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On Dec. 27, 2011, the Treasury Department and the IRS (the government) issued temporary and proposed regulations providing rules regarding the capitalization of expenditures related to acquiring, maintaining, or improving tangible property, as well as rules regarding materials and supplies and dispositions of modified accelerated cost recovery system (MACRS) property. 1 Shortly thereafter, on March 7, 2012, the government issued the corresponding procedural guidance taxpayers should follow to change their accounting methods to comply with the temporary regulations. 2
Following the issuance of the temporary regulations, the government received numerous written comments on various issues with the new rules and also held a public hearing on May 9, 2012. As a result of all of the comments received as well as the testimony at the public hearing, on Nov. 20, 2012, the government released Notice 2012-73, 3 announcing its intent to issue amended temporary regulations that would delay the applicability dates of the temporary regulations to tax years beginning on or after Jan. 1, 2014, and that it would provide taxpayers with the option to apply the temporary regulations to tax years beginning on or after Jan. 1, 2012. tax year. Additionally, Notice 2012-73 indicates that the government intends to issue final tangible property regulations in 2013, along with revised procedural guidance, as necessary. The government also stated that it intends to revise certain sections of the temporary regulations, including, for example, the de minimis rule, rules for dispositions of tangible property, and the routine maintenance safe harbor.
On Dec. 14, 2012, the government released technical amendments 4 revising the effective dates of the temporary regulations to generally apply to tax years beginning on or after Jan. 1, 2014. The amended temporary regulations generally provide taxpayers the option to apply the temporary regulations to tax years beginning on or after Jan. 1, 2012.
The complexity of the temporary regulations and accompanying procedural guidance has led to confusion and frustration as taxpayers have worked toward compliance. This article focuses on helping taxpayers to navigate through the myriad of rules and procedures in complying with the temporary regulations—whether taxpayers choose to early adopt or wait until 2014 to comply with the final regulations.
This article begins with a brief high-level overview of the temporary regulations before detailing the method change rules under the current automatic consent procedural guidance and then discussing the method changes that would be necessary to early adopt provisions of the temporary regulations.
Brief Overview of the Temporary Regulations
The temporary regulations provide rules in the following four general areas:
- Materials and supplies (collectively “supplies”);
- Costs to acquire or produce tangible property (including the de minimis rule);
- Costs to improve tangible property;
- Dispositions of MACRS property (including components thereof) and general asset accounts (GAAs).
Following is a brief overview of the rules for each of these areas to provide some context for the corresponding method change discussion. A more detailed analysis of the temporary regulations’ provisions is beyond the scope of this article.
Under the temporary regulations, consistent with pre-2012 law, incidental supplies are deductible when purchased, and nonincidental supplies are deductible when used or consumed. 5 However, the temporary regulations define supplies for federal income tax purposes as tangible property that is not inventory, is used or consumed in the taxpayer’s trade or business, and:
- Is a component acquired to maintain, repair, or improve a unit of tangible property 6 owned, leased, or serviced by the taxpayer, and that is not acquired as part of any single unit of property;
- Consists of fuel, lubricants, water, and similar items, that are reasonably expected to be consumed within 12 months or less, beginning when used in the taxpayer’s operations;
- Is a unit of property that has an economic useful life 7 of 12 months or less determined beginning with the date the property is first used or consumed in the taxpayer’s operations (e.g., jet fuel);
- Is a unit of property with a cost of $100 or less;
- Is a rotable or temporary spare part; or
- Is identified in published guidance as supplies. 8
In addition to the methods provided for incidental and nonincidental supplies, the temporary regulations give a taxpayer the option to annually elect to either (1) capitalize and depreciate all or a portion of its supplies 9 or (2) deduct supplies under the de minimis rule, provided such supplies meet all the requirements of the de minimis rule (discussed below). 10 A taxpayer may want to make this latter election to minimize the administrative burden of separately tracking supplies for tax purposes; however, the taxpayer would need to consider the impact of the election on the current de minimis rule ceiling limitation (described below).
The temporary regulations provide that a rotable or temporary spare part is used or consumed when it is disposed of, and provide a special optional method in addition to the elective capitalization method noted above. 11
Costs to Acquire or Produce Tangible Property
The temporary regulations generally require taxpayers to capitalize amounts paid to acquire or produce tangible property, including costs that facilitate the acquisition or production of tangible property. 12 However, employee compensation and overhead costs are deemed to not be facilitative and need not be capitalized under the temporary regulations (unless the taxpayer elects to do so), 13 but may nevertheless be capitalizable under Sec. 263A.
