Changes in IRS Tax Regulations Affect Ethanol Plants

New property definitions will change tax treatment of certain repairs
By Jim Schmidt and Beth Feuchtenberger | November 05, 2012

There has been significant controversy concerning expenditures on tangible property between taxpayers and the Internal Revenue Service. Taxpayers tend to see business expenditures as deductions for repairs and maintenance, while the IRS argues for capitalization and recovery over a period of years. This conflict has produced a number of court cases with decisions made in both directions.

On Dec. 23, 2011, the IRS issued temporary regulations that provide guidance for the deduction or capitalization of amounts paid to acquire, produce or improve tangible property. In developing these regulations, the IRS amalgamated case law and prior IRS guidance. The goal is to reduce controversies while both sides continue to address the issue. Even though temporary, taxpayers are expected to comply with the regulations, which are effective for taxable years ending on or after Jan. 1, 2012. As a result, businesses need to know how these regulations apply to insure compliance. Failure to comply with the regulations could cause the IRS to assess a deficiency during examinations.

To comply with these regulations and minimize examination risk, ethanol plant operators need to determine if they have the appropriate policies and procedures in place, as well as applicable tax elections. All of which may require changes to accounting methods.
Deducting Materials, Supplies
The regulations define materials and supplies as tangible property used or consumed in the taxpayer’s business operations (not inventory), and specifically defined as:

• A component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property.

• Fuel, lubricants, water or similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in taxpayers operations. 

• A unit of property with an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operation.

• A unit of property with an acquisition cost or production cost of $100 or less, or an item identified in published IRS guidance as materials and supplies.

The regulations allow a taxpayer to deduct nonincidental materials and supplies when used or consumed. If a taxpayer has no record of use, or an inventory is not maintained for the nonincidental materials and supplies, a taxpayer may deduct these expenditures when purchased, if taxable income is not distorted. These rules are consistent with prior law.  A taxpayer, with certain exceptions, has the right, however, to elect to capitalize the cost and depreciate any material and supply item. In general terms, capitalization of these items will provide an increase in taxable income for the year capitalized, and a deduction in future years based on the applicable taxable life.

While the regulations modify the ‘de minimis’ (minimal expense) rule from the prior proposed regulations, ethanol plants generally have material and supply costs that exceed the de minimus rule threshold.

Spare Parts Treatment
There is a new optional method of handling rotating and temporary spare parts, which allows quicker deductions on these parts, rather than the general rule to deduct as the part is disposed. Although the optional method requires more record keeping, the cash flow improvement may be worth the effort. Factors that help in the determination of electing capitalization would include a comparison of the number of turns in spare parts inventory versus the depreciation period of the capitalized cost.

Building Changes
One of the more important changes in the regulations is the definition of a unit of property, which now has two main categories: buildings and everything else. The smaller the unit of property, the more likely costs incurred in relation to that unit of property will be capitalized.

For repair purposes, the building category is divided into a building structure and nine designated building systems: HVAC, plumbing, electrical, all escalators, all elevators, fire and alarm, security, gas distribution and others, as designated by the IRS. Separating designated building systems into these new components is a significant change to prior rules.  It will require ethanol facilities to analyze the impact of the repair and determine the breakdown into the designated building systems. Facilities may also need to file a request for a change of accounting method to come into compliance, or to elect the flexibility provided under the General Asset Account rules.

To understand the potential effect of the designated building system concept, consider the following: If an improvement cost to an electrical system is measured against a total building under prior proposed regulations, the improvement cost may not rise to the level required for capitalization. But, when the same improvement cost to an electrical system is measured against the electrical system as the unit of property under the new regulations, required capitalization is more likely.

The regulations now allow, however, a current deduction for the remaining undepreciated cost of a building component that is replaced, where the related repair was required to be capitalized. This creates a current tax benefit, as well as an opportunity of reviewing past depreciation schedules to determine if deductions should have been claimed for building components that had been previously replaced.

The determination of costs in the “everything else” category is broken down as the following:

• Network—based on facts and circumstances and through specific industry programs.

• Plant—based on discrete major functions.

• General—based on a “functionally interdependent” test.

Most ethanol plants will find the most benefit by applying the safe harbor for routine maintenance. Under the safe harbor, capitalization is not required if maintenance does not improve the property, but rather keeps the property in its ordinary efficient operating condition and the maintenance is expected to be performed more than once during the class life of the property. Unfortunately, there is no “bright-line” test for the determination of a repair versus improvement, and each situation is dependent on the facts and circumstances of the expenditure. The regulations include many examples that help determine whether the expenditure has to be capitalized, including whether it results in a betterment to the unit of property, is a restoration to the unit of property or adapts the unit of property to a new use.

Next Steps
Talk to your accountant to learn more about how these regulations may apply to your production facility. Together, you can take steps to:

• Discuss questions and the implementation of the regulations.

• Develop written accounting procedures as required or suggested to provide support for safe harbor or other positions.

•  Determine if a change of accounting will be required to comply with the regulations and when it should be filed, or if an alternative treatment is more advantageous.

Authors: Jim Schmidt, CPA
Director of Renewable Energy, Eide Bailly

Beth Feuchtenberger, CPA
Partner, Eide Bailly


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