Accounting Method Changes Post Tax Reform

1. Accounting Method Changes Post Tax Reform Andrea Mouw

2. Disclaimer These materials, and the accompanying oral presentation, are for educational purposes only and are not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 This information is of a general nature and based on authorities that are subject to change

3. Today’s Presenter Principal in the National Tax Office of Eide Bailly LLP Practice emphasizes all aspects of accounting methods including income and expense recognition, capitalization and cost recovery and inventory issues. Conducts regular seminars and workshops on numerous tax reform and accounting method related topics Bachelor of Science, Business (with high distinction) -- Curtis L. Carlson School of Management Juris Doctorate (cum laude) -- William Mitchell College of Law Vice Chair of Capital Recovery and Leasing Committee and Member of Tax Accounting Committee of American Bar Association Tax Section. Andrea Mouw Eide Bailly LLP Principal - Accounting Methods amouw@eidebailly.com 612-253-6730

4. agenda Overview of Accounting Methods Methods v. elections Accounting Method Changes Background and procedural requirements Section 481(a) adjustments Fixed Asset Related Changes

5. Overview of accounting methods

6. Key concepts of accounting methods Timing Issue must involve “when” to report income or expense Cannot result in permanent difference in lifetime income Consistency Must report income and expenses consistently from year to year unless request IRS consent

7. Types of accounting methods

8. What is not a method? Accounting methods do NOT include Errors – i.e., mathematical or posting errors Errors generally “one-time” occurrences Consistently repeating an error can result in adopting a method Change in underlying facts i.e., building converted from primary residence to residential rental A change in an income or deduction amount that does not involve the proper time for recognizing income or expense i.e., omitting rental income

9. Elections v. methods Income or expenses that involve filing elections are generally not considered an accounting method Election not to claim bonus depreciation Election to apply de minimis safe harbor Election to deduct assets under Section 179 Election to claim partial asset dispositions Election to use Alternative Depreciation System Elections apply only to tax year filed Taxpayers wishing to modify these elections need to file either amended returns or letter ruling requests

10. Implications of method determination Taxpayer must apply consistently from year-to-year Applies even if current method is improper Taxpayer can only change method of accounting following IRS procedures Accounting methods cannot be corrected by filing amended returns No “self-help” Methods can only be changed in the current tax year i.e., cannot amend 2016 return and change accounting method; need to file change with 2018 return Income / expense adjustments resulting from change recognized in current year

11. Bonus depreciation elections Under Section 168(k), taxpayers are required to claim bonus depreciation unless they make an affirmative election NOT to claim bonus depreciation NOTE: Separate elections post-TCJA for bonus on “normal” assets acquired and assets acquired in connection with Section 743(b) basis adjustment Taxpayer places in service 5-year property in 2018 and acquires a partnership interest including 5-year property. Taxpayer can elect out of bonus for assets placed in service but claim bonus on assets associated with partnership interest

12. Bonus depreciation election example In 2015, Taxpayer places in service a building used in its manufacturing business. Taxpayer depreciates the building and all components over 39-years using the straight-line method. Taxpayer performs a cost segregation study in 2018 and re-classifies part of the property to 5, 7 or 15-years Can Taxpayer claim bonus depreciation on the re-classified 5, 7 and 15-year property, assuming all other requirements for bonus depreciation are satisfied?

13. Bonus depreciation election example

14. Section 179 Deduction Section 179 deduction is an election, NOT an accounting method Must be addressed in year property placed in service Taxpayers cannot modify or claim a Section 179 deduction by filing an accounting method change Adjustments to Section 179 deductions can only be made by filing amended tax returns No letter rulings generally required

15. Section 179 expense example In 2016, taxpayer places the following assets in service: Office furniture Manufacturing equipment Building Taxpayer claimed a Section 179 deduction for the office furniture, claimed 50% bonus depreciation on the manufacturing equipment and treated the entire building asset as 39-year nonresidential real property In 2018, Taxpayer hires Firm to complete a fixed asset analysis and cost segregation study on the assets placed in service in 2016

16. Section 179 Example, Cont’d Firm determines that a portion of the assets classified as office furniture and manufacturing equipment are properly classified as nonresidential real property and should be recovered over a period of 39 years. Firm also determines that a portion of the assets classified as nonresidential real property are properly classified as 5, 7 or 15-year property. What can Firm change by filing a Form 3115? Improper Section 179 deduction on office furniture? Improper depreciation (including bonus depreciation) on manufacturing equipment? Improper depreciation of tangible property assets being depreciated as part of the building? Can Firm claim bonus depreciation or Section 179 on these re-classified items?

