IRS Issues Guidance Regarding Transition Rules to Implement the Tangible Property Regulations

April 4, 2012

The Internal Revenue Service (IRS) and U.S. Department of Treasury issued on March 7, 2012, Revenue Procedures 2012-19 and 2012-20 providing taxpayers with additional guidance regarding implementation of the tangible property regulations. (See earlier blog post for coverage of specific changes included in the new regulations.) The Revenue Procedures allow taxpayers to file Form 3115, “Application for Change in Accounting Method,” and receive automatic consent to adopt the regulations for the first two tax years beginning after Dec. 31, 2011.

Calendar year-end taxpayers have until they file their 2013 tax returns to properly adopt the regulations under the automatic change procedures. For this two-year period, the scope limitations have been waived, allowing those taxpayers that have filed prior method changes for repair costs and those under examination the ability to file their method changes through the automatic change procedures.

Revenue Procedure 2012-19

Revenue Procedure 2012-19 covers method changes related to the treatment of 1) costs to improve or repair tangible property, 2) materials and supplies, 3) costs to acquire or produce tangible property, and 4) costs to sell tangible property.

1. Treatment of Costs to Improve or Repair and Maintain Tangible Property
The regulations stipulate that costs incurred to improve tangible property are required to be capitalized, and costs incurred to repair and maintain tangible property are currently deductible. Taxpayers implementing the regulations can change from capitalizing amounts paid or incurred for tangible property to deducting these amounts as repair and maintenance costs, or vice versa. This change also applies to taxpayers wanting to change their unit of property (UOP) definition for the purposes of determining whether amounts paid or incurred improve a UOP or should be classified as repair and maintenance expenses.

Generally, taxpayers implementing this method change will be required to compute a “catch up” (Section 481(a)) adjustment for the reclassification of costs from deductible to capitalizable, or vice versa. There are limitations on computing a Section 481(a) adjustment if the taxpayer elected to apply the repair allowance for any tax year in which the repair allowance election was made.

  • Safe Harbor for Routine Maintenance
    The regulations provide a safe harbor for routine maintenance related to tangible personal property. The safe harbor allows taxpayers to claim a deduction for more extensive maintenance if it is planned to occur two or more times over the class life of the property. The safe harbor does not apply to betterments to the UOP or buildings and their structural components. Taxpayers may change their method of accounting for amounts paid or incurred for routine maintenance performed on a UOP to the method of treating such amounts as amounts that do not improve the UOP.

    The rules regarding the Section 481(a) adjustment are consistent with the general rules described above for the method change related to improvements or repairs and maintenance costs.

  • Regulatory Accounting Method
    The regulations allow regulated taxpayers (those taxpayers subject to regulatory accounting rules of the Federal Energy Regulatory Commission or the Federal Communications Commission) to use their method of accounting for regulatory accounting purposes to determine whether an amount paid or incurred improves property. The change does not apply to, among other items, any tangible property that is not subject to regulatory accounting rules.

    The rules regarding the Section 481(a) adjustment are consistent with the general rules described above for the method change related to improvements or repairs and maintenance costs.

2. Treatment of General Materials and Supplies
The regulations provide that nonincidental supplies are capitalized until used or consumed. They also state that incidental supplies, those items that are not tracked or inventoried, are deducted when paid or incurred. Taxpayers currently treating nonincidental or incidental supplies inconsistent with the regulations may change their methods of accounting to comply with the rules and deduct such amounts in the proper tax year.

Taxpayers changing their method of accounting must calculate a Section 481(a) adjustment, but the calculation may only take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012.

  • Treatment of Nonincidental Rotable and Temporary Spare Parts
    Under the regulations, rotable and temporary spare parts are defined as parts that are acquired for installation on a UOP, removable, and repaired and reinstalled until the parts are no longer useful. These items only are deducted when the parts are physically disposed of. Taxpayers currently treating rotable or temporary spare parts inconsistent with the regulations may change to deducting those parts in the tax year in which the taxpayer disposes of the parts.

