New IRS Audit Guide for Capitalization Under the 'Repair Audit... · New IRS Audit Guide for...

New IRS Audit Guide for Capitalization Under the 'Repair Regs'

Eric P. Wallace, CPA

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Program Topics

• The main communications, points, procedures made to and mandated by the IRS in the new ATG

• Interpretation of the ATG as well as his practice notes and cautionary tips based on his review

• Where the IRS made mistakes or did not fully explain the instructions or examples

• The procedures, data, documents and analysis tax preparers must have ready for IRS audits on the TPRs


Eric Wallace, CPA

• Eric has extensive expertise in construction and real estate services, tangible property regulations (263(a)), depreciation, NOL, and 263(A) issues.

• Focuses on providing tax, accounting, auditing and consulting services.

• Provides specialized professional services, consulting, writing , and training to CPA firms, CPA organizations, publishing companies.

• Frequent speaker for AICPA and CCH Webinar Series including Tangible Property Regulations.


Introduction

As the TPRs are not an easy read nor ones that can be grasped by mere mortal tax preparers, the ATG seems to clearly be an effort by the IRS to educate its agents on this tough subject, provide information on implementation and applicability, to offer insight on procedures, and mandate audit techniques available to insure compliance.


Audit Technique Guide (ATG) Organization

1. Examination of tangible property

2. Compliance considerations

3. Unit of property

4. Amounts paid to acquire or produce property

5. De minimis safe harbor

6. Improvement rules – betterments

7. Improvement rules – restorations

8. Improvement rules – new or different use

9. Safe harbors – special rules – other provisions


Audit Technique Guide (ATG) Organization

10.Materials and supplies

11.Leased property

12.Disposition concepts and MACRS accounting rules

13.Dispositions in general

14.MACRS disposition rules

15.General asset account (GAA) rules

16.Accounting method changes

17.Accounting method changes – capitalization

18.Accounting method changes – depreciation and dispositions


Examination of Tangible Property – Chapter 1

• EPW Comment: The purpose of the IRS ATG is stated in its opening salvo – for IRS examiners to use as a tool for identifying potential tax issues, assess risk, apply the law to the facts and circumstances for issue involving capitalization and dispositions of tangible property.

• It is interesting to note that the following key terms were used here (1) law, (2) facts and circumstances, (3) capitalization and (4) dispositions.

• The TPRs are the law that is the subject of this ATG.

• Facts and circumstances of each situation is key.

• Note that in the ATG title the IRS employed the word “capitalization” and did not mention instead “repairs and maintenance.” Ending with the word “disposition” the IRS elevated this concept to be one that their agents should focus on.


TPR Terms and Definitions

• The IRS presents the following section titled “general terminology.” These are restatements of the TPR concepts, terms, definitions.



• Ameliorates Material Condition or Defect

• Applicable Financial Statements (AFS)

• Betterments

• De Minimis

• Functionally Independent

• Major Component/Substantial Structural Part

• Like-New Condition

• Materials and Supplies



• New or Different Use

• Costs Incurred during an Improvement

• Removal Costs

• Refreshing/Remodeling Property

• Repairs

• Restorations

• Rotable Spare Parts

• Routine Maintenance



• Unit of Property (Building)

Building Structure

Building Systems

• Unit of Property (Other than Buildings)

Plant Property

Network Assets

• Unit of Property (Lessee)

Leased Building

Leased Property other than Buildings


Examination Procedures—Chapter 1

• Comment: All but the last two chapters in the IRS ATG have specific steps or procedures that the IRS examiners should employ regarding the audit of the taxpayer’s compliance with the TPRs.

• Just listing the IRS audit procedures only takes up 32 pages in a Word document, after the elimination of the repeated or duplicate procedures!


Specific Instructions for IRS Agents

There are specific instructions, orders, procedures, stated in this chapter directed to its agents from which all taxpayers can learn from:

a) As the TPR regulations were developed over 10 years in various IRS releases, many taxpayers who changed their methods to match those earlier releases, are using methods that are inconsistent with the final TPRs.

b) Taxpayers were required to correct any prior methods that do not comply with the final TPRs on or after January 1, 2014.

c) The burden of proof rests with the taxpayer.

d) Sufficient contemporaneous records are required.


Compliance Considerations—Chapter 2

• The IRS advises its agents to address

1. Whether the taxpayer filed its TPR method changes, and

2. The timing of those accounting method changes to comply with the final TPRs.

1. The IRS does not communicate this issue to its auditors as one of a taxpayer choice whether to implement, only one of a choice of when to implement.



• In all cases (unless the taxpayer is a small taxpayer), this will require filing Form(s) 3115 to change their methods of accounting for costs addressed under the final regulations.

• Note compliance is not a choice - Filing Form 3115 method changes is a requirement. Taxpayers should have complied by “no later than their first tax year beginning on or after January 1, 2014.”

• Certain “qualifying small business taxpayers” could have implemented the TPRs, however, by instead complying with Rev. Proc. 2015-20 (i.e. those under the $10M thresholds)



• Advisory Note: Small taxpayers and qualified small business taxpayer terms are used interchangeably. These are taxpayers that have either $10M or less in tax assets or tax revenues over the past three tax years. The IRS released Rev. Proc. 2015-20 in February of 2015 to enable these small taxpayers to be able to unilaterally adopt the TPRs without filing Form 3115s.

