APPLYING THE NEW TANGIBLE PROPERTY REGULATIONS

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2 Hour(s) - Other Federal Tax

CTEC Provider #: 6209CTEC Course #: 6209-CE-0070

IRS Provider #: UBWMFIRS Course #: UBWMF-T-00222-21-S

NASBA: 116347

The information provided in this publication is for educational purposes only, and does not necessarily reflect all laws, rules, or regulations for the tax year covered. This publication is designed to provide accurate and authoritative information concerning the subject matter covered, but it is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

To the extent any advice relating to a Federal tax issue is contained in this communication, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

COURSE OVERVIEW.............................................................................................................................................................. 9

Course Description ....................................................................................................................................................................... 9

Learning Objectives ...................................................................................................................................................................... 9

THE TANGIBLE PROPERTY REGULATIONS IN PERSPECTIVE ............................................................................................. 9

Introduction................................................................................................................................................................................... 9

Repairs vs. Improvements ........................................................................................................................................................... 9

Methods of Accounting ..............................................................................................................................................................10

The Emergence of the New Regulations..................................................................................................................................10

SUBSTANTIVE ISSUES THAT AFFECT PLANNING ............................................................................................................. 12

Unit of Property ..........................................................................................................................................................................12

Materials and Supplies...............................................................................................................................................................14

Spare Parts ..................................................................................................................................................................................15

DISTINGUISHING BETWEEN REPAIRS AND IMPROVEMENTS......................................................................................... 16

In General ....................................................................................................................................................................................16

Betterments.................................................................................................................................................................................16

Adaptations .................................................................................................................................................................................17

Restorations ................................................................................................................................................................................18

Small Taxpayer Safe Harbor ......................................................................................................................................................20

Routine Maintenance Safe Harbor ...........................................................................................................................................21

ESSENTIAL FORM 3115 FILINGS........................................................................................................................................ 21

Changes in Accounting Methods Using Form 3115................................................................................................................21

Comparison of Advance Consent and Automatic Consent: ..................................................................................................23

Form 3115 Relief for Small Taxpayers......................................................................................................................................23

Changes to Materials and Supplies Accounting Method .......................................................................................................24

Changes in Depreciation or Amortization ...............................................................................................................................24

Pre-2003 Property.......................................................................................................................................................................25

Partial Asset Dispositions...........................................................................................................................................................26

Summary of Common Form 3115 Changes under the Final Regulations ...........................................................................27

ESSENTIAL ELECTIONS ...................................................................................................................................................... 27

De Minimis Safe Harbor.............................................................................................................................................................27

Partial Asset Dispositions...........................................................................................................................................................30

Summary of Common Elections under the Final Regulations ..............................................................................................33

ANALYZING SECTION 481(A) ADJUSTMENTS................................................................................................................... 33

Introduction.................................................................................................................................................................................33

REMAINING ADVANTAGEOUS USE OF GENERAL ASSET ACCOUNTS............................................................................. 34

In General ....................................................................................................................................................................................34

GLOSSARY .......................................................................................................................................................................... 36

Glossary .......................................................................................................................................................................................36

Course Description 9

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COURSE OVERVIEW

COURSE DESCRIPTIONThis course covers the application of the tangible personal property regulations that were finalized in 2013 and 2014. The concept of “unit of property” is addressed, as are the types of acquisition and production costs that must be capitalized. Of primary concern is distinguishing deductible repairs from improvements that must be capitalized, and to this end the capitalization categories of betterments, adaptations, and restorations are fully described.

The course also provides practical guidance on the procedures for making accounting method changes, especially those that are required to conform to the final regulations. A table indicating the most common accounting method changes, their assigned change numbers, and legal source will assist practitioners in preparing Form 3115, Application for Change in Accounting Method. In addition, each of the important elections that are available under the new rules is discussed in detail. Calculating the adjustments to income that may be required by an accounting method change is covered, as is the use of general asset accounts.

LEARNING OBJECTIVESAfter completing this course, you will be able to:

Distinguish deductible repairs from improvement costs that must be capitalized

Identify the accounting options available for materials and supplies and spare parts

Determine what constitutes a unit of property under the final regulations

Select the appropriate elections available under the final regulations

Identify the various safe harbors provided by the final regulations

Calculate Code section 481(a) adjustments

Recognize circumstances in which general asset accounts may still be beneficial

THE TANGIBLE PROPERTY REGULATIONS IN PERSPECTIVE

INTRODUCTIONA fundamental tax question, regarding property, involves when to capitalize and when to expense costs related to that property. This question arises at two junctures: first when a piece of property is obtained through acquisition or construction, and then again when some modification is made to that property. The former situation is less burdened by factual complexities than the latter. The fact of ownership or use of property is usually easily ascertained; all that remains is the policy issue of when an expenditure for such property should be deductible. Modifications to property, however, give rise to a host of questions about whether the modification is sufficiently significant to itself warrant capitalization.

While all “ordinary and necessary” expenses of a business are deductible, an amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate cannot be deducted, and neither can an amount expended in restoring property or in making good its economic exhaustion. Instead, a depreciation deduction is allowed for the reasonable exhaustion, wear and tear, or obsolescence of such property used in a trade or business or held for the production of income.

REPAIRS VS. IMPROVEMENTSModifications to property have traditionally been categorized as either “improvements” that must be capitalized and added to the basis of property or “repairs” that were currently deductible and did not affect basis. The U.S. Supreme Court attempted to clarify the issue by ruling that the distinction between the two is “one of degree, not kind.” On this basis, courts developed various facts and circumstances tests to distinguish between repairs and improvements. As

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10 The Tangible Property Regulations in Perspective

case law developed, bright-line rules evolved to determine whether a cost was attributable to a repair or an improvement. Generally, the distinction became centered on considerations involving the purpose, physical nature, and effect of the work for which the expenditure was made.

Common law, of course, can be slippery. As courts grappled with various factual situations the rules seemed, to many taxpayers, to be malleable and changing. Some courts distinguished repairs from improvements by focusing on whether the cost was expended to put or keep the property in its ordinary efficient operating condition. Others looked at the magnitude of the cost and its effect on the economic value of the underlying property. These fact-intensive inquiries led to a variety of approaches in practice and more than a little confusion and uncertainty for taxpayers.

The regulations now provide extensive guidance on distinguishing repairs from improvements. The approach actually utilized by the taxpayer constitutes a method of accounting, and as such has important ramifications for each taxpayer.

METHODS OF ACCOUNTINGFor practitioners, substantive rules regarding when property costs can be expensed or must be capitalized, represent only a part of the issue. Taxable income is required by the Code to be computed under a specific method of accounting; namely, that method which the taxpayer regularly uses in computing “book” or financial statement income. However, variations between financial and tax reporting are allowed where other Code requirements are met and the method of accounting “clearly reflects income.” A change in the characterization of an item, constitutes a change in method of accounting, if the change has the effect of shifting income from one period to another.

Once the taxpayer adopts a method of accounting by filing its return using such method, it may not adopt a different method of accounting by the filing of an amended return. Two returns using an improper method filed for consecutive years, establishes that as the method of accounting for the taxpayer, which then must be changed with consent of the IRS.

Code section 446(e) and the Treasury Regulations (”Reg.”) section 1.446-1(e) states that a taxpayer generally must secure the consent of the IRS before changing from an adopted or established method of accounting for federal income tax purposes. Specifically, the regulations require that, in order to obtain IRS consent to make a method change, a taxpayer must file a Form 3115, Application for Change in Accounting Method, during the taxable year in which the taxpayer desires to make the proposed change. Consent is obtained either through the advance or automatic consent procedures established by the IRS. Since conformity with the regulations, regarding property expensing and capitalization, may require taxpayers to change their method of accounting, the IRS had to issue guidance in that regard as well. Changes to methods of accounting for conformity with the new regulations, is addressed below.

THE EMERGENCE OF THE NEW REGULATIONSThe road toward greater certainty can trace its origins to proposed regulations, under Internal Revenue Code (“Code”) section 263(a), issued by the Treasury Department in August of 2006. Those proposed regulations were met with significant criticism and were withdrawn. Treasury tried again with a new set of proposed regulations in March of 2008.

After considering voluminous public comment on the 2008 proposed regulations, those regulations were withdrawn, and the Treasury Department concurrently released proposed and temporary regulations in December of 2011. During 2011, the IRS also updated the procedures by which a taxpayer obtains automatic consent for a change in method of accounting, by issuing Rev. Proc. 2011-14. The rules regarding advance consent from the IRS, were previously issued in the form of Rev. Proc. 97-27.

The regulations issued in December of 2011 were originally intended to be effective in 2012, but the practical difficulties of transitioning to the new rules prompted the IRS to postpone the effective date to January of 2014. With the postponement, the IRS announced that the final rules would amend certain sections of the temporary regulations

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The Emergence of the New Regulations 11

regarding the de minimis rule, dispositions of tangible property, and the routine maintenance safe harbor. Taxpayers that chose to apply the temporary regulations before 2014, could continue to obtain the automatic consent to change their method of accounting to conform to those regulations by virtue of Rev. Proc. 2012-19 and Rev. Proc. 2012-20.

On September 13, 2013, the IRS announced the final tangible property regulations under Code sections 162 and 263, as well as proposed regulations regarding the disposition of depreciable property, including a new rule regarding partial dispositions. Shortly thereafter the IRS issued Rev. Proc. 2014-16 describing the procedures to obtain automatic consent for changing to accounting methods, required or permitted, under the final and temporary regulations. Revenue Procedure 2014-16 superseded Rev. Proc. 2012-19 and updated Rev. Proc. 2011-14, to include procedures to obtain automatic consent for certain changes in accounting methods involving acquisitions, production, and improvements to tangible property.

Effective for taxable years beginning on or after January 1, 2016, the Internal Revenue Service in Notice 2015-82 increased the de minimis safe harbor threshold from $500 to $2,500 per invoice or item for taxpayers without applicable financial statements. In addition, the IRS will provide audit protection to eligible businesses by not challenging the use of the $2,500 threshold for tax years ending before January 1, 2016 if the taxpayer otherwise satisfies the requirements of Treasury Regulation § 1.263(a)-1(f)(1)(ii).

Revenue Procedure 2014-16 did not, however, address dispositions. Accounting method changes, pursuant to the proposed regulations regarding dispositions, were separately addressed in Rev. Proc. 2014-17, which superseded Rev. Proc. 2012-20 and applied to taxable years beginning on or after January 1, 2012 and before January 1, 2014.

Revenue Procedure 2014-16 and Rev. Proc. 2014-17, each addressed changes in accounting methods relating to asset grouping rules and disposition rules under the temporary and proposed regulations. The specific changes allowed were listed and each assigned a different automatic change number. Specific information related to each method change was detailed and simplified filing rules for small taxpayers with average annual gross receipts for the three preceding taxable years of $10 million or less were provided. Furthermore, certain so-called “scope limitations” were waived, allowing taxpayers to file the automatic accounting method changes even though they are under IRS exam or had filed the same type of method change within the past five years.

