The Internal Revenue Service has substantially simplified the requirements for small businesses to adopt the “repair regs” for 2014. Small businesses implementing the repair regulations for 2014 can change many of their accounting methods automatically, without filing Form 3115, Application for Change in Accounting Method, and without having to apply Code Sec. 481. Rev. Proc. 2015-20 provides this relief, in terms of both certain tax advantages and reduced administrative costs. The precise reach of this relief, and even whether it should be elected at all, should be considerations that will require a careful cost/benefit analysis in many cases.
FINAL REGULATIONS
In 2013, the IRS issued final repair regulations (T.D. 9636) for determining whether costs incurred with respect to tangible property should be deducted or capitalized under Code Secs. 162, 168 and 263. The final regs are effective for tax years beginning on or after Jan. 1, 2014; some provisions apply to costs incurred on or after Jan. 1, 2014. Complying with the regulations’ major provisions requires taxpayers to change their accounting methods starting this tax filing season. Taxpayers generally must obtain the IRS’s consent to change an accounting method.
Note: Taxpayers have the option to apply the regs to tax years beginning in 2012 or 2013. Because the regulations are generally taxpayer-favorable, taxpayers should consider whether to implement the final regs in the earlier years. However, there is no simplified relief offered for pre-2014 tax years.
ELECTIONS
Some provisions under the final regulations are elective, giving the taxpayer a choice from year to year whether to follow them. IRS consent is not required to make an election. An election is not a change of accounting method. If a provision is considered elective, a taxpayer can make the election for one year and change it for the next year, without the need to obtain the IRS’s consent
Elective provisions include, among others:
- The partial disposition election. Under this, a taxpayer can treat the retirement of a structural component as a disposition on which the taxpayer recognizes gain or loss;
- The de minimis safe harbor election. The de minimis safe harbor allows taxpayers with an applicable financial statement to deduct property that costs $5,000 or less, provided the taxpayer has a written policy in place that requires book expensing of costs up to a specified limit. For taxpayers without an AFS (generally small taxpayers), the safe harbor is $500; and,
- The election by small taxpayers to deduct building improvements. The building improvement election applies to buildings with an unadjusted basis of $1 million or less, where the taxpayer’s cost of repairs, maintenance and improvements does not exceed the lesser of $10,000 or 2 percent of the building’s unadjusted basis.
CHANGE OF ACCOUNTING METHOD
The IRS has attempted to smooth the adoption of the final regulations by granting automatic consent for taxpayers to change their methods of accounting. See Rev. Proc. 2014-16 and Rev. Proc. 2014-54. Taxpayers only have to make the change by the due date (including extensions) of their tax return. In these revenue procedures, the IRS exempted small filers from completing certain lines of Form 3115 but did not reduce the requirement to make a 481(a) adjustment.
The IRS also waived the scope limitations for taxpayers changing their methods of accounting for 2014. Taxpayers under audit or having made a method change in the last five years were still allowed to change their accounting methods for 2014.
Taxpayers changing an accounting method generally must make a Code Sec. 481(a) adjustment, unless the IRS provides otherwise. Code Sec. 481 requires taxpayers changing their methods of accounting to calculate an adjustment to their treatment of the same items for prior years, before the year of change (2014 for the repair regulations) — “If I was applying the new rules in the prior year, would the accounting treatment be different?” A 481 adjustment is designed to prevent any duplication of deductions or omission of income.
Some provisions in the regulations, such as the deduction of materials and supplies ($200 or less per item or per invoice), allow taxpayers to change their accounting method prospectively, on a cutoff basis, without making a Code Sec. 481(a) adjustment. Taxpayers also have to file Form 3115 to request IRS consent to change an accounting method, even where the IRS has granted automatic consent.
COMPLIANCE BURDEN
Many taxpayers were concerned about the burden of complying with the regulations for 2014. Small businesses in particular were concerned about the perceived burden of making the 481 adjustment and of filing Form 3115. Small business asked the IRS and Treasury to provide an optional cutoff method in the final regulations, but the government declined to do this.
