Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

As we have discussed in a prior issues of iTaxblog, the Tangible Property Regulations (TPRs) have focused practitioners’ attention on the treatment of tenant improvements. This new focus has led practitioners to pay more attention to existing issues with the leasing of property, especially how §110 treats construction allowances. Before examining how §110 and the TPR interact, it is important to understand the tax treatment of tenant improvements under prior law.

Prior Law Overview

The chart below captures the tax treatment of the tenant improvements (TI’s) under prior law. (Please note that the chart makes certain assumptions about the drafting of the lease agreement and that §467 does not apply.)

 

Situation Payor Tax Owner Tax Effect on Landlord Tax Effect on Tenant
Landlord constructs tenant improvements. Landlord Landlord Depreciate TI’s basis over 15 or 39 years under section 168. None
Landlord provides construction allowance to tenant for the construction of improvements. Landlord Tenant Amortize the basis of the improvements as a lease acquisition cost over the lease term under §178. Include construction allowance in gross income and depreciate the allowance over 15 or 39 years under §168.
Landlord provides rent reduction in lieu of construction allowance. Tenant Tenant The landlord’s gross income is decreased by the amount of the foregone rent. Lost rent deductions, but recovers the cost of the TI’s under §168.
Tenant constructs its own improvements. Tenant Tenant None Depreciate TI’s basis over 15 or 39 years under §168.
Tenant constructs improvements and then conveys them to landlord upon completion. Tenant Landlord Include basis of TI’s in gross income as a substitute for rent under §1.61-8(c) and depreciate over 15 or 39 years under §168. Amortize the basis of the TI’s as a lease acquisition cost over lease term under §178.

 

Code §110

As shown in the above chart, if a tenant receives a construction allowance, the tenant generally must include the amount of the allowance in income if it is the tax owner of the improvements. Given this harsh treatment, in 1997 Congress added §110 to the code. This code section provides limited relief to tenants who receive construction allowances for certain short-term, retail leases.

Though this section has been in place for almost 20 years, taxpayers rarely have qualifying leases. This is due to the many requirements for the section to apply.

  1. Under 1.110-1(b)(3), the lease agreement must expressly provide that the construction allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessee’s trade or business at the retail space. If the original lease agreement does not include this provision, the taxpayer has until the payment of the construction allowance to enter into an ancillary agreement with the provision.
  2. The lease must be short-term, which is 15 years of less.[1]
  3. The lease must be for retail space, which is qualified long-term real property used by the lessee in its trade or business of selling tangible personal property or services to the general public. Retail space includes back office and storage areas plus showroom or sales areas.[2]
  4. The qualified long-term real property is nonresidential real property that reverts to the lessor at the end of the lease. It does not include 1245 property.[3]
  5. The lessor must have consistent tax treatment.[4]
  6. Both the lessor and lessee must include in their timely filed tax returns a statement that includes the other party’s name, EIN, and address; the location of the retail space, including any location and store names; the amount of the construction allowance and the amount treated as for nonresidential property owned by the lessor.[5]

Section 110 has become more prominent in recent years, since the TPRs provide specific rules relating to it. Specifically, lessees must capitalize all related amounts it pays to improve leased property unless §110 applies to a construction allowance or the improvements were a substitute for rent.[6] Similarly, lessors must capitalize the related amounts it pays for improvements to leased property, including via a §110 construction allowance.[7]

If you need assistance applying these provisions, please contact one of our directors of business development.

[1] Treas. Reg. section 1.110-1(b)(iii)(2)(ii).

[2] Treas. Reg. section 1.110-1(b)(iii)(2)(iii).

[3] Treas. Reg. section 1.110-1(b)(iii)(2)(i).

[4] Treas. Reg. section 1.110-1(b)(5).

[5] Treas. Reg. section 1.110-1(c).

[6] Treas. Reg. section 1.263(a)-3(f)(2)(i).

[7] Treas. Reg. section 1.263(a)-3(f)(3)(i).