The temporary regulations include special rules for costs of acquiring real property, treating costs incurred in investigating or otherwise pursuing the acquisition of real property as noninherently facilitative and not subject to capitalization under Sec. 263(a) if such costs are performed in the process of determining whether to acquire real property and which real property to acquire. 14 Here again, however, taxpayers must consider whether the costs are nonetheless subject to capitalization under Sec. 263A.
Under the de minimis rule provided in the temporary regulations, a taxpayer that has an applicable financial statement (AFS), 15 has a written minimum capitalization policy as of the first day of the tax year, and follows that policy in its AFS, generally may deduct for tax purposes amounts expensed under that capitalization policy, subject to a ceiling. Specifically, the aggregate of amounts expensed under the de minimis rule for the tax year must be less than or equal to the greater of (1) 0.1% of tax gross receipts or (2) 2% of depreciation and amortization on the AFS. 16 Amounts in excess of the ceiling are capitalized and depreciated. 17 Taxpayers without an AFS currently cannot use the de minimis rule. 18
Costs to Improve Tangible Property
The rules for improvements to tangible property, commonly referred to as the “repair regulations,” begin with a definition of what constitutes a unit of property and then provide the standards to apply to expenditures with respect to the unit of property to determine if the expenditure must be capitalized. In general, a unit of property includes all components that are functionally interdependent (i.e., the placing in service of one component is dependent upon the placing in service of another component). 19 Additionally, if a taxpayer treats a component as a separate unit of property from another component and depreciates the separate component for tax purposes using a different recovery period from the larger property, then that component is treated as a separate unit of property. The temporary regulations provide special rules for determining the unit of property for the following:
- Buildings (and structural components of buildings);
- Leased property;
- Plant property; and
- Network assets.
Once a taxpayer has determined the appropriate unit of property, it must test expenditures with respect to the unit of property under the three improvement standards—betterment, restoration, and adaptation. A betterment is generally an expenditure that results in a material increase in value, output, strength, capacity, physical size, etc., relative to the state of the unit of property immediately preceding the event necessitating the expenditure. 20 A restoration is generally an expenditure that (1) restores basis that has been taken into account (e.g., as a loss or in computing gain or loss), (2) returns the unit of property to working order from a state of nonfunctional disrepair, (3) results in a rebuilding of the unit of property to a like-new condition after the end of the property’s alternative depreciation system class life, or (4) replaces a major component or substantial structural part of the unit of property. 21 Finally, an adaptation is an expenditure that adapts the unit of property to a new or different use. 22
The temporary regulations include a special rule under which routine maintenance for property other than buildings (or structural components of buildings or building systems) is currently deductible, even though the expenditure would be considered an improvement under the restoration provisions applicable to the rebuild of the unit of property to a like-new condition after the end of its class life or the replacement of a major component or substantial structural part of the unit of property (routine maintenance safe harbor). 23 Additionally, the temporary regulations include an optional method for determining capitalized improvements for certain regulated taxpayers (optional regulatory method). 24
The temporary regulations also include an overarching rule that requires expenditures that directly benefit or are incurred by reason of an improvement to be capitalized. 25 This rule effectively replaces the prior judicially created “plan of rehabilitation” doctrine. 26 In addition, the temporary regulations provide an aggregation rule, which requires a taxpayer to capitalize “the aggregate of related amounts” paid to improve a unit of property. 27 Thus, a taxpayer cannot avoid applicability of the improvement standards by incurring otherwise capitalizable costs with respect to a unit of property over a period of more than one tax year. 28
Dispositions/General Asset Accounts
The temporary regulations also contain provisions regarding dispositions of MACRS assets. The most significant change included in the temporary regulations is the requirement that taxpayers claim a loss on the retirement of a structural component of a building. 29 This rule is important because when a taxpayer claims a loss with respect to its basis in an asset, an expenditure to replace that basis is capitalized as an improvement under the restoration standard discussed above. To provide taxpayers with the flexibility to claim either a retirement loss or, if permitted, a repair deduction, the temporary regulations favorably revise the rules for general asset accounts (GAAs). 30
Automatic Consent Accounting Method Changes: Generally
Taxpayers generally must obtain consent of the IRS to change a method of accounting. 31 For certain accounting method changes, the IRS has granted automatic consent provided the taxpayer complies with the procedures as currently set forth in Rev. Proc. 2011-14 (or its successor). 32 Under Rev. Proc. 2011-14, a taxpayer generally files a Form 3115, Application for Change in Accounting Method, with its timely filed (including extensions) federal income tax return for the tax year the change is to be effective and files a copy of the Form 3115 with the IRS national office (or, in some cases at the IRS’s Ogden, Utah, address specified in the procedure) not later than when it timely files the Form 3115 with its tax return. There is no user fee for filing an automatic method change. Similar to most method changes, a taxpayer that properly files an automatic method change generally receives prior year audit protection for the item for which the change is being made.