• While this alternative seems attractive, a taxpayer that follows or followed the rules of this Rev. Proc. 2015-20 gives up two very valuable rights (1) audit protection for the prior year transactions, and (2) the opportunity to deduct prior year expenditures that when viewed under the RABI rules of the TPRs, compared to the proper unit of property, never should have been capitalized.


Prior Year Capitalization to Repair Studies

• Comments: The IRS does not focus on current year capitalization to repair studies, or those studies that are related to employment of the final TPR rules, which is a good thing.

• The IRS instead focuses on studies that were done during tax years 2006 to 2012.

• If a taxpayer filed method changes related to capitalization to repair studies for those tax years and did not subsequently file modifications or updates to those studies in tax years 2013 or later, the IRS will undoubtedly challenge those prior studies.


Prior Year Capitalization to Repair Studies—Caution

• “While “capitalization to repair” studies employing the final TPRs is a very valuable and required work effort for most taxpayers (see exception above for qualified small taxpayers) there are a significant number of taxpayers that did such studies inappropriately.”

• “Those improper studies are ones done in prior tax years based on the proposed or temporary regulations. Any improper “capitalization to repair” studies that were done must be redone and corrected employing the final TPR rules.”

• EPW: Any method changes filed for tax years 2006 through 2012 must be redone.


Prior IRS Examination Work • The IRS ATG also advises its agents to consider “prior

examination work”, whether such exam work was completed, what the resolution of any capitalization issues was, and to review prior examination work papers.

• EPW Caution: The IRS does not advise its agents and it is not clear, however, what to do with any prior IRS examination work related to capitalization verses repair determinations.

• Theoretically, the final TPRs supersede any and all prior rules, including any IRS examinations or conclusions on expenditures related to tangible property.

• EPW: The TPR scrubbing of prior year depreciation schedules should include assets that were adjusted as a result of any prior IRS audits.


Coordination with other Code Sections

• The TPRs do not change the treatment of any amount that is specifically provided for under any provision of the Code or Regulations other than §162(a) or §212. This has always been true and continues to be true under the final TPRs.

• Note: Two Code sections—263A and 280B—desire special notation in regards to their relationship to the TPRs.


Basis Adjustments

• “Employment of the TPRs often results in the deduction of the net remaining basis of prior year capitalized expenditures.”

• “Taxpayers should assure that it must match any prior year 179 or 168(k) (bonus rules) taken into account, any casualty rules and basis adjustments to be assured that its 481(a) calculations were done correctly.”

• Comment: The ATG requires the IRS agent to check on those calculations. Determining prior year 179 or bonus amounts taken, let alone the other potential basis adjustments, is not an easy task. Tax preparers need to keep all of the prior year depreciation rules in mind


§199 Domestic Production Deduction (DPAD)

• “Where the 481(a) adjustment is negative and related to QPAI, it must be taken into account 100% in the year of the method change.”

• “Where the 481(a) adjustment is positive, however, it must be taken into account for QPAI when it is taken into account according to the rules of taxable income inclusion.”



Identify potential audit issues

• Determine if the taxpayer filed TPR Form(s) 3115 and for what tax years and under what Rev. Proc. (i.e., the final or temporary or proposed).

• If 3115s not filed, determine if the taxpayer adopted a new/different method of accounting for assets acquired or produced, UOPs, improved assets, repairs, dispositions, or for materials or supplies for amounts paid or incurred in the year(s) under examination.

• Check Schedule M on the tax return and look for any book/tax differences for fixed assets, depreciation, and material and supplies.


Assess Audit Risk

• 481(a) adjustments:

Proper combination or netting?

• Capitalization to Repair Study done:

When, which tax years

What entities included in study

Population of assets included

Identify the UOP as defined by the taxpayer


Assess Audit Risk

Identify the method used to reclassify costs:

• Used a database search

• Reviewed project folders

• Interviewed employees with knowledge of assets

Sampling employed?

• How was population determined or other?

• Review the 3115s filed to identify each of the method changes. Done under the final TPRs?


Determine Audit Scope and Exam Timeline

• Identify types of assets:

For all taxpayers address buildings and their components; land improvements; DMSH, M&S, UOP definitions, improvements, repairs, dispositions, landlord and tenant issues

Retail: any remodel/refresh issues

• Make sure basis is properly calculated with 179, bonus, etc.

• Consider all current/prior cost segregation studies and consider the propriety of the UOP determinations.


Determine Audit Scope and Exam Timeline • Consider the treatment of prior asset dispositions, including

the disposal of a component or structural component of a larger UOP.

• Consider the use of specialists early in the exam.

• Consider the impact of the §481(a) adjustment to related tax computations including:

§199 - Domestic Production Deduction QPAI;

§263A - Inventory Property;

§263A - Self Constructed Property;

Impact to the AMT or ACE computation;

Any change to the adjusted basis of the property


Unit of Property (UOP)—Chapter 3

Comment: While not a new concept, the ATG advised the IRS agents that the unit of property rules are new to §1.263(a).

