On Sept. 13, 2013, the IRS released final regulations providing rules regarding the treatment of materials and supplies and the capitalization of expenditures for acquiring, maintaining, or improving tangible property (the final repair regulations). Additionally, on Aug. 14, 2014, the IRS issued final regulations on dispositions of tangible property, including rules for general asset accounts (GAAs) (the final disposition regulations). The final repair regulations and the final disposition regulations (the final regulations) are generally effective for tax years beginning on or after Jan. 1, 2014. 1 Thus, taxpayers with short tax years beginning on or after Jan. 1, 2014, and taxpayers with 52/53-week tax years beginning at the end of December 2013 are subject to the final regulations for those tax years. 2
In conjunction with the issuance of the final regulations, the IRS issued procedures for taxpayers to follow in making accounting method changes to comply with the final regulations. On Jan. 24, 2014, the government issued Rev. Proc. 2014-16, which provides the rules for taxpayers to change their accounting methods to comply with the repair regulations. On Sept. 18, 2014, the government issued Rev. Proc. 2014-54, which provides the rules for taxpayers to change their accounting methods to comply with the final disposition regulations. 3
On Jan. 16, 2015, the IRS issued Rev. Proc. 2015-13 and Rev. Proc. 2015-14, which collectively provide the rules for making accounting method changes, including those to comply with the final regulations. Additionally, on Feb. 13, 2015, the IRS released Rev. Proc. 2015-20, which provides an exception to the general procedures for complying with the final regulations for certain small business taxpayers. This article begins with an overview of the final regulations before discussing the procedural guidance and what taxpayers will need to consider in complying with the final regulations, including what minimum compliance might entail for a taxpayer not eligible for the small business taxpayer exception that simply wants to continue to follow its book capitalization policies for tax purposes.
Overview of the Final Regulations
The final regulations provide rules to determine whether an amount paid 4 during the lifecycle of a unit of tangible property is currently deductible or must be capitalized. Additionally, the regulations provide guidance for dispositions, which take into account the interrelationship between the disposition rules and the capitalization rules. Specifically, the final regulations provide rules covering five general areas:
Although the final regulations retain many of the provisions in the Dec. 27, 2011, temporary regulations, the final regulations also clarify, modify, and simplify a number of these rules. The final regulations also include provisions intended to reduce the administrative burden of complying with the regulations. For example, many of the provisions in the final regulations are elective and do not require a method change (see Exhibit 1 describing the various elective methods under the final regulations.)
Consistent with earlier regulations, supplies that are not material and for which no record of consumption is maintained (i.e., incidental supplies) are deductible when purchased. Nonincidental supplies are deductible when used or consumed. The final regulations define supplies as tangible property that is not inventory that is used or consumed in the taxpayer's trade or business, and:
Under the final regulations, a taxpayer may elect to capitalize only supplies that are rotable, temporary, or standby emergency spare parts. An elective optional method for rotable spare parts permits different treatment for a taxpayer with multiple pools of rotable spare parts where the taxpayer does not account for all pools on the optional method for book purposes.
If a taxpayer makes the de minimis safe-harbor election, any supplies that fit within the de minimis safe harbor are treated under the safe harbor and not as materials and supplies.
Observation: This definition of materials and supplies includes amounts in excess of $200 where a unit of property has a useful life of 12 months or less, or is a component acquired to maintain, repair, or improve a unit of tangible property. Thus, an item may be a deductible supply even if its cost exceeds $200 or the limits under the de minimis safe-harbor election, discussed below.
Observation: Although taxpayers that purchase a number of units of property costing $200 or less may capitalize and depreciate these amounts for book purposes, this cannot be done for tax purposes except for rotable and temporary spare parts. As a result, taxpayers may need to track this book/tax difference.
Capitalized Costs: De Minimis Safe-Harbor Election
Consistent with prior rules, under the final regulations, a taxpayer generally must capitalize amounts paid to acquire, produce, or improve tangible property. 10 However, the regulations provide an elective exception to this general capitalization rule for a taxpayer that has a minimum capitalization policy under which it expenses small-dollar items (de minimis safe-harbor election).
The de minimis safe-harbor election is an annual, irrevocable election that is available for all taxpayers; however, separate rules apply depending on whether a taxpayer has an applicable financial statement. The final regulations define an applicable financial statement as a financial statement that meets one of the following requirements (listed in descending priority):
Regs. Sec. 1.263(a)-1(f)(4) clarifies that an entity that does not have a separate applicable financial statement, but that is included in a consolidated applicable financial statement (e.g., a partnership or controlled foreign corporation), is considered to have an applicable financial statement based on its inclusion in the consolidated applicable financial statement.
A taxpayer that has an applicable financial statement may elect to treat amounts paid for the acquisition or production of a unit of tangible property as de minimis (and generally deductible in the year paid) if:
A taxpayer that does not have an applicable financial statement may elect to treat amounts paid to acquire or produce units of tangible property as de minimis if:
Observation:For a taxpayer with an applicable financial statement, the written accounting procedures must be in place as of the beginning of the tax year. The IRS has indicated this means that changes to the policy after the beginning of the tax year are not the written policy in place as of the first day of the tax year. For taxpayers without an applicable financial statement, there is no requirement for written procedures. Those taxpayers may generally deduct tangible property with an acquisition or production cost of $500 or less.
Observation: Importantly, for an item to qualify under the de minimis safe harbor, it must be treated as an expense on the taxpayer's applicable financial statements in accordance with the taxpayer's (written) accounting procedures or as an expense in the books and records of the taxpayer if the taxpayer does not have applicable financial statements in accordance with the taxpayers' accounting procedures. For example, if a taxpayer with an applicable financial statement has written accounting procedures that allow for the expensing of items costing less than $3,000, the taxpayer will be able to apply the safe harbor only to property that costs less than $3,000. Thus, a taxpayer with a de minimis threshold that is lower than the applicable threshold set by the final regulations may want to consider changing the terms of its capitalization policies to maximize the tax deduction available under the safe harbor. However, taxpayers should make sure to consult with their external auditors in this case, since any changes made to their capitalization policy must be permissible for financial accounting purposes.