    The regulations also provide an optional method allowing taxpayers to deduct rotable and temporary spare parts when they are in use and capitalize them when not in use. Any costs not deducted while in use would be taken upon the final disposal of the parts. Taxpayers may change their methods of accounting for rotable and temporary spare parts to the optional method of accounting.

    Taxpayers changing to deduct rotable and temporary spare parts upon disposal must calculate a Section 481(a) adjustment, but the calculation would only take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012. A taxpayer changing to use the optional method of accounting for rotable and temporary spare parts would compute a Section 481(a) adjustment similar to the rules discussed above for the method change related to improvements or repairs and maintenance costs.

3. Treatment of Costs to Acquire or Produce Tangible Property
The regulations require taxpayers to capitalize costs paid or incurred to acquire or produce tangible property, such as the cost of the item and costs to facilitate the acquisition of the item. The rules provide for special treatment of employee compensation and overhead costs that allow taxpayers to deduct those costs versus having to capitalize them. In addition, certain costs to acquire real property incurred prior to the decision date to purchase the property may be deductible. Taxpayers may change their method of accounting from deducting to capitalizing amounts paid or incurred to acquire or produce property, or vice versa, in the case of employee compensation and overhead costs. The change does not apply to the treatment of startup expenses amortizable under other tax law.

Taxpayers changing to comply with the regulations regarding the treatment of costs to facilitate the acquisition of tangible property must calculate a Section 481(a) adjustment, but the calculation would only take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012.

  • Deduction for De Minimis Amounts
    The regulations establish a framework for taxpayers to currently deduct amounts paid or incurred to acquire or produce de minimis tangible property up to a ceiling amount. Generally, the regulations allow taxpayers with applicable financial statements to currently deduct de minimis costs to acquire or produce tangible property. Taxpayers must have an established written policy regarding deducting the cost of units of property below a threshold amount and follow that policy for financial reporting purposes.

    The regulations provide that if the aggregate amount deducted under that policy exceeds the greater of 1) 0.1 percent of the taxpayer's gross receipts for the tax year as determined for federal income tax purposes, or 2) 2 percent of the taxpayer's total depreciation and amortization expense for the tax year as determined in its applicable financial statement, the excess must be capitalized. A taxpayer may change its method of accounting for amounts paid or incurred to acquire or produce tangible property to the method of applying the de minimis rule. The change does not apply to, among other expenses, inventory, amounts paid for property that is or is intended to be included in inventory, amounts paid for land, and startup expenses amortizable under other tax law.

    Taxpayers changing their method of accounting to apply the de minimis rule must calculate a Section 481(a) adjustment, but the calculation would only take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012.

4. Costs Incurred to Facilitate the Sale of Property

The regulations state that commissions and other costs incurred to facilitate the sale of tangible property generally must be capitalized. Those costs are recovered as an offset to the amount received on the sale of the property. Taxpayers can change their methods of accounting for commissions and other costs paid or incurred to facilitate the sale of property to the method of capitalizing such costs. However, the change does not apply to amounts paid or incurred to facilitate the disposition of assets that constitute a trade or business.

Taxpayers changing to capitalize transaction costs must calculate a Section 481(a) adjustment, but the calculation would only take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012.

  • Dealer Expenses Facilitating a Sale
    The regulations provide that commissions and other costs incurred by a dealer to facilitate the sale of tangible property are currently deductible. A dealer may change its method of accounting for commissions and other costs paid or incurred to facilitate the sale of tangible property from capitalizing the costs to treating the costs as ordinary and necessary business expenses. However, the change does not apply to liabilities incurred to facilitate the dispositions of assets constituting a trade or business.

    The regulations state that taxpayers changing their methods of accounting from capitalizing transaction costs to expensing them must calculate a Section 481(a) adjustment as of the first day of the year of the change.

Revenue Procedure 2012-20

Revenue Procedure 2012-20 covers three areas: 1) method changes related to the disposition of tangible property, 2) the use of general asset account election, and 3) depreciation of capitalized assets.