17. Accounting method changes

18. Adoption of Accounting methods Taxpayers can “adopt” any permissible method in first year they earn particular income item or incur particular expense Example: Taxpayer began business in 2018 and filed first tax return in 2018. Taxpayer can adopt any permissible methods Example: Taxpayer began business in 2000 but never owned fixed assets or incurred repair and maintenance expenses until 2018. Taxpayer has not adopted a method of accounting for repair and maintenance expenses prior to 2018

19. Adoption of depreciation methods Generally, can adopt a permissible method by filing one tax return; need two returns to adopt an impermissible method Taxpayer that properly deducts repairs in first tax year has adopted proper method for deducting repairs If taxpayer does not properly deduct repairs in first year, taxpayer needs to treat repairs improperly for a second year to adopt impermissible method Special rule for depreciation methods: can change assets placed in service in immediately preceding year by amending return or filing accounting method change Assets placed in service in 2017 can be changed by filing amended 2017 return prior to filing 2018 return or filing accounting method change with 2018 return

20. Accounting method changes Generally requested by filing Form 3115, Application for Change in Accounting Method IRS outlines procedures and requirements for requesting accounting method changes: Rev. Proc. 2015-13: outlines general rules for requesting method changes Rev. Proc. 2018-1: outlines procedures for fling accounting method changes and other letter rulings Instructions for Form 3115: provides guidance on completing Form 3115

21. Two types of accounting method changes Automatic method changes Nonautomatic method changes No user fees Must be filed by extended due date of return for year of change (i.e., Sept. 15, 2019 for 2018 changes) No IRS review of change unless taxpayer selected for examination User fee required – currently, $9,500 Must be filed by last day of year of change (i.e., Dec. 31, 2018 for 2018 changes) IRS must manually review and consent to change Review process can take 6-9 months or more to complete

22. General requirements for automatic change General procedural requirements for all automatic changes provided in Rev. Proc. 2015-13 and Rev. Proc. 2018-1 Limitation on filing same accounting method change multiple times within 5 years Limitation on filing in years of certain transactions Limitations on ability to receive audit protection if under IRS exam Duplicate filing requirement Form 3115 must be attached to tax return Signature not required if e-filed return Signed copy of Form 3115 must be sent to IRS at address specified in Rev. Proc. 2018-1 (currently Covington, KY)

23. Specific change requirements Taxpayer’s method change must be described in automatic change Rev. Proc. – currently Rev. Proc. 2018-31 Each section describes the requirements of the different method change or changes under that section Key information to watch for in each section “Description of change”: describes generally what is included in method change “Applicability”: describes the types of changes and methods that are covered by that section “Inapplicability”: describes restrictions and changes NOT covered by the section “Additional requirements”: any additional conditions the taxpayer must comply with to make change; could be additional information or restrictions

24. Example – Depreciation Change Rev. Proc. 2018-31, Section 6.01: Impermissible to Permissible Method of Accounting for Depreciation or Amortization

25. SECTION 6. DEPRECIATION OR AMORTIZATION (§ 56(a)(1), 56(g)(4)(A), 167, 168, 197, 280F(a), 1400I, 1400L, or 1400N(d), OR FORMER § 168) .01 Impermissible to permissible method of accounting for depreciation or amortization. (1) Description of change. (a) Applicability. This change applies to a taxpayer that wants to change from an impermissible to a permissible method of accounting for depreciation or amortization (depreciation) for any item of depreciable or amortizable property under the taxpayer’s present or proposed method of accounting: (i) for which the taxpayer used the impermissible method of accounting in at least two taxable years immediately preceding the year of change (but see section 6.01(1)(b) of this revenue procedure for property placed in service in the taxable year immediately preceding the year of change); (ii) for which the taxpayer is making a change in method of accounting under § 1.446-1(e)(2)(ii)(d); (iii) for which depreciation is determined under § 56(a)(1), § 56(g)(4)(A) (as in effect on the day before the date of enactment of Public Law 115-97, 131 Stat. 2054 (Dec. 22, 2017) (the “Act”)), § 167, §168, §197, §1400I, or §1400L(c), under § 168 prior to its amendment in 1986 (former § 168), or under any additional first year depreciation deduction provision of the Code (for example, § 168(k), § 168(l), § 1400L(b), or § 1400N(d)); and (iv) that is owned by the taxpayer at the beginning of the year of change (but see section 6.07 of this revenue procedure for property disposed of before the year of change).