In applying the de minimis safe harbor, the cost of an item includes costs for installation, delivery fees, etc., if those amounts are included on the same invoice as the item. For invoices with multiple items, the transaction costs can be allocated among the items using any reasonable basis, such as specific identification, pro rata, or a weighted average method. 13
Although the de minimis safe-harbor election provides cost limitations of $5,000 or $500, as under the earlier rules, a taxpayer is still permitted to treat items costing more than $5,000 (or $500) as de minimis for tax purposes if the taxpayer can show that that treatment clearly reflects income.
Practice tip: A taxpayer that intends to treat items costing more than the applicable threshold as de minimis should nonetheless make the election to apply the safe harbor to items qualifying under the safe harbor's requirements. The taxpayer will thus protect itself from challenge for qualifying items and will only need to prove that the deduction of amounts in excess of the safe harbor result in a clear reflection of income.
The de minimis safe-harbor election is made annually by attaching a statement to the taxpayer's timely filed tax return (including extensions) for the year the amounts are paid. It is not a method of accounting and may not be elected or revoked through a Form 3115, Application for Change in Accounting Method. 14 Additionally, the preamble to the final regulations provides that the IRS will not treat a change in the taxpayer's (written) accounting procedures as a change in accounting method.
Observation:The requirement of a statement to make this election means taxpayers and advisers must be diligent in attaching the statement to a timely filed return for each year the election is made. Otherwise, taxpayers may need to obtain relief under Sec. 9100 for filing the election late.
If the safe harbor is elected, the taxpayer must apply it to all qualifying items, including supplies. 15 Amounts properly falling under the de minimis safe-harbor election may not be capitalized, but instead must be deducted in the tax year in which they are paid provided the amounts otherwise constitute ordinary and necessary business expenses. 16
Amounts Paid to Acquire or Produce Tangible Property
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Taxpayers must capitalize costs paid to acquire or produce, or to facilitate the acquisition or production of, a unit of real or personal property. 17 Costs paid or incurred to acquire or produce a unit of property include the invoice price, transaction costs, and costs for work performed before the unit of property is placed in service (e.g., installation costs). 18 Additionally, amounts paid to defend or perfect title to property must be capitalized regardless of whether the amounts are paid before or after the property is acquired. 19
A taxpayer must also capitalize costs that facilitate the acquisition or production of this property, which means it is paid in the process of "investigating or otherwise pursuing" the acquisition, as determined based on all facts and circumstances. 20 The final regulations contain a list of 11 inherently facilitative costs that must be capitalized: 21 Transportation costs; appraisal, valuation, and pricing costs; negotiation and tax advisory costs; application, bidding, or similar costs; costs for preparing and reviewing the documents that effectuate the acquisition of the property; title examination and evaluation costs; regulatory approval or permit costs, including application fees; conveyance costs; finders' fees and brokers' fees, including contingency fees; architectural, geological, surveying, engineering, environmental, or inspection costs pertaining to particular properties; and costs for services provided by a qualified intermediary or other facilitator of a Sec. 1031 exchange.
Noninherently facilitative costs paid to determine whether to acquire real property and which real property to acquire are not required to be capitalized. 22 Employee compensation and overhead costs are also considered nonfacilitative unless a taxpayer makes an irrevocable election otherwise. 23
Observation: Employee compensation and/or overhead costs may still be required to be capitalized under Sec. 263A if the costs are the direct or allocable indirect costs of property produced by the taxpayer or property acquired for resale. 24
Facilitative costs are generally added to the basis of the property acquired and are recovered through depreciation deductions. Inherently facilitative costs (other than contingency fees) may be allocated between the basis of property acquired and property not acquired. 25 Contingency fees must be allocated to property acquired. 26
Amounts Paid to Improve Property
The first step in determining whether an expenditure is an improvement is identifying the unit of property. The final regulations generally define a unit of property as all components that are functionally interdependent (i.e., the placing in service of one component is dependent on the placing in service of another component). 27 Several special rules determine the unit of property for buildings, plant property, network assets, and leased property.
Small taxpayer safe-harbor election: An elective safe harbor is available for small taxpayers (i.e., taxpayers with average annual gross receipts of $10 million or less for the prior three tax years) to deduct certain expenditures for an eligible building. 32 An eligible taxpayer can deduct expenditures for the building, not exceeding the lesser of 2% of the unadjusted basis of the building or $10,000. An eligible building has a cost basis of $1 million or less, or, for a leased building, total rent payments of $1 million or less.
The safe harbor is an "all or nothing" provision because, if the expenditures for the building exceed the lesser of 2% of the building's unadjusted basis or $10,000, no amounts are eligible for the safe harbor. However, since the safe harbor is applied separately for each eligible building, if one building fails to qualify, it does not mean a separate building cannot qualify.
Observation: The $10 million gross-receipts test applies to each taxpayer and is not subject to an aggregation rule for related parties. For an S corporation or partnership, the election is made by the entity and not the shareholder or partner.
Once the taxpayer has determined the unit of property, the next step is to determine whether an expenditure for the unit of property is a deductible repair or a capitalizable improvement. In general, the direct costs of an improvement, as well as indirect costs that directly benefit or are incurred by reason of the improvement, must be capitalized. If a taxpayer disposes of a component and realizes gain or loss on the disposition, the taxpayer does not capitalize the costs of removing the component as an improvement. Alternatively, if the taxpayer disposes of a component, but the disposal is not a disposition for federal income tax purposes, then the taxpayer must determine if the removal directly benefits or is incurred by reason of an improvement and treat the removal costs accordingly.
An expenditure is a capitalizable improvement if it is a betterment, restoration, or adaptation (collectively, the "improvement standards"), each of which is briefly discussed below.