Unless otherwise provided for a specific method change, method changes made under Rev. Proc. 2011-14 require a Sec. 481(a) adjustment to ensure no amounts of income or deduction are omitted or duplicated as a result of the method change. In certain cases, the IRS will exercise its discretion and require a method change be made using a cut-off basis (i.e., prospectively), a modified cut-off basis, or with a modified Sec. 481(a) adjustment. A positive (or unfavorable) Sec. 481(a) adjustment is generally taken into account ratably over four tax years beginning with the year of change. 33 A negative (or favorable) Sec. 481(a) adjustment is taken into account in the year of change.
Rev. Proc. 2011-14 provides “scope limitations” under which certain taxpayers are not eligible for automatic consent, including:
- Subject to certain window periods and other exceptions (discussed below), a taxpayer that is under IRS examination;
- In limited cases, a taxpayer that has engaged in a transaction to which Sec. 381(a) applies during the tax year the change is to be effective (determined without regard to any closing of the tax year under Sec. 381(b));
- A taxpayer that, in the tax year the change is to be effective, ceases to engage in the trade or business to which the method change relates; or
- A taxpayer that changed its method of accounting for the same item during the prior five tax years ending with the year of change. 34
A taxpayer that is under IRS examination may file a method change during the first 90 days of its tax year, provided the taxpayer has been under continuous exam for 12 consecutive months (the 90-day window). 35 Additionally, a taxpayer may file an accounting method change request during the first 120 days immediately following the close of an IRS examination, even if a new IRS examination has commenced (the 120-day window). 36
These window periods are available only if the item for which the taxpayer wants to make the change is not an issue under consideration at the time the method change request is filed. 37 A taxpayer under IRS examination may also file an automatic method change if the taxpayer obtains the consent of the appropriate IRS director to file. 38 A taxpayer may request a method change under Rev. Proc. 2011-14 for an item that is an issue pending, but the taxpayer does not receive prior-year audit protection with respect to that item. 39
Accounting method changes made by controlled foreign corporations (CFCs) are generally eligible for the automatic consent provisions of Rev. Proc. 2011-14. However, special rules apply for determining when an issue is under consideration for a CFC, as well as for calculating and recognizing the Sec. 481(a) adjustment resulting from the method change. 40
Automatic Consent Accounting Method Changes: Complying with the Temporary Regulations
Taxpayers generally must follow the procedural guidance in Rev. Procs. 2012-19 and 2012-20 in making the following method changes to early adopt provisions of the temporary regulations:
Rev. Proc. 2012-19
Rev. Proc. 2012-20
Deduct incidental supplies when purchased
Depreciation or amortization of leasehold improvements
Deduct nonincidental supplies when used or consumed
Changes within single, multiple, or general asset accounts, including dispositions
Deduct rotable spare parts when used or consumed (i.e., when disposed of)
Dispositions of buildings or structural components of buildings
Change to the optional method for rotable spare parts
Dispositions of tangible depreciable assets (other than a building or its structural components)
Capitalize acquisition or production costs of tangible property
Dispositions of tangible depreciable assets in a GAA
Deduct dealer expenses that facilitate the sale of property
Late GAA and/or qualifying disposition elections 41
Capitalize nondealer expenses to facilitate the sale of property
Deduct noninherently facilitative pre-decisional investigatory costs of acquiring real property
Apply the de minimis rule
Deduct repairs/change unit of property
Capitalize improvements to tangible property
Change to the routine maintenance safe harbor on property other than buildings
Change to the optional regulatory accounting method
In general, method changes to early adopt provisions of the temporary regulations are made under the automatic consent procedures of Rev. Proc. 2011-14 (discussed above), as modified by Rev. Procs. 2012-19 and 2012-20. Thus, changes are made by (1) filing a Form 3115 with the taxpayer’s federal income tax return for the year the change is to be effective on or before the due date, including extensions, for that return, (2) filing a copy of the Form 3115 with the Ogden, Utah, address on or before the date the Form 3115 is filed with the taxpayer’s return, and (3) complying with the terms and conditions of the applicable procedures (e.g., Rev. Proc. 2012-19 or 2012-20 and Rev. Proc. 2011-14). As noted above, a taxpayer receives prior-year audit protection upon properly filing the copy of Form 3115 with the Ogden, Utah, address.
