This post was originally published on Forbes
Thanks to the new repair regulations 2015 is shaping up to be the worst tax season ever. I've been looking at and thinking about this issue for years as various versions of the regulations were issued and withdrawn. In 2012 I was working for a national firm that wanted its tax people to be consultative, leaving the nasty work of actually preparing returns to our brothers and sisters in Bangalore. There were initiatives to "go to market" with studies to help clients prepare for the imminent application of the regulations. Whatever else you might say about the regulations, they have been good for white collar employment at the more ethereal levels of the tax industry. Now, though, the rubber is finally hitting the road and the entire industry is facing the prospect of filing multiple accounting method changes (Form 3115) for every single business entity, including individuals with modest Schedule C businesses.
According to the Paperwork Reduction Act Notice on page 20 of the instructions to Form 3115, the form, on average for other than 1040 filers, requires 38 hours 29 minutes of record keeping, 19 hours and 54 minutes to learn about the law and the from and 23 hours and 48 minutes to prepare and send the form to the IRS. The notice says that the 3115 is wrapped into the estimates for Form 1040 filers. That is interesting because the OMB information on the estimate for the 1040 indicates that there was"No material or nonsubstantive change to a currently approved collection", which makes me wonder whether anybody told them about all those Forms 3115 that Schedule C filers will have to be doing.
At any rate, this could be great for the large national firms. Round up those OMB estimates to 100 hours per return and add at least $20,000 to $30,000 to each bill and send a couple of annoying technical people from the national office to India for the next year to supervise the folks doing the actual work. That's as good as it gets. As you move down the tax industry food chain it gets worse and worse and God help people who do their own returns
This post is something of a report from the middle of the fray.
The people I am working with expect me to give them the answers so that we can get some returns done and I am not pleasing them right now. It's not that there are not answers. There are multiple answers to every question anybody can think of. The people most passionate about their answers being the right answers have inside information from the IRS. They claim that the people they spoke to at the IRS are the ones who really know, unlike the IRS guys that the people with different answers spoke to.
I would break the problem down into two broad classes. People and entities who own business real estate and those that do not. I'm not even thinking about certain specialized industries so if you have somebody who owns tug boats or a fleet of airplanes, I'm not going to be much help. Let's start with the real estate.
Refunds Of Biblical Proportions
Real estate is the industry where there are some people who are very happy about these regulations. To oversimplify people would have a tendency to capitalize any work on a building that resulted in a big bill. That meant writing it off over 39 years (27.5 for residential property. I will only mention the 27.5 once.). Not only that when they capitalized the new roof, they continued to depreciate the old roof.
The new regulations call for a different standard. A building is divided into units of property such as HVAC, plumbing and electrical. When you get a bill you look at what was done in the context of the unit of property. So if you replace all the toilets , you have to capitalize that,since a plumbing system without toilets is not much of a plumbing system. On the other hand, if you replace 20 out of 100 sinks, with pretty much the same type of sinks, you can expense that. This concept will allow for some pretty big invoices to get expensed.
It gets better. If you replace all the windows, you will have to capitalize that. Somewhere on the depreciation schedule is the original cost of the whole building, which if it was placed in service 10 years ago still has nearly 25% of its basis left to depreciate. The new regs allow you to figure out how much of the original cost is attributable to those windows and write that much of the remaining basis off.
When you change your method of accounting, you figure out how much higher or lower your income would have been if you had always been using the new method. If your income would have been higher, you can generally spread that income over four years. If your income would have been lower, you take a whopping big deduction in the year of the change. Thus there will be some clients who will accept a big bill for Form 3115, since they will be getting a big tax benefit. I wrote about that a few weeks ago after speaking to Michael J Greenwald of Friedman LLP. Friedman is a top 20 accounting firm and has clients who own, for example, office buildings in Manhattan. Mike is overseeing the preparation of the returns with the refunds of biblical proportions.
As you move down, the refund opportunities are less exciting. A building with 10 elevators that replaced one of them a couple of years ago, will generate a big adjustment. A building where the one and only elevator was replaced has no change.
That's as good as it gets for real estate. The rest of the story is not so good.