• “In the past, the regulations did not define “property” for purposes of determining whether an amount paid adds value to the property, prolongs the useful life of the property, or adapts the property to a new or different use.”

• “Determining whether there is an improvement to property is a two-step process.

First, the UOP is established.

Second, the facts and circumstances are considered to determine whether the work constitutes an improvement to that UOP.”


ATG Statements about UOP Rules

• The examiner must consider certain building systems separate from the building structure in determining whether an improvement has occurred to the building.

• The size of the property is not determinative for the UOP.

For example, a building can be very small, (e.g. a tool shed, or very large, as in a fifty-story building).

• No matter the size, each building and its structural components are a single UOP.


ATG Statements about UOP Rules

• Special rules for UOP exist under the TPRs for:

Buildings

Plant or network property, and

• Improvements to property


Lease Buildings

• Where a lessee has made improvements to leased building property that are capitalized under the final regulations, for purposes of applying the improvement rules to the leased property in future taxable years, the lessee’s property generally includes these previous lessee improvements.

• EPW Comment: Regarding the UOP for tenant improvements the ATG uses the words “generally include … previous lessee improvements.” The TPRs do not include the word “generally” but state simply that they “include previous lessee improvements. Note that the TPR do not state that the lessee UOP does not include previous lessor improvements, but it must.


Property other than Buildings

• The ATG advises IRS examiners that the UOP used for applying the final regulations is not necessarily the same as the “asset” used for depreciation purposes.


Cost Segregation Studies: ATG Key Points

• Taxpayers have used cost segregation studies to determine what constitutes §1245 (personal) or §1250 (real) property for many years.

• With the issuance of the final regulations, the demand for cost segregation studies is on the rise.

• taxpayers … are hiring specialists with engineering expertise to determine units of property for purposes of applying the improvement rules.



• Even taxpayers that conducted these studies in the past are once again hiring specialty firms, or CPAs, to take another look at their units of property and associated costs.

• Cost segregation studies now serve additional purposes. For example, not only do these studies reclassify a building’s components into assets with shorter class lives, but they also identify building systems for purposes of applying the improvement rules.



• These studies are also used to identify functionally interdependent plant property and to determine individual components or groups of components that perform a discrete and critical function.

Based upon these statements, the ATG advises the agent:

The examiner should request and review all cost segregation (or similar) studies, past and present and may need to engage the services of an IRS engineer to determine whether the study was conducted properly.


Cost Segregation Studies: ATG Key Points Comment

EPW: The value of cost studies is elevated by the IRS, in its comments, to the TPR rules and method changes.

Tax practitioners and taxpayers would be wise to use these statements to employ cost studies as part of their TPR analysis and/or unit of property determinations, especially for plant property.


Examination Procedures – Chapter 3

Identify potential audit issues by:

• Determine if the taxpayer determined its units of property in accordance with the final regulations.

• Consider taxpayer’s line of business and whether plant property rules apply, network assets are owned, are buildings owned or leased.

Assess audit risk by:

• Determine what effect if any, have the final regulations had on the taxpayer’s definition of units of property


Examination Considerations

• Has the taxpayer changed the basis of any fixed assets in response to the UOP definition?

If so, how is the basis determined?

• Are building UOPs defined in terms of building structure and building systems?

Was a cost segregation study performed? If so, request a copy of the study and consider the need for an engineer.

Review the Cost Segregation Audit Technique Guide.


Amounts Paid to Acquire or Produce Property—Chapter 4 • The general rule that applies here is that amounts paid to

acquire or produce a unit of real or personal property include the invoice price, “transaction costs” as defined in the final TPRs, and costs for work performed before the unit of property (UOP) is placed in service by the taxpayer.


DMSH – Chapter 5

A key statement in the introduction in this ATG chapter is that the safe harbor is not a limitation on the amounts taxpayers are permitted to deduct under §162: “an otherwise deductible amount is still deductible, even if the amount exceeds the safe harbor ceilings….[if] they can prove clearly reflect income under §446.”


DMSH – Chapter 5

EPW Caution and Practice Note: The IRS reminds IRS auditors that the burden of proving that DMSH amounts in excess of the IRS TPR limitations are the taxpayer’s.

Taxpayers can best prove that their DMSH amounts in excess of the IRS dollar thresholds are reasonable by maintaining statistics

Comment: For larger taxpayers, annual statistics are ones that I calculate annually in anticipation of having the burden proof read to go.


DMSH—Caution

A concerning and incorrect statement on the DMSH in the ATG is the following:

• “A taxpayer must consistently apply the safe harbor to all amounts paid during an election year for the acquisition or improvement of tangible property, including the acquisition of materials and supplies that also meet the safe harbor requirements. A taxpayer cannot choose to apply the safe harbor to some items and not to others.”


DMSH—Comment

• The ATG is plain wrong in the above if one takes the DMSH rules literally. The IRS is either ignoring or not recalling one element in the DMSH requirements that must be met in order for the DMSH to be employable by the taxpayer—that the taxpayer must deduct the same item on its books and records. If a taxpayer does not deduct an item on its books and records it cannot deduct the item for tax.

