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QIP Accounting Method Changes for Partnerships

Posted on May 4, 2020

It’s our special lockdown edition of the Mother’s Day gift guide! Oh, no, the firm cut salaries! We’ll try to be sensitive to that. You’re stuck at home and you’re falling into your parents’ roles. The lockdown has given you a window on child care and an opportunity to endure some of it yourself. Children are a full-time job in and of themselves. “Corona divorce” is a thing in Tokyo and New York.

Hermès scarf. Normally that would be a pricey, clichéd gift, but everyone is watching Dr. Deborah Birx every day. Birx’s collection has its own fan sites. Some are Hermès 90-centimeter silk twill squares, which are practical because silk actually makes a good face mask, the way House Speaker Nancy Pelosi, D-Calif., wears them. The Hermès website sorts by size and color, but the U.S. distribution center is closed so you’ll have to send a picture or let the wife pick it herself.

Sheets. Pioneer Linens and Cuddledown will hook you up with good sheets — the latter for very colorful sheets. If there’s no one around to iron the sheets, get Matouk Key Largo percale at Pioneer Linens. Westin sells its no-iron hotel sheets online, as well as its great Heavenly Bed mattress. Measure the depth of your mattress before buying sheets.

Pillows. Those great down pillows you loved at good hotels come from Downlite, which offers a variety of weights and fills. The best pillow is the chamber pillow: down with a feather core. Downlite is also sold on Amazon.

Bath products. We love This Works Deep Sleep lavender products. For bath salts, Epsom salt from the drugstore relaxes muscles. No, you are not going to buy more wine, crystal glasses, or a silver-plated cocktail shaker. If either of you is drinking in lockdown, you should probably do less.

Italian food. Miss your favorite pasta place? Eataly is well stocked and delivers quickly. They also sell no-brainer gift baskets of pastas and matching sauces. Need a pot? For cooking a pound of pasta, we like Williams-Sonoma’s reasonably priced eight-quart multipot, which also happens to be pleasingly shiny .

Pancakes. Still eating mommy food and can’t get good pancake syrup? Go to the source. Real maple syrup has grades and flavors, and it’s sold online by the Vermont Country Store, which is good for all kinds of old-school products. They also sell pancake mix. You’ll want to cook pancakes on an inexpensive Bialetti square griddle.

Cookware. In normal circumstances, unless your wife is a gourmet cook, cookware is not a good gift, what with the domestic servitude implications. However, if — and we repeat, if — you see your wife struggling with a particular tool that has been in the drawer unused for years, you may replace it. There have been advances since some readers last cooked, like Kyocera ceramic knives that stay sharp.

Paper products. You’ve been eating in restaurants and are suddenly faced with those flimsy little paper napkins from the grocery store. The restaurants get their nice thick paper napkins and hand towels at SimuLinen.

Soap dispenser. Many are small, have to be refilled a lot, and tip over. For high-traffic areas, there’s OXO’s inexpensive 12-ounce stainless steel dispenser, which has a wide rubber top and a non-slip base and takes any brand of liquid soap. For the bathroom sink, Simple Human’s no-touch rechargeable soap dispenser is nice, but it does require its own brand of soap (both dispensers and soap at www.bedbathandbeyond.com).

Exercise equipment. A big no-no unless your wife asked for it, or something she uses has to be replaced, and then buy only the specific item she said she wants. If a Peloton is not in the budget, other exercise bikes do the job, and rowing machines offer full-body exercise. If weight loss is the goal, the first order of business is to stop eating mommy food and stop ordering in from restaurants. And then understand that homemade boot camp will make everyone crabby.

Department stores. They’re crazed, desperate, and offering across-the-board discounts. Neiman Marcus is about to file a chapter 11 petition, and the owner of Saks missed interest payments. Macy’s, which went through bankruptcy in 1992, is burning cash while trying to borrow $5 billion. Department store websites do have Mother’s Day suggestions, which usually run to frivolous perfumes and nightgowns, but they promise to deliver on time. Pajamas and robes might not be a bad idea this time. Avoid underwear and shoes — the sizes are too random.

Deborah Birx, White House Coronavirus Response Coordinator
Women are watching Dr. Birx and her scarves. (Andrea Hanks/White House/ZUMA Press/Newscom)

Around here, we know that you’d hide in the bathtub if it would work to get you away from calls from the demanding individual partners in big real estate partnerships. The IRS was very generous recently in allowing those partnerships to amend returns to conform to qualified improvement property (QIP) 15-year depreciation retroactively (Rev. Proc. 2020-23, 2020-18 IRB 1). The partnership audit rules, which govern most partnerships, do not contemplate amended returns. Rather, partnerships are supposed to make changes using administrative adjustment requests (AARs) (section 6227).

