Repair Regulation Elections for Business Income

A challenge for businesses is the proper tax classification of expenditures related to tangible property. A payment might be a repair, which is a currently deductible expense under Internal Revenue Code Section 162, or an improvement that must be capitalized under Section 263 and its cost recovered over time through depreciation. To provide clarity, the IRS issued comprehensive Tangible Property Regulations (TPRs) that establish a framework for this distinction.

The TPRs offer several annual elections that simplify accounting and can provide tax benefits by allowing the immediate deduction of costs that might otherwise be capitalized.

Understanding Key Repair Regulation Elections

De Minimis Safe Harbor Election

The De Minimis Safe Harbor Election permits businesses to deduct small-dollar expenditures for acquiring or producing tangible property that would otherwise be capitalized. The deduction limit depends on whether the business has an Applicable Financial Statement (AFS), which is a certified audited financial statement or a statement required to be filed with a federal or state agency.

For a business with an AFS, the threshold is $5,000 per item or invoice; without an AFS, the threshold is $2,500. To use this safe harbor, the business must have an established accounting procedure at the start of the year to expense these items for its non-tax bookkeeping purposes.

Safe Harbor for Small Taxpayers

A separate safe harbor is available for small businesses to simplify the treatment of expenses related to building property. A “small taxpayer” is defined as one with average annual gross receipts of $10 million or less for the three preceding tax years. To qualify, the business must own or lease an eligible building with an unadjusted basis of $1 million or less.

This safe harbor allows the taxpayer to deduct amounts paid for repairs, maintenance, and improvements to the building, capped at the lesser of $10,000 or 2% of the building’s unadjusted basis. This election is made on a building-by-building basis, providing flexibility.

Routine Maintenance Safe Harbor

The Routine Maintenance Safe Harbor allows for the current deduction of expenses for recurring activities that keep property in its ordinarily efficient operating condition. This safe harbor applies to buildings and other tangible property, based on the taxpayer’s expectation when the property is placed in service. An activity is “routine” if the business expects to perform it more than once during the property’s life.

For buildings, this means more than once in a 10-year period, and for other property, more than once during its depreciation class life. Examples include scheduled inspections, cleaning, testing, and replacing worn parts.

Election to Capitalize Repair and Maintenance Costs

A business can elect to capitalize costs that would otherwise be deductible as repairs and maintenance. This election is available if the business also treats these amounts as capital expenditures on its books and records for computing income.

A business might make this choice for strategic reasons, such as not needing additional deductions in a year with a net operating loss. Capitalizing the costs adds them to the property’s basis, allowing for depreciation deductions in future profitable years.

Information and Analysis for Making Elections

Reviewing Expenditures

Before making an election, a business must identify potential qualifying costs by reviewing the company’s general ledger, focusing on accounts for repairs, maintenance, supplies, and fixed assets. This review requires examining individual transactions to understand the specific nature of the work performed or the item purchased. A detailed analysis is necessary, as a payment to a contractor could be for either a deductible repair or a capital improvement.

Required Documentation

Supporting documentation, primarily the vendor or supplier invoice, is the foundation for these elections. A detailed invoice should describe the work performed or items purchased and itemize the costs associated with each component. For example, an invoice for HVAC work should separate repair costs from upgrade costs.

Businesses should also maintain contracts, work orders, and proof of payment to substantiate the expenditure’s nature, cost, and timing. Organized records are required to sustain deductions during an IRS examination.

Developing a Capitalization Policy

A prerequisite for using the De Minimis Safe Harbor is having a capitalization policy in place at the beginning of the tax year. For businesses with an Applicable Financial Statement (AFS), this policy must be in writing. While not required for those without an AFS, a written policy is a best practice.

The policy should state that the company treats amounts paid for property below a specified dollar threshold as expenses for non-tax, financial accounting purposes and must be followed consistently.

How to Make the Elections

The Election Statement

These repair regulation elections are not made by checking a box on a tax form but by preparing a specific statement and attaching it to the business’s timely filed original federal income tax return, including extensions. These are annual elections, so a new statement must be prepared and attached each year a business decides to use one of the safe harbors. Failing to attach the required statement means the election has not been made for that tax year.

Content of the Statement

The election statement must include specific information to be valid. It must clearly identify the specific election being made, typically by referencing the controlling Treasury Regulation section, and include:

• The taxpayer’s name
• Full address
• Taxpayer Identification Number (TIN)
• A title identifying the election, such as “Section 1.263(a)-1(f) de minimis safe harbor election” or “Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers”

The body of the statement should also include a sentence explicitly stating that the taxpayer is making the identified election for the applicable tax year.

Filing Instructions

The prepared election statement must be attached to the business’s annual income tax return. This applies to Form 1120 for corporations, Form 1120-S for S corporations, Form 1065 for partnerships, and Schedule C (Form 1040) for sole proprietorships.

When filing electronically, tax software provides a function for adding these statements; if filing by mail, the statement should be printed and attached. The statement must be submitted with the original return, as these elections cannot be made on an amended return without specific IRS consent.