Editor: Mary Van Leuven, J.D., LL.M.
The tangible asset regulations (the repair regulations) provide rules for distinguishing deductible repair costs from capital improvements that must be capitalized and recovered through depreciation (T.D. 9564). Although the IRS delayed the effective date of the repair regulations to tax years beginning after Dec. 31, 2013, taxpayers may opt to apply the repair regulations for tax years that began after Dec. 31, 2011 (Notice 2012-73 and Rev. Procs. 2012-19 and 2012-20).
Accounting method changes adopted under the repair regulations will, in certain cases, affect the computation of other deductions or credits allowed under the Internal Revenue Code. Taxpayers should carefully consider these collateral consequences when quantifying the effect of changes made under the repair regulations. This item discusses in detail some of those collateral consequences:
- Sec. 199: A taxpayer’s permanent Sec. 199 domestic production activities deduction could change.
- Sec. 263A: A taxpayer’s Sec. 263A uniform capitalization (UNICAP) computation could be significantly affected, whether the Sec. 263A method relates to inventory or self-constructed assets.
- LIFO: A taxpayer that uses the LIFO method of accounting for inventories must reduce the Sec. 481 adjustment for repairs by allocating a portion of the adjustment to prior-year LIFO layers.
- Ordering rule: A taxpayer must consider the ordering rule in the Sec. 263A regulations for computing Sec. 481 adjustments for multiple changes filed in the same year.
Sec. 199: Domestic Production Activities Deduction
A taxpayer’s permanent Sec. 199 deduction could be reduced, and the projected effective tax rate increased, if the change made to comply with the repair regulations yields a significant Sec. 481(a) adjustment in the taxpayer’s favor. Conversely, if the adjustment is unfavorable to the taxpayer, the Sec. 199 benefit may be increased. A closer look at the Sec. 199 deduction and Sec. 481(a) adjustment shows the correlation.
The American Jobs Creation Act of 2004, P.L. 108-357, added Sec. 199 to the Code to provide a permanent tax deduction for certain domestic production activities. In 2012, the deduction is equal to 9% of the lesser of (1) the taxpayer’s taxable income (determined without regard to the Sec. 199 deduction) for the tax year, or (2) the taxpayer’s qualified production activities income (QPAI) for the tax year. The deduction is limited to 50% of the W-2 wages allocable to production gross receipts (and actually paid during the year).
QPAI is domestic production gross receipts (DPGR) less allocable cost of goods sold (COGS), if any, less allocable expenses, losses, or deductions. For purposes of computing the deduction under Sec. 199, a taxpayer’s gross receipts, COGS, and other items are determined under the methods of accounting the taxpayer uses for federal income tax purposes for the tax year. Moreover, the Sec. 199 regulations provide that a positive or negative Sec. 481(a) adjustment from an accounting method change must be characterized as QPAI or non-QPAI, whether attributable to gross receipts, COGS, or other deductions.
A Sec. 481(a) adjustment (the cumulative catch-up adjustment) from a repair and maintenance method change may affect the calculation of the current-year Sec. 199 permanent deduction. For example, a negative (taxpayer-favorable) Sec. 481(a) adjustment associated with a taxpayer that changes from treating an item as a capital improvement to a deductible repair may be allocable to QPAI (i.e., related to income from the Sec. 199 qualifying activity), and, if so, would reduce the Sec. 199 deduction. Conversely, a positive (taxpayer-unfavorable) Sec. 481(a) adjustment, if allocable to QPAI, would increase the Sec. 199 deduction over the four-year period during which the adjustment is taken into account.
To determine the amount of the Sec. 481(a) adjustment from a repair regulations change that is includible in the Sec. 199 computation, the taxpayer needs to consider a multitude of factors, including the nature of the asset being repaired, how the asset is used in Sec. 199 qualifying activities, the year in which the so-determined repair occurred, and whether an interim repair regulation change was made that is being affected as a result of new rules. Because the Sec. 199 deduction provides a permanent benefit to taxpayers, the impact of the Sec. 481(a) adjustment from a repair regulation accounting method change is an important consideration for any taxpayer grappling with when to apply the new repair regulations.