But changing the depreciation method for QIP is not a choice. Only the means of achieving it is a choice. The revenue procedure was written by the IRS Office of Associate Chief Counsel (Procedure and Administration), and not the Office of Associate Chief Counsel (Income Tax and Accounting). Recently, a branch chief from the latter division explained that going from 39-year real estate depreciation to 15-year QIP depreciation would be an accounting method change, but that there are choices about how to make this method change.

Accounting Methods

Accounting method changes usually require consent, unless the particular change is on the automatic change list (Rev. Proc. 2019-43, 2019-48 IRB 1107).

As we keep saying, accounting methods are where the rubber meets the road. Timing is everything, more so in tax accounting than in life. Any treatment of any timing question is an accounting method. That means the IRS has to be concerned not just about the taxpayer’s principal method, like cash versus accrual, but about lots of little methods for the treatment of particular items. The seemingly smallest treatment can be a method of accounting. Inventory practices are methods of accounting (Primo Pants Co. v. Commissioner, 78 T.C. 705 (1982); Huffman v. Commissioner, 126 T.C. 322 (2006)).

The tax administrator’s authority under section 446(b) covers not only the taxpayer’s principal method of accounting, but its method of accounting for a specific item of income or expense. So “a material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction” (reg. section 1.446-1(a)). Moreover, “a change in method of accounting does not include adjustment of an item of income or deduction which does not involve the proper time for the inclusion of the item of income or the taking of a deduction” (reg. section 1.446-1(e)(2)(ii)(b)).

A taxpayer adopts a permissible accounting method when it files its first return. If the method is impermissible, two successive returns would establish a method. Changing a method voluntarily is cumbersome. Normally the taxpayer has to file Form 3115 and obtain the commissioner’s consent. A retroactive change requires consent, even if the taxpayer is trying to get off an impermissible method (Rev. Rul. 90-38, 1990-1 C.B. 57).

Even an impermissible method is a method of accounting, so changing to a permissible method requires the tax administrator’s consent. Section 446(e) provides that “a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.” Moreover, “consent must be secured whether or not such method is proper or is permitted under the Internal Revenue Code or the regulations thereunder” (reg. section 1.446-1(e)(2)(i)).

The tax administrator cannot push the taxpayer off a method that was authorized even if it is not the optimal method for the taxpayer’s situation. A method authorized by the code, however inaccurate, trumps the tax administrator’s ability to change a method that does not clearly reflect income (Williams v. Commissioner, 94 T.C. 464 (1990), aff’d, 1 F.3d 502 (7th Cir. 1993)).

An impermissible method is not a death sentence. It usually just means the method has to be corrected and the right adjustment made. The IRS may impose a change of accounting method when a taxpayer is under examination, in Appeals, or even in court. The IRS can make retroactive changes.

Taxpayers inadvertently adopt impermissible methods for depreciation all the time. They take their GAAP depreciation — which is supposed to measure actual life — and plug it into their tax returns. Accountants help them get better tax results by applying cost segments, meaning they go through the taxpayer’s assets to find the shorter-lived things. A building lasts a long time. Carpets in that building are eligible for shorter tax-depreciable life. Lumping them in with the building is technically an impermissible method.

In some situations, such as significant law changes, the IRS grants an automatic change of method. A taxpayer that makes a qualifying automatic change has the deemed consent of the tax administrator to the change. That is what happened for the QIP depreciable life changes. The law was changed in 2017 and then retroactively corrected last month. So the IRS granted a very generous automatic change of accounting method.

QIP Changes

Partnerships can’t stay on 39-year depreciation for QIP because the law changed. There are choices about how to correct the now-impermissible method. But it has to be corrected.

The substantive law changed, retroactively. The Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) corrected a glitch in the Tax Cuts and Jobs Act, retroactive to the effective date of the latter (section 168(e)(3)(E)(vii)). That means that all QIP put in service after 2017 must be depreciated at 15 years or 100 percent expensed, called bonus depreciation (section 168(k)). QIP can no longer be treated as 39-year property after 2017. That means everyone with QIP placed in service after 2017 has to fix their situation for returns filed for 2018, and has to get onto a permissible method for 2019.

QIP depreciation is an accounting method. An accounting method that was permissible when adopted can become impermissible by a retroactive law change. So if any taxpayer does not conform to the retroactive change to 15-year QIP depreciation, is it on an impermissible method? Yes. Even though its original 2018 return properly adopted the statutory treatment of QIP and was consistent with law at the time? Yes. And it has to get off the original method and onto 15-year QIP, or 100 percent expensing if applicable.

In Rev. Proc. 2020-25, 2020-19 IRB 1, the IRS gave its consent to an automatic method change for 15-year depreciation for eligible QIP for tax years 2018-2020. The revenue procedure explicitly says that the change is treated as a change from an impermissible method of accounting to a permissible method of accounting. To make the change, a partnership must file Form 3115, an amended return, or AAR.