26. (c) Inapplicability. This change does not apply to: (i) any property to which § 1016(a)(3) (regarding property held by a tax- exempt organization) applies; (ii) a taxpayer that is required under § 263A and the regulations thereunder to capitalize the costs with respect to which the taxpayer wants to change its method of accounting under this section 6.01 if the taxpayer is not capitalizing these costs, unless the taxpayer concurrently changes its method to capitalize these costs in conjunction with a change to a UNICAP method under section 12.01, 12.02, 12.08, or 12.12 of this revenue procedure (as applicable); (iii) any property for which a taxpayer is making a change in depreciation under § 1.446-1(e)(2)(ii)(d)(2)(vi) or (vii); (iv) any property subject to § 167(g) regarding property depreciated under the income forecast method; (v) any § 1250 property that a taxpayer is reclassifying to an asset class of Rev. Proc. 87-56, 1987-2 C.B. 674 (as clarified and modified by Rev. Proc. 88-22, 1988-1 C.B. 785), or Rev. Proc. 83-35, 1983-1 C.B. 745, as appropriate, that does not explicitly include § 1250 property (for example, asset class 57.0, Distributive Trades and Services);

27. (vi) any property for which a taxpayer is revoking a timely valid election, or making a late election, under § 167, § 168, § 179, §1400I, § 1400L(c), former § 168, § 13261(g)(2) or (3) of the Revenue Reconciliation Act of 1993 (1993 Act), 1993-3 C.B. 1, 128 (relating to amortizable § 197 intangibles), or any additional first year depreciation deduction provision of the Code (for example, § 168(k), § 168(l), § 1400L(b), or § 1400N(d)). A taxpayer may request consent to revoke or make the election by submitting a request for a letter ruling under Rev. Proc. 2018-1, 2018-1 I.R.B. 1 (or successor). However, if a taxpayer is revoking or making an election under § 179, see § 179(c) and § 1.179-5. See § 1.446-1(e)(2)(ii)(d)(3)(iii); (ix) any property for which depreciation is determined in accordance with § 1.167(a)-11 (regarding the Class Life Asset Depreciation Range System (ADR)); (x) any change in method of accounting involving a change from deducting the cost or other basis of any property as an expense to capitalizing and depreciating the cost or other basis, or vice versa (but see section 11.08 of this revenue procedure for making such a change in method of accounting under the final tangible property regulations);

28. (xiii) any change in method of accounting for any item of income or deduction other than depreciation, even if the change results in a change in computing depreciation under § 1.446-1(e)(2)(ii)(d)(2)(i), (ii), (iii), (iv), (v), (vi), (vii), or (viii). (xv) any change in the placed-in-service date of a depreciable or amortizable property. This change is corrected by adjustments in the applicable taxable year provided under § 1.446-1(e)(2)(ii)(d)(5)(v); or (xvi) any property for which the taxpayer has claimed a federal income tax credit (e.g., the rehabilitation credit under § 47).

