Want to lower your tax burden? What contractors need to know about the new repair regulation rules

 

By Tom Leach

As March 15 quickly approaches, tax filing obligations and end-of-year financial decisions are top of mind for contractors. They’ve likely heard about the IRS’ new repair regulation rules for capitalizing or expensing property since these rules have serious financial implications for the construction industry due to the large amount of repairs.

To expense, or not to expense?

In maximizing the potential tax benefits of the new rules moving forward, contractors need to understand a few key points. One of the primary provisions of the new rules focuses on the safe harbor to eliminate the grey area around whether the IRS will agree with a business owner’s treatment of expensing or capitalizing certain equipment purchases. The IRS has set two separate “de minimis” thresholds. If a policy on capitalization aligns with whichever threshold applies, the IRS won’t challenge the decision to expense or capitalize. For businesses that have one of the following, they can use the threshold of $5,000 per unit of property (if none applies, the threshold totals $500):

  • Financial statement filed with the SEC
  • Financial statements audited by a CPA
  • Financial statement – other than a tax return – required by a federal or state agency

Contractors can also determine their capitalization policy annually under the new regulations. This means their policy might state that they will expense all equipment purchases under $5,000 in the current year, but in the following year they could set the bar at $2,500. This flexibility seems like good news overall, but contractors must exercise caution. To qualify for this safe harbor treatment, they must treat items the same way on their books as they do on their tax return.

Don’t ignore the financial statements 

While most contractors view the latest regulations as a way to possibly reduce their tax burden, many fail to see the potentially negative impact on their financial statements. For example, let’s say a business owner sets a policy at $5,000. Then, the owner decides to replace 1,500 items (computers, tools, parts, etc.) that cost around $3,500 each. On one hand, the owner can write off $5.2 million of equipment in one year. But on the other hand, that owner just reduced the net income for the year by $5.2 million that he or she otherwise would have likely written off over at least a five year period. This could result in numerous negative repercussions, including:

  • Contractors could unintentionally violate their loan covenants, such as the debt-to-equity ratio, debt service coverage, etc.
  • Auditors may not give a ‘clean opinion’ on the contractor’s financial statements.
  • Changing the policy annually could create consistency concerns and negatively affect an auditor’s opinion. In addition, loan covenants may require an unmodified/clean opinion.
  • Stakeholders may not understand why the operations results for the year don’t align with expectations.
  • Contractors face a potential long-term reduction of the sales value of the business due to the reduced equity and equipment investment on the balance sheet.

Bottom line, it’s easy to get blindsided by focusing solely on the tax planning opportunities associated with these new regulations, but it’s critical that contractors consider the effect on the financial statements. If they don’t, they’ll run into numerous unexpected – and often unpleasant – surprises.

Tom Leach, CPA, is the partner-in-charge of Sikich LLP’s Decatur, Ill., office and has more than 29 years of experience serving clients in a variety of industries. He has worked with both commercial and local governmental audit clients and has also supervised audits of large State of Illinois agencies. Contact him at [email protected].

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