Full Employment For Cost Seg Specialists?
The reason I dived backed into the repair reg morass was a conversation I had with another accountant (Call him Harry) who is doing the return of a partnership that one of my clients is a partner in. He is with a good size regional firm and I was satisfied that he is on top of the regs. He has answers. Maybe not the right answers, but you can say that about anybody.
He believes that in order to properly implement the regulations for buildings of any significant cost (For talking purposes say more than a couple of hundred thousand), it is necessary to engage an engineer to break the original cost down into the units of property (HVAC, plumbing, electrical, etc). Although not married to them, his firm is using a particular firm (Call it Cost Seg Geniuses - CSG) and has persuaded them to do the breakdown for a reasonable price. I think it was around $1,500. That compares to the $10,000 or so that might have been paid for a cost segregation that carved out property that did not have to be depreciated over 39 years.
A common situation in the field that I play in is a commercial building maybe a professional office building or a small strip mall that is owned by a limited partnership. There are a lot of things that can make the entity more or less complicated. If you had one and you wanted me to do the return for you and said that you were paying $750 and you thought that was too much, I would laugh and give you the names of a couple of competitors I have grudges against. If you told me you were paying $15,000, you just found a new BFF. At any rate, in that context the extra $1,500 for a study is meaningful.
Breaking the building down into units of property does not yield any immediate benefit. The point is to help you implement the regulations down the road to decide whether to capitalize big bills or how much to carve out of the original cost when there is a replacement. I had spoken to a representative of CSG a few weeks ago and came away with a real concern. In the compliance side of the tax business, a touchdown is a return that will stand up well under audit and will not have any overlooked opportunities that your competitors could leap on when your client shows your return to them. You don't expect a study to score a touchdown for you, but I had a hard time seeing how the proposed report was even going to gain any ground. It reminds of what Peter Bernstein wrote:
The information you have is not the information you want. The information you want is not the information you need. The information you need is not the information you can obtain. The information you can obtain costs more than you want to pay.
I pictured myself in the year 2017 with an invoice from Joe's Heating And Cooling in the amount of $50,000. I say to myself "Self, wasn't it a great act of forethought to get my client to do that unit of property study back in 2015". What the CSG representative implied in our discussion is that I would be able to look at the study and compare the $50,000 to the amount of the original cost that was carved out for HVAC to determine whether to capitalize.
My own reading of the regulations had caused me to conclude that that was absolutely wrong. The regulations totally refer to the physicality of the building and except for some de minimus rules make no reference to dollars. The regs say that if you have 10 roof mounted HVAC units and you replace three of them, you can expense that. CSG takes that and makes the logical leap that if you have carved out $100,000 of the original building cost to HVAC and you have a bill for less than $30,000 you can expense it, more than $40,000 you have to capitalize with a gray area in between. At any rate that is what I understood the rep to have presented. I voiced my objection to that not reflecting what the regulations said and he indicated that might be true, but what else can you do and, of course, their IRS insiders had given the nod to this reasoning.
There was one other thing that Harry said, that sent me over the edge. It takes a few months to line up CGS, so they were going to delay implementation till the 2015 return. I think that was because their client hates to go on extension. So I reached out to a few people who are also in the fray and was pleased to hear back from some.
Ooh Wah Ooh Wah Cool Ooh Wah Cool Kitty
Bob Charron is the Tax Operations partner at Friedman LLP making him, I suppose, Mike Greenwald's boss, although maybe they don't look at it that way. Anyway, Bob was one of my bosses until he retired so he could move to New York and spend time with his grandchildren. It wasn't long before he was back in the game. He and Mike spoke to me together for about an hour to give me a sense on where they are at in implementing the regulations. Bob has been speaking on the repair regs and Friedman has a team working on implementing them. He has also been meeting with a roundtable of some of the top New York City firms to discuss the issues. He and Mike have answers. Maybe not the what will turn out to be the right answers, but answers that cannot be that wrong.
Do You Need The Engineers?