To encourage taxpayers to follow the temporary regulations, the government has waived the scope limitations under Rev. Proc. 2011-14 (i.e., the limitations that preclude certain taxpayers from eligibility for the automatic consent procedures) for accounting method changes to comply with the temporary regulations for a taxpayer’s first or second tax year beginning after Dec. 31, 2011. 42 It is anticipated that a similar scope limitation waiver will be provided for method changes made to comply with the final regulations.
The waiver of the scope limitations means that a taxpayer under examination may change its methods of accounting to comply with the temporary regulations without being in a window period and without director consent. This is true even if the item is an issue under consideration. The audit protection with respect to the item for which the method change is requested begins when the taxpayer files a complete and accurate Form 3115 with the Ogden, Utah, address. However, as noted above, a taxpayer will not receive audit protection with respect to a change in method of accounting of an item that is an issue pending.
The waiver of the scope limitations also permits a taxpayer that has changed its method of accounting with respect to the item in the prior five years to receive automatic consent for a method change with respect to the same item. 43 Thus, a taxpayer may early adopt the temporary regulations and later change under the automatic consent procedures to apply the final regulations for the same item(s). Additionally, the waiver of the scope limitations allows taxpayers that previously filed accounting method changes for repairs in the past five years to receive automatic consent to change their methods for repairs or improvements to comply with the temporary regulations.
A taxpayer that is required under Sec. 263A and the regulations thereunder to capitalize costs for which it wants to change certain of its methods under Rev. Proc. 2012-19 or Rev. Proc. 2012-20 is not permitted to make the change under the automatic consent procedures unless the taxpayer makes a concurrent automatic method change to comply with Sec. 263A for such costs. Taxpayers generally may make a change to comply with Sec. 263A for inventory under the automatic consent procedures of Rev. Proc. 2011-14, 44 but that is not the case if capitalization under Sec. 263A is required for self-constructed property. In such a case, the Sec. 263A method change would require advance consent. 45
Most of the method changes under Rev. Procs. 2012-19 and 2012-20 are made with a Sec. 481(a) adjustment. 46 However, as discussed below, in some cases a modified Sec. 481(a) adjustment is required, or the change is made on a cut-off or modified cut-off basis, under which no Sec. 481(a) adjustment is permitted. Rev. Procs. 2012-19 and 2012-20 also explicitly permit taxpayers to use statistical sampling methodologies as provided in Rev. Proc. 2011-42 47 in computing the Sec. 481(a) adjustment for certain accounting method changes. 48 Although the IRS has previously permitted extrapolation in other guidance involving tangible property capitalization, Rev. Procs. 2012-19 and 2012-20 do not currently provide for extrapolation.
A taxpayer may generally file a single Form 3115 for method changes it requests for a particular tax year under Rev. Proc. 2012-19, and a single Form 3115 for certain method changes it requests for a particular year under Rev. Proc. 2012-20, as indicated by the relevant appendix section of the applicable revenue procedure. However, even if a single Form 3115 is filed for concurrent method changes, the taxpayer must still provide all of the relevant information for each of the changes requested. This includes a description of the present and proposed methods, as well as separate Sec. 481(a) adjustments for each change, as applicable. As with all accounting method changes, the changes under Rev. Procs. 2012-19 and 2012-20 are made on an entity-by-entity basis (or if an entity has multiple trades or businesses, generally, for each separate trade or business). In the case of an affiliated group filing a consolidated return, a single Form 3115 may be filed for all entities making substantially identical method changes.
Rev. Proc. 2012-19 Method Changes
As noted above, Rev. Proc. 2012-19 currently provides rules with respect to 13 different accounting method changes available to a taxpayer that early adopts the temporary regulations for tax years beginning on or after Jan. 1, 2012 or Jan. 1, 2013. Below is a discussion highlighting some issues taxpayers should consider in making such method changes:
- Nonincidental supplies and incidental supplies (automatic method change numbers 164 and 165). The supplies method changes are made with a Sec. 481(a) adjustment. However, the Sec. 481(a) adjustment computation includes only amounts paid or incurred in tax years beginning on or after Jan. 1, 2012. This means that a taxpayer that changes its method of accounting for supplies to early adopt the temporary regulations for its 2012 tax year will not need to compute a Sec. 481(a) adjustment.
Taxpayers should consider whether the new definition of supplies is beneficial. For example, if the taxpayer has previously capitalized and depreciated small tools with an individual cost of $100 or less or because an aggregate purchase of equipment or furniture and fixtures each of which costs less than $100 was capitalized and depreciated, early adopting these provisions of the temporary regulations may be beneficial. Taxpayers will want to understand both their capitalization policies as they relate to supplies and de minimis amounts. Additionally, taxpayers will need to identify their general ledger accounts and track the data necessary to identify supplies for tax purposes under the temporary regulations.