Among the most significant changes under the 2013 proposed disposition regulations was the ability to recover basis upon the partial disposition of property, even if such property is not contained in a general asset account (“GAA”). The ability to do so was cast not as an accounting method change, but rather as an election not requiring the consent of the IRS. Significantly, Rev. Proc. 2014-17 expanded this rule to allow a “late” partial disposition election to be made for dispositions in prior taxable years. However, the late “election” is not treated as an election at all, but rather an accounting method change. Fortunately, this change can be undertaken through the automatic consent procedures rather than requiring an expensive advance consent. Under Rev. Proc. 2014-17 taxpayers could only make this change if they did so by the filing date of their 2013 return.

Furthermore, because partial asset dispositions could previously only be made with respect to assets in a GAA, many taxpayers made a late general asset account election under Rev. Proc. 2012-20. With elective partial asset dispositions decoupled from the GAA, many taxpayers may want to revoke GAA elections. Revenue Procedure 2014-17 permitted such a revocation to be made in either 2012 or 2013.

With the issuance of the final disposition regulations in August of 2014 and the subsequent issuance of Rev. Proc. 2014-54, the long journey to a complete and final set of capitalization regulations has at last come to an end, at least for now. The regulatory circle was completed in January 2015 when the IRS revised and replaced both the automatic and advance consent procedures by issuing Revenue Procedures 2015-13 and 2015-14. Revenue Procedure 2015-13, updates Rev. Proc. 2011-14, which previously provided procedures for automatic changes in method of accounting, as well as Rev. Proc. 97-27, which provided rules for obtaining IRS consent to make changes in a method of accounting. Revenue Procedure 2015-14 provides the list of changes to which the automatic change procedures in apply. This

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most recent guidance includes changes regarding rules on when a method change is available when audit protection is offered and the various time periods allowed for section 481 adjustments.

SUBSTANTIVE ISSUES THAT AFFECT PLANNING

UNIT OF PROPERTYMuch of the guidance in the final regulations is founded on the notion of a “unit of property.” This concept is crucial, for example, in determining whether a property-related expenditure must be capitalized or can be immediately expensed. The regulations address the definition of unit of property for buildings separately from unit of property for non-building property.

A unit of property for a building is comprised of the building and its structural components. The “repair or improvement” criteria, however, must be applied separately to the building structure and to each of eight identified building systems. Those building systems are:

Heating, ventilation, and air conditioning systems (HVAC);

Plumbing systems;

Electrical systems;

All escalators;

All elevators;

Fire protection and alarm systems;

Security systems; and

Gas distribution systems

Note that roofs are not listed as a separate building system. Note further that a roof is included in the definition of “building structure” under the investment tax credit regulations at Reg. §1.48-1(e)(1) and therefore are incorporated by reference into the definition of a “building structure” in the final repair regulations. Furthermore, there is a special rule pertaining to condominiums. The unit of property for a condominium is each individual unit, along with the structural components that are part of that unit.

Example 1:

A taxpayer owns an office building that contains a HVAC system. The HVAC system incorporates ten roof-mounted units that service different parts of the building. The roof-mounted units are not connected and have separate controls and duct work that distribute the heated or cooled air to different spaces in the building’s interior. The taxpayer pays an amount for labor and materials for work performed on the roof-mounted units. The taxpayer must treat the building and its structural components as a single unit of property and an amount is paid to improve a building if it is for an improvement to the building structure or any designated building system. The entire HVAC system, including all of the roof-mounted units and their components, comprise a building system. Therefore, if an amount paid by the taxpayer for work on the roof-mounted units is an improvement (see discussion below) to the HVAC system, the taxpayer must treat this amount as an improvement to the building.

Example 2:

A taxpayer owns a condominium unit in a condominium office building and uses the condominium unit in its business of providing medical services. The condominium unit contains two restrooms, each of which contains a sink, a toilet, water and drainage pipes and other bathroom fixtures. The taxpayer pays an amount for labor and materials to perform work on the pipes, sinks, toilets, and plumbing fixtures that are part of the condominium. As noted above, the taxpayer must treat the individual unit that it owns, including the structural components that are part of that unit, as a single unit of property. The pipes, sinks, toilets, and plumbing fixtures that are part of the taxpayer’s condominium comprise the plumbing system for the condominium. Therefore, if an amount paid by the taxpayer for work on pipes,

Unit of Property 13

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sinks, toilets, and plumbing fixtures is an improvement (see discussion below) to the portion of the plumbing system that is part of the taxpayer’s condominium, the taxpayer must treat this amount as an improvement to the condominium.

There is a special rule for leasehold improvements made by a lessee. An amount paid for a lessee improvement is treated as an amount paid to acquire or produce a unit of property, but the lessee’s unit of property cannot be larger than its leased portion of the building (assuming that the lease pertains to less than the whole building).

Determining the proper unit of property with respect to non-building property involves the application of the so-called “functional interdependence test.” Items of property are considered functionally interdependent if placing in service of one component is dependent upon the placing in service of the other component. When two such items are functionally interdependent they constitute a single unit of property. For example, a vehicle body and engine are considered a single unit of property because they are functionally interdependent. On the other hand, a laptop computer and a printer are not components that are functionally interdependent because the placing in service of the computer is not dependent on the placing in service of the printer.

Despite the general rule regarding functional interdependence, a component of a unit of property must be treated as a separate unit of property, if the component is within a different MACRS class than the MACRS class of the larger unit of property. The same is true if the taxpayer depreciates the component using a different depreciation method than the depreciation method used for the larger unit of property of which the component is a part.

Special rules apply to “plant property” and “network assets.” Plant property is defined as functionally interdependent machinery or equipment used to perform an industrial process, such as manufacturing, generation, warehousing, distribution, automated materials handling in service industries or other similar activities. The unit of property for plant property is comprised of each component (or group of components) within the plant that performs a discrete and major function or operation within functionally interdependent machinery and equipment.

Network assets are defined as railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayer. The functional interdependence test does not apply to network assets. Rather, the unit of property for network assets is determined by taking into account the taxpayer’s particular facts and circumstances. Previously issued guidance on network assets, such as telecommunications network assets, is not modified by the final repair regulations.

Determining the proper unit of property is an important step in deciding whether an expenditure should be capitalized or immediately expensed. Under the final regulations all expenditures used to acquire or produce a unit of property are capitalized, as are any costs incurred in defending title to that property. Acquisition and production costs include the full invoice cost, transaction costs, and the cost of work performed prior to the date the property is placed in service. Facilitative costs, such as amounts expended in investigating or otherwise pursuing the acquisition, are also capitalized.

There are some exceptions to this rather encompassing view of acquisition and production costs. For example, taxpayers are not required to capitalize transaction costs incurred prior to reaching a decision on whether to acquire real property and which property to acquire, unless the costs are "inherently facilitative.” An amount is inherently facilitative if it falls into one of six categories:

Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction;

Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction (for example, obtaining tax advice on the application of section 368);

Preparing and reviewing the documents that effectuate the transaction (for example, a merger agreement or purchase agreement);

Obtaining regulatory approval of the transaction, including preparing and reviewing regulatory filings;

Obtaining shareholder approval of the transaction (for example, proxy costs, solicitation costs, and costs to promote the transaction to shareholders); or

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Conveying property between the parties to the transaction (for example, transfer taxes and title registration costs).

Secondly, taxpayers are not required to capitalize transaction costs that consist of employee compensation or overhead costs. This second rule applies to acquisition of both real and personal property.

Because distinguishing deductible repairs from improvements that must be capitalized often involves a determination of whether a “major component” of a unit of property is involved, it stands to reason that the larger the unit of property, the less likely expenses subsequent to acquisition will have to be capitalized. The specific identification of a unit of property becomes crucial, therefore, in applying the final regulations.

MATERIALS AND SUPPLIESSpecial rules are provided for “materials and supplies” in the final regulations. Material and supplies are defined as tangible property that meets the following three criteria:

Used or consumed in the taxpayer’s business operations;

Not inventory; and

Falls into one of the following these categories:

A unit of property with an acquisition or production cost of less than $200;

A component that is acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer, and that is not acquired as part of any single unit of tangible property;

Fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in a taxpayer’s operations;

A unit of property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations; or

Any other tangible property identified in IRS guidance as a material or supply.

Under the final regulations, the cost of acquiring material and supplies is generally deferred and not deducted until the tax year the materials or supplies are first used or consumed. Gain on the disposition of a material or supply is ordinary income. However, materials and supplies that are “incidental” are immediately deducted in the tax year their cost is paid or incurred. An item constituting a material or supply is non-incidental if a record of consumption or inventory of the item is kept.

Example:

Assume the taxpayer purchases a supply of scanners each costing $50. The taxpayer maintains a physical count of the new scanners on hand at the beginning and end of each accounting period. Because the scanners are units of tangible property not costing more than $200 each, they are categorized as materials and supplies. Because the taxpayer maintains a physical count of them, the scanners are classified as “non-incidental” materials and supplies. As such, the cost of the scanners may be taken into account for tax purposes, only as each machine is removed from the supply closet and used in the taxpayer’s business. At that time, the cost of the scanner placed in service is fully deductible, even though the scanner may remain in use beyond the end of the tax year.

Note that under this definition, anything that is acquired as non-inventory business property for less than $200 can be considered materials and supplies and written off as when it is used or consumed in the business. This, of course, assumes that the taxpayer’s accounting method for materials and supplies conforms to the final regulations, which it probably does not. Therefore, a Form 3115 automatic consent change (No. 186), should be filed so that clients can write-off purchases less than $200 even if there is no overall de minimis safe harbor elected (see discussion below under Essential Elections).

There are two accounting method changes relating to materials and supplies that virtually every client is going to want to make. The first is a change to deducting the cost of non-incidental materials and supplies, to the year used or

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Spare Parts 15

consumed. This is done via a Form 3115 change No. 186 citing Reg. section 1.162-3(a)(1). The second is to change to deducting the cost of incidental materials and supplies to the year paid or incurred. The second change is accomplished by filing a Form 3115 change No. 187 citing Reg. section 1.162-3(a)(2). Both of these method changes are to “paid or incurred” methods that require the calculation of a modified cut-off 481(a) adjustment.

Practice Tip:

In order to consider all purchases under $200 to be materials and supplies, the taxpayer’s accounting method must be conformed to the new regulations by filing an automatic consent change, via Form 3115, filed with the federal income tax return (with a copy to the Ogden Service Center). Since it is probable that a taxpayer’s prior accounting method for materials and supplies does not conform to the new regulations, virtually all business taxpayers should take advantage of this opportunity by filing a Form 3115 with their return.

Potential problems could arise if the taxpayer uses a material or supply to improve property. What would otherwise be considered materials and supplies that are used to improve property are not treated as materials and supplies, but rather must be capitalized and depreciated as part of the cost of the improvement instead of deducted in the year used or consumed. This is true whether or not the materials and supplies are “incidental.” As a result, any taxpayer involved in making improvements to property must keep careful track of the use of materials and supplies.

When a current deduction is taken for an amount that should be capitalized, the taxpayer should correct the mistake through an amended return if a subsequent return has not yet been filed. If a subsequent return has been filed, the improper deduction constitutes an accounting method that should be corrected by a change in accounting method under the automatic procedure of Rev. Proc. 2015-13. Arguably, however, the taxpayer should not be required to make the correction if the amounts at issue are immaterial and if at the time of the deduction there was no reasonable expectation that the materials and supplies would be used to improve a property.