• Therefore, a taxpayer can choose to apply the safe harbor to some items and not to others by simply not deducting the particular items it does not want to deduct for tax by not deducting the item(s) for its books and records.


Examination Procedures

Identify potential audit issues by:

• Has the taxpayer attached an election to its timely filed federal income tax return? If so, determine which entities elected the safe harbor

• Determine if the taxpayer had an AFS during the years at issue


Examination Procedures

Assess audit risk

• Review the taxpayers written accounting procedures identifying de minimis amounts for book and financial purposes.

i. Is the policy in writing?

ii. Is the policy in effect at the beginning of the tax year?

iii. Has the policy changed to comply with the final regulations or Notice 2015-82 (increasing the safe harbor limit from $500 to $2500) for non-AFS taxpayers?

iv. Has the taxpayer established a dollar threshold for expensing for book or financial purposes?

v. Has the taxpayer established an economic useful life of 12 months or less for book or financial purposes?

vi. Does the taxpayer follow the policy established for book or financial purposes?

vii. Does the policy differ for financial statement purposes? If so, determine the policy used for the financial statement with the highest priority.



• Determine that the cost of tangible property items deducted as de minimis are not also deducted under §179 and §168

• Determine that the taxpayer consistently applied the safe harbor to all amounts paid in the taxable year, including all units of tangible property acquired or produced, tangible property used to repair, maintain or improve units of tangible property, and all eligible materials or supplies.



• Determine that the taxpayer properly capitalized and depreciated, or treated as materials and supplies, amounts paid for items that do not qualify for the safe harbor.

• Ensure that the costs of property deducted under the safe harbor did not exceed the limitation of $2500 or $5000 per invoice (or per item as substantiated by invoice).



• If amounts do not qualify for the safe harbor, determine whether the amounts are deductible as repairs and maintenance under §1.162-4, or materials and supplies under §1.162-3. See chapters 6 through 10.

• If the taxpayer provides supporting documentation/proof, consider whether taxpayer’s deduction or de minimis policy for items that cost more than the safe harbor limit clearly reflects the taxpayer’s income.


Intermission

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Improvement Rules—Betterments – Chapter 6

• A UOP is improved if after the property is placed in service for a betterment to the UOP; to restore the UOP; or to adapt the UOP to a new or different use.

• These three improvement rules are comprised of 10 specific “tests” for identifying improvements.

• Each test must be considered separate and apart.

• If any one of the ten tests applies to a given set of facts and circumstances, amounts paid result in an improvement to the UOP under §263(a), unless a particular exception or safe harbor applies.


Betterment Rules—Comment

• The IRS does a good job of identifying why 263(a)(1) rule (that no deduction shall be allowed for any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate) does not apply to the TPR rules:

The betterment tests do not measure an increase in value in terms of a monetary worth.

A material increase in fair market value, insured value, residual value, property value, business enterprise value or going concern value, is not pre-requisite to any of the betterment tests.

Instead, the measure of betterment depends entirely on the nature of the expenditure and the effect the expenditure has on the UOP.


Troubling IRS ATG Instructions—Comment

The ATG does mostly a good job in just referring to the TPRs or quoting the same words written in the TPRs. It is when the ATG goes beyond the TPRs in providing its own examples or interpretations that creates issues. The following is such an example:

For example, while the replacement of a roof membrane with a comparable new roof membrane is generally not a material betterment of the building structure, the replacement of a roof membrane with a new membrane made of materials designed to materially increase the strength and efficiency of the roof should result in a betterment to the entire building structure.


Troubling IRS ATG Instructions—Comment

• Rubber membranes on a flat roof are replaced for the purpose of preventing rain water from leaking into the building, not to provide strength. I am also perplexed as to how a roof rubber membrane can provide greater roof efficiency. The TPRs are clear in their rubber membrane roof examples, that such a replacement, if it has deteriorated under the current taxpayer’s ownership is a repair. This unfortunate IRS example will cause taxpayers a hurdle to get over when it should not have.




• Consider the taxpayer’s line of business.

How frequently are buildings refreshed or remodeled?

How frequently is plant property repaired or improved?

How frequently is personal property repaired or improved?

Is the taxpayer a lessor of property?

Is the taxpayer a lessee of property?

Was plant property or equipment moved and reinstalled, and for what purposes?



Assess audit risk

• Has the taxpayer filed Form(s) 3115 to change its method of accounting for capitalization or repairs?

Consider whether the Form 3115 is the initial change or a change to “true up” or reverse any previous accounting method change(s).


Examination Considerations—Chapter 6

• Consider how the taxpayer accounts for repairs to fixed assets.

Has the definition of a repair changed in the last 10 years?

Did the taxpayer rely on the proposed regulations?

Did the taxpayer follow the definition in the final regulations?

• Is the taxpayer using the safe harbor for routine maintenance for recurring activities to keep the UOP in ordinarily efficient operating condition?

• Does the taxpayer qualify for the safe harbor for small taxpayers?



• Consider the taxpayer’s written policy for determining whether amounts paid result in an improvement or a repair.