- Deduct rotable spare parts when used or consumed (automatic method change number 166). A change in method to deduct rotable spare parts when used or consumed (i.e., when disposed of) is made with a Sec. 481(a) adjustment that takes into account only amounts paid or incurred in tax years beginning on or after Jan. 1, 2012 if filed for such year. This method may be least burdensome administratively and may be beneficial to extend expiring net operating losses or credits. Many taxpayers, however, likely will choose to capitalize and depreciate rotable spare parts 49 (see Temp. Reg. Sec. 1.162-3T(d)) or will elect the optional method (automatic method change number 167).
- Change to capitalize amounts paid to acquire or produce tangible property (automatic method change number 173). This method change applies only with respect to a change to comply with the Temp. Reg. Sec. 1.263(a)-2T, including costs for the defense or perfection of title to property (described in Temp. Reg. Sec. 1.263(a)-2T(e)) and transaction costs (described in Temp. Reg. Sec. 1.263(a)-2T(f)). It is made with a Sec. 481(a) adjustment that takes into account only amounts paid or incurred in tax years beginning on or after Jan. 1, 2012 if the method change is implemented for such year. This method change is fairly expansive and may allow a taxpayer under exam to change its method for an item that may be an issue under consideration during the two-year period that the scope limitations are waived. Use of a statistical sampling methodology permitted under Rev. Proc. 2011-42 is allowed in computing the Sec. 481(a) adjustment for this method change.
- Change to deduct noninherently facilitative pre-decisional investigatory costs of acquiring real estate (automatic method change number 170). The method change is made with a Sec. 481(a) adjustment that includes only those amounts paid or incurred in tax years beginning on or after Jan. 1, 2012 if effectuated for such year. As briefly noted above, this method applies only to costs incurred with respect to real property. Thus, a taxpayer that incurs costs investigating property including both real and personal property will need to allocate the costs using a reasonable method. 50
- Change to apply the de minimis rule (automatic method change number 169). In computing the Sec. 481(a) adjustment for this method change, only those amounts paid or incurred in tax years beginning on or after Jan. 1, 2012, are taken into account if implemented for such year. Importantly, the de minimis rule and, therefore, the method change do not apply to amounts paid for property that is inventory (i.e., property held for sale by the taxpayer in the ordinary course of the taxpayer’s trade or business), amounts paid for land, or start-up expenditures. As previously mentioned, the de minimis rule will likely be favorably changed by the final regulations, so taxpayers should carefully weigh any potential benefit from early adopting the temporary regulations for this item against the potential administrative costs of making the change.
- Change to deduct repairs and/or change in unit of property (automatic method change number 162). This method change is made with a Sec. 481(a) adjustment and a separate Sec. 481(a) adjustment must be provided for each MACRS property classification (e.g., three-year property, five-year property, nonresidential real property, etc.). This method change does not apply to a change in method of accounting for dispositions of depreciable property, including a change in the asset disposed of (see the discussion below concerning method changes for dispositions of MACRS property). Additionally, this change does not include a change to capitalize improvements to tangible property. This will generally be favorable for taxpayers as the repairs method change typically will result in a favorable Sec. 481(a) adjustment, which is taken into account in taxable income in the tax year the method change is effective.
- Change to capitalize improvements to tangible property (automatic method change number 174). Similar to the repairs change discussed above, this method change is made with a Sec. 481(a) adjustment that is separately provided for each MACRS property classification, and it does not include asset disposition changes. Unlike prior “repair” method changes made by a number of taxpayers where the focus was on the balance sheet and fixed asset accounts, taxpayers will likely need to review their book repair and maintenance accounts for this change as well. A change to capitalize improvements typically will result in an unfavorable Sec. 481(a) adjustment that should be computed without regard to the statute of limitation.
- Change to apply the routine maintenance safe harbor (automatic method change number 171). Changes to use this favorable method are made with a Sec. 481(a) adjustment. The routine maintenance safe harbor and, therefore, this method change do not currently apply to buildings or structural components of buildings (or building systems), but as noted above, favorable changes are expected with respect to this rule. Nonetheless, taxpayers may want to make this change to begin taking advantage of this rule, the change to which likely should result in a favorable Sec. 481(a) adjustment.