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

On September 14, 2016, the IRS released a new audit techniques guide for the Tangible Property Regulations. This guide provides IRS examiners with a tool to identify potential audit issues arising from the use and adoption of the Tangible Property Regulations and prior law provisions. The guide covers not only the substantive rules relating to acquisitions, betterments, adaptations, restorations, and improvements, but also the safe harbors, MACRS accounting, materials & supplies, dispositions, and related accounting method changes.

Overview: In 2010, the IRS released an audit techniques guide that dealt with capitalization issues for repairs and improvements. With the release of the final TPR in 2013 and the final disposition regulations in 2014, an update to the ATG was widely anticipated. The new TPR ATG, at 185 pages, is over six times longer than the prior ATG. Though most of this increase is explained by the greater breadth of coverage for dispositions and other issues, some of it is attributable to the voluminous detail given to procedural issues like accounting method changes and many useful charts. It is also important to note that many of the Examination Considerations or Audit Procedures identified at the end of each chapter relate to Large Business and International taxpayers, especially to public C corporations. Notwithstanding this focus, the very thorough steps provide an excellent guideline for practitioners to assess taxpayers of all sizes.

Even though the Service has provided a hitherto unseen level of written documentation in this ATG, there are no real surprises for regular readers of iTaxblog or attendees at our CPE sessions. The guidance is consistent with prior informal comments from Service personnel at conferences, the IRS TPR FAQ, and prior IRS webinars on the TPR. We will look at the highlights of some of these issues.

  • The De Minimis Safe Harbor.
    • The ATG confirms that, if the DMSH is elected, assets and improvements in excess of the DMSH safe harbor may be expensed, but subject to a clear reflection of income analysis unless the amounts are immaterial.
    • The ATG also provides that the safe harbor amount, ($5000 for taxpayers with an Applicable Financial Statement or $2500 for taxpayers without an AFS), also applies to items with a useful life of 12 months or less, though those items in excess of the safe harbor amount may be classified as material or supplies.
  • Leasehold or Tenant Improvements.
    • Following prior Service comments, the ATG explicitly describes breaking out section 1245 assets from possible section 1250 improvements as the first step when dealing with tenant improvements. Generally speaking, a newly acquired section 1245 asset like a desk, carpeting, or a file cabinet would be capitalized when replacing prior tenant improvements. In this situation, each item, (e.g. each desk or file cabinet), is a newly acquired asset and a separate Unit of Property. (These assets still may qualify for expensing under another provision, like the DMSH.) After breaking out section 1245 assets, taxpayers would then apply the improvement tests to section 1250 improvements.
    • The ATG continues the Service’s policy of applying section 263A as an independent capitalization provision. This means that even if a tenant improvement is not an improvement under the BAR rules of section 1.263(a)-3, its constructions still might constitute “production” under section 263A and require capitalization. Since this interpretation of section 263A is contrary to its historical treatment, we will keep you apprised of developments in this area.
  • Single Asset Accounts. The ATG confirms that a building can be in a Single Asset Account (assuming all other requirements are met). Though the example used involved an acquisition, there is no reason that a newly constructed building that is placed in service all at once would not also qualify for Single Asset Account treatment.

These highlights represent areas where the Service has been consistent in its pronouncements, but may be at odds with how many repair studies or TPR projects have been implemented. If you have any questions about how these areas or other TPR issues affect your clients or your firm, please reach out to one of our directors of business development.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

Enhancement 1: Start-up companies are able to use the research credits generated in tax years beginning after December 31, 2015 against payroll tax

Q. What is the definition of a qualified small business (start-up company)?
A. A qualified small business is defined, with respect to any taxable year, as a corporation (including an S corporation) or partnership with gross receipts of less than $5 million for the taxable year and no more than 5 years of gross receipts history.

Q. What part of the payroll tax is refundable?
A. The employer OASDI liability of 6.2% is refundable. The credit does not apply against the employee portion.

Q. Is there a limit to the amount of payroll tax that can be offset with the credit?
A. The payroll tax credit is limited to $250,000 per year for no more than five years.

