The Tangible Property Regulations’ Small Business Exceptions: To File or Not to File

Most small business taxpayers and practitioners welcomed the relief the IRS provided in early 2015 when it issued Rev. Proc. 2015-20.¹ This guidance enables small business taxpayers to adopt the final tangible property regulations² using simplified procedures. Although the relief provided by Rev. Proc. 2015-20 is a favorable development, small business taxpayers should be aware of the implications of adopting the regulations through the small business exception.

As discussed in more detail below, eligible small business taxpayers will be deemed to have adopted the tangible property regulations by filing their 2014 tax return even if they do not file Form 3115, Application for Change in Accounting Method. Taxpayers that do not file Form 3115 with their 2014 tax return to adopt the tangible property regulations and do not wish to adopt the regulations by way of the small business exception must include a statement with their 2014 tax return acknowledging they are not adopting the final tangible property regulations under Rev. Proc. 2015-20.

Overview of Rev. Proc. 2015-20

The small business exception permits taxpayers to change their methods of accounting to comply with the final tangible property regulations on their 2014 tax returns without including a Form 3115 or a separate statement. Taxpayers using the small business exception are only required to take into account amounts paid or incurred beginning in the 2014 tax year. Therefore, no Sec. 481(a) adjustment is required. A taxpayer opting to use the small business exception is not granted back-year audit protection for its treatment of expenditures covered by the tangible property regulations.

The relief provided in Rev. Proc. 2015-20 is available only for a taxpayer’s first tax year beginning on or after Jan. 1, 2014. Additionally, a taxpayer using the small business exception cannot choose to implement some of the method changes using the revenue procedure and other changes by filing Form 3115 and claiming a Sec. 481(a) adjustment. Furthermore, using the small business exception limits a taxpayer’s ability to claim deductions for certain dispositions that occurred prior to a tax year beginning on or after Jan. 1, 2014, by filing a Form 3115.

A taxpayer is eligible for the small business exception if it has one or more separate and distinct trades or businesses (as defined in Regs. Sec. 1.446-1(d)) that have:

• Total assets of less than $10 million as of the first day of the tax year for which a change in accounting method under the final tangible property regulations and corresponding procedures regarding related changes in method of accounting is effective; or
• Average annual gross receipts of $10 million or less for the prior three tax years (as determined under Regs. Sec. 1.263(a)-3(h)(3), substituting “separate and distinct trade or business” for “taxpayer”).

These thresholds are applied at the level of each separate trade or business, so no aggregation or controlled-group rules are provided for purposes of applying the $10 million asset or $10 million gross-receipts test.

Guidance in the tax law regarding what constitutes a separate and distinct trade or business is limited. In recently issued frequently asked questions, the IRS indicated that for purposes of applying the small business taxpayer exception “[g]enerally, a separate and distinct trade or business refers to each trade or business for which you keep a complete and separate set of books and records.”³

Summary of Options If Rev. Proc. 2015-20 Requirements Are Met

A small business taxpayer that has one or more separate and distinct trades or businesses that each has assets of less than $10 million or average annual gross receipts of $10 million or less for the prior three years should consider the following options to comply with the final tangible property regulations for the 2014 tax year:

Option 1: Adopt the final tangible property regulations using Rev. Proc. 2015-20:

• On a cutoff basis with no Sec. 481(a) adjustment, forgoing any deductions for items that were capitalized that would otherwise be classified as repair and maintenance expenditures or dispositions under the new rules.
• Without filing Form 3115, but possibly including a statement with the return as evidence of compliance with the regulations, even though a statement is not required under Rev. Proc. 2015-20. For instance, the statement could indicate that “pursuant to the small business exception under Section 10.11(6)(b)(iii) of Rev. Proc. 2015-14 (as modified by Rev. Proc. 2015-20), the taxpayer is changing to adopt the final tangible property regulations prospectively with its tax year beginning Jan. 1, 2014, and without filing a Form 3115.”
• Complying with the final tangible property regulations in computing taxable income for 2014 and subsequent years, using the new rules.