SPARE PARTSSpare parts are defined components of units of property that are considered materials or supplies and that fall into one of three categories: rotable spare parts, temporary spare parts, or standby emergency spare parts. A rotable spare part is one that is intended to be installed, removed for refurbishing after a period of use, and then later re-installed. The classic example is an airplane engine. Temporary spare parts are designed to replace a component temporarily until a new or repaired part can be installed. A “donut” spare tire is a good example of a temporary spare part.

Standby emergency spare parts are defined as components set aside for use as a replacement, to avoid substantial operational time loss caused by emergencies due to failure of the replaced part. To constitute a standby emergency spare part, the part must be relatively expensive, directly related to the machinery or equipment it services, available only on special order (i.e., not readily available from a vendor or manufacturer), and not subject to normal periodic replacement. A computer hard drive, especially loaded with a company’s software, for example, may be considered a standby emergency spare part. Prior to the final regulations, standby emergency spare parts were not considered materials and supplies at all, but were rather capitalized and depreciated.

Practice Tip:

Because they are materials and supplies, the cost of spare parts is generally deductible when they are used or consumed. A special rule applies, however, so that a spare part is not considered to be “used or consumed” until it is disposed of. Essentially, therefore, spare parts have to be capitalized and not depreciated. It is unlikely that most taxpayers are utilizing this method of accounting for spare parts. Therefore, a Form 3115 change (change No. 188) citing Reg. sections 1.162-3(a)(3) or 1.162-3(c)(2)) will have to be filed.

There are two other options available to taxpayer with regard to spare parts. First, the “optional method of accounting” for rotable and temporary spare parts (but not for standby emergency spare parts) may be used, whereby the cost is deferred and deducted when the part is first installed. Then, the fair market value of the part is taken into gross

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income when it is removed. Any costs to repair or refurbish it are added to the part’s basis and then the adjusted basis is deducted when it is later re-installed. Note that this optional method is not an election; it must be adopted via a Form 3115 automatic consent change (change No. 189 citing Reg. section 1.162-3(e)). Note that a full section 481(a) adjustment will generally be necessary.

If a change to the optional accounting method is not made, an election may be made to capitalize and depreciate rotable, temporary, or standby emergency spare parts. This election is made by simply claiming a depreciation deduction for the affected spare parts on a timely filed original return for the year the part is placed in service. The election is made at the partnership or S corporation level for those entities, not at the partner or shareholders level. Furthermore, the election applies on a part-by-part basis and does not need to be made for all of a taxpayer’s eligible rotable, temporary, or standby emergency parts.

DISTINGUISHING BETWEEN REPAIRS AND IMPROVEMENTS

IN GENERALAs noted above, repair expenditures are immediately expensed, whereas improvements to property must be capitalized. The final regulations extensively discuss the criteria for what constitutes an improvement; by definition, all other post-acquisition (or post-production) costs with respect to property are considered repairs and therefore immediately deductible. To be considered an improvement, an expenditure with respect to property must fall into one of three categories: betterments, adaptations, or restorations.

BETTERMENTSA “betterment” is any amount paid with respect to property that: (1) ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property (whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production); (2) is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component to the unit of property or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or (3) is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.

Under this definition, an amount is paid to improve a building if it is paid for an increase in the efficiency of the building structure or any one of its building systems, such as the HVAC system.

Where an expenditure is necessitated by normal wear and tear or damage to the unit of property, that occurred during the taxpayer’s use of the unit of property (as opposed to prior to acquisition), the determination of whether an expenditure is for the betterment of the unit of property is made by comparing the condition of the property immediately after the expenditure, with the condition of the property immediately prior to the circumstances necessitating the expenditure. However, if a taxpayer replaces a part of a unit of property that cannot reasonably be replaced with the same type of part, the replacement of the part with an improved, but comparable, part does not, by itself, result in a betterment to the unit of property.

Example 1:

In Year 1, the taxpayer purchases a store located on a parcel of land that contains underground gasoline storage tanks left by prior occupants. Assume that the parcel of land is the unit of property. The tanks had leaked prior to the taxpayer’s purchase, causing soil contamination, but the taxpayer was not aware of the contamination at the time of purchase. In Year 2, the taxpayer discovers the contamination and incurs costs to remediate the soil. The remediation costs are for a betterment to the land because the taxpayer incurred the costs to ameliorate a material condition or defect that existed prior to the taxpayer’s acquisition of the land.

Example 2:

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In Year 1, the taxpayer purchases new cash registers for use in its retail store located in leased space in a shopping mall. Assume that each cash register is a unit of property. The taxpayer capitalizes the costs of acquiring and installing the new cash registers. In Year 3, the taxpayer’s lease expires, and he decides to relocate the retail store to a different building. In addition to various other costs, the taxpayer pays $5,000 to move the cash registers and $1,000 to reinstall them in the new store. The cash registers are used for the same purpose and in the same manner that they were used in the former location. The amounts that the taxpayer pays to move and reinstall the cash registers into its new store, do not result in a betterment to the cash registers.

ADAPTATIONSA taxpayer must capitalize as an improvement an amount paid to adapt a unit of property to a new or different use. In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's ordinary use of the unit of property at the time originally placed in service by the taxpayer.

For example, suppose a manufacturer owns a building that it has used for manufacturing since 1980. In 2014, the owner pays an amount to convert its manufacturing building into a showroom for its business. To convert the facility, various structural components are removed and replaced to provide a better layout for the showroom. The amount paid to convert the manufacturing building into a showroom, adapts the building structure to a new or different use, because the conversion to a showroom is not consistent with the owner’s ordinary use of the building structure at the time it was placed in service. Therefore, the owner must capitalize the amount paid to convert the building into a showroom, as an adaptation-type improvement to the building.

On the other hand, preparing the building for sale does not constitute a new or different use for the building structure. Suppose a taxpayer owns a building consisting of twenty retail spaces and decides to sell the building. In anticipation of the sale, the taxpayer pays an amount to repaint the interior walls and to refinish the hardwood floors. Since the cosmetic changes do not, in themselves, adapt the building to a different use, the expenses are not considered to be improvements.

Suppose, however, that the taxpayer owns a building in which it operates a grocery store. The store contains several specialized counters to sell deli products, baked goods, and specialty foods. The taxpayer decides to add a sushi bar where customers can order freshly prepared sushi from the counter for take-home or to eat at the counter. To create the sushi bar, a sushi counter and chairs are added, as well as additional wiring and outlets to support the counter. Additional pipes and a sink are also installed to provide for the safe handling of the food. Finally, the taxpayer also pays to replace flooring and wall coverings in the sushi bar area with decorative coverings, to reflect more appropriate décor.

The amount paid to convert a part of the retail grocery into a sushi bar area does not adapt the building structure, plumbing system, or electrical system to a new or different use, because the sale of sushi is consistent with the taxpayer’s intended, ordinary use of the building structure and these systems in its grocery sales business, which includes selling food to its customers at various specialized counters. Accordingly, the amount paid to replace the wall and floor finishes, add wiring, and add plumbing to create the sushi bar space does not improve the building unit of property and is not required to be capitalized as an adaptation-type improvement. Note that the sushi counter and chairs are considered Code section 1245 property and the amounts paid for them should be treated as costs of acquiring new units of property.

On the other hand, if a taxpayer who ran a dry cleaning business decided to install a sushi bar, the addition would not be consistent with the owner’s originally intended use. The costs of installing a sushi bar in a dry cleaning establishment, therefore, would likely qualify as an adaptation-type improvement that would have to be capitalized.

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RESTORATIONSAn amount is considered to be expended for a restoration-type improvement only if it falls into one of the following six categories:

The replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component, other than a casualty loss;

The replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;

The restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under Code section 165, or relating to a casualty event described in section 165;

Returning the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;

Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or

The replacement of a part or combination of parts that comprise a “major component” or a “substantial structural part” of a unit of property.

The amount treated as a restoration-type improvement of property under the third category above is limited to the excess of the adjusted basis of the property over the amount paid for restoration of damage to the unit of property. For purposes of the fifth category above, a unit of property is rebuilt to a like-new condition if it is brought to the status of new, rebuilt, remanufactured, or a similar status under the terms of any federal regulatory guideline or the manufacturer's original specifications. Generally, a comprehensive maintenance program, even though substantial, does not return a unit of property to a like-new condition. Amounts spent in excess of these limits may need to be capitalized as improvements.

Example A:

Assume the taxpayer owns an office building that it uses in its trade or business. A storm damages the office building at a time when the building has an adjusted basis of $500,000. The taxpayer deducts a casualty loss in the amount of $50,000, and properly reduces its basis in the office building to $450,000. A contractor is hired to repair the damage to the building, including the repair of the building roof and the removal of debris from the building premises. Suppose the taxpayer pays the contractor $70,000 for the work. Under these circumstances, the taxpayer must treat the $70,000 amount paid to the contractor as a restoration of the building structure because the amount does not exceed an amount representing the adjusted basis of the property ($500,000) over the amount paid for restoration ($70,000). Therefore, the amount paid to the contractor is an improvement to the building that must be capitalized.

Example B:

Suppose the taxpayer owns a building that it uses in its trade or business and a storm damages the building at a time when the building has an adjusted basis of $500,000. Assume the taxpayer determines that the cost of restoring its property is $750,000. Consequently, the taxpayer deducts a casualty loss in the amount of $500,000, and reduces its basis in the building to $0. A contractor is hired to repair the damage to the building and the taxpayer pays the contractor $750,000 for the work. The work involves replacing the entire roof structure of the building at a cost of $350,000 and pumping water from the building, cleaning debris from the interior and exterior, and replacing areas of damaged dry wall and flooring at a cost of $400,000. Although resulting from the casualty event, the pumping, cleaning, and replacing damaged drywall and flooring, does not directly benefit and is not incurred by reason of the roof replacement.

Under these circumstances the taxpayer must capitalize as an improvement the $350,000 amount paid to the contractor to replace the roof structure because the roof structure constitutes a major component and a substantial structural part of the building unit of property. In addition, the taxpayer must treat as a restoration the remaining

Restorations 19

costs, limited to the excess of the adjusted basis of the building ($500,000) over the amounts paid for the improvement ($350,000). Accordingly, in addition to the $350,000 to replace the roof structure, the taxpayer must also capitalize the $150,000 as an improvement to the building unit of property. The remaining $250,000 repair and cleaning costs would not be capitalized, but may be expensed as repairs.

A “major component” is defined as a part, or combination of parts, that performs a discrete and critical function in the operation of the unit of property. An incidental component of the unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally will not, by itself, constitute a major component. 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.

All of the facts and circumstances must be considered to determine whether an amount is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of the unit of property. Among the facts and circumstances to consider, include both the quantitative and qualitative significance of the part or combination of parts in relation to the unit of property.

Example 1:

Assume the taxpayer owns a fleet of petroleum hauling trucks and pays amounts to replace the existing engine, cab, and petroleum tank of one of the trucks with a new engine, cab, and tank. Assume the tractor of the truck (which includes the cab and the engine) is a single unit of property and that the trailer (which contains the petroleum tank) is a separate unit of property. The new engine and the cab each constitute a part or combination of parts that comprise a major component, because they perform a discrete and critical function in the operation of the tractor. In addition, the cab constitutes a part or combination of parts that comprise a substantial structural part of the tractor. Therefore, the amounts paid for the replacement of the engine and the cab must be capitalized. Moreover, the new petroleum tank constitutes a part or combination of parts that comprise a major component and a substantial structural part of the trailer. Accordingly, the amounts paid for the replacement of the tank also must be capitalized.