• Does the taxpayer maintain a work order system for all capital expenditures and major repair jobs tracking all project costs?

• Ensure that the taxpayer tracks all direct and allocable indirect costs for self-constructed property.



• Review the repair and maintenance accounts for the period under exam to determine that capital additions are not included.

• Review fixed asset studies conducted by or on behalf of the taxpayer.

• Consider whether the study conforms to the final regulations UOP and improvement rules.

• Ensure that project requests, purchase orders, invoices and related documents were reviewed as part of the study.


Improvement Rules—Restorations—Chapter 7

IRS ATG statement on restoration percentages: “Appropriate considerations include the quantitative and qualitative evaluations of the replaced components in relation to the UOP. While there is no bright line test to make this determination, the regulations provide many examples to assist in the evaluation of specific fact patterns. These examples are intended to illustrate that the decision to capitalize is based on all of the facts and circumstances in each situation. The examples are not meant to provide bright-line percentages or proportions of property that result in repair or improvement to the UOP. In other words, while the quantitative analysis is important, a qualitative analysis must be considered as well.”



Comment: The IRS restoration examples provided in the TPRs do clearly provide bright line percentages or proportions of property (or building components or building systems) that would therefore not qualify as restorations. While the highest example provided for a 40% amount, another IRS example in the TPRs of 40% (example 29 where 40% of the flooring was replaced) required capitalization. As such, I use a percentage of 1/3 or less as amounts that do not meet this restoration standard.



IRS ATG on major component, significant portion: “For example, assume a TP owns a building with an HVAC system of 3 furnaces, 3 AC units, and duct work. Assume that one of the furnaces fails, but the remaining two furnaces continue to provide adequate heating to the whole building, although not quite as efficiently. Under these facts, the 3 furnaces, working together, perform the discrete and critical function of heating for the HVAC system, and are not incidental to the HVAC system. Therefore, the 3 furnaces are a major component of the HVAC system under the final regulations, and a single furnace is a part of that major component. In addition, the replacement of one of the 3 furnaces that heat the building does not comprise a significant portion of a major component (the 3 furnaces) of the HVAC system.



As a variation of these facts, assume a taxpayer owns an office building with three wings: A, B, and C. Assume that furnace 1 breaks down, and as result, wing 1 receives no heat. The taxpayer incurs costs to replace furnace 1.

Because the expenditures involve a building, the taxpayer evaluates the building systems, in this case the HVAC system, to determine whether the replacement of furnace 1 is a restoration of the building.

Under these facts, furnace 1 provides the discrete, critical and non-incidental function of heating for wing A, and is, therefore, a major component of the HVAC system.

As a result, assuming the routine maintenance safe harbor does not apply, under §263(a) the taxpayer must capitalize the costs of replacing furnace 1 as a cost of restoring the HVAC system.



Comment and Caution: The IRS ATG takes an additional step that is not found in the TPRs, i.e. that a taxpayer has to determine if portions replaced service a specific area of a building component or system. Note that none of the IRS examples in the TPRs (list provided above) took this additional step.




• Review the tax return.

Consider assets sold or otherwise disposed of on Form 4797.

Consider asset additions on Form 4562.

Consider the repairs and maintenance deduction and repair and maintenance that may have been included in the inventory calculation.

Were any assets transferred in a §1031 exchange?



• Review the repair and maintenance accounts for the period under exam to ensure that capital additions are not expensed.

• Review fixed asset studies conducted by or on behalf of the taxpayer.

• Consider whether the taxpayer computes salvage value for federal income tax purposes.


Improvement Rules—New or Different Use— Chapter 8

• When determining whether there has been an improvement that must be capitalized as an adaptation, the main consideration is whether the UOP continues to be used in the same way as it was when originally placed in service.

• EPW Comment: The above statement by the IRS is not an element provided for in the TPRs. The rule for adaption is one, and is straight forward for a building - paid to adapt the building structure or any one of its buildings systems to a new or different use.


Safe Harbors—Special Rules—Other Provisions—Chapter 9 Removal Costs

• Comment: Removal costs are an important new issue raised by the TPRs. Most removal costs were typically capitalized as indirect costs by taxpayers. Now removal costs can deducted certainly if the partial asset dispositions apply, but also in many other cases as well.

• EPW Caution: Generally, I have advised tax practitioners and taxpayers to file DCN 21 on removal cost method changes, even if they cannot specifically identify any 481(a) adjustments that may be beneficial to such a filing. By filing a DCN 21, the taxpayer protects itself from any IRS assertion that it is not able to take/deduct removal costs from lack of a filing of a method change.


Examination Considerations—Removal Costs

• How does the taxpayer define components? Are components (or groups of components) defined using the discrete and major function test?

• Has there been a disposition for tax purposes of an asset or a component?

• Has the taxpayer properly elected to treat the removal of a component as a partial disposition?

• Did the taxpayer file a Form 3115 to change its method of accounting for removal costs?


Leased Property—Chapter 11

This is an important chapter as many taxpayers either lease or lease to other real or personal property. Those taxpayers that do should read this summary carefully for issues that may affect them.

