We addressed earlier about the extensive IRS regulations that (1) address whether expenses incurred in connection with tangible property are immediately deducted or, instead, must be capitalized and (2) provide for the tax consequences of disposing of tangible depreciable property.
As you also may know, these regulations, referred to below as the “repair regs” (and also commonly referred to as the capitalization regs or the tangible property regs) must be complied with no later than a taxpayer’s first tax year beginning after calendar year 2013 (the 2014 year).
But, additionally, even though reporting expenditures and dispositions in compliance with the rules changed by the repair regs is mandatory, the IRS, because most of the required changes are considered to be “changes in method of accounting,” requires that taxpayers receive IRS “consent” to most of the required changes.
The consent process can be onerous, requiring, in connection with a tax return, the preparation of one or more Forms 3115 (Application for Change in Accounting Method). These forms further require calculations known as 481(a) adjustments, intended to prevent items of income or deduction from being omitted or duplicated. For example, if a calendar year taxpayer deducted in 2012, as a repair cost, a cost that, under the repair regs, must instead be capitalized as a cost of a property improvement, the taxpayer would have to begin taking depreciation deductions in the 2014 year (calculated as if the taxpayer had, in 2012, capitalized the cost and begun taking depreciation deductions for the cost). To prevent the taxpayer from getting both the benefit of the 2012 deduction of the cost and of the depreciation deductions to be taken in 2014 and later years (the post-2013 depreciation deductions), the taxpayer must make a 481(a) adjustment that is an increase, usually spread over a four-year period, of the taxpayer’s gross income by the amount of the post-2013 depreciation deductions.
The above example, the 481(a) adjustment is unfavorable to the taxpayer, but other 481(a) adjustments can be favorable—for example, adjustments required because amounts that in pre-2014 years were required to be capitalized are, instead, deducted under the repair regs. Because of the particularly large burden of the accounting method consent process as applied to changes made to comply with the repair regs, the IRS has provided optional relief to small business taxpayers. For the purpose of this relief, a small business is a business that has (1) less than $10 million in total assets or (2) for the three years preceding the accounting method change year, average annual gross receipts of less than $10 million.
Under the relief, the taxpayer, for many of the accounting method changes required by the repair regs, isn’t required to make 481(a) adjustments or file Form(s) 3115 if the taxpayer, beginning with costs paid or incurred and dispositions in the 2014 year, otherwise complies with the required changes.
Some taxpayers will choose to not avail themselves of the relief. For example, if, for a taxpayer, the sum of all of the 481(a) adjustments for changes eligible for the relief (which applies on an all-or-nothing basis) is a substantial favorable adjustment, the taxpayer is likely to make the 481(a) adjustments and file the required Form(s) 3115.
There are some negative effects of choosing to take the relief—including, but not limited to, lack of audit protection in pre-2014 years for the tax items that are subject to the relief and surrender of the right to make late loss-recognition elections in connection with certain property retirements.
Our firm will be reviewing all relevant information and looking at the advantages and disadvantages of taking the relief from the usual accounting method change consent procedures on a taxpayer by taxpayer basis.