Tax Solutions Corner: Getting a Grip on the Tangible Property Regulations
By Joanne Kearbey, Tax Manager, Brown Smith Wallace LLC and Sarah Stubbs, Tax Principal, Johnson Lambert LLP
Surely, there hasn’t yet been enough discussion about the final Tangible Property Regulations (“TPRs”) that were issued by the IRS back in September, 2013, and so we’ll continue the conversation here in an effort to provide a simplified understanding of the rules. Recall that these Regulations are effective for years beginning on or after January 1, 2014 and provide guidance as to whether tangible property costs should be deducted or capitalized.
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They apply to all taxpayers (including both C and S corporations, partnerships, LLCs and certain individuals) who incur expenditures for material and supplies, repairs and maintenance or who acquire, produce or improve tangible real or personal property. These final regulations also contain several simplifying provisions that are either elective and/or prospective in their application.
The de minimis safe harbor election is an annual election that would allow an immediate expensing of each item or invoice amount under a certain threshold. Taxpayers who receive a certified audited financial statement or submit financial statements to a federal or state agency (e.g. the NAIC annual statement), are allowed an increased expensing threshold in accordance with the written policy that must be in place at the start of the tax year that specifies the per-item or per-invoice amount up to $5,000. For taxpayers without the particular statements identified previously, the threshold is up to $500 per item or invoice.
Another two new elections provide for consistency between the book and tax treatment for items related to repair costs or materials and supplies. If these items are capitalized for book purposes, and otherwise expensed for tax, these new elections allow the items to be capitalized for tax purposes, thereby eliminating any deferred tax liability related to different treatment.
Small taxpayers are afforded even more expensing opportunities. These taxpayers are defined as those that have average annual gross receipts of $10 million or less and own or lease property with a cost of $1 million or less. When repairs, maintenance and improvements for the year don’t exceed $10,000, small taxpayers can annually elect immediate expensing of these costs for tax purposes which might ordinarily be capitalizable.
ACCOUNTING METHOD CHANGES
There are a multitude of accounting method changes that fall under the TPRs including, but not limited to, a change from an impermissible to a permissible method of accounting, a change from general or multiple asset accounts to single asset accounts, a change to the unit of property definition and a change to deducting inventoriable materials and supplies upon use rather than upon purchase. Accounting method changes are made by filing Form 3115 and we strongly encourage you to obtain the advice of your tax advisor if you have not yet assessed or quantified the changes that you will need to make. Suffice it to say for purposes of this article that it is expected that all taxpayers will be reporting a method change of one kind or another, and the IRS will be looking for Forms 3115 to be attached to all 2014 tax returns.
For your “light” reading pleasure, additional resources can be found at:
Revenue Procedure 2015-20 provide small taxpayers relief from filing Form 3115 to adopt the TPRs. A small taxpayer is defined as one with a) Less than $10 million of assets at the beginning of 2015; or b) a three-year average gross receipts of $10 million or less.
Knowing that the Tangible Property Regulations exist is the easy part. Yet, application of them need not be a task to dread. With this publication’s audience in mind, here are some simple steps that should get you through any basic assessment efficiently:
1) Create an excel document of the fixed asset inventory as of December 31, 2013;
2) Ensure that the list shows each asset’s full description, placed in service date, cost, useful life, depreciation method, Section 179 allowance, bonus depreciation and regular depreciation by year through December 31, 2013;
3) Sort the list by placed in service date;
4) Look for fixed assets not fully depreciated that could have been expensed under the de minimis safe harbor rule. Highlight them so you can revisit them later;
5) Analyze useful lives – read through each asset description and compare to the adopted useful lives that have been applied. Highlight erroneous lives;
6) Analyze depreciation methods – First, make sure that each method is an approved MACRS method. Second, calculate the percentage of assets placed in service in the fourth quarter of any given year. If the percentage exceeds 40%, revisit disposal records from prior years to determine if that percentage is accurate or if it ever decreases below 40%. As soon as it does, you need not go back any further – the proper method should be a half year convention rather than a mid quarter convention. Highlight erroneous methods;
7) Analyze Section 179 allowance – Review prior tax return Forms 4562 and compare the Section 179 expense taken to the expensing limits for each year. In the excel document, highlight the expensing column for assets from years in which excess Sec 179 was taken;
8) Analyze bonus depreciation – Review prior tax returns for any opt-out elections. For years without elections, ensure that proper bonus depreciation was taken. Highlight the bonus column for assets with errors; and then,
9) Analyze regular tax depreciation – Scan the annual depreciation adjustments for possible errors: negative values, equal depreciation each year, depreciation that does not decrease as time passes, etc. Highlight possible erroneous values.
1) Within the excel document, copy the ANALYSIS tab into a second tab in which corrections can be made;
2) Revisit all of the highlighted errors and correct them in the new tab. Recalculate annual depreciation, as necessary; and,
3) Compare the net depreciable value in the “as-is” inventory to the “as-corrected” inventory. The difference is your Section 481(a) adjustment which will be reported on Form 3115.
1) Prepare Form 3115, Application for Change in Accounting Method. You may need to file more than one method change; and,
2) Report any 481(a) adjustment on the appropriate Form 3115. Attach a schedule of the analyzed inventory that was prepared.
As simplified as this might seem, there are some technicalities to keep in mind. The TPRs actually do apply to all years since inception, but the only items missing from the fixed asset inventory at December 31, 2013 are prior disposals. While the Regulations would require the gathering of all that data, such historical records may not be readily accessible for review. For any prior disposals that may have been incorrectly calculated as to depreciation, the correcting difference would have an inverse correlation to the gain or loss recognized upon disposal. The net effect would be zero.
That net effect may still result in a timing difference. Recall that net long term Section 1231 gains are reported as capital gains, while all short term 1231 gains and all 1231 losses are treated as ordinary income. Depreciation corrections under the TPRs could recharacterize income or loss in any given year, and perhaps shift recognized losses from one year to another. Over time, however, those shifts would net to zero and the resulting exposure of potential interest charges for underreporting in one year and overreporting in another may not be a cost beneficial use of time given that time is always short when it comes to general tax compliance.
Another key point to remember is that compliance with the TPRs is mandatory. Under no circumstance is a taxpayer advised to forego this analysis. For those worried about attracting the attention of the IRS, filing a 2014 tax return without a Form 3115 is most likely going to be a “red flag.” The cost of self-compliance with the Regulations will be a one-time hit but having to deal with an IRS examination is a drawn-out process that will cost more in the long run.
We would also cautiously suggest that most insurance or service-type companies who are subject to these TPRs are likely to realize a favorable adjustment. Recent experience in administering these analyses to various clients, especially those who do not own buildings, shows that most errors in the application of MACRS rules relate to longer than necessary lives having been employed or the failure to take bonus depreciation when required. So the results are providing for an additional reduction to taxable income in many instances.
Chances are that most of you are not preparing your own corporation’s tax return. Be proactive, though – have the conversation with your tax preparer(s) about what data you may need to provide, perhaps delegate a point person to ensure the project is timely completed, or just reach out to your tax advisor so that he or she might be able to set your mind at ease that they are already handling the process of compliance for you.
For further information please contact:
Joanne Kearbey, Tax Manager, Brown Smith Wallace LLC at firstname.lastname@example.org or
Sarah Stubbs, Tax Principal, Johnson Lambert LLP at email@example.com