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.

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

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

On March 2, 2015, the Internal Revenue Service published long-awaited relief for small taxpayers implementing the new Tangible Property Regulations (“TPR”). This relief took the form of Rev. Proc. 2015-20. This revenue procedure allows each eligible small taxpayer to adopt most of the tangible property regulations on an effective cut-off basis, but without prior year audit protection. Relief is available for each qualifying separate and distinct trade or business and no taxpayer action is required to elect the relief provisions. The lack of an affirmative election has created a large problem for some taxpayers: Accidentally electing the relief provisions.

Background:

Rev. Proc. 2015-20 applies to a taxpayer with one or more separate or distinct trades or businesses that either has:

  • less than $10 million in assets on January 1, 2014 (for calendar year taxpayers), or,
  • average annual gross receipts of less than $10 million over the prior three years.

The revenue procedure requires no action on the part of a taxpayer’s qualifying trade or business to elect these provisions. For affected method changes, this is an all-or-nothing proposition: Use Rev. Proc. 2015-20 or use the normal method change procedures. The Service stated during an IRS webinar in July that taxpayers with qualifying trades or businesses that do nothing will be considered to have elected into the relief provisions of Rev. Proc. 2015-20.

The Problem:

If a taxpayer accidentally elects into Rev. Proc. 2015-20, there are three main issues for the taxpayer to confront.

  1. First, there is no back-year audit protection for years before the year of change, (pre-2014 years for calendar year taxpayers). While this may not be a problem for the majority of taxpayers whose methods mostly comply with the new TPR already, taxpayers with deficient methods who would like a de facto cut-off method change will be at risk.
  2. Second, the taxpayer would not be able to make any changes within the scope of Rev. Proc. 2015-20 on an automatic method change basis for five years. Depending on the taxpayer’s gross income, user fees for non-automatic method changes run from $2,200 to $8,600, with most taxpayers paying $8,600 per method change.
  3. Third, the taxpayer would lose all §481(a) adjustments attributable to pre-2014 tax years when making a subsequent method change. More than the user fee, the lack of pre-2014 favorable adjustments will discourage taxpayers from making a method change in post-2014 tax years.

The Solution:

While the IRS’s position is unfavorable, they have also provided a solution. The IRS has publicly suggested that eligible taxpayers may elect out of Rev. Proc. 2015-20 by filing a statement to that effect with their 2014 tax returns. Since this would be a regulatory election, taxpayers who have already filed their 2014 returns should be able to use the §9100 relief provisions to file this statement with an amended return. For calendar year taxpayers, this amended return would be due by September 15, 2015 for C corps and S corps and October 15, 2015 for partnerships and individuals. Alternatively, taxpayers can file their 2014 returns with a Form 3115 for a method otherwise within the scope of Rev. Proc. 2015-20 to elect out of Rev. Proc. 2015-20. The §9100 relief rules are also available to file a Form 3115 with an amended 2014 tax return.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

A recent court case provides guidance on owner compensation and when it qualifies as a research expense under §174.  This qualification under §174 then dovetails with the §41 research and development (R&D) tax credit calculation and can have a huge impact.  Many companies are led by entrepreneurs who spend significant time developing or improving the company’s products and processes rather than managing day-to-day operations.  These qualifying activities can have a substantial impact on the size of a company’s credit.

In Eric G. Suder vs. Commissioner, Mr. Suder claimed that 75 percent of his time was devoted to research activities.  Mr. Suder was the creative genius behind the company’s products, spending most of his time guiding product development from idea generation through testing. As a result, the company grew from a one-man, garage-based startup to a thriving 125-person organization. Like many entrepreneurial CEOs, Mr. Suder spent very little time managing day-to-day operations. Instead, his time was spent contributing to senior product strategy and follow up product meetings, reviewing product specifications, and researching networking technology that could be incorporated into the company’s products.

However, the IRS disallowed Mr. Suder’s R&D credits and also challenged whether the compensation paid to Mr. Suder was reasonable under §174.  Mr. Suder argued that engineering’s role was to execute on his innovative ideas, and that his compensation was based on his creative contributions. Mr. Suder’s total compensation package during the period in question ranged from ~$8-11 million and was comprised of a base salary and bonuses, with bonuses based on growth, overall value and cash flow.

After a thorough analysis by the court, 75 percent of Mr. Suder’s salary was confirmed as qualified.   Mr. Suder was able to convince the court through documentation and oral testimony that he participated heavily in research. Mr. Suder provided credible documentation supporting his research efforts.

With respect to his compensation, according to the law, “Under §174(e) a taxpayer may deduct a research and development expenditure only to the extent that the amount thereof is reasonable under the circumstances.” The amount of an expenditure is considered reasonable if “the amount would ordinarily be paid for like activities by like enterprises under like circumstances.”  The court addressed the issue of “reasonable” with respect to how much of an owner’s compensation can be included in the credit computation.  The court evaluated eight factors including the employee’s qualifications, the nature, extent and scope of the employee’s work, the size and complexities of the business, and the prevailing rates of compensation for comparable positions in comparable concerns.