Rev. Proc. 2012-20 Method Changes
The six method changes covered by Rev. Proc. 2012-20 focus on complying with the MACRS property disposition rules and the GAA provisions in the temporary regulations. Below are highlights of the two most common of those method changes:
- Change in method of accounting for dispositions of buildings or structural components of buildings (automatic method change number 177). This method change allows a taxpayer to change its method of identifying buildings or structural components of buildings for purposes of claiming a loss on disposition but does not apply to property that is not depreciated under Sec. 168, to property for which the taxpayer made a valid GAA election, or for any multiple buildings, condominium units, or cooperative units that are treated (or will be treated) as a single building. This change is made with a Sec. 481(a) adjustment. For example, in the case of a building owned as of Jan. 1, 2012, a taxpayer’s Sec. 481(a) adjustment resulting from a change from depreciating a previously disposed structural component of a building to recognizing loss upon disposition would permit the taxpayer to recover its entire basis in such structural component even if the year of disposition is closed under the statute of limitation.
Taxpayers that own buildings should consider making this method change. As a further example, if a taxpayer owns a building, replaced the roof on the building, and capitalized the costs of the replacement roof—such that the taxpayer presently depreciates both the original and replacement roofs—the taxpayer may change its method of accounting to claim a loss on the retirement of the old roof, where the amount of the loss is equal to the adjusted basis of the roof at the time of the retirement. Because the temporary regulations currently require the retirement to be recognized, many taxpayers that own buildings will likely need to make this method change to comply with the temporary regulations. Importantly, making this change for dispositions will require taxpayers to assess whether previously deducted amounts must be capitalized under the restoration rules of the temporary regulation improvement standards. Taxpayers making a late GAA election for one or more buildings should consider making a qualified disposition change as part of the late GAA election, as discussed below.
- Change to make late GAA and/or qualifying disposition elections (automatic method change number 180). This change applies to a taxpayer making a late GAA election, a late election to recognize gain or loss upon the disposition of all of the assets or the last asset in the GAA, or, for an item for which the taxpayer made a valid GAA election, a late election to recognize gain or loss upon the disposition of that item in a qualifying disposition. The respective changes are made with a Sec. 481(a) adjustment if the taxpayer does not own the property as of the first day of the year of change, and on a modified cut-off method if the taxpayer owns the property on the first day of the year of change.
Taxpayers should carefully consider making late GAA elections under this provision. As discussed above, making such election provides a taxpayer with flexibility in determining whether to claim a loss on disposition or a repair deduction (if available). A late GAA election currently can only be made for a taxpayer’s first or second tax year beginning after Dec. 31, 2011. As a result, taxpayers should take time now to decide whether to make the late election, as after the prescribed period only prospective elections will be permitted, while keeping in mind that this is another area of the regulations likely to change.
Taxpayers may include on a single Form 3115 both a late GAA election and a late election to recognize gain or loss on the qualifying disposition of an item. For example, assume a taxpayer placed a building in service in 2000. Further assume the taxpayer replaced the building roof in 2009 but did not claim a loss on the retirement of the old roof, so presently depreciates the original roof and the replacement roof. Finally, assume that costs of replacing the roof would be capitalized under the restoration improvement standard. Under this method change provision, the taxpayer may make a late GAA election for the building and also make a late election to treat the roof as a single item that was disposed of in a qualifying disposition (and claim the loss on such disposition equal to the adjusted basis of the original roof as of the first day of the tax year for which the change is effective) as part of a single method change request.
The delay of the effective date of the final regulations provides welcome relief for taxpayers struggling to implement the temporary regulations. Additionally, the ability to apply the temporary regulations for tax years beginning on or after Jan. 1, 2012, and the continued availability of the automatic method change procedures provide taxpayers with an opportunity to determine which aspects of the temporary regulations to adopt, depending on their circumstances and tax planning goals (e.g., planning to mitigate the scheduled 2013 increase in individual tax rates or seeking to utilize or increase a net operating loss). In assessing whether to early adopt the temporary regulations, taxpayers should also take into account the likelihood that certain provisions in the temporary regulations will be revised when final regulations are issued.
Early adoption of the temporary regulations (and ultimate compliance with the final regulations) will likely require considerable effort on the part of taxpayers. Taxpayers will need to understand their present book and tax capitalization policies and identify the differences between the two, and to what extent the present tax capitalization policies differ from the temporary regulations. Taxpayers whose present accounting methods differ from those required by the temporary regulations may need to file multiple accounting method changes based on the current procedural guidance.
As indicated by Notice 2012-73, the government anticipates publishing the final regulations during 2013. As part of finalizing the regulations, the government is reviewing and considering the comments received to date from taxpayers and practitioners. Although some of the new rules provided by the temporary regulations will likely be favorably revised (e.g., revisions to de minimis rule to make it less administratively burdensome or relief for small businesses), it is reasonable to anticipate that the final regulations will not change the basic framework of the temporary regulations. The government has indicated a willingness to simplify the method change procedures, so, as previously noted, taxpayers should look for revised procedural guidance to be issued when the final regulations are released.
