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.

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

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

On November 20, 2015, the Internal Revenue Service released an advance copy of Revenue Procedure 2015-56. This revenue procedure provides relief for some taxpayers that own retail and restaurant properties.  This relief comes in the form of a safe harbor accounting method where taxpayers are allowed to deduct 75 percent of the qualified costs of remodel-refresh projects instead of applying the facts and circumstances rules of the Tangible Property Regulations (“TPR”).

Who is Eligible?

To qualify for the safe harbor a taxpayer must meet three conditions:

  • The taxpayer must have an Applicable Financial Statement (“AFS”) or be consolidated on a related party’s applicable financial statement. An AFS is a;
    1. Financial statement filed with the SEC;
    2. Certified audited financial statement accompanied by the report of an independent CPA that is used for credit purposes, reporting to shareholders or partners, or other substantial non-tax purposes; or
    3. Non-tax return financial statement required to be provided to any state or federal agency other than the SEC or IRS.

 

  • The taxpayer must primarily report or conduct activities within a qualifying 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.
    1. For taxpayers in the trade or business of selling merchandise to customers at retail, the qualifying NAICS codes are 44 and 45 with the exception of codes; 4411 (automotive dealers), 4412 (other motor vehicle dealers), 447 (gas stations), 45393 (manufactured home dealers), and 454 (nonstore retailers).
    2. For taxpayers in the trade or business of preparing and selling meals, snacks, or beverages to customer order for immediate on-premises or off-premises consumption, the qualifying NAICS code is 722. Code 7223 (Special food services like caterers and food trucks) are excluded. Taxpayers that are primarily in the business of operating hotels, motels, civic or social organization, amusement parks, theaters, casinos, country clubs, and similar recreation facilities are also excluded.

Practical Tip: Unlike under the UNICAP rules, selling merchandise at retail includes the sale of identical goods to resellers if the sales to resellers are conducted in the same building and in the same manner as retail sales to non-reseller customers (for example, warehouse clubs or  home improvement stores).

  • The taxpayer must incur remodel-refresh costs.

What is Eligible for the Safe Harbor?

Seventy-five percent of qualifying remodel-refresh costs that are paid by a qualified taxpayer for remodel, refresh, repair, maintenance, or similar activities performed on a qualified building as part of a remodel-refresh project are eligible for the safe harbor. The remaining 25 percent must be capitalized as a capitalizable improvement to the qualified building.

  • A qualified building means each building Unit of Property used by a qualified taxpayer primarily for selling merchandise at retail or as a restaurant. Just as under the TPR, there are special rules for condominiums, cooperatives, and leased property.
  • A remodel-refresh project is a planned undertaking to alter the physical appearance or layout of a qualified building for certain qualifying purposes. These qualifying purposes generally include maintaining a contemporary appearance, making the layout more efficient or conforming to current building standards or practices, standardizing the consumer experience across buildings, or offering the most relevant products or services based on popularity or changing demographics. A remodel-refresh project does not include planned projects involving only the repainting or cleaning of the interior or exterior of an existing qualified building.
  • Qualifying remodel-refresh costs are remodel-refresh costs less excluded remodel-refresh costs.
  • Excluded remodel-refresh costs are amounts paid during a remodel-refresh project for §1245 property (tangible personal property), intangibles (including computer software), land or land improvements, the initial acquisition, construction, or lease of a qualified building (including the initial buildout for a new tenant), ameliorating pre-existing defects, casualty event restorations, adapting more than 20 percent of the total square footage of the qualified building to a new or different use, material additions to the qualified building or its building systems, rebranding the building within two years of the acquisition or initial lease of the building, remodel-refresh costs during a closure of the business for at least 21 consecutive days, and deductions under §179, §179D, or §190.

Practical Tip: The safe harbor requires a cost segregation analysis to identify §1245 property, land improvements, and other costs not subject to the safe harbor.

Caution: Use of the safe harbor delays the deduction of the deductible 75 percent of qualifying remodel-refresh costs until the year the capital expenditure portion is placed in service.

How is the Safe Harbor Applied?

A taxpayer may adopt the safe harbor by filing a Form 3115, Application for Change in Accounting Method using DCN 222. This change requires the adoption of the safe harbor method and the (late) election of General Asset Accounts for the qualified building and its improvements. If the taxpayer has prior year partial asset disposition elections or dispositions of qualified building components under the temporary TPR, the taxpayer may unwind those method changes and take the resulting positive §481(a) adjustment into account entirely in the year of change using DCN 221, which should be filed on the same Form 3115 as DCN 222 for the first or second taxable year ending after December 31, 2013. Unwinding these prior dispositions permits the taxpayer to conduct a lookback study using the safe harbor. If the prior dispositions are not unwound, the taxpayer must use a cut-off method to adopt the safe harbor and may not apply the safe harbor to any qualifying remodel-refresh costs from prior to the year of change. The final year of a trade or business and the five-year item eligibility rules do not apply to either of these changes for the first or second taxable year beginning after December 31, 2013. The remodel-refresh safe harbor method change is available only for taxable years beginning on or after January 1, 2014.

Practical Tip: Taxpayers who already have performed detailed facts-and-circumstances TPR studies that include partial asset dispositions, repairs, and improvements have the option of unwinding the prior partial asset dispositions. This would be advisable if the sum of the repairs and partial asset dispositions are less than 75 percent of the qualifying remodel-refresh costs.

Caution: The safe harbor requires the use of General Asset Accounts, which limits the ability of the taxpayer to make partial asset disposition outside of remodel-refresh projects.

Caution: The Safe Harbor for small taxpayers is not available for any remodel-refresh costs. The routine maintenance safe harbor is not available for any qualifying remodel-refresh costs or amounts not related to a remodel-refresh project.