Example 2:

Assume the taxpayer owns a machine shop in which it makes dies used by manufacturers. In 20X1, the taxpayer purchased a drill press for use in its production process. In 20X4, it is discovered that the power switch assembly, which controls the supply of electric power to the drill press, has become damaged and cannot operate. To correct the taxpayer pays to replace the power switch assembly with comparable and commercially available replacement parts. Assume that the drill press is a unit of property and the power switch assembly is a small component of the drill press that may be removed and installed with relative ease. As such, the power switch assembly is not a major component because, although the power assembly may affect the function of the drill press by controlling the supply of electric power, the power assembly is an incidental component of the drill press. In addition, the power assembly is not a substantial structural part of the drill press. Therefore, the taxpayer would not be required to capitalize the costs to replace the power switch assembly.

Example 3:

Suppose a taxpayer owns a building in which it conducts its retail business. The roof decking over the building is covered with a waterproof rubber membrane. Over time, the rubber membrane begins to wear, and the taxpayer begins to experience leaks into its retail premises. However, the building is still functioning. To eliminate the problems, a contractor recommends that the membrane on the roof be replaced with a new rubber membrane. Accordingly, the taxpayer pays the contractor to strip the original membrane and replace it with a new rubber membrane. The new membrane is comparable to the original membrane but corrects the leakage problems. The roof, including the membrane, is part of the building structure. Because the entire roof performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure. Although the replacement membrane may aid in the function of the building structure, it does not, by itself, comprise a significant portion of the roof major component. In addition, the replacement membrane does not comprise a substantial structural part of the

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building structure. Therefore, the taxpayer is not required to capitalize the amount paid to replace the membrane as a restoration of the building.

Note that Example 3 above, illustrates a treatment that is inconsistent with the standard practice of many taxpayers. In the past, a replacement of part of the roof would generally be added to the depreciable basis of the building rather than expensed as a repair. Under the final regulations, the unit of property is the building and the roof is a major component. Hence, replacement of the entire roof would be considered a restoration-type improvement, but the replacement of a part of the roof (such as the membrane in the above example) would not require capitalization.

SMALL TAXPAYER SAFE HARBORThe rules for distinguishing between deductible repairs and improvements that must be capitalized ostensibly apply to all taxpayers. However, the final regulations do provide some relief with respect to building improvements for taxpayers with average annual gross receipts of no more than $10 million during the preceding three years. Specifically, with respect to buildings that have an unadjusted basis (i.e., original cost) of $1 million or less, a taxpayer with no more than $10 million in annual gross receipts may be able to elect to treat expenditures as deductible repairs, regardless of their nature.

Under this provision, a small taxpayer is not required to capitalize expenditures (even if they would otherwise meet the definition of improvements) if the total amount expended during the year does not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building.

Example:

Assume a taxpayer has annual gross receipts of less than $10 million and owns an office building that was purchased for $750,000. In 20X1, the taxpayer pays $5,500 for improvements to the building. As long as these expenses are no more than the lesser of 2% of the original cost (in this case, $15,000) or $10,000, the taxpayer can immediately deduct all of the costs, regardless of their nature. Because the $5,500 meets these criteria, the small taxpayer safe harbor applies. Now assume the same facts except that the taxpayer spends $10,500 for costs related to the building during 20X1. Since $10,500 exceeds the lesser of 2% of the original cost or $10,000, the small taxpayer safe harbor is not available and the taxpayer must capitalize any expenditures that qualify as improvements.

Note that the availability of the safe harbor is an “all or nothing” proposition as to each building owned by the taxpayer; that is, if the expenditure limits are exceeded, the safe harbor does not apply at all with respect to that building. There is no “pro rata” application of the safe harbor permitting a portion of the costs (i.e., the first $10,000) to be immediately expensed. Note also that amounts deducted under the general overall de minimis safe harbor or the safe harbor for routine maintenance (see the separate discussions below) are counted toward the expenditure limit.

Practice Tip:

Taxpayers who might qualify for the small taxpayer safe harbor should carefully watch their expenses so as to stay under the spending limit each year. Expenditures that would put the taxpayer over the limit should be deferred until the next year when possible.

Qualifying lessees may also take advantage of this safe harbor with respect to leasehold improvements. A lessee with annual gross receipts of no more than $10 million applies the safe harbor by substituting the total amount of rent due over the lease term for the unadjusted basis of the building.

Example:

Suppose a qualifying small taxpayer leases a retail store on a triple net lease basis for 20 years requiring monthly rent payments of $4,000. Assume the taxpayer pays $7,000 leasehold improvements during 20X1. The substitute for “unadjusted basis” in this case would be $960,000 ($4,000 x 12 months x 20 years). Two percent of $960,000 is $19,200, so the safe harbor spending threshold would be $10,000. Since the taxpayer spent less than that amount for

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Routine Maintenance Safe Harbor 21

improvements, the safe harbor election is available, and the taxpayer can immediately deduct the $7,000 spent in 20X1.

The small taxpayer safe harbor is not automatic; it is an annual election that must be affirmatively made by the taxpayer. In this case, the election is made by attaching a statement to the taxpayer’s return that is labeled “Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers.” The statement should include the taxpayer’s name, address, tax identification number, a description of each eligible building to which the taxpayer is applying the election, and the amount expended during the year. In the case of S corporations or partnerships (including LLCs taxed as partnerships), the election is made by the entity, not by the individual shareholder or partner.

ROUTINE MAINTENANCE SAFE HARBORIn addition to the small taxpayer safe harbor there is a “routine maintenance” safe harbor that applies to all taxpayers. The safe harbor for routine maintenance, permits a deduction for any expenditures that are reasonably anticipated to be required more than once during an asset’s class life (or over 10 years in the case of buildings). It is not essential that the maintenance activities in fact be performed more than once during the class life. The safe harbor is still applicable if the client can substantiate that, at the time the property was placed in service, there was a reasonable expectation that the activities would be performed more than once.

The specific form of substantiation will vary from asset to asset, but documentation from the seller or manufacturer recommending a maintenance schedule consistent with the safe harbor would be optimal.

ESSENTIAL FORM 3115 FILINGS

CHANGES IN ACCOUNTING METHODS USING FORM 3115The manner of adopting a method of accounting depends on whether the method is proper (i.e., permissible) or improper. A method of accounting is proper only if it “clearly reflects income.” For any method of accounting that is proper, the method is said to be adopted simply by using that method with respect to an item on the first federal income tax return that reflects the item. An improper method of accounting is adopted through “consistent treatment” of the item, meaning that the treatment of a material item in the same way in determining the gross income or deductions in two or more consecutively filed federal income tax returns, constitutes adoption of the improper method.

This is crucial because, once a taxpayer has adopted a method of accounting, it generally cannot be changed without the consent of the IRS. This leads to the somewhat counter-intuitive result that, even if a taxpayer has inadvertently adopted an impermissible method of accounting, the taxpayer is not free to simply “correct” its error by changing the method of accounting on its own initiative. Permission of the IRS is needed even to change from an improper method to a proper one.

Taxable income must be computed under the method of accounting, on the basis of which the taxpayer regularly computes income in keeping the taxpayer’s books. This is sometimes referred to as the “book-tax conformity requirement.” Regulations section 1.446-1(a)(4), requires each taxpayer to maintain accounting records that will enable the taxpayer to file a correct return and states that accounting records include the taxpayer’s regular books of account and other records and data as may be necessary to support the entries on the taxpayer’s books of account and on the taxpayer’s return, as for example, a reconciliation of any differences between such books and his return. Thus, a taxpayer satisfies the book-tax conformity requirement if the taxpayer reconciles the results obtained under the method of accounting used in keeping its records and accounts and the method used for federal income tax purposes and maintains sufficient records to support that reconciliation.

A change in method of accounting occurs when the method of accounting to be used by the taxpayer for an item in computing its taxable income for the year of change, is different than the taxpayer’s established method of accounting used to compute the taxpayer’s taxable income for the immediately preceding taxable year. A change in method of

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22 Essential Form 3115 Filings

accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability, such as errors in computation of the foreign tax credit, net operating loss, percentage depletion, or investment credit.

Generally, a taxpayer must secure the consent of the IRS before changing a method of accounting for any item for federal income tax purposes. Unless specifically authorized by the IRS or by statute, a taxpayer may not change an established method of accounting by simply amending its prior federal income tax return(s). Furthermore, unless specifically authorized by the IRS or by statute, a taxpayer may not request, or otherwise make, a retroactive change in method of accounting.

Form 3115 must be filed during the taxable year for which the taxpayer desires to make the proposed change in method of accounting. Typically, Forms 3115 filed under the non-automatic (i.e., advance) change procedures require additional information and development. Therefore, the IRS recommends that taxpayers file a Form 3115 under the non-automatic change procedures as early as possible during the requested year of change.

Ordinarily, a taxpayer may request only one change in method of accounting on a single Form 3115. If the taxpayer wants to request a change in method of accounting for more than one unrelated item or sub-method of accounting, the taxpayer must submit a separate Form 3115 for each unrelated item or sub-method, except in certain situations in which the IRS specifically permits certain unrelated changes to be included on a single Form 3115.

Accounting method changes come in two categories. First, a change may be made through the “automatic consent” procedures. To file under the automatic consent procedures, the original Form 3115 must be attached to the timely filed (including extensions) return for the year of change. A copy of Form 3115 must be filed with the IRS National Office no earlier than the first day of the year of change, and no later than the date the original Form 3115 is filed with the timely filed federal income tax return. For example, a calendar year taxpayer who files its year 20X1 return (with proper extensions) on September 1, 20X2, may file a copy of the Form 3115 with the IRS National Office during the year of change, or no later than September 1, 20X2 to obtain consent to the change for the year 20X1.

Automatic consent procedures only apply to those changes specifically listed in Rev. Proc. 2015-14 and certain changes to conform to the new tangible property regulations. If the automatic consent procedures can be used, the taxpayer merely files Form 3115 and makes any applicable 481(a) adjustment (see discussion below). No user fee is required. The IRS does not send an acknowledgment of receipt for a Form 3115 (original or copy) filed under the automatic change procedures.

If automatic consent is not available, the other alternative is known as the “advance consent” procedure and likewise is requested using Form 3115. For an advance consent, the taxpayer is required to file Form 3115 during the year of change. For example, a calendar year taxpayer must file Form 3115 by December 31, 20X2, in order to request a change for the 20X2 tax year. Unlike the automatic consent procedures, the taxpayer must receive an accounting method change ruling letter (consent) from the IRS prior to implementing a method change. Perhaps more importantly, a user fee is required for an advance consent request. That user fee is $10,800 (for requests received after February 1, 2020) for most accounting method changes.