Sec. 263A: UNICAP
The Sec. 263A UNICAP rules generally require the capitalization of direct costs and indirect costs that directly benefit or are incurred by reason of the performance of production or resale activities. The transition guidance generally permits repair method changes to be filed under the automatic consent procedures described in Rev. Proc. 2011-14. However, for most of those changes, the transition guidance specifically provides that the automatic consent procedures do not apply if Sec. 263A requires the taxpayer to capitalize the costs, the taxpayer wants to change its method of accounting for the costs, and the taxpayer is not capitalizing the costs—unless the taxpayer concurrently files a change under Sec. 263A to begin capitalizing the costs. Examples of Sec. 263A methods that may be affected by this rule include the following:
- A taxpayer does not capitalize repair expense on factory plant and equipment to a taxpayer’s inventory under Sec. 263A, and the taxpayer wants to file a method change for those costs under the repair regulations.
- A taxpayer does not properly adjust its Sec. 263A costs to reflect tax costs (Schedules M) with regard to fixed-asset expenses. A common example of this is that a taxpayer uses book, rather than tax, depreciation in its Sec. 263A computation.
- A taxpayer did not initially capitalize the correct amounts of costs to self-constructed buildings or improvements and wants to claim disposition losses on building components under the repair regulations. The unrecovered basis of a retired component may be different had the original basis been correctly capitalized.
A taxpayer that uses improper Sec. 263A methods for costs it wants to change under the repair regulations must file a concurrent method change under Sec. 263A (or otherwise risk the validity of the repairs change). Sec. 263A changes for self-constructed assets are generally made under the advance consent procedures of Rev. Proc. 97-27. It must be emphasized that advance consent changes must be filed before the end of the year of change rather than with the return for the year of change as is the case with automatic changes. Most other changes under Sec. 263A are generally automatic consent changes, although they should all be carefully reviewed to ensure they fit within the terms of the automatic consent procedure.
Sec. 481(a) Adjustments: FIFO, LIFO, and Ordering Adjustments
Sec. 481(a) computations involving repair method changes and Sec. 263A can be complex, and care should be taken to ensure they are done correctly. When a taxpayer files a repair method change but is not required to file a concurrent Sec. 263A method change, the taxpayer must still take into account the impact of Sec. 263A in computing the Sec. 481(a) adjustment for repairs. For example, a taxpayer that filed a capitalization-to-repair change in 2012 would have to reduce its Sec. 481(a) adjustment (computed as of the beginning of 2012) in the amount of the repair adjustment allocable to inventory under Sec. 263A. This step should not present too much difficulty for taxpayers using the FIFO cost flow assumption, because the adjustment would generally affect the Sec. 263A computation only as of the beginning of the year of change.
Taxpayers using the LIFO cost flow assumption may face the additional task of allocating the Sec. 481(a) adjustment for repairs to prior-period LIFO layers. In that case, the amount of the benefit that may be expected from a capitalization-to-repair method change would be reduced by the portion of the Sec. 481(a) adjustment allocable to prior-period LIFO layers. Presumably, the IRS would favor an approach in which the taxpayer recomputes each prior layer taking into account the portion of the additional repairs expense that would have been incurred in each year that a layer was added (see Regs. Sec. 1.263A-7(c)(2)(iii)(D) and Rev. Rul. 2001-8). If the taxpayer lacks sufficient records to apply the repair expense to each prior layer, the three-year average method of Regs. Sec. 1.263A-7(c)(2)(v) may be available to simplify the computation. The three-year average method permits a taxpayer to apply an average of Sec. 263A costs over a three-year period to all prior-year LIFO layers.
A taxpayer that is using an improper Sec. 263A method for costs for which it will file a repair and maintenance change is required to file a concurrent Sec. 263A change and must follow the ordering rules for determining the Sec. 481(a) adjustments from concurrent changes (see Regs. Sec. 1.263A-7(b)(2)(i)(A)). The ordering rules provide that Sec. 263A changes generally are deemed to occur before other method changes filed concurrently with the Sec. 263A change.
However, Regs. Sec. 1.263A-7(b)(2)(i)(B)(4) provides an exception to the general ordering rule for depreciation changes, which requires that the Sec. 481(a) adjustment for depreciation be computed before the adjustment is computed under Sec. 263A. The exception for depreciation changes does not apply to method changes for repairs. Accordingly, a taxpayer that files concurrent changes for (1) a depreciation method, (2) a Sec. 263A method, and (3) a repair method would have to implement those changes and calculate the Sec. 481 adjustments in that order.
Taxpayers considering filing repair and maintenance method changes under the temporary regulations should carefully consider the collateral consequences the changes may have on the computation of other income and deductions. In addition, the computation of the Sec. 481(a) adjustment from a repair and maintenance change can be complex, and care should be taken to ensure that related accounts are considered in calculating the repair and maintenance Sec. 481(a) adjustment.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.