Betterment: An expenditure is a capitalizable betterment if it:
In applying the betterment standard, taxpayers compare the condition of the unit of property immediately before the event necessitating the expenditure (or if due to normal wear and tear, the last time the taxpayer corrected the effects of normal wear and tear). The final regulations do not provide rules for determining materiality under the betterment standard. However, they include numerous examples illustrating application of the rules.
Observation:Comparing the condition of the property immediately before the event is a taxpayer-favorable standard that differs from the standard applied for financial accounting purposes, which generally looks to the condition of the property after the event that necessitated the expenditures. Thus, taxpayers may have a favorable book/tax difference resulting from the different comparison standards.
Restoration: An amount paid is a capitalizable restoration only if the expenditure:
A major component is a part or combination of parts that performs a discrete and critical function in operating a unit of property. An incidental component generally will not constitute a major component even though it may perform a discrete and critical function. 35 A substantial structural part is a part or combination of parts that comprises a large portion of the physical structure of the unit of property. 36 For a building, an amount is for the replacement of a major component or a substantial structural part if the replacement includes a part or combination of parts that comprises a major component or a significant portion of a major component of the building structure or any system, or the replacement includes a part or combination of parts that comprises a large portion of the physical structure of the building structure or any system. 37
Observation: Although the final regulations do not provide a bright-line test for determining whether a replacement of a major component or substantial structural part is a restoration, the examples indicate that the IRS does not consider the replacement of one-third or less of a unit of property to be a replacement.
The final regulations also include a special casualty loss rule under which a taxpayer is required to capitalize amounts paid to restore damage to property for which the taxpayer has properly recorded a basis adjustment, but the costs required to be capitalized are limited to the excess of (1) the taxpayer's basis adjustments resulting from the casualty, over (2) the amount paid to restore the damage to the unit of property that otherwise is a capitalizable restoration. Effectively, this rule mitigates the potentially harsh result of the restoration standard for a taxpayer with high-value, low-adjusted-basis property destroyed in a casualty.
Observation: The casualty loss rule falls short of the result desired by taxpayers that had claimed casualty losses under Sec. 165 (the amount of the loss computed based on the cost to repair the damaged property) and deducted the cost of repairing the damaged property.
Adaptation: A taxpayer must capitalize amounts paid to adapt a unit of property to a new or different use not consistent with the taxpayer's ordinary use of the unit of property at the time originally placed in service. 38 For a building, an amount is paid to improve it under the adaptation standard if it adapts the building structure or any one of its building systems to a new or different use. 39
Under the routine-maintenance safe harbor, an amount paid for routine maintenance is not an improvement to the property. 40 The routine-maintenance safe harbor applies to amounts that would otherwise be capitalizable improvements because the expenditure is for the replacement of a major component or substantial structural part or results in the rebuilding to a like-new condition after the end of the property's alternative depreciation system (ADS) class life under the restoration standard.
Routine maintenance includes the recurring activities that a taxpayer expects to perform to keep the property in its ordinarily efficient operating condition. Routine maintenance may be performed any time during the useful life of property, but the activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the class life of the property, or for a building (or structural component or building system) more than once during the 10-year period, beginning when the taxpayer placed the property in service.
Provided the taxpayer can substantiate that it had a reasonable expectation that it would perform the maintenance at the time the property was placed in service, the taxpayer's expectation will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the class life, or during the 10-year period for building property. Relevant facts and circumstances, such as the recurring nature of the activity, industry practice, manufacturers' recommendations, and the taxpayer's experience with similar property, are taken into account in determining whether maintenance is routine.
Observation: The routine-maintenance safe harbor is not elective, but applies automatically when a taxpayer meets the requirements. This safe harbor is meant to cover the majority of typical repair and maintenance costs that taxpayers currently deduct and will continue to deduct under the final regulations.
The final regulations include a capitalization election under which taxpayers may annually elect to capitalize otherwise deductible repairs if those amounts are capitalized in their books and records. 41 The election applies to all amounts that are eligible for the election for that year. A taxpayer makes this annual, irrevocable election by attaching a statement to its timely filed (including extensions) return for the tax year the election is to be effective.
Observation:The regulations do not permit a "late" capitalization election method change. It applies prospectively for the tax year for which it is elected. Taxpayers whose prior years' methods of accounting for repairs and improvements do not comply with the final regulations may have exposure for those years and later years in which the taxpayers claim depreciation on the overcapitalized amounts. Thus, even if taxpayers are considering making the book capitalization election for all years prospectively, they should consider filing a method change to comply with the final regulations for the prior years' methods when those methods are not in compliance with the final regulations.
Observation: Taxpayers considering making the book capitalization election should assess the long-term effects of making the irrevocable election in light of the potential for legislation decreasing corporate tax rates. The election results in an increase in future depreciation deductions that could be recognized in a lower-tax-rate year, creating a permanent effect on the corporation's effective tax rate.
Dispositions of MACRS Property
In response to considerable criticism about the disposition, GAA, and restoration rules under the temporary regulations, the final regulations eliminate the mandatory disposition of a structural component of a building and the expansive definition of a qualifying disposition under the GAA rules, and add a partial-disposition election. The effect of these changes is to allow a taxpayer to choose to claim a loss on the disposition of a component of an asset when the asset (or component of an asset) is disposed of, if, for example, the costs to replace the component are capitalized as an improvement.
A disposition occurs when the taxpayer transfers ownership of an asset or permanently withdraws an asset from use in its trade or business or in the production of income, including the sale, exchange, retirement, physical abandonment, or destruction of an asset. It also occurs upon the transfer of an asset to a supplies, scrap, or similar account. 42 Other dispositions include partial disposition of an asset in a casualty event, a partial disposition for which gain is not recognized in whole or part under Sec. 1031 or 1033, a transfer of a portion of an asset in a transaction described in Sec. 168(i)(7)(B), a sale of a portion of an asset, or the disposition of a portion of an asset if the taxpayer makes a partial-disposition election. 43
A taxpayer makes a partial-disposition election by recognizing the gain, loss, or other deduction on its timely filed (including extensions) original tax return for the tax year in which the taxpayer makes the partial disposition. 44 A taxpayer is permitted to make a late partial-disposition election if the IRS, upon examination of the taxpayer's return, disallows a repair deduction for an amount paid or incurred for the replacement of a portion of an asset and instead requires the amount to be capitalized. 45
Example: Taxpayer A replaces the entire original roof on a building it owns. The building (including its structural components) is the asset for disposition purposes. Assume that the replacement of the roof is required to be capitalized under the improvement standards discussed above.