5 Incidental materials and supplies are those for which a record of consumption is not maintained and physical inventory is not taken. Conversely, nonincidental materials and supplies are those for which a record of consumption is maintained or a physical inventory is kept (Temp. Regs. Sec. 1.162-3T). Otherwise deductible supplies may still be capitalized under Sec. 263A.
6 For this purpose, a unit of property is determined under Temp. Regs. Sec. 1.263(a)-3T(e).
7 Economic useful life generally is the period over which the property is reasonably expected to be useful to the taxpayer in its trade or business or for the production of income, as applicable (Temp. Regs. Sec. 1.162-3T(c)(3)(i)). However, if a taxpayer has an applicable financial statement (i.e., a financial statement with the highest priority of the following (listed in descending priority): a financial statement required to be filed with the SEC (the 10-K or annual statement to shareholders); a certified audited financial statement that is accompanied by the report of an independent CPA (or similarly qualified independent professional in the case of a foreign entity) that is used for credit purposes, reports to owners, or another substantial nontax purpose; or a financial statement (other than a tax return) required to be provided to the federal or a state government or an agency thereof (other than the SEC or IRS)), the economic useful life is the useful life initially used by the taxpayer in determining depreciation in its applicable financial statement (Temp. Regs. Sec. 1.162-3T(c)(3)(ii)).
8 Published guidance is guidance published in the Federal Register or in the Internal Revenue Bulletin. See, e.g., Rev. Proc. 2002-12, 2002-1 C.B. 374 (generally permitting restaurants to treat smallwares as materials and supplies), and Rev. Proc. 2002-28, 2002-1 C.B. 815 (generally permitting qualifying small business taxpayers to treat certain otherwise inventoriable items as materials and supplies).
9 Temp. Regs. Sec. 1.162-3T(d).
10 Temp. Regs. Sec. 1.162-3T(f).
11 Temp. Reg. Secs. 1.162-3T(a)(3), 1.162-3T(c)(2), 1.162-3T(d) and 1.162-3T(e).
12 Temp. Regs. Sec. 1.263(a)-2T. In general, an amount is paid to facilitate the acquisition or production of tangible property if it is paid in the process of investigating or otherwise pursuing the acquisition or production (Temp. Regs. Sec. 1.263(a)-2T(f)(2)).
13 Temp. Regs. Sec. 1.263(a)-2T(f)(2)(iv).
14 Temp. Regs. Sec. 1.263(a)-2T(f)(2)(iii).
15 See footnote 7 above for a definition of applicable financial statement. See also Temp. Regs. Sec. 1.263(a)-2T(g).
16 Temp. Regs. Sec. 1.263(a)-2T(g).
17 Temp. Regs. Sec. 1.263(a)-2T(g)(4).
18 Taxpayers should be aware that in Notice 2012-73, the government indicated that the de minimis rule is one area of the temporary regulations is likely to be revised in the final regulations.
19 Temp. Regs. Sec. 1.263(a)-3T(e). Note that the definition of a unit of property provided under Temp. Regs. Sec. 1.263(a)-3T is applicable only for purposes of Temp. Regs. Secs. 1.263(a)-1T, -2T, -3T, and 1.162-3T.
20 Temp. Regs. Sec. 1.263(a)-3T(h).
21 Temp. Regs. Sec. 1.263(a)-3T(i).
22 Temp. Regs. Sec. 1.263(a)-3T(j).
23 Temp. Regs. Sec. 1.263(a)-3T(g). The routine maintenance safe harbor is a provision the government anticipates favorably revising in the final regulations.
24 Temp. Regs. Sec. 1.263(a)-3T(k).
25 Temp. Regs. Sec. 1.263(a)-3T(f)(3).
26 The plan of rehabilitation doctrine is a court-created doctrine that has caused a lot of controversy over the years due to its being interpreted in many different ways. When applicable or imposed, it required the capitalization of otherwise deductible repair and maintenance costs if such costs were incurred as part of an overall plan of rehabilitation to the property. See Moss, 831 F.2d 833 (9th Cir. 1987); Wehrli, 400 F.2d 686 (10th Cir. 1968); Norwest Corp., 108 T.C. 265 (1997).
27 Temp. Regs. Sec. 1.263(a)-3T(d).
28 Temp. Regs. Sec. 1.263(a)-3T(f)(4). Whether amounts are related to the same improvement depends on the facts and circumstances of the activities being performed and whether the costs are incurred by reason of or directly benefit a single improvement (id.).
