Tucked away within the pages of the CARES Act is a provision that retroactively “fixes” the so-called “retail glitch” created by the 2017 tax reform legislation.
The “retail glitch” refers to an apparent oversight in the 2017 tax reform legislation that treated qualified improvement property as nonresidential real property—so that it did not qualify for the valuable bonus depreciation option. This relief now allows restaurants and retailers—some of the businesses hardest hit by the COVID-19 pandemic—to take advantage of 100% bonus depreciation on qualified improvement property through 2022. Because the relief applies retroactively, the IRS has offered these small business clients several options for taking advantage of retroactive bonus depreciation.
Before jumping in, the client should carefully consider each option in order to maximize the value of the benefit, including conducting a case-by-case analysis of the interplay between bonus depreciation, the business interest deduction rules and NOL relief.
The Retail Glitch Fix
Qualified improvement property (QIP) includes improvements made to the interior of a building, such as renovations made to a restaurant’s interior. By classifying QIP as property with a 39-year recovery period, the 2017 tax reform legislation rendered this property ineligible for bonus depreciation, which is generally only available for property with a recovery period of 20 years or less.
The CARES Act provided relief for many business owners, primarily in the retail and restaurant businesses, by fixing the retail glitch to allow businesses to take advantage of 100% bonus depreciation on QIP through 2022. The CARES Act retroactively reduced the recovery period for QIP placed in service after 2017 from 39 years to 15 years. Because of this, eligible small business clients may be entitled to a refund for 2018 and 2019.
Relatedly, the IRS has also provided relief for taxpayers who elected to be treated as real property trades or businesses. These taxpayers essentially elected out of the new business interest deduction limits and, as a trade-off, opted to forgo bonus depreciation. Under Revenue Procedure 2020-22, these businesses can revoke that election in order to take advantage of the new bonus depreciation fix. The business must file an amended return, AAR or amended Form 1065 by October 15, 2021.
Because of the burden caused by filing an amended return for a prior tax year, IRS Revenue Procedure 2020-25 allows taxpayers to change their depreciation method for QIP in 2018-2020 by filing for an automatic accounting method change. The IRS will treat this as though the taxpayer changed from an impermissible method of determining depreciation to a permissible method.
As a result, taxpayers can generally make, revoke or withdraw elections with respect to bonus depreciation by filing an amended tax return, AAR or Form 3115 (with the taxpayer’s federal income tax return or Form 1065). Using the Form 3115 option essentially allows the client to “catch up” in the year of change, so that the taxpayer gets the added deductions in the year the change is made (2020 or 2021), rather than the year when the property was actually placed in service. Clients have until October 15, 2021 to make this filing for the 2018 tax year.
For some taxpayers, however, choosing to claim the adjustment for 2018 and 2019 on a 2020 return may be beneficial if the option increases the taxpayer’s losses in 2020. Under the CARES Act, taxpayers are also permitted to carryback net operating losses to prior years, where the taxpayer may have been in a higher income tax bracket.
Filing an amended return comes with its own costs. Each partner will be allocated their share of the bonus depreciation benefit in the year the property was placed in service. Individual partners could, therefore, be required to amend their own returns to reflect the changes made in the partnership’s amended return.
If an amended return is not an option (the relief only permits extensions for amended returns with respect to the 2018 and 2019 tax years), the partnership may wish to consider the AAR option. However, filing the AAR could delay benefits until at least 2021. Under the AAR procedure, adjustments to the prior year income are pushed out to partners who, in turn, make a claim for a refund (essentially, as though the AAR adjustment was taken into account on the original year’s return). In some cases, the partner’s 2020 income may have decreased significantly, so that the partner could have insufficient 2020 income to take advantage of the adjustment.
Partnerships Subject to BBA 2015
Existing law may have prevented certain partnerships subject to the BBA 2015 centralized audit rules from filing amended Forms 1065 and Schedules K-1 to take advantage of the retroactive relief. Instead, partnerships would have been required to file an AAR, so that partners would not have received relief until filing returns for the current tax year.
Revenue Procedure 2020-23 allows those partnerships to file amended returns and issue revised Schedules K-1 for 2018 and 2019 to take advantage of retroactive CARES Act relief until September 30, 2020. The relief applies for 2018 and 2019 as long as the original Forms 1065 and Schedules K-1 were filed/issued before April 13, 2020 (the date Rev. Proc. 2020-23 was released).
The CARES Act retail glitch fix provided a valuable (and long-awaited) relief to many small business owners. Before selecting the procedure they will use to take advantage of that relief, these clients should consider all angles of the three key options offered by the IRS.