If the taxpayer does not make a partial-disposition election:
If the taxpayer makes a partial-disposition election:
GAAs provide an alternative to single-asset accounting. Each GAA includes assets with the same depreciation method, recovery period, and applicable convention that are placed in service during the same tax year. Assets for which bonus depreciation was taken may only be grouped into a GAA with assets for which the same percentage of bonus depreciation was claimed (e.g., 30%, 50%, or 100%).
Annual depreciation is computed for each GAA. In general, no loss is realized upon the disposition of an asset from a GAA; however, proceeds received from the sale of an asset are recognized in income. The unadjusted depreciable basis and the depreciation reserve of a GAA generally are not affected as a result of a disposition of an asset or a portion of an asset from a GAA. This is the case even if all of the assets in the GAA have been disposed of, unless the taxpayer affirmatively elects to terminate the GAA.
A taxpayer can elect to terminate a GAA and recover the remaining adjusted depreciable basis of the account upon the disposition of all of the assets, the last asset, or the remaining portion of the last asset from the account or in the case of a qualifying disposition of an asset within the GAA. A qualifying disposition is a disposition that is the result of a:
Observation: Under the final regulations, a taxpayer will likely only choose to use GAAs when it is burdensome or costly to separately track asset dispositions or when the taxpayer wants to defer recognizing losses upon the disposition of an asset or group of assets.
Practice tip: Taxpayers that made late GAA elections and/or late qualifying disposition elections under the temporary regulations likely will want to change their accounting methods to terminate the GAA, primarily because these taxpayers cannot make partial-disposition elections for assets included in GAAs.
Procedural Guidance
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Rev. Proc. 2014-16 provides the procedures for taxpayers to obtain automatic consent for method changes to comply with the final Secs. 162 and 263(a) regulations. Additionally, Rev. Proc. 2014-17 provides guidance for taxpayers to comply primarily with the temporary and reproposed regulations 46 under Secs. 167 and 168. 47 Finally, Rev. Proc. 2014-54 provides guidance for taxpayers to comply with the final disposition regulations (see Exhibit 2 for a list of the method changes under each procedure).
In general, accounting method changes to comply with the temporary, final, and reproposed tangible property regulations have automatic consent. Additionally, the scope limitations under Section 4.02 of Rev. Proc. 2011-14 generally are waived for changes made to comply with the final tangible property regulations for tax years beginning before Jan. 1, 2015. Thus, for example, a taxpayer under examination can file a method change to comply with the tangible property regulations.
The procedural guidance also includes simplified filing procedures for taxpayers that have average annual gross receipts of $10 million or less for the prior three tax years.
On Jan. 16, 2015, the IRS issued Rev. Proc. 2015-13 and Rev. Proc. 2015-14, which provide the procedures for accounting method changes made after Jan. 15, 2015, for tax years ending on or after May 31, 2014. Rev. Proc. 2015-13 provides the general rules for making automatic and nonautomatic method changes, and Rev. Proc. 2015-14 provides a list of automatic method changes, including those provided in Rev. Proc. 2014-16 and Rev. Proc. 2014-54 to comply with the temporary, final, and reproposed regulations.
The discussion below refers to the rules under Rev. Procs. 2014-16 and 2014-54, which are generally the same as under Rev. Proc. 2015-14 (any differences are noted). Rev. Proc. 2015-13 does not include scope limitations, but instead provides eligibility requirements and exceptions to filing without back-year audit protection. 48 The procedures for taxpayers that are not under exam when filing method changes to comply with the final regulations are substantially the same under Rev. Proc. 2011-14 and Rev. Proc. 2015-13. However, taxpayers under exam will likely want to file under the transition rule that permits a taxpayer to file an automatic method change for a tax year ending on or after May 31, 2014, and on or before Jan. 31, 2015, under the procedures set forth under Rev. Proc. 2011-14. 49 This is because a taxpayer under exam not meeting one of six exceptions has no back-year audit protection for the item for which the method change is being made. 50
Observation:Fiscal-year taxpayers that are under exam should pay careful attention to the date restrictions in the transition rule. For example, a taxpayer with a March 31 year end is not eligible for the transition rule. Thus, a taxpayer that is making a method change to comply with the final regulations for its tax year ending March 31, 2015 (i.e., its first tax year beginning on or after Jan. 1, 2014) will need to meet one of the exceptions to make the change with back-year audit protection.
Practice tip: The transition rule requires that the taxpayer indicate on the Form 3115 or the statements that the taxpayer is making the change under the transition rule. Taxpayers that want to use the transition rule should include a statement such as "Filed Pursuant to the Transition Rule Under Section 15.02(1)(a)(ii) of Rev. Proc. 2015-13"on either page one of Form 3115, the statements included with the Form 3115, or both.
On Feb. 13, 2015, the IRS issued Rev. Proc. 2015-20, which, as discussed in more detail below, provides an exception to the method change filing requirements under Rev. Proc. 2014-16 and Rev. Proc. 2014-54 (as superseded by Rev. Proc. 2015-14) for certain small business taxpayers. Under the exception, an eligible small business may prospectively adopt the final regulations with no Sec. 481(a) adjustment (i.e., apply the final regulations beginning in its first tax year beginning on or after Jan. 1, 2014) and without filing a Form 3115 or providing any disclosure in its tax return for the tax year of adoption.