• 1245 Property must first be considered separately

• EPW: The IRS correctly starts the approach to leasehold improvement issues by stating that the taxpayer must first separate out and account for separately acquired 1245 property, in addition to any repairs and maintenance.


Lessee’s Improvements to Building Property

The IRS states that where the lessee pays amounts to improve the leased building, the taxpayer must capitalize the related amounts paid to improve the building except:

• To the extent that §110 applies to a construction allowance received by the lessee; or

• Where the improvements constitute a substitution for rent.

Comment: Note that when a tenant receives a reimbursement from the landlord for any tenant improvement paid, there is nothing to capitalize in any case, as the expenditure would net to a zero sum. Whether such reimbursement is under a 110 lease or otherwise does not matter.


Lessor’s Improvements to Building Property

• Comment: The issue related to a landlord’s expenditure for leasehold improvements is whether such expenditures meet the RABI rules under the TPRs compared to the proper UOP, as measured from the landlord perspective. All of these issues related to expenditures for leasehold improvements are moot, except for the section 110 lease expenditures, if such are considered repairs and maintenance under the RABI rules.




• Determine if the taxpayer is a lessee of buildings or personal property.

• Determine if the taxpayer is a lessor of buildings or personal property.

Assess audit risk

• Consider book treatment.

Are the leases classified as a capital leases?

Are the leases classified as operating leases?



• Consider all significant leases.

• Is the taxpayer the lessor or the lessee?

What are the terms of the lease?

Which party to the lease bears the benefits and burdens of ownership?

Establish the length of the lease, provisions for renewals, and purchase options

Determine which party has the responsibility for improvements or repairs.



• Establish the type of expenditures (i.e., maintenance, improvements), and whether it is covered by the lease.

• Identify whether the improvement relates to the leased building property or to other real or tangible personal property.

• Is a construction allowance provided by the lessor?

Was the construction allowance treated as a qualified lessee construction allowance by the lessee and the lessor under §110?

Were any improvements made in lieu of rent?


Disposition Concepts and MACRS Accounting Rules—Chapter 12

“For the first time, taxpayers may elect to dispose of part of a MACRS asset. Taxpayers will use their existing records and may also supplement their records with one of the reasonable methods described in the regulations to determine the amount of loss on a partial disposition. It is important to understand the records taxpayers should have available as well as changes to the recordkeeping requirements made by the disposition regulations.”


Disposition Concepts and MACRS Accounting Rules

The following are the key concepts communicated to the IRS auditors in this chapter

• The capitalization rules will generally take precedence, with the partial disposition election available at the taxpayer’s option. However, certain mandatory dispositions may trigger capitalization. Thus, it is important to consider both the capitalization and disposition rules for any improvement.

• The definition of a disposition for MACRS property now includes a partial disposition. In addition to certain mandatory partial dispositions, the regulations contain a voluntary partial disposition election.

• The disposition regulations do not apply to any pre-MACRS property.


Disposition Concepts and MACRS Accounting Rules

Comment: The MACRS disposition rules and just that—applicable to MACRS assets. The MACRS disposition rules cannot apply to ACRS assets (those assets placed in service 1981 to 1986.) Note, however, that the rules for assets placed in service before 1981, i.e., the §167 rules, did and continue to allow partial asset dispositions. If a taxpayer had a partial asset disposition from pre 1981 assets it should have taken such partial assets dispositions in the tax year in which the partial asset disposition previously occurred.


IRS Exam Issues Stated in the ATG

Exam should avoid focusing only on the capitalization and the depreciation aspects of MACRS property without also considering its disposition. While a 39-year recovery period for an asset might seem to have little audit potential, treating the asset as a building structural component has other implications including:

Is the replacement asset a separate asset for disposition purposes?

Did the taxpayer dispose of an asset or a portion of an asset?

If the taxpayer disposed of a portion of an asset, did the taxpayer make a partial disposition election or is the disposition a mandatory partial disposition?


Records and the IRS ATG

• MACRS property records are also a major focus in the final disposition regulations.


Accounting for Dispositions • “Note that dispositions of assets from MAAs and SAAs are

generally recognized. Dispositions of an entire asset from an MAA or SAA are always recognized. The recognition of certain limited partial dispositions is mandatory but taxpayers generally have the option to elect to recognize the disposition of part of an asset. This is an annual election that must be done on a timely filed tax return.”

• EPW: the above is not what the TPRs state: “A disposition also includes the retirement of a structural component (or a portion thereof) of a building only if the partial disposition rule applies to such structural component (or a portion thereof)”. There are 4 mandatory disposition rules, but none of those are separately stated partial assets.



Develop an understanding of the taxpayer’s historical MACRS accounting

• Determine how the taxpayer has historically handled dispositions and partial dispositions

Does the taxpayer recognize partial dispositions for book purposes?

EPW Comment: So what if the taxpayer does or does not recognize partial asset dispositions for book. That is NOT an element/requirement in the disposition TPRs. This is misleading to the uninformed IRS auditor.



• Determine if a “study” was conducted to apply the final regulations with regard to the disposition of assets.

Read the engagement letter to determine the extent of the study.