Form 3115 must include all relevant facts. In the case of a Form 3115 filed under the automatic change procedures, the taxpayer must include the designated automatic accounting method change number (found in the applicable section of the List of Automatic Changes in Rev. Proc. 2015-14) on the applicable line of Form 3115. For example, the designated automatic accounting method change number for a change from an impermissible to permissible method of accounting for depreciation or amortization is 7. Therefore, a taxpayer requesting consent for the change in method of accounting from an impermissible to permissible method of accounting for depreciation or amortization for the taxable year ending December 31, 20X1, must enter the number “7” on Line 1(a) of Form 3115.

Most accounting method changes are granted with audit protection, which means that the IRS will not require the taxpayer to change its method of accounting for the same item for a taxable year prior to the year of change. For example, suppose a taxpayer has been using an impermissible method of accounting for several years for certain items. In 20X1, the taxpayer files an application to change to a proper method of accounting for such items. If the

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Comparison of Advance Consent and Automatic Consent: 23

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change is made with audit protection, the IRS would not be able to propose an adjustment for the improper method of accounting for such items in an examination of an earlier taxable year.

In general, a taxpayer may enter only one designated automatic accounting method change number on a Form 3115. However, where Rev. Proc. 2015-14 or other guidance published in the IRB specifically permits or requires a taxpayer to request two or more particular changes in method of accounting on a single Form 3115, the taxpayer must enter the designated automatic accounting method change number for each such particular change being requested on the applicable line of the Form 3115.

A taxpayer with multiple trades or businesses filing a Form 3115 for one or more of those trades or businesses must identify, by name, the trades or businesses to which the change relates. The taxpayer must also identify, by name, all other trades or businesses and explain the method of accounting used for each trade or business for the particular item that is the subject of the Form 3115. Generally, the taxpayer must submit a separate Form 3115 and, in the case of a non-automatic change, a separate user fee for each trade or business of the taxpayer for which consent for a change in method of accounting is requested.

The Form 3115 must be signed by, or on behalf of, the taxpayer requesting the change in method of accounting by an individual who has personal knowledge of the facts of, and authority to bind the taxpayer in, such matters. Further, if the individual who, for compensation, prepared the Form 3115 is not the taxpayer or an individual with authority to sign the Form 3115 on behalf of the taxpayer, the preparer must also sign the Form 3115.

COMPARISON OF ADVANCE CONSENT AND AUTOMATIC CONSENT:

Advanced Consent Automatic Consent

Applies to all changes other than changes subject to the automatic consent procedures.

Applies only to certain changes designated for automatic consent.

Taxpayer gets a consent letter. Taxpayer does not get a consent letter.

National Office reviews change request before issuing the consent letter.

No review is conducted before consent is granted. "Post-consent" review may be conducted by the National Office (if the Form 3115 is selected) or by examiners (if taxpayer is audited).

Taxpayer must wait to receive its consent letter before filing.

Taxpayer gets automatic consent and may file on the new method without waiting.

One Form 3115 filed with National Office. Two Forms 3115 required: a copy of Form 3115 is filed with National Office, and original is attached to a timely filed return for the year of change.

Taxpayer must file during the year of change

Taxpayer has through the extended due date of the return for the year of change to complete its filing.

Taxpayer filing is acknowledged. Taxpayer gets no acknowledgement of filing.

User fee is charged. No user fee is required.

FORM 3115 RELIEF FOR SMALL TAXPAYERSA taxpayer whose average annual gross receipts for the three preceding taxable years are less than or equal to $10,000,000 (a “qualifying taxpayer”), is required to complete only the following information on Form 3115:

The identification section of page 1 (above Part I);

The signature section at the bottom of page 1;


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Part I, line 1(a);

Part II, all lines except lines 11, 13, 14, 15, and 17;

Part IV, lines 25 and 26; and

Schedule E, line 3.

CHANGES TO MATERIALS AND SUPPLIES ACCOUNTING METHODTaxpayers should carefully consider how they define materials and supplies and the timing of when they deduct the cost of such items. Many taxpayers do not distinguish between incidental and non-incidental materials and supplies or spare parts. Those taxpayers will have to file a Form 3115 to change their accounting method to conform to the final regulations.

Recall that the final regulations define “materials and supplies” to include any non-inventory business purchases for $200 or less. If the item purchased qualifies as incidental (i.e., no inventory or record of consumption is maintained), the cost can be expensed immediately. This should apply to shop materials, routine office supplies, and the like.

Additionally, it is possible that some taxpayers’ materials and supplies will fall under the annually elected overall de minimis safe harbor of $5,000 ($2,500 for taxpayers without an applicable financial statement – see the discussion below under Essential Elections). However, even in this case, it may be necessary to file a Form 3115 to put the taxpayer on a proper method of accounting for materials and supplies so that in a later year, if the taxpayer chooses not to elect the de minimis safe harbor (or inadvertently fails to attach the safe harbor election statement), its treatment of incidental materials and supplies as deductible in the year purchased will nonetheless be protected.

Practice Tip:

Assuming a taxpayer has not been following the requirements of the final regulations regarding materials and supplies and spare parts, a Form 3115 will have to be filed to conform to the new rules. Specifically, one or more of the following designated automatic accounting method change numbers should be used:

Change to deducting non-incidental materials and supplies when used or consumed (No. 186);

Change to deducting incidental material and supplies when paid or incurred (No. 187);

Change to deducting non-incidental rotable and temporary spare parts (No. 188); and

Change to the optional method for rotable and temporary spare parts (No. 189)

CHANGES IN DEPRECIATION OR AMORTIZATIONRegulations section 1.446-1(e)(2)(ii)(d)(2) provides that each of the following changes in depreciation or amortization is a change in method of accounting:

A change in the depreciation method or amortization method, period of recovery, or convention of a depreciable or amortizable asset;

A change in the accounting for depreciable or amortizable assets from a single asset account to a multiple asset account (pooling), or vice versa, or from one type of multiple asset account (pooling) to a different type of multiple asset account (pooling);

For depreciable or amortizable assets that are mass assets accounted for in multiple asset accounts or pools, a change in the method of identifying which assets have been disposed of; and

Any other change in depreciation or amortization, as the Secretary, may designate by publication in the Federal Register or in the Internal Revenue Bulletin.

However, Reg. section 1.446-1(e)(2)(ii)(d)(3), provides that none of the following changes in depreciation or amortization, is a change in method of accounting:

An adjustment in the useful life of a depreciable or amortizable asset for which depreciation is determined under § 167. However, if a taxpayer is changing to or from a useful life that is specifically assigned by the Code

Pre-2003 Property 25

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(for example, § 167(f)(1), § 168(c), § 168(g)(2), § 168(g)(3), or § 197), such a change is a change in method of accounting;

The making of a late depreciation or amortization election or the revocation of a timely valid depreciation or amortization election, except as otherwise expressly provided by the Code, the regulations thereunder, or other guidance published in the Internal Revenue Bulletin;

Any change in the placed-in-service date of a depreciable or amortizable asset, except as otherwise expressly provided by the Code, the regulations thereunder, or other guidance published in the Internal Revenue Bulletin; and

Any other change in depreciation or amortization as the Secretary may designate by publication in the Federal Register or in the Internal Revenue Bulletin.

Section 1.446-1(e)(2)(ii)(d)(5)(iii), provides generally, that no Code section 481(a) adjustment is required or permitted for a change from one permissible method of computing depreciation or amortization to another permissible method of computing depreciation or amortization, for an asset. Instead, this change is implemented by either a cut-off method or a modified cut-off method, as appropriate. Under the modified cut-off method, the adjusted depreciable basis of the asset as of the beginning of the year of change, is recovered using the new permissible method of accounting. Section 1.446-1(e)(2)(ii)(d)(5)(iii) also provides that a change from an impermissible method of computing depreciation or amortization to a permissible method of computing depreciation or amortization for an asset results in a § 481 adjustment.

Perhaps the most significant (if expected) development under Rev. Proc. 2014-54 is that it allows taxpayers to file an accounting method change to make a late partial disposition election under the final regulations during a tax year beginning in 2014. The final regulations, however, changed the rule by which the Consumer Price Index (“CPI”) rollback method could be used to determine basis in a partial asset disposition by substituting the Producer Price Index and indicating that the CPI rollback method is unreasonable. The latest revenue procedure includes accounting method changes for taxpayers who used the CPI method in various contexts to switch to a reasonable method such as the PPI rollback method.

PRE-2003 PROPERTYFor depreciable or amortizable property, placed in service in tax years ending before December 30, 2003 (“pre-2003 assets”), a taxpayer may treat a change to comply with the final MACRS regulations for some or all of such assets as a change that is not a change in accounting method. This is consistent with a litigation position announced by the IRS in Chief Counsel Notice 2004-007.

Pursuant to this rule, the IRS will not assert that the following changes in computing depreciation are changes in method of accounting: changes in computing depreciation under §§ 167, 168, 197, 1400I (the commercial revitalization deduction), 1400L(b) (additional first-year depreciation for “qualified New York Liberty Zone property,”), and 1400L(c) (5-year recovery period for “qualified New York Liberty Zone leasehold improvement property,”).

In these situations the taxpayer can take the position that a change in computing depreciation for a pre-2003 asset is not a change in method of accounting and file amended federal tax returns for the earliest year open under the statute of limitations, for assessment under § 6501(a) (but not earlier than the placed-in-service year of the depreciable asset) and all later affected tax years. All of the changes in computing depreciation for the depreciable asset, must be made in the same manner if there are two or more changes in computing depreciation for a depreciable asset (for example, a change in depreciation method and a change in recovery period).

Thus, if, for example, a taxpayer completed a cost segregation study in 2004 for its MACRS property placed in service in 2001 and determined that some of the taxpayer's MACRS property that is reported as being placed-in-service by the taxpayer in 2002 was actually placed-in-service by the taxpayer in 2001, IRS will not assert that the change in computing depreciation resulting from this change in placed-in-service date is a change in method of accounting.


The same rule is applicable for changes to comply with the final regulations. The taxpayer simply files amended returns for the placed-in-service year of the pre-2003 asset and all later tax years (to the extent the years are still open), to implement the change. If the taxpayer files amended returns for the pre-2003 assets, neither an adjustment under Code Sec. 481 nor a similar cumulative depreciation adjustment is required or permitted.

For example, pursuant to Reg. §1.167(a)-4, capital expenditures made by either a lessee or lessor for the erection of a building or for other permanent improvements on leased property are recovered by the lessee or lessor under the provisions of the Code applicable to the cost recovery of the building or improvements, if subject to depreciation or amortization, without regard to the period of the lease. For example, if the building or improvement is property to which § 168 applies, the lessee or lessor determines the depreciation deduction for the building or improvement under § 168.

Under Rev. Proc. 2014-17, Sec. 3.01(2), this change can be made without the necessity of filing a Form 3115 or making a full 481(a) adjustment. Specifically, for assets placed in service in a tax year ending before December 30, 2003 (“pre-2003 assets”), a taxpayer can treat the change to comply with Reg. § 1.167(a)-4 for all, or some, of the pre-2003 assets as not a change in method of accounting. Rather than filing a Form 3115, the taxpayer can implement the change to comply with Reg. § 1.167(a)-4 by filing amended federal tax returns for the placed-in-service year of the pre-2003 asset and all later tax years, but only insofar as those tax years remain open under the statute of limitations. Note, however, that no cumulative depreciation adjustment is required or permitted.