If the procedures of Rev. Proc. 2015-20 are used, no audit protection is available for previously deducted expenditures that would be capitalized under the final property regulations.

Option 2: Use the procedures of Rev. Proc. 2015-20 described in option 1 and make the annual election to capitalize repair and maintenance costs under Regs. Sec. 1.263(a)-3(n) (book-conformity election) to follow books prospectively (in other words, capitalizing expenditures for both book and tax purposes as improvements that otherwise would be deducted as repair and maintenance costs for tax purposes under the new rules). This is an annual election and applies only to expenditures incurred in the year the election is made.

Option 3: Adopt the final tangible property regulations under Rev. Procs. 2015-13 and 2015-14 (or under Rev. Proc. 2011-14 if the transition rule is used) by:

• Computing a Sec. 481(a) adjustment equal to the difference between present and proposed methods under the final tangible property regulations.
• Filing Form 3115.
• Complying with regulations by computing taxable income for 2014 and subsequent years under the new rules or making the annual book-conformity election (if available and if the taxpayer wants to follows book capitalization methods for tax purposes).

By following these procedures, taxpayers achieve audit protection for previously deducted expenditures that would be capitalized under the final property regulations.

Because taxpayers do not receive audit protection for tax years beginning before Jan. 1, 2014, under option 1 or 2, they should evaluate whether they have exposure in back years attributable to deducting expenditures that are subject to capitalization under the final tangible property regulations. If it is determined that a taxpayer has exposure, it should consider adopting the regulations using option 3.

Taxpayers that filed their 2014 tax return under option 1 or 2 and want to file a method change to gain audit protection can use the automatic late relief procedures contained in Rev. Proc. 2015-13 to file a Form 3115 with an amended tax return. The automatic relief requires corrective actions to be taken within six months from the original due date of the tax return, without extension, or the extended due date of the tax return, if earlier. For a calendar-year taxpayer, corrective action generally must be taken no later than Sept. 15, 2015, for corporations, partnerships, and trusts and Oct. 15, 2015, for individuals.

Small Business Taxpayer Safe-Harbor Election

In addition to following one of the options described above, a small business taxpayer that owns or leases one or more buildings can make an annual safe-harbor election not to apply the improvement capitalization rules to certain qualifying building property if it meets the following requirements:⁴

• The taxpayer pays no more than the lesser of 2% of the unadjusted basis of the property or $10,000 total for the year for repairs, maintenance, and improvements for eligible building property for the tax year for which the election is made. Eligible building property is defined as a building, condominium, cooperative, leased building, or leased portion of a building with an unadjusted basis of $1 million or less.⁵
• The taxpayer has average annual gross receipts for the previous three years that are less than or equal to $10 million.
• The taxpayer files the election statement annually with its tax return.⁶

If a taxpayer no longer meets any of the small business taxpayer safe-harbor election requirements, it will need to apply the regulations when computing taxable income for the year in which the taxpayer or the property no longer qualifies for the safe harbor. In addition, it will need to file Form 3115 to adopt the regulations related to improvements that no longer qualify for the safe harbor. Additionally, because this safe harbor is an annual election, it applies only to expenditures incurred in the year the election is made and not to those incurred previously.

Final Thoughts

Rev. Proc. 2015-20 streamlines the process of adopting the final tangible property regulations for small business taxpayers and practitioners by eliminating the need to compute a Sec. 481(a) adjustment and file a Form 3115. Taxpayers and practitioners should evaluate the advantages and disadvantages to adopting the regulations under the revenue procedures so they can make an informed decision regarding which option they take to implement the regulations.

Footnotes

¹ Rev. Proc. 2015-20 modifies Rev. Proc. 2015-14, which provides a list of areas to which procedures described in Rev. Proc. 2015-13 for automatic consent to change a method of accounting apply.

² T.D. 9636 and T.D. 9689.

³ IRS webpage, “Tangible Property Regulations—Frequently Asked Questions.”

⁴ See Regs. Sec. 1.263(a)-3(h).

⁵ Regs. Sec. 1.263(a)-3(h)(4).

⁶ In the manner and form described in Regs. Sec. 1.263(a)-3(h)(6).