Improvements versus repairs at power plants remain an area with heavy IRS audit activity.

The IRS issued an internal directive on July 6 in an effort to reduce the number of disputes.

The cost of improvements must be added to the “tax basis” in the power plant and recovered over time through depreciation. The cost of repairs can be deducted immediately. The IRS tried to make it easier to distinguish between the two in 2013 by issuing guidelines that break power plants into smaller “units of property” and “major components.” Replacing either of these would normally be considered an improvement. The guidelines are in Revenue Procedure 2013-24. (For earlier coverage, see the June 2013 Project Finance Newswire article Improvements.)

The IRS is treating replacing “substantially all” – meaning 80% or more – of a major component as an improvement, and it is letting companies replacing less than that treat the work as a repair.

The latest directive says that IRS agents must get approval from the “assigned counsel and director of field operations” to take a contrary position and agents “should not challenge” taxpayers who use either of two calculations to determine whether the 80% threshold was reached. A taxpayer can compare the actual replacement cost to either the “undepreciated cost” or the estimated replacement cost of the major component on its financial statements.