PARTIAL ASSET DISPOSITIONSSince the old regulations treated structural components of a building as separate assets for tax disposition purposes, taxpayers were required to recognize a gain or loss on the disposition of any such structural component, unless a general asset account (“GAA”) election had been made (see discussion below). As a result, in the absence of a GAA election, the removal of a roof was always considered a disposition under the old regulations that would result in a loss (to the extent of any remaining basis in the roof).

The final disposition regulations, however, provide that a building itself (including its structural components) is the asset for disposition purposes. Furthermore, the definition of a disposition has been modified to include the retirement of a structural component of a building if a partial disposition election is made. As a result, clients now have the choice to forgo a loss upon disposition of a structural component of a building even if no GAA election has been made.

Thus, the final regulations allow clients to claim a loss upon the disposition of a structural component of a building (or a component of any other asset) without the necessity of having to identify the component as an asset before the disposition event. This partial disposition election is an annual election (rather than an accounting method change) applied on an asset-by-asset basis on the timely filed original (not amended) tax return, including extensions, for the tax year in which the portion of the asset is disposed of.

Note that if the IRS subsequently disallows the client’s characterization of the replacement of a portion of an asset as a deductible repair and proposes an adjustment to capitalize such replacement cost, the client has the option to make the partial disposition election by filing an application for change in accounting method, provided the underlying asset to which the disposed portion related was still owned by the client at the beginning of the year of change.

Revenue Procedure 2014-54 allows for “late” partial disposition elections for tax years beginning January 1, 2012 or later and before January 1, 2015. Thus, in tax year 2014, taxpayers will be allowed to file an accounting method change to make a late partial disposition election to claim a retirement loss on retired structural components of buildings (as well as components of other assets), that were retired in tax years beginning before January 1, 2012.

Practice Tip:

Many taxpayers continue to depreciate the entire cost of a roof (as part of the building depreciation) when a portion of it is replaced. Typically, the cost of the replacement is added to the depreciable basis of the building, resulting in

Summary of Common Form 3115 Changes under the Final Regulations 27

concurrent depreciation of the removed portion of the roof and the new replacement portion. Under the new regulations, “ghost assets”, such as the replaced portion of the roof, can now be written off as a late partial asset disposition election (see discussion below) if the taxpayer files a Form 3115 change in accounting method.

SUMMARY OF COMMON FORM 3115 CHANGES UNDER THE FINAL REGULATIONS

Issue Reg. Section Change No.

Materials and Supplies 1.162-3(a) 186,187

Rotable and temporary spare parts 1.162-3(e) 188, 189

Repairs 1.162-4 184

Leased property 1.167(a)-4 175, 199

Amounts paid to sell property 1.263(a)-1(e) 190, 191

Acquired or produced tangible property 1.263(a)-2(d) 192

Defense or protection of title 1.263(a)-2(e) 192

Recovery of capitalized amounts 1.263(a)-2(h) 192

Capitalized amounts paid for improvements 1.263(a)-3(d) 184

Unit of property 1.263(a)-3(e) 184

Improvements to leased property 1.263(a)-3(f) 184

Special rules for improvement costs 1.263(a)-3(g) 21, 184

Safe harbor for routine maintenance 1.263(a)-3(i) 184

Capitalization of betterments 1.263(a)-3(j) 184

Capitalization of restorations 1.263(a)-3(k) 184

Capitalization of adaptations 1.263(a)-3(l) 184

Accounting for MACRS property 1.168(i)-7 176, 180, 200

Disposition of a portion of an asset 1.168(i)-8(d)(2) 177, 178, 196

ESSENTIAL ELECTIONS

DE MINIMIS SAFE HARBORWithout regard to any of the rules discussed above, de minimis safe harbor expensing of amounts up to $2,500 or $5,000 (depending on the type of financial statements used by the taxpayer) is allowed under the final regulations if certain conditions are met.

Recall that Code section 446 establishes a two-fold standard for tax accounting. First, the taxpayer is required to compute taxable income under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. Second, if the IRS feels that the method used does not clearly reflect income, it can force the taxpayer to change to a method that, in its opinion, does clearly reflect income.

The meaning of “clearly reflect income” for this purpose is anything but clear. In various rulings and cases, the IRS and the courts have interpreted the clear-reflection-of-income doctrine and have developed some specific guidelines as to

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what it means and what it requires. Generally, a method of accounting that constitutes the consistent application of generally accepted accounting principles (“GAAP”) in a particular trade or business in accordance with accepted conditions or practices in that trade or business will be regarded as clearly reflecting income, provided that all items of gross income and expense are treated consistently from year to year. However, there is no presumption that GAAP always represents a clear reflection of income.

For example, in one case the IRS (and the Eighth Circuit Court of Appeals) held that, even though a taxpayer’s system of valuing inventory using shrinkage estimates based on sales conformed to the best accounting practice and was consistent with GAAP, this method of accounting it did not clearly reflect income because the taxpayer could not prove that there was a strong correlation between sales and shrinkage. In fact, even if the taxpayer could prove that the actual and estimated shrinkage rates as a percentage of sales were identical, that did not explain the distribution of losses from shrinkage within inventory periods (i.e., whether the losses occurred during the stub period—the interval between the physical inventory and the end of the tax year).

On the other hand, an accounting method that does not accord with GAAP in a trade or business will almost always be treated as not clearly reflecting income for federal income tax purposes. For example, when a bank accrued the total amount of interest due on loans that it made in the year in which the loans were made, the IRS held that the method did not clearly reflect income because it was inconsistent with GAAP.

When a taxpayer establishes a capitalization policy that calls for the immediate expensing of all purchases below a specified amount for financial accounting purposes, therefore, this amount arguably should also be deducted for income tax purposes. However, the taxpayer may get into a dispute with the IRS as to whether or not the policy results in a clear reflection of income. Given the broad discretion granted to the IRS under Code section 446(b), this is a dispute as to which the taxpayer is decidedly at a disadvantage.

Fortunately, the final regulations call a truce of sorts by establishing write-off levels pursuant to capitalization policies under which the IRS will not assert the clear reflection of income doctrine. Those levels are $5,000 for taxpayers with an “applicable financial statement” (“AFS”) and $2,500 for those without an AFS. An AFS is either: (1) a financial statement required to be filed with the Securities and Exchange Commission (“SEC”); (2) a certified audited financial statement that is accompanied by the report of an independent certified public accountant that is used for any substantial non-tax purpose (such as obtaining credit or reporting to owners); or (3) a financial statement (other than a tax return) required to be provided to the federal or a state government or agency other than the SEC or the IRS.

The de minimis election is made by attaching a statement to a timely filed original federal tax return (including extensions) for the tax year in which the amounts are paid. The statement must be titled “Section 1.263(a)-1(f) de minimis safe harbor election” and include the taxpayer's name, address, and taxpayer identification number, and a statement that the taxpayer is making the de minimis safe-harbor election under Reg. 1.263(a)-1(f). In the case of affiliated groups of corporations filing a consolidated return, the election statement must include the names and identification numbers of each member making the election. Taxpayers are not required to attach the written de minimis policy to the tax return, nor are they required to indicate the specific capitalization threshold identified in the policy.

When a de minimis policy is elected, it applies to all acquisitions of property other than: (1) land; (2) inventory; (3) rotable, temporary, and standby emergency spare parts that are capitalized and depreciated; and (4) rotable and temporary spare parts accounted for under the optional method of accounting for rotable parts. A “pick-and-choose” de minimis election is not available.

Even if a taxpayer determines that its method does accord with the final regulations, it may be beneficial to file a Form 3115 that explains how the taxpayer’s present method of accounting aligns with the regulations. This change may be made automatically under appendix section 10.11 of Rev. Proc. 2011-14, as modified by Rev. Proc. 2014-16, and is generally filed with a modified section 481(a) adjustment (i.e., the section 481(a) adjustment should take into account

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De Minimis Safe Harbor 29

only amounts paid or incurred in tax years beginning on or after January 1, 2014. The scope limitations included in Rev. Proc. 2011-14 are waived as long as the taxpayer’s year of change is a tax year that begins before January 1, 2015.

It is possible a taxpayer that has historically overcapitalized repair costs for book purposes and has followed this treatment for tax, may not be required to file a Form 3115 to adopt the improvement rules contained in the final regulations, as long as the taxpayer will make the election to capitalize repair costs under Reg. section 1.263(a)-3(n) in 2014 and future tax years. However, taxpayers should note that if they decide not to make this election, they will likely have to file a Form 3115 to adopt the improvement rules under the final regulations. In this narrow fact pattern, the taxpayer may be able to make this change with a $0 section 481(a) adjustment.

Additionally, it may be beneficial for taxpayers to file a Form 3115 to adopt the new improvement rules even if they do intend to make the election to capitalize repair costs. In such a case, even if the taxpayer chooses not to make this capitalization election in a future year, it will already be on a proper method of accounting for such costs. A change to adopt the improvement rules of the final regulations may be made under the automatic consent procedures.

Suppose your client pays $45,000 for the purchase and installation of wireless routers in each of its 10 office locations. Assume that each wireless router is a unit of property under § 1.263(a)-3(e). The client receives an invoice from its supplier indicating the total amount due ($45,000), including the material price per item ($2,500), and total delivery and installation ($20,000). The client can allocate the installation cost in any reasonable manner, including on a pro rata basis. If the client does so, the cost of each router would be $4,500 ($2,500 materials + $2,000 labor and overhead). Assuming the client has an AFS and a written policy requiring the expensing of purchases under $5,000 for book purposes, the amounts paid for each router, including the allocable additional invoice costs, meet the requirements for the de minimis safe harbor. If the client elects to apply the de minimis safe harbor, it may not capitalize the amounts paid for the 10 routers (including the additional invoice costs) or any other amounts meeting the criteria for the de minimis safe harbor for the year.

Now suppose your client is a corporation that provides consulting services to its customer. The company does not have an AFS, but has accounting procedures in place at the beginning of the year to expense amounts paid for property costing up to $2,500. During the year the company pays $2,000 to an interior designer to shop for, evaluate, and make recommendations regarding purchasing new furniture for its conference room. As a result of the interior designer’s recommendations, the company acquires a conference table for $2,500 and 10 chairs for $250 each. Assume the company receives an invoice from the interior designer for $2,000 for his services, and a separate invoice from the furniture supplier indicating a total amount due of $2,500 for the table and $250 for each chair.

Assume further, that the company treats the amount paid for the table and each chair as an expense on its books and records, and elects to use the de minimis safe harbor for amounts paid for tangible property that qualify under the safe harbor. The amount paid to the interior designer is a cost of facilitating the acquisition of the table and chairs under Regs. §1.263(a)-2(f). Therefore, the company is not required to include in the cost of tangible property the additional costs of acquiring such property if these costs are not included in the same invoice as the tangible property; it is not required to include an allocation of the amount paid to the interior designer to determine the application of the de minimis safe harbor to the table and the chairs.

On the other hand, suppose the design work and the table and chairs were all invoiced together. The Company would then have to allocate the cost of the design work to the items of property. This could be done pro rata ($2,000 ÷ 11) or on a weighted average method by multiplying the design cost by the ratio of the cost of each item to the total cost ($2,000 x [$2,500 ÷ $5,000] = $1,000 allocated to the table). The company could not, under these circumstances, allocate all of the design cost to the chairs unless such costs were specifically identified only with the chairs.