Likewise, a change from not claiming bonus depreciation to claiming it for QIP is a change from an impermissible method of accounting to a permissible method of accounting. If the taxpayer makes no election, bonus depreciation is the default setting for eligible property. If a taxpayer elects not to take bonus depreciation, it must formally elect out of bonus depreciation for the entire class of property. Normally the election out must be made in the year the property is placed in service, but Rev. Proc. 2020-25 provides for late elections and revocations.

It would have been clearer to all affected if Rev. Proc. 2020-25 had preceded Rev. Proc. 2020-23, which permits a partnership to amend its 2018 and 2019 Form 1065 for QIP 15-year depreciation retroactively.

Allowing an amended return for an accounting method that has been established by being used on two consecutive returns is a big deal. KPMG LLP told its clients that this is a departure from the policy of section 6.01(1)(b) of Rev. Proc. 2019-43 and Rev. Rul. 90-38, which do not permit retroactive accounting method change requests. And the partnership audit rules do not permit amended returns (section 6031(b)).

To get into Rev. Proc. 2020-23, the partnership must have already filed Form 1065 for 2018 or 2019 and sent Schedules K-1 to its partners for that year. Mostly we’re talking about 2018, since a correct return can be filed for 2019 and many partnerships would not have filed that return yet (discussed below). An AAR would be the usual process to correct 2018 return QIP treatment. What’s wrong with that? Partners would not see the benefits of QIP changes until 2021.

Assume a big-money real estate partnership with a few individual partners, each of whom has his own tax advisers. It owns one or more commercial buildings with QIP placed in service in 2018 and 2019. It is covered by the partnership audit rules (sections 6221 to 6241). It filed a 2018 Form 1065, and the partners filed individual returns, claiming 39-year depreciation for the QIP placed in service that year. It has not filed its 2019 return. It is now faced with a decision how to correct the impermissible method on its 2018 return for QIP placed in service in 2018, and how to depreciate QIP placed in service in 2019.

Some partners may not want to make the QIP depreciation changes. The partnership may be running flat (income and deductions exactly offset) and its partners may not need or want the extra depreciation deductions. Doesn’t matter. A correction to 2018 returns is not optional. The law changed, and QIP conformity for previously filed 2018 returns is required. For 2019, conformity is also required, but a partnership may choose between 15-year depreciation or bonus depreciation. It cannot continue 39-year depreciation for QIP for either year or going forward.

Amended returns are just one of three partnership choices for conformity. The partnership may alternatively choose the normal procedure of AAR to get the benefits of QIP. This would be a forward-looking adjustment, which means that adjustment-year partners get stuck with items properly belonging to reviewed-year partners. Or the partnership could file for an automatic accounting method change.

The necessity of conforming to the statutory change is what Kathleen Reed, branch 7 chief, IRS Office of Associate Chief Counsel (Income Tax and Accounting), was trying to communicate at an April 27 webcast sponsored by Eversheds Sutherland (US) LLP. She said she believed that the retroactive technical correction in the CARES Act makes QIP 15-year property all the way back to the effective date of the TCJA. That is correct. (Related coverage: p. 846.)

Reed explained that the retroactivity of the technical correction made the 39-year class life for 2018 and 2019 QIP an improper tax accounting method as soon as the CARES Act was signed. However, there is nothing requiring a taxpayer to fix the method as soon as possible, she said. Here she was referring to the special window for a partnership to make an AAR or amended return. The deadline is the earlier of October 16, 2021, or the expiration of the statute of limitations for the return being amended.

A taxpayer can wait for its 2020 tax return, the last year for which the IRS has waived the eligibility rule that normally prevents a taxpayer from making an automatic accounting method change less than five years after a prior automatic change, according to Reed. Rev. Proc. 2020-25 waives the normal five-year limitation on changes after adoption of a method. “If that’s not a problem with their filing an automatic [accounting method change], they can even wait beyond 2020 — they can wait until 2021 or later,” Reed added.

Reed might have been thinking about previously filed 2018 returns with this statement. For 2019 returns that have not yet been filed, taxpayers and return preparers are obliged not to sign returns that are inaccurate or incorrect, even if the item is favorable to the IRS, according to Eric Lucas, principal in charge of the income tax and accounting group in the Washington National Tax practice of KPMG (Circular 230 and AICPA Statements on Standards for Tax Services 3). So for 2019 returns, taxpayers and return preparers may not have the option to treat QIP as 39-year property and wait until 2020 or 2021 to file a method change request to correct it if they know the taxpayer has QIP placed in service in 2019, Lucas explained.

