Tangible Property Regulations – The Latest and Greatest for Tax Year 2015 and Beyond
Eric P. Wallace CPA
The IRS recently issued the final tangible property regulations (TPRs). With 60 years in the making these TPRs now provide guidance on the decision process of how to properly categorize expenditures on tangible property, that is already in service, as either repairs and maintenance (R & M) or items requiring capitalization. The TPRs were generally required to be employed by all taxpayers starting in tax year 2014. If you, as a taxpayer, have or had expenditures for either: materials and supplies (M & S), R & M, asset purchases, improvements to assets, depreciation on assets, and/or dispositions of assets; the TPRs are applicable to you.
If you have not yet implemented the TPRs for your Company or for your clients, there is no better time than tax year 2015 in which to get started. However, in order to implement, many of the TPRs require tax method change filings. Those tax method filings can be done and included in the taxpayer’s 2015 income tax filings. If the Company or the client has properly filed the IRS method changes in tax year 2014, those taxpayers will now need to be sure that the new TPR rules and methods are employed to their 2015 expenditures to assure that those are properly classified as R & M or as assets that must be capitalized.
To address the “technical” end, under Internal Revenue Code (IRC) Sec. 263(a), amounts paid to acquire, produce, or improve tangible property must be capitalized and not deducted. Under IRC Sec. 162(a) a taxpayer may deduct all ordinary and necessary business expenses, such as R & M or M & S, paid or incurred during the tax year in carrying on a trade or business. The IRS intended that the TPRs were a guide to taxpayers to better determine whether certain expenditures should be capitalized or deductible. The TPRs are meant to provide objective measurements and the administrative convenience rules such as the de minimis safe harbor of Reg. Sec. 1.263(a)-1(f) (DMSH).
In order to determine if an expenditure, made on an asset after the asset is already in service, is required to be capitalized, the taxpayer must now employ certain determined criterion of Reg. Sec. 1.263(a)-3 and compare those rules to the taxpayer’s appropriate unit of property (U of P) of Reg. Sec. 1.263(a)-3(e) to answer the question about capitalization. Those new rules are referred to as the 1.263(a)-3 restoration, adaption, betterment and improvement (RABI) criterion. If the expenditure is less than the taxpayer’s DSMH the employment of the RABI rules is not necessary; the taxpayer can just deduct the expenditure. A building is a U of P. Building comparisons, however, must be further drilled down to a comparison to any building component, like a roof, or listed building systems, such as HVAC, that performs a major and discrete function within that building component or system. These determinations must also be done “back in time” for any asset that is or should exist on the taxpayer’s tax depreciation schedule.
There are many other facets of the TPRs that could be applicable to a taxpayer including the M & S regulation of 1.162-3 for non-incidental and incidental M & S; rotable, temporary, and stand by definitions of M & S of 1.162-3; R & M of 1.162-4; general rules for capital expenditures of 1.263(a)-1; amount paid for acquisition or production of tangible property of 1.263(a)-2; to the general asset account of 1.268(i)-1; to the partial asset disposition rules of 1.168(i)-8(d).
While most of the TPRs cannot be employed without the filing of a properly submitted IRS Form 3115, beyond the DMSH, the IRS also introduced five other potential annual elections. The listing of the elections include the DMSH of 1.263(a)-1(f); election to capitalize employee compensation and overhead; the small taxpayer safe harbor of 1.263(a)-3(h); election to capitalize R & M in the current tax year of 1.263(a)-3(n); election to capitalize M & S and depreciate them; and the partial asset disposition election of 1.168(i)-8(d).