Q. Are members of the same controlled group treated as a single taxpayer?
A. Yes. The amount of the credit is allocated among the members in proportion to each member’s qualified research expenses. Each member may separately elect the payroll tax credit for its portion of the credit.

Q. How do you elect the payroll tax credit?
A. A taxpayer makes an annual election specifying the amount of its research credit that will be applied to its payroll tax, not to exceed the $250,000 limitation. The taxpayer will make the election on or before the due date of its originally filed return, including extensions. The election cannot be revoked without the consent of the Secretary of the Treasury. In the case of a partnership or S Corp, the election to apply the credit against OASDI liability is made at the entity level.

Q. How is the credit applied against OASDI tax liability?
A. The payroll tax is allowed as a credit in the first calendar quarter beginning after the date in which a taxpayer files its tax return for that taxable year. The credit may not exceed the tax liability for a calendar quarter. The excess is allowed as a credit against subsequent calendar quarters until the entire credit amount is used.

Enhancement 2: Small businesses are able to use the research credits generated in tax years beginning after December 31, 2015 against Alternative Minimum Tax

Q. Who can apply the research credit against AMT?
A. An eligible small business can apply the credit against AMT. An eligible small business is defined as either a non publicly-traded organization, a partnership or sole proprietorship whose average gross receipts for the prior three years is less than $50 million.

Q. Will prior year credits carried forward into 2016 be usable against AMT?
A. No. Prior year credits are still subject to the AMT limitation. However, any credits carried forward will be used before any current year credits. To the extent a taxpayer has regular tax due above minimum tax in 2016, the carryforward credit would be used first down to the minimum tax amount, and then the current year credit would be applied against minimum tax.

Imran Syed, PE, LEED AP, Manager, Cost Segregation & EPAct §179D

Imran Syed, PE, LEED AP, Manager, Cost Segregation & EPAct §179D

Overview

On Friday, December 18, 2015, President Obama signed in to law the Protecting Americans from Tax Hikes (“PATH”) Act of 2015, Public Law No. 114-113. The PATH Act retroactively extended the §179D Energy Efficient Commercial Buildings deduction through the end of 2016. The PATH Act also modified the §179D deduction beginning in 2016. Popularly known as the EPAct §179D deduction, this deduction helps commercial building owners and designers of government-owned properties to build energy-efficient properties.

This deduction applies to building owners who have installed or retrofitted a property with energy-efficient lighting, HVAC and building envelope systems. The designers of government-owned buildings such as public schools, universities, federal and state offices, public libraries and government dormitories (four stories or higher) may also receive the deduction.

To receive the EPAct §179D deduction of up to $1.80 per square foot, a taxpayer must install building systems that reduce the building’s annual energy and power costs by 50 percent or more compared to the American Society of Heating, Refrigerating, and Air-Conditioning Engineers (“ASHRAE”) standard baseline building. US Department of Energy-approved software uses simulations to calculate the reduction in energy and power costs. If a building does not qualify for the full deduction, there are partial deductions available for meeting energy reduction targets for the Lighting system, the HVAC and Service Hot Water system, and the Building Envelope system. The partial deduction is $0.60 per square foot. The energy savings targets are 25 percent for Lighting, 15 percent for HVAC, and 10 percent for the Building Envelope. There is also an Interim Lighting Rule that allows a building to qualify for a partial deduction if the interior lighting power density (watts per square foot of the interior lighting) can be reduced by at least 25 percent when compared to ASHRAE 90.1-2001. The deduction varies from $0.30/square foot to $0.60/square foot as the reduction increases from 25 percent to 40 percent. In addition to the reduction in lighting power density, the building must have certain automatic controls and bi-level switching.

Section 179D changes in 2016

Since the EPAct §179D deduction was first introduced, Congress required the energy modeling software to use the ASHRAE 90.1-2001 as the baseline standard. This standard will continue to apply for buildings placed in service in 2015, but buildings placed in service in 2016 will use an updated standard. The updated standard for 2016 is the ASHRAE 90.1-2007.