Rev. Proc. 2014-16
As noted above, Rev. Proc. 2014-16 51 provides guidance for making the following method changes to comply with the final tangible property regulations:
Rev. Proc. 2014-16 also supersedes Rev. Proc. 2012-19 and provides the exclusive procedures for method changes to comply with the temporary tangible property regulations under Secs. 162 and 263(a) for method changes filed after Jan. 24, 2014. These changes are:
Taxpayers changing one or more accounting methods under Rev. Proc. 2014-16 are encouraged to file a single Form 3115 for all those changes. If a taxpayer includes more than one change on a single Form 3115, it must provide information for each change separately—including a description of the present and proposed methods, a cite to the regulations supporting the proposed method, and, to the extent applicable, separate Sec. 481(a) adjustments for each change. In addition to the information normally required, a taxpayer must include the following information on the form or the attachment:
In addition to attaching the Form 3115 to its timely filed (including extensions) federal income tax return, the taxpayer must file a copy of the Form 3115 at the Ogden, Utah, address no later than when it files the Form 3115 with its return.
Rev. Proc. 2014-16 clarifies that taxpayers can make a change to comply with the tangible property regulations if they are not presently using a permissible Sec. 263A method. Instead, Rev. Proc. 2014-16 extends the scope-limitation waiver to changes to certain automatic consent Sec. 263A method changes provided those changes are included on the same Form 3115 as a change to comply with the final regulations.
Observation: The waiver of the scope limitations for certain changes in a taxpayer's Sec. 263A methods provides an opportunity for a taxpayer to correct its Sec. 263A method and receive audit protection even if the method is an issue in an IRS examination. However, a taxpayer whose Sec. 263A method is an "issue pending" because the taxpayer has received a proposed adjustment notice will not qualify for audit protection.
Rev. Proc. 2014-16 also provides automatic consent for a taxpayer that wants to change its method of accounting to use a reasonable allocation method under Regs. Sec. 1.263A-1(f)(4) for self-constructed property. This method change is generally meant to provide automatic consent to properly apply Sec. 263A to self-constructed improvements.
A change in method of accounting under Rev. Proc. 2014-16 will generally require a Sec. 481(a) adjustment. However, for certain method changes, 52 a taxpayer is required to calculate a Sec. 481(a) adjustment as of the first day of the taxpayer's tax year of change that takes into account only amounts paid or incurred in tax years beginning on or after Jan. 1, 2014 (a modified Sec. 481(a) adjustment). Taxpayers can choose to apply the regulations to years beginning in 2012 and take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012. For example, a calendar-year taxpayer changing its method of accounting to deduct nonincidental materials and supplies when used or consumed effective for its tax year beginning Jan. 1, 2014, may compute a Sec. 481(a) adjustment that takes into account only amounts paid or incurred on or after Jan. 1, 2014 (i.e., a zero Sec. 481(a) adjustment), or may compute a Sec. 481(a) adjustment taking into account amounts paid or incurred in its tax year that began Jan. 1, 2012.
Taxpayers may use the statistical sampling procedures in Rev. Proc. 2011-42 to compute the Sec. 481(a) adjustment, unless the method change is one that is made with a modified Sec. 481(a) adjustment.
Observation: Because of the broad impact of the tangible property regulations, it is unlikely that a taxpayer is presently in compliance with all of the methods in the final regulations. Thus, taxpayers not eligible for the small business taxpayer exception will probably need to file at least one method change.
Observation: A taxpayer does not file an accounting method change to make a prospective election. Thus, a taxpayer that is making the de minimis safe-harbor election does not file a Form 3115. Similarly, the small taxpayer safe-harbor election and the book capitalization election are made under the time-and-manner provisions set forth in the regulations and not by filing a Form 3115.
Rev. Proc. 2014-54
Rev. Proc. 2014-54 modifies, but does not supersede, Rev. Proc. 2014-17, and provides guidance for making the following method changes to comply with the final Sec. 168 disposition regulations: 53
Importantly, the following method changes are available for only a limited time:
Observation: The most common disposition method changes likely will be for a taxpayer that claims a loss on the retirement of a structural component of a building. If the taxpayer desires to continue to claim the loss, it would need to correct its disposition method (because the retirement of a structural component of a building is not a disposition without a partial-disposition election) and make a late partial-disposition election to claim the loss.
In addition to the general scope-limitation waivers discussed above, Rev. Proc. 2014-54 also provides for a waiver of the scope limitations for depreciation method changes (under Appendix §6.01 of Rev. Proc. 2011-14) 54 if the depreciation method change is made for the same asset(s), and is made on the same Form 3115 as a disposition method change under Rev. Proc. 2014-54. This may enable taxpayers to concurrently file method changes to clean up depreciation issues that taxpayers identify when adopting the final disposition regulations. Similar to all of the scope-limitation waivers under the tangible property regulation guidance, this scope-limitation waiver is available only for a tax year beginning before Jan. 1, 2015. The IRS also clarified in Rev. Proc. 2014-17 that a change from expensing to capitalizing (or vice versa) the cost or other basis of an asset is disregarded in determining whether a taxpayer made a method change in the prior five years for purposes of applying the scope limitations to depreciation automatic method changes. 55
In general, a taxpayer must file a separate Form 3115 for each change request under Rev. Proc. 2014-54. There are exceptions, and certain method changes should be included on a single Form 3115. For example, a taxpayer making the same method change for more than one asset should file a single Form 3115 and provide a single Sec. 481(a) adjustment for all of the changes. Similarly, a taxpayer that is making a late partial-disposition election would include in the late partial-disposition election the change to define the asset consistent with the definition of the asset for disposition purposes under the regulations. The taxpayer does not file a separate disposition change to change the definition of the asset and then a separate partial-disposition election change.
A taxpayer makes a method change under Rev. Proc. 2014-54 by filing Form 3115 with its timely filed U.S. federal income tax return for the tax year the change is to be effective. In addition to attaching the Form 3115 to its income tax return, the taxpayer must file a copy at the Ogden, Utah, address no later than when it files the Form 3115 with its return. The taxpayer must also comply with the terms and conditions for each specific change, including any additional information required by the particular change.
