As follow up to our Bottom Line Breaking News, we wanted to provide you with a more in-depth review of the document with some commentary. By way of reference, this document was released earlier this month by the Large Business and International (LB&I) division of the IRS. This 195-page document does a very good job of summarizing the Tangible Property Regulations (TPRs) which most taxpayers have been dealing with since 2014.
The Audit Techniques Guide (ATG) is broken down into 18 Chapters as follows:
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
10. Materials and Supplies
11. Leased Property
12. Disposition Concepts and MACRS Rules
13. Dispositions in General
14. MACRS Disposition Rules
15. General Asset Account Rules
16. Accounting Method Changes
17. Accounting Method Changes – Capitalization
18. Accounting Method Changes – Depreciation and Dispositions
For the purposes of this communication, we shall deal with how the TPRs and ATG relate only to building assets.
Chapter 1 confirms the years of confusion created by the issuance of various notices; temporary, proposed and final regulations; and various directives. What is clear though, is that the final regulations apply to all taxpayers effective for tax years commencing 2014. Included in Chapter 1 is a very handy General Terminology Table, with definitions and Authority references.
Chapter 2 seems to introduce some ammunition to the IRS examiner, as it makes reference to the timing of IRS Form(s) filing. This is an important consideration as Chapters 16, 17 and 18 go into elaborate detail as to determining whether the correct process was followed when completing the 3115. Of particular interest is the statement regarding Capitalization to Repair studies. We have been cautioning our clients for the past three years that when adopting the new regulations, close attention should be given to the methodology by which the 481(a) adjustment was arrived at. We suspect that upon examination, this aspect will be aggressively scrutinized, as it could constitute “low hanging fruit” for the IRS in the case where taxpayers relied on little to no data, or flawed conclusions provided by sub-standard cost segregation consultants. Bedford has cautioned against the use of Statistical Sampling when inappropriate, or when the sampling group and properties were not of the nature to provide a statistically valid benchmark. The ATG affirms our position and provides the process for those taxpayers who wish to implement that strategy. Perhaps one of the most notable elements of this Chapter pertains to the determination of proper depreciable basis. While this may seem to be common sense, sadly, we have seen many reports completed by unqualified firms that for some reason, disregarded the importance of this analysis! An important note for this and other chapters is that the Examination Considerations give you a really good idea as to what to expect during an examination, as well as a “Post-TPR Adoption” validation to see just how buttoned-up your process was, or should be.
Chapter 3 discusses the Unit of Property. This is where things get a bit interesting, as the ATG introduces a few more nuances in the description of elements that constitute a Unit of Property. Also, the example regarding exterior window replacement is a poor illustration and somewhat conflicts with examples provided in the TPRs. Interestingly, the IRS does state that “the demand for cost segregation studies is on the rise”. That is certainly a true statement as we have seen an up-tick in business since 2014. Despite the release of the regulations and their mandatory nature, many taxpayers have still taken a view from the sidelines and have not considered using the data from a cost segregation study for other beneficial purposes – an observation made by the IRS in the ATG! Since the Examination Considerations reference the review of previously completed cost segregation studies, the value of a well prepared, engineering-based, detailed report will be realized and appreciated by the taxpayer.
Chapter 4 essentially reemphasizes the regulations as released. There is really no need to elaborate.
Chapter 5 discusses the De Minimis Safe Harbor. It reaffirms that taxpayers must elect this Safe Harbor annually. It does not require IRS Form 3115 (as many might have thought). The Safe Harbor must be applied consistently, so be aware that upon examination that this may be called into question. Interestingly, AFS clients are required to have a written accounting policy, while non-AFS taxpayers are not required to do so. Nonetheless, we feel it still makes sense to have a written policy on file so everyone knows the process. The ATG also states that Examiners should not negotiate to set De Minimis thresholds beyond the Safe Harbor limits. Some of our clients have chosen to establish limits higher than those prescribed (against our recommendations) – I guess they now have their answer! Of course, the Anti-Abuse Rule is mentioned, suggesting that examiners apply adjustments and penalties. Under the Audit Procedures Section, there is a suggestion that examiners ask for written policies for non-AFS clients. WAIT!! Didn’t I just say that there was no requirement for a written policy?? Don’t shoot me – I’m only the messenger. This only emphasizes the need for a written policy, hopefully one that matches what you are actually doing in practice.
Chapter 6 covers the Betterment rules, and each of the three tests to determine Betterment. It also provides some examples. Of particular interest is the statement on page 56 whereby betterment of a UoP does not qualify for Routine Maintenance Safe Harbor. As with each chapter, the Audit Procedures provide a good sense as to what to expect upon audit.
