Expenses versus capital improvements

In this age of disposables, the cost of repairs and maintenance remains a significant expense for many lawn care businesses. However, the immediate tax deduction for what might appear to be repairs or maintenance is being increasingly labeled as expenditures for capital improvements, expenditures that are recoverable only via depreciation deductions spread over a number of years.

It often seems that the only ones able to tell the difference between a currently deductible maintenance expense and an expenditure for capital improvements that is only recoverable over long depreciation periods is the ever-vigilant Internal Revenue Service. Now, however, new guidelines released by the IRS may provide some guidance.

Repair or abandon

The expenses incurred to operate a turf, landscape or lawn care business are the basis for its tax deductions. However, as with almost all of our tax regulations, the rules governing trade and business expenses are complex. Is that expenditure for repairs that are fully deductible on the turf care professional’s annual tax return or must it be labeled as a capital expenditure that can only be deducted over a number of years, if at all?

One school of thought says any legitimate business expenditure that does not create an asset or benefit the business for a period longer than one year is an expense. Many turf-related business owners and managers believe that normal inspection, cleaning and testing, and the replacement of parts with comparable and commercially available replacement parts are routine maintenance.

In the eyes of the IRS, however, those expenditures are all too often labeled as part of capital improvements, and their cost recoverable only through depreciation deductions. In fact, any expenditure that contributes to prolonging the life of equipment, or any business property, is considered by the IRS to be a capital expense and must be treated, and deducted over the same period, as the underlying asset.

Although lawmakers created the tax deduction and restrictions governing immediately deductible business expenses and the longer write-off periods for capital expenditures, it is the IRS that is tasked with determining what expenditures qualify in each category.

Capital means permanent to some

Capital expenditures include those for building improvements or betterments of a long-term nature, machinery, architect’s fees and even the cost of defending or perfecting title to property.

Generally, a capital expenditure either adds an asset to the business or increases the value of an existing asset. In other words, the amounts paid to acquire new property for resale, such as inventory, or to keep for one or more years, are capital expenditures. Capital expenditures also include amounts paid to improve equipment or property already owned.

Whether expenditures are a deduct­ible repair or a capital improvement often depends on the context in which the expenditure was made. If an expenditures was, for instance, made as a part of a general plan of rehabilitation, modernization or improvement to equipment or other business property, the expenditure must usually be capitalized even though, standing alone, the expense would be currently deductible.

Planning not always a capital improvement

In the past, the courts often ruled that capital improvements and ordinary repairs made simultaneously were capital expenditures. The courts often drew an analogy between constructing a new building and rehabilitating an older one. The courts reasoned that during building construction, expenditures associated with carting away trash, painting windows or even washing windows could not be, realistically, separated from other building costs and, thus, must be capitalized.

Generally, repair work done as part of an overall program of rehabilitation and conditioning should, according to at least one court, be treated as a cost of acquiring a lease with the new tenant and must be capitalized. Thus, when ordinary repairs and capital improvements are made at the same time, the courts may invoke a so-called “rehabilitation doctrine.” Under this doctrine, the distinction between repairs and capital improvements may disappear when such expenditures combine to change an asset’s use, value or life.

New safe harbor guidelines

Under a newly created safe harbor, the maintenance performed on equipment or business property is generally not considered an improvement of that unit of property and, therefore, would be currently deductible. Routine main­tenance would be the recurring activities that a business owner expects to perform as a result of its use of the equipment or property to keep it in operating condition. The newly proposed IRS rules allow repairs made at the same time as an improvement, but which do not directly benefit it or which were made strictly because of the improvement, to be deducted as repairs.

Using the IRS’s example, a company owning several trucks decides to replace the existing engines and beds with new components. All of these costs would have to be capitalized because they are so-called restoration costs. If the company decides to paint the truck cabs and replace a broken taillight (both repair costs if made separately), at the same time the new components are installed, the cost would be a capital expenditure. They would have to capitalize the cost of painting (treated as an expense that directly benefits or is incurred because of the truck restoration). Of course, the company could currently deduct the cost of repairing the broken taillight (treated as an expense that does not directly benefit and is not incurred because of the truck restoration).

Viva la difference

Among the temporary rules proposed by the IRS is another safe harbor, one designed to virtually guarantee the immediate deduction for repairs and maintenance. The new safe harbor applies if, at the time the equipment or property was placed in service, the lawn care or landscaping business reasonably expected to perform the activities more than once during the life of the equipment or business property.

In other words, whether an expense is routine maintenance would depend on factors such as the recurring nature of the activity, industry practice, manufacturer’s recommendations, the taxpayer’s experience and the taxpayer’s treatment of the activity on its applicable financial statements.

The balancing act

At the heart of our tax system is the principle that a business’ income for the tax year should only be offset or reduced by expenses that contribute to earning the income for that tax year. If, for example, floor space is added to the operation’s business premises, or a new business vehicle purchased, the business has acquired an asset that will benefit the operation for a number of years.

On the other hand, if the landscaping business were to deduct the full cost of that asset in the year it was acquired, income for that year would be understated—and overstated in all later years that asset remained part of the business. Thus, instead of permitting immediate deductions for the cost of equipment, assets or property of a more permanent nature, the tax rules require such expenditures to be capitalized.

How confusing is the IRS’s reasoning? Consider an example offered by the IRS: a small retail shop that suffers storm damage to some of its roof shingles. Redoing the entire roof with wood shingles would not have to be capitalized as a betterment to the shop and neither would redoing the entire roof with asbestos shingles if wood shingles were not available. However, redoing the entire roof with shingles made of a lightweight, composite material that is maintenance free, nonabsorptive, and has a 50-year life and a Class A fire rating, would have to be capitalized as a betterment to the shop.

For many turf care professionals, the issue of whether expenditures should be labeled as a business expense or as a capital expenditure is purely a tax question with the business most often seeking the immediate expense write-off. What about a new business or one that is struggling to keep afloat? They may have little incentive to minimize taxable income and/or maximize current deductions.

In general, maintenance is usually defined as a periodic expenditure undertaken to preserve or retain an asset’s operational status for its originally intended use. The expenditure does not improve or extend the life of the asset or property. A good example of maintenance is the cost of a tune-up for a business vehicle. An example of a capital expenditure would be a new motor for that business vehicle.

While far from being simple, the difference between the costs of maintenance or repairs and capital improvements seemingly boils down to the impact on the business, its equipment or other business property. Spelling out a periodic schedule for maintenance and regular routine repairs can help. Clearly separating routine maintenance or repair expenditures from a larger plan of rehabilitation or modernization can also help maximize the current tax deduction for maintenance expenses, if that will benefit the operation’s tax bill the most.

Mark E. Battersby is a frequent contributor to Turf, writing on financial and business matters. He resides in Ardmore, Pa.