In general, a taxpayer that makes a change in method of accounting under Rev. Proc. 2014-54 computes a single net Sec. 481(a) adjustment for all assets for which the change is made. Taxpayers may have flexibility in computing the Sec. 481(a) adjustment where one or more of the changes in the single Form 3115 generate a negative Sec. 481(a) adjustment and other changes in that same Form 3115 generate a positive Sec. 481(a) adjustment. In this case, taxpayers may provide a single negative Sec. 481(a) adjustment for all the changes that are included in that Form 3115 and a single positive Sec. 481(a) adjustment for all those changes in that Form 3115. This could provide a favorable tax result because, in general, a negative (favorable) Sec. 481(a) adjustment is taken into account in the year of change and a positive (unfavorable) Sec. 481(a) adjustment is taken into account ratably over four tax years beginning with the year of change.
Under Rev. Proc. 2014-54, certain method changes must be made on a cutoff or modified cutoff basis (prospective application of the method) rather than with a Sec. 481(a) adjustment. Additionally, certain method changes require the taxpayer to take the Sec. 481(a) adjustment into account in the year of change even if it is positive (e.g., revocation of a GAA election).
For certain method changes, a taxpayer may use the statistical sampling procedures in Rev. Proc. 2011-42 to compute the Sec. 481(a) adjustment. The IRS generally will not challenge the taxpayer's statistical sampling on exam.
Observation: Unlike Rev. Proc. 2014-16, Rev. Proc. 2014-54 provides special disclosure requirements and separate rules for each specific method. Accordingly, taxpayers will need to review the various method changes to ensure they are changing under the correct section of the revenue procedure. Additionally, as noted above, each revenue procedure provides a limited list of method changes that must be made on a single Form 3115—so unlike a change under the final repair regulations, a taxpayer may be required to file more than one Form 3115 under the final disposition regulations.
Rev. Proc. 2014-54 provides transition rules for taxpayers that filed accounting method changes under Rev. Proc. 2014-17 on or before Sept. 18, 2014, and that want to change to apply the final disposition regulations for the same year of change. Under these transition rules, on or before Dec. 31, 2014, a taxpayer must file an amended federal income tax return using the new method of accounting, attach the original of the amended Form 3115 filed under Rev. Proc. 2014-54 to the amended return for the year of change, write on Page 1 of Form 3115 of the Ogden, Utah, copy of the amended Form 3115 "FILED UNDER SECTION 5.02(2) of REV. PROC. 2014-54," and file the amended Form 3115 with the Ogden, Utah, address no later than when the amended Form 3115 is filed with the amended federal income tax return.
Practice tip: Rev. Proc. 2014-54 also provides helpful charts outlining the changes under the final, temporary, and proposed regulations.
Observation: Most taxpayers likely need not make any method change under Rev. Proc. 2014-54. The changes under Rev. Proc. 2014-54 generally allow taxpayers to take advantage of more-favorable disposition rules and general asset or mass-asset accounts. One exception to this would be a taxpayer that currently claims a loss on the partial disposition of a structural component of a building (e.g., if the taxpayer claims a loss when it replaces all or a portion of the roof of a building). In that case, the taxpayer should make the late partial-disposition election method change that is available only for tax years beginning before Jan. 1, 2015.
Impact of Rev. Procs. 2015-13 and 2015-14
As noted above, for taxpayers not under exam, the filing requirements under Rev. Procs. 2011-14, 2014-16, and 2014-54 are the same under revised procedural guidance in Rev. Proc. 2015-13 and Rev. Proc. 2015-14. For taxpayers under exam, the rules are significantly different unless the taxpayer chooses to apply the transition rule, under which the taxpayer may file an automatic method change under Rev. Proc. 2011-14 (as revised by Rev. Procs. 2014-16 and 2014-54) for a tax year ended on or after May 31, 2014, and on or before Jan. 31, 2015, or otherwise meets one of the exceptions to filing without back-year audit protection while under exam.
Simplified Procedures for Eligible Small Business Taxpayers
Illustration by mecaleha/istock
On Feb. 13, 2015, the IRS issued Rev. Proc. 2015-20, which provides an exception to procedures originally provided in Rev. Proc. 2014-16 and Rev. Proc. 2014-54 to adopt the final regulations for certain small business taxpayers. Specifically, Rev. Proc. 2015-20 permits a small business taxpayer to adopt the final regulations prospectively (i.e., without computing a Sec. 481(a) adjustment) and without filing a Form 3115 for its first tax year that begins on or after Jan. 1, 2014. Instead, if an eligible taxpayer applies the exception, the taxpayer simply adopts the final regulations on its federal tax return. 56 No disclosure is required to apply the exception. 57
A taxpayer is eligible for the small taxpayer exception if it has one or more separate and distinct trade(s) or business(es) (as defined in Regs. Sec. 1.446-1(d)) that has:
Only a separate and distinct trade or business that meets one of these criteria is eligible to use the small business exception. 60 An eligible taxpayer that opts to apply the small business exception does not have back-year audit protection for the item. Additionally, a taxpayer using the small business exception cannot choose to implement a portion of the method changes under Section 10.11 of Rev. Proc. 2015-14 (or certain disposition changes under Sections 6.37, 6.38, and 6.39 of Rev. Proc. 2015-14) by filing a Form 3115 and with a Sec. 481(a) adjustment computed taking into account amounts paid or incurred (or dispositions) prior to a tax year beginning on or after Jan. 1, 2014. 61
Observation: The $10 million asset and gross-receipts tests do not require aggregation. Accordingly, a taxpayer with multiple separate and distinct trades or businesses each separately meeting the tests would be eligible for the exception. Similarly, related parties are not required to aggregate gross receipts or total assets, which should permit more taxpayers to be eligible for the small business exception.