The American Institute of CPAs wrote to the IRS in October 2014 to express concern about the burden on small businesses, which under the final repair regs must change their methods of accounting for 2014. The organization also highlighted the burden on practitioners to meet their practice obligations under Circular 230 if small businesses could not comply with the regs. The AICPA proposed that small businesses be allowed to apply the repair regs prospectively, without having to calculate adjustments to prior-year tangible property costs under Code Sec. 481. There was also a concern that some businesses may never have filed a Form 3115.
RELIEF PROVIDED
In Rev. Proc. 2015-20, the IRS allows small businesses to change their methods of accounting on a cutoff basis under Code Sec. 481, by taking into account only amounts paid or incurred in 2014, without making an adjustment for their treatment of the same items in prior years. This effectively allows taxpayers to change their accounting methods prospectively.
Rev. Proc. 2015-20 also excuses small businesses from filing Form 3115, although this relief is not as significant as the 481 relief. Instead, small taxpayers may change their methods of accounting for 2014 solely by filing their federal tax return, without submitting a Form 3115 or a separate statement. A transition rule allows a qualifying taxpayer that previously filed a Form 3115 for 2014 to withdraw the filed form by the due date of the taxpayer’s timely filed return (including extensions).
The relief provided by Rev. Proc. 2015-20 is available to taxpayers that have one or more separate and distinct trades or businesses that have total assets under $10 million at the beginning of their 2014 tax year, or that have average annual gross receipts of $10 million or less for the prior three years. Some practitioners have observed that this dollar cap effectively covers more than 90 percent of all business tax returns filed.
AUDIT PROTECTION
In many cases, the IRS routinely provides audit protection to taxpayers changing a method of accounting for years prior to the year of the change. If the IRS provides audit protection, it will not challenge the prior year’s accounting treatment. Audit protection is discretionary with the IRS. The government decided that taxpayers using Rev. Proc. 2015-20 and not filing a Form 3115 or making a 481(a) adjustment would not receive audit protection for years before 2014.
CHOICE OF STRATEGIES
After Rev. Proc. 2015-20, small businesses and their tax preparers still have some decisions to make. For some taxpayers, Rev. Proc. 2015-20 can reduce the compliance burden, but the revenue procedure does not change the fact that the regulations are effective for 2014 and that taxpayers must comply with them. The repair regulations are comprehensive, but they can be tremendously beneficial. Practitioners owe it to themselves and to their clients to study, understand and apply the regulations, especially the look-back process under Code Sec. 481.
Some taxpayers may not have much in the way of tangible property, but most will have some tangible property and can reduce their taxes by making the adjustments for prior years (a negative 481 adjustment). Taxpayers may have under-deducted and over-capitalized their costs. Calculating the proper 481 adjustment will increase the taxpayer’s cash flow. Taxpayers can go back as far as their records allow and can include in their 481 adjustment whatever amounts they have the records to support. Thus, another factor in calculating the adjustment is the reliability of the taxpayer’s records. The quality of data matters.
For those taxpayers that have already filed their returns that included Form 3115, the decision to file an amended return and now opt for the simplified method should be considered. However, since the administrative costs of preparing a Form 3115 have already been incurred, along with the benefits resulting from a negative Section 481 adjustment in most cases along with audit protection, most small-business taxpayers should probably leave well enough alone. Some practitioners in fact have even suggested that a withdrawal of Form 3115 at this point may raise a red flag to IRS auditors that a negative Code Section 481(a) adjustment might be found.
By the same token, if a taxpayer that has not yet filed is concerned about the lack of audit protection for years prior to 2014, it can still file a Form 3115 with the appropriate adjustments under Code Sec. 481(a). This will protect the taxpayer from audit risk for prior years. Rev. Proc. 2015-20 also indicates that filing a Form 3115 will provide the taxpayer with a “clear record” of a change in accounting method.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer, CCH Tax and Accounting.