Read the study, presentation materials, and correspondence to evaluate the depth, accuracy, and methodology of the study.

Determine if any basis adjustments resulting from the disposition study was recorded in the taxpayer’s records on an asset-by-asset basis


Dispositions in General—Chapter 13

• Definition of a Disposition

• Disposition of Leasehold Improvements

Section 168(i)(8)(B), allows a lessor to recognize gain or loss upon the disposition of certain leasehold improvements at the termination of the lease instead of when the entire building is disposed of.

• EPW Comment: Notice the key word “allows”. Disposition of prior leasehold improvements recognition is not mandatory. Capitalization of the replaced leasehold improvements is mandatory if the prior leasehold improvements are written off.

• Taxpayers must be careful when considering to deduct tenant improvements on lease termination.


Determination of the Disposed Asset

• Key Point in the IRS ATG

The IRS ATG states to its agent that it is important to distinguish if a disposition involves an asset or a portion of an asset. It advises its agents that the disposition of a complete asset is mandatory whereas a partial disposition is often elective.


Determination of the Disposed Asset—IRS Example

Consider an example of a building where the taxpayer replaces the roof in year three and capitalizes the replacement roof as an improvement. Since the original roof was part of the original building asset, the retirement of the old roof would be the disposition of a portion of an asset. After the disposition of the roof, the taxpayer would have two assets related to the building, the original building and original structural components (less the original roof) and the replacement roof. If the taxpayer replaced the roof again in year 15, the taxpayer would recognize a disposition of an asset (the year 3 replacement roof) versus a portion of an asset. Since the replacement roof is an entire asset, the disposition would be mandatory.


Determination of the Disposed Asset—IRS Example

• Comment: Restated, this phase means that while a partial asset disposition is optional, a separately stated partial asset disposition is not optional? A prior year partial asset that was disposed of cannot be corrected with a method change. A prior year separately stated partial asset disposition can, however, be corrected with a DCN 205 or 206 method filing. A prior year whole unit of property that was abandoned or disposed of must be accounted for in the year of disposition. If such property is not, there is no IRS automatic method that can correct the situation years afterwards.


MACRS Dispositions Rules—Chapter 14

Comment: None of the following sections in this chapter of the IRS ATG has any surprises. These sections repeat the words of the TPRs and fortunately no new “creativity” is injected by the ATG:


General Asset Account (GAA) Rules—Chapter 15

Election of a GAA

• GAA is available to simplify the accounting for taxpayers who own large numbers of assets of relatively small value in comparison to the entire group. A taxpayer may make a GAA election by checking the applicable box on Form 4562 of its tax return by the due date (including extensions) of the return for the year the MACRS property is placed in service. The §1.168(i)-1 GAA regulations must be followed by the taxpayer in computing its taxable income for the election year and all subsequent tax years.


General Asset Account (GAA) Rules—Chapter 15

Comment: The IRS ATG does not address the opportunity that a GAA offers for a building put into a GAA when the taxpayer demolishes the building and the taxpayer elects not to terminate the GAA. to demolish a building that is in a GAA and instead continues to depreciate the building.


• Not presented in this webinar


Accounting Method Change—Chapter 16

Methods of Accounting – In General

EPW Comment: This section states a summary of the general rules about method changes with no noted errors or areas of concern. An important comment, however, is the following: “Most of the method changes made to comply with the final tangible property regulations are automatic changes, and are included in the list of automatic changes in Rev. Proc. 2015-14 or Rev. Proc. 2016-29.”

This statement leads one to conclude that there must be then, non-automatic methods that a taxpayer could file in order to implement the TPRs. There is no “list” of non-automatic method changes.


Form 3115 Filed Prior to August 27, 2009

• EPW Comment: A taxpayer who employed such a filing should have revisited that method change to see what changes were demanded/required by the final TPRs. It is almost guaranteed that a taxpayer who filed a method change to reflect the proposed TPRs in such a prior year method change filings will get a visit from the IRS to audit to see if those taxpayers brought that filing into current and proper compliance under the final TPRs.


Forms 3115 for Tax Years on or after January 1, 2012 and before January 1, 2014 under Temporary Regs

EPW Comment: Any method changes that were filed for either tax year 2012 or 2013 (which is before the final TPRs were issued in late September 2013) are most likely valid with no required changes to match the final TPRs, except for the MACRS disposition rules. The temporary rules allowed for partial asset dispositions, but those were calculated under the CPI rollback method and not under the PPI rollback method.


3115s for Tax Years on or after January 1, 2012 and before January 1, 2014 under Proposed Disposition and Final Regulations

EPW Comment: These method changes should also be final and not require any correcting changes, other than the potential use of the CPI rollback method for partial asset dispositions filed under the proposed regulations. See description above for correcting method filing.


Taxable Years Ending on or after September 30, 2015

EPW Comment: For this time period, the ATG discusses the issuance of the Rev. Proc. 2016-29 that updated automatic method changes in the replacement of Rev. Proc. 2015-14. The significant change from this issuance was the extension of the waiver of the eligibility rules for automatic method changes.



• Was the §481(a) amount properly computed?