Observation: This very favorable exception should eliminate the need for a significant number of taxpayers to compute a Sec. 481(a) adjustment and to file a Form 3115 to comply with the final regulations.
Practice tip: Although no disclosure is required, a taxpayer should consider including a statement on its return indicating that the taxpayer is applying the small business exception. For example, a taxpayer applying the exception for the final repair regulations might include a statement indicating that the taxpayer is applying the small business exception under Section 10.11(6)(b)(iii) of Rev. Proc. 2015-14 for the particular trades or businesses for which the exception applies to show its compliance with the final repair regulations.
Taxpayers will need to comply with the final regulations when filing their 2014 U.S. federal income tax returns. The above discussion illustrates the complexity of the final regulations and the related procedural guidance. For taxpayers looking to increase deductions, the final regulations have a number of favorable provisions, and most taxpayers that have not previously filed accounting method changes for repairs generally end up with additional tax deductions upon adopting the final regulations.
Taxpayers not eligible for the small business taxpayers exception looking to do the minimum to comply with the final regulations, and that want to follow their book capitalization policies for tax purposes, should consider making the annual de minimis safe-harbor election, making the annual book capitalization election, and filing a single Form 3115 under Rev. Proc. 2014-16 that includes the following changes:
Although the last change on the list is made with a Sec. 481(a) adjustment, a taxpayer that believes its current method (i.e., its book capitalization method) would result in no Sec. 481(a) adjustment or a negative (i.e., taxpayer-favorable) adjustment could indicate that on the Form 3115 with a zero Sec. 481(a) adjustment, avoiding the burden of computing the adjustment.
No single approach will work for all taxpayers complying with the final regulations. Some taxpayers may view filing a single Form 3115 as too costly or burdensome, while others may benefit by filing one or more Forms 3115 not only to adopt the improvement standards and material and supplies definitions, but also to recognize prior-year partial or full dispositions. Taxpayers (and their tax advisers) will need to determine the best approach to comply with the final regulations. However, as discussed above, the favorable method change scope-limitation waivers are available only for tax years beginning before Jan. 1, 2015 (and only under the transition rule provided in Section 15.02(1)(a)(ii) of Rev. Proc. 2015-13 for those tax years), so taxpayers should focus on complying in their 2014 tax years to avoid potential complexity that may arise by postponing compliance to later years.
Editor's note: This article won The Tax Adviser's best article award for 2015.
1 Certain provisions of the final repair regulations are effective for amounts paid or incurred in tax years beginning on or after Jan. 1, 2014.
2 For the effective date of the final regulations, 52/53-week tax years are deemed to begin on the first day of the calendar month nearest to the first day of the 52/53-week tax year. See Regs. Sec. 1.441-2(c).
3 Note that Rev. Proc. 2014-17 provides the procedures for a taxpayer to change its method of accounting to apply the temporary regulations issued in December 2011 or proposed regulations issued in September 2013, under Secs. 167 and 168 that relate to dispositions of tangible property, including the rules for GAAs.
4 The final regulations provide that in the case of an accrual-method taxpayer, "amounts paid" and "payment" mean a liability incurred within the meaning of Regs. Sec. 1.446-1(c)(1)(ii) (Regs. Sec. 1.263(a)-3(c)(1)).
5 For this purpose, a unit of property is determined under Regs. Sec. 1.263(a)-3(e).
6 The final regulations provide that an item's economic useful life is the period over which the property is reasonably expected to be useful to the taxpayer (Regs. Sec. 1.162-3(c)(4)(i)). However, if a taxpayer has an applicable financial statement (defined below), the economic useful life is the useful life initially used by the taxpayer in determining depreciation in its applicable financial statement (Regs. Sec. 1.162-3(c)(4)(ii)).
7 Rotable spare parts are supplies that are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation. Temporary spare parts are supplies that are used temporarily until a new or repaired part can be installed and then are removed and stored for later installation (Regs. Sec. 1.162-3(c)(2)).
8 Standby emergency spare parts include supplies that are (1) acquired when particular equipment is acquired (or later acquired and set aside for use in particular equipment); (2) set aside for use as replacements to avoid substantial loss of operating time from equipment failure; (3) located at or near the site of the installed related equipment; (4) directly related to the particular equipment they serve; (5) normally expensive; (6) only available on special order and not readily available from a vendor or manufacturer; (7) not subject to normal periodic replacement; (8) not interchangeable in other equipment; (9) not acquired in quantity; and (10) not repaired and reused.
9 Regs. Sec. 1.162-3(c)(1). Published guidance is guidance published in the Federal Register or in the Internal Revenue Bulletin. See, e.g., Rev. Proc. 2002-12 (generally permitting restaurants to treat smallwares as materials and supplies) and Rev. Proc. 2002-28 (generally permitting qualifying small business taxpayers to treat certain otherwise inventoriable items as materials and supplies).
10 Regs. Sec. 1.263(a)-1. See Regs. Sec. 1.263(a)-4 for the rules regarding capitalization of intangibles.
11 Regs. Sec. 1.263(a)-1(f)(1)(i).
12 Regs. Sec. 1.263(a)-1(f)(1)(ii).
13 Regs. Sec. 1.263(a)-1(f)(3)(i).
14 Regs. Sec. 1.263(a)-1(f)(5).
15 Regs. Sec. 1.263(a)-1(f)(3)(ii).
16 Regs. Sec. 1.263(a)-1(f)(3)(iv). If the amount of the property comprises the direct or allocable indirect costs of other tangible property produced by the taxpayer or acquired for resale, the taxpayer may still be required to capitalize the amounts under Sec. 263A (Regs. Sec. 1.263(a)-1(f)(3)(v)).