The DMSH was recently in the news when the IRS issued Notice 2015-82 increasing the DMSH safe harbor amount from $500 to $2,500, effective January 1, 2016, for taxpayers that do not have an annual audit. In order to employ the DMSH the taxpayer must have a policy in place before the beginning of its tax year, stipulate the amount that it is going to deduct (such as all items under $1,000), have an invoice for each item, write the item off in its books and records, and make the election statement in its tax return. With the change to $2,500 many taxpayers and their preparers believe that their 2015 DMSH amount can automatically be increased to $2,500. While the IRS stated in its Notice that it would not question taxpayer’s DMSH amounts for tax years prior to 2016 that were under the $2,500 amount, the taxpayer must still meet the required elements to employ the DMSH. One of those elements, the requirement for the DMSH policy to be in place before the beginning of the start of its tax year will prohibit a taxpayer from increasing its prior year policies after the fact.
The IRS Form 3115 was stated to be updated and in effect December 15, 2015, its first update in six years. All tax method change requests must be filed under the new Form using the revised IRS Form 3115 instructions. While the Form 3115 retains the same 8 pages in length, many of the questions on the form have been moved around, expanded, or are new. With the new form, the IRS updated instructions require taxpayers to provide more in depth details not limited to items such as the details of its trades or businesses, the legal support for its method(s) request, a separate listing of its designated change method number (DCN) if the filing is an automatic method filing, why it is eligible to file for an automatic method change request, if applicable, and more. Form 3115 filers should consult the new Form 3115, its instructions, and any other applicable IRS guidance to be sure that method change filings include all of the needed answers such as supporting schedules, calculations, and affirmations.
Many of the TPR method changes were required and others were optional for tax year 2014. Other than DCN 196 on prior year partial asset dispositions or late GAA election of DCN 197 are available to taxpayers in 2015. Rev. Procs. 2015-13 and 2015-14 provide the guidance on accounting method changes related to the TPRs and all other automatic and non-automatic method change filings. The most common accounting method changes for the TPRs are a:
DCN 184, 186, 187, or 192 filing: DCN 184, 186, 187, or 192 was required to be filed on a Form 3115 in tax year 2014 for all applicable taxpayers. These method changes permitted taxpayers to comply with the TPRs for their M & S and R & M verses capitalization costs, U of P identification, and acquisition and production costs. If a taxpayer did not file a concurrent DCN 184, 186, 187, or 192 for tax year 2014, it can file this method change grouping for tax year 2015, as long as it meets the IRS “eligibility” rules. The IRS “eligibility rules generally require that the taxpayer is not undergoing nor has the IRS notified the taxpayer of an audit, the taxpayer or its trade or business is not going out of business in the current tax year, nor has the taxpayer filed certain method changes in the past four tax years prior to the method filing. Filing the TPR method changes in 2015 will allow a taxpayer to take advantage of its potential negative Sec. 481(a) adjustment (i.e. a tax deduction). Better yet, it will provide audit protection to the taxpayer.
DCN 21 filing: DCN 21 permits a taxpayer to choose whether it wishes to capitalize or currently deduct removal costs, including removal costs associated with a partial asset disposition. A taxpayer may file a DCN 21 for tax year 2015 if it has removal costs in the current or prior tax years that it would now like to currently expense. A taxpayer can still decide to capitalize prior, current, or future removal costs with a DCN 21 filing.
DCN 7 filing: This DCN addresses impermissible to permissible depreciation changes. This method filing will result in either a positive (when a taxpayer has taken too much depreciation on an asset) or a negative (when the taxpayer took too little) Sec. 481(a) adjustment. A taxpayer may file DCN 7 change in tax year 2015 to correct an impermissible depreciation method from any year prior to 2015 even if it has filed another DCN 7 in a prior tax year.
DCN 196: This is a late partial disposition election filing for tax years prior to tax year 2014. If properly and timely filed, DCN 196 provide taxpayers the ability to deduct the net remaining depreciable basis of the portion of an asset in tax year 2013 or 2014. Note that DCN 196 was allowed only for a tax year that ended before January 1, 2015. Unless a taxpayer is operating under an open fiscal year 2014, a taxpayer cannot make this method change, nor can any taxpayer make this method change for tax year 2015 or after.