The major impact of the updated 90.1-2007 ASHRAE standards will be to the Interim Lighting Rule. The 90.1-2007 standard for interior lighting power density is more stringent than the 90.1-2001 standard. For example, under the old standard, a university was allowed a Lighting Power Density of 1.5 watts per square foot. Under the new standard, the allowed Lighting Power Density will be 1.2 watts per square foot.  Another area of impact will be for non-residential buildings of five floors or less that are more than 25,000 square feet and less than 75,000 square feet. The ASHRAE 90.1-2007 baseline HVAC system type for this type of building is different and more efficient compared to the previous standard.

If you have questions about how these changes affect you or your clients, please contact us. SourceHOV|Tax has performed numerous §179D studies across the United States using its streamlined process to certify buildings and increase tax deductions.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

On December 18, 2015, President Obama signed the Protecting Americans from Tax Hikes (“PATH”) Act of 2015, Public Law No. 114-113. The PATH Act permanently extended the §179 small business expensing limitations and phase-out amounts of $500,000 and $2 million, respectively and made §179 elections revocable on amended returns.  Additionally, the act permanently extended the special rules that allow expensing qualified real property (QRP) which includes; qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. Beginning in 2016, the expensing limits and phase-outs will be indexed for inflation and the $250,000 cap on expensing qualified real property will be eliminated.  The PATH Act also removed the restriction on expensing heating and air-conditioning units. Some may interpret this as meaning that all HVAC units may now qualify for §179, but this is not the case. Those that are either tangible personal property or QRP will qualify while most will remain as 39-year §1250 real property, and will not qualify. With all these changes, now is a good time to review the opportunities to use §179 expensing in conjunction with cost segregation studies. Before looking at how cost segregation and §179 interact, it is important to understand the basics of how §179 works.

The Limitations

When trying to understand §179, there are three important parts: 1) the expensing limitation; 2) the phase-out amount; and, 3) the income limitation.

  • The expensing limitation is currently $500,000 per year but will be indexed for inflation beginning in 2016. For 2010 through 2015, there is a separate limitation of $250,000 for qualified real property, which counts towards the general $500,000 expensing limitation.
  • The phase-out applies if a taxpayer invests more than $2 million in §179 property. If so, the §179 deduction is reduced dollar-for-dollar, but not below zero. This is known as the phase-out amount and means that a taxpayer will not have a §179 deduction if it has invested more than $2.5 million in §179 property in a year.
  • Once a taxpayer has determined the available §179 deduction, it is further limited by the taxpayer’s income. Generally, the income limitation is the taxpayer’s net income, but does not include credits, tax-exempt income, the §179 deduction, shareholder compensation for S corporations or guaranteed payments to partners, and net operating loss deductions. Amounts disallowed under the income limitation are carried forward to later tax years. After looking at §179’s limitations, how it interacts with cost segregation will make more sense.
Year QRP Deductible? Expensing Limit Phase-Out  Starts At QRP Limit
2004 No $100,000 $410,000 N/A
2005 No $102,000 $420,000 N/A
2006 No $105,000 $430,000 N/A
2007 No $125,000 $500,000 N/A
2008-2009 No $250,000 $800,000 N/A
2010-2015 Yes $500,000 $2,000,000 $250,000
2016+ Yes $500,000 + Inflation Adj. $2M + Inflation Adj. No Separate Limit

 

Cost Segregation and §179

When a taxpayer has a cost segregation study, the results identify tangible personal property, short-life land improvements, and qualified real property. Both tangible personal property and qualified real property may qualify for the §179 deduction if they were acquired by purchase (including self-constructed assets). Unlike bonus depreciation, §179 can also apply to used assets. However, §179 is not allowed for non-corporate lessors unless the lessor constructs or manufactures the property or the lease meets certain, other requirements. Section 179 is also unavailable for investors in residential rental property who hold the property for the production of income. For acquired properties, the opportunities are limited to C corporations or where the stringent lease requirements are met.