29 Temp. Regs. Sec. 1.168(i)-8T.
30 See Temp. Regs. Sec. 1.168(i)-1T. In Notice 2012-73, the government indicated that the final regulations likely will favorably revise the rules applicable to dispositions. The disposition rules, especially those involving making general asset account and qualifying disposition elections, have been widely criticized as overly complicated by taxpayers and practitioners.
31 Sec. 446(e).
32 Rev. Proc. 2011-14, 2011-1 C.B. 330.
33 Rev. Proc. 2011-14, §5.04. The recognition of a positive Sec. 481(a) adjustment may be accelerated if the taxpayer ceases to engage in the trade or business to which the Sec. 481(a) relates (Rev. Proc. 2011-14, §5.04(3)(c)).
34 Rev. Proc. 2011-14, §4.02. For special rules for taxpayers that have engaged in a Sec. 381(a) transaction during the tax year of change, see Rev. Proc. 2012-39, 2012-41 I.R.B. 470.
35 Rev. Proc. 2011-14, §6.03(2).
36 Rev. Proc. 2011-14, §6.03(3).
37 Rev. Proc. 2011-14, §3.09. A taxpayer’s method of accounting is an issue under consideration if the taxpayer receives written notice (e.g., in the examination plan, an information document request (IDR), or notice of proposed adjustments or income tax examination changes) from the examining agent citing the treatment of the item as an issue under consideration.
38 Rev. Proc. 2011-14, §6.03(4).
39 Rev. Proc. 2011-14, §6.03(6). An issue is pending for a tax year if the IRS has provided written notice to the taxpayer indicating an adjustment is being made or will be proposed with respect to the taxpayer’s accounting method.
40 See, e.g., Rev. Proc. 2011-14, §§3.09(4) and 5.06.
41 This method change is currently available only for a taxpayer’s first or second tax year beginning after Dec. 31, 2011 (Rev. Proc. 2011-14, Appendix §6.32(2), as modified by Rev. Proc. 2012-20).
42 Rev. Proc. 2011-14 as modified by Rev. Proc. 2012-20.
43 The scope limitation waiver does not affect the lack of audit protection for a taxpayer making a change for an issue pending. Importantly, the Large Business and International (LB&I) Division issued a directive (LB&I-4-0312-004 (3/15/12)) that applies to exam activity relating to positions taken on original returns relating to the following issues: (1) whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Sec. 263(a); and (2) any correlative issues involving the disposition of structural components of a building or dispositions of tangible depreciable assets. The directive does not apply to costs for which the IRS issues separate specific guidance, such as Rev. Proc. 2011-43, 2011-37 I.R.B. 326. The directive generally instructs examining agents to suspend examinations of the issues covered by the directive for pre-2012 tax returns. This means that if the issues covered by the directive were issues pending for a taxpayer, the suspension of the examination of such issues should remove them as issues pending. As a result, changes made under Rev. Procs. 2012-19 and 2012-20 for items with such issues should receive prior-year audit protection under the normal method change procedural guidance.
44 See e.g., Rev. Proc. 2011-14, Appendix §§11.01 and 11.02.
45 Advance consent method changes are currently made in accordance with the procedures set forth in Rev. Proc. 97-27, 1997-1 C.B. 680 (or its successor), and generally require the Form 3115 be filed by the last day of the tax year for which the change is to be effective and requires a user fee, which is currently $7,000 for a single entity request.
46 As noted above, requiring a Sec. 481(a) adjustment will effectively treat a taxpayer, where applicable, as if it had always been using the new methods established as of the beginning of its first tax year beginning on or after Jan. 1, 2012 if the method change is made for such year, so that no items are omitted or duplicated.
47 Rev. Proc. 2011-42, 2011-2 C.B. 318.
48 A taxpayer may use statistical sampling in computing the Sec. 481(a) adjustment and annual amounts under accounting methods not specifically stated in the revenue procedures; however, the use and methodology of statistical sampling in such cases would be subject to review at examination.
49 See Rev. Proc. 2011-14, Appendix §6.20, for the method change to capitalize and depreciate rotable spare parts.
50 See Temp. Regs. Sec. 1.263(a)-2T(f)(iii)(B).
Jane Rohrs is a director with the Washington National Tax group of Deloitte Tax LLP in Washington, D.C. Natalie Tucker is a director with the Washington National Tax Group of McGladrey LLP in Washington, D.C. They are co-chairs of the AICPA Repair Regulations Task Force.