Healthy Outcomes – Make Sure Materials, Supplies Are Deducted in Correct Tax Year

The tax deductibility of materials and supplies in a medical practice is often overlooked. Depending on your facts and circumstances, you may not be able to deduct these costs for tax purposes in the year purchased.
In order to properly apply the tax rules and avoid a potential IRS audit adjustment, it is important to understand the definition of materials and supplies and their classification so that they are deducted in the correct tax year. The following is an analysis of the steps that should be taken to determine if you have materials and supplies, the general rules on their deductibility, and a discussion of an election that can be made to get a deduction for many of these items in the year of purchase.

Step One: Do You Have
Materials and Supplies?
The tangible property regulations (TPRs) that were made final in September 2013 define materials and supplies as tangible property that is not inventory. It is property that is used or consumed in the taxpayer’s operations and includes items in any one of the following categories:
(1) Components acquired to maintain, repair, or improve a unit of tangible property;
(2) Fuel, lubricants, water, and similar items, such as gauze or Band-Aids, that are reasonably expected to be consumed in 12 months or less;
(3) A unit of property with an economic useful life of 12 months or less;
(4) A unit of property with an acquisition cost or production cost of $200 or less; or
(5) Any other amount identified in IRS guidance as a material and supply.
The term ‘unit of property’ (UOP) as referred to above includes all components that are functionally interdependent, such that one component can’t be placed in service without the other component.
Though the first definition above includes components acquired to improve a UOP as a material and supply, these items may be recharacterized as a cost of an improvement that must be capitalized and depreciated as part of the overall improvement. For instance, lumber (a component) used to improve a building must be capitalized as part of the overall building.
The new regulations do not supersede prior published guidance concerning the tax treatment of materials and supplies. This includes a 2002 revenue procedure that allows certain qualifying small businesses, though they may have inventories that would otherwise require the accrual method, to elect to use the cash method. An example would be an orthopedic practice, which maintains an inventory of crutches, braces, and other related items.
Taxpayers that meet this exception must select one of three options to use the cash method. Two of the methods involve maintaining inventories; however, the third option allows the cash method and requires that inventoriable items be treated as non-incidental materials for tax purposes. As you will later see, this impacts the tax year in which the items are deductible.

Step Two: Classification
Once identified as a material and supply, an item must then be classified as incidental or non-incidental, which will determine the year in which it is deductible for tax purposes. Incidental materials and supplies are ones kept on hand where no record of consumption is maintained and no physical inventory is taken at the beginning and end of the year. Incidental supplies are deductible in the tax year that they are paid for as long as this method clearly reflects income. They are typically items of low importance, such as Band-Aids or cotton balls.
Non-incidental supplies are supplies where records are kept of the amount held. These supplies are deductible in the tax year in which the materials and supplies are first used or consumed in the taxpayer’s operations. Cash-basis taxpayers, as well as accrual-basis taxpayers with non-incidental supplies, may not deduct the costs of these items in the year purchased unless they are first used or consumed in the year of purchase.
Here’s an illustration: In year 1, Medical Corp. pays $500 for one box of 10 toner cartridges for its printers; each toner cartridge is a separate $50 UOP. In year 1, Medical Corp.’s employees place eight of the toner cartridges in printers and store the remaining two cartridges for use in a later tax year. The toner cartridges are materials, and, although purchased in one box costing more than $200, the allocable cost of each UOP is $50. As a result, the $400 paid by Medical Corp. for eight of the cartridges is deductible in year 1, the tax year in which it first uses each of those cartridges, while the amounts paid for the remaining two cartridges ($50 each) are deductible in the tax year in which each cartridge is first used in its business.
For medical practices, this treatment would apply to medical supplies, vaccines, and other medicines that are tracked for reorder purposes or for any other record-keeping purposes.

Step Three: De Minimis Safe-harbor Election
In order to avoid the capitalization of non-incidental materials and supplies that are unused at year end, a taxpayer may consider making a de minimis safe-harbor election. To qualify, the taxpayer must have a capitalization policy in effect as of the beginning of the tax year for which the election is to be effective. The policy must be followed for both book and tax purposes. The book-capitalization policy must specifically provide for the expensing of property with an economic useful life of 12 months or less in order to deduct such items under the de minimis safe harbor.
Depending on the specified dollar amount of the capitalization policy, taxpayers with audited financial statements may expense property costing up to $5,000 per item. If a taxpayer doesn’t have an audited financial statement, it may use the safe harbor to deduct amounts paid for tangible property up to $2,500 per invoice or item (as long as this is in accordance with the capitalization policy). The final regulations do not allow selective capitalization of materials and supplies, so the capitalization policy must be applied consistently.
An amount qualifying for the de minimis safe harbor isn’t treated as a capital expenditure or as a material and supply, and may be deducted in the tax year the amount is paid provided the amount qualifies as an ordinary and necessary business expense.
The safe-harbor election is made annually by attaching a statement to the taxpayer’s timely filed original income-tax return. Once made, the election is irrevocable for that year.

In Summary
Understanding the proper tax treatment of materials and supplies involves identifying the types of costs that fall under the definition and then a determination of whether the costs are incidental or non-incidental. As many supplies will fall under the definition of non-incidental, a current tax deduction will not be available until the year used or consumed unless a capitalization policy is adopted and a de minimis safe-harbor election has been properly made.
It is a good idea to consult with your tax practitioner to determine whether you are properly handling your medical practice’s materials and supplies and whether your business should be making a current-year de minimis safe-harbor election.