Type of Property (Newly Constructed or Purchased) §1245 or §1250 Recovery Period 179 Eligible
Non-Residential Real Property 1250 39 No
Residential Rental Property 1250 27.5 No
Qualified Leasehold Improvements 1250 15 Yes
Qualified Restaurant Improvements 1250 15 Yes
Qualified Retail Improvements 1250 15 Yes
Tangible Personal Property 1250 5 or 7 (Typ.) Yes

Once the general requirements of §179 are met, taxpayers can use the expensing election to greatly enhance the results of a cost segregation study by immediately expensing some or all of the indentified tangible personal property or qualified real property. Unlike ordinary depreciation deductions, the §179 deductions cannot create a loss. Since these deductions cannot create a loss, but are carried over under the income limitation, §179 deductions can also be used to avoid suspended passive activity losses. This is due to the difference in how active businesses are identified for §179 purposes and for §469 purposes. For these reasons, the combination §179 and cost segregation can be a powerful tax-planning tool for small businesses.

Dealing with Partnerships

Section 754 in a Nutshell:

When taxpayers form a partnership, the partnership generally has the same basis in a contributed asset as the partner who contributed it.[1] The partnership’s basis in the asset is called the “inside basis.” When a partnership interest changes hands, the basis of the new partner’s partnership interest will be equal to the purchase price.[2] The partnership’s basis in its assets, however, will remain the same inside basis. Where a partnership’s assets have appreciated, a new partner will often be faced with deductions arising from the much lower, original cost basis of the partnership assets. Fortunately, Congress created an election that allows a new partner to effectively equalize the partnership’s inside basis and the new partner’s outside basis (the purchase price for the partnership interest).[3] This is called a “§754 election.” When dealing with improved real estate and partnership transactions, the most common result of a §754 election is that the new partner, and only the new partner, has newly place- in-service depreciable property with a basis equal to the difference between the outside and inside basis in the asset. This results in larger depreciation deductions for the new partner than for the old partners.

Example 1:

Three taxpayers form a partnership and they contribute a building to the partnership with a basis of $3 million. The partnership has an inside basis in the building of $3 million. After five years, one of the partnership interests is sold to a new partner. At this time, the building has a fair market value of $6 million. The partnership’s inside basis in the building remains $3 million. The partnership has a §754 election in place. After computing the adjustments required by §754, the new partner’s outside basis in the building is $2 million. The difference between the new partner’s outside basis and its allocable portion of the inside basis is treated as new depreciable property. In this example, that is $2 million less $1 million, or $1 million. This newly placed-in-service $1 million building asset is commonly called the §754 step-up and generates additional depreciation deductions for the incoming partner.

Cost Segregation in a Nutshell:

When taxpayers acquire an improved property, the property is often composed of different components for tax purposes.[4] Ordinarily, taxpayers allocate the purchase price between land and building. The land cannot be depreciated and the building is depreciated over 27.5 or 39 years. A cost segregation study allows taxpayers to identify portions of the building that qualify for shorter depreciation recovery periods such as depreciable land improvements and building components that are treated as tangible personal property for federal income tax purposes.  This opportunity is available not only for newly constructed or acquired buildings but for almost all buildings placed in service since 1987. Even better, the tax laws allow taxpayers to catch-up on the missed, extra depreciation for all the years since it was placed in service.

Example 2:

A taxpayer acquires a $5 million office building (purchase price net of land costs). The goal of a cost segregation is to properly identify as much qualifying 5, 7, 15-year property as possible. The remaining non-qualifying property remains as 39-year building property. A reasonable allocation for an office building in a suburban setting is 6% – 8% as 5-year tangible personal property (carpeting, data cabling, etc.) and 8% – 12% as qualifying land improvements (paving, storm drainage, etc.) Assuming a tax rate of 40% and a discount rate of 6%, the estimated benefits of the cost segregation study are:

Cumulative net present value $109,000 $153,000
1st Year Increased cash flow $28,000 $39,000
1st 5-year Increased cash flow $141,000 $195,000

 

Estimated Cumulative Net Present value Of Tax Referral: Net Present Value is a method used in evaluating investments whereby the net present value of all cash outflows, such as the cost of the investment, and cash inflows (returns) is calculated using a given discount rate.[5] In other words, it is a representation of the estimated benefit, over the life of a property, calculating the time value of the increased cash flow.

