It is no secret that business owners generally – with some exceptions – prefer to deduct as much as possible up front rather than capitalize and then depreciate over time.
For this reason, it has become increasingly important for business owners to be aware of the tax laws associated with materials and supplies. These laws can be found among various other equally important topics in the seemingly endless final repair regulations, released Sept. 19, 2013, which became effective Jan. 1, 2014.
Proposed regulations were issued in August 2006, followed by temporary regulations in December 2011, with which your business may or may not be in compliance. Unfortunately, determining deductible materials and supplies isn’t as simple as choosing an arbitrary dollar threshold to expense smaller items used in your business operations.
Materials and supplies defined
The following information outlines the basics of what constitutes materials and supplies as well as the various tax treatments of those expenses.
The basic definition of materials and supplies is tangible property used or consumed in your business operations that is not inventory and that meets one or more of five possibilities:
- It was acquired to maintain, repair or improve a unit of property owned, leased or serviced by the taxpayer and was not acquired as any single unit of property.
- It consists of fuel, lubricants, water and other similar items that are reasonably expected to be consumed within 12 months or less.
- It is considered a unit of property with an economic useful life of 12 months or less, beginning when the unit is first used in the business operations.
- It is a unit of property with an acquisition or production cost of $200 or less.
- It is specifically identified in the Federal Register or Internal Revenue Bulletin.
Taxpayers that were previously in compliance with the temporary regulations may notice that they were given a slight break with the increase in the previous $100-or-less limitation to $200.
During the discussion phase, some consideration was given to increasing the limit to $500, which the IRS felt was too high. But keep an eye on this threshold in the future because the IRS still has the power to amend the amount.
Treatment of material and supply types
A distinction between various types of materials and supplies dictates their particular treatments. These types are:
- Nonincidental materials and supplies
- Incidental materials and supplies
- Rotable spare parts
- Temporary spare parts
- Emergency spare parts
Both nonincidental and incidental materials and supplies are those that are kept on hand for the maintenance, repair or improvement of a unit of property.
However, a record of consumption is kept of nonincidental materials and supplies, and a deduction is allowed in the first year that the material or supply is used or consumed. Incidental materials and supplies differ in that there is no record of consumption, and the deduction is allowed only in the year when the business pays for the materials or supplies.
Rotable and temporary spare parts are generally deductible in the year they are disposed of, unless an optional accounting method (described below) is elected allowing for a deduction upon initial installation.
A rotable spare part is a part that is acquired for a unit of property, is removable and can be repaired or improved before being reinstalled on either the same unit of property or a different unit or stored for later use. A temporary spare part is a part that can be installed on a temporary basis until a new or repaired part becomes available, at which point the temporary part may be stored for future installation.
Emergency spare parts are also deductible in the year they are disposed of, as are rotable and temporary spare parts. However, the optional accounting method is not available to them.
In short, an emergency spare part would be considered either rotable or temporary, except that it is normally very specific to a particular unit of property. It isn’t interchangeable, tends to be very expensive and difficult to obtain, and isn’t repaired or reused.
Optional accounting method
As mentioned above, the optional method of accounting allows for immediate expensing when installed. However, this method imposes additional tracking and administrative responsibilities that a taxpayer may or may not be willing to perform.
Basically, upon each removal from the unit of property on which the part had been installed, the taxpayer must recognize the part’s fair value in gross income and subsequently include this amount, as well as any removal costs, in the basis of the part. Any amounts paid to maintain, repair or improve the part must be included in the basis but not deducted currently. When the part is reinstalled on a different unit of property, the basis is deducted along with any reinstallation costs.
Capitalizing election
Sometimes deducting everything at once is not the best option. When this is the case, there is the option to capitalize rotable, temporary and emergency spare parts. This election may lessen the business’s administrative burden by aligning the company’s book capitalization policy with its tax policy, effectively eliminating book to tax differences.
To capitalize the allowable supplies and materials, the taxpayer must elect on its tax return for each item to be capitalized in the year the item is placed in service. This election may not be revoked unless the taxpayer files a request for a private letter ruling. Regulations dictate that the Commissioner of Internal Revenue will grant this letter ruling if it is deemed that the taxpayer acted reasonably and in good faith and if the revocation will not prejudice the government’s interests.
Keep in mind that a letter ruling’s authority is specific to individual items. In addition, a letter ruling is usually quite expensive to obtain. Do not try to revoke this election by filing an application for a change in accounting method or filing an amended return.
Safe harbor
There are many more intricacies of the finalized repair regulations. In fact, the materials and supplies topic is really only one component with which other components within the repair regulations may become intertwined.
For example, there is a safe harbor, found in the section of regulations dealing with capital expenditures, that allows for items that would otherwise require capitalization to be treated essentially as material or supplies and expensed up front. It’s allowed provided that the item’s cost on a per invoice basis is at or below either $5,000, with audited financials, or $500, without audited financial statements.
As demonstrated, it can’t be stressed enough how numerous and complicated the rules get. This is why consulting with your tax professional is highly recommended.
Although materials and supplies may seem immaterial by themselves, cumulatively, they can have a huge effect on taxable income – either positive or negative – depending on how they are managed.