DCN 205/206: These are two separate method changes that can be filed concurrently (i.e. together) if applicable. DCN 205 applies where a taxpayer has disposed of a building or building component or system, compared to DCN 206 that applies to dispositions other than building assets, such as parts of tangible personal property or land improvements. These method filings are not the same as a DCN 196 filing. A taxpayer that has a depreciable asset that was purchased and separately broken out on its fixed-asset listing can file a DCN 205 or 206 to remove that depreciable asset that had been disposed of in the past but was not written off. The taxpayer can file a DCN 205 and/or 206 method change with its timely filed 2015 tax return and deduct the net remaining tax basis of the asset as a 481(a) adjustment.
Rev. Proc. 2015-20 was issued by the IRS in February of 2015. It provided “qualified” taxpayers a simplified procedure in which to implement the TPRs. A qualified taxpayer is one that met the $10 million thresholds – total tax assets of less than $10 million on the first day of the tax year for which an accounting method change is effective; or has three prior year’s average annual gross receipts of $10 million or less. A taxpayer that meets either of these thresholds can choose to change to certain methods of the TPRs by taking into account only amounts paid or incurred in tax years beginning on or after January. 1, 2014. That adopting taxpayer will not have a 481(a) adjustment for the first tax year beginning in 2014 and will not be required to file TPR method changes in Form(s) 3115 for 2014. The taxpayer will be deemed to have implemented the TPRs prospectively. As such, Rev. Proc. 2015-20 states that the taxpayer will only need to file its 2014 federal tax return to comply with TPRs. Another negative aspect of employing 2015-20 is that the taxpayer will not receive audit protection for prior-year TPR issues. If adopting the TPRs under 2015-20, for 2015, that taxpayer will need to apply the TPRs to its R & M, verses capitalization decisions, its M & S, and asset acquisitions.
Unfortunately, many taxpayers that met the $10M thresholds for the simplified procedures under Rev. Proc. 2015-20 and its preparers did not file any TPR related Form(s) 3115 in 2014. These taxpayers may now consider filing the TPR Form 3115s in tax year 2015 nevertheless to take advantage of any potential prior-year(s) negative Sec. 481(a) adjustments and/or at least to obtain audit protection for their prior year expenditures. If a taxpayer did not file any TPR method changes in tax year 2014, many are under the impression that a taxpayer defaulted to accepting the procedures of Rev. Proc. 2015-20 automatically forfeits any opportunity to correct expenditures that it could have expensed in years prior to 2014. There is no written IRS guidance prohibiting this approach. As long as a taxpayer has not violated the eligibility rules of filing automatic method changes of Rev. Proc. 2015-13, I take the position that the taxpayer has not forfeited its ability to file the TPR method changes in tax years after 2014, such as in 2015 or even tax year 2016.
While their does not exist any current IRS prohibition on filing the TPRs for qualified taxpayers after tax year 2014, there seems to be support for such filings when consulting the IRS website on the TPRs under its FAQ section. The website states that a taxpayer who does not wish to employ 2015-20 could include, but is not required to include, a statement with its 2014 tax return, that it is not choosing the “simplified” procedures of 2015-20.
Until the IRS issues a prohibition against taxpayers who meet the $10 M thresholds, that TPR Form 3115s cannot be filed, I will continue to file the TPR method changes for small business clients that can benefit from the TPR filings, warning them however, of the possible consequences. Note that those filings are still automatic method filings, do not require any filing fees, can be filed as the extended due date of the 2015 return, do not permit DCN 196 filings, but do require that the taxpayer meet the eligibility filing requirements.
Taxpayers who are large taxpayers and who have not yet filed the TPRs should do such before an IRS audit or notification of such. Large taxpayers cannot “default” to the employment of the TPRs, actual proper method filings must be prepared and submitted. Taxpayers or their tax return preparers who ignore the proper filing or implementation of the TPRs face the potential of the assessment of interest and penalties, denial of the net remaining basis of assets that should have been written off as R & M, loss of clients, and/or law suits.