Where m is Present Value; n is Net Present Value; i is Discount Rate; and f is Amount Depreciated in a given year:

m = f * i * Tax Rate

n = m + n (previous)

As with the annual increased cash flow, the present value will net out to $0 over the life of the property. However, the cumulative net present value or NPV increases dramatically.

Estimated Increased Cash Flow in Year 1: Increased cash flow is the increase in depreciation expense deductions, above that generated by straight line depreciation, created by front loading a property’s depreciation through a cost segregation study.  Increased cash flow is calculated by multiplying the increased amount depreciated by the property owner’s tax rate.

Where g is Increased Cash Flow; and f is Amount Depreciated in a given year:

g = f * Tax Rate

Estimated Increased Cash Flow in Years 1-5: This is calculated in the same manner as the Increased Cash Flow in Year 1 but is a reflection of the first 5 years following the implementation of a cost segregation study.

Cost Segregation and §754 Step-ups

One downside of cost segregation is that it frontloads depreciation during the early years after a building has been placed in service. For the first six to 16 years after a cost segregated building has been placed in service, the building will generate increased annual depreciation deductions. In later years, however, the building will generate smaller annual depreciation deductions than if it had not been cost segregated. Due to the cash benefit of the catch-up depreciation in the current year, most taxpayers will still perform cost segregation studies on buildings in their later years in spite of the decreased future depreciation deductions. For older buildings owned by partnerships with one or more §754 step-ups reflected on the tax depreciation schedule, the incentive to have a cost segregation study may increase greatly not just in the early years, but also in later years.

This increased benefit is due to all partners receiving the cash benefit for the catch-up depreciation and the partners with §754 step-ups receiving even more catch-up depreciation and possibly increased future depreciation deductions. Where no cost segregation study has been performed in the past, and depending on how the partnership agreement treats partnership interest dispositions, the availability of catch-up depreciation for the inside basis and greater depreciation deductions from the §754 step-ups may make partnership interests more attractive to investors.  Combining §754 step-ups with cost segregation can greatly benefit real estate partnerships.

[1] I.R.C. § 723.

[2] Treas. Reg. § 1.742-1.

[3] I.R.C. § 754.

[4] For a general overview of cost segregation, see the IRS Cost Segregation Audit Techniques Guide available at: http://www.irs.gov/Businesses/Cost-Segregation-Audit-Techniques-Guide—Chapter-1—Introduction

[5] John Downes & Jordan Elliot Goodman, eds. Dictionary of Finance and investment Terms. 6th Edition. New York: Barron’s, 2003.

Permanent increase in expensing limits under §179 creates big benefits for small businesses.

Recent passage of the Protecting Americans Against Tax Hikes (PATH) Act of 2015 makes permanent or extends several provisions.  This is particularly noteworthy for small businesses that often rely on the cash flow these incentives create to invest in additional staff or equipment.

A permanent extension of the §179 Expensing Rules extends the small business expensing limitation and phase-out amounts in effect from 2010 through 2014 to $500,000 and $2 million, respectively.  This is a significant increase from the current amounts of $25,000 and $200,000 and another win for small businesses.  The provision also modifies the expensing limitation by indexing both the $500,000 and $2 million limits for inflation beginning in 2016.

Also permanently extended are the special rules that allow expensing for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.  The provision modifies the expensing limitation with respect to qualified real property by eliminating the $250,000 cap beginning in 2016.

In addition, heating and air condition units placed in service in tax years beginning after 2015 can now be expensed.

15-year straight-line cost recovery for qualified leasehold improvements, restaurant buildings and improvements, and retail improvements are now permanent benefits.