• A taxpayer is required to attach Forms 3115, filed under the automatic change procedures, to the tax return for the year of change.

The tax return should be reviewed to determine whether the taxpayer filed a Form 3115 to change its method of accounting pursuant to a specific revenue procedure to comply with the regulations.

The examiner should take additional steps to confirm whether a Form 3115 was filed.

Each §481(a) adjustment should be risk-assessed and included as an examination item where appropriate.


Initial Interview

“During the initial interview, the examiner should ask the taxpayer whether it has filed any Forms 3115 with respect to items addressed in the final regulations and/or the final depreciation and disposition regulations for the year(s) under examination as well as prior and subsequent years.

For prior years, this could include method changes for “capital to repair” (including DCN 144), materials and supplies, or other items addressed in the final regulations.”


Information and Documentation

• “The examiner should request information and documentation for voluntary method changes made under the non-automatic and automatic change procedures in Rev. Proc. 2015-13 and Rev. Proc. 2015-14 or Rev. Proc. 2016-29, as applicable, and under prior accounting method change revenue procedures.

• This is particularly important with respect to capital-to-repair changes since both types of consent procedures have applied to such changes and/or the changes may affect a current-year change.”



• “Information for each current year change, and each entity requesting the change, should include, but is not limited to the following:

Copies of all Forms 3115 filed under non-automatic change procedures (see Sections 3.10 and 3.11 of Rev. Proc. 2015-13) relating to the current change

Correspondence between the taxpayer and National Office relating to the method change

Copies of all Forms 3115 filed under automatic change procedures (see Rev. Proc. 2015-13 and Rev. Proc. 2015-14 or Rev. Proc. 2016-29, as applicable) relating to the current change

Any information that may have been missing or omitted from any filed Forms 3115”



• “To determine the correctness of the §481(a) adjustment, the examiner should secure detailed work papers and/or schedules showing the computation of the §481(a) adjustment, which should address the following:

How was the §481(a) computed?

Did the taxpayer take into account, or true up, all prior method change §481(a) amounts?

Did the taxpayer take into account amounts from all years using the prior method (i.e., years between the prior year of change and the current year of change)?”



“Where is the §481(a) amount included on the tax return (e.g., line 26, Schedule M, etc.)?

What is the amount of the §481(a) adjustment?

How is the §481(a) adjustment taken into account (i.e., what is the spread, if any)?

Have all adjustments (e.g., depreciation, bonus depreciation, those relating to dispositions) necessary to prevent items from being duplicated or omitted been taken into account?”


Accounting Method Changes—Capitalization—Chapter 17

EPW Comment: In this chapter the IRS addresses method change numbers 184 to 193. This chapter does not address any depreciation nor asset disposition changes. Those other issues are addressed in the IRS ATG chapter 18.

Also, note that this and the final chapter 18 does not have any IRS examination procedures listed at the end of the chapter, as the IRS has done for every other chapter in the ATG. Presumably the IRS examination procedures at the end of chapter 16 also covered the method change procedures of chapters 17 and 18.


Accounting Method Changes—Capitalization

• Accounting Method Change Procedures

• Scope Limitations and the “5-year rule”

• Accounting Method Change v. Election

• Changes under 263A

• Multiple Concurrent Changes under the Final Regulations

• Reduced Filing Requirements for Small Taxpayers

• Small Business Taxpayer Relief

• Section 481(a) Adjustment

• Statistical Sampling


Audit Protection

EPW Comment: Audit protection is an important issue and one of the main reasons that most taxpayers should file TPR method changes. The ATG supports this with the statement that: “a taxpayer that timely and properly files a Form 3115 to change to a method of accounting under the final regulations pursuant to section 10.11 of Rev. Proc. 2015-14 or 11.08 of Rev. Proc. 2016-29 receives audit protection for that item for taxable years prior to the year of change.”

Note that while taxpayers receive audit protection, their TPR method change filing and its related 481(a) adjustments are subject to audit if the IRS chooses to audit the taxpayer for the year of filing the 3115.


Specific Method Changes to Comply with the Final Capitalization Regulations (TPRs) In this section the ATG provides a brief summary of each of the TPR method changes. The key statements in the comment TPR methods are listed below.

• Repairs and Maintenance (DCN 184)

“DCN 184 requires a full §481(a) adjustment. That is, the §481(a) calculation may reach into prior taxable years.”

• Comment: Tax preparers and even IRS agents are confused on this very important point. They mistakenly believe the statement in the regulations that the TPRs are applicable for taxable years beginning after January 1, 2012 means that the 481(a) adjustments cannot go back beyond that date. This statement in the ATG should resolve that issue should an IRS auditor assert such a statement to your taxpayer.


Specific Method Changes to Comply with the Final Capitalization Regulations (TPRs)

If a taxpayer files a 3115 to comply with the final regulations, and did not file a prior change for repairs, the change will generally result in a negative, or taxpayer-favorable, §481(a) adjustment.

• EPW Comment: The above statement is also great evidence for the many taxpayers that will undoubtedly undergo IRS audits on their TPR filings. Noting that most method changes under DCN 184 will have negative 481(a) adjustments is very helpful to taxpayer’s audit issues


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