Clients should be educated to be sensitive to invoicing practices when acquiring property that might be eligible for safe harbor expensing; if expensing is desired, it may be prudent to ask that additional costs be separately invoiced.


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PARTIAL ASSET DISPOSITIONSSuppose a taxpayer replaces the roof of a building in 2005. Under the regulations then in effect, the old roof would continue to be depreciated over its remaining useful life, despite its removal. The new roof, of course, would also be depreciated, resulting in the accounting recognition of two assets (or, more specifically, two asset components) in a situation where only one exists. The ghost asset produced by this anomaly was addressed in the subsequent regulations allowing the write-off of the remaining basis of such asset components upon disposal.

The approach taken in the original temporary regulations, however, was modified when the final regulations were issued. Under the temporary regulations issued in 2011, a taxpayer was required to treat the retirement of a structural component of a building as a disposition, thus enabling the taxpayer to claim a loss on the remaining cost basis of that component. Additionally, Rev. Proc. 2012-20 permitted the taxpayer to request an automatic accounting method change to take a partial disposition loss on assets disposed of in a prior year.

Under the new repair regulations issued in 2013, a structural component of a building is no longer a separate asset for disposition purposes; instead, the entire building is the asset. Nonetheless, taxpayers can make an annual partial disposition election to claim a loss on the remaining cost basis of a retired component. Thus, partial dispositions are now the subject of an annual election opportunity. The regulations expand the availability of a partial disposition election to significant components of tangible personal property as well as to structural components of buildings.

As a result, taxpayers can make an election to apply the rules regarding dispositions of assets to a disposition of only a portion of an asset. This is an election and not a change in method of accounting. However, the taxpayer must classify the replacement portion of the asset under the same asset class as the disposed portion of the asset. The election must be made by the due date, including extensions, of the original federal tax return for the taxable year in which the portion of an asset is disposed of by the taxpayer. The election is made by simply reporting the gain, loss, or other deduction on the taxpayer's timely filed tax return for that taxable year.

When the final regulations were issued, the question remained as to how a taxpayer could claim a loss on a partial disposition that occurred in a prior year. Rev. Proc. 2014-17 addressed this issue by allowing taxpayers to request an automatic accounting method change to make a “late” partial disposition election on property retired in any tax year prior to the year for which the change is filed. Additionally, Rev. Proc. 2014-17 permits the use of statistical sampling to assist taxpayers with identifying particular assets retired in prior years (particularly those for which the retirement occurred many years ago).

Revenue Procedure 2014-54 extended the opportunity to make late partial disposition elections to tax years beginning before January 1, 2015, so such late elections may be made on the 2014 return. The late partial asset disposition election is made by filing a Form 3115 indicating change number 177 (for a building or structural component) or 178 (for other assets). In order to make a late partial asset disposition election, the asset must be owned by the taxpayer at the beginning of the year of change. A taxpayer making this change for more than one asset for the same year of change should file a single Form 3115 for all such assets. Finally, the taxpayer must file a signed copy of its completed Form 3115 with the IRS in Ogden, UT (Ogden copy), in lieu of filing the national office copy, no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with its federal income tax return for the year of change.

To make a late partial asset disposition election, the taxpayer must:

Apply § 1.168(i)-8(h)(1) and (3) (accounting for asset disposed of);

Classify the replacement portion of such asset under the same asset class as the disposed portion of the asset in the taxable year in which the replacement portion is placed in service by the taxpayer;

File a Form 3115 indicating change number 177 or 178;

If the taxpayer continues to deduct depreciation for the disposed portion of the asset under the taxpayer’s present method of accounting, change from depreciating such disposed portion to recognizing gain or loss for the disposed portion or, if § 280B and § 1.280B-1 apply to the disposition, change from depreciating such

Partial Asset Dispositions 31

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disposed portion to capitalizing the loss sustained on account of the demolition to the land on which the demolished structure was located; and

If the taxpayer recognized a gain or loss under § 1.168(i)-1T or § 1.168(i)-8T for the disposed portion of the asset in a taxable year prior to the year of change, recognize gain or loss for such disposed portion under § 1.168(i)-8 or Prop. Reg. § 1.168(i)-8, as applicable.

Depending on how they calculated the remaining cost basis of the replaced component, taxpayers that already made the late partial disposition election on their 2012 or 2013 tax returns may have needed to file another accounting method change on their 2014 tax returns to correct it. When a taxpayer does not know the exact remaining cost basis of a replaced component (which will often be the case when the replaced component was acquired as part of a larger asset acquisition, for example, the roof of a building), the taxpayer can use any reasonable method to calculate the remaining cost basis of the replaced component.

Under the proposed regulations, the "CPI rollback method", which took the cost of the replacement asset and rolled its cost back to the year the original component was placed in service based on the Consumer Price Indices in those years, was considered a reasonable method. Under the final regulations, however, the CPI rollback method is deemed unreasonable. Therefore, taxpayers who made partial disposition elections (late or current) on 2012 or 2013 tax returns using the CPI rollback method needed to file an accounting method change on their 2014 returns recalculating the write-off of the replaced component using a different method, such as the Producer Price Index rollback method (which the final regulations explicitly mention as a reasonable method).

Example 1:

X, a calendar year taxpayer, acquired and placed in service a truck in 2009. X depreciates the truck under § 168. X does not reasonably expect to replace the engine of the truck more than once during its class life of 6 years. The engine is a major component of the truck.

In 2012, X replaced the engine of the truck. Because the truck is the asset for disposition purposes, X did not recognize a loss on the retirement of the engine and continues to depreciate the original engine. Further, X capitalized the new engine as an improvement and also depreciates the new engine under § 168.

X decides to make the late partial disposition election for the truck’s original engine that X retired in 2012. Although the truck is the asset for disposition purposes under § 1.168(i)-8(c)(4)(ii)(C), the partial disposition rule results in the retirement of the engine being a disposition under § 1.168(i)-8(b)(2). Thus, X may file a Form 3115 with its 2014 federal income tax return to make the late disposition election for the engine and change from depreciating the original engine to recognizing a loss upon its retirement.

Example 2:

Y, a calendar year taxpayer, acquired and placed in service a building and its structural components in 2000. The roof is a structural component of the building. Y replaced the entire roof in 2010. On its federal income tax return for the taxable year ended December 31, 2010, Y did not recognize a loss on the retirement of the original roof and continued to depreciate the original roof. Y also capitalized the cost of the replacement roof and has been depreciating that roof since June 2010.

The adjusted depreciable basis of the original roof at the time of its retirement in 2010 was $11,000, and Y claimed depreciation of $1,000 for such roof after its retirement and before the 2012 taxable year.

Under the temporary regulations, Y filed a Form 3115 with its 2012 income tax return to treat the building as an asset and each structural component of the building as a separate asset for disposition purposes, and also to change from depreciating the original roof to recognizing a loss upon its retirement. The amount of the net negative § 481(a) adjustment on this Form 3115 is $10,000 (adjusted depreciable basis of $11,000 for the original roof at the time of its retirement (taking into account the applicable convention) less depreciation of $1,000 claimed for such roof after its retirement and before the 2012 taxable year).


Y complies with § 1.168(i)-8 beginning with its taxable year ending December 31, 2014. Y also decides to make the late partial disposition election for the building’s original roof that Y retired in 2010. Although the original building (including its original roof and other original structural components) is the asset for disposition purposes under § 1.168(i)-8(c)(4)(ii)(A), the partial disposition rule results in the retirement of the original roof being a disposition under § 1.168(i)-8(b)(2). Thus, Y may file a Form 3115 with its 2014 federal income tax return to make a late partial disposition election for the original roof, treat the original building (including its original roof and other original structural components) as an asset and the replacement roof to the building as a separate asset for disposition purposes, and recognize a loss upon the retirement of the original roof under § 1.168(i)-8. Because the net loss of $10,000 was recognized when the 2012 Form 3115 was filed, there is no net §481(a) adjustment on the 2014 Form 3115.

The taxpayer cannot make a late partial disposition election, if it no longer owns the underlying, larger asset as of the beginning of the year of change. For example, supposed the roof of Building A was replaced in 2005, resulting in the existence of a ghost asset under the old rules. In 2008 the taxpayer disposes of Building A. Under these circumstances, no late partial disposition election would be available because the entire building has been disposed of.

As provided in Rev. Proc. 2014-17, the late partial disposition election accounting method change was only available for tax years beginning on or after January 1, 2012, and beginning before January 1, 2014. Rev. Proc. 2014-54, however, extends the opportunity to make some late partial disposition elections in tax year 2014. Specifically, If a change under section 6.33 of the APPENDIX to the revenue procedure is made pursuant to § 1.168(i)-8(d)(2)(i), this change may be made for any taxable year beginning on or after January 1, 2012, and beginning before January 1, 2015.

As a result, taxpayers should identify all prior year retirements that are still being capitalized. Close scrutiny should be applied to any circumstances in which an existing building, or machine was improved, or renovated, or older components are demolished, or removed to accommodate new ones. It may be prudent to establish a materiality cut-off and review fixed asset schedules for renovation or improvement costs exceed a specified amount. Notably, in addition to claiming immediate retirement deductions, this process will also allow the taxpayer to avoid paying Code section 1245 or 1250 recapture tax on building components that no longer exist.

Suppose, for example, that the taxpayer acquired a building for $5 million in 2007 and three years later spent $1 million to remodel approximately 10% of the property. Assume the taxpayer conducts an asset retirement study in conjunction with the remodeling and determined that the cost basis of the components removed (ceilings, walls, plumbing, electrical, etc.) was $500,000. If no late partial disposition election is made, the taxpayer would recover the $500,000 basis over the remaining 39-year life of the building (i.e., until 2046) through continued depreciation of what have become ghost assets. If a cost segregation study had been conducted upon placing the building in service, some of the removed components may have a shorter depreciable life, but would likely still have years of depreciation remaining. Instead, a late partial disposition election made pursuant to Rev. Proc. 2014-54 would result in the immediate recognition of a loss in the amount of the $500,000 less any depreciation already taken.

Furthermore, upon a sale of the building recapture under either Code section 1250 (at 25%) or 1245 (at ordinary income rates) would apply. Even if all of the removed components constituted Code section 1250 property, the recapture tax would amount to $125,000 ($500,000 x 25%). If instead a late partial disposition election was made, that amount would constitute capital gain on the sale and would be taxed at the capital gain rates then in effect. Assuming current rates, the capital gain tax attributable to the removed components would be $100,000 ($500,000 x 20%), resulting in $25,000 of taxes saved.

Summary of Common Elections under the Final Regulations 33

SUMMARY OF COMMON ELECTIONS UNDER THE FINAL REGULATIONSIssue Regs SectionElection to capitalize materials and supplies1.162-3(d)De minimis safe harbor 1.263(a)-1(f)Capitalization of transaction costs 1.263(a)-2(f)Safe harbor for small taxpayers 1.263(a)-3(h)Optional regulatory accounting method 1.263(a)-3(m)Election to capitalize repairs & maintenance1.263(a)-3(n)

ANALYZING SECTION 481(A) ADJUSTMENTS

INTRODUCTIONGenerally, changes made to comply with the final repair regulations constitute a change in method of accounting under Code section 446(e) and the regulations thereunder. A change in accounting method usually requires a full section 481(a) adjustment, which means clients should evaluate their current methods of accounting to determine what changes may be required to conform to the regulations.

