Jan 21st 2010
By Bruce Zicari, CPA, CVA, The Bonadio Group
If you're a small business owner, it's likely that by this time you've met with your accountant to review your 2009 business situation, and your upcoming tax obligations. You've had a long and difficult year, and your Profit and Loss Statement isn't quite what you expected or wanted it to be.
But what if there was one line on your P&L statement – a line that has a "hidden" deduction possibility - that could actually generate a significant tax advantage and put cash back into your pocket?
You'll find that line in the expense category or section of your P&L, most likely called "depreciation." That's where the voyage from your balance sheet to your P&L statement ends, because it's where you've depreciated the expenditures associated with capital improvements – things like resurfacing your parking lot or replacing an HVAC unit.
Let's take a look at that parking lot resurfacing that cost you $10,000. Typically, you would depreciate this cost as a 15 year land improvement.
What if it were possible to grab a $10,000 deduction on your 2009 taxes? Here's why it may be possible:
Repair vs. Capitalization
There's a very narrow window of opportunity for business owners to take advantage of what's known as the "repair vs. capitalization" opportunity.
The essence of this opportunity is that it may be possible to move certain capitalized items and reclassify them as a repair, and by doing so, change the deduction equation significantly in your favor.
But hold on - it may be a simple concept, but it's execution is not simple.
The history behind this issue and why it is currently "hot" is very similar to the history behind Cost Segregation Studies. Cost Seg Studies have been performed since the 1960s. However, it took the landmark Hospital Corporation of America Tax Court Case in 1997, and the IRS agreeing in 1999 to follow the court case's findings, to make Cost Seg Studies meaningfully beneficial to taxpayers.
Business owners may have a similar tax saving opportunities with a Repairs vs. Capitalization Review. Over the years there have been many IRS regulations, notices, and tax court rulings on this subject – and not always resulting in the taxpayer's favor. However, in 2004, the landmark FedEx Tax Court Case was settled in the taxpayer's favor.
This past year the Service agreed to follow this Court Case and issued Proposed Regulations on the subject. Items that in the past had been considered "gray" and were capitalized are now considered "black and white" and can be expensed. In fact, the IRS will allow you to write off items on this year's tax return that may have been incorrectly capitalized in the past!
Items that real estate owners incur on a cyclical basis, such as outdoor painting and parking lot sealing, and noncyclical basis, like HVAC and roof repairs, may be eligible for reclassification. The potential tax savings resulting from this write off can be huge!
For example, after reviewing the records of a small manufacturing facility, we noted that they had capitalized as equipment over $300,000 of replacement parts and service calls for their large presses. Through filing a Change In Accounting Method and deducting the remaining equipment basis, the owner saved about $73,000 in taxes on their current year tax return.
In another case, an owner of several rental properties had capitalized over $278,000 worth of repairs and replacements. By reclassifying these items as either 5 year equipment or repairs, the owner is going to save over $88,000 on the 2009 tax return.
There are a couple of speeds bumps along the way before a business owner can realize these tax savings.
First, the clock is ticking on the opportunity to expense these previously capitalized items. Once the Service's Proposed Regulations officially become law, the IRS may limit the opportunity to recover prior year items by stating that taxpayers can only change their accounting method on a "going forward" basis.
Second, there's paperwork involved and lots of it. There are myriad calculations and forms and submittals to the IRS that need to be completed before you see that big refund check.
And last, but not least, you'll need to have access to both tax expertise, and a depth and breadth of construction engineering experience in order to capture every single last penny of tax savings that is your due,
If you think that a repair vs. capitalization opportunity exists, then the very first step that will be necessary is to do a review of your capital improvements and your tax depreciation records. That sets the stage for identifying any opportunities that will allow you and your company to benefit from meaningful tax savings.
That trip from balance sheet to P&L to huge tax savings is one that's well worth taking, and you should be starting your journey now, as the IRS will most likely be closing the road in the very near future.