29. (3) Additional requirements. A taxpayer also must comply with the following: (a) Permissible method of accounting for depreciation. A taxpayer must change to a permissible method of accounting for depreciation for the item of depreciable or amortizable property. The permissible method of accounting is the same method that determines the depreciation allowable for the item of property (as provided in section 6.01(7) of this revenue procedure). (b) Statements required. A taxpayer (including a qualified small taxpayer as defined in section 6.01(4)(b) of this revenue procedure) must provide the following statements, if applicable, and attach them to the completed Form 3115: (i) a detailed description of the present and proposed methods of accounting. (ii) statement describing the taxpayer’s business or income-producing activities; (iii) statement of the facts and law supporting the proposed method of accounting, new classification of the item of property, and new asset class in, as appropriate, Rev. Proc. 87-56 or Rev. Proc. 83-35 ; (iv) statement identifying the year in which the item of property was placed in service by the taxpayer; (vi) additional information for retail motor fuel outlets (vii) required statement if taxpayer changing property classification from Section 1250 property to Section 1245 property

30. Benefits of filing Form 3115 “Audit protection” IRS cannot change taxpayer’s method in prior year i.e., taxpayer depreciating building asset over 5 years. If taxpayer files Form 3115 for 2018, IRS cannot adjust depreciation on the building for pre-2018 tax year 4-year spread period for unfavorable Section 481(a) adjustments No interest or penalties on Section 481(a) adjustments Taxpayer not required to amend or modify previously filed returns

31. Section 481(a) adjustment Cumulative amount of income or loss that would have been recognized if taxpayer had previously been using proposed method Must be computed as of beginning of tax year of change – January 1, 2018 for 2018 method changes If Section 481(a) is favorable (i.e., a reduction in taxable income), entire adjustment is recognized in year of change If Section 481(a) adjustment is unfavorable (i.e., an increase in taxable income), adjustment must be spread over 4 years

32. Section 481(A) adjustment example Taxpayer acquires building A for $1,000,000 in June 2015. Taxpayer depreciates the building over 39-years. In 2018, Taxpayer performs a cost segregation study on the building and re-classifies $300,000 of the building basis as 5-year property. Taxpayer’s Section 481(a) adjustment for the change is computed as follows:

33. Section 481(A) adjustment – Repairs Taxpayer incurs $100,000 in June 2016 to replace the shingles on its roof. Taxpayer capitalized the cost of the repair and depreciated the cost over 39-years. In 2018, Taxpayer analyzed its repair expenses and determined that the 2016 roof costs should be treated as deductible repair and maintenance costs Taxpayer’s Section 481(a) adjustment for the change is computed as follows:

34. Section 481(a) adjustment – other rules Taxpayer’s Section 481(a) adjustment may vary for different purposes Regular tax: depreciation generally computed under General Depreciation System (GDS) AMT: depreciation may be computed under Alternative Depreciation System (ADS) State Taxes: states may choose whether to allow bonus depreciation and may vary percentage from federal rate States may also choose to de-couple from Section 179

35. Fixed asset changes

36. Common automatic changes – Fixed Assets Depreciation / Amortization Section 179D Full Asset Dispositions Repair and Maintenance Expenses Materials and Supplies

37. Filing Fixed asset changes Method changes must be filed by taxpayer that owns the asset being changed i.e., partnership must file change rather than partners Assets must generally be owned by taxpayer at the beginning of the year of change but see separate method change available for disposed assets

38. Depreciation Methods • Methods • Change in depreciation method, recovery period or convention • Change in asset classification • Change to claiming bonus depreciation • Re-classification from non-depreciable to depreciable • NOT Methods • Change in placed-in-service date • Change in use

39. Importance of depreciation methods No such thing as a “conservative” depreciation method Both over-depreciation and under-depreciation have significant implications Basis reduction “allowed or allowable” rule can cause significant permanent tax consequences for under-depreciated assets

40. Depreciation method example Taxpayer holds the following assets with the recovery period and A/D IRS audits the taxpayer in 2018 and determines that the proper recovery period for the carpet was 5-years and the building lighting was 39-years

41. Depreciation method example, cont’d The IRS determines the “correct” depreciation to be the following: IRS does not have to allow the taxpayer to claim the missed depreciation on the carpet but is allowed to reduce the basis of the carpet by the full amount of depreciation that should have been claimed

42. Depreciation method example, cont’d What is the impact of under-depreciating the carpet? Total Cost Basis $10,000 Depreciation Claimed ($652) Depreciation Allowable ($8,560) Greater of Allowed / Allowable ($8,560) Remaining basis available for depreciation $1,440 Total Basis Available to Taxpayer $2,092 “Lost” Basis $7,908

43. QUESTIONS?

44. THANK YOU Andrea Mouw, JD Principal amouw@eidebailly.com 612.253.6730