Overall Assessment

The remodel-refresh safe harbor promises to greatly reduce IRS examinations of taxpayers in the retail and restaurant industries. For taxpayers who have expensed less than 75 percent of qualifying remodel-refresh costs, there is also an opportunity. The safe harbor does come with two primary limitations:

  • Deferred expensing of qualifying remodel-refresh costs where the capital expenditure portion is placed in service in a later year and
  • The mandatory use of General Asset Accounts for qualified buildings which has its own drawbacks.
Charles Duncan, Director, Cost Segregation & EPAct §179D

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

Since our last post regarding the impact of Rev. Proc. 2015-20 on the 2014 filing season, we have fielded many questions about whether taxpayers need to file an election out of Rev. Proc. 2015-20. Below we discuss how Rev. Proc. 2015-20 interacts with the general method change procedures and whether it makes sense for a taxpayer to elect out of Rev. Proc. 2015-20.

General Rules for Method Changes and Rev. Proc. 2015-20

In general, taxpayers may make an automatic change in method of accounting if the change is described in Rev. Proc. 2015-14 and the taxpayer meets the eligibility requirements in §5 of Rev. Proc. 2015-13. These eligibility requirements include that the taxpayer has not engaged in a §381(a) transaction during the year of change, that the year of change is not the final year of the trade or business to which the method change applies, and that the taxpayer has not changed the same method of accounting within the prior five years (including the year of change). The IRS can waive these eligibility requirements. For example, the IRS has waived the eligibility requirements for TPR changes through the 2014 tax year. With the expiration of this waiver in 2015, the five-year item eligibility will once again be in force.

Under this rule, if the taxpayer makes a method change for the same item, for example, a change under DCN 184 from capitalizing costs as improvements to expensing them as repairs, the taxpayer would no longer be able to make the same method change within five years under the automatic consent procedures. For the qualifying small taxpayer under Rev. Proc. 2015-20 who does not file a Form 3115 or an election-out statement, this means that the taxpayer will not be able to file an automatic method change within the scope of Rev. Proc. 2015-20 until 2019. (The affected changes include DCNs 184-193, 205, and 206. Some changes under DCNs 200 and 207 are affected. Though not within the scope of Rev. Proc. 2015-20, filing a Form 3115 for DCN 196 makes the taxpayer ineligible for relief under Rev. Proc. 2015-20.)

Consider a qualifying small taxpayer under Rev. Proc. 2015-20 who has not filed any TPR Forms 3115 and has not filed an election out statement. The IRS will view the taxpayer as having adopted the TPR in 2014 with a §481(a) adjustment of zero. Because the taxpayer has already taken pre-2014 TPR §481(a) adjustments into account, even if the taxpayer files a non-automatic method change in 2016 to comply with the TPR, their §481(a) adjustment is limited to costs paid or incurred during the 2014 and 2015 tax years. The same limitation on the §481(a) adjustment applies even if the taxpayer waits until 2019 to file an automatic method change for affected TPR DCNs. For small taxpayers, this limited §481(a) adjustment presents a more difficult problem than the five-year prior item change rule.

This difficulty lies in how Forms 3115 are treated on exam. An examining agent is free to adjust the amount of a §481(a) adjustment. If the examining agent wants to reject a Form 3115 on exam, however, the agent has to put in a request for Technical Advice from the IRS National Office. Since challenging an invalid Form 3115 is discretionary on the IRS’s part, the most likely resolution of this situation is for an examining agent to adjust the §481(a) adjustment to include only amounts paid or incurred after January 1, 2014. If the IRS takes this approach, however, it may also open an opportunity for qualifying small taxpayers who face unfavorable §481(a) adjustments for pre-2014 years.

Under Rev. Proc. 2015-20, qualifying small taxpayers do not receive back year audit protection. Once the pre-2014 tax years have been closed by the statute of limitations, however, it is arguable that the IRS is limited to post-2013 TPR-related §481(a) adjustments when a taxpayer automatically qualifies for the relief provisions of Rev. Proc. 2015-20. Unfortunately, since this approach would require a practitioner to take a return filing position contrary to a regulation (presumably without a good faith challenge to the validity of the regulations and perhaps without a reasonable basis as well), it may not meet ethical or professional standards even with disclosure.

Given these different scenarios, how should a tax practitioner approach electing out of Rev. Proc. 2015-20?

First, practitioners should assess whether a taxpayer appears to have pre-2014 favorable, TPR-related adjustments by examining the fixed asset ledger and supporting records. If so, the taxpayer should be advised to elect out of Rev. Proc. 2015-20 to preserve these adjustments when filing a later method change. If the practitioner determines that the taxpayer appears to have pre-2014, TPR-related deficiencies, on the other hand, the taxpayer should be advised on the choice between filing under Rev. Proc. 2015-20 or Rev. Procs. 2015-13 and 2015-14 and how it relates to back year audit protection.

Second, the type of entity should be considered. Calendar-year corporations, (both C and S), will no longer be able to file an amended or superseding return under regulation §301.9100-2 to elect out of Rev. Proc. 2015-20 after the extended filing deadline of September 15th. Calendar year individuals and partnerships will be able to use this regulation to elect out of Rev. Proc. 2015-20 until October 15. Finally, if it is too late in the filing season to re-examine corporate returns, practitioners should ponder how the IRS’s approach to this issue might evolve and how the practitioner community might successfully challenge the scenarios we have described above. At the present time, electing out of Rev. Proc. 2015-20 is not required, but it appears to be the best way to preserve pre-2014 favorable, TPR-related §481(a) adjustments.