Implementing the new tangible property regulations can be a daunting task for any tax department—large or small. The new tangible property regulations apply to all current and certain prior-year tangible assets, creating both massive compliance efforts and potentially huge opportunities for immediate and long-term tax savings.
Given the organizational effort necessary to implement the tangible property regulations, deadlines for compliance are closer than one may think. The regulations generally are effective for tax years beginning on or after Jan. 1, 2014. This means that the regulations must be implemented and the change in accounting method Form 3115, Application for Change in Accounting Method, must be filed no later than with the 2014 tax return. Additionally, the one-time retroactive election for partial dispositions of tangible assets in prior years can be made only for tax years beginning before Jan. 1, 2015. This one-time opportunity will be a large benefit to many U.S. companies.
Similarly, the new rules for determining repairs vs. improvements are another area of the tangible property regulations where many taxpayers may find a large benefit by accelerating tax deductions rather than depreciating improvements over long recovery periods. Those that do not make the retroactive election for prior-year partial dispositions or take advantage of the new repair deduction rules could be locking themselves into less advantageous tax treatment for years to come. With the clock ticking, how can all the necessary tangible property tax work get accomplished by the 2014 filing?
Sampling Is Practical
Statistical sampling and estimation is an efficient means of tackling the tangible property compliance efforts and potentially gaining some tax benefits along the way. It can be used in the short term to address the compliance efforts, but also currently and going forward for further efficiencies and tax benefits in future years.
The IRS not only accepts estimates derived from proper statistical sampling, but also in many cases the IRS suggests it—specifically in the implementation of the new tangible property regulations. Current applicable IRS revenue procedures pertaining to sampling include: Rev. Proc. 2011-42, which contains criteria for acceptance of taxpayer-conducted samples and provides safe-harbor statistical methods—subsequent revenue procedures listed below point back to this procedure for statistical methods; Rev. Proc. 2011-43, which allows estimates from current years of electric transmission and distribution property to be applied to nonsampled earlier years—one of the rare instances when the IRS allows methods from one period to be applied to a nonsampled period; Rev. Procs. 2012-19 and 2012-20, which suggest taxpayers use sampling in numerous settings; and Rev. Procs. 2014-16, 2014-17, and 2014-54, which confirm the acceptance of sampling.
In addition, the IRS Cost Segregation Audit Technique Guidelines accept and address audit considerations for taxpayer estimates based on sampling. Statistical tools may reduce the difficulties in trying to apply the tangible property regulations advantageously by making elections for 2014 tax returns and years to come. Instead of reviewing thousands or tens of thousands of assets, a well-designed sample of a few hundred assets may be all that is necessary to cover the compliance requirements and realize tax benefits.
Samples of a few dozen buildings in a portfolio of a hundred or more can be another feasible approach. The capitalized and expensed amounts found in the sampled records are used to estimate amounts for the entire company. These estimates can be made precise enough to meet IRS guidelines.
Where Sampling Is Used
Sampling typically produces efficiencies in tax settings when accountants must make facts-and-circumstance determinations on a listing of records. This occurs throughout tangible property tax work; common applications include, but are not limited to:
3. Cost segregation;
4. Materials and supplies; and
5. Reducing audit risks.
These are briefly discussed below.
Under the new regulations, costs will be moved to and from fixed-asset listings. Samples of assets from a fixed-asset download may identify additional repair expenses. Samples of repair expenses listed in general ledger accounts may identify previously expensed repairs that should now be capitalized and depreciated as improvements. Both samples may be used to estimate amounts to currently and retroactively expense as repairs or capitalize as improvements for federal tax purposes.
When a sampled asset is determined to properly remain capitalized rather than deducted as a repair, there may still be an opportunity to take a loss on the disposition of removed components. Therefore, repair samples may be dual-purpose to also identify and quantify dispositions.
