IRS Issues Guidance for Taxpayers Adjusting Depreciation on Qualified Improvement Property

Revenue Procedure 2020-25 (the “Revenue Procedure”), released by the IRS on April 17, provides much needed guidance for taxpayers on how to make certain adjustments resulting from the recent CARES Act. Specifically, a change in the recovery period of qualified improvement property (“QIP”) provides a significant tax benefit for certain taxpayers. Not only is there a reduced recovery period for QIP, but the new classification also provides that QIP acquired by a taxpayer after September 27, 2017, and placed in service after December 31, 2017, is eligible for bonus depreciation. Since the change was retroactive to January 1, 2018, taxpayers have needed guidance on how to update tax returns already filed for 2018 and possibly for 2019. The Revenue Procedure discusses the procedures for taxpayers to implement the retroactive change.

Certain QIP Not Affected by the Revenue Procedure

It should be noted that the Revenue Procedure is not applicable to QIP placed in service by a taxpayer that made a late election, or withdrew an election, under IRC Sec. 163(j)(7)(B) to be treated as an electing real property trade or business or under IRC Sec. 163(j)(7)(C) to be treated as an electing farming business. Any changes to depreciation for such QIP, or other depreciable property, affected by a late election or withdrawn election are made in accordance with Rev. Proc. 2020-22.

Furthermore, QIP for which the taxpayer deducted or deducts the cost or other basis of such property as an expense is also not affected by this Revenue Procedure.

Depreciation Elections Affected by the Revenue Procedure

Also addressed in the Revenue Procedure are certain elections relating to depreciation. Now that QIP has a recovery period of 15 years, and is therefore eligible for bonus depreciation, certain elections taxpayers may have made for 2018 and/or 2019 may cause unintended consequences for taxpayers. Conversely, some of these elections may now be preferred by taxpayers. The following elections are addressed in the Revenue Procedure. Included in the Revenue Procedure are methods for taxpayers to make late elections as well as revoke/withdraw previously made elections.

1. IRC Sec. 168(g)(7) allows a taxpayer to make an election to depreciate under the alternative depreciation system (“ADS”) any class of property placed in service by the taxpayer during the taxable year.
2. IRC Sec. 168(k)(5) allows a taxpayer to make an election to apply special additional depreciation rules to one or more specified plants that are planted, or grafted to a plant that has already been planted, by the taxpayer in the ordinary course of its farming business.
3. IRC Sec. 168(k)(7) allows a taxpayer to make an election not to deduct bonus depreciation for any class of property that is qualified property placed in service during the taxable year.
4. IRC Sec. 168(k)(10) allows a taxpayer to make an election to deduct 50%, instead of 100%, bonus depreciation for: (a) all qualified property acquired by the taxpayer after September 27, 2017 and placed in service by the taxpayer during its taxable year that includes September 28, 2017; and (b) all specified plants that are planted, or grafted to a plant that has already been planted, after September 27, 2017, by the taxpayer in the ordinary course of the taxpayer’s farming business during its taxable year that includes September 28, 2017, if the taxpayer makes the IRC Sec. 168(k)(5) election for that taxable year.

Procedures for Taxpayers to Implement QIP and Election Changes

For the change of depreciation for QIP as well as late or revoked elections discussed above, the Revenue Procedure provides that taxpayers have the following options to change their previously filed tax returns. It should be noted that the guidance provided applies to property placed in service by a taxpayer during its 2018, 2019, and/or 2020 taxable years.

Furthermore, some of the options below are only available for a limited period of time.