After evaluating these factors and hearing from expert witnesses for Mr. Suder and the IRS, both of whom compared Mr. Suder’s wages to those of other CEOs performing similar services in similar companies, the court determined that while they agree with Mr. Suder’s high compensation as a CEO, the amounts were unreasonable under §174.  The court determined that reasonable wages under §174 would be $2.3-2.6 million. These wage amounts represented base salary, annual incentive and long-term incentive.  The court confirmed that wage comparison should be to that of other CEOs not to that of other employees within a company or other engineers or researchers.

The Suder case highlights that owners and other highly compensated executives who participate in R&D activities can be included in calculating the R&D credit.  It also highlights the importance of supporting documentation as evidence of participation in qualified research activities.

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

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

The release of final Treasury regulations on the disposition of MACRS property has increased interest in the current legal treatment of demolition costs. In general, taxpayers may now rely on the final regulations of Treasury Decision 9689 when determining how to treat asset dispositions. Though these final regulations describe when an asset disposition occurs, the related final regulations on tangible property capitalization in Treasury Decision 9636 control how to treat the demolition costs.

Under those final regulations, when a taxpayer realizes gain or loss on the disposition of an asset, the taxpayer may expense the demolition and removal costs for that asset. When the taxpayer does not realize gain or loss on an asset disposition, the costs of demolishing or removing the asset are capitalized. The following chart summarizes how to treat demolition and removal costs under the final regulations.

Transaction Type Gain or Loss Realized? Demolition/Removal Cost Treatment
Sale Yes Not capitalized (expensed)
Exchange Yes Not capitalized (expensed)
Involuntary conversion Yes Not capitalized (expensed)
Physical abandonment (whole asset) Loss only Not capitalized (expensed)
Partial asset retirement w/partial disposition election Loss only Not capitalized (expensed)
Partial asset retirement w/o partial disposition election No Capitalized to replacement asset if costs directly benefit or incurred by reason of new improvement. Otherwise, expensed.
Section 280B building demolition No Capitalized to non-depreciable land account
Conversion to personal use Gain only Not capitalized (expensed)
Transfer to supplies or scrap account Loss only Not capitalized (expensed)
GAA asset disposition, no partial disposition election and no GAA-terminating event Loss = Zero for removal cost purposes Not capitalized (expensed)

 

Please note that the above chart is based on realization, not recognition. Exchanges and involuntary conversions are often non-recognition events for federal income tax purposes. Nonetheless, they are dispositions and realization events, which dictates the treatment of asset removal costs.

Under the final regulations, demolition and removal costs are only capitalized when gain or loss is not realized. Examples of this type of situation include a building demolition that is capitalized to a non-depreciable land account under §280B or when a component of an asset is replaced without a partial disposition election. This provides taxpayers some flexibility to lower current year expenses when making structural improvements by capitalizing removal costs.

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Provisions Offer Additional Tax Benefits

In late July the Senate Finance Committee approved a modified and expanded version of the tax extenders bill that would provide a two-year retroactive extension of more than 50 expired business and individual tax provisions. Most noteworthy are enhancements to the research and development tax credit; §179 expensing provision; and the §179D deduction for sustainable design and construction of commercial properties.

R&D tax credit expansion would benefit small and medium sized businesses

The proposed R&D tax credit extension includes an AMT patch, which would allow companies paying AMT with less than $50 million in average sales over the prior three years to claim the credit. Start ups, defined as companies with less than $5 million in gross receipts and less than five years old, would be able to use the credit to offset up to $250,000 in payroll taxes annually.

Fixed asset benefits from enhancements to bill

The proposed bill would index the increased §179 expensing and phase-out limits ($500,000 and $2 million, respectively) to inflation. This is in addition to the extension of bonus depreciation and 15-year recovery for qualified properties.

Energy-efficient commercial building deduction expanded

The §179D commercial green building deduction would be expanded to allow nonprofits and tribal organizations to allocate the deduction to the primary designer of the property, a provision currently in place for government or other public entities.

If passed, all of the extenders would be set to expire on December 31, 2016. The modifications proposed for the extenders listed here could potentially provide significantly higher benefits for many small to medium sized businesses. The bill now has to make its way to the full Senate, although congressional debate will likely delay enactment until year-end.

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

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

The enactment of the Tangible Property Regulations (“TPR”) has confused many taxpayers on how to deal with tenant improvements.  The most common area of confusion is whether tenant improvements may be expensed as repairs. Though the TPRs provide substantial opportunities to write off tenant improvements as repairs or maintenance, there are many traps for the unwary. The primary pitfalls are: 1) the §1245 trap; 2) the betterment trap; and, 3) the disposition trap. Taxpayers can avoid these traps by engaging experienced tax practitioners and cost segregation consultants to help navigate the TPRs.