Retailers, restaurant operators and businesses with increasing leasehold needs can now count on the 15-year recovery period, provided they meet the established criteria for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements.

Bonus depreciation is extended with sunset.

Bonus depreciation has been a lucrative incentive since 2001.  The PATH Act extends 50 percent bonus depreciation for 2015, 2016 and 2017.  It reduces to 40 percent for 2018 and 30 percent in 2019.

Interestingly, the provision modifies bonus depreciation to permit certain trees, vines and plants bearing fruit or nuts to be eligible for bonus depreciation when planted or grafted rather than when placed in service.

  • 179D energy-efficient property extended.

Also extended is the §179D green building deduction for the construction of commercial properties that meet certain ASHRAE standards for energy-efficient installation of lighting, HVAC and building envelope.  This deduction can be taken by building owners, or in the case of public buildings such as schools, hospitals or other government-owned properties, it can be taken by the primary designer.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act of 2015, extending many of the business and individual tax provisions and finally making permanent the research and development (R&D) tax credit.

 

Start-ups and small businesses benefit from changes to R&D tax credit

In addition to making the credit permanent, the Act also contains two favorable changes for small businesses and start-ups beginning in 2016. These two noteworthy enhancements are:

  • The credit is now able to offset Alternative Minimum Tax (AMT) for eligible small businesses, companies with less than $50 million in gross receipts. For small business owners, the AMT limitation was the largest obstacle that kept companies from taking advantage of the research credit. For 2016 and forward this limitation is lifted.
  • Start-up companies, whether corporations or partnerships, can apply the credit to offset up to $250,000 in payroll taxes beginning in tax years after December 31, 2015. Start-ups are defined as businesses with less than $5 million in gross receipts in the current year and less than five years of historical gross receipts.

A permanent credit provides stability and certainty to all companies while the enhancements are game changers for small businesses.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

Start-ups and small businesses benefit from changes to R&D tax credit

The House today passed a permanent extension of the Research and Development (R&D) tax credit as part of the Protecting Americans from Tax Hikes Act of 2015. Finally companies can rely on the permanency of the credit, which will allow them to better plan for investments in research.  In addition to making the credit permanent, the Act also contains two favorable changes for small businesses and start-ups beginning in 2016.  These two noteworthy enhancements are:

  • The credit is now able to offset Alternative Minimum Tax (AMT) for eligible small businesses, companies with less than $50 million in gross receipts. For small business owners, the AMT limitation was the largest obstacle that kept companies from taking advantage of the research credit.  For 2016 and forward this limitation is lifted.
  • Start-up companies, whether corporations or partnerships, can apply the credit to offset up to $250,000 in payroll taxes beginning in tax years after December 31, 2015. Start-ups are defined as businesses with less than $5 million in gross receipts in the current year and less than five years of historical gross receipts.

A permanent credit provides stability and certainty to all companies while the enhancements are game changers for small businesses. The bill is now waiting for Senate approval after which the president is expected to sign it into law.

Charles Duncan, Director, Cost Segregation & EPAct §179D

Charles Duncan, Director, Cost Segregation & EPAct §179D

With the close of the 2014 calendar tax year filing season on October 15, many taxpayers have turned their attention away from the Tangible Property Regulations (TPR). The TPR still provide substantial benefits to many taxpayers such as fiscal-year taxpayers, taxpayers with current year partial asset dispositions, certain taxpayers in the retail and restaurant industries, taxpayers without prior repair reg studies and taxpayers without Applicable Financial Statements (AFS).

Fiscal Year Taxpayers PAD Possibilities

The TPR are effective for tax years beginning on or after January 1, 2014. Late partial asset disposition (PAD) elections may only be made through the automatic accounting change procedures for any tax year beginning on or after January 1, 2012 and beginning before January 1, 2015. For calendar year taxpayers, the ability to make late, prior-year PAD elections through the automatic accounting method change procedures ended with September or October 15, 2015. Fiscal year taxpayers, however, may file a DCN 196 late PAD election under the automatic change procedures for any fiscal 2015 tax year that began before January 1, 2015. For example, a retailer with an October 31 fiscal tax year-end has until June 15, 2016 to file a late PAD election through the automatic method change procedures. Both fiscal year and calendar year taxpayers can continue to file private letter ruling requests under regulation §301.9100-3 to make late PAD elections once the automatic accounting method change procedures are no longer available.