1. Amend Tax Returns or Administrative Adjustment Requests
   1. BBA partnerships (i.e., those subject to the centralized partnership audit regime) should follow amended tax return rules in Rev. Proc. 2020-23. Generally, guidance provided there states that BBA partnerships that apply that revenue procedure must file their 2018 or 2019 amended tax returns and furnish corresponding Schedules K-1 by September 30, 2020.
   2. For BBA partnerships not amending a tax return under Rev. Proc. 2020-23, an administrative adjustment request (“AAR”) can be filed on or before October 15, 2021, for the tax year in which property was placed in service, but not later than the expiration of the statute of limitations.
   3. All other taxpayers can file an amended tax return on or before October 15, 2021, for the year in which property was placed in service, but not later than the expiration of the statute of limitations.
   4. Amended returns or AARs must include adjustments to taxable income for the respective change in depreciation, late election, and/or revocation of elections, as well as any other collateral adjustments to taxable income. Furthermore, any collateral adjustments must also be made on original or amended returns, or AARs, for any affected succeeding taxable years.
2. File Form 3115 – Change of Accounting Method
   1. For the change of depreciation for QIP, taxpayers can file Form 3115 for a change of accounting method.
      1. Generally, a taxpayer cannot file to apply for a change of accounting method until an impermissible method of accounting was reported on at least two tax returns. However, an exception is provided in the Revenue Procedure for changes to depreciation for QIP where a taxpayer can still file Form 3115 even if the impermissible method was used for only one year.
      2. The Revenue Procedure provides a reduced filing requirement on Form 3115 where taxpayers are only required to complete certain sections.
      3. The automatic accounting method change number to be used on Form 3115 for depreciation changes relating to QIP is 244.
   2. For the late elections and/or revocation of elections under IRC Sec. 168(k)(5), IRC Sec. 168(k)(7), IRC Sec. 168(k)(10), and IRC Sec. 168(g)(7) discussed above (other than the withdrawal of the IRC Sec. 168(g)(7) election), Form 3115 can be filed with a taxpayer's timely filed original income tax return for the first or second tax year succeeding the tax year in which property was placed in service, or if later, with any tax return that is filed on or after April 17, 2020, and on or before October 15, 2021.
      1. Taxpayers can only make late elections and/or revoke elections if they timely filed their tax return on or before April 17, 2020.
      2. Late IRC Sec. 168(k)(5), IRC Sec. 168(k)(7), IRC Sec. 168(k)(10), or IRC Sec. 168(g)(7) elections are treated as changes of accounting methods during this limited time period only
      3. Revocations of IRC Sec. 168(k)(5), IRC Sec. 168(k)(7), or IRC Sec. 168(k)(10) elections are treated as changes of accounting methods during this limited time period only.
      4. The Revenue Procedure provides a reduced filing requirement on Form 3115 where taxpayers are only required to complete certain sections.
      5. The automatic accounting method change number to be used on Form 3115 for election changes is 245.
   3. If multiple changes are made under the Revenue Procedure such as a change of depreciation for QIP and late or revoked elections, only one Form 3115 should be filed showing the net taxable income adjustment.
   4. Filing Form 3115 is not an option for the withdrawal of the IRC Sec. 168(g)(7) election.

Significance of Revenue Procedure Guidance

Many professionals had hoped for a simplified method to make changes to tax returns for QIP resulting from the CARES Act. However, the Revenue Procedure only provides for the standard options of amending tax returns or filing for a change of accounting method with Form 3115. Noted departures from standard procedures for amended tax returns or Form 3115 filings are the following:

1. Generally, changes to depreciation on an amended tax return can only be made when affected property was placed in service on a tax return which was the last filed tax return and no subsequent tax returns were yet filed. This is due to the fact that once a depreciation method has been reported on two consecutive tax returns, an accounting method has generally been adopted by a taxpayer and therefore Form 3115 would need to be filed by the taxpayer to report a change of accounting method.
   1. The Revenue Procedure provides that a taxpayer can file an amended income tax return or for the placed-in-service year of the QIP on or before October 15, 2021, but in no event later than the close of the statute of limitations for such placed-in-service year. Therefore, a taxpayer could technically file an amended tax return for 2018 even if the 2019 tax return was already filed. However, note that adjustments must also be made on original or amended returns (or AARs) for any affected succeeding taxable years. Therefore, the 2019 tax return would also need to be amended in this fact pattern.
2. Generally, Form 3115 requires a significant amount of questions to be answered and analysis to be attached thereto. The Revenue Procedure provides a reduction in filing through the designation of a limited amount of sections that need to be completed.
3. The making of a late depreciation election or the revocation of a timely valid depreciation election is not a change in method of accounting unless expressly provided in the tax law. The elections noted above are generally subject to Commissioner approval for revocation through a private letter ruling, which can be a lengthy and costly process. More significantly, the IRC Sec. 168(g)(7) election is generally irrevocable.
   1. The Revenue Procedure provides significant relief to taxpayers by making changes to these elections eligible to be accounting method changes for a limited period of time. Therefore, rather than necessitating the filing of a private letter ruling, taxpayers have the opportunity to file for a change of accounting method using Form 3115.
4. It is important to note that the Revenue Procedure is applicable for federal tax purposes. Taxpayers must also consider the implications of any federal changes on their state and local tax returns. Many states have historically decoupled from various federal provisions including the bonus depreciation rules. Furthermore, some states conform to federal tax provisions as of a certain date whereas others have rolling conformity. This may have implications relating to the change of the recovery period for QIP. Therefore, taxpayers need to consider the possible state and local tax filing requirements, including amended tax returns.

Next Steps

Although the Revenue Procedure does answer questions that many taxpayers and professionals have had regarding how to implement changes under the CARES Act, a significant amount of analysis and tax reporting will still be required to effectuate the changes. Nevertheless, due to the potential tax benefits and cash-flow effects, investing in the analysis and tax reporting process can prove to be beneficial for many taxpayers. Also, since the depreciation rules changed retroactively, taxpayers need to pursue one of the remedial methods described above since not doing so will cause taxpayers to be using impermissible methods of accounting. Using an impermissible method of accounting could result in unintended tax consequences in the future.