Similarly, when a sampled fixed asset is determined to properly remain capitalized, this is a good opportunity to check whether it currently has the correct life or could be accelerated into a shorter depreciation period. Often with just a small amount of extra effort, a sample for the purpose of repairs can be expanded to also realize a cost-segregation tax benefit—or vice versa.
Materials and Supplies
Even modest-size companies may find there are numerous case-by-case determinations to be made regarding whether specific expenditures meet the new tax definition of materials and supplies or are now supposed to be treated as depreciable property instead. Companies may find sampling expenditures to be one of the few practical means to determine amounts to capitalize versus expense as materials and supplies.
Rotable and temporary spare parts are another potential application for sampling. Under the new tangible property regulations, a special method is adopted or an election to capitalize is made. These are required to be deducted in the year a part is disposed of. Determining when parts were disposed of could be an onerous task for some tax departments. Sampling can reduce that effort.
Reducing Audit Risks
When a taxpayer files an estimate based on a valid statistical sample, traditionally the IRS reviews the taxpayer's sample instead of drawing a completely new sample under audit.
Sampling gives taxpayers a huge advantage managing IRS audits: Savvy, risk-averse taxpayers use samples preemptively to estimate values for federal tax purposes so they know a priori which documents will come under review if audited by the IRS. The strategy allows taxpayers to prepare fully supported tax determinations on a manageable sample of cases. The documentation for a handful of sample items can be much more thorough than what is practical to accumulate for 100% of the records. Further, this documentation is gathered and vetted on the taxpayer's schedule rather than under time pressures of an IRS audit. Additionally, the taxpayer is in control of designing the sample, which provides much more flexibility than when it is left to the IRS.
Similarly, these samples for federal tax estimates are useful for considerations of FIN 48, Accounting for Uncertainty in Income Taxes (now mostly codified in FASB Accounting Standards Codification Subtopic 740-10). The well-vetted samples can provide quantifiable risks of tax positions taken. While it is too late for calendar-year taxpayers to consider for 2014, something to consider in future years or for fiscal-year taxpayers is that completion or partial completion of sampling can be timed to coordinate with quarterly provision work. With well-planned tax sampling, preliminary estimates can be made—and be accurate enough—to allow tax departments to comfortably use predicted tangible property federal tax estimates for provision work and avoid reissuing financial statements. Reserves can be determined based on highly supportable figures.
Other Applications in Tangible Property
Is sampling restricted to applications where the IRS explicitly permits it? No, there is no restriction; sampling may be more generally applied as taxpayers encounter new uses. According to Rev. Proc. 2011-42, the IRS allows sampling when there is no better probative information and the effort of completing a 100% review is burdensome. Tax departments will find these modest criteria are easily satisfied in numerous aspects of tangible property tax work.
In each example above, a listing of known values pertaining to a tax issue can be readily constructed (i.e., a fixed-asset download). But the tax issue further requires more labor-intensive facts-and-circumstance determinations to be made to quantify values needed for tax (e.g., pulling invoices, reviewing blueprints, talking to engineers, determining units of property, and deciphering the new IRS tangible property regulations).
There Is a Catch
There are two cautions in using statistical samples. First, if the sample is not accurate enough or improperly implemented, taxpayers will experience unfavorable adjustments to amounts the IRS allows them to claim. Statisticians can provide cost/benefit analyses for various sample size options and assure the sample selection and estimation techniques will meet IRS standards.
Second, going forward, the fixed-asset listing is maintained with estimated rather than actual values. There are several appropriate methods for incorporating the estimated values into the fixed-asset listing; however, that topic is beyond the scope of this item.
Despite the two drawbacks, sampling is a cost-effective means to comply with the new tangible property regulations, meet 2014 filing requirements, realize tax benefits, and reduce audit risks. The IRS accepts sampling and has incorporated it into the new tangible property revenue procedures. Sampling can ease the stress from what will otherwise be a labor-intensive effort for the upcoming 2014 tax year filings.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.