Ongoing PAD Opportunities

Under the TPR, taxpayers may identify current year partial asset dispositions in the same year in which they occur but will no longer be permitted to identify late PADs. Taxpayers need to be aware that this is a significant, taxpayer friendly expensing opportunity that may easily be missed. Anytime there is a major remodel/renovation project or even a reroofing project, the taxpayer needs to notify their CPA and/or cost segregation professional so that the scope of the opportunity can be assessed and the proper measures taken.

The best way to maximize the identification of PADs is to identify them prior to demolition. Once demolition has occurred, assigning a value to the assets may no longer be easy. For example, a CPA or cost segregation professional may have little recourse in identifying PADs in a showroom that has been remodeled if there is no evidence of what was once there. That is why it’s incumbent upon the taxpayer to notify their CPA prior to commencing major demolition so that PADs may be accurately identified and the tax benefit maximized. Once a remodel/renovation project is underway, it may no longer be possible to identify those PADs that have already been demolished.

Repair Reg Studies

Many taxpayers and tax practitioners are under the impression that there are no more TPR automatic method changes available after October 15, 2015. While the late PAD elections are no longer available as method changes once the extended filing deadline for the 2015 tax year has passed, other TPR method changes are still available. The primary limitation is for taxpayers with prior TPR method changes. If a taxpayer has previously made the same accounting method change for the same item in the past five years (including the year of change), the taxpayer would have to file a non-automatic method change and pay the IRS a user fee. The user fee is currently $8,600. For taxpayers who have not yet made any method changes under the TPR, most method changes will still be available under the automatic accounting method change procedures.

The Remodel-Refresh Safe Harbor

In Rev. Proc. 2015-56, the IRS provides a new safe harbor method of expensing repairs and capitalizing improvements for remodel-refresh projects. Under this safe harbor, taxpayers with an Applicable Financial Statement (AFS) and who primarily conduct activities within a qualifying retail or restaurant North American Industry Classification System (NAICS) code or lease a qualified building to a taxpayer that reports or conducts activities within a qualifying NAICS code must expense 75 percent, (and capitalize 25 percent), of qualifying remodel-refresh costs. Taxpayers using the safe harbor must also make (late) General Asset Account elections for the qualified building and its improvements. To use the safe harbor for prior years, taxpayers must unwind prior PADs and component dispositions under the proposed TPR. The primary benefits of the safe harbor are reduced controversy with the IRS and a simplified substantiation procedure for deducting remodel-refresh expenses.

Increased De Minimis Safe Harbor

The De Minimis Safe Harbor (DMSH) is a part of the TPR that allows taxpayers to deduct immediately:

  • the cost of Units of Property (UoP)
  • property with an economic useful life of less than a year
  • components of UoP that cost less than a certain dollar amount

To deduct a UoP, component, or short-life property under the DMSH, the taxpayer must have a book accounting procedure as of the beginning of the tax year under which it deducts items under a dollar threshold or with a short economic useful life and the taxpayer must make a DMSH election on that year’s tax return. In brief, the DMSH is a book conformity policy with a ceiling. When the TPRs were finalized the ceiling was $500 per invoice or invoice line item. In Notice 2015-82, the IRS has raised the ceiling to $2,500 for tax years beginning on or after January 1, 2016. If a taxpayer has used a higher book expensing threshold to deduct items on its returns for years prior to 2016, the IRS has provided retroactive audit protection for items under $2,500. This audit protection applies even if the issue is under exam or before appeals or the US Tax Court.

To learn more about these opportunities, please contact us at SourceHOV | Tax.