Chapter 7 covers the Rules pertaining to Restoration and the six tests to determine whether you have a restoration. Again, the routine maintenance safe harbor cannot be applied to all restorations. The IRS introduces an interesting twist to their analysis of the rules when the replacement of one of three furnaces occurs (page 66). The first example follows what has been explained in the TPRs, three furnaces in one building, but in the second example, the concept of discrete function coupled with the fact that the building has thee wings and one set of HVAC for each wing suggests that the same furnace replacement is now a restoration. We are not sure if the examiners would ever get down to that granular level of analysis but taxpayers had best beware. This example is in direct contradiction with the examples in the TPRs.
Chapter 8 covers Adaptation to a New or Different use. There is not much to say other than routine maintenance safe harbor is not an option here.
Chapter 9 covers Routine Maintenance Safe Harbor. An important note is that in order for an item to be eligible for the treatment, you must expect to perform the maintenance more than once during a 10-year period, for a building. Note that under the Examination Considerations, betterment and restoration questions might be asked by the examiner. To adopt the Routine Maintenance Safe Harbor a taxpayer must file a Form 3115 under the DCN 184 (same as the repair/UoP DCN).
Chapter 10 pertains generally to Materials and Supplies.
Chapter 11 covers Leased Property, which has been a major topic of debate recently. Generally, the guidance provided follows the TPRs. There is some good information regarding the impact of §110. We were surprised that the Service did not elaborate on the abuse of the regulations pertaining to leasehold improvements, as many taxpayers took very aggressive expense treatments on tenant improvements when the TPRs were initially released.
Disposition and MACRS Accounting Rules are covered in Chapter 12. With respect to buildings, the ATG states that “assets and UoPs are different concepts”. This is a factual statement that many taxpayers grapple with. What is vitally important (and is emphasized in the ATG) relates to the fact that the building may consist of numerous assets for disposition purposes. So, while the UoP is always there in the background, assets placed in service subsequent to the initial in-service would need to be accounted for – especially when dispositions are considered. Given the level of detail contained in the Building Audit Considerations section (with guidance focusing on a myriad of potential issues, including capitalization, MACRS recovery periods, booked replacement assets, past partial asset dispositions and the like), the level of detail associated with dispositions will be critical. We suspect that examiners will question practices and methodologies utilized to arrive at disposition amounts claimed. A well-prepared Cost Segregation Study, such as a Bedford’s AMS Study, will provide the detail required to meet the requirements of the examiner. In other words, adequate substantiation will be the operative words upon audit.
Chapter 13 provides more detail on Dispositions in General. We have cautioned our clients about the perils of §280B demolition rules. The ATG provides examples from the regulations comparing structural modifications vs. demolition. Remember that 75% percent of exterior perimeter walls and 75% of internal structural framework , must remain intact during a building reconfiguration; otherwise you can say hello to an increased basis in land! With respect to tenant improvements paid for by a landlord, the ATG re-affirms that lessor may recognize any applicable losses in the year of disposition.
Chapter 14 provides guidance on MACRS Disposition Rules. A significant amount of guidance is given with respect to the interplay between disposition rules and Single, Multiple, and General Asset Accounts (SAA, MMA and GAA). There is some good guidance and again, the IRS stresses the need for an acceptable means to determine the Adjusted Basis of assets, or portions thereof. This chapter also provides a significant amount of insight as to what to potentially expect upon audit.
Chapter 15 elaborates on the numerous and complex rules pertaining to General Asset Accounts.
Chapter 16 covers Accounting Method Changes and explains the nuances associated with the flurry of 3115 activity we have all seen in the past few years associated with the temporary, proposed, and final regulations. As with other chapters, the examiner is encouraged to evaluate and determine whether an appropriate 481(a) adjustment was arrived at; once more underscoring the need for accurate, detailed information that can be easily retrieved and correlated to depreciable basis, Unit of Property and/or asset details. Cost segregation studies are once again mentioned on page 169 and that “expense” items should be closely scrutinized.
Chapter 17 covers in great detail the various Revenue Procedures, Scope Limitations, Method Change vs. Election, and other items available to Small Taxpayers. There is some brief description on Statistical Sampling and Audit Protection, with the most valuable content being the Table which contains the various DCNs used.
Finally Chapter 18 discusses the Accounting Method Changes for depreciation and dispositions. There is lots of good information along with a very handy table to help tax professionals sort things out.
In summary, the ATG is at the very least, a centralized repository of relevant facts and reference for anyone who wants or needs to understand the impact of the TPRs. While some examples are perhaps contrary to those set forth in the TPRs, this document suggests what a taxpayer may experience upon audit. While the ATG cannot be cited as authority, the guidance to examiners is an indication of what you should probably prepare for when the IRS comes for a visit. Over the past few years, we have worked closely with our clients to assist them with compliance and strategies related to the TPRs. Based on the content of the ATG, we are confident that our Cost Segregation and TPR Studies contain the approach, quality of information and level of detail sufficient to withstand the most rigorous scrutiny.
As we enter the year-end tax planning season, Bedford is poised to assist you with any matters related to the TPRs, whether it be expense vs capital analysis, current-year dispositions or Cost Segregation. Please do not hesitate to contact your local Bedford representative for a complementary evaluation of your current situation.