Now, some partnerships have already sent 2019 Schedules K-1 to partners showing 39-year depreciation for QIP. But the partnership may not yet have filed Form 1065 for 2019. In the wake of Rev. Proc. 2020-25, a return preparer cannot sign a 2019 Form 1065 showing 39-year depreciation for QIP. Preparers who are still at work on 2019 returns need to dig into the taxpayer’s assets to find QIP. Then the taxpayer has to elect between 15-year depreciation or 100 percent expensing for that QIP. Then the preparer can sign that return (Circular 230 and AICPA Statements on Standards for Tax Services 3).

What if the taxpayer doesn’t know whether its additions meet the definition of QIP? “In some cases it may be reasonable to assume that a 2019 addition is 39-year property unless further information is obtained. Preparers are not necessarily required to audit the taxpayer’s returns to identify QIP, and fixed asset records can be voluminous for large taxpayers,” said Lucas. “On the other hand, if the preparer knows or has reason to know that the property is QIP, it should be treated as such on the 2019 return.”

At this juncture, your wife has retreated to the bathtub with the nice gifts you bought her, and the individual partners you represent are griping that they don’t want to have to make the QIP depreciation changes for 2018 using any of the modes in Rev. Proc. 2020-25. You have to explain to them that if they let the 2018 returns slide uncorrected, they will have to disclose that fact on the 2019 return. Some preparers will allow an additional year to correct as long as the failure to correct is disclosed. “In that case, they could file the form 3115 with the 2019 return to correct the 2018 QIP without amending the 2018 return. The difference with QIP placed in service in 2019 is that it’s the adoption year, and we have to treat those correctly,” said Lucas.

Math Errors

If the partnership files an amended return for QIP changes and the partners failed to amend their own returns, any underpayment could be immediately assessed on audit of the partners.

“Why does the IRS even care if I deducted less QIP depreciation in 2018 than I’m entitled to?” Expletives deleted, that’s what the now irate individual partner just said to you. You responded that he could be subject to yet another high-net-worth audit, and he testily replied he is now reimbursing the partnership for the use of the jet.

According to Rev. Proc. 2020-23, a partnership’s amended return replaces its original return for purposes of partner consistency on their own returns (section 6222). The consistency requirement means that if the partnership amends its 2018 return, the partners must also amend their 2018 individual returns. A partnership return includes Schedules K-1. So when the partnership amended its 2018 Form 1065, it would have to provide a new Schedule K-1 to each partner. That partner may have little choice but to amend.

Generally speaking, there is no duty to amend, and the partnership audit rules do not contemplate amended partner returns. That was the point of the AAR. A partner should report consistently, but can file a return inconsistent with the partnership return as long as the inconsistency is disclosed (section 6222(c)(1)(B)). An underpayment attributable to an undisclosed inconsistency will be immediately assessable as a math error, with no right to appeal to the Tax Court.

But the Rev. Proc. 2020-23 reference to section 6222 makes it clear the consistency requirement applies to an amended partnership return. And that also means that the partners’ individual state income tax returns would have to be amended. “That is why a lot of partnerships really don’t want to amend to take advantage of the change for qualified tenant improvements, because the cost of amending for all partners can exceed the tax benefit,” said Richard Lipton of Baker & McKenzie.

If the partners don’t amend, the IRS could make a math error assessment of any underpayment attributable to the inconsistency between a partner’s return and the amended partnership return. When a partnership is a partner in another partnership, any adjustment made on account of the former’s failure to file consistently with the latter will be immediately assessable as a math error with no request for abatement permitted. So the IRS could assess tax against an upper-tier partnership that did not amend its return or file an AAR to pick up its share of additional income and report it out to its partners.

A math error isn’t the end of the world either. Normally a partner can prevent a math error assessment by disclosing the inconsistency on Form 8082, “Notice of Inconsistent Treatment or AAR.” Many upper-tier partnerships already file Form 8082 when they rely on estimates from partnerships in which they own interests.

A math error — formally known as a computational adjustment — only arises if there is an underpayment, not when there is an overpayment. Our stubborn partner didn’t amend his 2018 return, despite having a corrected Schedule K-1 to follow. He and the partnership will both file correct 2019 returns. But since partners can’t ask for AARs, the rules do not contemplate disclosure of 2018 mistakes with 2019 returns.

Specifically, Form 8082 is supposed to be attached to the return for the tax year for which the inconsistency is being reported, otherwise it doesn't count (reg. section 301.6222-1(c)). Once a partner receives a notice of inconsistency, the rules provide an election to be treated as having reported inconsistently because of incorrect information (reg. section 301.6222-1(d)). But the partner’s possession of a new, correct 2018 Schedule K-1 might make that election untenable. That is, the partner can’t gripe about incorrect information when he was in possession of correct information when he got his notice.

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