Final Tangible Property Regulations
For decades, the IRS and taxpayers have fought over expenditures classified as Repairs vs. Capitalization. You, the SMB owner, want to write off your expenditures as repairs to reduce your taxes, while the IRS wants you to capitalize your expenditures forcing you to depreciate that expenditure over time (sometimes 39 years!) thus increasing your taxable income and therefore, your current year's tax burden. The new Tangible Property Regulations (TPR) spell-out what should be capitalized and what should be written off as a repair.
Who has to comply with the new TPR rules?
Everyone must abide by the new TPR rules for 2014 and future years. It is how you comply with the transition that is the big problem with this change.
The IRS code states that when a taxpayer changes their accounting method, they must file Form 3115. With the introduction of the new TPR rules, the IRS has essentially mandated that everyone must file Form 3115. But the change impacts so many areas of the tax code, multiple Form 3115's would have to be filed by taxpayers. This was a mandated burden on taxpayers and the AICPA (which I am a long time member) fought to get the IRS to change the compliance method. On Friday the 13th of this month, the IRS gave SMB's relief from their draconian requirement.
Now, the size of your business will determine whether or not you must file Form 3115 to convert to the new TPR rules. SMBs with $10 million or more in sales and $10 million or more in assets are required to apply the new TPR rules by filing one or more Forms 3115 as required.
There is relief from filing Form 3115 for SMBs with less than $10 million in sales or less than $10 million in assets. Qualified SMB's simply apply the new TPR rules to assets purchased in 2014 and future years without the requirement of filing Form 3115. Clients that choose this method will continue depreciating their old assets under the old rules but must capitalize or write off as a repair all future expenditures using the new TPR rules.
However, there will be many instances when SMBs under $10 million in sales or $10 million in assets will want to voluntarily file one or more Forms 3115 to formally convert to the new rules.
What is "Form 3115" and what impact does it have on my taxes?
You file a Form 3115 (Application for Change in Accounting Method) to change the way you record income and/or expenses for your business. When you change your accounting method, you must go back through your records and ask yourself, "If I had used this new accounting method from the very beginning, would that have changed my previous income and expenses? If so, would I have reported more income or, would I have reported larger deductions on my prior tax returns?" If you would have reported more income, you have a positive adjustment. If you would have reported larger deductions, you have a negative adjustment. You record this adjustment on your current year's tax return. These adjustments are known as a 481(a) adjustment.
SMBs with $10 million or more in sales and $10 million or more in assets are required to file Form 3115 so they are required to calculate their 481(a) adjustment. Regardless of whether that adjustment is positive or negative, they will have to report that adjustment on their 2014 tax return.
SMBs under $10 million in sales or $10 million in assets are not required to file Form 3115. However, they must ask themselves if they should voluntarily file if they have a negative 481(a) adjustment which they could deduct to reduce their 2014 taxable income.
How do I know if I should voluntarily file Form 3115?
That is what you have us for! This year, we will be reviewing our clients' depreciation schedules to determine whether or not voluntarily filing (for those eligible) Form 3115 makes sense for them. If filing Form 3115 creates a negative 481(a) adjustment that reduces your taxes, why not voluntarily file and take advantage of that adjustment?
There may be instances when there is no 481(a) adjustment but you will still want to file Form 3115 to remove assets from your depreciation schedule. There may be times when the new rules allow you to remove an asset from your depreciation schedule that you were required to keep on your depreciation schedule under the old rules. Removing assets from the depreciation schedule also removes all prior depreciation taken on that asset. So, if you sell that asset (or group of assets) in the future, there will potentially be less "depreciation recapture" (taxed at ordinary tax rates!) upon sale. Key point here is - there may be no immediate benefit to filing Form 3115 but, there may be a huge future benefit in the form of less depreciation recapture.
Fasten your Seat Belts
The 2015 tax year will be like no other we have had in recent years. While some of you will see no change in your tax returns, many of you will. Tax returns will be more costly and getting them out this year will take more time. I ask that you please be patient with me and my staff this season as we do our due diligence and review your account thoroughly to determine the new TPR rules' impact on you. We are dealing with a huge change that will impact your taxes for many years. If it isn't handled properly in this year of transition, you may not like the result in the future.