17 For this purpose, a unit of property is determined under Regs. Sec. 1.263(a)-3(e) (Regs. Sec. 1.263(a)-2(d)(1)).
18 Regs. Sec. 1.263(a)-2(d).
19 Regs. Sec. 1.263(a)-2(e).
20 Regs. Secs. 1.263(a)-2(f)(1)-(2).
21 Regs. Sec. 1.263(a)-2(f)(2)(ii).
22 Regs. Sec. 1.263(a)-2(f)(2)(iii)(A).
23 Regs. Sec. 1.263(a)-2(f)(2)(iv).
24 Regs. Sec. 1.263(a)-2(f)(2)(iv).
25 Regs. Sec. 1.263(a)-2(f)(3)(ii).
26 Regs. Sec. 1.263(a)-2(f)(3)(iii). Contingency fees are defined as amounts paid that are contingent on the successful closing of the acquisition of real or personal property (Regs. Sec. 1.263(a)-2(f)(3)(iii)).
27 Regs. Sec. 1.263(a)-3(e)(1).
28 Regs. Sec. 1.263(a)-3(e)(2)(ii). Additionally, special rules determine the unit of property for condominiums, cooperatives, and leased buildings. See Regs. Secs. 1.263(a)-3(e)(2)(iii)—(v). The final regulations also include rules for determining the unit of property for lessee and lessor improvements. See Regs. Sec. 1.263(a)-3(f).
29 Regs. Sec. 1.263(a)-3(e)(3)(ii).
30 Regs. Sec. 1.263(a)-3(e)(3)(iii).
31 Regs. Secs. 1.263(a)-3(e)(2)(v), (e)(3)(iv), and (e)(4).
32 Regs. Sec. 1.263(a)-3(h).
33 An exception is provided if a unit of property has been fully depreciated and the loss is attributable only to remaining salvage value (Regs. Sec. 1.263(a)-3(k)(3)).
34 Regs. Sec. 1.263(a)-3(k)(1).
35 Regs. Sec. 1.263(a)-3(k)(6)(i)(A).
36 Regs. Sec. 1.263(a)-3(k)(6)(i)(B).
37 Regs. Sec. 1.263(a)-3(k)(6)(ii).
38 Regs. Sec. 1.263(a)-3(l)(1).
39 Regs. Sec. 1.263(a)-3(l)(2).
40 Regs. Sec. 1.263(a)-3(i).
41 Regs. Sec. 1.263(a)-3(n).
42 Regs. Sec. 1.168(i)-8(b)(2).
43 Regs. Secs. 1.168(i)-8(d)(1) and (d)(2).
44 Regs. Sec. 1.168(i)-8(d)(2)(ii). If the election is made for a portion of an asset that is properly included in asset classes 00.11 through 00.4 of Rev. Proc. 87-56, the replacement portion of the asset must be classified under the same asset class as the disposed portion of the asset in the tax year in which the replacement portion is placed in service by the taxpayer.
45 Prop. Regs. Sec. 1.168(i)-8(d)(2)(iii) (Sept. 13, 2013). The election is made by filing an application for change in accounting method, provided the asset of which the disposed portion was a part is still owned by the taxpayer at the beginning of the year of change. See the discussion of Rev. Proc. 2014-54, below.
46 The temporary regulations were issued Dec. 27, 2011, and the reproposed regulations were issued Sept. 13, 2013. Under Rev. Proc. 2014-17, taxpayers are permitted to make changes to apply the temporary and/or reproposed regulations generally for 2012 and 2013 tax years only. The changes available under Rev. Proc. 2014-17 are provided in Exhibit 2 but are not discussed in this article.
47 Rev. Proc. 2014-17 also provides guidance for changing to the final regulations for certain leasehold improvements amortized under Regs. Sec. 1.167(a)-4 and for certain changes involving multiple-asset accounts.
48 See Sections 5 and 8, respectively of Rev. Proc. 2015-13.
49 Section 15.02(1)(a)(ii) of Rev. Proc. 2015-13.
50 See Section 8.02 of Rev. Proc. 2015-13 for a list of the exceptions. A complete discussion of the provisions of Rev. Proc. 2015-13 is beyond the scope of this article.
51 Rev. Proc. 2014-16 includes the following method changes and provisions that are not discussed in this article: (1) automatic method change to the treatment of costs under Sec. 263A by banks with respect to certain foreclosure property; (2) an extension of the scope-limitation waivers for method changes to the safe-harbor method of accounting for electric transmission and distribution assets under Rev. Proc. 2011-43; and (3) expansion of the present automatic method change for removal costs to include costs related to partial dispositions.
52 These changes include changes for materials and supplies (other than a change to use the optional method) and certain changes for acquisition costs under Regs. Sec. 1.263(a)-2.
53 Regs. Secs. 1.168(i)-1, -7, and -8; T.D. 9689.
54 Rev. Proc. 2011-14 has been superseded by Rev. Proc. 2015-13 and Rev. Proc. 2015-14 for Forms 3115 filed on or after Jan. 16, 2015, for a year of change ending on or after May 31, 2014. However, the relevant sections of Rev. Proc. 2015-14 provide similar eligibility requirement waivers. See, e.g., Section 6.37(2)(b)(ii) of Rev. Proc. 2015-14.
55 See Section 3.02 of Rev. Proc. 2014-17, modifying Appendix Section 6.01(2) of Rev. Proc. 2011-14. Rev. Proc. 2011-14 has been superseded by Rev. Proc. 2015-13 and Rev. Proc. 2015-14 for Forms 3115 filed on or after Jan. 16, 2015, for a year of change ending on or after May 31, 2014. However, Section 6.01(2) of Rev. Proc. 2015-14 includes a similar provision.
56 Section 5.01 of Rev. Proc. 2015-20.
58 Regs. Sec. 1.263(a)-3(h)(3) generally provides that gross receipts are the taxpayer's receipts for the tax year that are properly recognized under the taxpayer's tax method of accounting and include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest under Sec. 103), dividends, rents, royalties, and annuities, regardless of whether those amounts are derived in the ordinary course of the taxpayer's trade or business.
59 Section 4.01 of Rev. Proc. 2015-20.
60 Section 4.02 of Rev. Proc. 2015-20.
61 Section 5.01 of Rev. Proc. 2015-20.