Note, however, that the de minimis rule and the several other provisions noted above are implemented on a “cut-off basis” rather than with a section 481(a) adjustment. Under the cut-off method, only the items arising on or after January 1, 2014 are accounted for under the new method of accounting. Any items arising before that date continue to be accounted for under the client’s former method of accounting.

Whenever a change in method of accounting is either imposed on or initiated by a taxpayer, there is a possibility for duplication or omission of income or deductions relating to transactions occurring in a year prior to the year of change. Therefore, a change in method of accounting generally requires an adjustment under Code section 481(a) (hereinafter “481(a) adjustments”). Code section 481(a) requires those adjustments necessary to prevent amounts from being duplicated or omitted to be taken into account when the taxpayer’s taxable income is computed under a method of accounting different from the method used to compute taxable income for the preceding taxable year. When there is a change in method of accounting to which Code section 481(a) is applied, income for the taxable year preceding the year of change must be determined under the method of accounting that was then employed, and income for the year of change and the following taxable years must be determined under the new method of accounting as if the new method had always been used.

The 481(a) adjustment is computed as of the beginning of the taxable year for which the method is being changed. The adjustment represents the cumulative difference between the present and proposed methods. This cumulative difference is determined without regard to the statute of limitations. As a consequence, the 481(a) adjustment may increase income (a “positive adjustment”) or decrease income (a “negative adjustment”).

A net positive 481(a) adjustment is unfavorable to the taxpayer because it increases income. On the other hand, a net negative adjustment is taxpayer favorable because income decreases with the adjustment. Generally a net negative 481(a) adjustment is taken into account in the year of change . A net positive 481(a) adjustment is taken into account over four years starting with the year of change.

The IRS sometimes determines that certain changes in method of accounting will be made without a 481(a) adjustment, instead imposing the use of a so-called “cut-off” method. Under the cut-off method, only the items arising on or after the beginning of the year of change are accounted for under the new method of accounting. Any items arising before the year of change continue to be accounted for under the taxpayer’s former method of accounting. Because no items are duplicated or omitted from income, when a cut-off method is used to effect a change in accounting method, no 481(a) adjustment is necessary. The cut-off method may be used in a taxpayer-initiated method change only where specifically allowed or required by statute, regulation or by the IRS in published guidance. For example, Rev. Proc. 2014-16 specifies that the cut-off method be used for a change to deducting

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34 Remaining Advantageous Use of General Asset Accounts

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amounts paid or incurred in the process of investigating or otherwise pursuing the acquisition of real property under Reg. section 1.263(a)-2(f )(2)(iii) and a change from capitalizing to deducting employee compensation and overhead costs incurred to investigate acquisition of real property under Reg. section 1.263(a)-2(f )(2)(iv).

When a change results in a continuing effect on the basis of an asset, a “modified cut-off” method is employed, whereby the unadjusted depreciable basis and the depreciation reserve of the asset as of the beginning of the year of change are accounted for using the new method of accounting. Thus, the adjusted depreciable basis of the asset as of the beginning of the year of change is recovered using the new permissible method of accounting under the modified cut-off method. For example, a taxpayer changing to a method of accounting under Reg. section 1.162-3 regarding materials and supplies, is generally required to calculate a 481(a) adjustment, as of the first day of the taxpayer’s taxable year of change that takes into account only amounts paid or incurred in taxable years beginning on or after January 1, 2014.

Most accounting method changes are granted with audit protection, which means that the IRS will not require the taxpayer to change its method of accounting for the same item for a taxable year prior to the year of change. Additionally, the so-called “scope limitations” are the rules within a voluntary method change procedure that indicate when (in what circumstances) the taxpayer may or may not use such guidance to request a voluntary method change. A scope limitation, generally prohibits taxpayers from requesting consent for a method change more than once every five years, or after they have been contacted for examination. In some instances, the scope limitations that would otherwise apply to a voluntary method change request may be waived by statute, regulation, or IRS publication.

REMAINING ADVANTAGEOUS USE OF GENERAL ASSET ACCOUNTS

IN GENERALGeneral asset accounts (“GAAs”) group together assets that share common characteristics and are depreciated as if they collectively represent one asset. Their use is authorized by Code section 168(i)(4).

Each asset in a GAA must have the same:

asset class;

depreciation method;

applicable recovery period;

applicable convention; and

initial tax year in which it is placed into service.

Furthermore, none of the assets in a GAA may be used for personal activity at any time during the taxable year in which the asset is placed in service and asset is placed in service and disposed of during the same taxable year cannot be placed in a GAA. GAAs, are most commonly used when a business purchases a large number of similar assets, such as laptop computers.

Assets, as to which a Code section 179 election has been made, can be placed into a GAA, but only the remaining (i.e.,post-179 election) basis is added to the GAA. For example, suppose that in 2014 a calendar year taxpayer purchases and places in service one item of equipment that costs $550,000. Assume the taxpayer makes a Code section 179 to expense $25,000 of the equipment’s cost and also makes an election to include the equipment in a GAA. As a result, the taxpayer can include only $525,000 of the equipment’s cost in the GAA.

Furthermore, if all the assets in a GAA are eligible for the additional first year depreciation deduction (i.e., “bonus depreciation”), the taxpayer first must determine the allowable additional first year depreciation deduction for the GAA and then must determine the amount otherwise allowable as a depreciation deduction for the placed-in-service year and any subsequent taxable year. The remaining adjusted depreciable basis of the general asset account is

In General 35

depreciated using the applicable depreciation method, recovery period, and convention for the assets in the account. Those subsequent depreciation allowances must be recorded in a depreciation reserve account for each GAA.

An asset in a GAA, is disposed of when ownership of the asset is transferred, or when the asset is permanently withdrawn from use, either in the taxpayer’s trade or business or in the production of income. A disposition includes the sale, exchange, retirement, physical abandonment, or destruction of an asset. A disposition includes a disposition of a portion of an asset in a GAA, only if the taxpayer makes the election to terminate the GAA, or makes the election under paragraph (e)(3)(iii) of this section for that disposed portion.

Generally, the basis of any asset within a GAA, is deemed to be zero, when that asset is disposed of, and any proceeds received from the disposition are treated as ordinary income, as it would be with depreciation recapture. No loss may be recognized on such dispositions, and the basis and the accumulated depreciation of the GAA are unaffected by the disposition. The taxpayer therefore continues to depreciate the disposed of “ghost assets” for the full class life. This may be particularly advantageous when no consideration is likely to be received upon disposition (as is often the case with outdated laptops and other electronic equipment) and any loss would otherwise be capital.

However, certain types of dispositions, specifically those resulting from a casualty or theft, charitable contribution, termination of the business, or certain nonrecognition transactions (other than like-kind exchanges or involuntary conversions under section 1031 or 1033), are treated as “qualifying dispositions.” In the case of a qualifying disposition of an asset, a taxpayer may make an election under which the GAA treatment for the asset terminates as of the first day of the taxable year in which the qualifying disposition occurs, and the amount of gain, loss, or other deduction for the asset is determined by taking into account the asset’s adjusted depreciable basis at the time of the disposition.

A GAA is created by the taxpayer’s irrevocable election under Regs. §1.168(i)-1(l), by writing “General Asset Account Election Made Under Section 168(i)(4),” at the top of Form 4562 attached to the timely filed return of the taxpayer for the year in which the assets included in the general asset account are placed in service. The taxpayer must maintain records that identify the assets included in each GAA, that establish the unadjusted depreciable basis, and depreciation reserve of the GAA, and that reflect the amount realized during the taxable year upon dispositions from each GAA.

Under the old (2011) regulations, taxpayers were allowed to elect to recognize gain or loss on the qualifying disposition of an asset within the GAA. As a result, many taxpayers made the accounting method change to retroactively place assets (e.g., buildings) in GAAs to provide maximum flexibility in determining whether the replacement of a component constituted a repair or a disposal whereby a loss would be recognized.

The final disposition regulations, however, eliminated the qualifying disposition election on assets within a GAA and replaced it with a new partial asset disposition election. Consequently, many taxpayers that had made the late GAA elections under the 2011 temporary regulations suddenly wished they had not done so. Not to worry, however, for Rev. Proc. 2014-17 provides those taxpayers relief by allowing them to file an automatic accounting method change to revoke any GAA elections made for the 2012 or 2013 tax years. Revenue Procedure 2014-54 extends the accounting method change to revoke a GAA election for tax years beginning on or after January 1, 2012, and beginning before January 1, 2015.

The final rules on GAAs, generally follow what was contained in the proposed regulations. The final regulations do add one additional rule with respect to Code section 280B. Under Code section 280B, if a taxpayer demolishes a building, the existing basis of the building gets rolled into the cost of the land and is no longer depreciable. However, the final rules provide that if the building is in a GAA, it is not subject to the section 280B rule as long as the taxpayer does not make a GAA termination election. It will be possible, then, for the taxpayer to keep depreciating the basis of the property. This rule is beneficial for taxpayers who utilize GAAs containing property that will be demolished in the future.

The final regulations generally apply to tax years beginning on or after January 1, 2014. However, according to the regulations, a taxpayer may choose to apply the final regulations to tax years beginning on or after January 1, 2012. A

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taxpayer also may choose to rely on the provisions of the 2013 proposed regulations for tax years beginning on or after January 1, 2012, and beginning before January 1, 2014. Finally, a taxpayer may choose to apply the temporary regulations to tax years beginning on or after January 1, 2012, and beginning before January 1, 2014.

Clients contemplating a revocation of a GAA election, should make sure to consider the effect that Section 280B may have on the underlying assets, if there is a plan to demolish them in the near future. This may be particularly important for depreciable assets that have significant tax basis remaining.

GLOSSARY

GLOSSARY

Term Meaning

Amortization The spreading out of capital expenses for intangible assets over a specific period of time (usually over the asset's useful life) for accounting and tax purposes. Amortization is similar to depreciation, which is used for tangible assets, and to depletion, which is used with natural resources.

Capitalize To set up (expenditures) as business assets in the books of account instead of treating as expense.

De minimis safe harbor

The de minimis safe harbor election eliminates the burden of determining whether every small-dollar expenditure for the acquisition or production of property is properly deductible or capitalizable. If you elect to use the de minimis safe harbor, you don't have to capitalize the cost of qualifying de minimis acquisitions or improvements.

Depreciation Method used to recover the cost of tangible income-producing property, other than natural resources.

Expense Money spent or costs incurred that are tax-deductible and reduce taxable income.

Improvements An addition that adds to the value of property, prolongs its useful life, or adapts it to new uses.

MACRS The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system in the United States. Under this system, the capitalized cost (basis) of tangible property is recovered over a specified life by annual deductions for depreciation.

Repairs Costs that keep property in good operating condition, but do not add value to the property or substantially prolong its life.

Tangible property

Property that is physical in nature.

APPLYING THE NEW TANGIBLE PROPERTY REGULATIONS

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