1. Disposition of Tangible Property – Building or Structural Component
The regulations require taxpayers to dispose of structural components of a building, condominium unit, cooperative unit, or an improvement or addition thereto that were replaced in prior year. Taxpayers can change their methods from depreciating the disposed asset to recognizing gain or loss upon disposition. This applies to taxpayers that make the change for assets disposed of in a prior tax year but continue to deduct depreciation for the disposed asset under their present accounting method.

When implementing this method change, taxpayers generally will be required to compute a Section 481(a) adjustment for disposing structural components that are currently being depreciated. Taxpayers should consider coordination with the method change allowing taxpayers to use general asset accounts for buildings and their structural components. Special rules apply if a general asset account election is made.

  • Dispositions of Other Tangible Property
    The regulations allow taxpayers to dispose of components of tangible personal property, a depreciable land improvement, or an improvement or addition. Taxpayers may change their method from depreciating the disposed asset to recognizing gain or loss upon disposition.

    The rules regarding the Section 481(a) adjustment are consistent with the general rules described above for the disposal of structural components. Taxpayers should consider coordination with the method change allowing taxpayers to use general asset accounts for tangible depreciable assets.

2. General Asset Account Elections
Under the disposition rules, taxpayers generally must dispose of a building structural component upon replacement. For tangible personal property, the rules vary based on how a taxpayer treats components of a UOP. Making a general asset account election provides taxpayers with more flexibility in determining if gain or loss should be recognized upon disposal of the component. Taxpayers may file a method change to make a late general asset account election for one or more items of Modified Accelerated Cost Recovery System (MACRS) property placed in service in a tax year beginning before Jan. 1, 2012. Also, taxpayers may make an election to recognize gain or loss upon the disposition of that item in a qualifying disposition for an item of MACRS property for which they made a valid general asset account election. These changes also may affect whether a taxpayer must capitalize amounts paid to restore a unit of property under the restoration rules. This change only applies to the first or second taxable year beginning after Dec. 31, 2011.

The changes to make a late general asset account election for one or more items of MACRS property owned by a taxpayer at the beginning of the year of the change will be made using a modified cut-off method where the new method will be used on a prospective basis or a Section 481(a) adjustment where the election will be applied retrospectively.

3. Depreciation of Capitalized Assets
The regulations provide for specific treatment for the items of MACRS property related to single-asset, multi-asset, and general-asset accounts. Taxpayers may file a method change to go from one permissible depreciation method to another permissible method as provided for in the regulations. There are several method changes under this section of the Revenue Procedure and taxpayers should consult with their tax adviser to determine which apply to their specific facts and circumstances.

Under this section of the Revenue Procedure, many of the changes are implemented using a Section 481(a) adjustment while others are implemented on a cut-off basis and are dependent on the specific method change being filed.

  • Depreciation of Leasehold Improvements
    The regulations require leasehold improvements to be depreciated over the proper MACRS recovery period. Taxpayers may change their accounting methods from improperly depreciating the leasehold improvements over the term of the lease to properly depreciating these improvements over the applicable recovery period.

    Taxpayers changing their method of accounting from depreciating leasehold improvements generally must calculate a Section 481(a) adjustment as of the first day of the year of the change. The Revenue Procedure does not address the transition rule.

Statistical Sampling

Both Revenue Procedures permit statistical sampling in some instances to compute a Section 481(a) adjustment. Taxpayers must use the methodology provided for in Revenue Procedure 2011-42; other methods of statistical sampling are deemed to be inappropriate. Careful consideration should be given to the use of statistical sampling and how it may be used to compute the Section 481(a) adjustment for years the taxpayer has available information.

Recommendations

In light of the various method changes available, taxpayers need to understand their current accounting methods related to tangible property to begin to assess the best way to implement the new regulations. Taxpayers should consult their tax professional to determine how the new rules apply to their facts and circumstances and to assess the requirement to file an accounting method change.

Dave Strong is with Crowe Horwath LLP in the Grand Rapids, Mich., office. He can be reached at 616.752.4251 or david.strong@crowehorwath.com.

Ed Meyette is a partner with Crowe Horwath LLP in the Grand Rapids, Mich., office. He can be reached at 616.752.4234 or edward.meyette@crowehorwath.com.

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David Strong
Managing Director