Is it a repair, or a capital expense?

In this age of disposables, many veterinary practices still pay substantial sums for repairs and maintenance. However, instead of allowing immediate tax deductions, the Internal Revenue Service increasingly is labeling repair and maintenance expenses as "capital improvements," making them recoverable only through depreciation spread over a number of years.

It often seems that the IRS is the only entity able to tell the difference between a currently deductible maintenance expense and a long-term capital expenditure, but some newly released IRS guidelines may help clear the confusion.

One school of thought has been that any legitimate business expense that does not create an asset or benefit the practice for more than a year is immediately deductible. Examples might include normal inspection, cleaning and testing of equipment. The replacement of parts with comparable, commercially available ones would seem to be routine maintenance.

But in the eyes of the IRS, such expenditures all too often are considered capital improvements. The IRS says basically that any expenditure that contributes to prolonging the life of equipment, or any practice property, is a capital expense.

While lawmakers created the deduction for repairs and upkeep, the IRS is tasked with determining what expenditures qualify.

Capital means permanent — to some

Capital expenditures include those for building improvements or other long-term betterments, new equipment, architect's fees — even the cost of defending or perfecting title to property.

A simple fix or capital expense?

Generally, a capital expenditure either adds an asset or increases the value of an existing one. 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. That also includes whatever a practitioner pays to improve existing equipment or property.

Whether it's a deductible repair or a capital improvement often depends on the context. For instance, if an expenditure is part of a general plan of rehabilitation, modernization or improvement to equipment or other business property, it usually must be capitalized, even though by itself it would be currently deductible.

Planning not always a capital expense

Most courts in the past ruled that ordinary repairs made at the same time as capital improvements were capital expenditures. They often drew an analogy between constructing a new building and refurbishing an older one, reasoning that, during building construction, costs of carting away trash, painting windows or even washing windows could not realistically be separated from other building costs and therfore must be capitalized.

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 a new tenant and must be capitalized. It's been called the "rehabilitation doctrine," and when invoked 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 one newly created safe harbor, however, maintenance performed on equipment or practice property generally is not considered as improving that unit of property (and, therefore, would be currently deductible).

Routine maintenance would include recurring activities that a practice principal or manager expects to perform to keep something in ordinarily efficient 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 deductible as repairs.

Using an IRS example, a company owning several trucks might decide to replace the engines and beds with new components. The cost would have to be capitalized because it is for "restoration" purposes. Should the company decide to paint the truck cabs and replace a broken tail light (both would be repair costs if made separately) at the same time the new components are installed, the painting would be a capital expenditure. But the company could currently deduct the cost of repairing the broken tail light because it does not directly benefit, and is not incurred, because of the truck restoration.

Another proposed safe harbor is designed to virtually guarantee the immediate deduction of repairs and maintenance. It applies if, at the time the equipment or property was placed in service, the veterinary practice reasonably expected to perform the activities more than once during the life of the equipment or property.

In other words, whether an expense is "routine maintenance" would depend on factors such as the recurring nature of the activity, industry practice, manufacturers' 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 practice's taxable income in any year should be offset or reduced only by expenses that contribute to that year's earnings. If, for example, floor space is added or a new vehicle is purchased, the practice has acquired an asset that will benefit it for a number of years.

If the practice 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 equipment, assets or property of a more permanent nature, tax rules require such expenditures be capitalized.

How confusing is the IRS's reasoning? Consider its own example:

Some wooden roof shingles on a small veterinary clinic are damaged by a storm. Redoing the entire roof with wood shingles would not have to be capitalized as a betterment to the clinic, and neither would redoing the entire roof with another type of shingle if wooden ones were not available.

However, redoing the entire roof with shingles made of a lightweight, composite material that is maintenance-free, non-absorptive, has a 50-year life and a Class A fire rating would have to be capitalized as a betterment to the clinic.

For many veterinarians, the issue of how expenditures should be labeled is purely a tax question. Most want the immediate expense write-off. But, what about a new veterinary practice 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 defined as a periodic expenditure to preserve or retain an asset's operational status for its originally intended use, not to improve it or extend its life. A tune-up for a business vehicle, for example, would be maintenance; a new motor would be a capital expense.

The difference seemingly boils down to the impact on the practice.

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 — assuming that will benefit the practice's tax bill the most.

Battersby is a financial consultant in Ardmore, Pa.