Tenant Improvements: The Starting Point

“Tenant improvements” are not a tax concept. Both lessors and lessees can own improvements to a leased property. Though itself a complex topic, this is not the primary area of confusion. The confusion lies with the treatment of lessor improvements.

Under the TPRs, lessors must capitalize the related amounts it pays to improve a leased Unit of Property (“UoP”). These payments may be direct or indirect using a construction allowance.  Lessors must also capitalize the related amounts paid by the lessee to improve a leased UoP as a substitute for rent. Once taxpayers work through these issues to determine whether the lessor owns the improvement, taxpayers can analyze the related costs under the ten improvement tests. These tests are:

  • Betterments- An expenditure is paid for a betterment if it:
  1. Ameliorates a material condition or defect that existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property (whether or not the taxpayer was aware of the defect at the time of acquisition or production);
  2. Is for a material addition, including a physical enlargement, expansion, extension or addition of a major component to the unit of property, or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or
  3. Is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the unit of property.
  • Restorations- A taxpayer must capitalize expenditures made to restore a unit of property if it:
  1. Is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under §1.165-7);
  2. Is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
  3. Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under §165;
  4. Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
  5. Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or
  6. Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.

 

  • Adapt Property to a New or Different Use
  1. A taxpayer must capitalize as an improvement an amount paid to adapt a unit of property to a new or different use. An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in service by the taxpayer.

While applying these tests to possible improvement costs, taxpayers should be aware of several traps.

The §1245 Trap

Taxpayers may be familiar with classifying building components as section §1250 (long-life) or §1245 (short-life) assets as part of a cost segregation study. These classifications are based on the former Investment Tax Credit regulations found in §1.48-1. This regulation also defines the building UoP as §1250 building property. The problem is that many taxpayers only record a single asset on their books for each tenant suite buildout without breaking down the costs into §1245 and §1250 property. Identifying property as §1245 or §1250 is not elective. Many common improvements, (such as carpeting, demountable partitions, window treatments or cabinetry), are §1245 property, the replacement of which must be treated as a new asset acquisition. This is in contrast to the replacement of §1250 property, which may often be deducted as a repair. On audit, the IRS may force taxpayers to capitalize replacement §1245 assets instead of expensing each tenant buildout as a repair. Further reading: Regulation §1.263(a)-3(j)(3), Examples 5-8 and 22 provides examples of common §1245 assets.

The Betterment Trap

In general, taxpayers focus on the restoration rules when analyzing whether lessor improvements must be capitalized. Though this is usually the correct approach, taxpayers should not neglect the possibility that some costs are attributable to betterments, especially material additions under Test 2.

This test provides that a material addition includes a physical enlargement, expansion, extension or addition of a major component to the unit of property. These tests apply at the level of the major component of the UoP. A major component is a part, or combination of parts, that perform a discrete and critical function in the operation of the UoP. For buildings, a major component can also include a significant portion of a major component. As the examples are currently written, the IRS may consider routine tenant buildouts as betterments, such as adding or removing and rebuilding partitions. Further reading: Regulation §1.263(a)-3(j)(3), Examples 8 and 22.

 The Disposition Trap

For MACRS disposition purposes, improvements and additions placed in service after the underlying asset was placed in service are separate assets. For example, a taxpayer constructs and places into service an office building. As each tenant leases its space, the taxpayer builds out that space for that tenant. Since each suite is generally placed into service after the initial building, the assets of each buildout will be considered separate assets from the underlying building. This means, instead of an elective partial disposition, taxpayers will often be faced with the mandatory disposition of an entire asset when the buildout is replaced. Since each lessor improvement generally is not a separate UoP from the underlying building, the taxpayer will be required to capitalize the replacement UoP components as a restoration under Test 4. This forces taxpayers on a path where each tenant buildout is always a restoration.

It is worth noting that this same trap may or may not apply to acquired properties, depending on the facts and circumstances. If an entire building is acquired and placed into service with all tenant suites fully occupied and finished out, the existing tenant improvements and building will constitute a single UoP of §1250 building property and a single asset for disposition purposes. The building will not fall into the disposition trap initially. Due to the §1245 trap and the betterment trap, later tenant buildouts may be improvements for repair purposes, which would put the taxpayer back into the disposition trap.

Further reading: Regulation sections 1.168(i)-8(c)(4)(ii)(D) and 1.263(a)-3(k)(7), Examples 1 and 24.

The Solution

SourceHov|Tax brings experienced cost segregation consultants and tax practitioners who can assist taxpayers and CPAs in navigating the new TPRs. With Big Four experience ranging from cost segregation to repair, disposition, and fixed asset studies, we are able to help you document your unique facts and circumstances and sustain these finding on audit.