the repair regulations require taxpayers to capitalize the costs they incur to facilitate the acquisition or production of tangible property. (30) A taxpayer incurs a cost to facilitate the acquisition or production of property if, based on all the facts and circumstances, it incurs the cost "in the...