Nonprofit Organizations and the Tangible Property Regulations (Part Two)

Last week, I discussed tangible property regulations and what nonprofits need to know broadly. This week, in part two, I provide some additional considerations and best practices for nonprofits to keep on their radars.

Small Taxpayer Safe Harbor

The regulations provide an election for a simplified repair versus improvement analysis for small taxpayers. A small taxpayer, for purposes of this safe harbor, is an organization with average annual revenue for the prior three years of not more than $10 million. Small taxpayers meeting the revenue threshold may expense costs to repair, improve or maintain building property(s) if those expenditures in aggregate, per building, do not exceed the lesser of $10,000 or two-percent of the original building cost. This simplified analysis may be applied to each building a small taxpayer owns that has an original cost (or total amount of rent payments expected to be paid by the lessee under the term of the lease, including renewal periods) of not more than $1 million.

Conformity to Book Capitalization of Repair and Maintenance

It is a common occurrence that an amount may be capitalized for financial accounting purposes but deductible under the regulations for taxable income purposes, or vice versa. Another means of simplifying the adoption of the regulations is an election that allows a taxpayer to capitalize amounts that are deductible for taxable income purposes, if those amounts are capitalized for financial accounting purposes. This election allows a taxpayer to capitalize for taxable income purposes amounts already capitalized for financial accounting purposes.

In addition to the formal elections discussed above, the regulations contain numerous other elections, not discussed herein, that are made simply by taking a position on the organization’s tax return.

Manner of Adoption

The regulations, as stated above, are adopted through elections where indicated and by filing Form(s) 3115, Application for Change in Accounting Method, as indicated by the IRS in separate guidance. Consideration should be given to the taxable situation and nature of each nonprofit’s activities to determine whether filing of Form 3115 is necessary. A Form 3115 is generally, but not always, filed with a retroactive catch up adjustment that is the difference between the deductions claimed to date under the old method and the deductions that should have been claimed to date under the new method. This adjustment will factor in all amounts from prior years unless otherwise specified by IRS guidance. However, adjustments for certain accounting method changes are required to be calculated on a prospective basis. Filing a Form 3115 provides protection against IRS audit penalties where the old method of accounting could have resulted in unfavorable IRS audit adjustments.

The IRS recently provided relief to simplify the procedures for small businesses making accounting method changes. A small business, for this purpose, is defined as a trade or business with average total revenues for the prior three years of not more than $10 million or total assets not more than $10 million. If either test is met, then a nonprofit may adopt the regulations through these simplified procedures. The new procedures allow small businesses to change a method of accounting on a prospective basis without filing Form 3115 or calculating retroactive adjustments. No formal election or statement is required to be filed to request a change in accounting method under these simplified procedures. Eligible small businesses following the simplified adoption procedures will compute taxable income starting with the 2014 tax returns according to the regulations without having to file a Form 3115. However, taxpayers will still be subject to additional taxes, penalties and interest if, upon IRS exam, amounts were deducted in pre-2014 years that should have been capitalized and deducted in a later year or depreciated over time.

Plan for the Future

Organizations should consider how they are affected by these regulations currently, as well as potential future implications. An organization that currently does not have unrelated business taxable income may feel little impact from the regulations from an income tax perspective. There will be little incentive for the IRS to enforce the regulations for many nonprofits where income tax is not paid. However, where a nonprofit pays unrelated business income tax, has taxable subsidiaries, or loses its tax exempt status, it should absolutely address these regulations currently. A nonprofit should anticipate filing Form 3115 in future years subject to unrelated business income tax, even if not currently subject to income tax. It is generally recommended that an organization make the de minimis safe harbor election regardless of whether it currently pays unrelated business income tax.

Consideration should also be given to determine whether these regulations could change the way overhead percentages are calculated for benchmarking purposes, statement of financial position (balance sheet) implications to assets or activities potentially eligible for a future sale, spin-off or other separation resulting in tax concerns upon separation, or taxable income implications for activities that cycle in and out of taxable activities. The tangible property regulations may also result in changes to the capitalization practices for financial accounting purposes.

The regulations provide broad ranging guidance on what must be capitalized as tangible property. However, they do not change any depreciation rules. For amounts required to be capitalized under these regulations, nonprofits will need to continue to apply the appropriate tax depreciation rules to elect appropriate tax depreciation methods.

Although these regulations affect many issues related to tangible property, they offer flexibility and options for determining the best course of action. Nonprofits, although not affected in the same manner as for-profit entities, are nevertheless subject to these regulations, and should discuss with their tax adviser the potential implications in order to plan for and mitigate unexpected and potentially adverse consequences.

This article originally appeared in the Spring 2015 Nonprofit Standard newsletter.