Just to be clear, there is general agreement that you need the engineers for a cost segregation study that carves out from your acquisition items that do not have to be depreciated over 39 years. That is something that has been going on for years. The study that breaks down the 39 year stuff into the building units of property (HVAC, plumbing, electrical, etc.) is another matter. Mike understood my issues with the study not really being the information that you need, but he still believes that it is useful. The HVAC example in the regs is nice and simple. You can count the roof mounted units. What if there is a lot of duct work replaced? Will anybody be able to tell you what percentage of the total duct work that is. Likewise with wiring. So having the total cost allocated among the units of property might be helpful as a reference. Mike indicated that an accountant might be able to figure out the broad breakdown from the scheduled values of the American Institute of Architects draw request forms from when the building was built. Harry, of course, would not approve of that.
What If There Is No Adjustment?
The question that is plaguing the industry is whether it is really necessary to unleash a tsunami of Forms 3115 with no adjustments on the IRS. One argument is that they must be required since with all the new concepts nobody could have possibly been using methods anything like them. The counterargument is that if you reached the same conclusion as you have under the new regulations, then you are not really changing anything and don't have to file Form 3115. I heard that argument most strongly from Peter Birrkholz , who teaches for Lu Gauthier's Boston Tax Institute. That Peter, of course, has spoken to the person inside the IRS who really knows.
Bob Charron is of the opposite school of thought from Peter Birkholz. Going beyond real estate, the need, as he sees it, extends to all business entities since there is also the matter of routine maintenance and material and supplies. The argument he makes, which is widely, although not universally shared is that the IRS expects Form 3115 from "everybody" and will commence a project to target those who have not filed it resulting in much weeping and gnashing of teeth. He sees it as extremely hazardous for entities with significant repairs and maintenance expense or materials and supply expense to not file Form 3115.
Another County Heard From
I also heard back from fellow Forbes contributor Tony Nitti. Tony just addressed the question of the value of the unit of property study.
Peter, I agree that what they are selling wouldn’t appear to offer much benefit other than for purposes of the partial disposition rule. Applying the actual repair rules (the BAR tests) has little to do with materiality as a percentage of total cost. Instead, as you point out, whether a cost has to be capitalized as a restoration is really based on whether the part being repaired or replaced is a major size (say, 60% of a roof) or major functional component (say, a truck engine) of the unit of property. It’s got nothing to do with cost of the replacement part as a percentage of the total cost.
For the most part, the people who have been really looking at these regulations have had a large firm perspective. To be a just a little cynical, they actually kind of like all this complexity, since they can make a case for sending out big bills to entities that can afford to pay them. My brief time at the national level, not Big 4, but with many former Big 4 people made me realize there is a radically different perspective at that level. They are used to having a very small number of competitors for any client who more or less sing from the same hymn book. The client people that they deal with are quite likely fellow members of the Big 4 cult rather than tight fisted entrepreneurs who resent every penny they spend on professionals.
Now the rest of the profession is clamoring for a simple streamlined solution, since they can't make such a big production out of this. The AICPA response as of January 28 was.
Thank you very much for your comments. We have long realized that this is a very challenging issue and in addition to our advocacy efforts, the AICPA has been exploring ways to develop tools that would be useful. The complexity that makes these regulations so challenging also complicates the development of a practical compliance tool for use by all members, as the number of potential scenarios for method changes can easily number in the hundreds or thousands. We appreciate your patience and will be communicating new resources to you shortly.
Wait And See
Bob Charron was quite adamant that Harry is not right about the option to kick the can down the road and implement in 2015. Of course, that would require Harry's client to extend and his client does not like to extend. It turns out that even a highly sophisticated firm like Friedman has clients who are adamant about not extending. Bob is imploring them to allow for an extension just this one year. For the most part, you can probably come up with a good extension number, regardless of the uncertainty.
So after all that angst, I am back into the wait and see mode, which so frustrates my partners. We have the luxury of clients who are used to routinely extending. I will say that if you do extend a partnership or an S corp because of uncertainty about how to handle the regulations, don't wait until August 15 to pick the return back up again. I will start back up July 1 at the latest. So if you can spend tax season just coming up with good extension numbers, it might not be that bad a winter. Promises to be a miserable summer, though.